Management of underwriting risk in life/health insurance

Typical risks in life/health primary and reinsurance stem from policies containing long-term benefit guarantees. Along with interest rate risk, biometric and lapse risks are particularly relevant here.

Biometric risk

Biometric actuarial bases such as mortality, longevity and morbidity are established when the policy is taken out and used to calculate premiums and reserves as well as to assess deferred acquisition costs. Over time, however, these assumptions may no longer prove to be accurate, in which case additional expenditures may be required. The adequacy of biometric actuarial bases is therefore regularly reviewed.

Due to this risk, the calculation bases and our expectations may prove inadequate. Our life insurers use a variety of tools to counter this possibility.

  • In calculating premiums and technical provisions, Group companies use prudently quantified biometric actuarial parameters, the adequacy of which is regularly assured by continuously comparing claims expected according to mortality and morbidity tables against claims actually incurred. In addition, the actuarial bases make appropriate allowance for risks of error, random fluctuation and change by applying commensurate safety margins
  • Life insurance policies are typically long-term contracts with a discretionary surplus participation. Minor changes in assumptions with respect to biometric factors, interest rates and costs used as a basis for calculations are absorbed by the safety margins built into the actuarial bases. If such safety margins are not needed, they generate surpluses that are largely passed on to policyholders in accordance with statutory requirements. The impact on profitability in the event of a change in risk, cost or interest rate expectation can thus be limited by adjusting the policyholders’ future surplus participation
  • We regularly review the lapse patterns of our policyholders and the lapse trends of our insurance portfolio
  • Additional protection is obtained through reinsurance against certain – primarily biometric – risks

The described biometric risk is also of special importance in life/health reinsurance. Reserves are mainly calculated using information provided by our cedants. The plausibility of this information is checked against reliable biometric actuarial bases. Furthermore, local regulatory authorities ensure that cedant-calculated reserves satisfy all requirements in terms of the adopted actuarial methods and assumptions (e.g. use of mortality and morbidity tables, assumptions regarding lapse rates). Lapse risk and credit risk are also of importance when prefinancing our cedants’ acquisition costs. Interest guarantee risk, on the other hand, has only minimal relevance in most instances due to the structures of the contracts.

The volume of reinsurance cover relative to gross written premium is determined by the retention ratio, which shows the proportion of the underwritten risks that we bear.

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  IN %
    2013 2012 2011 2010 2009 2008 2007 2006 2005 2004
  Retail Germany 93.9 94.4 93.6 92.9 90.4 n. a. n. a. n. a. n. a. n. a.
  Retail International 95.8 89.7 82.8 84.1 83.3 n. a. n. a. n. a. n. a. n. a.
  Life/Health Primary Insurance 1) n. a. n. a. n. a. n. a. n. a 87.9 86.9 86.0 85.2 78.7
  Life/Health Reinsurance 87.7 89.3 91.0 91.7 90.7 89.3 90.8 85.4 92.8 91.2
  Total life/health insurance 90.9 91.3 91.8 91.8 90.1 88.4 88.5 85.8 88.2 86.5
  1) In 2010 the Group brought its segment reporting into line with IFRS 8 “Operating Segments” after having implemented a corporate reorganisation by customer group in its primary insurance business. Because of cost/benefit considerations, however, reporting for periods prior to 2009 was not retroactively adjusted

Sensitivity analysis

We measure sensitivity to these risks using an embedded value analysis. The MCEV (MCEV) is a key risk management tool. It describes the present value of future shareholders’ earnings plus shareholders’ equity less the cost of capital for life/health primary and reinsurance business 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 and risk neutral, with the modelling of financial instruments providing current market prices.

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

The MCEV is calculated for our major life insurers and for the Life/Health Reinsurance business written by Hannover Rück SE. Sensitivity analyses highlight the areas of life/health insurance in which the Group’s life insurers and hence the Group as a whole are exposed, and they offer indications of the areas that should be emphasised from a risk management standpoint. The analyses take into account sensitivity to mortalities, lapse rates, administrative expenses, interest rates and equity prices.

In reinsurance business, MCEV sensitivity is determined by the technical risk. Whereas changes in assumptions regarding mortality/morbidity, lapse, and costs have a significant influence on the MCEV, the impact from changes in basic economic conditions is minor. By contrast, the MCEV in primary insurance business is chiefly influenced by basic economic conditions. The main driving force is change in interest rates, whereas technical risk has less of an influence on the MCEV. In conformity with International Financial Reporting Standards – IFRS  4, we describe below the relevant sensitivities and their effects on the MCEV in exclusively qualitative terms.

