Insurance. Munich Reinsurance Company. And Subsidiaries. Reinsurers / Germany. Full Rating Report. Key Rating Drivers. Rating Sensitivities

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1 Reinsurers / Germany And Subsidiaries Full Rating Report Ratings Insurer Financial Strength Rating Long-Term Foreign-Currency IDR Subordinated debt Senior unsecured debt (issued by Munich Reinsurance America Corporation) Outlooks Insurer Financial Strength Rating Long-Term Foreign-Currency IDR Financial Data 31 Dec 2013 AA AA A A+ Stable Stable 31 Dec 2012 Total assets (EURm) 254, ,416 Total equity (EURm) 26,226 27,439 Gross written premiums 51,060 51,969 (EURm) Net income (EURm) 3,342 3,204 Reinsurance combined ratio (%) Primary insurance combined ratio (%) Key Rating Drivers Resilience of P&C Reinsurance: s property and casualty (P&C) reinsurance business is expected to account for a major part of the company s operating earnings in future. Maintaining earnings metrics at a level commensurate with AA, in adverse market conditions, is viewed as key in the next 12 to 18 months. The pricing outcome of the 1 January 2015 renewal will be viewed as an important indicator of prospective performance, given the significant proportion of Munich Re s business renewed at this time. Large Market Position: Munich Re s reinsurance operation is one of a select group that have the scale, diversity and financial strength to attract the highest quality business being placed in the global reinsurance market. Fitch Ratings views this strength as a key factor that should assist the reinsurer in protecting its market share, in the event of a protracted soft market and the continued ingress of alternative capital into the sector. Mixed Performance from Primary Operations: The performance of Munich Re s ERGObranded primary insurance businesses is mixed, but the contribution to earnings is expected to prove more consistent in the medium term. The German primary life operations continue to faces challenges related to high levels of interest guarantees, due to the persistence of low investment yields. Positively, P&C insurance achieved good growth and strong underwriting profitability during 2014, which should continue in Very Strong Capitalisation: Fitch regards Munich Re s capitalisation as very strong measured by the agency s Prism factor based model (FBM). The reinsurer s IFRS equity is sensitive to interest-rate-induced movements in the market value of its fixed-interest investment portfolio. The agency believes that on an economic-value basis, such sensitivity would be reduced by offsetting movements in the value of liabilities. Munich Re s strong capitalisation enables it to provide underwriting capacity on a continuous and large basis, should it so wish. Leverage and Coverage Adequate: Munich Re s debt leverage of 16% at end-2013 is commensurate with its rating. Strong earnings continue to generate strong debt servicing capabilities, with the fixed-charge coverage being 14.6x at end-2013 (end-2012: 15.3x). Limited Retrocession, Manageable Exposure: Munich Re makes only limited use of retrocession or other forms of risk mitigation, so its net losses are relatively close to its gross losses. Fitch considers Munich Re s catastrophe risk as manageable, in the context of a highly diversified catastrophe portfolio by geography and in light of the group s strong capital position. Rating Sensitivities Related Research Global Reinsurance Guide 2015 (September 2014) Global Insurance Rating Criteria and Sector Credit Factors (September 2014) Analysts Martyn Street martyn.street@fitchratings.com Improved Profitability: Munich Re s ratings could be upgraded if the reinsurer improves profitability on a sustainable basis, including a return on equity of 10% or above and a run-rate P&C reinsurance combined ratio of 96% or lower, provided the capital base remains very strong as assessed by FBM. Weakened Capitalisation: The key rating triggers that could result in a downgrade include a sustained material drop in the company s risk-adjusted capital position to below very strong, as measured by FBM, a run-rate combined ratio of 102% or above, or strong underperformance relative to peers. Harish Gohil harish.gohil@fitchratings.com 19

