Risk and Capital Management

Risk and Capital Management Alm. Brand Alm. Brand A/S Midtermolen 7 DK-2100 Copenhagen Ø (CVR) no. 77 33 35 17 1

Contents 1 INTRODUCTION 3 2 GROUP RISK ORGANISATION 4 2.1 Risk reporting to the board of directors and management 5 3 CAPITAL MANAGEMENT 6 3.1 Capital target 6 3.1.1 ORSA/ICAAP 8 3.2 Calculation of individual solvency need and aggregate capital requirement 8 4 THE ALM. BRAND INSURANCE GROUP 11 4.1 Individual solvency need 11 4.2 Insurance risk 12 4.2.1 Non-life Insurance risks 12 4.2.2 Life insurance risks 15 4.3 Credit risk 15 4.4 Market risk 16 4.5 Liquidity risk 21 5 ALM. BRAND BANK 22 5.1 Individual solvency 22 5.2 Credit risk 23 5.2.1 Direct banking activities 23 5.2.2 Derivative agreements 28 5.3 Market risks 29 5.4 Liquidity risk 33 5.5 Supervisory diamond 36 6 OTHER RISKS FACING THE GROUP 37 6.1 Operational risks and control environment 37 6.2 Other business risks 38 2

1 Introduction The aim of the Risk and Capital Management Report is to provide insight into Alm. Brand A/S risk and capital management. This report identifies the principal risks Alm. Brand faces. The report outlines the structure of the organisation with respect to risk management and then goes on to explain Alm. Brand s capital management. The principal risks facing the group s individual business units and the group overall are reviewed, including insurance, credit and market risks. The capital target is based on expectations regarding future capital requirements according to Solvency II (insurance companies) and Basel III (banks). The final wording of the capital requirements may cause the group s capital target to be changed. The capital requirement calculation is based on the methodologies laid down by the authorities and, as far as Non-life Insurance is concerned, on the application of an internal capital model. Unless otherwise indicated, all figures in the report are stated as at 31 December 2012. The year 2012 The financial markets were highly volatile in 2012. The growth scenario continued to have elements of both good and bad in 2012. Leading central banks have taken entirely new approaches in their efforts to stabilise the financial markets, and they seem to be succeeding. Non-life insurance operations generated a pre-tax profit for the year of DKK 853 million, against DKK 460 million in 2011. The strong profit uplift was essentially due to lower claims expenses. Alm. Brand Liv og Pension A/S posted an aggregate pre-tax profit of DKK 90 million compared to DKK 137 million in 2011. In 2012, the full risk premium was booked to equity for all contribution groups except one, for which only a partial risk premium was booked. Alm. Brand Bank posted a pre-tax loss of DKK 519 million in 2012, against a loss of DKK 1,154 million in 2011. The loss for the year remained strongly influenced by major impairment writedowns and credit-related value adjustments resulting from the difficult market conditions. Upcoming legislation Solvency II is the set of rules that will apply to the group s insurance operations in future. These rules will change the calculation of capital requirements in a number of ways, including the calculation of provisions for life insurance companies. The final wording of the requirements for calculation of provisions under Solvency II is a key determinant of the extent of the capital requirements, as the distribution among provisions, capital base and buffer has a major impact on this. The implementation of the rules has been postponed from 1 January 2014 to (probably) early 2016, but until then a transition phase may be introduced to gradually phase in Solvency II in Danish reporting practice. In recent years, Alm. Brand has been preparing to meet all the requirements Solvency II is expected to comprise. The industry is in ongoing discussions with the Danish FSA about Solvency II. Judging from the calculation assumptions presently known, it is expected that the Solvency II requirement for the group overall will not be significantly different from the current individual solvency requirement. The Basel III rules are expected to introduce a requirement for an equity ratio of 10.5% of risk-weighted assets, including a capital conservation buffer. In addition, Basel III is expected to introduce a requirement for an additional 2.5% countercyclical buffer to protect the bank against future cyclical downturns. These requirements are not expected to come into force until 2019 at the earliest. 3

2 Group risk organisation The Alm. Brand Group assumes a number of risks, including the highly different risks associated with operating its various business areas and the more uniform financial risks related to managing its liquidity and investment strategy. Managing the Alm. Brand Group s risk exposure is a key executive focus, because uncontrolled developments in different risks may have a substantial impact on the group s financial performance and solvency and hence its future business potential. The board of directors of each individual subsidiary defines and approves the overall policy for the company s acceptance of risks, and the board of directors determines the overall limits for such risks and the required reporting. On this basis, the individual management boards determine each subsidiary s operational risk management. The statutory audit committee supports the board of directors, among others, in the risk and capital management work. The audit committee is composed of three members of the board of directors of the relevant group company. The figure below shows the group s organisation. Internal audit Compliance Board of directors Audit committee ORSA/ICAAP Risk reports Recommandations Policies Guidelines Management committee Risk committee Management board Investment committee Follow-up Monitoring Business processes Operational risk forum Organisation Alm. Brand has set up a group risk committee to ensure coordination and uniformity in the group companies with respect to accepting, calculating and reporting risk. In addition, a group investment committee has been set up to ensure that the group s investments and market risks are within the limits defined by the board of directors and the policies of the individual companies. A compliance function has been established at group level to ensure that Alm. Brand complies with applicable legislation, regulations, internally defined rules and guidelines as well as ethical standards. 4

