Disclosures on risks from insurance contracts and financial instruments
Interest-rate risks
A distinction must be made between risks of changes in interest rates on the one hand and interest-rate guarantee risks on the other. Risks of changes in interest rates would result from the discounting of the provision for future policy benefits and of parts of the provision for outstanding claims. In accordance with accounting valuation rules, the discount rate is fixed at contract commencement and will generally not be adjusted during the term of the contract. To this extent, the accounting valuation of these technical provisions does not depend directly on the level of market interest rates.
Economically, however, an interest-rate risk derives in principle from the need to earn a return on investment covering the provision that is commensurate with the discount rate used in measuring the provision.
In life insurance, an implied or explicit guaranteed interest rate is normally granted over the whole duration, based on a fixed interest rate applying at the time the contract is concluded. The discount rate used to calculate the provi- sion for future policy benefits is identical with this inter- est rate for the majority of contracts in our portfolios. An appropriate minimum return needs to be earned in the long term from the investment result (possibly also with assistance from the technical result) for contractually guaranteed benefits. In health insurance, a discount rate is used for calculating the provision for future policy benefits, too; but for long-term business, this rate can generally be altered by way of premium adjustment. For short-term business, there is no direct interest-rate risk.
The discount rates relevant for the portfolio which relate to provisions for future policy benefits and provisions for out- standing claims are shown in tables [16b] and [17a] of the Notes to the consolidated financial statements.
Moreover, in German health insurance, the valid discount rate is also used to calculate the provision for premium surcharge provisions and for the provision for the reduced premiums in later years which, according to the German Commercial Code, form part of the provision for future policy benefits and which are to be shown under the provi- sion for premium refunds under IFRS. In principle, however, the discount rate can be changed whenever there is an adjustment made to premiums within the allowed range of 0–3.5%.
Provisions that are not covered by retained deposits are covered by investments. In the case of a discrepancy between the durations of these investments and the liabilities (“duration mismatch”), the main risk lies in the fact that if interest rates fall markedly over the remain- ing settlement period of the liabilities, the return on the re invested assets may be lower than the discount rates and thus necessitate further expenses. But a complete duration matching of liabilities with fixed-interest invest- ments of identical maturities would not be expedient, because if interest rates rise significantly, policyholders might make increasing use of their surrender rights, result- ing in a liquidity requirement for premature payouts. We measure sensitivity to this interest-rate risk using an embedded value analysis (see pages 127).
Lapse risks
In reinsurance, a lapse risk derives primarily from the indirect transfer of lapse risks from cedants. As a rule, both this risk and the financial risk from extraordinary termination of reinsurance contracts are largely ruled out through appropriate contract design.
In life insurance, the reported technical provision in the case of contracts with a surrender option is generally at least as high as the relevant surrender value. Expected surrenders are taken into account in the amortisation of deferred acquisition costs in life insurance. The policy- holder’s right in some contracts to maintain the contract with a waiver of premium and an adjustment of the guaranteed benefits constitutes a partial lapse and is taken into account in the calculations analogously. The lump-sum option right for a deferred annuity gives the policyholder the option to have the annuity paid out in a lump sum on a given date. There is a potential risk here if, following a level of interest which is significantly above the level used to calculate the annuity, an unexpectedly large number of policyholders exercise their lump-sum option. However, there is no direct interest or market sensitiv- ity as the exercising of the option is influenced decisively by individual factors concerning the policyholder because there is an insurance component involved. Contractual aspects are also relevant, as the lump-sum option is some- times excluded or severely limited, such as with company
pensions or with state-subsidised products. The adequacy test for underwritten liabilities in accordance with IFRS 4 explicitly takes this policyholders’ option into considera- tion. Based on the relevant legal parameters, reserves for health insurance business are calculated considering amounts payable due to transfer of policies. The underlying assumptions are regularly checked.
The sensitivity towards a change in the lapse probability in life insurance as well as for long-term health insurance contracts are measured as part of an embedded value analysis (see page 127).
Other market risks and embedded derivatives
Risks to be considered are – besides the interest-rate guarantee, which we analyse in the modelling of the interest-rate risk – are particularly risks from unit-linked life insurance. Other embedded derivatives are economically insignificant.
For unit-linked insurance contracts in our portfolios, invest- ments are held for the benefit of life insurance policyhold- ers who bear the investment risk, meaning that there is no direct market risk. Appropriate product design ensures that the necessary premium portions for payment of a guaranteed minimum benefit on occurrence of death are based on the current fund assets. In addition, unit-linked insurance policies may contain a guaranteed gross pre- mium which is assured by an issuer in certain cases. As a result, our market risk is reduced accordingly, although there is a bad debt risk. In order to reduce this risk, we make high demands of the creditworthiness of the issuer.
Liquidity risks
or ERGO, there could be a liquidity risk if the cash outflow for insurance claims payments and the costs related to the business were to exceed the cash inflow from premiums and investments. For our mainly long-term business, we therefore analyse the expected future balance from cash inflows due to premium payments and outflows for pay- ment of insurance claims and benefits plus costs.
As regards business in force on the balance sheet date, this results in the future expected technical payment balances shown in the table on the next page according to duration bands. As only the technical payment flows are consid- ered, inflows from investment income and investments that become free are not included in the quantification. Taking into account the inflows from investments, whose cash flows are largely aligned with those of the liabilities through our asset-liability management, items in the future expectations are positive throughout, so that the liquidity risk of these insurance contracts is minimised accordingly.
With these numerical estimates, it should be borne in mind that these forward-looking data may involve considerable uncertainty.
Further information on the liquidity risk is provided in the risk report on page 37.
Claims risk
The claims risk occurs when benefits have to be paid out of a previously determined premium. Here the scope of benefits has been agreed beforehand, but the risk lies in not knowing how medical expenses and benefits will develop in the future. The promise of benefits plays an important role in this aspect. In future, we also expect that medical possibilities will improve still further with more applications and, hence, higher costs. Consequently, the relationship of calculated costs to the benefits required is constantly monitored. Premiums will be adjusted for those tariffs where the required benefits deviate from calculated benefits on a permanent basis. Actuarial assumptions used
ERGO Insurance Group
Annual Report 2013
126