2 Figure 1 Gross Premium by Segment, 2013 Primary - Life 11% Primary - P&C 11% Primary - Health 11% Munich Health 13% Source: Munich Re Reinsurance - P&C 33% Reinsurance - Life 21% Market Position and Size/Scale Strong Market Position Excellent Reinsurance Franchise Scale and diversification a key positive Primary operations concentrated in Germany ERGO in transition Limited risk appetite for M&A Multi-channel distribution Scale and Diversification Key Positive Fitch views Munich Re as one of a small group of global reinsurers with the scale and financial strength to attract the highest quality reinsurance business being placed in the market. The reinsurer sits at the upper end of the large position and scale. Measured by premium volume, Munich Re is the world s largest reinsurer, with reinsurance gross written premiums totalling EUR27.8bn in The reinsurance segment, of which the P&C business is the largest activity within the group, is strengthened by an excellent franchise. Revenue and earnings in life reinsurance and Munich Health are growing, leading to a more balanced split between non-life and life reinsurance. Overall, Fitch considers the Munich Re group to have a leading global market position and to be of large scale. Figure 2 Ratings Range Based on Market Position and Size/Scale IFS Rating Debt Large market position and size/scale Medium market position and size/scale Small market position and size/scale AAA AA AA A A BBB BBB BB <BBB <BB Primary Operations Concentrated in Germany Although the group s reinsurance business is written globally, most of the primary business is concentrated in Germany. The group is aiming to increase the proportion of its international primary business, which has led to more geographical diversification in that segment in recent years. ERGO in Transition Munich Re is restructuring its primary operations, which operate mainly through its ERGO subsidiary, to improve efficiency and market reach. Fitch views this positively but believes the changes entail some operational risks regarding the acceptance of the restructured distribution channels. Fitch views Munich Re s primary operations as well integrated into the group due to the shared ERGO brand across the majority of primary entities. Management has publically expressed its commitment to its primary operations. Limited Risk Appetite for M&A Related Criteria Insurance Rating Methodology (September 2014) Management s approach to takeovers is disciplined; the price and the strategic fit of the targets are emphasised in equal measure. Takeover targets tend to be small to medium-sized, and Fitch expects Munich Re to maintain this cautious stance towards M&A. Fitch views management s stance towards asset risk as conservative, as the group aims to create value as a liability-driven (re)insurer. 2

3 Multi-Channel Distribution The group s reinsurance business is derived either through direct co-operation with primary insurers or via brokers. It also has strong partnerships with leading broker firms and receives business from large clients through captives or alternative risk-transfer initiatives. ERGO s strategy encompasses various distribution channels. In addition to its own sales network of 22,000 tied agents, ERGO has forged partnerships with a variety of brokers and has strong links with the UniCredit group for bancassurance distribution. Munich Reinsurance America Corporation is the principal vehicle through which the Munich Re group accepts risk in the US. It benefits from writing business through a US entity, which helps the group avoid being treated as an alien reinsurer in the US and therefore having to collateralise its reinsurance obligations. 3

4 Ownership Neutral to Rating Corporate Governance and Management Corporate governance and management are effective and neutral to the rating. Corporate governance is led by collaboration between the Supervisory Board and the Board of Management. A total of five Supervisory Board committees meet at regular intervals to raise and discuss important issues. In 2013, Munich Re was incompliance with all of the recommendations of the German Corporate Governance Code. Munich Re is a listed group, with 89% per cent of its shares held by institutional investors and 11% by private investors. The group s largest shareholder at end-november 2014 was Warren E. Buffett, who holds a stake of 11.6% in Munich Re via several companies in his group, including Berkshire Hathaway Inc., OBH Inc. and National Indemnity Co. According to Munich Re, Berkshire s objective is to generate trading profits, not to implement strategic objectives. Therefore, Berkshire does not aim to exercise an influence on the composition of Munich Re s management or supervisory boards, or to fundamentally change the company s capital structure. The second-largest shareholder is asset manager BlackRock, with around 6%, followed by the People s Bank of China/SAFE, with around 3%. Figure 3 Group Structure (Showing entities rated by Fitch) Munich-American Holding Corporation ERGO Versicherungsgruppe AG Munich Re America Corporation HSB Group Inc. ERGO Lebensversicherung AG Vorsorge Lebensversicherung AG Europaeische Reiseversicherung AG DKV Deutsche Krankenversicherung AG Munich Reinsurance America, Inc The Hartford Steam Boiler Inspection and Insurance Company Source: Transaction documents 4

