7.5 Risk profile

The main types of risk to which the PZU Group is exposed includes credit risk (in particular risk related to bank credit portfolio), actuarial risk, market risk (in particular interest rate risk, foreign exchange risk, and risk related to financial instruments and commodities), concentration risk, operational risk, compliance risk and models risk.

When managing each type of risk, the PZU Group identifies, measures and monitors risk concentration; for the banking sector, these processes occur on the entity level, according to requirements in the sector. To meet the regulatory obligations imposed on capital groups identified as financial conglomerates, intensive adjustment is pending to extend the current risk concentration management model.

7.5.1. Credit and concentration risk

Credit risk is the risk of a loss or adverse change in the financial situation resulting from fluctuations in the trustworthiness and creditworthiness of issuers of securities, counterparties and all debtors, materializing through a counterparty’s default on a liability or an increase in credit spread. This definition also includes credit risk in financial insurance.

Credit risk in the PZU Group includes:

• credit spread risk, the possibility of incurring a loss due to a change in the value of assets, liabilities and financial instruments resulting from a change in the level of credit spreads as compared to the term structure of interest rates of debt securities issued by the State Treasury or fluctuations of their volatility;
• counterparty default risk, the possibility of incurring a loss as a result of unexpected default of counterparties and debtors or deterioration of their credit rating;
• credit risk in banking activity, credit risk resulting from activity in the banking sector, associated mainly with the possibility that a debtor or borrower defaults on their obligations;
• credit risk in financial insurance, credit risk resulting from activity in the financial insurance sector, related mainly to the possibility that a third party counterparty, or a debtor/borrower defaults on their obligations to a PZU Group client; this threat may result from failure to complete an undertaking or adverse influence of the business environment.

Concentration risk, a risk stemming from the failure to diversify an asset portfolio or from large exposure to the risk of default by a single issuer of securities or a group of related issuers.

Exposure to credit risk in the PZU Group arises directly from banking, investment activities, activity in the financial insurance and guarantee segment, reinsurance agreements, and bancassurance operations. The PZU Group distinguishes the following kinds of credit risk exposure:

• risk of a customer defaulting against the PZU Group under contracted credits or loans (in banking activity);
• the risk of bankruptcy of the issuer of financial instruments invested in or traded by the PZU Group, such as corporate bonds;
• the risk of counterparty default, for example in reinsurance or OTC derivative instruments and bancassurance activities;
• the risk of PZU Group customer defaulting against a third party, for example in insurance of cash receivables, insurance guarantees.

7.5.1.1. Concentration risk arising out of lending activity

This section presents information related to lending activity of PZU Group’s banks.

To prevent adverse events that could result from excessive concentration, both Pekao and Alior Bank mitigate the concentration risk by setting limits and applying concentration standards arising from both external and internal regulations. They include the following:

• rules for identifying areas where concentration risk arises in credit activity;
• taking concentration into account when estimating internal capital;
• the process of setting and updating limit levels;
• the process of managing limits and defining actions taken if the permitted limit level is exceeded;
• concentration risk monitoring process, including reporting;
• oversight over the concentration risk management process.

In the process of setting and updating concentration limits, the following information is taken into account:

• information on the level of credit risk of limited portfolio segments and their impact on realization of assumptions related to risk appetite in terms of credit portfolio quality and capital position;
• sensitivity of limited portfolio segments to changes in the macroeconomic environment, assessed in regular stress tests;
• reliable economic and market information concerning each exposure concentration area, especially macroeconomic and industry ratios, information on economic trends, including the projections of interest rate levels, exchange rates, political risk analysis, ratings of governments and financial institutions;
• reliable information about the economic situation of companies, industries, branches, economic sectors, general economic information including news on the economic and political situation of countries, as well as other information needed to evaluate concentration risk;
• interactions between different kinds of risk, i.e. credit, market, liquidity and operational risk.

Risk analysis is performed using both an individual and a portfolio approach. Measures are undertaken to:

• minimize credit risk for an individual loan with the assumed level of return;
• reduce overall credit risk arising from a specific credit portfolio.

In order to minimize the risk level of a single exposure, the following is assessed every time when a loan or other credit product is granted:

• reliability and creditworthiness, including detailed analysis of the source of exposure repayment;
• collaterals, including review of their formal, legal and economic status, having regard to the loan to value (LTV) adequacy ratio.

In order to enhance control over the risk of individual exposures, customers are monitored regularly and appropriate measures are taken if increased risk factors are identified.

In order to minimize credit risk arising from a particular portfolio:

• concentration limits are set and tracked;
• early warning signs are monitored;
• the credit portfolio is monitored regularly, with particular supervision of material credit risk parameters;
• regular stress tests are carried out.