Independently of the controls defined, the internal auditors conduct regular independent reviews of the group s control procedures and monitor compliance with management s guidelines. Alm. Brand has a forum for operational risk, which collates information about operational events in Alm. Brand Forsikring and Alm. Brand Bank. Participating in this forum are Risk Management, Compliance and Internal Audit. Business risks are managed in the individual business areas. The management of each business area is hence responsible for identifying, quantifying and monitoring all risks relevant to their business area and for defining and implementing relevant risk management controls and strategies. In addition, an approval committee for financial products has been set up. This committee is responsible for ensuring that business procedures, processing routines, etc. are in place before new products or activities are implemented, thereby helping to mitigate operational risk. 2.1 RISK REPORTING TO THE BOARD OF DIRECTORS AND MANAGEMENT Alm. Brand has laid down processes for current reporting of risks and risk management to the management boards and boards of directors of the group and the relevant subsidiaries. Risk reporting is an integral part of the current management reporting, keeping the management and board of directors of Alm. Brand A/S and of each group subsidiary regularly informed about developments in lending, premiums and claims records, market risks, risk allocation, performance, etc. The measurement is carried out in various IT systems depending on the specific business and risk area, and the resulting data is then ready to go through one or more stages before becoming part of the reporting. Current identification and monitoring of market risks take place in interaction between the individual business areas and the group risk management department, which has a coordinating responsibility for the management of market risk at group level. The risk management department performs daily market risk calculations and verifications for the individual business areas. Interest rate risk is calculated at different relevant aggregation levels, such as portfolio level, company level and group level, and compared to relevant benchmarks. For departments trading in interest rate options, the maximum percentage loss in the event of a given interest change is also measured. A part of the equity portfolio is unlisted, meaning that these equities are not marked to market on a regular basis. Valuation of the equities is based on the net asset value calculated on the basis of the company s most recent financial statements. Illiquidity also characterises the pricing of mortgage deeds, which are therefore priced using a mark-to-model approach. Where sufficient liquidity is deemed to exist in the market, the most recent, publicly available trading price may be applied. 5

3 Capital management The purpose of capital management is to ensure a healthy business. This section describes the capital management and capital requirement calculation method applied by the Alm. Brand Group and shows the calculation of the individual solvency need and the adequate capital base. 3.1 CAPITAL TARGET The capital target reflects management s goal that the group s capital resources should be sufficiently robust to absorb a number of external events or highly adverse developments in the financial markets. The capital target means that Alm. Brand aims to hold capital at a level substantially higher than the statutory minimum capital requirements expected to be laid down in Solvency II and Basel III. The group s overall capital resources and capital target The capital target of the Alm. Brand Group is defined as the sum of the capital targets of the three subsidiaries less a diversification effect of DKK 300 million. The table below shows Alm. Brand A/S capital base and capital targets: CAPITAL TARGET DKKm CAPITAL BASE DKKm Non-life Insurance (40% of gross premiums) 1,946 Consolidated equity 4,506 Life Insurance (9% of life insurance provisions) 1,065 Intangible assets 0 Alm. Brand Bank Tax assets -665 (3% higher than individual solvency need or 13%) 1,858 Supplementary capital 1,654 Capital tied-up in minority interests 40 Diversification effect -300 Total capital target 4,609 Total capital base of the group 5,495 Statutory capital requirement of the group at end-2012 3,085 Excess relative to statutory capital requirements 2,410 Excess relative to internal capital target 2012 886 2011 160 The difference between the aggregate capital base and the capital target of the Alm. Brand Group was DKK 886 million at 31 December 2012. On 26 February 2013, Alm. Brand A/S contributed DKK 700 million to Alm. Brand Bank. The capital injection is made to ensure that the bank has adequate capital excess coverage and will be used to repay DKK 430 million of the state-funded hybrid core capital, which currently totals DKK 856 million. The group will carefully monitor the capital excess coverage in the upcoming periods and, when deemed prudent, the outstanding amount of the state-funded hybrid core capital will be repaid in full or in part. The capital target basically consists of two parts: the statutory minimum capital requirement/solvency need ensuring that customers can withdraw their money and an extra capital buffer on top of the statutory requirement ensuring that the company can continue as a going concern. At 31 December 2012, the excess relative to the statutory capital requirement amounted to around 6