5 Sovereign and Country-Related Constraints Fitch rates the sovereign obligations of Germany at AAA with a Stable Outlook, and the Country Ceiling is also AAA. Therefore, the ratings of German insurance organisations and other corporate issuers are not constrained by sovereign or macroeconomic risks. Industry Profile and Operating Environment Reinsurers Face Intense Market Pressure but Maintain Financial Strength The fundamental outlook for the reinsurance sector is negative, as intense market competition and sluggish cedent demand has resulted in a softening market. The onslaught of alternative capital, which Fitch views as enduring, leads us to expect that prices will continue to fall, and for terms and conditions to weaken in 2015 across a wider range of business lines. The agency moved to a negative global reinsurance sector outlook in January Despite growing headwinds, Fitch maintains a stable rating outlook. This assumes a base case scenario that over the next months a majority of reinsurers will be able to maintain overall adequate profitability and strong capitalisation despite softening prices, and that any declines in earning will be within ranges that current ratings can tolerate. While ratings for most reinsurers are expected to be unchanged, there is heightened risk that a select group of smaller monoline companies, especially those with property catastrophe books, could suffer downgrades or be moved to Negative Outlooks. In aggregate, this may be offset by selective upgrades of a small group of well-established larger and more diversified players viewed as most resilient to market conditions. Price adequacy is expected to decline in 2015, although rates of return are expected to remain above reinsurers cost of capital. Earnings pressure is forecast to increase across the sector as softening pricing in property business will migrate to other lines, such as casualty, as reinsurers look to redeploy capital in more profitable areas. Persistence of low investment yields increases the risk of adverse investor behaviour as both reinsurers and investors seek higher returns. The inflow of alternative capital has included select use of hedge fund-based investment strategies, which not only impact balance sheet quality, but are designed to provide a pricing advantage for the reinsurer that can intensify the effect of softening markets. Alternative reinsurance and changes in reinsurance purchasing are expected to have long-term implications. The growth of alternative capital is viewed as a credit negative for traditional reinsurers ratings, as a significant portion of capital-market funds is expected to remain permanent. Thus, Fitch views the current soft market as not just a normal cycle. Figure 4 Ratings Range Based on Industry Profile/Operating Environment IFS Rating Debt Non-life AAA AA AA A A BBB BBB BB <BBB <BB Reinsurance lines Composite 5

6 Peer Analysis Diversified Insurance Group With Strong Financial Profile The group of (re)insurance businesses that combine to form the Munich Re group dilutes the effectiveness of some comparative ratios that are used to assess the reinsurer against its closest peers. Munich Re operates significant primary operations, which accounted for 33% of the group s premiums written at end Munich Re s average reinsurance combined ratio between 2009 and 2013 was 98.5%, which is at the high end of the range among its natural peer group. This is partly explained by the greater level of proportional (generally lower margin), but less volatile business written compared with peers, which typically results in a higher combined ratio, all else being equal. Relative to multinational primary insurance groups, Munich Re s regulatory solvency and financial leverage metrics compare favourably. Profitability metrics have recovered since 2011, helped by a lower level of large natural catastrophe losses incurred by the reinsurance sector. Figure 5 Peer Analysis Net premiums written b Combined ratio (%) Combined ratio volatility (pp) d Shareholders equity (USDm) a IFS rating Five-year average c Five-year average ACE Limited AA/Stable e 17,025 16, ,825 27,531 AA /Stable 65,706 64, ,794 35,621 Berkshire Hathaway AA /Stable e 37,210 35, , ,647 Lloyd s of London AA /Stable 31,688 30, ,788 31,121 Hannover Re AA /Stable 16,519 15, ,112 7,936 Partner Reinsurance Company Ltd AA /Stable 5,397 4, ,856 6,040 Everest Reinsurance Company AA /Stable 5,005 4, ,968 6,733 Swiss Re A+/Positive 30,478 25, ,952 34,002 SCOR S.E. A+/Positive e 12,143 10, ,860 6,300 Combined ratio: Net losses and loss-adjustment expenses divided by net premiums earned plus underwriting expenses divided by net premiums earned. Shareholders equity is organisation-wide equity and therefore depends on the company's reporting practices; it may include equity that supports operations other than property/casualty reinsurance operations. Financial statement figures for some European reinsurers have been translated into US dollars using year-end or 12-month average rates of exchange, as appropriate. This has led to some exchange-rate distortion between financial years. a Foreign exchange rates used for NPW = average rate. foreign exchange rates used for shareholders equity = year-end rate. b NWP includes primary and reinsurance operations. c , non-life reinsurance business. Comparability may be distorted by individual companies financial reporting. d Standard deviation. e Denotes operating company insurer financial strength rating. Source: Company annual reports, financial supplements, and SEC filings. 6

