8.1 Derivative financial instruments and financial guarantees

Derivatives are financial instruments, the fair value of which is derived from an underlying instrument such as equities, bonds, indices or currencies. We use derivative financial instruments in order to hedge parts of our portfolio against interest rate and market price risks, optimise returns or realise intentions to buy / sell. In this context we take special care to limit the risks, select first-class counterparties and adhere strictly to the standards defined by investment guidelines.

The fair values of the derivative financial instruments were determined on the basis of the market information available at the balance sheet date. Please see section 3.2 “Summary of major accounting policies” with regard to the measurement models used.

Hannover Re holds derivative financial instruments to hedge interest rate risks from loans connected with the financing of real estate; these gave rise to recognition of other liabilities in an amount of EUR 1.0 million (EUR 2.5 million) and other financial assets at fair value through profit or loss in an amount of EUR 0.5 million (EUR 0.2 million).

Hannover Re’s portfolio contained derivative financial instruments as at the balance sheet date in the form of forward exchange transactions taken out to hedge currency risks. These transactions gave rise to recognition of other liabilities in an amount of EUR 17.7 million (EUR 10.0 million) and other financial assets at fair value through profit or loss in an amount of EUR 2.0 million (EUR 16.8 million). The increase in equity from hedging instruments recognised directly in equity pursuant to IAS 39 in an amount of EUR 1.4 million (reduction in equity recognised directly in equity of EUR 4.9 million) derived solely from the forward exchange transactions taken out to hedge currency risks from long-term investments in foreign operations. These hedging instruments resulted in the recognition of other liabilities in an amount of EUR 2.4 million (EUR 2.3 million). Ineffective components of the hedge were recognised in profit or loss under other investment income in an amount of EUR 0.2 million (other investment expenses of EUR 0.6 million).

In order to hedge the risk of share price changes in connection with the stock appreciation rights granted under the share award plan, Hannover Re has taken out hedges since 2014 in the form of so-called equity swaps. The fair value of these instruments amounted to EUR 0.8 million as at the balance sheet date and was recognised under other liabilities (EUR 0.8 million recognised under other financial assets at fair value through profit or loss). The hedge gave rise to a decrease in equity from hedging instruments recognised directly in equity in an amount of EUR 1.5 million (EUR 0.9 million). Ineffective components of the hedge were recognised in a minimal amount under other investment expenses.

The maturities of the fair values and notional values of the hedging instruments described above can be broken down as follows:

The net changes in the fair value of these instruments resulted in a charge of EUR 3.8 million to the result of the financial year (EUR 6.6 million).

Hannover Re enters into derivative transactions on the basis of standardised master agreements that contain global netting agreements. The netting agreements set out below normally do not meet the criteria for netting in the balance sheet, since Hannover Re has no legal right whatsoever at the present moment in time to netting of the recognised amounts. The right to netting can, as a matter of principle, only be enforced upon occurrence of certain future defined events. Collateral furnished or received is recognised per counterparty up to at most the amount of the respective net liability or net asset.

Derivative financial instruments in connection with reinsurance

A number of treaties in life and health reinsurance meet criteria which require application of the stipulations contained in IFRS 4 “Insurance Contracts” governing embedded derivatives. These accounting regulations require that certain derivatives embedded in reinsurance contracts be separated from the underlying insurance contract (“host contract”), reported separately at fair value in accordance with IAS 39 “Financial Instruments: Recognition and Measurement” and recognised under investments. Fluctuations in the fair value of the derivative components are to be recognised through profit and loss in subsequent periods.

Within the scope of the accounting of “modified coinsurance” and “coinsurance funds withheld” (ModCo) reinsurance treaties, under which securities deposits are held by the ceding companies and payments rendered on the basis of the income from certain securities of the ceding company, the interest-rate risk elements are clearly and closely related to the underlying reinsurance arrangements. Embedded derivatives consequently result solely from the credit risk of the underlying securities portfolio.

Hannover Re calculates the fair values of the embedded derivatives in ModCo treaties using the market information available on the valuation date on the basis of a “credit spread” method. Under this method the derivative is valued at zero on the date when the contract commences and its value then fluctuates over time according to changes in the credit spreads of the securities. The derivative had a positive value of EUR 25.1 million (EUR 24.6 million) as at the balance sheet date and was recognised under other financial assets at fair value through profit or loss. In the course of the year the change in the fair value of the derivative gave rise to income of EUR 3.7 million before tax (EUR 0.5 million).

