Nature of risks associated with insurance contracts and financial instruments

Management of risks from investments

The structure of the investments under own management (excluding funds held by ceding companies) is regularly examined in order to review the strategic asset allocation. The breakdown for the Group as at 31 December 2010 was as follows:

Weighting of major asset classes

Parameter as per investment guidelines

Position as at 31.12.2010

Position as at 31.12.2009

%

     

Bonds (direct holdings and investment funds)

At least 50

86

84

Listed equities (direct holdings and investment funds)

At most 25

2

3

Real estate (direct holdings and investment funds)

At most 5

2

2

In this regard it is evident that the bonds, equities and real estate are within the defined Group limits. In accordance with the company’s risk-carrying capacity and regulatory requirements, the investment goals of security, profitability, liquidity as well as mix and spread are given adequately balanced consideration under our holistic asset/liability management systems. The main opposing risks are market risks, default risks and liquidity risks.

Market risks

The market risk consists primarily of the risk of changes in the market prices of fixed-income assets and equities as well as the exchange rate risk associated with fluctuations in exchange rates if there is no matching cover. This may necessitate value adjustments or lead to the realization of losses in the event of disposal of financial assets. A decline in the interest rate level can also lead to reduced investment income.

A vital tool used to monitor and manage market price risks is constant analysis of the value at risk (VaR), which is increasingly evolving from an assets-side measurement approach into an assets/liabilities concept. The VaR defines the estimated maximum loss that will not be exceeded within a set holding period (e.g. 10 days) and with a set probability (e.g. 95%).

The VaR is established daily on the basis of historical data. Within the scope of these calculations the loss potentials of both the total portfolio and partial portfolios are monitored and limited. The calculation of this maximum loss potential is performed on the basis of a confidence level of 95% and a holding period of ten days. This means that this estimated loss potential will be exceeded within 10 days with a probability of 5%.

The daily updated holdings are fed into the calculation as input data. The scope of the market data history used for risk analysis is 181 weeks. On this basis, 180 weekly changes are calculated for each relevant market parameter, such as equity prices, exchange rates and interest rates, and these are then used to establish the value at risk. Market observations of the recent past are weighted more heavily through the use of a decay factor in order to refine the sensitivity of the VaR model to current volatility changes and hence improve the forecast quality. The time series on the basis of which the risk parameters are calculated are updated weekly. In this context, the market parameters of the oldest week are removed and replaced by those of the current week. The risk model is recalibrated on the basis of the updated market data.

The risk model used is based on a multi-factor model. This multi-factor model is grounded on numerous representative time series, e.g. interest rates, exchange rates and stock indices. All risk-relevant factors can be determined from these time series using main component analysis. The correlations existing between the time series are incorporated into the weighting of the risk factors. In this way allowance is made in the risk assessment for cumulative and diversification effects. The individual elements of the portfolio are analyzed through regression towards these factors. The factor weightings thereby determined create a correlation between the movements in the factors derived from the movements in the representative time series and the movements in the securities. The risks associated with securities are arrived at through simulation of the factor developments. The risk associated with options is arrived at through a comprehensive simulation. Consideration is thus given to the non-linear correlations between option prices and the price movements of the underlying instruments.

Normal market scenarios are used to calculate the value at risk. In addition, stress tests are conducted in order to be able to map extreme scenarios. In this context, the loss potentials are simulated on the basis of already occurred or notional extreme events. Actual market developments may diverge from the model assumptions.

The VaR (confidence level of 95%, holding period of 10 days) as at 31 December 2010 amounted to EUR 1.1 billion, a figure equivalent to 1.6% of the assets under consideration.

The range of management tools is complemented by stress tests and scenario analyses. In the case of interest-rate-sensitive products and equities, we calculate a possible change in fair value using a historic “worst case” scenario on a daily basis, estimating the potential loss under extreme market conditions. With the aid of scenarios we simulate changes in equity prices, exchange rates and yields on the basis of historical data. Interest rate risks refer to an unfavorable change in the value of financial assets held in the portfolio due to changes in the market interest rate level. Declining market yields lead to increases and rising market yields to decreases in the fair value of fixed-income securities portfolios. Share price risks derive from unfavorable changes in the value of equities and equity or index derivatives due, for example, to downward movements on particular stock indices. We spread these risks through systematic diversification across various sectors and regions. Currency risks are of considerable importance to an internationally operating insurance enterprise that writes a significant proportion of its business in foreign currencies.

The following table shows scenarios for the development of investments held by the Group as at the balance sheet date. The amounts shown are gross amounts; in particular, the effects illustrated disregard taxes and the provision for premium refunds. Effects arising on the basis of the surplus participation of policyholders in life primary insurance thus do not form part of the analysis. Making allowance for these effects, the repercussions indicated for the results and shareholders’ equity would be considerably reduced.

Scenarios for changes in the fair value of assets held by the Group as at the balance sheet date:

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Portfolio

Scenario

Recognized in
the statement
of income 1)

Recognized directly in equity 1)

31.12.2010

Portfolio change
based on fair value 2)

31.12.2009

Portfolio change
based on fair value 2)

Figures in EUR million

           

Equity securities 3)

Share prices

+20%

+17

+345

+361

+347

 

Share prices

+10%

+8

+173

+181

+170

 

Share prices

–10%

–8

–184

–191

–166

 

Share prices

–20%

–14

–367

–382

–320

             

Fixed-income securities

Yield increase

+200 basis points

–37

–2,149

–6,297

–5,613

 

Yield increase

+100 basis points

–19

–1,122

–3,346

–2,977

 

Yield decrease

–100 basis points

+19

+1,203

+3,456

+2,966

 

Yield decrease

–200 basis points

+38

+2,501

+7,245

+6,202

             

Exchange-rate-sensitive investments

Change in
exchange rates 4)

+10%

–1,614

–136

–1,750

–1,493

 

thereof USD

 

–894

–95

–989

–911

 

thereof GBP

 

–188

–6

–194

–164

 

thereof AUD

 

–150

–150

–108

 

thereof other

 

–381

–36

–418

–310

 

Change in
exchange rates 4)

–10%

+1,614

+136

+1,750

+1,493

 

thereof USD

 

+894

+95

+989

+911

 

thereof GBP

 

+188

+6

+194

+164

 

thereof AUD

 

+150

+150

+108

 

thereof other

+381

+36

+418

+310


1) Amounts shown are gross (before taxes and surplus participation)
2) Including financial assets belonging to the categories “loans and receivables” and “held to maturity”
3) Including derivative holdings
4) Exchange-rate fluctuations of +/–10% against the euro based on balance sheet values

The breakdown of our investments by currency was as follows:

Currency

31.12.2010

31.12.2009

%

   

EUR

76

78

USD

13

13

GBP

3

2

AUD

2

2

Other

6

5

Total

100

100

We use short-call and long-put options as well as swaps to partially hedge portfolios, especially against price, exchange and interest rate risks. In the year under review we also used derivative financial instruments to optimize our portfolio in light of risk/return considerations. The contracts are concluded solely with first-class counterparties and compliance with the standards defined in the investment guidelines is strictly controlled in order to avoid risks – especially credit risks – associated with the use of such transactions. By systematically adhering to the principle of matching currency coverage, we are also able to significantly reduce the foreign currency risk within the Group.