7 Figure 6 Capitalisation and Leverage (EURbn) Fitch s expectation Group solvency (%) Capitalisation and leverage is expected to remain Gross leverage (x) strong across a number of key metrics. Future Net leverage (x) capital management through share buy-back Net premiums written / equity (%) programmes will depend on the level of major Net premiums written / equity (%) non-life losses. Financial leverage (%) Total financing and commitments ratio (x) Capitalisation Remains Commensurate With Rating Very Strong Prism score Average total financing commitments ratio Strong regulatory solvency margins Economic solvency benefits from improved risk balance Very Strong Prism Score Munich Re scored very strong on Fitch s Prism FBM based on year-end 2013 results. This score is the ratio of total available capital (TAC) divided by target capital (TC) at various stress levels, with the Prism score being equal to the highest category where TAC exceeds TC. Fitch s TAC gives some credit for value of in-force business and subordinated debt, whereas Fitch Core Capital (FCC), which is restricted to very high quality capital, does not. If companies have a significant value of in-force business or subordinated debt, the ratio FCC/TAC will be lower, indicating weaker quality of capital. Figure 7 TFC Range and Ratio Descriptions TFC range (x) Qualitative description 1.5 and over Well above average Above average Average Under 0.4 Below average Fitch s TAC measure is used to calculate the Prism score. Fitch believes there can be value in looking at the FCC, as this indicates the coverage of TC by very high quality capital. Average Total Financing Commitments Ratio Munich Re s TFC ratio remained stable at 0.5x in 1H14, which falls within the average range. The ratio compares favourably when considered in the context of close reinsurance peers. Fitch recognises that a significant proportion of the ratio numerator consists of utilised letter-ofcredit (LOC) facilities. The agency believes that in the remote circumstances that the LOC facilities became unavailable, Munich Re would have sufficient financial resources to maintain the business currently backed by the LOC facilities. Strong Regulatory Solvency Margins At year-end 2013, group solvency remained strong, with the margin reducing slightly to 262% (end-2012: 278%), mainly due to a decline in shareholders equity. Economic Solvency Benefits from Improved Risk Balance Munich Re uses a sophisticated internal risk-based capital model to assess capital requirements for individual units and for the group as a whole. The economic risk capital corresponds to 1.75x the value at risk with a confidence level of 99.5%, corresponding to 1.75x the capital that the company considers likely to be necessary under Solvency II. The group s economic solvency ratio increased to 153% at end-2013 (end-2012: 129%). The improvement was driven by a reduction in economic risk capital (the denominator), due to an improved balance of insurance and capital market risks. Available financial resources (the numerator) improved through economic earnings. In line with Fitch s rating methodology and due to the difficulties in making comparisons among companies, the output from (re)insurers internal models has little bearing on Fitch s overall capital assessment. 7

8 Figure 8 Debt-Service Capabilities and Financial Flexibility (%) Fitch s expectation Fixed-charge coverage ratio Fixed-charge coverage is expected to Fixed-charge coverage ratio (incl. realised and unrealised gains) remain at or above a level commensurate with a AA rating over the rating horizon, assuming catastrophe losses do not exceed the long-term average. Holding Company Liquidity Munich Re AG is the group s holding company and main reinsurance operating company. In 2011/2012, Munich Re refinanced subordinated debt callable in 2013 (which has since been called), and it currently has no refinancing requirements until Strong Financial Flexibility and Fixed-Charge Coverage Strong fixed-charge coverage Good access to capital markets Future share buy-backs dependent on major losses Strong Fixed-Charge Coverage Munich Re s five-year average fixed-charge coverage ratio is 10.2x (or 11.9x including realised and unrealised gains and losses), which is commensurate with the AA rating category. In recent years, Munich Re has kept both the level of hybrids and senior debt and the level of interest to be paid relatively stable. Changes in the fixed-charge coverage ratio have been primarily driven by changes in earnings. Good Access to Capital Markets The agency views Munich Re s frequently demonstrated ability to tap the capital markets as a positive rating factor. This applies to both debt and equity markets. Future Share Buy-Backs Dependent on Major Losses Fitch views the continued management of capital through share repurchase programmes as dependent on the level of major loss activity. The agency believes that programmes announced in 2013 and 2014 reflect both the strength of Munich Re s balance sheet as well as the lower level of major losses incurred by the reinsurance sector. During 2014, Munich Re confirmed the commencement of a further EUR1bn share buy-back programme that is set to run until April Since 2006, the reinsurer has returned in excess of EUR14bn to its shareholders via share buybacks and dividends. The dividend yield was 4.5% for 2013 (2012: 5.2%), which is high but not out of line with peers. 8

