Munich Re manages its business on the basis of a consolidated Group view, using its own integrated risk model to determine the capital needed to ensure the Group’s ability to meet its commitments even after extreme loss events.
Our risk model indicates the profit and loss distribution of the available financial resources over a one-year time horizon. It is based on specially modelled distributions for the risk categories “property-casualty”, “life and health”, “market”, “credit” and “operational risks”. We regularly review these distribution assumptions, comparing them, for example, with loss events that have actually occurred and adjusting them if necessary.
Every risk category is depicted in both reinsurance and primary insurance. In the Munich Health segment, the life and health risk category and operational risks are shown, but not market and credit risk, which we cover in the reinsurance and insurance segments through our internal risk control.
We also show the diversification effects we achieve through both our broad spread across the different risk categories (underwriting, market and credit) and our combin- ation of primary insurance and reinsurance business. At the same time, we recognise by means of tail dependencies that the various risks are not independent of each other. This gives rise to a smaller diversification effect than if independence is assumed.
On pages 120 ff., we provide examples of the above-mentioned risks and how we deal with them
A key figure calculated using the internal model is our economic risk capital (ERC). By economic risk capital, we mean the amount of capital that Munich Re needs to have available, with a given risk appetite, to cover unexpected losses in the following year. To determine Munich Re’s economic risk capital, we use the economic profit-loss distribu- tion across all risk segments. The economic risk capital corresponds to 1.75 times the value at risk of this distribution over a one-year time horizon with a confidence level of 99.5%. The value at risk with a confidence level of 99.5% gives the economic loss for Munich Re which, given unchanged exposures, will be statistically exceeded in no more than one year in every 200. It represents the future risk tolerance under Solvency II. By setting its own capital requirement at 1.75 times this risk tolerance, our Group follows a conservative approach, offering its clients a high degree of security.
The distribution of economic losses between the individual legal entities in Munich Re may vary, but the ability of one unit to support another in the event of a loss is in some cases subject to legal constraints. In determining Munich Re’s capital requirements, restrictions of capital fungibility resulting from legal or regulatory requirements are therefore taken into account.
The table shows Munich Re’s economic risk capital and risk categories as at 31 Decem- ber 2012. Over last year, the economic risk capital rose by €2.9bn. The following factors contributed to the increase:
— The economic risk capital for our life and health business rose by €0.6bn. In primary insurance, the rise resulted from further falls in interest rates, especially in the euro- zone. In addition, lower risk cushions, for example for future policyholder bonuses, are increasing the risk for insurers. In reinsurance, the changes are due primarily to the substantial increase in new business in Asia and Canada. For Munich Health, the
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economic risk capital (eRC)
31.12.2012
Segment
Primary Munich diversi-
€bn Group Reinsurance insurance Health fication
Property-casualty 9.7 9.6 0.6 – –0.5
Life and health 7.2 5.3 2.8 0.7 –1.6
Market 14.0 6.1 11.1 – –3.2 Credit 6.7 4.4 2.6 – –0.3 Operational risk 1.4 1.0 0.6 0.1 –0.3 Subtotal 39.0 26.4 17.7 0.8 –5.9 Diversification effect –11.7 –9.3 –3.4 – – Total 27.3 17.1 14.3 0.8 –4.9
Prev. year Change
Segment
Primary Munich diversifi-
€bn Group Reinsurance insurance Health cation Group
Property-casualty 9.5 9.4 0.6 – –0.5 0.2
Life and health 6.6 4.8 2.5 0.6 –1.3 0.6
Market 11.4 5.7 8.5 – –2.8 2.6 Credit 6.7 4.5 2.2 – – – Operational risk 1.2 0.9 0.6 0.1 –0.4 0.2 Subtotal 35.4 25.3 14.4 0.7 –5.0 3.6 Diversification effect –11.0 –8.8 –3.1 – – –0.7 Total 24.4 16.5 11.3 0.7 –4.1 2.9
ERC has risen as a result of more precise modelling of the pandemic risk. We have also adapted the model to take account of the higher degree of uncertainty in the US health insurance market.
— The economic risk capital for market risks grew by €2.6bn due both to increased equities and foreign-currency exposure and to lower interest rates, which have led to a rise in risk capital in life primary insurance in particular. An improvement in the way the spread risks in life and health primary insurance are depicted also caused risk capital to increase.
