Asset Liability Management at Munich Reinsurance Company

Asset Liability Management at Munich Reinsurance Company Helsinki, 17 th November 2004 Bernhard Kaufmann and Jochen Mayer

Agenda ALM: Governance and Management The Munich Re ALM-Model: ALM on Macro Level The general Concept The different modules Reports and Analysis ALM and pricing: ALM on Micro Level 2

Strategic objectives for ALM Deliver a return to shareholders in excess of cost of capital Operational profitability Business focus Risk limitation Financial strength Strict underwriting discipline Rigorous application of Value Based Management Commitment to financial targets Reinsurance Focus on achieving a leading market position in target markets depending on the cycle Exit business not achieving target returns Primary insurance - Comprehensive risk management Integrated view on insurance risk and financial mismatch risk De-risk balance sheet Retain clients and investors confidence Reduce dependency on equity market developments, thereby increasing flexibility Strong platform for profitable growth Sustainable strengthening of business model 3

Evolution of ALM in global insurance market 66% of insurers are less than 50% of the way through the evolutionary journey 3 4 Development of coherent Integrated Risk Management Framework ALM processes integrated with active capital management and other financial risk management processes Governance processes provides independent oversight of aggregate financial risk position ALM function and processes developed to integrate risk profiles of both assets and liabilities Management action focused on the integrated asset and liability view Governance process provides independent oversight of ALM 1 2 Enhanced awareness of the value of formalized ALM process Development of partially integrated asset and liability measurement processes ALM governance primarily focused on asset-side Identification, measurement and monitoring of asset and liability risks undertaken in isolation, with varying degrees of sophistication Limited or informal / ad hoc integration of individual risk profiles 90% of insurers believe that benefits outweigh the costs of the journey Source: Ernst & Young LLP. 2004 4

ALM in the Solvency II project Special Call for advise from CEIOPS (MARKT/2506/04-EN App.2): In the future all insurance undertakings need to have an asset-liability management system (ALM) as part of their general business and risk management processes. General principles concerning A/L analysis shall be harmonized at the EU level.... One major use for ALM in pillar I is to contribute to investment planning. standard formula for calculating the solvency capital requirement should capture the ALM risk in a sufficiently prudent approach. The pillar II supervisory review process should encompass the undertaking s ALM. 5

ALM Governance of Munich Re Group ALM GOVERNANCE LIABILITIES REPLICATING PORTFOLIO STRATEGIC ASSET ALLOCATION TACTICAL ASSET ALLOCATION ASSETS Stochastic representation of cash flows associated with insurance and reinsurance obligations on a class of business Portfolio of assets that most closely matches the risk characteristics associated with the stochastic representation of the liabilities Asset allocation targets that provide optimal level of return given the predetermined appetite of Board and other investment constraints, as dictated by external stakeholders (e.g. regulators, rating agencies) Asset allocation targets that are selected by the Asset Manager to optimize return within given investment and risk constraints The risks and cash flows associated with assets of the Group 6

Agenda ALM: Governance and Management The Munich Re ALM-Model: ALM on Macro Level The general concept The different modules Reports and Analysis ALM and pricing: ALM on Micro Level 7

What would happen if? The ALM model is an evaluation tool An optimisation tool generates, for example, a strategic asset allocation The AL-team analyses the simulated results for the considered SAA and trades off risks and chances The optimiser The AL-team The ALM model Capital market model Asset module Liability model Life Non life Corporate model Reports The ALM model simulates the implications of the considered SAA over a 5 year horizon in combination with the liabilities 8

The ALM model allows to analyse the impact of strategic decisions and changes in the general framework General framework Accounting rules Regulation Volatility sources Capital market scenarios Operative business ALM- Model Distributions of corporate results Balance sheet P&L statement Risk positions Strategic decision Investment strategy Operative strategy 9

Agenda ALM: Governance and Management The Munich Re ALM-Model: ALM on Macro Level The general Concept The different modules Reports and Analysis ALM and pricing: ALM on Micro Level 10

The different Modules Capital market model Asset model Liability model Corporate model Sub models HGB IFRS Reports 11

The capital market model: 3000 Scenarios form the basis of the ALM simulation 10% EURO Zinsraten über einen 5-Jahres-Horizont 9% 8% 7% Interest rate 6% 5% 4% 3% 2% 1% 1 Y 3 Y 5 Y 7 Y 10 Y Maturity 1% quantile 5% quantile 10% quantile 25% quantile 50% quantile 75% quantile 90% quantile 95% quantile 99% quantile start mean Short term interest rates are more volatile than long term rates For most of the scenarios interest rates are below the average In many of the scenarios the spread between long and short term rates reduces over time 12