9 Figure 9 Financial Performance and Earnings (EURm) Fitch s expectation Net income 2,564 2, ,204 3,342 Fitch expects Munich Re s reinsurance combined Combined ratio P&C RI (%) ratio to remain close to its 94% target for 2014, Combined ratio - Primary Ins. (%) subject to catastrophe activity. Return on equity (%) Fitch believes the RORAC target of 15% is Change in net written premiums a (%) (3) (2) 18 (5) 3 ambitious due to the interest rates. a P&C Reinsurance Source: Munich Re Group Earnings Resilient P&C Re: Resilience of earnings is key Life Re: Contribution grows ERGO s profitability constrained by low investment yields RORAC target of 15% ambitious in current markets P&C Re: Resilience of Earnings Is Key The resilience of Munich Re s P&C reinsurance earnings in the current adverse market conditions is viewed as a key rating factor in the next 12 to 18 months. Earnings from the P&C reinsurance segment are set to remain the primary source of Munich Re s operating earnings in future, currently accounting for over half of this metric. The outcome of the 1 January 2015 renewal will be an important indicator of performance, given the significant proportion of business that Munich Re renews at this time. The overall price reduction of 1.5% achieved on the renewed portfolio at 1 January 2014 is viewed favourably by Fitch and illustrates the diversity of the reinsurance portfolio, as well as the ability to maintain pricing discipline that Munich Re s scale affords. Munich Re writes a greater amount of proportional business compared with peers, which tends to lead to a higher combined ratio. Proportional business is typically less volatile and therefore carries a lower profit margin. The agency expects Munich Re to achieve the 94% combined ratio that it has guided for full year This was a downward revision due to lower incurred losses through 3Q14. This falls within the range that Fitch would expect for reinsurance companies at this rating level, although achieving it is dependent on catastrophe losses remaining within budget. Life Re: Contribution Grows The growth of Munich Re s life reinsurance business is led by financial reinsurance, particularly in the Asia region. Fitch believes that it will be some time before organic growth will deliver the scale necessary to provide sufficient earnings diversification to offset volatility in the P&C reinsurance segment. Nevertheless, the agency expects the consistency of near-term bottom line contributions to improve, helped by the continued resolution of experience related to legacy Australian disability and US mortality businesses. The company s expertise and reach allow it to access lines of business and treaty layers that smaller reinsurers do not have the capacity to write. Fitch views the increased contribution of life reinsurance to the group s earnings positively, as the segment s steady cash flows add stability to the more volatile property and casualty reinsurance results. ERGO s Profitability Constrained by Low Investment Yields The restructuring of Munich Re s primary insurance businesses and subsequent modifications to reporting dilute the comparability of ERGO s main operations across years. In 2013, besides the impact of low interest yields, the restructuring of distribution channels added to ERGO s 20.2% declined APE in life. However, P&C insurance showed good growth and confirmed its 9

10 strong underwriting profitability. It reported a combined ratio of 96.1% for German operations (market: 99.2%) despite floods and exceptionally high hailstorms and 99.2% for international operations. The subgroup reported net income of EUR436m (2012: EUR290m). However, its operating income decreased to EUR732m in 2013 from EUR958m in The contradictory trend was caused by a one-off refund in taxation. In 2014 and 2015, the German primary life operations face challenges related to high levels of interest guarantees because of the persistent low investment yields. The underwriting result in the German P&C business should benefit from the market s continued strong premium growth. ERGO s receiver swaption programme has a significant impact on the life segment s IFRS earnings as it results in material write-ups if interest rates fall and write-downs if interest rates rise. The comprehensive interest-rate hedge in place means that the German primary life business is better protected against low interest rates than many other German life insurers. While the programme contributed earnings of EUR42m to reported income in 2012 it has reduced 2013 s result by EUR32m. Based on market performance at end-november 2014, Fitch expects the swaption programme to contribute about EUR50m to ERGO s 2014 bottom line. RORAC Target of 15% Ambitious in Current Markets The group has a financial target of a return on risk-adjusted capital (RORAC) of 15%. It also monitors return on equity and the combined ratio but considers them secondary to RORAC. Fitch regards positively the use of the RORAC target as a measure that reflects risk-adjusted performance. The target also closely matches Munich Re s internal value-based management, which it has identified as one of its key corporate governance tools. However, even in a year of more normal catastrophe activity, Fitch would consider a RORAC of 15% hard to achieve due to the current low interest rates. 10

