Market risk is the risk that volatility in the financial markets will impact our results of operations and financial position.
We define the asset mix based on the instructions approved by the Supervisory Board, including limits on types of assets and the geographic distribution and risk profile of bonds, shares and real property for each company in the Group. Our asset mix and investment activities focus mainly on interest rate risk, security and liquidity.
Interest rate risk
Fluctuating interest rate levels is a very important market risk to which we are exposed. Interest rate changes affect our investment assets as well as our provisions for claims, both of which are stated at market values. If interest rates fall, the value of the bond portfolio would rise, while a lower interest rate would at the same time cause the provisions for claims to rise. Fluctuating interest rates thus impact the financial results in two opposite direction, and the risk of profit variations depends on the degree to which these two movements offset each other.
Our portfolio of fixed-interest securities stood at DKK 30.3bn at 31 December 2007, while the provision for claims discounted using a market rate amounted to DKK 19.7bn, net of reinsurance. The respective durations were 1.9 and 3.0 years. The variation in duration is attributable to our bond portfolio being significantly larger than the discounted provisions. A parallel shift of interest rates of 1% would reduce the market value of our securities by DKK 568m, while the opposite impact on provisions would be DKK 547m, triggering a net impact of DKK 21m.
In connection with the switch to discounting annuities in Danish workers' compensation insurance using a market rate, the average duration of provisions discounted using a market rate increased by 0.7 years to 3.0 years per 31 December 2007 with a corresponding increase in the duration of the bond portfolio to ensure continued matching interest rate sensitivity for assets abs liabilities.
Currency risk
We are not subject to any significant currency risk. Our premium income in foreign currency is mostly matched by claims and expenses in the same currencies, primarily NOK, EUR, SEK and USD. We do not hedge the remaining, limited currency risk in connection with future cash flows in foreign currencies.
We use currency derivatives to hedge the risk of loss of value of balance sheet items due to exchange rate fluctuations in accordance with a general hedge ratio of 90-100 for each currency. We aim to hedge 89-100% of the net book value of the Norwegian entity.
Credit risk
We are exposed to credit risk in connection with the collection of receivables. In the case of the insurance operations, counterparties may be customers, suppliers or reinsurers. In connection with the investment activities, our primary counterparties are issuers of bonds and counterparties in other financial instruments.
Receivables from policyholders arise on an ongoing basis and amounted to DKK 901m or 5.3% of gross premiums at 31 December 2007. The risk related to receivables from customers is limited because the insurance cover lapses if they fail to pay.
Other market risk
The equity and real property portfolios are exposed to changes in equity markets and real property markets, respectively. We manage such risk through investment limits for various asset classes. In certain circumstances, we also use interest rate and equity derivatives in our investment activities.
The equity portfolio primarily focuses on the large, liquid equity markets in Europe, the USA and Japan. We have defined a strategy with relatively little exposure in the Nordic region. This is done in order to reduce company risk, because a few companies account for large parts of the markets in the two countries.
Furthermore, we have tied each equity mandate to a recognised benchmark, which we monitor closely. The portfolio tracks the benchmark fairly closely, even outperforming it over time. The 25 largest equities in our portfolio account for some 31% of the total listed equity portfolio.
Last update: 07 April 2008