DKK 1.5 billion for the group overall and around DKK 1.2 billion for the insurance group, making for an aggregate capital target of around DKK 2.7 billion including the diversification effect. At 26 February 2013, Alm. Brand Forsikring made an extraordinary dividend distribution of DKK 500 million to the parent company Alm. Brand A/S. Alm. Brand Liv og Pension and Alm. Brand Bank had capital excess coverage relative to the capital target of DKK 554 million and DKK 298 million, respectively, at 31 December 2012. Capital target of the Non-life Insurance group At year-end 2012, Alm. Brand Forsikring changed the method for calculating the individual solvency need. Until that point, the individual solvency need was calculated on the basis of the standardised model for calculating SCR according to QIS4 with a few adjustments. The new approach is also based on QIS4, but premium and reserve risk and natural catastrophes for all lines, except for workers compensation and personal accident, are calculated using Alm. Brand s internal capital model. The transition to the new model means that the individual solvency need is reduced by DKK 118 million relative to the old model. The solvency requirement is lower than the standardised model applying input from the capital model, as such input is based on Alm. Brand s actual risk profile. For that reason, the capital target is lowered relative to the level prevailing throughout 2012 from 45% of gross premiums to 40% of gross premiums in Alm. Brand Forsikring. This equals a reduction of around DKK 215 million. The capital target consists of a capital buffer added to the solvency capital requirement. As a result of this capital buffer of just over DKK 1 billion. Non-life Insurance has, in addition to the prudence already comprised in the rules for calculating the solvency capital requirement, calculated capital excess coverage sufficient to withstand a 1:200-year loss event without becoming insolvent. The buffer is calculated based on diversification between the companies and application of input from the internal capital model in a QIS4 standardised model. There is uncertainty about the rules on individual solvency to be implemented in Denmark effective from end-2013. The new rules may entail a requirement that all companies have to apply the Solvency II QIS5 standardised model in their calculation, but perhaps it will also be possible to continue to apply an internal capital model for Non-life Insurance operations. If the Solvency II QIS5 standardised model is applied without input from the internal capital model, the defined capital target will still provide the Alm. Brand insurance group with substantial excess. The capital target of Alm. Brand Liv og Pension totalled 9% of life insurance provisions at 31 December 2012 but was lowered to 8.75% effective 1 January 2013. Focus is on risk in the form of the volatility of provisions rather than calculating the capital target based on premium levels. In step with outflow on the portfolio s high guarantees and inflow of new insurances on low guarantees, the risk on the company s portfolio will diminish. Alm. Brand Liv og Pension is therefore intending to adjust its capital target, lowering it to 8% in 2016 by way of a gradual reduction of 0.25 of a percentage point per year. The capital target of Alm. Brand Liv og Pension is considerably higher than the SCR but has been fixed so as to ensure the desired excess relative to the SCR under a number of specific stress scenarios. This means that Alm. Brand Liv og Pension will be able to withstand interest rate fluctuations without customer returns being unduly reduced through forced sales or an unnecessary and expensive hedging strategy. Capital target of Alm. Brand Bank The capital target of Alm. Brand Bank has been fixed at an excess cover corresponding to a solvency ratio of at least 13.0, always provided that the target must be at least 3 percentage points higher than the individual solvency need. The capital structure will be based primarily on equity after repayment of the outstanding state-funded hybrid core capital, which will take place as and when possible. In doing so, Alm. Brand will be abreast of the future requirements of the Basel III rules in terms of capital adequacy. The capital target of Alm. Brand Bank has been calculated based on management s desire to consistently maintain an excess cover relative to both the individual solvency need and the statutory minimum requirement of 8% of risk-weighted assets. Several capital elements, e.g. equity, hybrid core capital and subordinated capital, contribute to meeting the capital target. 7

3.1.1 ORSA/ICAAP Important elements enabling the board of directors to ensure compliance with future capital requirements are the ORSA report for Alm. Brand Forsikring and Alm. Brand Liv og Pension and the ICAAP report for Alm. Brand Bank. The reports keep the board of directors up to date on the relevant company s capital and risk issues. In connection with the adoption of the budget for the upcoming year, the group s management considers whether the current capital base is adequate to ensure the desired strategic flexibility. This is done on the basis of sensitivity and scenario analyses. The choice of scenario is based on the areas assessed to have the greatest impact on the group. The scenarios for 2013 are outlined below: SCENARIOS IN ALM. BRAND 1. Decline in interest rates (100 bps) and decline in equities (15%) 2. Spread widening (100 bps) 3. Decline in interest rates (100 bps), decline in equities (15%) and spread widening (100 bps) 4. Credit scenario for mortgage deeds (unemployment increases by 20%, residential housing prices decline by 9% and commercial property prices decline by 20%) 5. Credit scenario for other loans and advances (gross collateral security declines by 10% and 5% of the healthy portfolios are marked for objective evidence of impairment) 6. All scenarios (3+4+5) at the same time The above scenarios are calculated each month and submitted to the board of directors of Alm. Brand on a quarterly basis. Each subsidiary prepares its own scenario analyses, which are presented to that subsidiary s board of directors at both company and group level. These scenarios include insurance risks and operational risks. The scenarios are also used in the ongoing monitoring of risk appetite. 3.2 CALCULATION OF INDIVIDUAL SOLVENCY NEED AND AGGREGATE CAPITAL REQUIREMENT The boards of directors of Alm. Brand s subsidiaries are responsible for identifying and quantifying the principal risks which the company currently faces or may face in future. Moreover, the board of directors approves the results and methodology relative to the calculation of the capital requirement. The management board is responsible for ensuring that instructions from the board of directors are actually implemented in the company and for ensuring that the board of directors is informed about significant changes in the assumptions underlying the capital requirement or the amount thereof. The aggregate capital requirement is calculated for all of the group s companies subject to supervision. Responsibility for calculating the capital need per subsidiary rests with the individual subsidiaries, while overall modelling responsibility rests with the group risk management department. This approach ensures that risks are assessed where the relevant expertise is available. The risk management department supports this process in all subsidiaries by calculating the market risk of the assets and subsequently by consolidating the capital need of the subsidiaries at group level. The internal audit department is responsible for performing an independent evaluation of the calculation of the individual solvency need. 8