11 Figure 10 Investment and Asset Risk (%) Fitch s expectation Risky assets to equity Fitch expects Munich Re to stick to its Non-investment grade bonds to equity conservative strategy regarding Unaffiliated equity investments to equity investment risk. Equity exposure could Affiliated investments to equity slightly increase. Figure 11 Investment Portfolio, 2013 Shares/ equity funds 5% Misc. 12% Land & buildings 3% Low to Moderate Investment Risk Increased but still low equity exposure Moderate credit risk exposure Quality of loan portfolio considered to be very good Increased but Still Low Equity Exposure Loans to policy-holders 28% Source: Munich Re Fixed-interest 53% Munich Re s investment portfolio largely consists of highly rated fixed-interest instruments and loans, making up 81% of total investments. The carrying amount of the group s equity portfolio increased to EUR10.0bn at end-2013 (end-2012: EUR8.3bn), or 4.6% (3.7%) of total investments. Equity exposure after hedging increased to 4.5% of total investments at end-2013 (end-2012: 3.4%). Affiliated and unaffiliated equities totalled 35.2% of shareholders funds (end-2012: 28%), which is commensurate with the group s rating level. Figure 12 Loans Portfolio, 2013 Policyholder/ mortgage 9% Gov./semigov. 38% Figure 13 Banks/ other 6% Source: Munich Re Corporate <1% Pfandbriefe/ CB 46% 'Other Loans' Quality, 2013 The group has increased its potential alternative investment budget to EUR8bn, which will be deployed over the coming years if suitable investments can be identified. This represents about 4% of total investments. Moderate Credit Risk Exposure Credit quality is good, with 68% of fixed-income securities rated AA or AAA while 46% of the fixed-income portfolio is invested in government bonds of high credit quality. In 2014 Munich Re increased slightly its exposure to government bonds and invested in US, French, Spanish and Italian government bonds. As at 9M14, the majority of government bonds were represented by US and German bonds, with 9% of bonds from Italy, Spain, Portugal and Ireland. Credit risk in the group s corporate bond portfolio (16% of the fixed-income portfolio) is moderate, with 58% of securities rated below the A category. Within the bank portfolio (4% of the fixed-income portfolio), the portion of subordinated bonds and loss-bearing bonds is limited at 16%. Munich Re has moderately increased its exposure to emerging-market debt and increased the diversification of its covered bond portfolio, reducing the German portion and extending its investments in French and UK covered bonds. AA 36% BBB or lower 6% A 10% Not rated 1% AAA 47% Quality of Loan Portfolio Considered Good The investment portfolio contained a sizeable loan portfolio totalling EUR61bn at end The agency views this exposure as manageable in the context of the diversity offered by the wider investment portfolio. The exposure is mitigated by the quality of the loans, with 83% being rated either AAA or AA, and a further 8% secured against mortgages. Source: Munich Re 11

12 Figure 14 Asset/Liability and Liquidity Management (%) Fitch s expectation Liquid assets to technical reserves Fitch expects the duration gap between assets and liabilities to remain close to its current level. Exposure to Interest Rate and Currency Movements Despite Sophisticated Asset-Liability Management Duration gap much reduced Receiver swaptions mitigate interest-rate exposure IFRS equity exposed to currency movements Adequate liquidity in investment portfolio Duration Gap Much Reduced Fitch views positively the work undertaken by Munich Re to reduce the duration gap of assets and liabilities, at the group level. As at half-year 2014, the gap between assets and liabilities had been reduced to 0.1 years (end-2012: 0.7 years). Within its reinsurance operations, the duration of Munich Re s assets remains longer than that of its liabilities. However, in the primary operations, the reverse is true, which offsets the duration gap from the group perspective. Receiver Swaptions Mitigate Interest-Rate Exposure ERGO has derivatives in place to protect the life operations against sustained low interest rates. The value of these receiver swaptions rises and offsets the increased economic value of the liabilities as interest rates fall,. Fitch sees this transaction as tangible evidence of strong risk management and views positively the potential relief that such transactions can provide. In times of rising interest rates, the receiver swaptions will reduce the life operation s IFRS profitability. In addition to the hedge against low interest rates, ERGO has acquired structured products that provide a hedge against rapidly increasing interest rates. IFRS Equity Exposed to Currency Movements Munich Re applies economic steering principles that aim to limit currency risk, including extensive matching of assets and liabilities. Although the company runs a largely neutral economic currency position, under IFRS a weaker euro tends to benefit shareholders equity and to burden the profit and loss account. Adequate Liquidity in Investment Portfolio Fitch regards liquidity in Munich Re s investment portfolio as adequate. Of the group s EUR218bn investment portfolio, 53% is fixed-income securities. At end-2013, Munich Re held 2.5% of its investments in real estate and 28% in loans, which are relatively illiquid. 12

