Nature of risks associated with insurance contracts and financial instruments

Management of market risks in life insurance

Typical risks in life insurance (life primary insurance and life/health reinsurance) are associated with the fact that policies contain long-term benefit guarantees. Along with interest rate risks, biometric risks and lapse risks are therefore particularly relevant here. Biometric actuarial bases such as mortality, longevity and morbidity are established at the inception of a contract in order to calculate premiums and reserves and measure deferred acquisition costs. Over time, however, these assumptions may prove to be no longer accurate and may therefore necessitate additional expenditures. The adequacy of the biometric actuarial bases is therefore regularly reviewed.

In view of the aforementioned risks, the calculation bases and our expectations may prove inadequate. Our life insurers use a variety of tools to counter this possibility:

  • In order to calculate premiums and technical provisions the Group companies use prudently quantified actuarial bases, the adequacy of which is regularly assured through a continuous reconciliation of the claims expected according to the withdrawal tables and the claims actually incurred. In addition, the actuarial bases make appropriate allowance for the risks of error, random fluctuation and change by means of commensurate safety loadings.
  • Life insurance policies for the most part involve long-term contracts with a discretionary surplus distribution. Minor changes in the assumptions with respect to the biometric factors, interest rates and costs on which tariffs are based are absorbed by the safety loadings built into the actuarial bases. If these safety loadings are not required, they generate surpluses that are for the most part – in accordance with statutory requirements – passed on to policyholders. The impact on profitability in the event of a change in the risk, cost or interest rate expectations is thus limited by adjustment of the future surplus participation of policyholders.
  • We regularly review the lapse pattern of our policyholders and the lapse trend of our in-force portfolio.
  • Additional protection is obtained against certain – primarily biometric – risks by taking out reinsurance treaties.

In life and health reinsurance, too, the previously described biometric risks are of special importance. The reserves in life and health reinsurance are based principally upon the information provided by ceding companies. The plausibility of the figures is checked using reliable biometric actuarial bases. Furthermore, local insurance regulators ensure that the reserves calculated by ceding companies satisfy all requirements with respect to actuarial methods and assumptions (e.g. use of mortality and morbidity tables, assumptions regarding the lapse rate etc.). The lapse and credit risks are also of importance with regard to the prefinancing of cedants’ new business acquisition costs. The interest guarantee risk, on the other hand, is of only minimal risk relevance in most instances due to the structure of the contracts.

The volume of reinsurance protection relative to the gross written premium can be measured according to the level of retained premium; shown below broken down by segments, this indicates the proportion of written risks retained for our risk:

Retention by segments

2010

2009

%

   

Retail Germany

92.9

90.4

Retail International

84.1

83.3

Life/Health Reinsurance

91.7

90.7

Total

91.8

90.1

We measure sensitivity to these risks using an embedded value analysis. The Market Consistent Embedded Value (MCEV) is a key risk management tool. It refers to the present value of future shareholders’ earnings plus the shareholders’ equity less the cost of capital for the life insurance and life/health reinsurance portfolio after appropriate allowance for all risks underlying this business. The embedded value is market-consistent inasmuch as it is arrived at using a capital market valuation that meets certain requirements: free of arbitrage, risk-neutral, the modeling of the financial instruments provides the current market prices.

The New Business Value (NBV) is also taken into consideration. The MCEV and NBV denote the present value of future shareholders’ earnings from business in life insurance and life/health reinsurance after appropriate allowance for all risks underlying the business in question.

The MCEV is calculated for our major life insurers as well as the life/health reinsurance business written by Hannover Re. Sensitivity analyses highlight the areas in which the Group’s life insurers and hence the Group as a whole are exposed in the life sector, and they provide pointers to the areas which should be emphasized from a risk management standpoint. Sensitivities to mortalities, lapse rates, administrative expenses as well as interest rate and equity price levels are considered in the analyses.

Sensitivities to mortalities

The degree of exposure of the Group’s life insurers varies according to the type of insurance product. Thus, a lower-than-expected mortality has a positive effect on products primarily involving a death and/or disability risk and a negative impact on products with a longevity risk – with corresponding implications for the MCEV.

Sensitivities to lapse rates

Under contracts with a right of surrender the recognized benefit reserve is at least as high as the corresponding surrender value, and hence the economic impact of the lapse pattern tends to be more influenced by the level of lapse discounts and other product characteristics. A higher-then-expected lapse rate would to some extent negatively affect the MCEV.

Sensitivities to administrative expenses

Higher-then-expected administrative expenses would result in a reduction of the MCEV.

Sensitivities to interest rate and equity price levels

The commitment to generate the minimum return for the contractually guaranteed benefits gives rise to a considerable interest guarantee risk in life primary insurance. The fixed-income investments normally have a shorter duration than the obligations under the insurance contracts (durations mismatch). This creates a reinvestment risk for already accumulated credit balances and a new investment risk for future premiums. If the investment income generated across the remaining settlement period of the liabilities falls short of the interest due under the guarantees, this leads to a reduction in income and a decrease in the MCEV. A decline in the equity price level would also negatively impact the MCEV.

Derivatives embedded in life insurance contracts that are not recognized separately

Insurance products may include the following major options on the part of the policyholder, insofar as they were agreed upon when the contract was taken out:

  • Possibility of surrender and premium waiver for the contract
  • Increase in insured benefit without another medical examination – usually with the actuarial bases applicable at the time with respect to biometric risks and guaranteed interest rate (index-linked adjustment, supplementary insurance guarantees in the event of certain changes in living conditions)
  • Possibility of a one-time payment of the insured benefit (lump-sum option) under deferred annuities instead of pension transition. This gives rise to a potential risk if an unexpectedly large number of policyholders were to exercise their option at an interest rate level significantly above the discount rate used to calculate the annuities. The adequacy test required by IFRS 4 makes allowance for this option.

Under unit-linked products the policyholder can opt for transfer of the relevant units upon maturity of the contract instead of payment of their equivalent value.