7.5.1.2. Credit risk arising out of lending activity

Risk assessment in credit process

The provision of credit products is accomplished in accordance with loan granting methodologies appropriate for a given client segment and type of product. The internal rating process in both banks constitutes a significant part of assessing credit risk of both the client and the transaction. It is an important step in the credit decision-making process for new loans and for changes of lending terms, and in monitoring loan portfolio quality. Each bank has developed its own models used in the client creditworthiness assessment process, which must be completed before a credit decision is made. The models are based on external information and on internal data. Credit products are granted in the banks in accordance with the operating procedures, whose purpose is to set out the proper steps that must be taken in the credit process, identify the units responsible for those activities and the tools to be applied.

Credit decisions are made in accordance with the existing credit decision system (with decision-making powers at specific levels matching the risk level of a particular client and transaction).

In order to conduct regular assessment of accepted credit risk and to mitigate potential losses on credit exposures, the client’s standing is monitored during the lending period by identifying early warning signals and by conducting regular individual reviews of credit exposures.

To minimize credit risk, security interests are established in line with the level of exposure to credit risk and in accordance with the client’s ability to provide the required collateral. The establishment of a security interest does not waive the requirement to examine the client’s creditworthiness.

Collateral is taken to secure repayment of the loan amount with due interest and costs if the borrower fails to settle its due debt within the dates stipulated in a loan agreement and restructuring activities are not successful. Accepted forms of collateral include: guarantees, sureties, account freezes, registered pledges, transfers of title, assignments of receivables, assignment of credit insurance, promissory notes, mortgages, powers of attorney to bank accounts and security deposits (as special forms of collateral). The assets constituting collateral are reviewed in the credit process in terms of their legal capacity to establish effective security interest and also the recoverable amount in a possible enforcement procedure.

Scoring and credit rating

The rating scale differs by bank, client segment and transaction type. The following tables present the quality of credit portfolios for exposures covered by internal rating models. Because of the different rating models employed by Pekao and Alior Bank, the data are presented for each of the banks separately.

Permanent protection of credit portfolio quality is provided by continuous monitoring of timely service of loans and regular reviews of the financial and economic standing of clients and the value of accepted collateral. This process is applied to all credit exposures of individual and business clients.

Pekao

Alior Bank

7.5.1.3. Application of forbearance

Forbearance is used if a threat arises that a client may default on the terms of a contract because of the financial difficulties, including problems with the service of debt. In such a situation, the terms and conditions of the agreement can be modified to ensure that the borrower is capable of servicing debt. Changes in terms and conditions of contracts may include: reduction of interest rates, principal installment amounts, accrued interest, rescheduling of principal or interest payments.

Accounting policies for the assessment and determination of impairment losses for forborne exposures are broadly in line with the principles for determining impairment losses under IFRS 9.

The PZU Group identifies a significant increase in the credit risk of assets for which forbearance modifications have been applied for the purpose of assessing impairment in accordance with IFRS 9.

7.5.1.4. Credit risk arising out of investing activity

The management principles for credit risk arising from investing activity in the PZU Group are governed by a number of documents approved by supervisory boards, management boards and dedicated committees.

Credit risk exposures to respective counterparties and issuers are subject to restrictions based on exposure limits. The limits are established by dedicated committees, based on the analyses of risks associated with a given exposure and taking into account the financial standing of entities or groups of related entities and the impact of such exposures on the occurrence of concentration risk. Qualitative restrictions on exposures established by individual committees in accordance with their powers form an additional factor mitigating the credit risk and concentration risk identified in investment activities.

The limits refer to exposure limits to a single entity or a group of affiliated entities (this applies to both credit limits and concentration limits). The use of credit risk and concentration risk limits is subject to monitoring and reporting. If the limit is exceeded, appropriate actions, as defined in internal regulations, are taken.

Credit risk assessment of an entity is based on internal credit ratings (the approach to rating differs by type of entity). Ratings are based on quantitative and qualitative analyses and form one of the key elements of the process of setting exposure limits. The credit quality of counterparties and issuers is regularly monitored. One of the basic elements of monitoring is a regular update of internal ratings.

Risk units identify, measure and monitor exposure to credit risk and concentration risk related to investment activity, in particular they give opinions on requests to set exposure limits referred to individual committees.

Information on the credit quality of assets related to investing activity is presented in section 36.

Exposure to credit risk

The following tables present the credit risk exposure of individual credit risk assets in respective Fitch rating categories (if a Fitch rating was missing, it was substituted by a Standard&Poor’s or Moody’s rating). Credit risk exposures arising from conditional transactions are presented as an exposure to the issuer of the underlying securities.