The table below shows how the different risks are assessed by Alm. Brand. RISKS Insurance Banking group Alm. Brand Alm. Brand group Methodology Group Group QIS4 described by Internal models/ Internal the Danish FSA methodology assessments PILLAR 1 Insurance X X Credit X Market X X Operational X X PILLAR 2 Liquidity X Growth in business volume X Control environment X Strategic X Reputational X Settlement X External X Earnings X Concentration X X Calculation of the capital requirement and individual solvency need Each individual company s aggregate capital requirement is calculated as the higher of the minimum capital requirement, the solvency requirement and the adequate capital base/the individual solvency need. The aggregate capital requirement of the Alm. Brand Group is calculated as the sum of the aggregate capital requirements of all subsidiaries. The figure below shows the capital bases and capital requirements of each subsidiary. 6,000 Capital requirement Capital base 5,000 4,000 3,000 2,000 1,000 0 Life Insurance Non-life Insurance Insurance group Banking, parent Banking group A/S group The aggregate capital requirement of the Alm. Brand Group is DKK 3,085 million with a corresponding capital base of DKK 5,495 million. 9

Composition of capital in Alm. Brand In light of the strong insurance performance in 2012, the group s capital base has been lifted compared with 31 December 2011. See the table below. The composition of capital is largely unchanged, although the supplementary capital has declined by DKK 100 million due to the bond maturity effect on the amount includable. Capital base of Alm. Brand Bank and the Alm. Brand Group ALM. BRAND BANK ALM. BRAND GROUP DKKm 2011 2012 2011 2012 Equity/Core capital (Tier 1) 1,093 996 4,206 4,506 Proposed dividends 0 0 0 0 Intangible assets 0 0 0 0 Deferred tax assets -459-287 -600-437 Core capital less primary deductions 634 709 3,606 4,069 Hybrid core capital (included in core capital) 634 709 1.030 1.030 Core capital including hybrid core 1,268 1,418 4,636 5,099 capital less primary deductions Other deductions -15-16 -666-682 (half of the solvency need in subsidiaries) Core capital including hybrid core 1,252 1,402 3,970 4,417 capital less deductions Supplementary capital 721 546 575 475 Capital base (before deductions) 1,973 1,948 4,545 4,892 Deductions in capital base -15-16 -666-682 (half of the solvency need in subsidiaries) Capital base (after deductions) 1,958 1,932 3,879 4,210 Solvency ratio 16.8 19.4 27.6 31.9 Core capital (Tier 1) including hybrid core capital and capital base is calculated in accordance with the Executive Order on the Calculation of Capital Base. When including Alm. Brand A/S DKK 700 million capital injection into Alm. Brand Bank made on 26 February 2013 and a partial repayment of DKK 430 million of the state-funded hybrid core capital, the solvency ratio will increase to 22.1% for the Alm. Brand Bank parent company and drop to 28.6% for the Alm. Brand Group. The bank s capital base less deductions will then amount to DKK 2.2 billion. 10

4 The Alm. Brand insurance group The organisation of Alm. Brand is structured to the effect that Alm. Brand Liv og Pension is a subsidiary of Alm. Brand Forsikring, which is in the business of Non-life Insurance. The Alm. Brand Group s core business is Non-life Insurance. Alm. Brand is the fourth largest non-life insurer in the Danish market with annual gross premium income of DKK 4.9 billion and a market share of around 10%. Non-life Insurance focuses exclusively on the Danish market with a special segment focus on private customers, small and medium-sized businesses, property owners and property administrators, agricultural customers and the public sector. The group has deliberately opted not to focus on major corporate and marine customers, as competition for these customers increasingly takes place at the pan-nordic level. The group offers Non-life Insurance products to selected segments through several different distribution channels. The private customer portfolio comprises approximately 400,000 customers, 200,000 of whom are full-service customers who have largely all of their insurances with the company. The commercial and agricultural customer portfolio comprises approximately 100,000 customers. The life insurance activities of Alm. Brand Liv og Pension comprise life insurance, pension savings, pension insurance and health and personal accident insurance. The group s pension operations focus on individual schemes and on small and medium-sized corporate schemes. Target groups are private individuals, owners and employees of small businesses and farmers, all of whom are offered a pension concept tailored to their specific needs. The group has opted not to offer labour market pensions proper. The product range comprises insurance cover and various types of savings. The principal insurance types are coverage on death, reduced capacity for work and critical illness. Savings comprise capital pension plans, instalment pensions and annuity schemes. 4.1 INDIVIDUAL SOLVENCY NEED The boards of directors of Alm. Brand A/S, Alm. Brand Forsikring A/S, Alm. Brand Liv og Pension A/S and Alm. Brand Bank A/S consider the companies individual solvency needs on a regular basis. Until 31 December 2012, Alm. Brand Forsikring and Alm. Brand Liv og Pension used the QIS4 standardised model for the calculation of Pillar I risks (insurance risk, market risk, biometric risk and operational risk) as well as a number of stress tests for the quantification of the solvency need for other risks. The process implies that a diversification effect is deducted in the calculation of the aggregate risks, as the probability of simultaneous occurrence of all risks is minimal. Moreover, the expected results are offset. For Alm. Brand Liv og Pension, only the results attributable to the unconditional shares are offset, i.e. the company s return on equity and the portfolio of insurances without bonus entitlement. The reason why Alm. Brand Liv og Pension does not deduct conditional shares, i.e. the company s risk premium, is that they will probably be forfeited in the year in question if the solvency scenarios materialise. In particular, life insurance companies may furthermore deduct collective bonus potential and to a certain extent bonus on paid-up policies from the individual solvency need. The Solvency I requirement of Alm. Brand Liv og Pension is deducted from the statement of capital base of Alm. Brand Forsikring. There is no need to reserve capital for the risk in Alm. Brand Liv og Pension in the individual solvency need of Alm. Brand Forsikring, as this is already included through a reduction of the capital base. Alm. Brand Forsikring has developed an internal capital model, which as from end-2012 will be used to calculate the individual solvency need of Alm. Brand Forsikring by computing natural catastrophe risks and premium and reserve risks but not in relation to 11

