4.2. Risk categories

4.2.1. Market risk

Market risk is powerfully influenced by the risk of changing interest rates, particularly in the life insurance line. The risk of changing interest rates results from the “duration gap” between assets and liabilities. The revision of the current ALM strategy should bring significant improvements to this situation in the medium term.

Another major risk is the spread risk, which also affects comparable peer companies. In this category, very high capital requirements for credit structures (ABS) in the calculation methodology for future equity requirements under Solvency II are particularly important. Moreover, portfolio components such as emerging markets bonds or poorly rated state bonds are a risk driver.

The share risk of the UNIQA Group is driven especially by alternative investments such as hedge funds and private equity.

About 10 per cent of market risk comes from risks associated with land and buildings.

Other market risks, such as concentration and currency risks, play a minimal role in the UNIQA Group at this time.

There were no major year-on-year changes in terms of the methods and processes for managing and measuring these risks. Adjustments with regard to Solvency II are in the draft stage.

Description of market risk categories:

Interest risk: due to the investment structure and the high proportion of interest-bearing titles, the interest rate risk forms a very important component of the financial risks. The following table shows the interest-bearing securities and the average interest coupons arranged by the most important investment categories and their average coupon interest rate on the reporting date.

Long-term policies and life insurance policies with guaranteed interest and profit sharing

Insurance policies with guaranteed interest and additional profit sharing contain the risk that the guaranteed interest rate will not be achieved over a sustained period of time. Capital income produced over and above the guaranteed interest rate will be shared between the policyholder and the insurance company, with the policyholder receiving an appropriate share of the profit. The following table shows the comparison of assets and debts for such insurance policies.

The capital-weighted average remaining term of technical liabilities is around 9.0 years (2010: 8.0 years).

Long-term unit-linked and index-linked life insurance policies

In the segment of unit-linked and index-linked life insurance, the interest income and all fluctuations in value of the dedicated investments are reflected in the technical provisions. There is therefore no financial risk from the point of view of the insurer. The following table shows the investment structure of financial investments that are used to cover the technical provisions arising from unit-linked and index-linked life insurance policies.

Long-term health insurance policies

The actuarial interest rate for the actuarial provision in health insurance lines, which is selected depending on the type of life insurance, is 3 per cent. However, this interest rate is not guaranteed and can, upon presentation of proof to the insurance supervisory authority, be reduced to any lower capital income that may be expected. The following table shows the investment structure available to cover insurance liabilities.

Property and casualty insurance policies

Most property and casualty insurance policies are short-term. The technical provisions are not discounted, meaning that no interest is calculated for the short-term investment. The average terms of interest-bearing securities and loans invested to cover technical provisions are shown in the following table.

Evaluation of the stock of Asset-Backed Securities

The UNIQA Group held 2.5 per cent (2010: 2.6 per cent) of its investments in Asset-Backed Securities (ABS). Model risks are associated with the valuation of ABS securities.

The securities held in the direct portfolio and fund portfolio are mostly valued using a mark-to-model method.

The individual transactions vary with regard to structure, risk profile, interest claims, rating and other parameters.

UNIQA is of the view that it will not be possible to ascertain a fair value for these securities on the basis of market prices or market transactions for the year 2011 due to low liquidity. So-called market prices, insofar as these can even be identified in individual cases, pertain only in the rarest of cases to securities that are held directly in the portfolio or even to securities from the same issuer, but rather generally to another paper that is similar in terms of rating and securitisation category.

Direct transfer of such prices does not appropriately take into account either the complexity or the heterogeneity of the different structures. For these reasons, UNIQA has decided to set the fair value of the specified papers by means of a model approach.

ABS papers are noted for being highly complex and are therefore extensively documented. Due to its longstanding activity in the area of securitisation, UNIQA has developed various models on its own or with others that permit high-quality analyses at acceptable expense.

The main parameters of the model for assessing the value of ABS are estimates of the future development of the (financial) economic environment, especially the speed of repayment, the failure frequency, the failure severity and the discount rate.

All parameters refer to the assets used to collateralise the transaction, i.e. to the corporate credits, bonds, preferential shares, etc. The future payments are calculated using external forecasts for failure rates. The modelling system of Intex Solutions, Inc., which represents a widely accepted market standard, serves as the basis for the analysis. UNIQA now uses the forecasts of Moody’s Investors Service for forecasting the failure rates of companies. These forecasts encompass a period of five years each. Other parameters besides the failure rates are calibrated with the help of the data history. Objective and predetermined values are used for the discounting.