The tables do not include loan receivables from clients and receivables due under insurance contracts. This was because these asset portfolios are very dispersed and therefore contains a significant percentage of receivables from unrated entities and individuals.

The table below presents credit risk coefficients used by the PZU Group to measure credit risk:

The credit risk level attributable to the assets where the risk is carried by the PZU Group as at 31 December 2018 was PLN 6,924 million (as at 31 December 2017 it was PLN 8,866 million; if the coefficients of 31 December 2018 were used, the value would be PLN 8,662 million).

7.5.1.5. Reinsurer’s credit risk in insurance activity

PZU Group enters into proportional and non-proportional reinsurance contracts aiming to reduce liabilities arising from its core business. Reinsurance is exposed to credit risk associated with the risk that a reinsurer default on its obligations.

Assessment of reinsurers’ creditworthiness is conducted based on market data, information obtained from external sources, such as Standard&Poor’s and also based on an internal model. The model divides reinsurers into several classes, depending on the estimated risk level. A reinsurer will not be accepted if its risk is higher than a pre-defined cut-off point. The acceptance is not automatic and the analysis is supplemented by assessments by reinsurance brokers. In the credit risk monitoring process, this assessment is updated on a quarterly basis.

The following tables present the credit risk of the reinsurers that cooperated with PZU Group companies.

Counterparty risk related to reinsurance is mitigated by the fact that the PZU Group cooperates with numerous reinsurers with reliable credit ratings.

7.5.1.6. Risk concentration in credit risk

The following table presents the concentration of PZU Group’s balance-sheet and off-balance-sheet exposures using the sections of the Polish Classification of Business Activity (PKD):

• exposure to financial investments such as equity instruments, debt securities, loans granted buy-sell-back transactions, bank accounts and term deposits;
• amounts of extended insurance guarantees;
• value of loans (balance-sheet and off-balance-sheet exposure without interest, collected fees and impairment losses) less security deposits paid in cash;
• unauthorized overdrafts in current accounts;
• treasury limits less security deposits paid in cash, including debt securities issued by an entity from each section.

7.5.2. Actuarial risk (non-life and life insurance)

Actuarial risk is the possibility of loss or of adverse change in the value of liabilities under the executed insurance agreements and insurance guarantee agreements, due to inadequate premium pricing and technical provisioning assumptions. Actuarial risk includes:

PZU Group manages its actuarial risk among others through:

• calculation and monitoring of adequacy of technical provisions;
• tariff strategy, monitoring of the current estimates and evaluation of premium adequacy;
• underwriting;
• reinsurance.

Calculation and monitoring of adequacy of technical provisions

PZU Group manages its technical provisioning adequacy risk by using appropriate calculation methodology and by controlling provision calculation processes. The provisioning policy is based on:

• prudent approach to the calculation of technical provisions;
• continuity principle, which entails making no changes in the technical provisioning methodology if no significant circumstances occur to justify such changes.

For non-life insurance, the level of technical provisions is evaluated once a month and in specific circumstances (when a payment is made or new information obtained from adjusters or lawyers) their amount is updated. The historical developments and payments of technical provisions over the years are used in the current analyses of technical provisions. This analysis provides an assessment of precision of the current actuarial methods.

For life insurance products, the main sources of data used to estimate the expected frequency of claims include public statistical data (life expectancy tables) published by specialized statistical institutions and analysis of historical insurance portfolio data. Periodic statistical analysis of claim incidence are made at the level of product groups, individual insurance portfolios and properly defined homogeneous risk groups. These analyses form the basis for measuring relative incidence of events compared to publicly available statistical data. The use of appropriate statistical methodologies allows the Group to determine the significance of the statistics and where required – define and apply appropriate safety margins in the determination of technical provisions and risk measurement.

Estimation of technical provisions in the PZU Group is supervised by chief actuaries.

Tariff strategy, monitoring of current estimates and evaluation of premium adequacy

The objective of the tariff policy is to guarantee adequate level of premium (sufficient to cover current and future liabilities under in-force policies and expenditures). Along with developing a premium tariff, simulations are conducted with regard to the projected insurance profit/loss in subsequent years. Additionally, regular premium adequacy and portfolio profitability studies are carried out for each insurance type based on, among others, evaluation of the technical result on a product for a given financial year. The frequency of analyses is adjusted to the materiality of the product and possible fluctuations of its result. If the insurance history is unfavorable then measures are taken to restore the specified profitability level, which involves adjustments to premium tariffs or to the insured risk profile, through amendments to general terms of insurance.

