7.5 Risk profile

PZU Group is exposed to the following main types of risk: credit risk (in particular related to the banks’ credit portfolio), actuarial risk, market risk (in particular interest rate risk, foreign exchange risk and commodity risk), concentration risk, operational risk and compliance risk.

7.5.1. Credit and concentration risk

Credit risk is the risk of loss or of adverse change in the financial situation, resulting from fluctuations in the credit standing of issuers of securities, counterparties and any debtors.

Credit risk types in the PZU Group include:

• counterparty default risk is the possibility of incurring loss as a result of default of the counterparties and debtors;
• credit risk in banking activity is the credit risk arising from activity conducted in the banking sector, associated mainly with the possibility that a debtor or borrower defaults on its obligations;
• credit risk in financial insurance is the credit risk arising from activity conducted in the financial insurance sector, associated mainly with the possibility that a client, debtor or borrower defaults on its obligations to a third party; the risk may result from a failure of a venture or adverse influence of the economic environment.  

Concentration risk is the risk stemming either from lack of diversification in the asset portfolio or from large exposure to default risk 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 and reinsurance and bancassurance operations. PZU Group distinguishes the following types of credit risk exposure:

• risk of a customer’s default against PZU Group under contracted loans (in banking activity);
• risk of bankruptcy of an issuer of financial instruments in which PZU Group invests or which it trades, e.g. corporate bonds;
• counterparty default risk, e.g. reinsurance or OTC derivatives and bancassurance activity;
• risk of default of a PZU Group’s customer against a third party, e.g. 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 of identifying the areas where concentration risk arises in credit activity;
• process of setting and updating limit levels;
• process of managing the limits and adopting the rules of conduct if the permitted limit level is exceeded;
• concentration risk monitoring process, including reporting;
• oversight over the concentration risk management process.

The following table presents the concentration of balance-sheet and off-balance-sheet exposures of Pekao and Alior Bank by industry, using the sections of the Polish Classification of Business Activity (PKD):

• loan amount (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.

The process of setting and updating concentration limits takes the following 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 about economic trends, including the projection of the levels of interest rates, exchange rates, political risk analysis, ratings of governments and financial institutions;
• reliable information about economic situation of companies, industries, branches, economic sectors, general economic information including news about 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, in individual and 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 repayment;
• collateral, which entails review of the formal, legal and economic status, including loan to value adequacy.

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

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

• concentration limits are set and tracked;
• early warning signals are monitored;
• credit portfolio is monitored regularly, especially 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 rating 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 (e.g. CBD DZ, CBD BR, BIK, BIG databases) 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.

The following table presents the PZU Group’s credit risk exposures on account loan receivables from clients.

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

No comparative data is presented, as Pekao has been part of the PZU Group since 7 June 2017.

The following table presents the breakdown of the portfolio of loans granted to Pekao clients into loans covered and not covered by internal rating models.

Alior Bank

Bank BPH’s Core Business, acquired by Alior Bank, uses a different rating model, the 31 December 2016 figures for this part are presented separately.

7.5.1.3. Application of forbearance and related practices

The forbearance practices are used if a threat arises that a client may default on the terms of a contract because of the financial difficulties. In such circumstances, contract terms may be amended in a way that allows a borrower to service or refinance the debt in full or in part. Changes in terms and conditions of contracts may include: reductions of interest rates, principal installment amounts, accrued interest, rescheduling of principal or interest payments.

Assessment of impairment of exposures subject to forbearance practices

Stricter criteria for identifying signs of impairment are applied to exposures subject to forbearance practices. In addition to the standard catalogue of signs of impairment, additional criteria are applied, which are defined as occurrence of one of the following situations when the forbearance decision is made:

• more than 30 days past due;
• analyst’s assessment that timely service is at risk (for retail clients);
• economic and financial standing assessed as sub-standard or worse (for business clients).
• other evidence of impairment.

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 and concentration risk limits are set by dedicated committees.

Limits for banks and other issuers of debt securities are set in reference to exposure levels. The limits take the form of exposure limits to a single entity or a group of entities (this applies to both credit limits and concentration limits). The use of credit risk and concentration risk limits is monitored. Exceeding a limit entails an obligation to prepare and  present an exposure reduction plan.

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 provide the basis for setting the limits. Ratings are updated for credit quality monitoring purposes.

Information on the credit quality of assets related to investing activity is presented in section 33.7.

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 credit risk level attributable to the assets where the risk is carried by the PZU Group as at 31 December 2017 was PLN 8,866 million (as at 31 December 2016 it was PLN 1,684 million; if the coefficients of 31 June 2017 were used, the value would be PLN 1,649 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.

7.5.2. 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:

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

Due to the climate conditions of the region where PZU Group operates, concentration risk may occur in the case of catastrophic losses, such as floods or cyclones. Accordingly, the PZU Group’s exposure to such losses is presented broken down by voivodeships (for operations conducted in Poland) and countries (for foreign operations).

Concentration of risk in non-life insurance – TPL insurance

Due to the considerable dispersion of the motor TPL insurance portfolio, the concentration risk in this insurance group is not significant from PZU Group’s perspective.

The concentration of risk in non-life non-motor liability insurance, measured by the level of gross written premiums, is presented by guaranteed amounts and types of insurance cover.

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.