To this extent, the losses expected by an investor on a transaction are already taken into consideration when the payment streams are generated. In order to represent an additional risk discount, a risk premium above the pure interest rate was added to the applied discount rate. This premium corresponds to the surcharge originally applied on execution of the individual transaction.

The sensitivity analysis of the ABS portfolio with regard to a rise or a fall in the failure rates in the investments underlying the ABS structures is also based on the forecast values from Moody’s Investors Service.

The sensitivities for these securities subjected to model-based analysis are also determined using Moody’s failure scenarios. According to Moody’s, these failure scenarios correspond to the 10 per cent quantile or the 90 per cent quantile of the distribution function of the failures.

Valuation of STRABAG SE

UNIQA has a participating interest in STRABAG SE of 14.97 per cent as at the reporting date of 31 December 2011 (31 December 2010: 14.97 per cent). Even following the re-entry of a major investor, UNIQA retained a significant influence over the business activity of STRABAG SE. UNIQA is therefore continuing the participating interest in STRABAG SE as an associated share. In the fourth quarter of 2010, a purchase option was conceded to a strategic investor for an additional 1.4 million individual shares of STRABAG SE. It can be exercised between July 2012 and July 2014.

The valuation on the reporting date takes place in consideration of the option agreement and the expected proportional equity on the reporting date. The current market value of the option was determined as the difference between the current book value and the price for exercising the option.

Information about investments in the PIIGS nations

The EU accompanying measures by euro zone countries for Greece also anticipates participation from private investors. This is why devaluations of Greek bonds took place at the market exchange rate as at 31 December 2011. This led to depreciation of € 387,622 thousand. Currently it must be assumed that government bonds from other member countries will be completely paid back and the current risk reduction on bond prices in some European countries will not last.

The difference to the cost of acquisition of this investment (excluding Greece) affects mainly the revaluation reserve, reduced by the deferred profit-sharing arrangement (in life insurance) and deferred taxes.

ALM

The financial risks have different weightings and various degrees of seriousness, depending on the investment structure. However, the effects of the financial risks on the value of the investments also influence the level of technical liabilities to some extent. A partial dependence therefore exists between the growth of assets and debts from insurance policies. UNIQA monitors the income expectations and risks of assets and liabilities arising from insurance policies as part of an Asset-Liability Management (ALM) process. The aim is to achieve a return on capital that is sustainably higher than the updating of the technical liabilities while retaining the greatest possible security. Here, assets and debts are allocated to different accounting groups. The following table shows the main accounting groups generated by the various product categories.

These values refer to the following balance sheet items:

C. Technical provisions
D. Technical provisions for unit-linked and index-linked life insurance
G.I. Reinsurance liabilities (only deposit liabilities held under reinsurance business ceded)
G. Share of reinsurance in the technical provisions
H. Share of reinsurance in technical provisions for unit-linked and index-linked life insurance

4.2.2. Actuarial risks

Actuarial risk non-life

Actuarial risk in non-life includes premium, reserve and catastrophic risk.

Premium risk is defined as the risk of future benefits from insured events exceeding the assumptions of the premium calculation. The result is incorrect pricing for an insurance product that leads to a loss.

The reserve risk is defined as the risk that actuarial provisions for damage claims that have already occurred were not sufficient.

Catastrophic risk is defined as the risk that financial losses may occur due to natural disaster events such as storms, hail, flooding or earthquakes. These events affect a number of policyholders at once, yet do not occur on a constant basis. These events are described as low-frequency/high-severity claims.

The greatest actuarial risk in non-life in the Group is held by UNIQA property insurance and UNIQA RE. In CEE, SEE and EE, non-life business, particularly motor vehicle insurance, is in the foreground; this means that the actuarial risk of non-life is foremost in these companies.

A major risk for the UNIQA Group is the risk of natural disasters. Storm-related catastrophes are especially relevant for the north Austrian and Czech regions.

The risk of catastrophic flooding is of major significance for markets in Austria, Czech Republic, Poland, Hungary, Romania and Bulgaria.

This risk is managed accordingly with analyses of exposure to catastrophes and inclusion of such considerations in product and price formation, as well as the provisioning of appropriate reinsurance capacity.

Profitability in the core business is a decisive factor.

