Risk management

Being an insurance business, TrygVesta’s concept is to create peace of mind for customers by helping them manage and handle situations when a claim has occurred. Risk management is therefore at the core of the business, and it is only natural that TrygVesta also focus in-house on managing the risks that the operations expose the Group to. Structured and competent risk management is fundamental to maintaining confidence in TrygVesta and living up to the vision of being perceived as the leading peace-of-mind provider in the Nordic region.

Risk management environment and risk identification
The Supervisory Board has overall responsibility for the Group’s risk management (see the section on Corporate governance). The Supervisory Board defines the risk management framework, including risk appetite, in the Supervisory Board’s capital and risk management instructions. TrygVesta has set up a number of risk committees and drafted policies for the purpose of optimising the controlling, monitoring and handling of the present and future risk exposure. The supreme body of this structure is the risk management committee which, in addition to the Group CEO and the Group CFO, consists of the chairmen of the respective risk committees. In order to support the risk management environment in the best possible way, an Enterprise Risk Management (ERM) department has been set up as a body anchoring and supporting risk management in TrygVesta.

In addition to the risk management committee TrygVesta has set up four special committees to handle the risk management process within the areas of

underwriting and reinsurance
provisions
investment risk
operational risk and security.

The special committees report to the risk management committee, and their chairmen are also members of the risk management committee.

The risk management committee is directly responsible for strategic risk management and capital management. All committees focus on risk management and have no business responsibility.

The business units are involved in the risk management environment through membership of the relevant committees, as risk managers and as participants in the annual mapping of risk, through compliance with and implementation of policies and controls, including by setting up rules with respect to authority, binding signatures and implementation of the relevant system support. A standard project model is applied for implementing TrygVesta’s strategy in specific projects, of which risk assessment is an integral element. TrygVesta has defined a structured process for mapping risk throughout the Group. The risk managers describe risk, assess the potential impact and probability and evaluate the adequacy of the control environment. Such data is compiled in TrygVesta’s risk data base, which forms the basis for further processing in the risk management environment in the representation of TrygVesta’s overall risk exposure. The risk exposure is supplemented by a number of scenarios illustrating the consequences of special events that may impact several risks simultaneously. The Group’s overall risk exposure is presented in an annual risk report submitted to the Executive Management and the Supervisory Board.

There is a direct correlation between the scenarios identified by the risk managers and the Group’s calculation of its Individual Solvency Need.

The Individual Solvency Need is determined by calculating one-year consequences of such risk scenarios and converting them to the level of probability on the basis of which the capital is made up. An element covering the worst case of such sub-scenarios overlapping is added
to the Individual Solvency Need.

The individual risks are grouped into five risk types: underwriting/reinsurance risk, provisioning risk, investment risk, strategic risk and operational risk. All risk types are treated in the risk identification process and described in the following. The three charts show a simplified representation of some of these risks.

The mapping process shows that insurance risk and strategic risk are the most dominanting risks followed by investment risk. Operational risk is less important than the other risk types.

RISK TYPES
Underwriting and reinsurance risk

Underwriting risk
Underwriting risk is the risk related to entering into insurance contracts and thus the risk that premiums charged do not adequately cover the liabilities TrygVesta has assumed. The risk may materialise as losses either as a result of single events or over a period of time due to a general adverse trend in the performance of claims or to premiums that are too low. Conversely, there is also a risk that premiums charged are too high, resulting in a loss of competitiveness. TrygVesta manages underwriting risk through tariffs and by monitoring profitability on an ongoing basis as well as through business procedures, acceptance policies and authorities. Single events are controlled and protected, primarily through reinsurance. The risk related to underlying trends is controlled through close follow-up and extensive reporting on the most important key ratios of the individual insurance areas.

Reinsurance
Reinsurance is an important element of the day-to-day risk management. The ongoing risk management is supported by TrygVesta’s internal ALM model, which is also used for assessing the impact of different reinsurance alternatives. The Group buys reinsurance for the aggregate Nordic business, thereby generating substantial price synergies.

