STRESS EVENTS - RESILIENCE VERSUS CAPITAL EFFICIENCY

Hermann Pohlchristoph, CFO ReinsuranceSun City, June 11th 2012

Financial Management often means to manage opposing targets

Return

Equity

Regulators Investors

Analysts

Clients

Stakeholders have different requirements in terms of security and financial return.Stakeholders have different requirements in terms of security and financial return.

Every company needs to find and maintain the right equilibrium.Every company needs to find and maintain the right equilibrium.

State-of-the-art risk management processes should ensure a sustainable value creation to shareholders while protecting the balance sheet of a company against extraordinary shock events.

State-of-the-art risk management processes should ensure a sustainable value creation to shareholders while protecting the balance sheet of a company against extraordinary shock events.

High returnsHigh returns

Performance of share price

Performance of share price

Capital efficiencyCapital efficiencyResilience against stress events

Resilience against stress events

LiquidityLiquidity

Low results volatilityLow results volatility

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Agenda

1. A regulator’s view on capital adequacy: Solvency II

2. A shareholder’s view: optimizing resilience and capital efficiency

3. Limits of models and how to cope with it

Solvency II – Fuelling a global trend towards risk-based supervision(?)

Various supervisory regimes aiming for recognition under Solvency II ("equivalence"), e.g. Bermuda, Switzerland and South Africa.

Evidence of the trendEvidence of the trendInfluence of Solvency II on other supervisory regimesInfluence of Solvency II on other supervisory regimes

IAIS – International Association of Insurance Supervisors

COMMON FRAMEWORK FOR THE SUPERVISION OF INTERNATIONALLY ACTIVE INSURANCE GROUPS

Multilateral framework aiming for worldwide coherence of supervision among global insurance companies.

Multilateral framework aiming for worldwide coherence of supervision among global insurance companies.

Adjustments of risk-based-capital-type models in USA and Canada.

Adjustments of risk-based-capital-type models in USA and Canada.

Planned adaption of Solvency II, inter alia in Japan, Israel and Mexico.

Planned adaption of Solvency II, inter alia in Japan, Israel and Mexico.

HarmonizationNo separate framework.

HarmonizationNo separate framework.

ConvergenceNo additional supervision.

ConvergenceNo additional supervision.

Solvency II motivates the insurance industry to fully adopt stringent risk-based economic steering

Changes compared to Solvency I

Principle-based (in contrast to Solvency I rules)

Economic and market-consistent valuation of all material risks

Reinsurance and other risk mitigation instruments fully applicable under Solvency II (no more 50% cap on non-life reinsurance)

Some issues remain, especially with regard to non-proportional reinsurance

Consideration of diversification effects

Investment risks are compre-hensively taken into account

Changes compared to Solvency I

Principle-based (in contrast to Solvency I rules)

Economic and market-consistent valuation of all material risks

Reinsurance and other risk mitigation instruments fully applicable under Solvency II (no more 50% cap on non-life reinsurance)

Some issues remain, especially with regard to non-proportional reinsurance

Consideration of diversification effects

Investment risks are compre-hensively taken into account

3 pillars of Solvency II3 pillars of Solvency II

Quantitative Qualitative Transparency

Solvency requirements

Supervisory process

Market transparency

Standard approach or internal model

Efficient risk management and control

Disclosure requirements to strengthen market discipline

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Enterprise risk management to replace the traditional accounting-based focus, facilitating a stringenteconomic and holistic approach to managing risks

Enterprise risk management to replace the traditional accounting-based focus, facilitating a stringenteconomic and holistic approach to managing risks

In the past, success was measured by combined ratio and investment income – in the future, the focus will be on return on risk capital

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Divergence in opinion between European regulators and the insurance industry at Level 2 (selected issues)

European regulators & insurance industryEuropean regulators & insurance industry

Insurance industry perspectiveInsurance industry perspectiveEuropean regulators perspective

Level 1

Level 2/3

Pillar 3Pillar 3

Pillar 2Pillar 2

Pillar 1Pillar 1

Comprehensive reporting requirements to permit efficient supervisory review.

Increased capital requirements in general.

No consideration of diversification between solo entities of a group in risk margin.

Very strict rules for 3rd country equivalence. Preference for a discretionary approach for

countercyclical premium.

