3. Risk management and procedures
The financial condition and operating results of the Company are affected by a number of key risks, namely, insurance risk, financial risk, compliance risk and operational risk. The Company’s policies and procedures in respect of managing these risks are set out below.
Operational risks are inherent in the business, including the risk of direct or indirect loss resulting from inadequate or failed internal and external processes, people and systems or from external events. The nature of the insurance business means a large number of transactions are required to be processed and assigned to individual insurance products. Controls are in place within systems and processes and are designed to ensure that the operational risks associated with the Company’s activities are appropriately controlled. However, the risk control procedures and systems the Company has established can only provide reasonable and not absolute assurance against material misstatement or loss.
3.1. Strategy in using financial instruments
The nature of the operations of the Company involves the managed acceptance of risk arising from the underwriting of policies, which incorporate financial guarantees and commitments. To mitigate the risk that these guarantees and commitments are not met, the Company purchases financial instruments, which broadly match the expected policy benefits payable, by their nature and term.
The composition of the portfolio of investments is governed by the nature of the insurance liabilities, the expected rate of return applicable to each class of asset and the capital available to meet the price fluctuations of each asset class.
In addition to insurance risk arising from the underwriting of policies, the Company is exposed to a number of risk factors including market risk, credit risk, foreign currency risk, interest rate risk and liquidity risk. These are discussed in more detail below. The Company also utilizes various financial instruments, including derivative instruments, to mitigate foreign currency and interest rate risk or, conversely, to maximize the return from investments.
3.2. Market risk
The Company takes on exposure to market price risks. Market risk arises from open positions in interest rate, currency and equity products, all of which are exposed to general and specific market movements and changes in the level of volatility of market rates or prices such as interest rates, credit spreads, foreign exchange rates and equity prices. The Board of Directors sets the strategy for the portfolio characteristics and limits on the level of risk that may be accepted, which is monitored on a daily basis. Financial investments are diversified in accordance with currently valid Czech insurance legislation. Limits are set on financial investments in any one company or industry. However, the use of this approach does not prevent losses outside of these limits in the event of more significant market movements. To reduce market risk and to facilitate effective investment management, derivative instruments are used by the Company. In the case of unit-linked products, the market risk is fully borne by the policy holder.
3.3. Credit risk
The Company takes on exposure to credit risk which is the risk that a counterparty will be unable to pay amounts in full when due.
Commercial and personal business is also written primarily through intermediaries who are subject to rigorous annual checks of financial and other information, to mitigate the associated credit risk of dealing with these intermediaries.
The Company uses reinsurance in managing insurance risk. However, this does not discharge the Company’s liability as primary insurer, and should a reinsurer fail to pay a claim for whatever reason, the Company would remain liable for the payment to the policyholder. The Company periodically monitors the creditworthiness of reinsurers and their financial situation. The Company periodically monitors the creditworthiness of reinsurers and their financial situation using the credit ratings of reputable rating agencies.
When deciding on the structure of financial investments, the Company assesses the creditworthiness of counterparties or issuers, which is also subject to a subsequent regular review. The Company assesses the situation in the markets and subsequently adjusts the portfolio and its geographic and credit diversification.
3.4. Currency risk
Company assets and liabilities are primarily denominated in the domestic currency. Amounts in foreign currencies are hedged by financial derivatives, particularly currency swaps, in order to minimize the risk of exchange rate movements. The Company mitigates currency risk on financial investments related to technical reserves by setting and complying with limits for individual and total investments in foreign currencies. Compliance with limits is monitored regularly.
3.5. Interest rate risk
The Company takes on exposure to the effects of fluctuations in the prevailing levels of market interest rates on its financial position and cash flows. Income from financial investments may increase as a result of such changes but may reduce or create losses in the event that unexpected movements arise e.g. if the financial investment yield is lower than the technical interest rate. A cash-flowbased analysis is used to create a portfolio of securities whose value changes in line with the value of liabilities when interest rates change. The Company also uses derivatives, particularly interest rate swaps, to mitigate the risks posed by changes in interest rates.
3.6. Liquidity risk
The Company is exposed to daily calls on its available cash resources from insurance claims, maturing policies and policy surrenders. Liquidity risk is the risk that payment of obligations may not be met in a timely manner at a reasonable cost.
In compliance with the valid legislation, the Company maintains a sufficient portion of its financial investments in liquid and secure financial instruments, which are used to cover insurance claims, maturities and surrenders.
3.7. Insurance risk
insured event. Insurance risk includes the following risks:
- occurrence risk – the possibility that the number of insured events will differ from those expected;
- severity risk – the possibility that the costs of the events will differ from those expected;
- development risk – the possibility that changes may occur in the amount of an insurer’s obligation at the end of a contract period or
in the timing of the commitment against original expectations.
- the use of reinsurance to limit the Company’s exposure to large single claims and catastrophes;
- maintenance of a surplus of readily available assets over the expected pattern of claim payments;
- the maintenance and use of sophisticated management information systems that provide up to date, reliable data on the risks to
which the business is exposed at any point in time; - the use of prudent underwriting policies.
The Company reinsurance program consists mainly of proportionate reinsurance (quota/surplus reinsurance) combined with excess of loss reinsurance and catastrophe related reinsurance.
3.8. Compliance and fiscal risk, regulation and solvency
Adherence to the Czech regulatory requirements is monitored by internal compliance managers. Regular reports are also submitted to the Board of Directors.
Compliance risk includes the possibility that transactions may not be enforceable under applicable law or regulation. In addition, it includes the cost of the rectification and fines, and the possibility that changes in law or regulation could adversely affect the Company’s position. The Company seeks to minimize compliance risk by seeking to ensure that transactions are properly authorized and by submitting new or unusual transactions to legal advisers for review.
Fiscal risks arise from changes in tax laws and enforcement policies and in reviews by authorities of tax positions the Company has taken. This risk and risks associated with changes in other legislation and regulation are managed through ongoing review by relevant departments of proposed changes to tax legislation and by membership on relevant trade and professional committees which comment on draft proposals.
Solvency margin requirements established by the regulator are in force for insurers. In long-term insurance measures are also in place in order to assess the Company´s ability to meet client expectations.
The actual solvency margin measures the excess of the value of the insurer’s assets over the value of its liabilities, each element being determined in accordance with the applicable valuation rules. This margin must be higher than the required level throughout the year.