For property risks, major events in 2009 are protected by catastrophe reinsurance of DKK 5bn with a retention up to a maximum of DKK 105m in Denmark and NOK 105m in Norway. The primary risk of single events is claims caused by storm. TrygVesta has defined the level of cover using simulation models to the effect that protection would statistically be inadequate less than once every 250 years. TrygVesta’s exposure to natural disasters in Norway is furthermore limited through participation in the Norwegian Pool of Natural Perils.

The catastrophe reinsurance programme also covers other catastrophe events, including terrorist-related events, for up to DKK 3.75bn, with terrorist events being covered for buildings, building contents and consequential loss for risks with a total insured value of up to DKK 500m. TrygVesta has bought catastrophe reinsurance up to DKK 1.5bn for the personal accident and workers’ compensation policies with a retention of DKK 50m, covering the risk of multiple injuries from the same cause, including terror.

In addition, TrygVesta also buys reinsurance for certain lines for which experience has shown that claims vary considerably. The largest single risks in the corporate portfolio are property risks protected by reinsurance cover up to DKK 1.5bn/NOK 1.6bn/SEK 1.8bn with a retention of DKK/NOK/SEK 100m for the first claim and DKK/NOK/SEK 50m for subsequent claims. For property risks exceeding the upper level, facultative reinsurance is bought. Other lines covered by reinsurance include liability and motor, marine, fish farms and guarantee insurance.

Exposure to terrorist losses of a biological, chemical or radioactive character can be covered only partly by reinsurance today. TrygVesta has for several years played an active role under the Danish Insurance Association in the work to establish a national arrangement to address this issue. The work was finalised in 2008 with the Danish Folketing passing the act on a terrorist insurance arrangement in the general insurance area in June. The act provides for the government to provide a guarantee of up to DKK 15bn for the total Danish market to cover such losses in excess of the level that can be protected in the reinsurance market.

In the event of a major insurance event comprised by the reinsurance programmeTrygVesta may have large balances outstanding with reinsurers, and thus be exposed to credit risk. TrygVesta manages this risk by defining requirements to reinsurers’ ratings and spreading the reinsurance on several reinsurers. In addition, TrygVesta has set up a security committee focusing specifically on managing credit risk in connection with reinsurance receivables.

PROVISIONING RISK

After the period of the policy’s cover has expired, insurance risk relates to the provisions for claims made to cover future payments on claims already incurred. Customers generally report claims with a certain delay. Depending on the complexity of the claim, a fairly long period of time may pass until the claim has been finally calculated. This may be a prolonged process particularly for personal injuries. Even when the claim has been settled there is a risk that it will be resumed at a later date, triggering further payments.

The size of the provisions for claims is determined both through individual assessments and statistical calculations. At 31 December 2008, the provisions for claims amounted to DKK 19,715m with an average duration of 3.3 years.

Most of the provisions for claims relate to personal injury claims. They are exposed, among other risks, to changes in inflation, the discount rate (see also the heading interest rate risk under investment risk), disbursement patterns, economic trends, legislation and court decisions. The calculation of provisions for claims will always be subject to considerable uncertainty. TrygVesta manages this risk through a provisioning policy, model analysis, control calculations, follow-up and reviews in order to obtain the best possible match between provisions and claims payments. Historically, many insurers have experienced substantial negative as well as positive impacts on profit (run-off) resulting from provisioning risk, and that may also happen in future. Provisions for claims relating to annuities in Danish workers’ compensation insurance are discounted using the current market rate and are also revalued by the wage inflation rate each year. This exposes TrygVesta to explicit inflation risk in case of changes in Danish wage inflation. TrygVesta hedge such risk using an inflation swap.

INVESTMENT RISK

Investment risk is the risk that volatility in the financial markets will impact the results of operations and thus the financial position. TrygVesta defines the asset mix based on the investment policies approved by the Supervisory Board, including limits on types of assets and the geographic distribution and risk profile of bonds, equities and real estate for each company in the Group. The asset mix and investment activities focus mainly on interest rate risk, security and liquidity.

Interest rate risk
Fluctuating interest rate levels is one of the most important elements in determining investment risk. As TrygVesta furthermore discounts provisions for claims in accordance with the IFRS accounting rules (market value), the provisions for claims are also exposed to interest rate risk. If interest rates fall, the value of the Group’s bond portfolio would increase, but at the same time it would cause the provisions for claims to rise. Changes in the level of interest rates thus have an opposite effect on assets and liabilities. An important element of TrygVesta’s risk management is to have a bond portfolio mix ensuring that the two opposite effects are counterbalanced as exactly as possible.