In the risk management process for actuarial risks in the non-life segment, standardised monitoring systems supervise Group risk management and Group actuarials monitor actuarial risks of premium risk and reserve risk on a periodic basis.

The Group segments for risk management and Group actuarials support the local companies by providing Group-wide standardised tools and professional training and education.

An essential element in risk assessment and further risk management is the use of the NON-life partial model. This risk model quantifies premium, reserve and catastrophic risk by means of a Monte Carlo simulation procedure. This quantification is conducted at insurance branch level (sector), at company level and Group level.

In addition to risk figures relevant for risk management, this risk model also delivers the economic earnings figures (RoRAC: Return of Risk Adjusted Capital) and an EVA (Economic Value Added), which are then indispensable for goal- and values-oriented company management.

These economic figures provide information about how much capital expenditure is necessary for the underwriting of various insurance products and how much profit is earned on the required risk capital.

Actuarial risk life

The risk of an individual insurance contract lies in the occurrence of the insured event. The occurrence is considered random and therefore unpredictable. The risk in life insurance outside of Austria is of minor importance due to the low volume (approximately 20 per cent). Various risks exist in Austria, particularly in classic life insurance. The insurance company takes on this risk for a corresponding premium paid by the policyholder. When calculating the premium, the actuary refers to the following carefully selected bases of calculation:

Interest: the actuarial interest is set so low that it can be produced with certainty in each year.

Mortality: the probabilities of dying are deliberately and carefully calculated for each type of insurance.

Costs: the costs are calculated in such a way that the costs incurred by the policy can always be covered by the premium.

The careful selection of the bases of calculation gives rise to scheduled profits, an appropriate amount of which is credited to the policyholders as part of profit sharing.

The calculation of the premium is also based on the acceptance of a large, homogenous inventory of independent risks, so that the randomness inherent in an individual insurance policy is balanced out by the law of large numbers.

The following risks exist for a life insurance company:

• The bases of calculation prove to be insufficient despite careful selection.
• Random fluctuations prove disadvantageous for the insurer.
• The policyholder exercises certain implicit options to his advantage.

The risks of the insurer can be roughly divided into actuarial and financial risks.

Capital and risk insurance

UNIQA's portfolio consists primarily of long-term insurance policies. Short-term assurances payable at death play a minor role.

In the following table, the number of insurance policies is divided by rate groups and insured sum categories; included here are the policies of the companies UNIQA Personenversicherung AG, Raiffeisen Versicherung AG, Salzburger Landes-Versicherung AG and CALL DIRECT Versicherung AG.

Mortality

Insurance policies with an assurance character implicitly include a safety surcharge on the risk premium in that the premium calculation is based on an accounting table (the Austrian Mortality Table for 1990/92 or for 2000/02).

Using risk selection (health examinations) means that the mortality probabilities of the portfolio are consistently smaller than those of the overall population; in addition, the gradual advancement of mortality means that the real mortality probabilities are consistently smaller than the values shown in the accounting table.

Homogeneity and independence of insurance risks

An insurance company takes great pains to compose a portfolio of the most homogenous, independent risks possible, in accordance with the classic, deterministic approach to calculating premiums. Because this is virtually impossible in practice, a considerable risk arises for the insurer due to random fluctuations, in particular from the outbreak of epidemic illnesses, because not only could the calculated mortality probabilities prove to be too low, the independence of the risks can also no longer be assumed.

Cumulative risks contained in the portfolio can be reduced by using reinsurance contracts. As the first reinsurer, UNIQA Versicherungen AG operates with a retained risk of € 200,000 per insured life; the excesses are mostly re-insured with Swiss Re, Münchener Rück and Gen Re. A catastrophic excess (CAT-XL) contract is also held with Swiss Re, although it excludes losses resulting from epidemics.

Antiselection

The portfolios of Raiffeisen Versicherung AG and UNIQA Personenversicherung AG contain large inventories of risk insurance policies with a premium adjustment clause. This allows the insurer to raise the premiums in case of a (less probable) worsening of the mortality behaviour. However, this presents the danger of possible antiselection behaviour, meaning that policies for good risks tend to be terminated while worse ones remain in the portfolio.

Retirement annuities

Mortality

The reduction of mortality probabilities represents a large uncertainty for retirement annuities. The gradual advancement of mortality as a result of medical progress and changed lifestyles is virtually impossible to extrapolate.