Sensitivity to mortalities

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

Sensitivity to lapse rates

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

Sensitivity to administrative expenses

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

Sensitivity to interest rates and equity prices

In life primary insurance, the obligation to generate minimum returns to cover contractually guaranteed benefits gives rise to considerable interest guarantee risk. Fixed-income investments normally have a duration shorter than that for obligations under insurance contracts (duration mismatch).

Technical provisions are arranged according to the expected maturity, and investments, according to the remaining contract duration. Contained in this is a duration (Macaulay Duration) of 9.9 (9.6) for recognised obligations and of 7.2 (6.8) for fixed-income securities (including interest rate derivatives).

This leads to a risk in terms of re-investing accumulated credit balances as well as to a first-time investment risk for premiums received in the future. If the investment income generated over the remaining duration of the obligations falls short of the interest payable under the guarantees, this leads to a reduction in income and a decrease in the MCEV.

Because of the way life insurance contracts are structured, German life insurers in particular are affected by interest guarantee risk. For German life insurance companies and pension funds in the Talanx Group, the average guaranteed interest rate – weighted according to the companies’ gross provisions – is 2.97 (3.13)% in 2013.

A decline in equity prices would also negatively impact the MCEV, although this impact would be very minor due to the currently low share of equities.

Derivatives embedded in life insurance contracts and not recognised separately

Insurance products of primary life insurers may include the following major options on the part of policyholders if agreed upon when the contract was taken out:

  • Minimum returns/guaranteed interest rate: This entails a risk that current interest rates might be significantly lower than the discount rate used to calculate the insurance benefits. In this case, generated interest earnings may not suffice to cover compounding amounts. This option is taken into account with respect to adequacy testing pursuant to IFRS 4.
  • Surrender of policy and premium waiver: There is a risk that, on the one hand, surrender may result in the obligation to pay the corresponding insurance benefit in cash to policyholders and, on the other, a premium waiver may result in cessation of further liquidity flows on account of the lack of premium payments by policyholders. Allowance is made for this risk through suitable liquidity planning.
  • Increase in insured benefit without subsequent medical examination – usually with the actuarial bases with respect to the biometric factors and the guaranteed return applicable at that time (index-linked adjustment, supplementary insurance guarantees in the event of certain changes in living conditions): Here there is a risk that policyholders may be able to obtain insurance at a premium lower than that corresponding to their health risk, since possible surcharges may not have been imposed.
  • Possibility under deferred annuity policies to take a one-time payment of the insured benefit (lump-sum option) instead of drawing a pension. This entails a risk that an unexpectedly large number of policyholders might exercise their lump-sum option at an interest rate significantly higher than the discount rate used to calculate the annuities. However, there is no direct interest rate or market sensitivity to exercise the lump-sum option, since personal factors of policyholders have a material influence on existing insurance components. This option is taken into account with respect to adequacy testing pursuant to IFRS 4.

With unit-linked products, policyholders may opt to take ownership of the accumulated units upon maturity of the contract (benefit in kind) instead of accepting payment of their equivalent value at that time. In this regard, there is no direct market risk.

Other embedded derivatives are economically insignificant.

With life/health insurance, a number of contracts have features that require embedded derivatives to be split from the underlying insurance contract and, pursuant to IAS 39, recognised separately at market value. In this regard, cf. our remarks in item 13 in the Notes, “Derivative financial instruments and hedge accounting”.

Concentration risks

With life insurance, concentration risk is not as significant as interest guarantee risk. In this regard, cf. the  subsection “Sensitivity analysis” and the remarks on “Sensitivity to interest rates and equity prices”.

With respect to geographical concentration, cf. the following table, which depicts the distribution of the benefit reserve by region on both a gross and a net basis (after allowing for the reinsurers’ share of these provisions) for life/health insurance.

    Gross Re Net
  Germany 37,789 477 37,312
  United Kingdom 4,922 18 4,904
  Central and Eastern Europe including Turkey (CEE) 962 962
  Rest of Europe 2,445 47 2,398
  USA 2,164 110 2,054
  Rest of North America 490 490
  Latin America 15 15
  Asia and Australia 850 179 671
  Africa 39 39
  Total 49,676 831 48,845
  Germany 36,721 489 36,232
  United Kingdom 4,769 17 4,752
  Central and Eastern Europe including Turkey (CEE) 705 705
  Rest of Europe 2,289 75 2,214
  USA 2,891 125 2,766
  Rest of North America 88 219 –131
  Latin America 20 20
  Asia and Australia 632 92 540
  Africa 46 46
  Total 48,161 1,017 47,144
  1) After elimination of internal transactions within the Group across segments

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