workers compensation and health and personal accident insurance. The internal capital model is based on Alm. Brand s own data and thus tailored to Alm. Brand s risk scenario. For Non-life Insurance, the expected results will no longer be directly offset, whereas this will still be relevant for Alm. Brand Liv og Pension. The individual solvency need of the Alm. Brand insurance group at 31 December 2012 is shown below. RISK TYPE (DKKm) 2011 2012 Market risk 1,025 1,104 Insurance risk 1,128 672 Biometric risk 194 183 Health risk 507 471 Counterparty risk 114 74 Diversification -536-521 Operational risk 127 130 Applied bonus potential and PAL -717-858 Other risks -270 40 1,572 1,295 The aggregate capital requirement of Alm. Brand Forsikring was DKK 1,295 million at 31 December 2012, against DKK 1,572 million at 31 December 2011. This decline was due to the transition to using the internal capital model in Non-life Insurance as well as to the development in the country spread, which is incorporated in the yield curves of the Danish FSA, having the effect that this risk currently does not contribute to Alm. Brand Liv og Pension s aggregate capital requirement. The aggregate capital requirement of Alm. Brand Liv og Pension was DKK 511 million at 31 December 2012, against DKK 440 million at 31 December 2011. The aggregate capital requirement of Alm. Brand Liv og Pension is greater than the individual solvency need because of the higher Solvency I requirement. 4.2 INSURANCE RISK For Alm. Brand, insurance risk comprises both Non-life Insurance risks, i.e. risks related to Non-life Insurance products, and biometric risks related to life insurance and pension products. Non-life Insurance risks are mainly reduced by way of reinsurance, efficient claims processing and acceptance and writing rules at customer and product level. The core business of Alm. Brand Liv og Pension are the biometric risks comprising mortality, life expectancy and disability, but these risks are limited by health declarations, which all customers are required to provide. 4.2.1 NON-LIFE INSURANCE RISKS Alm. Brand writes insurances for private customers, small and medium-sized business enterprises, property owners and administrators as well as agricultural and public sector customers. In all significant areas, it has been considered what the desired risk profile of Non-life Insurance is. Business procedures and controls in that respect have been designed and reports are submitted to the board of directors and management board of Alm. Brand Forsikring on a regular basis. 12

The board of directors has defined precise guidelines for the Non-life Insurance risks that Alm. Brand Forsikring may accept. For example, for each industry the board of directors has considered the maximum acceptable loss on a claim expressed by the company s maximum retention. Storms and similar natural catastrophes may hit many insurances at the same time, and the board of directors has also approved the company s coverage for this loss exposure. The management of risk tolerance in connection with new business written is set out in the company s acceptance policy. The acceptance policy provides rules for the types and size of risks that can be written in individual contracts. The lines posing the greatest risk to Alm. Brand from an overall point of view are workers compensation, properties and motor insurance. In autumn 2012, Alm. Brand concluded an agreement with insurance company AIG on the writing of workers compensation insurances. In future, AIG will write all of its workers compensation insurances through Alm. Brand. Accordingly, Alm. Brand will fix prices and conditions and manage claims processing under the agreement. Alm. Brand already has a growing portfolio in the workers compensation insurance market. The new agreement will give Alm. Brand access to a customer portfolio which is expected to drive up the group s premium income by an amount in the double-digits of millions in 2013. The new collaboration agreement provides Alm. Brand with a new significant distribution channel. Overall, this will result in an increase in the SCR, although at a limited effect. The control environment is a big priority. A large number of ad hoc random tests are performed regularly in specific sub-areas and reported to the management board. Based on the results of these random tests, it is determined whether the acceptance policy has been observed and, on this basis, a number of proposals for improvements are prepared. This may, for example, imply updating of business processes, additional training of employees, restructuring of competencies on a greater number of employees and more quality measurement. Before a new significant product is introduced, analyses of profitability and potential market, operational and credit risks need to be performed. This ensures that the risks associated with the product have been assessed before the product is offered to customers. The calculated risks are primarily assumed as premium risks (upon acceptance of the policy), reserve risks (risk of provisions being too low relative to the cost of the loss) and catastrophe risks (extreme events costs). Premium risks Premium risk is the risk that expenses related to claims and costs exceed earned premiums. This risk is assessed for each individual type of business and, accordingly, there are multiple premium risks. If, in any one year, the company records a high number of large claims, or if the tariff is out of step with trends in the underlying risk, the premium may prove insufficient to cover the claims expenses and the company s costs. The risk is reduced by using reinsurance and by frequently monitoring trends in tariff parameters. In addition to the ongoing work performed by actuaries, a Pricing Forum assesses pricing and capital return in each individual segment/industry. This forum receives a lot of its input from the sales and claims organisation but also from the internal capital model based on Alm. Brand s historic premium risk data. Another way to reduce premium risk is to ensure that acceptance and writing rules are available at customer and product level. Written risks are assessed for the possibility that several policies can be affected by the same loss event (accumulation). Moreover, each salesperson has been given instructions as to what risks can be accepted. Reserve risks Reserve risk is the risk that the claims provisions made are too low relative to the ultimate cost of claims incurred. At the end of the financial year, the company reserves funds for payment of reported but not settled claims and incurred but not reported claims. The company s claims provisions are estimated by actuaries. The payments and other liabilities to the policyholders may at a later stage prove greater than assumed at the beginning of the year and, in such case, the company will incur a loss. 13