— As the composition of the portfolio remained stable, the economic risk capital for credit risks remained at approximately the same level as for the previous year. — As last year, we used scenarios to determine the economic risk capital requirement
for operational risk. Various teams of experts in the Group have compiled the scen- arios and adjust them annually. The change in economic risk capital resulted from the updating of the expert estimates.
— The diversification effect between the risk categories “property-casualty”, “life and health”, “market”, “credit” and “operational risk” grew by €0.7bn, due primarily to a €3.6bn rise to €39.0bn in the sum of the economic risk capital requirements for the individual risk categories.
A separate analysis as at the end of 2012 showed that all the changes to the model increased the Group’s economic risk capital by a total of approximately 5%.
Property-casualty
The underwriting risk capital for property-casualty is made up as follows:
Losses with a potential cost exceeding €10m at Group level are classified as large losses. Accumulation losses are losses affecting more than one risk (or more than one line of business). We classify all other losses as basic losses. For basic losses, we calculate the risk of subsequent reserving being required for existing risks within a year (reserve risk) and the risk of under-rating (premium risk). To achieve this, we use analytical methods that are based on standard reserving procedures, but take into account the one-year time horizon. In the case of the basic losses, the annual readjustment of the models resulted in an increase in the economic risk capital requirement, due primarily to a recalibration of the interdependencies between the segments.
Munich Re actively manages its risk exposure. This includes restricting our exposure through limits and budgets for natural catastrophe risks, where our experts consider scenarios for possible natural events, the scientific factors, occurrence probabilities and potential loss amounts. On the basis of these models, the impact of various events on our portfolio is calculated and represented in mathematical terms in the form of a stochastic model. These models form the basis for the ERC calculation for the “large and accumulation losses” category, which apart from natural hazard scenarios includes man-made losses, and for the limits and budgets for accumulation losses.
economic risk capital (eRC) – Property-casualty
31.12.2012 Prev. year Change
Segment Segment
Re- Primary diversi- Re- Primary diversi-
€bn Group insurance insurance fication Group insurance insurance fication Group
Basic losses 4.8 4.6 0.5 –0.3 3.9 3.8 0.5 –0.4 0.9
Large and accumulation
losses 9.0 8.9 0.3 –0.2 9.0 9.0 0.2 –0.2 –
Subtotal 13.8 13.5 0.8 –0.5 12.9 12.8 0.7 –0.6 0.9
Diversification effect –4.1 –3.9 –0.2 – –3.4 –3.4 –0.1 – –0.7
Total 9.7 9.6 0.6 –0.5 9.5 9.4 0.6 –0.5 0.2
current limit utilisation is determined by a bottom-up process. As ERGO’s portfolio is more stable, its exposure is only updated annually. The economic risk capital for large and accumulation losses was virtually unchanged from the previous year, with opposite effects offsetting each other. As in 2011, the largest natural catastrophe exposure for Munich Re is the €3.3bn currently retained for the “Atlantic Hurricane” scenario (value at risk for a 200-year return period). With a retention of €2.7bn, “Cyclone Australia” is the second-largest scenario. The modelling of the scenario has been fundamentally revised, leading to an increase in the value at risk calculated. The scenario was expanded geographically, and risks from other classes of business and exposures were depicted in the model. The effect of various return periods on the portfolio structure was also reflected more precisely. In addition, there has been an expansion in the business exposed to this scenario. Our exposure to European windstorms has been quantified at €2.0bn using the scenarios we have drawn up.
The diagrams show our estimated exposure to these peak scenarios for a return period of 200 years.
Atlantic Hurricane
Aggregate VaR (return period: 200 years) €bn (before tax), retained
0 1 2 3 4 2012 2011 3.3 3.5 Cyclone Australia
Aggregate VaR (return period: 200 years) €bn (before tax), retained
0 1 2 3 4 2012 2011 2.7 1.4 Storm europe
Aggregate VaR (return period: 200 years) €bn (before tax), retained
0 1 2 3 4
2012
2011
2.0
As a global risk carrier, we can diversify our portfolio through the broadest possible mix and spread of individual risks, significantly reducing the volatility of total claims payments and substantially increasing the value added by all parts of our business.
life and health
In life and health business, the risk modelling takes account of countervailing develop- ments with both short- and long-term effects on the risk drivers that influence the value of our business.
