E.4. Market risk

Unexpected movements in prices of equities, real estate, currencies and interest rates might negatively impact the market value of the investments.

These assets are invested to meet the obligation towards both life and non-life policyholders and to earn a return on capital expected by the shareholders. The same changes might affect both assets and the present value of the insurance liabilities.

The market risk of the Company’s investment portfolios’ financial assets and liabilities is monitored and measured on a continuing basis, using a Value at Risk analysis and other methods (cash-flow matching, duration analysis, etc.).

Risks are monitored on a fair value basis so that some accounting categories with insignificant risks are omitted from further chapters. Investment portfolios therefore include all Investments except for Investments in subsidiaries, Unit-linked policies, Receivables and some specific immaterial investments. It also includes Cash and cash equivalents and Financial liabilities.

Trade receivables face mainly risk of default. Due to the short-term pattern of trade receivables the Company considers a market risk of trade receivables as insignificant.

E.4.1. Interest rate risk

The Company’s operations are subject to the risk of interest rate fluctuations to the extent that interest-earning assets (including investments) and interest-bearing liabilities mature or reprice at different times or in differing amounts. In the case of floating rate assets and liabilities, the Company is also exposed to an interest rate cash flow risk, which varies depending on the different repricing characteristics of the various floating rate instruments.

Interest rate derivatives are primarily used to bridge the mismatch in the repricing of assets and liabilities. In some cases derivatives are used to convert certain interest-earning assets to floating or fixed rates to reduce the risk of losses in value due to interest rate changes or to lock in spreads.

The Company monitors the sensitivity of financial assets and liabilities to various standard and non-standard interest rate scenarios. Standard scenarios that are considered on a monthly basis include a 100 basis point (bp) parallel fall or rise in all yield curves worldwide.

Assets are divided into 3 groups: Bonds, Interest rate sensitive instruments (group Interest rate derivatives) and others (group Money market instruments) which are almost insensitive to interest rate shocks. Unit-linked instruments are excluded from sensitivities due to the fact that investment risk is borne by the policyholders. The sensitivities shown in the following table concern only assets at their fair value as it was at the end of the year. The overall impact on the Company’s position is the result of sensitivity analysis on both the asset and liability side that creates a mitigating effect.

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Sensitivity of insurance liabilities is disclosed in note C.2.4.

Table below shows reconciliation of Investment portfolio bearing interest rate risk as detailed in relevant Notes:

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The reconciling items in 2014 in the amount of CZK 9 million are unique derivatives (FX swaps of UniCredit Bank Czech Republic, a.s.).

Reconciliation in 2013 is made up by reinsurance deposits (CZK 2 million), unique FX derivatives (with UniCredit Bank Czech Republic, a.s., CZK 5 million) and different valuation of loan provided to Apollo Business Center IV a.s. (CZK 13 million).

E.4.2. Asset liability matching

A substantial part of insurance liabilities carries an interest rate risk. Asset-liability management is significantly involved in interest rate risk management. The management of interest rate risk, implied from the net position of assets and liabilities, is a key task of asset-liability management.

GPH has an Asset and Liability Committee which is an advisory body of the Board of Directors of the Company and is in charge of the most strategic investment and ALM-related decisions. The committee is responsible for setting and monitoring the GPH Group’s strategic asset allocation in the main asset classes, i.e. government and corporate bonds, equities, real estate, etc. and also the resulting asset and liability strategic position. The objective is to establish appropriate return potential together with ensuring that the GPH Group can always meet its obligations without undue cost and in accordance with the GPH Group’s internal and regulatory capital requirements. In order to guarantee the necessary expertise and mandate, the Committee consists of representatives of top management, asset management, risk management and ALM experts from business units.

The ALM manages the net asset-liability positions in both, life and non-life insurance, with the main focus on traditional life with the long-term nature and often with embedded options and guarantees. The insurance liabilities are analysed, including the embedded options and guarantees and models of future cash flows are prepared in cooperation with actuaries. The models allow for all guarantees under the insurance contracts and for expected development of the key parameters, primarily mortality, morbidity, lapses and administration costs.

At first government bonds are used to manage the net position of assets and liabilities and in particular its sensitivity to parallel and non-parallel shifts in the yield curve. Next corporate bonds and derivatives, primarily interest rate swaps, can be used. However, in line with the credit risk management policy, investments in long-term and thus also high-duration instruments focus on government bonds. The use of interest rate swaps is limited due to their accounting treatment – as their revaluation which is reported in the income statement does not match with the reporting of the insurance liabilities.

There is a strategic target asset-liability interest rate position set within the strategic asset allocation process (SAA). With the goals being a) to deliver rates of return that are in line with both, commercial needs and strategic planning targets, and b) that the overall SAA, including equity, credit, real estate allocation and also including the strategic asset & liability duration position, is in line with the risk and capital management policy. Despite that for number of reasons it is e.g. not possible to perfectly match future cash flows of assets and liabilities, the position has been substantially reduced within the last years, primarily via purchases of long-term government bonds. In addition to the management of the strategic position, there are certain limits allowed for tactical asset managers’ positions, so that asset interest rate sensitivity can deviate from the benchmark in a managed manner.

E.4.3. Equity price risk

Equity price risk is the risk that equity prices will fluctuate affecting the fair value of equity investments and other instruments that derive their value from a particular equity investment or index of equity prices.