More balanced treatment of all risk categories, especially within market risk (e.g. spread risk).

Full allowance of diversification in risk margin.

More flexibility towards 3rd country equivalence. Rule-based approach for countercyclical

premium to make adjustments more predictable.

Strict requirements for the approval process for internal models.

Approval of internal models to be an achievable option without incurring excessive costs.

Content and degree of detail of reporting requirements excessive, leading to high costs.

European regulators and the insurance industry agree on a Level 1 Framework Directive that represents an

adequate compromise which must be respected as a basis for Level 2 consultation process.

The current stage of Level 2 discussion indicates a level of restriction which goes beyond the intentions of the Framework Directive.

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An aggressive asset allocation will not compensate any more technical losses – higher risk capital for venturous asset allocation

Reduction of volatile asset categories

An aggressive asset allocation will not compensate any more technical losses – higher risk capital for venturous asset allocation

Reduction of volatile asset categories

Actual products are put to test (risk capital intensive?) New products will appear (less risk capital intensive)

Actual products are put to test (risk capital intensive?) New products will appear (less risk capital intensive)

Better qualitative processes for risk steering/control Use of quantitative models for an overall risk modelling Value proposition of risk transfer is measurable

Better qualitative processes for risk steering/control Use of quantitative models for an overall risk modelling Value proposition of risk transfer is measurable

Assets and Liabilities will be evaluated by a "market value approach" The available capital will rise but the volatility will be higher in time

Assets and Liabilities will be evaluated by a "market value approach" The available capital will rise but the volatility will be higher in time

Identification and evaluation of all relevant risks Long term products will require more capital (more volatile)

Identification and evaluation of all relevant risks Long term products will require more capital (more volatile)

1.1.

2.2.

3.3.

4.4.

5.5.

Asset RiskAsset Risk

Product adaptationsProduct adaptations

Risk management & transparency

Risk management & transparency

…and Available capital too…and Available capital too

Capital requirements will rise…

Capital requirements will rise…

Some general assumptionsSome general assumptions

The impacts of Solvency II will change the insurance sector

ReasonsReasonsCriterionCriterion

Advantages of reinsurance solutions

Advantages of reinsurance solutions

Advantages of reinsurance solutions

Rating and capital strength of reinsurers are differentiating criteria

Explicit consideration of reinsurance credit risk through a deduction from capital relief (see chart1)

Rating and capital strength of reinsurers are differentiating criteria

Explicit consideration of reinsurance credit risk through a deduction from capital relief (see chart1)

Capital strength and rating of reinsurer

Capital strength and rating of reinsurer

Capital management as an additional driver for reinsurance

Comparison of internal cost of capital with the cost of reinsurance (cost of capital + administration cost + counterparty risk) will be possible and will influence decisions

Capital management as an additional driver for reinsurance

Comparison of internal cost of capital with the cost of reinsurance (cost of capital + administration cost + counterparty risk) will be possible and will influence decisions

Capital management by reinsurance

Capital management by reinsurance

Effective and available independent of capital market access

Faster and more flexible than capital market solutions

Reinsurance available to all insurance segments and provides highest confidentiality

Effective and available independent of capital market access

Faster and more flexible than capital market solutions

Reinsurance available to all insurance segments and provides highest confidentiality

1 Chart based on QIS5 technical specifications.

Agenda

1. A regulator’s view on capital adequacy: Solvency II

2. A shareholder’s view: optimizing resilience and capital efficiency

3. Limits of models and how to cope with it

Aiming for higher target capitalisation – Management intervention much more responsive than supervisory scheme

Munich Re solvency ratioMunich Re solvency ratioMunich Re actions1Munich Re actions1 Regulatory actions2Regulatory actions2