In addition to the simple risk of random fluctuations resulting in higher claims expend- iture in a particular year, the countervailing developments with a short-term impact that we model notably include the risk of above-average claims that could arise on the occurrence of rare but costly events such as pandemics.
However, particularly life primary insurance products, and a large part of our health primary insurance business, are long-term in nature, and the results they produce are spread over the entire duration of the policies. We show the value of business in force and value sensitivities for such long-term portfolios in the notes to the consolidated financial statements. The countervailing development of risk drivers with a long-term impact, such as changes in the forecast mortality and disablement trends, can cause the value of the insured portfolio to fall (trend risks). The risk modelling then attributes probabilities to each modified assumption and produces a complete profit and loss dis- tribution.
Market risks
Market risks are determined using a scenario-based simulation calculation. The scenarios are calibrated on the basis of long historical data series.
Equity risk
The market value of our investments in equities, including participating interests, was €8.4bn (€6.7bn) as at 31 December 2012. As at that date, on a market-value basis the ratio of equities to total investments was 3.7% (3.2%) before taking derivatives into account, and 3.4% (2.0%) after derivatives. The rise on the previous year is the reason for the higher risk capital for equities.
Interest-rate risks
In reinsurance, the interest-rate risk on fixed-interest investments in units of modified duration (interest-rate sensitivity) was 6.7, whereas the modified duration of liabilities was 4.1. The sensitivity of available financial resources to a parallel increase of one basis point in all interest-rate curves (DV01) amounted to –€13.3m. Were such a paral- lel shift in the interest-rate curves to occur, the available financial resources would change by that amount.
Further information on the value of business in force and on value sensitivities is provided in the notes to the consolidated finan- cial statements under ”Risks from
life and health insurance busi- ness” on page 251 ff.
economic risk capital (eRC) – Market
31.12.2012 Prev. year Change
Segment Segment
Re- Primary diversi- Re- Primary diversi-
€bn Group insurance insurance fication Group insurance insurance fication Group
Equity risk 5.7 4.4 1.3 – 3.8 2.6 1.4 –0.2 1.9
General interest-rate risk 8.3 3.2 9.0 –3.9 7.8 3.7 7.2 –3.1 0.5 Specific interest-rate risk 6.1 2.1 5.2 –1.2 4.1 2.1 2.8 –0.8 2.0
Property risk 2.1 1.3 0.8 – 2.2 1.2 1.0 – –0.1 Currency risk 1.9 1.8 0.2 –0.1 0.9 0.8 0.1 – 1.0 Subtotal 24.1 12.8 16.5 –5.2 18.8 10.4 12.5 –4.1 5.3 Diversification effect –10.1 –6.7 –5.4 – –7.4 –4.7 –4.0 – –2.7 Total 14.0 6.1 11.1 –3.2 11.4 5.7 8.5 –2.8 2.6
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The modified duration in primary insurance is 8.1 for fixed-interest investments and 9.2 for liabilities. This exposure to falling interest rates arises mainly out of the long-term options and guarantees in life insurance business. These risks were reduced substan- tially by the extensive interest-rate-risk hedging programme first implemented in 2005. The sensitivity of available financial resources to a parallel shift of one basis point in all interest-rate curves (DV01) amounts to €16.1m.
The rise in the general interest-rate risk is essentially due to the fall in interest rates compared to the previous year and the effect of that fall on life primary insurance business. The specific interest-rate risk increased as a result of an improvement in the depiction of the spread risks in life and health primary insurance.
Currency risk
The currency risk increased in relation to the end of the previous year due to somewhat higher foreign-currency exposure in the reinsurance portfolio.
Credit risks
Munich Re determines credit risks using a portfolio model, which takes into account both changes in market value caused by rating migrations and debtor default. The model is calibrated over a credit cycle.
The market value of our investments in fixed-interest securities and loans as at 31 December 2012 was €188.4bn, representing 83.9% of the market value of Munich Re’s total investments. These securities thus made up the bulk of the portfolio. In our internal risk model, we calculate and allocate risk capital even for highly rated government bonds.
Our provisions ceded to reinsurers and retrocessionaires were assignable to the follow- ing rating categories as at 31 December 2012:
The shifts are mainly due to the change in rating of a small number of reinsurers/ retrocessionaires.