The portfolio of fixed-interest securities stood at DKK 29.5bn at 31 December 2008, while the provisions for claims discounted using a market rate amounted to DKK 19.7bn, net of reinsurance. The respective durations were 1.7 and 3.3 years. The difference in duration is attributable to the bond portfolio being significantly larger than the discounted provisions. A parallel shift of interest rates of 1% would reduce the market value of the securities by DKK 512m, while the opposite impact on provisions would be DKK 562m, triggering a net impact of DKK 50m.

TrygVesta intends to minimise the net interest rate exposure, and will therefore in 2009 start dividing total investment assets into a hedge portfolio and an active portfolio. The hedge portfolio will consist exclusively of interest-bearing assets, as far as possible matching the expected cash flow from the discounted provisions. Accordingly, the net interest rate exposure of the hedge portfolio together with the provisions would be approximately nil to a random change in the yield curve.

The first figure shows by stochastic simulation based on TrygVesta’s internal model the impact of value adjustment on liabilities and on assets in the hedge portfolio. Based on the internal model, the Group has calculated that the net interest rate risk would have a 90% certainty to stay within a range of +/- DKK 115m.

Value adjustments of assets are determined by yield changes on the actual bond portfolio, which to a great extent comprises Danish mortgage bonds, while the counteracting adjustments of provisions are determined by changes in the discount curve prescribed by the Danish Financial Supervisory Authority. Until recently, this curve was calculated as the Euro zero-coupon yield curve plus a spread between the Danish and German government zero coupon yield curve. In connection with the financial crisis the spread between mortgage bond yields and government bond yields has widen significantly. When updating the internal model to account for an interest rate scenario as seen in 2008, the net interest rate risk is increasing significantly, as illustrated in the figure After increase in interest rate spread. In this situation, the net interest rate risk would have a 90% certainty to fluctuate within a range of +/- DKK 260m. In response to the problems the financial crisis has caused for life insurers in particular, the Danish Financial Supervisory Authority in October 2008 revised the methodology for calculating the yield curve for discounting the provisions of Danish insurance companies. The calculation now considers developments in Danish mortgage bonds to a much greater extent. Using the new methodology, TrygVesta’s internal model shows a significant reduction in the net interest rate risk to a level where fluctuations would in 90% of the cases be within a range of +/- DKK 120m.

Equity and real estate risk
The equity and real estate portfolios are exposed to changes in equity markets and real estate markets, respectively. TrygVesta manages such risk through investment limits for various asset classes. In certain circumstances, TrygVesta also uses interest rate and equity derivatives in the investment activities.

The equity portfolio primarily focuses on the large, liquid equity markets in Europe and the USA (see the graph in the section on Investment activities). TrygVesta has defined a strategy with relatively little exposure to the Nordic region (around 20% at 31 December 2008) in order to reduce company risk, because a few companies account for large parts of the markets in these countries. Furthermore, TrygVesta has tied each equity mandate to a recognised benchmark (MSCI), which is monitored closely. The 25 largest equities in the portfolio accounted for some 32% of the total listed equity portfolio at 31 December 2008.

TrygVesta reduced its proportion of equities significantly in January 2008. The equity proportion accounted for 3.4% at 31 December 2008 against 11.9% at the end of 2007 and 15.4% in May 2007. This reduction has limited the Group’s equity losses significantly. Overall, the financial crisis triggered equity losses of DKK 887m. In 2008, TrygVesta bought the head office in Ballerup, thereby increasing the proportion of real estate significantly. This proportion is expected to be reduced over time.

Currency risk
TrygVesta is exposed to exchange rate fluctuations. This exposure is minimised through currency derivatives, and cash flows are mostly matched. The Group’s premium income in foreign currency is mostly matched by claims and expenses in the same currencies, primarily NOK, EUR, SEK and USD. This means that an expected profit would be adversely impacted by depreciating exchange rates relative to DKK. TrygVesta does not hedge the remaining, limited currency risk in connection with future cash flows in foreign currencies.