Capital repatriation Increased risk-taking Holding excess capital to

meet external constraints

Capital repatriation Increased risk-taking Holding excess capital to

meet external constraints

1 Based on Munich Re capital model (MRCM): 175% of VaR 99.5%.2 Based on Solvency II calibration: VaR 99.5%.

Obligation to submit a short-term realistic finance scheme

Regulator may restrict or prohibit the free disposal of insurer's assets

Ultimate supervisory intervention: Withdrawal of authorisation

Obligation to submit a short-term realistic finance scheme

Regulator may restrict or prohibit the free disposal of insurer's assets

Ultimate supervisory intervention: Withdrawal of authorisation

>140%Excellent capitalisation>140%Excellent capitalisation

Tolerate and monitor (Partial) suspension of

capital repatriation

Tolerate and monitor (Partial) suspension of

capital repatriation

100%–140%Comfortable capitalisation100%–140%Comfortable capitalisation

80%–100% Adequate capitalisation80%–100% Adequate capitalisation

<80% Below target capitalisation<80% Below target capitalisation

Risk transfer Scaling down of activities Raising of (hybrid) capital

Risk transfer Scaling down of activities Raising of (hybrid) capital

35–100% Below target capitalisation35–100% Below target capitalisation

Obligation to submit a comprehensive and realistic recovery plan

Insurer to take necessary measures to achieve compliance with the SCR

Obligation to submit a comprehensive and realistic recovery plan

Insurer to take necessary measures to achieve compliance with the SCR

<35% Insufficient capitalisation<35% Insufficient capitalisation

2008 2009 2010 2011

140%

100%

80%

245%

175%

140%

100%

35%

Solvency IIMRCM

Solvency ratio adjusted for capital repatriation

Actual solvency ratio

Elements of Munich Re’s Enterprise Risk Management

Risk modelling

Central competition factorin the right balance

between flexibility and stability

Risk steering

Intelligent system consistingof triggers , limits und measures …

In cooperation

…with responsible management actions

Risk management culture as solid base

Risk identification and early warningNecessity for

comprehensive overview but with special focus

on main issuesERMCycle

Risk strategy

Risk-based incentive systems

and sustainable responsibility

Clear limits indicateprecise signals for the internal & external world and define the framework for operative actions

Risk modelling

Risk identification & early warning

Sound risk governanceand effective risk management functions

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E.g.:E.g.:

Strategic Risk Management Framework of Munich Re

Wholeportfoliocriteria

Wholeportfoliocriteria

OthercriteriaOthercriteria

Financial strengthFinancial strength

Counterparty-credit risk Single risks Alternative investments Non-investment-grade

investments

Counterparty-credit risk Single risks Alternative investments Non-investment-grade

investments

CategoryCategory Risk criteriaRisk criteria Criteria's objectiveCriteria's objectiveMeasureMeasure ERM objective addressedERM objective addressed

Safeguarding sufficient excess capital and limiting frequency of negative economic results of Munich Re's entire risk portfolio.

Safeguarding sufficient excess capital and limiting frequency of negative economic results of Munich Re's entire risk portfolio.

Limiting risks that could sustainably damage the trust of stakeholders in Munich Re

Limiting risks that could sustainably damage the trust of stakeholders in Munich Re

ERC Rating Solvency

ERC Rating Solvency

Individual risk limits in absolute value

Individual risk limits in absolute value

Negative economic earnings tolerated every 10 years

Negative economic earnings tolerated every 10 years

Maintaining Munich Re's financial strength, thereby ensuring that all liabilities to our clients can be met

Protecting and increasing the value of our shareholders' investment

Maintaining Munich Re's financial strength, thereby ensuring that all liabilities to our clients can be met

Protecting and increasing the value of our shareholders' investment

Safeguarding Munich Re's reputation, thus perpetuating future business potential

Safeguarding Munich Re's reputation, thus perpetuating future business potential

Avoiding financial distressAvoiding financial distress

Supple-mentarycriteria

Supple-mentarycriteria

Limiting losses from individual risks or accumulation exposure and liquidity risks that could endanger Munich Re's survival capability.

Limiting losses from individual risks or accumulation exposure and liquidity risks that could endanger Munich Re's survival capability.

VaR limits as % of AFR or limit for maximum exposure

VaR limits as % of AFR or limit for maximum exposure

Peak risk management

ALM limits Liquidity

Peak risk management

ALM limits Liquidity

Longevity Financial

sector limit

Individual nat cat perils

Terrorism Pandemic

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Risk Management CultureSteering based on economic principles

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• Define the risk appetite• Set limits and budgets for peek exposures • Calculate adequate risk capital per segment

Business planning Pricing

Performance evaluation and incentive system

The “return on risk” idea is deeply implemented in every business decision

Planning parameter take the underlying risk into account:

•RoRaC targets•Allocated risk capital•Budgets and limits

Pricing parameter take the underlying risk into account:

•RoRaC targets•Risk capital loadings•Budgets and limits

Achieved RoRaC and economical value added are parts of the incentive system

Risk strategy

Annual planning of business units as an application for scarce resources (economic risk capital)

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Service

Sup

portC

hallenging

Assessm

ent of plans

• Controlling department provides necessary data, processes and systems for an efficient business planning exercise.