The capital market model: Equity indices EUROSTOXX 10.000 9.000 8.000 7.000 Value 6.000 5.000 4.000 3.000 2.000 1.000-1 Year 3 Years 5 Years Horizon The mean of the chosen calibration is clearly positive: 5- year return EUROSTOXX: 6,7% p.a. The probability of a loss for the EUROSTOXX is nevertheless very high at 28%. 13

The asset model: Focus of the analysis should rule the granularity of the model MODELLING EURO ASSETS - IAS Asset Classes Market value modelling Book value modelling IAS Governments Corporates Pfandbriefe Loans (ABS/MBS) Interest yield curve (term) + Static Spreads (Dynamic Spreads) Market Value Bonds Available for sale Bonds Held to maturity Bonds Trading Loans Equities Relevant price index and divident yield (Eurostoxx) Affiliated Companies - consolidated Participations Ergo Allianz HVB Commerzbank Price index and dividend yield (DAX) Insurance index and dividend yield Banking index and dividend yield Market Value Affiliated Companies non consolidated Associated Companies Equity Available for sale Equity - Trading Real Estate Relevant real estate index Market Value Real Estate Cash Short term interest rate Market Value Cash 14

Major Non-Life Loss and Combined Ratios (Mean and Quartiles) 210% 180% 150% 120% 90% 60% 30% 0% 2003 2004 2005 2006 2007 2003 2004 2005 2006 Casualty Property 2007 2003 2004 2005 2006 2007 2003 2004 2005 2006 2007 Marine Other Asset-liability management for insurance companies The non life model simulates catastrophe, basic and large losses based on MR risk model INCURRED LOSSES AND PROVISIONS FOR OUTSTANDING CLAIMS ARE PROCESSED BY MEANS OF STOCHASTIC PAY OUT PATTERN Flexible premium and budget development (GDP, CPI) Consideration of internal/external retrocession and FRe-treaties Derivation of commission and admin expenses as ratios of earned premiums Interaction with other modules Non-Life Module Claims Division Report Ext. Retro Finite Re LoB Report Currency Report Input Output Input Input Cash Flows Balance sheet Income statement 15

Life model: reserving is strongly affected by interest rates Average "Umlaufrendite" over 10 years (yield in %) 2) 6 5.5 5 4.5 4 3.5 3 Change in Interest Sensitive Reserves 3) 2003 2004 2005 2006 0.03 2007 2008 0.025 99%-Quantil 0.02 0.015 0.01 95%-Quantil 0.005 0 2003 2004 2005 2006 2007 16

Agenda ALM: Governance and Management The Munich Re ALM-Model: ALM on Macro Level The general Concept The different modules Reports and Analysis ALM and pricing: ALM on Micro Level 17

A number of ALM reports can be generated International & local GAAP financial statements Capital market model scenarios Risk analysis Technical results Return and growth Investments and investment result 18

Balance sheet IAS m mean over scenarios ASSETS Actuals 2003 2004 2005 2006 2007 Intangible assets 131 130 130 130 130 Investments I. Real Estate 1.050 1.040 990 978 1.068 II. Investments in affiliated and associated enterprises 6.808 6.823 6.825 6.826 6.828 III. Loans (mortgage loans, loans to aff/ass) 666 580 582 604 627 IV. Other Securities - Available for sale (excluding Allianz) 14.459 14.557 14.939 15.764 17.014 - Available for sale (Allianz only) 2.347 2.483 2.656 2.884 3.060 - Trading 56 56 56 56 56 Total 16.862 17.096 17.651 18.704 20.130 V. Other investments 11.893 12.527 12.620 12.956 13.054 Total 37.279 38.067 38.667 40.068 41.706 Ceded share of underwriting provisions 1.789 1.527 1.503 1.520 1.529 Other assets 4.499 4.584 4.711 4.729 4.724 Balancing item Assets 0 410 410 410 410 19

The ALM model simulates balance sheet and income statement numbers for MR AG under HGB and IFRS Development of insurance business, premiums and claims 1. Stochastically simulated figures Incurred losses (gross and net expenses for claims and benefits) Gross and net underwriting provisions 2. (Deterministically) projected figures Gross and net earned premiums Gross written premiums 3. Derived figures (by ratios) Commission and admin expense ratios Loss ratios (LR) Expense ratios (ER) Combined ratios (CR):= LR + ER Ins. business result ratio:= 1 _ LR _ ER Rentability Return on equity (RoE) Comprehensive income per equity Assets and investment return Asset structure at book and market values Unrealised capital gains and losses Net investment return (components) RoI (referring to the average market value of total investments) Performance of selected asset classes Duration Security and risk measures Relevant rating figure (S&P CAR) Relevant solvability figures (solo solvency) Value at risk Currency over/under coverage Duration missmatch 20