The Company manages its use of equity investments in response to changing market conditions using the following risk management tools:
a) the portfolio is diversified,
b) the limits for investments are set and carefully monitored.

The equity price risk is part of the Market Value at Risk (MVaR) calculation and through it the equity price risk is measured (for details on the methodology, see E.4.5.). The MVaR is calculated for a one-year time horizon at a 99.5% confidence level.

The positive impact of diversification can be seen in the table below.

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Table below shows reconciliation of Investment portfolio bearing equity price risk as detailed in relevant Notes:

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The reconciliation amount in 2014 represents subsidiaries Apollo Business Center IV a.s. (CZK 891 mil.), Pařížská 26, s.r.o. (CZK 345 mil.), PALAC KRIZIK a.s. (CZK 526 mil.), ČP Invest realitní uzavřený investiční fond a.s. (CZK 1,747 mil.) and 1.Fond kvalifikovaných investorů GPH (CZK 218 mil.).

E.4.4. Currency risk

The Company is exposed to currency risk through transactions in foreign currencies and through its assets and liabilities denominated in foreign currencies. As the currency in which the Company presents its financial statements is CZK, movements in the exchange rates between selected foreign currencies and CZK affect the Company’s financial statements.

The general strategy of the Company is to fully hedge currency risk exposure. The Company ensures that its net exposure is kept on an acceptable level by buying and selling foreign currencies at spot rates when considered appropriate, or using short-term FX operations. The FX position is regularly monitored and the hedging instruments are reviewed on a monthly basis and adjusted accordingly. Derivative financial instruments are used to manage the potential earnings impact of foreign currency movements, including currency swaps, spot and forward contracts. When suitable, options and other derivatives are also considered and used.

The Company’s main foreign exposures are to European countries and the United States of America. Its exposures are measured mainly in Euros (“EUR”), U.S. Dollars (“USD”) and Polish Zloty (“PLN”), because the Company established a branch in Poland in 2012.

The currency exposure is shown in the following tables.

The following table shows sensitivities of the portfolio to changes in currency risk. The portfolio does not contain instruments covering unit-linked policies, as the investment risk is transferred from the Company to the policyholder. Currency shocks are considered to be a rise or a fall in the value of foreign currency position by a specified percentage. This approach is in line with the Solvency II definition of the currency risk.

Due to hedge accounting, the impact of potential increase or decrease of foreign exchange rates is limited and recognized through the income statement:

*   functional currency
** functional currency of the branch in Poland – see Note A.4

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The following table shows sensitivities of the insurance liabilities to change in currency risk.

*   functional currency
** functional currency of the branch in Poland – see Note A.4

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The following table shows the composition of financial assets and liabilities with respect to the main currencies:

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E.4.5. Risk limits and Market Value at Risk

The principal tools used to measure and control market risk exposure within the Company’s investments portfolios are a system of risk limits and Market Value at Risk (MVaR).

The system includes single and total limits on foreign currency (FX), interest rate (IR) and equity (EQ) risks. The primarily aim of the system of limits is to control exposure to single type of risks. Limits are monitored on daily basis and allow Risk Management to take immediate action and actively manage the level of the undertaken risks.

Risk Management uses the combination of the system of limits and MVaR as an effective tool for entire RM system which allows taking operative short-term measures and monitor risks on long-term basis as well.

Investment portfolios include all Investments except for Investment property, Investments in subsidiaries, Unit-linked policies, Receivables and some specific immaterial investments. It also includes Cash and cash equivalents and Financial liabilities.

Value at Risk represents the potential losses from adverse changes in market factors for a specified time period and confidence level. The approach, based on JP Morgan Risk Metrics methodology, calculates the Value at Risk using a covariance matrix of relative changes in market factors and net present value of actual positions assuming that these relative changes are normally distributed. The MVaR is calculated for a one-year time horizon at a 99.5% confidence level.

The assumptions on which the MVaR model is based give rise to some limitations, especially the following:
a) A holding period assumes that it is possible to hedge or dispose of positions within that period. This is considered to be a realistic assumption in almost all cases but may not be the case in situations in which there is severe market illiquidity for a prolonged period.
b) A confidence level does not reflect losses that may occur beyond this level. Even within the model used, there is a 0.5 percent probability that losses could exceed the MVaR.
c) The methodology is applicable to instruments with a linear relationship between position value and market risk factors. In the case of nonlinearity (e.g. for options), the analytical delta/gamma approximation is used.
d) MVaR is calculated on an end-of-day basis and does not reflect exposures that may arise on positions during the trading day.
e) The use of historical data as a basis for determining the possible range of future outcomes may not always cover all possible scenarios, especially those of an exceptional nature. The model is also sensitive on the length of the historical data used. The Company uses historical data for the most recent year to cover enough of history and also to reflect the current market situation.
f) The MVaR measure is dependent upon the Company’s position and the volatility of market prices. The MVaR of an unchanged position reduces if the market price volatility declines and vice versa.

The MVaR positions of the whole portfolio of the Company were as follows. To show the sensitivity and also the development of the total MVaR, the average, minimum and maximum of the MVaR within the year (calculated from end-of-month values) and their corresponding distribution into three main categories (FX risk, IR risk, equity price risk) are also presented:

* Minimum, maximum and average VaR is determined based on overall VaR calculated during the year and it is not necessarily indicative for minimum, maximum and average values on each single component of VaR.

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