Evalua

tion

of success

• Support of business units throughout the planning by dedicated controllers

• Challenging of the calculation of economic risk capital by the business units.

• Challenging of the ambition level and achievability of the plan by the controlling department.

• Discussion of critical points between business and controlling units.

• Business units „apply“ in form of a business plan for scarce resources (economic risk capital, staff), which are to be approved by the board of management.

• The board of management receives an independent assessment of the business plans from the controlling department, incl. recommendations on the approval and allocation of scarce resources.

• Assessment of target/plan achievement by the controlling department.

• Value Added und RoRaC as fundamental KPIs.

• Variable compensation linked to plan achievement.

(especially explanation of input parameters like economic risk capital or yield curves).

High shareholder returns1 with low volatility.High shareholder returns1 with low volatility.

Munich Re: Low volatility in shareholder returns with a volatile business model through efficient capital management.

1 Annualised total shareholder return defined as price performance plus dividend yield over the period from 1.1.2005 until 29.2.2012; based on Datastream total return indices in local currency; volatility calculation with 250 trading days per year. Peers: Allianz, Axa, Generali, Hannover Re, Swiss Re, Zurich Financial Services.

2 Dividend divided by year-end share price.

Efficient deployment of capital over time.Efficient deployment of capital over time.

• Volatility in single years is a function of the reinsurance business model.

• This has to be dealt with prudent risk and capital management.

• Volatility in single years is a function of the reinsurance business model.

• This has to be dealt with prudent risk and capital management.

19.04.23 15

CAGR: 12.4%

Dividend yield2 (%)

% Total shareholder return (p.a.)

Volatility of total shareholder return (p.a.)

Agenda

1. A regulator’s view on capital adequacy: Solvency II

2. A shareholder’s view: optimizing resilience and capital efficiency

3. Limits of models and how to cope with it

Resilience to shock events - 2011 as a real-life stress test (I)

Proved the value of risk modeling and active exposure management despite the inevitable problem of model uncertainty.

Confirmed the need to continuously revise and enhance underlying models.

Emphasized again the necessity for sufficient profitability thresholds to sustainably write Cat business.

Shed a special spotlight on the issue of CBI claims in the industrial primary insurance market.

2011 saw for the reinsurance segment of Munich Re a combined ratio of 113.6% of which 32.5% were due to large losses (28.8% nat cat).

Largest single losses were EQ Japan (€1.5bn), EQ Christchurch (€1.3bn) and the Flood in Thailand (€0.5bn).

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2011 Nat Cat events…

Geophysical events

Meteorological events

Hydrological eventsMajor loss events

Climatological events

FloodsThailand, Aug.–Nov.

Severe weather, tornadosUSA, 20–27 May / 22–28 April

WildfiresCanada, 14–22 May

Hurricane IreneUSA, Caribbean 22 Aug.–2 Sep.

FloodsUSA, April–May

Floods, flash floods Australia, Dec. 2010–Jan. 2011

EarthquakesNew Zealand, 22 Feb. / 13 June

Earthquake, tsunami Japan, 11 March

Resilience to shock events - 2011 as a real-life stress test (II)

• 2011 underlines the need for a limited risk-appetite and a high degree of diversification on the asset side .

• Especially as “risk-free assets” virtually ceased to exist. • Despite the turmoil Munich Re managed to achieve a RoI of ~ 3.4%.

• 2011 underlines the need for a limited risk-appetite and a high degree of diversification on the asset side .

• Especially as “risk-free assets” virtually ceased to exist. • Despite the turmoil Munich Re managed to achieve a RoI of ~ 3.4%.