Attempts to predict this effect were made when producing the generation tables. However, such tables only exist for the Austrian population, and this data cannot be applied to other countries. Moreover, the past shows that the effect of these changes was seriously underestimated, which meant that subsequent reservations had to be made for retirement annuity contracts.

Antiselection

The right to choose pensions for deferred retirement annuities also results in antiselection. Only those policyholders who feel very healthy choose the annuity payment; all others choose partial or full capital payment. In this way, the pension portfolio tends to consist of mostly healthier people, i.e. worse risks than the population average.

This phenomenon is countered by corresponding modifications to the retirement mortality tables. A further possibility exists in the requirement that the intention to exercise the right to choose annuity payments must be announced no later than one year in advance of the expiration.

Financial risks

The actuarial interest that may be used in the calculation for writing new business is based on the maximum interest rate ordinance, and currently amounts to 1.75 per cent per annum (“Lebensaktie“, “Zukunftsplan“) or 2.25 per cent per annum (other life insurance policies). However, the portfolio also contains older contracts with actuarial interest of up to 4.0 per cent per annum, while the average rate for the portfolio is 2.66 per cent (2010: 2.71 per cent).

Since these interest rates are guaranteed by the insurance company, the financial risk lies in not being able to generate these returns. Since classic life insurance predominantly invests in interest-bearing titles (loans, credits etc.), the unpredictability of long-term interest rate trends is the most significant financial risk for a life insurance company. The interest risk weighs especially heavily on retirement annuities, because these are extremely long-term policies.

The interest risk functions in the following ways:

Investment and reinvestment risk

Premiums received in the future must be invested at an interest rate guaranteed at the time the policy was taken out. However, it is entirely possible that no corresponding titles are available at the time the premium is received. In the same way, future income must be reinvested at the actuarial interest rate.

Ratio of assets to liabilities

For practical reasons, the goal of duration matching cannot be fully achieved on the investment and liability side. The duration of the assets is 4.0 years (2010: 5.1 years), while for liabilities it is considerably longer. This creates a duration gap, which means that the ratio of assets to liabilities reduces as interest rates fall.

Value of implicit options

Life insurance policies contain implicit options that can be exercised by the policyholder. While the possibilities of partial or full buy-back or the partial or full release of premiums in fact represent financing options, these options are not necessarily exercised as a consequence of correct, financially rational decisions. However, in the case of a mass buy-back, for example due to an economic crisis, this represents a considerable risk to the insurance company.

The question of whether a capital or an annuity option should be exercised is, in addition to subjective motives of the policyholder, also characterised by financially rational considerations; depending on the final interest level, a policyholder will opt for the capital or the annuity, which means that these options represent a considerable (cash) value for the policyholder and therefore a corresponding risk for the insurer.

The guarantee of an annuitising factor represents another financial risk. Here, the insurance company guarantees to annuitise a sum unknown in advance (namely the value of the fund shares at maturity or, for classic life insurance, the value of the insured sum including profit-sharing) in accordance with a mortality table (the risk involved is not exclusively financial) and an interest rate set at the time the policy is taken out.

Besides these actuarial and financial risks, the cost risk must also be specified. The insurer guarantees that it will deduct only the calculated costs for the entire term of the policy. The business risk here is that the cost premiums are insufficient (e.g. due to cost increases resulting from inflation).

The capital-weighted average remaining term of technical liabilities is around 9.0 years (2010: 8.0 years).

Actuarial risk health

The health insurance business is operated primarily in Austria (82 per cent domestic and 18 per cent international). As a result, the focus lies on risk management in Austria.

Health insurance is a loss insurance calculated under consideration of biometric risks and is operated in Austria “similar to life insurance”.

Terminations by the insurer are not possible except in the case of obligation violations by the insured. Premiums must therefore be calculated in such a way that the premiums are sufficient to cover the insurance benefits that generally increase with age, assuming probabilities that remain constant. The probabilities and cost structures can change frequently over time. For this reason, it is possible to adjust the premiums for health insurance as necessary to the changed bases of calculation.

When taking on risks, the existing risk of the individual is also evaluated. If it is established that an illness already exists for which the cost risk is expected to be higher than for the calculated portfolio, then either this illness is excluded from the policy, an adequate risk surcharge is demanded or the risk is not underwritten.

In health insurance, assurance coverage (“ageing provision”) is built up through calculation according to the “type of life insurance” and reduced again in later years because this is used to finance an ever larger part of the benefits that increase with age.