13 Figure 15 Reserve Adequacy (%) Fitch s expectation Loss reserves / CY incurred losses Fitch expects Munich Re to continue with Change in loss reserve / Earned premium ratio - (1.6) (2.6) (8.4) 0.4 its prudent reserving standards. One year development / PY equity (%) (1.9) (2.7) (3.3) (4.1) (3.1) Favourable Reserving History Comfortable reserve buffer Level of asbestos and environmental reserves in line with peers Reserve releases support results Comfortable Reserve Buffer Fitch considers Munich Re s reserving history to be favourable. The reinsurer s reserve profile has been given an implied weighting of High, based on a combined leverage assessment relative to capital ( High ) and incurred losses ( Medium ). This view is supported by the significant portion of casualty reinsurance business written by Munich Re, which lengthens the duration of liabilities. Over a three- and five-year period, loss reserves growth is assessed as Neutral by Fitch, indicating that reserve growth has been in line with underwriting exposures. Over the same time period experience is viewed as Positive, with reserves generating a surplus on a regular basis. These indicators suggest a consistent and prudent reserving philosophy. Munich Re s reserve adequacy is also viewed as Positive, based on an assessment of reserving-point estimates over actuarial estimates, which indicates a consistent level of prudence over a number of years. Level of Asbestos and Environmental Reserves in Line With Peers Fitch regards asbestos liability as an important area of uncertainty in relation to reserves, and believes that this source of risk could limit future earnings. Munich Re s asbestos and environmental three-year survival ratios were 11.7x (end-2012: 10.1x) and 11.4x (8.7x), respectively, at end The asbestos survival ratio is at the lower end of the range for the industry, whilst the environmental ratio is closer to the average. Munich Re s survival ratio for asbestos risks has been stable in recent years, and Fitch would expect any reported reserve deterioration to be substantially lower in future years. Reserve Releases Support Results Munich Re released reinsurance reserves of about EUR759m in 2013 (2012: EUR877m). The reinsurer typically expects reinsurance reserve releases of EUR600m a year, equivalent to 4pp on the combined ratio. 13

14 Figure 16 Reinsurance, Risk Management and Catastrophe Risk (%) Fitch's expectation NWP/GWP Fitch expects Munich Re's prudent risk management and conservative reinsurance purchasing to continue. Reinsurance, Risk Management and Catastrophe Risk Material but Manageable Exposure to Catastrophe Risk Limited use of retrocession and other risk mitigation Effective risk management Catastrophe exposure high but manageable Limited Use of Retrocession and Other Risk Mitigation Munich Re uses limited retrocession coverage or other forms of risk mitigation, leaving net losses relatively close to gross losses. It acts as an opportunistic purchaser of retrocession capacity focusing on economic efficiency. The group also uses derivatives and risk swaps as tools to dampen volatility in earnings. Since end-2006, Munich Re has become more active in supplementing its retrocession programme through the use of alternative capital market solutions. The use of such alternative instruments acts as a form of diversification within the group s risk management programme. Overall, Munich Re s tail risk is manageable due to its highly geographically diversified catastrophe portfolio and strong capital position. Fitch regards the current retrocessional programme as effective. The security of the retrocessionaires remains strong. Effective Risk Management Munich Re s risk management function is advanced and has proved effective in monitoring and mitigating investment risk as worldwide economic conditions have deteriorated. Risk management has taken a central role within the organisation, and Fitch expects further progress in enterprise risk management to aid in the identification, quantification and control of risks. Fitch views Munich Re s cycle management and peak exposure management as effective, and will follow the rate developments in Munich Re s new business. Catastrophe Exposure High but Manageable Munich Re was more exposed to the Asia-Pacific catastrophe events in 2011 than some of its peers, although the losses were not out of line with the company s market share in the respective regions. As Munich Re uses limited retrocession coverage or other forms of risk mitigation, this left net losses close to gross losses. For its peak exposures, Munich Re s losses are partly covered by retrocession and catastrophe bonds, resulting in a net exposure of EUR3.3bn for a return period of 200 years for Atlantic Hurricane and EUR2.0bn for European Storm. Fitch regards Munich Re s catastrophe risk as manageable in the context of a highly geographically diversified catastrophe portfolio and strong capital position. The group continues to generate most of its profits from its P&C reinsurance operations, benefiting from overall solid margins within its catastrophe book. Overall pricing outcomes achieved at recent renewals were largely stable. 14