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10-year German Bund yield1 Credit spreads1,2 EURO STOXX 501

–113 bps +145 bps –17%

1 Change between 31.12.2010 and 31.12.2011. 2 IBOXX EURO Corporate vs. BofAML German Government 7–10 years.

Several countries downgraded in the course of 2011.

Historically low interest rates for „secure“ government bonds.

General high volatility in the financial markets.

Limits of mathematical models for business decisions... (I)

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Changed jurisdiction Dependency on assumptions Model changes

Example: Motor UK•Motor claims in UK used to be paid as a lump sum.•Jurisdiction started to move towards periodical payments (PPOs), even retrospectively.•As a consequence, the inflation and investment risk is transferred from the insured to the (re-)insurance company.

Example: LongevityOne risk in life insurance is the average life expectation in an insured portfolio.

Example: PandemicOnly scarce empiric data is available on pandemic risks. Sensitivity of changed assumptions can be material and can change the overall assessment of a book of business.

Example: RMS11•RMS, one of the leading risk modeling companies, introduced in 2011 a revised model for US wind exposures.• As a consequence of the changes, the modeled loss expectation for several US exposures increased.

Limits of mathematical models for business decisions...(II)

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Trend risks Immanent weaknesses And now...?

Example: Bodily injury•Calculated risk capital of „long-tail“ lines of business (too?) low on a regular basis.•Biggest losses of the insurance industry happened to be in exactly this class of business (Workers comp, Motor, Asbestos).•Are trend risks, which manifest slowly, correctly captured in the models?

Example: Allocation of economic risk capital•The allocation of the group-wide modeled economic risk capital to business units / single contracts follows a mathematical algorithm.• Results of this algorithm can never fully reflect reality (the more granular - the more incorrect)

Does the systematic consideration of risk in

controlling systems create any benefit at all?

Consequences of model insufficiencies for decision making

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Communication& TransparencyCommunication& Transparency

• Principles of economic KPIs must be understood by decision makers – also with respect to the

immanent insufficiencies.

• However, the general question has to be clearly answered: an approximation of reality is clearly

better than not considering the risk factor at all.

• Value Added und RoRaC should not be taken as the only truth.

• Especially for management incentives, there should be a sense for

proportion (however, in both directions).

• Not every „scientific“ finding on risk measurement has to be immediately incorporated in

performance measurement.

• For every change in methodology it has to be assessed, if the initiated management impulse is really intended. Implementation of a gatekeeper function for model changes is advisable.

Sense of proportionSense of

proportion

Stability of models

Stability of models

•Regular review and „benchmarking“ of risk modeling results.

• Annual monitoring of input parameters by the controlling department.

• Discussion of findings with business units.

MonitoringMonitoring

Mathematical models and KPIs do not supersede common sense and entrepreneurial intuition.

Let‘s dare an outlook what the future will hold for the insurance industry...

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Ext

erna

l Dev

elop

men

tsE

xter

nal D

evel

opm

ents

• Local regulations will become more and more aligned.

• Globally, the valuation of risks will follow economic and market consistent approaches.

• Regulation will become in tendency more (and maybe too) onerous.

• Local regulations will become more and more aligned.

• Globally, the valuation of risks will follow economic and market consistent approaches.

• Regulation will become in tendency more (and maybe too) onerous.

• The lessons learned will lead in many cases to a changed assessment of risks.

• Especially the crisis in the banking sector and the sovereign debt crisis revealed severe problems in risk models.

• The lessons learned will lead in many cases to a changed assessment of risks.

• Especially the crisis in the banking sector and the sovereign debt crisis revealed severe problems in risk models.

RegulationRegulation

Financial CrisisFinancial Crisis

Inte

rnal

Rea

ctio

nsIn

tern

al R

eact

ions

• Decreasing appetite for risky bets on assets (incl. sovereign ratings).

• Increased levels of diversification.

• Higher focus on underwriting profitability will be key.

• The pure existence of internal models does not prevent negative surprises. A prudent balance of models and common sense is key.

• Decreasing appetite for risky bets on assets (incl. sovereign ratings).

• Increased levels of diversification.

• Higher focus on underwriting profitability will be key.

• The pure existence of internal models does not prevent negative surprises. A prudent balance of models and common sense is key.

Success FactorsSuccess Factors

Only if the industry draws the right conclusions, the stock markets and investors will appreciate the development.