Example 1: Risk/return analysis for different strategic asset allocations (SAAs) Comprehensive Income in bn Unchanged SAA Increase in equities (SAA with higher risk) Mean Decrease in equities (SAA with lower risk) 2004 2005 2006 2007 Standard Deviation 21

Example 2: Impact of dynamic investment strategies Static investment strategy Dynamic investment strategy linked to VaRlimit 22

Example 3: Analysis of duration mismatch Definition EUR-Duration: = Change in market value of assets and liabilities if all interest rates change by 100 basispoints EUR-Duration:= MacAulay-duration* market value * 0.01 23

Example 4: Analysis of currency mismatch at book and market value Def: Currency mismatch = Market value of assets - Market value of liabilities 24

Example 5: Effect of changes in accounting standards (e.g. after tax profit under IAS 39 old and new) 6.0 5.0 4.0 3.0 2.0 1.0 0.0-1.0 IAS Profit (in Billion EUR) with 90%-Confidence bands new 2003 old 2003 new 2004 old 2004 new 2005 old 2005 new 2006 old 2006 new 2007 old 2007 The graph shows the change of the IAS profit as a result of the first-time implementation of IAS 32/39 (rev. 2003) compared to the previous version. 25

Agenda ALM: Governance and Management The Munich Re ALM-Model: ALM on Macro Level The general Concept The different modules Reports and Analysis ALM and pricing: ALM on Micro Level 26

Primary Life Insurance the past must be placed in perspective, lessons have been learned for the future 12% % PA 8% Max Discount / "Min. G'teed Rate" Market Value Raturn (2) Average Participation Rate (3) (1) Interlinking the Fundamentals 4% 0% 1994-4% 1996 1998 2000 2002 2004 The Future ALM -8% Pricing German Life Dynamic Bonus Market Value Earnings Exceed Declared Rates (Surpluses Accumulated) Start of Deregulated Market Market Value Earnings Less than Declared Rates (Draw Down of Surplus) Hedging (1) Estimated for 1994 & 1995, Actual for later years (2) Before allowance for Terminal Bonus, typically in the range of 0.3% to 0.5% (3) Rate applying to business written in that year 27

Securing Risk Adequate Prices in German Primary Life Business Market Consistent Pricing of Guarantees What is meant by market-consistent pricing of a guarantee? The cost of a portfolio of assets with the same pay-offs as guarantee in all possible scenarios i.e. the cost of hedging risk Why is it useful? Pricing: Shareholder cost of writing guarantee Capital: Minimum capital required to hedge risks. Can indicate drivers of risk-based capital requirements For simple guarantees, formula may be available:e.g. plain-vanilla put options => Black Scholes formula Insurance guarantees usually more complex : cost dependent on Bonus and asset management rules Simple formula not available Use simulation model 28

Improving Capital Productivity Requires Optimising Management Actions on Both Sides of the Balance Sheet Managing the Liabilities Managing the Assets Bonus Smoothing Policies (Annual & Terminal Bonus) Making use of direct bonus declaration ( Direktgutschrift ) Consideration of cost of guarantees and embedded options in setting bonus rates Special treatment for policies close to maturity proactively managing policyholders reasonable expectations Shareholder participation pre and post 1994 Rules Defining the Strategic Asset Allocation and Portfolio Rebalancing Rules Developing a sound dynamic hedging strategy Optimising reinvestment and disinvestment decisions Management of unrealised gains and losses Flexing the equity backing ratio in response to changing excess capital levels 29

Active ALM can improve the risk/return profile substantially German Primary Life Business Improving Capital Productivity - ILLUSTRATION FOR ENDOWMENT ASSURANCE - MARKET CONSISTENT PRICING Passive Bonus Policy Market Dynamic Bonus Policy Market Consistent Consistent in % Cost Cost AUM 1.5 Passive Policy (Market Consistent Cost) 1.0 Dynamic Policy (Market Consistent Cost).1 1 Pricing Discipline Vision Business Focus Strategy 100% - ILLUSTRATION FOR ENDOWMENT ASSURANCE - ASSET/ LIABILITY MANAGEMENT Required Shareholder Risk Capital Assets Invested in Assets Covered in Bonds (Base by Structured % Case) Hedge 150% Passive Policy (Market Consistent Cost) Dynamic Policy (Market Consistent Cost) 100 25 0.5 Risk Management 50% 0 Power of Management Actions to Reduce Costs of Guarantee & Improve Returns for Shareholders Distribution & Cost Management 0% Optimising Investment Strategy for Shareholder Funds Provides Leveraged Potential to Improve Capital Productivity 30

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