TrygVesta uses currency derivatives to hedge the risk of a loss of value of balance sheet items due to exchange rate fluctuations in accordance with a general hedge ratio of 90–100% for each currency. The aim is to hedge 98–100% of the net book value of the Norwegian entity.

NOK depreciated from 93.51 to 75.72, or 19%, against DKK in 2008. This was the main reason for the year’s negative DKK 640m exchange rate adjustment of the value of the foreign entities. Under the hedge policy, this currency risk was hedged with a resulting gain of DKK 615m. The net effect was thus negative at DKK 25m. Both items have been taken directly to equity.

Credit risk
Credit risk is the risk of incurring a loss if counterparties fail to meet their obligations. In connection with the investment activities, the primary counterparties are bond issuers and counterparties in other financial instruments. TrygVesta manages credit risk and concentration risk through investment limits and rating requirements (see the section on Investment activities for an overview of the bond portfolio distributed on ratings and geography). Receivables with Danish banks are covered by a government guarantee from October 2008 to 2010.

The financial crisis in 2007 and 2008 emphasised the importance of managing risk, including credit risk. TrygVesta has no investments in sub-prime loans, CDOs or similar products, and accordingly has not incurred financial losses in this respect in connection with the financial crisis.

Debtor risk
There is a risk that customers fail to pay for their insurance. Accordingly, TrygVesta has intensified efforts and processes towards customers with an account arrangement, large customers and commercial customers in sectors strongly impacted by economic trends. A separate review has been made of ratings for customers with large premium volumes in order to assess the risk of bankruptcy.

Provisions for debtor risk were increased in 2008 by 13% to DKK 120m in 2008.

OPERATIONAL RISK

Operational risk relates to errors or failures in internal procedures, fraud, breakdown of infrastructure, IT security and similar factors. As operational risks are mainly internal, TrygVesta focuses on establishing an adequate controlling environment in the Group’s operations. In practice, this work is organised through a structure of procedures, controls and guidelines that cover the various aspects of the Group’s operations, including the IT security policy. TrygVesta has also set up a security and investigation unit to handle matters such as fraud, IT security, physical security and contingency plans.

In order to avoid any unintentional violations of competition law, a competition law training programme for the entire organisation has been completed.

TrygVesta has prepared contingency plans to handle the most important areas, such as the contingency plans in the individual parts of the business to handle an event of a prolonged IT breakdown. The Group has also set up a crisis management structure should TrygVesta be hit by a major crisis.

STRATEGIC RISK

Strategic risk relates to TrygVesta’s choice of strategic position, including IT strategy, time-to-market, business partners and reputation as well as changed market conditions, including the competitive environment, falling premium rates and developments in New Markets.

Strategic risk is managed through a strategic planning process. The Supervisory Board defines the overall strategy within the framework of the Group’s corporate vision, and the Group Executive Management uses this as the basis for further strategy work. The balanced scorecard is used as a tool to ensure current follow-up on the implementation of the strategy and the initiatives launched in the business areas. During the year, the strategy is managed in Executive Management meetings and meetings to follow up on the balanced scorecard performance by business areas and staff functions. TrygVesta maintains full strategic focus on the business partners, and protects the reputation through corporate values, by maintaining focus on handling complaints and through internal and external communication policies. The Group also continuously monitors the market to ensure that the assessment of external conditions rely on an up-to-date basis, be it competitors’ market initiatives, new legislation or other external factors that may impact the Group.

THE OVERALL RISK EXPOSURE

TrygVesta considers strategic risk and insurance risk (underwriting and provisions) to be the most important types of risk TrygVesta is exposed to. Both types of risk are closely related to the operations as a general insurer. Investment risk is at a satisfactory level due to the current investment strategy. TrygVesta considers the operational risk to be less important than the other risk types.

The financial crisis has had an adverse impact on TrygVesta albeit only to a fairly limited extent, thereby illustrating the results of effective risk management in the Group. TrygVesta considers the risk identification process and overall risk exposure to be satisfactory relative to the risk appetite defined by the Supervisory Board. However, TrygVesta is continuously seeking to optimise the relationship between risk and return and to reduce unwanted risks further.