Alm. Brand Forsikring has a provisioning committee in which key claims processors and product developers provide the actuaries with input on new trends, changed legal practice and similar issues that may impact expectations for upcoming claims payments. This provides valuable knowledge sharing and exchange of experience across the organisation, thereby ensuring that key employees can keep fully up to date. The amount of run-off gains and losses is also evaluated in the annual actuarial report relative to the expectations from the company s internal capital model. This check contributes to providing a true and fair view of the risk of run-off losses. Catastrophe risk and reinsurance Catastrophe risk is risk related to extreme events. Catastrophe risk is covered through reinsurance. An insurer can protect itself against losses by taking out reinsurance, often with major international reinsurers with a high credit rating. A reinsurance programme can be designed in different ways depending on which losses, the insurance company wishes to control. The purpose of Alm. Brand s reinsurance programme is to ensure that a single loss event or a random accumulation of large losses does not lead to unacceptable loss of capital and, moreover, to reduce the size of fluctuations in technical results. The reinsurance programme is approved annually by the management board and the board of directors. The need for reinsurance is assessed on an ongoing basis using experience from the programme s efficiency. Market experience, the company s capital resources and prices of reinsurance cover are also included in the assessment. Alm. Brand s internal capital model is also used in the risk assessment. The structure and size of the reinsurance programme is optimised according to Alm. Brand s exposure. The reinsurance department is responsible for the tactical and operational handling of reinsurance. The largest single risks in Non-life Insurance are natural catastrophes and terrorist attacks. The risk of natural catastrophes is assessed by means of a number of scenarios based on the portfolio s exposure and on a calculated probability. These show that the current reinsurance programme will provide cover at least for losses resulting from a 1:200-year storm. For 2013, Alm. Brand purchased catastrophe reinsurance up to DKK 4.1 billion with retention of DKK 75 million. The reinsurance programme covers property losses up to DKK 500 million and personal injury on personal accident and workers compensation losses up to DKK 700 million. Retention is DKK 30 million and DKK 20 million per insured event, respectively. Moreover, the company has taken out frequency cover on major property claims covering large fire losses between DKK 5 million and DKK 30 million. However, the cover will not take effect until Alm. Brand has incurred claims in the amount of at least DKK 150 million in this range. Alm. Brand has also purchased reinsurance cover for medium-size cloudburst and snow load claims up to DKK 200 million. This will cover losses between DKK 7.5 million and DKK 75 million after an aggregate claims payment of DKK 100 million. Motor (comprehensive and liability) and liability claims in general are covered together with retention of DKK 20 million. The reinsurance programme provides extensive and broad coverage. The greatest risk in connection with the programme is whether the upper limit for catastrophe reinsurance is adequate. If the coverage is too high, the company will pay an unnecessary reinsurance premium, and if the coverage is too low, the company will risk having to pay large unforeseen expenses. Alm. Brand s risk in the event of a terrorist attack is considered to be covered by the so-called terrorism pool and the government guarantee scheme covering nuclear, biological or chemical loss events and by the relevant parts of the reinsurance programme after retention under the relevant programmes or to be exempted in the risks insured. Alm. Brand has taken out specific coverage for selected buildings in relation to conventional terrorist attacks. 14