The actuarial interest rate for this actuarial provision is a prudent 3 per cent, which means that the investment risk of health insurance in Austria is relatively low. If it were expected, for example, that 3 per cent could no longer be obtained in future, this fact would have to be taken into account for future benefits and included in the premium adjustment.

The legal risks arise primarily from the effects that changes to legislation have on the existing private health insurance business model. This includes, in particular, changes to the legal framework that make it harder or impossible to adapt to changed circumstances or that sharply reduce the income opportunities. Developments in this area will be observed by the insurance association, and an attempt will be made where necessary to react to negative developments from the perspective of the private health insurer.

The EU Directive on the equal treatment of men and women in insurance, which is implemented in Austria by the Insurance Amendment Act 2006 (VersRÄG 2006), was also taken into account in the calculation of premiums in the 4th quarter of 2007. This means that the costs of birth and pregnancy had to be distributed across both sexes. No significant risk to profit has been identified here.

In the meantime, a decision reached by the European Court of Justice regarding insurance policies results in a new situation as of 21 December 2012: by this point in time at the latest, only completely identical premiums are allowed for men and women, excluding considerations such as age and individual pre-existing conditions. Because yearly new business in the health insurance line does not have a very high share of the overall portfolio in this sector, we do not anticipate a high risk of miscalculation from this angle. It is more difficult to assess the problem of converting existing female policies to the new UNISEX tariff, but we can expect, based on our experience with the (partial) unisex tariff since 2007, that this risk will remain within a limited range.

The risk of the health insurance business outside Austria is dominated primarily by Mannheimer Krankenversicherung (approximately € 124.8 million in annual premiums) as well as UNIQA Assicurazioni in Milan (approximately € 31.9 million in annual premiums). Both companies currently have relatively stable holdings, meaning that risk scarcely changes. For tariffs with an outdated calculation basis, with aging holdings, the insured should be converted in the coming years to tariffs with a modern calculation basis. Because this affect tariffs that are not life-long, the conversion problem is less significant than it is for life-long tariffs.

The remaining premiums (approximately € 33.3 million) are divided among multiple companies and are of only minor importance there. Only in Switzerland (Geneva) is health insurance the primary business (approximately € 6.8 million); however, the Swiss Solvency Test resulted in sufficient risk capital.

Life-long health insurance policies without termination options by the insurer rarely exist outside of Austria, meaning that the risk can be considered low for this reason as well.

4.2.3. Other risks

Operational risks

Operational risks include losses that are caused by insufficient or failed internal processes, as well as losses caused by systems, personnel resources or external events.

Operational risk includes legal risk, but not reputation and strategic risk. Legal risk is the risk of uncertainty due to complaints or uncertainty in the applicability or interpretation of contracts, laws or other legal requirements.

The UNIQA Group’s risk management process also defined the risk process for operational risks in terms of methodology, expiration and responsibilities. The risk manager is responsible for compliance in all subsidiaries.

The particularity of operational risks is that they can surface in all processes and departments. This is why operational risks are identified and evaluated in every operational company at a very broad level in the UNIQA Group. Risk identification is carried out with the aid of a standardised risk catalogue that is regularly checked for completeness. Scenarios are defined for evaluating these risks; these scenarios are designed to convey the likelihood of occurrence and the amount of damages. The results are then presented by the risk manager in the form of an aggregated risk report.

This process is conducted twice a year on a standard basis.

Reputation and strategic risks

Reputation risk describes the risk of loss that arises due to possible damage to the company’s reputation, deterioration in prestige, or a negative overall impression due to negative perception by customers, business partners, shareholders or supervisory agencies.

Reputation risks that occur during the course of core processes such as claims processing or advising and service quality are identified, evaluated and managed as operational risks in our subsidiaries.

The most important reputation risks are presented, like operational risks, in an aggregated form in the risk report.

Group risk management then analyses whether the risk observed in the Group or in another unit may occur, and whether the danger of “contagion” within the Group is possible.

Strategic risk describes the risk that results from management decisions or insufficient implementation of management decisions that may influence current / future income or solvency. This includes the risk that arises from management decisions that are inadequate because they ignore a changed business environment.

Like operational and reputation risks, strategic risks are evaluated twice a year. Furthermore, important decisions in various committees, such as the Risk Committee, are discussed with the Management Boards.