Underwriting

For corporate and SME customers, the underwriting process is separate from the sales function. The insurance sales process to corporate customers is preceded by analysis and assessment of risk carried out by dedicated underwriting teams. The underwriting process consists of a risk acceptance system based on the assigned decision-making powers and limits.

Reinsurance

The purpose of the PZU Group’s reinsurance program in non-life insurance is to secure its core business by mitigating the risk of catastrophic events that may adversely affect the its financial position. This task is performed through obligatory reinsurance contracts supplemented by facultative reinsurance.

PZU Group limits its risk among others by way of:

• non-proportional excess of loss treaties, which protect the portfolios against catastrophic losses (e.g. flood, cyclone);
• non-proportional excess of loss treaties, which protect property, technical, marine, aviation, TPL (including motor TPL) portfolios against the effects of large single losses;
• a proportional treaty, which protects the financial insurance portfolio.

Optimization of the reinsurance program in terms of protection against catastrophic claims is based on the results of internal analyses and uses third-party models.

7.5.2.1. Exposure to actuarial risk – non-life and life insurance

The expense ratio is the ratio of total acquisition expenses, administrative expenses, reinsurance commissions and profit participation, to the net earned premiums.

The net loss ratio is the ratio of claims and the net movement in technical provisions, to the net earned premiums.

The reinsurer’s retention ratio is the ratio of the reinsurer’s share in gross written premiums, to the gross written premiums.

The combined ratio is the ratio of the sum of acquisition expenses, administrative expenses, reinsurance commissions and profit participation, claims and net movement in technical provisions to the net earned premiums.

The following tables present the development of technical provisions and payments in successive reporting years.

Motor insurance – motor own damage (autocasco) and motor TPL – is the core component of the PZU Group’s portfolio. Both types of insurance are generally concluded for one year, in which the loss must occur for the claim to be paid out. In the case of motor own damage, the time for reporting a loss is short and it is not the source of uncertainty. Motor TPL is a whole different situation – the period for reporting losses may be up to 30 years. The level of property losses is sensitive especially to the number of litigation claims reported and court rulings awarded in respective cases. In the case of TPL insurance contracts, new types of long-tail losses arise, which makes the process of estimating technical provisions much more complicated. 

Risk concentration in non-life insurance

Within actuarial risk, the PZU Group identifies concentration risk with regard to possible losses caused by natural disasters, such as, in particular, floods and cyclones. The table below presents sums insured in the specified ranges, broken down by voivodeships (for operations conducted in Poland) and countries (for foreign operations). With regard to the exposure to the risk of floods and cyclones, the risk management system in the PZU Group allows to monitor it regularly and the reinsurance program in place reduces significantly the potential net catastrophic loss levels.

Capitalized annuities

The following results do not take into account the impact of changes in valuation of investments included in provision calculations.

7.5.2.2. Exposure to insurance risk – life insurance

The PZU Group has not disclosed information on the development of claims in life insurance, since uncertainty about the amount and timing of claims payments is typically resolved within one year.

Risk concentration is associated with the concentration of insurance contracts or sums insured. For traditional individual insurance products, where concentration risk is related to the possibility that an insurable event occurs or is related to the potential level of payouts arising from a single event, the risk is assessed on a case-by-case basis. The assessment includes medical risk and – in justified cases – also financial risk. Consequently, risk selection occurs (a person concluding an insurance agreement is evaluated) and the maximum acceptable risk level is defined.

In group insurance, concentration risk is mitigated by the sheer size of the contract portfolio. This significantly reduces the level of disturbances caused by the random nature of insurance history. Additionally, the collective form of a contract, under which all the persons insured have the same sum insured and coverage is an important risk-mitigating factor. Therefore, some risks within the contract portfolio are not concentrated.

In the case of group insurance contracts in which insurance cover may be adjusted at the level of individual group contracts, a simplified underwriting process is used. It is based on information about the industry in which the work establishment operates, assuming appropriate ratios of the insureds to employees in the work establishment. The insurance premiums used in such cases and appropriate mark-ups result from statistical analyses conducted by PZU Life on incidence of claims at the level of defined homogeneous risk groups, including relative frequency of events compared to public statistical data.

It should be noted that for most contracts, the claim amount is strictly defined in the insurance contract. Therefore, compared to typical non-life insurance contract, concentration risk is reduced, since single events with high claims payments are relatively rare.

Annuity products in life insurance

Life insurance products excluding annuity products

Effects of lapses in life insurance

Calculation of mathematical technical provisions for life insurance does not include the risk of lapses (resignations). The effects of hypothetical lapses 10% of all life insurance customers are presented below.