Stress Events - Resilience versus Capital Efficiency

Stress Events - Resilience versus Capital Efficiency Hermann Pohlchristoph, CFO Reinsurance Sun City, June 11th 2012

Financial Management often means to manage opposing targets Stakeholders have different requirements in terms of security and financial return. High returns Low results volatility Analysts Return Liquidity Performance of share price Regulators Investors Equity Resilience against stress events Capital efficiency Clients Every company needs to find and maintain the right equilibrium. State-of-the-art risk management processes should ensure a sustainable value creation to shareholders while protecting the balance sheet of a company against extraordinary shock events. 2

Agenda • A regulator’s view on capital adequacy: Solvency II • A shareholder’s view: optimizing resilience and capital efficiency • Limits of models and how to cope with it

Various supervisory regimes aiming for recognition under Solvency II ("equivalence"), e.g. Bermuda, Switzerland and South Africa. Solvency II – Fuelling a global trend towards risk-based supervision(?) Influence of Solvency II on other supervisory regimes Evidence of the trend IAIS – International Association of Insurance Supervisors Common framework for the supervision of internationally active insurance groups Adjustments of risk-based-capital-type models in USA and Canada. Multilateral framework aiming for worldwide coherence of supervision among global insurance companies. Planned adaption of Solvency II, inter alia in Japan, Israel and Mexico. HarmonizationNo separate framework. ConvergenceNo additional supervision. Convergence towards a common framework to be expected in the medium term.

Changes compared to Solvency I Principle-based (in contrast to Solvency I rules) Economic and market-consistent valuation of all material risks Reinsurance and other risk mitigation instruments fully applicable under Solvency II (no more 50% cap on non-life reinsurance) Some issues remain, especially with regard to non-proportional reinsurance Consideration of diversification effects Investment risks are compre-hensively taken into account 3 pillars of Solvency II Solvency II motivates the insurance industry to fully adopt stringent risk-based economic steering 1 2 3 Transparency Qualitative Quantitative Solvency requirements Supervisory process Market transparency Standard approach or internal model Efficient risk management and control Disclosure requirements to strengthen market discipline Enterprise risk management to replace the traditional accounting-based focus, facilitating a stringenteconomic and holistic approach to managing risks In the past, success was measured by combined ratio and investment income – in the future, the focus will be on return on risk capital

Divergence in opinion between European regulators and the insurance industry at Level 2 (selected issues) Level 1 European regulators & insurance industry European regulators and the insurance industry agree on a Level 1 Framework Directive that represents an adequate compromise which must be respected as a basis for Level 2 consultation process. Level 2/3 European regulators perspective Insurance industry perspective Pillar 1 • Increased capital requirements in general. • No consideration of diversification between solo entities of a group in risk margin. • Very strict rules for 3rd country equivalence. • Preference for a discretionary approach for countercyclical premium. • More balanced treatment of all risk categories, especially within market risk (e.g. spread risk). • Full allowance of diversification in risk margin. • More flexibility towards 3rd country equivalence. • Rule-based approach for countercyclical premium to make adjustments more predictable. Pillar 2 • Strict requirements for the approval process for internal models. • Approval of internal models to be an achievable option without incurring excessive costs. Pillar 3 • Comprehensive reporting requirements to permit efficient supervisory review. • Content and degree of detail of reporting requirements excessive, leading to high costs. The current stage of Level 2 discussion indicates a level of restriction which goes beyond the intentions of the Framework Directive.

The impacts of Solvency II will change the insurance sector • Some general assumptions 1. Capital requirements will rise… • Identification and evaluation of all relevant risks • Long term products will require more capital (more volatile) 2. …and Available capital too • Assets and Liabilities will be evaluated by a "market value approach" • The available capital will rise but the volatility will be higher in time 3. Risk management & transparency • Better qualitative processes for risk steering/control • Use of quantitative models for an overall risk modelling • Value proposition of risk transfer is measurable 4. Asset Risk • An aggressive asset allocation will not compensate any more technical losses – higher risk capital for venturous asset allocation • Reduction of volatile asset categories 5. Product adaptations • Actual products are put to test (risk capital intensive?) • New products will appear (less risk capital intensive)

Advantages of reinsurance solutions Criterion Reasons • Capital strength and rating of reinsurer • Rating and capital strength of reinsurers are differentiating criteria • Explicit consideration of reinsurance credit risk through a deduction from capital relief (see chart1) • Advantages of reinsurance solutions • Effective and available independent of capital market access • Faster and more flexible than capital market solutions • Reinsurance available to all insurance segments and provides highest confidentiality • Capital management by reinsurance • Capital management as an additional driver for reinsurance • Comparison of internal cost of capital with the cost of reinsurance (cost of capital + administration cost + counterparty risk) will be possible and will influence decisions Solvency II will lead to transparency in risk capital relief and will make the added value of reinsurance much more visible. 1 Chart based on QIS5 technical specifications.