A derivative financial instrument was also unbundled from another similarly structured transaction. This gave rise to recognition of other financial assets at fair value through profit or loss in an amount of EUR 7.4 million (EUR 4.1 million). The performance of this derivative improved the result by EUR 3.5 million in the financial year (EUR 7.5 million).

A number of transactions concluded in the life and health reinsurance business group in previous years, under which Hannover Re companies offer their contracting parties coverage for risks from possible future payment obligations arising out of hedging instruments, are also to be classified as derivative financial instruments. The payment obligations result from contractually defined events and relate to the development of an underlying group of primary insurance contracts with statutory reserving requirements. The contracts are to be categorised and recognised as stand-alone credit derivatives pursuant to IAS 39. These derivative financial instruments were carried in equity on initial recognition because receivables recognised under other assets were to be carried in the same amount. Please see section 6.6 “Other assets”. The fair value of these instruments was EUR 165.1 million (EUR 168.9 million) on the balance sheet date and was recognised under other liabilities. The change in value in subsequent periods is dependent upon the risk experience and led to an improvement of EUR 30.0 million (EUR 22.6 million) in investment income in the financial year.

A Retrocession agreement exists in the area of life and health reinsurance under which the premiums were deposited with Hannover Re and invested in a structured bond. The Retrocessionaire has furnished a guarantee for its fair value. In accordance with the requirements of IFRS 4 this guarantee was to be unbundled from the retrocession agreement and is carried as a derivative financial instrument at fair value. The derivative was recognised with a positive fair value of EUR 2.2 million (EUR 10.6 million) as at the balance sheet date under other financial assets at fair value through profit or loss. In the course of the year the change in the fair value of the derivative resulted in a charge of EUR 7.4 million (income of EUR 10.1 million). Conversely, the performance of the structured bond, which is also measured at fair value, gave rise to income (expense) in the same amount.

In the area of life and health reinsurance a reinsurance treaty was also written with a financing component under which the amount and timing of the return flows are dependent on lapse rates within an underlying primary insurance portfolio. This treaty and a corresponding retrocession agreement, which were classified as financial instruments pursuant to IAS 39, resulted in the recognition of other liabilities of EUR 20.4 million and other financial assets at fair value through profit or loss in an amount of EUR 49.0 million. Altogether, these arrangements gave rise to an improvement in income of EUR 1.8 million in the year under review.

At the end of the year under review an index-linked cover was written for longevity risks. The resulting derivative was recognised as at the balance sheet date with a negative fair value of EUR 52.6 million under other liabilities. There were no effects on income owing to initial recognition close to the balance sheet date.

All in all, application of the standards governing the accounting for derivatives in connection with the technical account led to recognition of assets totalling EUR 86.3 million (EUR 40.6 million) as well as recognition of liabilities in an amount of EUR 244.7 million (EUR 174.3 million) from the derivatives resulting from technical items as at the balance sheet date. Improvements in investment income amounting to EUR 40.2 million (EUR 40.9 million) as well as charges to income of EUR 8.6 million (EUR 1.8 million) were recognised in the year under review from all separately measured derivatives in connection with the technical account.

Financial guarantees

Structured transactions were entered into in the life and health reinsurance business group in order to finance statutory reserves (so-called Triple-X or AXXX reserves) of US ceding companies. In each case such structures necessitated the involvement of a special purpose entity. The special purpose entities carry extreme mortality risks securitised by the cedants above a contractually defined retention and transfer these risks by way of a fixed / floating swap to a member company of the Hannover Re Group. The total amount of the contractually agreed capacities of the transactions is equivalent to EUR 3,229.1 million (EUR 3,674.6 million); an amount equivalent to EUR 2,525.9 million (EUR 2,745.8 million) had been taken up as at the balance sheet date. The variable payments to the special purpose entities that are guaranteed by the Hannover Re Group cover their payment obligations. Under some of the transactions the payments resulting from the swaps in the event of a claim are reimbursed by the parent companies of the cedants by way of compensation agreements. In this case the reimbursement claims from the compensation agreements are to be capitalised separately from and up to the amount of the provision.

Under IAS 39 these transactions are to be recognised at fair value as financial guarantees. To this end Hannover Re uses the net method, according to which the present value of the agreed fixed swap premiums is netted with the present value of the guarantee commitment. The fair value on initial recognition therefore amounted to zero. The higher of the fair value and the amount carried as a provision on the liabilities side pursuant to IAS 37 is recognised at the point in time when utilisation is considered probable. This was not the case as at the balance sheet date.