4.2.2 LIFE INSURANCE RISKS It is standard policy with Alm. Brand Liv og Pension that customers must always provide personal health information. This means that the company has deliberately opted not to write typical labour market pensions, as such pensions may be set up without personal health information. Biometric risks related to life insurance and pension products Biometric risk comprises mortality, life expectancy and disability. The risk of disability and death is restricted by guidelines for how large a risk the company may accept. It is Alm. Brand Liv og Pension s policy to not write risk coverage without the customer providing individual health information. Moreover, risks are limited through a reinsurance programme which mitigates the effects of losses incurred on large customers. The reinsurance programme also comprises catastrophe cover in the event of several customers/lives being hit by the same event. To cover any future fluctuations in mortality or disability rates, a risk premium is added to market value provisions, which is calculated by increasing the risk intensities for mortality and disability by 12% or lowering the mortality intensities by 12% for insurance types dependent on rising life expectancy. The market value parameters for use in the calculation of market value provisions are assessed at least once a year. The return on equity principles have been adjusted to the effect that 100% of the risk result is allocated to equity. As a result, the company has reduced its dependence on the investment result but increased the risk on the core business, i.e. the biometric risk, effective from 2011. The breakdown into contribution groups means that there is no collective bonus potential in the contribution groups for mortality, life expectancy and disability, respectively. This generally means that losses incurred in these groups will be paid through equity. However, the overall buffers may be applied through the use of negative bonus, thereby limiting the risk to the reaction rate of bonus rate adjustments. Life expectancy risk has received a lot of focus recently. Alm. Brand Liv og Pension has a relatively small exposure to life expectancy, as the company s portfolio is predominantly composed of capital and instalment pensions. Alm. Brand uses the Danish FSA s benchmark for life expectancy assumptions for the calculation of provisions and the industry standard described by the Danish Society of Actuaries for the assessment of life expectancy risk. In 2012, the Danish FSA introduced the concept of realisation risk in the calculation of individual solvency. Its effect is marginal due to the scope of the annuity portfolio and also calculated on the basis of the industry standard described by the Danish Society of Actuaries. 4.3 CREDIT RISK Credit risk is the risk of incurring a financial loss due to counterparties breach of their payment obligations. For the insurance group, this risk mainly arises through reinsurers or financial counterparties. Financial counterparties may be counterparties in a bilateral derivative agreement, a bond issuer or a trading counterparty. The credit risk on bond issues is limited by means of guidelines for the desired ratings of the bond portfolios, while the settlement risk is reduced by the extensive use of settlement systems ensuring that delivery takes places simultaneously with payment. Credit risk related to reinsurance most often arises in the event that Alm. Brand s non-life reinsurers go into insolvent liquidation, resulting in a partial loss of receivables and in new coverage of the business having to be purchased. There are two types: reinsurers not being able to pay reinsurers going bankrupt and Alm. Brand therefore having to purchase new coverage 15

In order to minimise the risk related to each reinsurer, reinsurers must be rated at least A- with Standard & Poors, Moody s and/or A.M. Best. Deviations from this rating must be approved by the board of directors. The reinsurance department is responsible for following up regularly on reinsurer ratings. Moreover, Alm. Brand Forsikring limits the risk by spreading its reinsurance cover on many reinsurers. Counterparty risk arises when a counterparty in a financial agreement fails to meet its obligations. Alm. Brand Forsikring reduces its exposure to counterparties by means of margin agreements and netting with the counterparties. Margin agreements ensure that a counterparty provides collateral to another counterparty when the other counterparty s exposure to the first counterparty exceeds a certain defined level. This collateral reduces the potential loss arising in the event of a counterparty s breach. The collateral management policy is described in detail in the form of an ISDA Credit Support Annex to the ISDA Master Agreements governing the overall relationship between Alm. Brand and its counterparties. Since Alm. Brand is not rated, the collateral is not rating-dependent. COUNTERPARTY RISK ON DERIVATIVE INSTRUMENTS 31. december 2012 DKKm Non-life Insurance Life Insurance Derivatives with a positive market value 251 598 Netting 16 2 Exposure after netting 235 595 Collateral received 234 549 Exposure after netting and collateral 1 46 Netting is described in the ISDA Master Agreements and means that gains and losses on derivative financial instruments may be offset if a counterparty breaches its obligations. Agreements on derivative financial instruments of a longer-term nature can only be concluded if they also have a netting agreement with collateral provided. If deemed expedient, deviations from this general rule may in rare circumstances be accepted subject to management consent. 4.4 MARKET RISK The strategic market risk aim is to achieve an optimum return without putting the capital bases of Alm. Brand Forsikring and Alm. Brand Liv og Pension at risk of significant deterioration due to financial market developments or financial difficulties of individual counterparties. Market risk is the risk of loss caused by fluctuations in assets and liabilities resulting from changes in market conditions. The boards of directors of Alm. Brand Forsikring and Alm. Brand Liv og Pension annually adopt an investment policy and associated guidelines determining benchmarks and investment limits, thereby ensuring the desired risk profile. The market risk policy aims to ensure that risks assumed from time to time are calculated and reflect the company s business strategy, risk profile and capital resources. The management board delegates powers to the relevant entities of the company in question. The Alm. Brand insurance group uses different models for the calculation and management of risk on assets and liabilities as well as stress testing in the form of e.g. the Danish FSA s risk and capital assessments (traffic lights and QIS risk scenarios). The company uses derivative instruments to ensure that, for instance, the interest rate, currency and inflation exposure on assets is adequate. The guidelines are specified by and allocated to relevant operational business areas in market risk instructions to be checked against the risk positions and reported to management. The risk management department is responsible for an independent calculation, verification and reporting of risks. The risk management department is organisationally separate from the operational business areas accepting risks for the group in connection with the performance of investment activities. 16