15 Figure 17 Key Non-Insurance Operations/Exposure (EURm) Fitch s expectation Asset-management operating result Fitch expects Munich Re to focus on insurance Funds under management a 7,900 10,200 10,400 11,500 12,900 and reinsurance business as its core competency. a Third party investment Non-Insurance Operations of Small Scale Limited Third-Party Asset Management MEAG MUNICH ERGO AssetManagement GmbH (MEAG) is the asset manager of Munich Re. In addition to its asset management function for the group, MEAG offers its expertise to private and institutional clients. Assets under management for institutional clients outside the group rose to EUR10.2bn in 2013 (2012: EUR9.3bn). 15

16 Appendix: Other Ratings Considerations Complete Ratings List (Core Entities) IFS: AA Munich Reinsurance America Corporation IDR: A+ Munich Reinsurance America, Inc. IFS: AA Hartford Steam Boiler Inspection and Insurance Company IFS: AA ERGO Versicherungsgruppe AG IDR: A+ DKV Deutsche Krankenversicherung AG IFS: AA ERGO Lebensversicherung AG IFS: AA VORSORGE Lebensversicherung AG IFS: AA Europaeische Reiseversicherung AG IFS: AA Below is a summary of additional ratings considerations of a technical nature that are part of Fitch s ratings criteria. Group IFS Rating Approach The entities listed to the left are considered Core entities under Fitch s group rating methodology. The operating entities share the same IFS Ratings based on Fitch s evaluation of the strength of the group as a whole. The entities listed in Figure 17 are considered Very Important by Fitch under the agency s group rating methodology. Notching Based on the definitions set out in the agency s insurance rating methodology, European reinsurers (including those in Germany) operate under what Fitch characterises as a Moderate regulatory environment, as reinsurance policyholders do not benefit from any priority in case of liquidation, but there is a strong capital regime. For primary insurance business, Fitch characterises Germany as having a Strong regulatory environment, with restrictions on payments from the operating companies to the holding companies and with priority afforded to policyholder obligations. Figure 18 Notching Summary Holding Company Not applicable (as the top company is also the main operating company of the group). IFS Ratings With regard to the reinsurance operating companies (Munich Re AG) and Munich Reinsurance America, Inc., a baseline recovery assumption of Average was used for the IFS Ratings, due to the lack of policyholder priority. The IFS Ratings are therefore aligned with the respective IDRs. For the primary insurance operating companies ERGO Lebensversicherung AG and DKV Deutsche Krankenversicherung, a Good baseline recovery assumption was applied to the IFS Ratings, and standard notching was used based on the existence of policyholder priority. The IFS Ratings of these operating companies are therefore one notch higher than the implied IDRs. Debt Outstanding senior unsecured debt issued by Munich Reinsurance America Corporation (MRAC) has been rated using a baseline recovery assumption of Average. Based on standard notching, the rating is therefore aligned with the IDR of MRAC. Hybrids For the five outstanding subordinated note issues, a baseline recovery assumption of Below Average was used. In addition, all of the issues are regarded as having Material loss absorption features (such as ability to defer coupons). Based on the combination of these two characteristics, standard notching was applied, placing these hybrids two notches below the IDR. Short-Term Ratings Not applicable 16

17 Hybrids Equity/Debt Treatment Munich Re s total amount of subordinated debt was EUR4.4bn at end Fitch regards this subordinated debt as 100% capital within its capital adequacy ratio and as 100% debt within its financial leverage ratio calculation. Figure 19 Hybrids Treatment Hybrid Amount CAR Fitch (%) CAR reg. override (%) FLR debt (%) XS EUR1,000m XS GBP300m XS EUR1,349m XS EUR900m XS GBP450m CAR = Capitalisation ratio; FLR = Financial leverage ratio For CAR, % tells portion of hybrid value included as Available Capital, both before (Fitch %) and after the Regulatory Override For FLR, % tells portion of hybrid value included as debt in numerator of leverage ratio Exceptions to Criteria/Ratings Limitations None. 17

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