Aiming for higher target capitalisation – Management intervention much more responsive than supervisory scheme Munich Re actions1 Munich Re solvency ratio Regulatory actions2 >140%Excellent capitalisation MRCM Solvency II 35–100% Below target capitalisation Solvency ratio adjusted for capital repatriation • Capital repatriation • Increased risk-taking • Holding excess capital to meet external constraints • Obligation to submit a comprehensive and realistic recovery plan • Insurer to take necessary measures to achieve compliance with the SCR 100%–140%Comfortable capitalisation Actual solvency ratio <35% Insufficient capitalisation 80%–100% Adequate capitalisation • Obligation to submit a short-term realistic finance scheme • Regulator may restrict or prohibit the free disposal of insurer's assets • Ultimate supervisory intervention: Withdrawal of authorisation • Tolerate and monitor • (Partial) suspension of capital repatriation <80% Below target capitalisation • Risk transfer • Scaling down of activities • Raising of (hybrid) capital 1 Based on Munich Re capital model (MRCM): 175% of VaR 99.5%. 2 Based on Solvency II calibration: VaR 99.5%.

Elements of Munich Re’s Enterprise Risk Management Risk strategy • Clear limits indicateprecise signals for the internal & external world and define the framework for operative actions • Risk steering • Intelligent system consistingof triggers , limits und measures … • In cooperation • …with responsible management actions • Risk identification and early warning • Necessity for comprehensive overview but with special focus on main issues Risk identification & early warning ERMCycle Risksteer-ing • Risk modelling • Central competition factorin the right balance between flexibility and stability Risk modelling Risk-based incentive systems and sustainable responsibility Sound risk governanceand effective risk management functions Risk management culture as solid base

Strategic Risk Management Framework of Munich Re Category Risk criteria Measure Criteria's objective ERM objective addressed Whole portfolio criteria Financial strength • ERC • Rating • Solvency Safeguarding sufficient excess capital and limiting frequency of negative economic results of Munich Re's entire risk portfolio. Maintaining Munich Re's financial strength, thereby ensuring that all liabilities to our clients can be met Protecting and increasing the value of our shareholders' investment Avoiding financial distress Negative economic earnings tolerated every 10 years Supple-mentary criteria • Peak risk management • ALM limits • Liquidity VaR limits as % of AFR or limit for maximum exposure Limiting losses from individual risks or accumulation exposure and liquidity risks that could endanger Munich Re's survival capability. • Individual nat cat perils • Terrorism • Pandemic • Longevity • Financial sector limit Other criteria E.g.: • Counterparty-credit risk • Single risks • Alternative investments • Non-investment-grade investments Individual risk limits in absolute value Limiting risks that could sustainably damage the trust of stakeholders in Munich Re Safeguarding Munich Re's reputation, thus perpetuating future business potential

Risk Management CultureSteering based on economic principles Risk strategy • Define the risk appetite • Set limits and budgets for peek exposures • Calculate adequate risk capital per segment Business planning Pricing • Pricing parameter take the underlying risk into account: • RoRaC targets • Risk capital loadings • Budgets and limits • Planning parameter take the underlying risk into account: • RoRaC targets • Allocated risk capital • Budgets and limits Performance evaluation and incentive system Achieved RoRaC and economical value added are parts of the incentive system The “return on risk” idea is deeply implemented in every business decision

Annual planning of business units as an application for scarce resources (economic risk capital) • Controlling department provides necessary data, processes and systems for an efficient business planning exercise. Service • Support of business units throughout the planning by dedicated controllers (especially explanation of input parameters like economic risk capital or yield curves). Support • Challenging of the calculation of economic risk capital by the business units. • Challenging of the ambition level and achievability of the plan by the controlling department. • Discussion of critical points between business and controlling units. Challenging • Business units „apply“ in form of a business plan for scarce resources (economic risk capital, staff), which are to be approved by the board of management. • The board of management receives an independent assessment of the business plans from the controlling department, incl. recommendations on the approval and allocation of scarce resources. Assessment of plans • Assessment of target/plan achievement by the controlling department. • Value Added und RoRaC as fundamental KPIs. • Variable compensation linked to plan achievement. Evaluation of success

Munich Re: Low volatility in shareholder returns with a volatile business model through efficient capital management. Efficient deployment of capital over time. High shareholder returns1 with low volatility. % Total shareholder return (p.a.) Volatility of total shareholder return (p.a.) CAGR: 12.4% • Volatility in single years is a function of the reinsurance business model. • This has to be dealt with prudent risk and capital management. Dividend yield2 (%) • Annualised total shareholder return defined as price performance plus dividend yield over the period from 1.1.2005 until 29.2.2012; based on Datastream total return indices in local currency; volatility calculation with 250 trading days per year. Peers: Allianz, Axa, Generali, Hannover Re, Swiss Re, Zurich Financial Services. • Dividend divided by year-end share price. 15