The table below shows the market risk calculated at 31 December 2012 and the change since 31 December 2011 for Alm. Brand Forsikring and Alm. Brand Liv og Pension, respectively, as well as the individual solvency contribution of the individual market risk factors. ALM. BRAND FORSIKRING EXCLUDING SUBSIDIARIES Market risk (DKKm) 2011 2012 Interest rate risk 68.6 76.0 Equity risk 6.6 3.9 Property risk 4.7 3.1 Credit risk 34.4 41.5 Concentration risk on equities, bonds, etc. 0.0 0.0 Currency risk 11.9 13.5 Less diversification effect (QIS4) -33.9-35.5 Total market risk 92.3 102.6 Alm. Brand Forsikring s market risk has increased by DKK 10 million since 31 December 2011. The increase was mainly attributable to a greater difference in interest rate risk on assets and liabilities, respectively. The higher credit risk was attributable to portfolio changes and effects resulting from developments in the underlying markets. ALM. BRAND LIV OG PENSION GROUP Market risk (DKKm) 2011 2012 Interest rate risk 360.5 379.8 Equity risk 475.8 519.1 Property risk 295.3 286.8 Credit risk 91.7 115.5 Concentration risk on equities, bonds, etc. 24.1 12.9 Currency risk 68.5 118.8 Less diversification effect (QIS4) -384.1-432.1 Total market risk 931.8 1,000.8 Alm. Brand Liv og Pension s market risk has increased by DKK 69 million since 31 December 2011. The increase was mainly attributable to higher equity and credit risks, among other things, due to developments in the underlying markets in 2012. The increase in currency risk was, among other things, attributable to a combination of developments in the markets for emerging market bonds, which improved in 2012, and Alm. Brand Liv og Pension having exposure against these markets in local currency. At least once each month and otherwise as needed, Alm. Brand Liv og Pension carries out sensitivity analyses on the expected profit for the year and on the individual solvency need according to a selection of financial scenarios (combinations of a rise or fall in interest rates, decline in equities and a widening of the credit spread (OAS)). These calculations first show the effect of the financial scenario on provisions, collective bonus potential and equity. The individual solvency need is then calculated based on the new point of reference (new interest rate level with resulting change of shock level, new benchmark values for provisioning and bond values, new exposure to equities after scenario, new collective bonus potential, new amount of equity, etc.). 17

In that connection sensitivity is also calculated on collective bonus potential in interest rate contribution groups, including which combinations of interest rate movements and falling equity prices use up the collective bonus potential in the group. The scenario effects and the development in the individual solvency need are then reported to the board of directors. Interest rate sensitivity on assets, liabilities and buffers is calculated in the event of immediate parallel interest rate shifts of up to +/- 2 percentage points in the Danish FSA s discount rates after tax on pension investment returns (PAL). Limits for the company s risk tolerance have been defined relative to different scenarios. The interest rate sensitivity limit is set at a maximum loss of DKK 600 million after netting of bonus potentials at a given parallel shift in the yield curve. Alm. Brand Liv og Pension s principal market risks are related to insurances with guaranteed benefits. Until 1994, Alm. Brand Liv og Pension wrote policies with average guaranteed benefits calculated by means of an interest rate of 4.5% after PAL. From 1994 to 1999, an interest rate of 2.5% after PAL was used, and from 1999 the rate was 1.5%. With effect from 1 April 2011, the interest rate was lowered once again to stand at 0.5%. Alm. Brand Liv og Pension s insurance portfolio is divided into four interest rate groups characterised by the different guarantee levels on which the insurances are based. There are fair-sized investment buffers on low interest rate groups, whereas the highest interest rate group had only a very limited investment buffer at 31 December 2012. The investment strategies of the individual interest rate groups are carefully designed to match the investment buffers of each individual group. This means that the highest interest rate group has a relatively small share of higher-risk assets relative to provisions. Alm. Brand Liv og Pension has introduced the principle that the full amount of any surplus on the policies interest rate, risk or expense results must be used to lower the future required rate of return on the insurances. This gradually reduces the guarantees for the interest rate groups and has the effect that, over time, they will be moved to interest rate groups with lower guarantees. No new business is written in the highest group, which predominantly consists of insurances under disbursement or close to retirement. As a result, the portfolio dwindles automatically. The tax reform coming into force in early 2013 is expected to further accelerate this trend. The reform, among other things, entails a tax rebate in 2013 for policyholders withdrawing their capital pension savings or converting them into a new retirement savings product. Asset allocation Alm. Brand takes a cautious approach to allocation of own and customer investment funds. and has limited exposure to equities, credit and high-yielding bonds and no exposure to exotic products. The asset allocation of Alm. Brand Forsikring and Alm. Brand Liv og Pension, respectively, is shown below. Alm. Brand Forsikring Alm. Brand Liv og Pension Asset class 2011 2012 2011 2012 Government bonds 2% 1% 15% 13% Mortgage bonds 93% 93% 57% 57% Credit bonds 4% 3% 2% 3% Emerging market bonds 0% 0% 2% 3% Mortgage deeds 0% 0% 0% 0% Other interest-bearing 0% 2% 3% 3% Equities 1% 1% 9% 9% Properties 0% 0% 12% 11% 18