Resilience to shock events - 2011 as a real-life stress test (I) • 2011 saw for the reinsurance segment of Munich Re a combined ratio of 113.6% of which 32.5% were due to large losses (28.8% nat cat). • Largest single losses were EQ Japan (€1.5bn), EQ Christchurch (€1.3bn) and the Flood in Thailand (€0.5bn). 2011 Nat Cat events… • Proved the value of risk modeling and active exposure management despite the inevitable problem of model uncertainty. • Confirmed the need to continuously revise and enhance underlying models. • Emphasized again the necessity for sufficient profitability thresholds to sustainably write Cat business. • Shed a special spotlight on the issue of CBI claims in the industrial primary insurance market.

Resilience to shock events - 2011 as a real-life stress test (II) 10-year German Bund yield1 Credit spreads1,2 EURO STOXX 501 –113 bps +145 bps –17% Several countries downgraded in the course of 2011. Historically low interest rates for „secure“ government bonds. General high volatility in the financial markets. • 2011 underlines the need for a limited risk-appetite and a high degree of diversification on the asset side . • Especially as “risk-free assets” virtually ceased to exist. • Despite the turmoil Munich Re managed to achieve a RoI of ~ 3.4%. 1 Change between 31.12.2010 and 31.12.2011. 2 IBOXX EURO Corporate vs. BofAML German Government 7–10 years. 18

Limits of mathematical models for business decisions... (I) Changed jurisdiction Dependency on assumptions Model changes • Example: RMS11 • RMS, one of the leading risk modeling companies, introduced in 2011 a revised model for US wind exposures. • As a consequence of the changes, the modeled loss expectation for several US exposures increased. Example: Longevity One risk in life insurance is the average life expectation in an insured portfolio. Example: Pandemic Only scarce empiric data is available on pandemic risks. Sensitivity of changed assumptions can be material and can change the overall assessment of a book of business. • Example: Motor UK • Motor claims in UK used to be paid as a lump sum. • Jurisdiction started to move towards periodical payments (PPOs), even retrospectively. • As a consequence, the inflation and investment risk is transferred from the insured to the (re-)insurance company.

Limits of mathematical models for business decisions...(II) Trend risks Immanent weaknesses And now...? • Example: Allocation of economic risk capital • The allocation of the group-wide modeled economic risk capital to business units / single contracts follows a mathematical algorithm. • Results of this algorithm can never fully reflect reality (the more granular - the more incorrect) • Example: Bodily injury • Calculated risk capital of „long-tail“ lines of business (too?) low on a regular basis. • Biggest losses of the insurance industry happened to be in exactly this class of business (Workers comp, Motor, Asbestos). • Are trend risks, which manifest slowly, correctly captured in the models? Does the systematic consideration of risk in controlling systems create any benefit at all?

Consequences of model insufficiencies for decision making Communication & Transparency • Principles of economic KPIs must be understood by decision makers – also with respect to the immanent insufficiencies. • However, the general question has to be clearly answered: an approximation of reality is clearly better than not considering the risk factor at all. • Value Added und RoRaC should not be taken as the only truth. • Especially for management incentives, there should be a sense for proportion (however, in both directions). Sense of proportion • Not every „scientific“ finding on risk measurement has to be immediately incorporated in performance measurement. • For every change in methodology it has to be assessed, if the initiated management impulse is really intended. Implementation of a gatekeeper function for model changes is advisable. Stability of models Monitoring • Regular review and „benchmarking“ of risk modeling results. • Annual monitoring of input parameters by the controlling department. • Discussion of findings with business units. • Mathematical models and KPIs do not supersede common sense and entrepreneurial intuition.

Let‘s dare an outlook what the future will hold for the insurance industry... Regulation Success Factors • Local regulations will become more and more aligned. • Globally, the valuation of risks will follow economic and market consistent approaches. • Regulation will become in tendency more (and maybe too) onerous. • Decreasing appetite for risky bets on assets (incl. sovereign ratings). • Increased levels of diversification. • Higher focus on underwriting profitability will be key. • The pure existence of internal models does not prevent negative surprises. A prudent balance of models and common sense is key. External Developments Internal Reactions Financial Crisis • The lessons learned will lead in many cases to a changed assessment of risks. • Especially the crisis in the banking sector and the sovereign debt crisis revealed severe problems in risk models. • Only if the industry draws the right conclusions, the stock markets and investors will appreciate the development.

Stress Events - Resilience versus Capital Efficiency