7.5 Risk profile (continued)

7.5.3. Market risk

Market risk means the risk of loss or of adverse change in the financial situation resulting, directly or indirectly, from fluctuations in the level and in the volatility of market prices of assets, credit spread, value of liabilities and financial instruments.

Market risk types in the PZU Group include:

• equity risk is the possibility of incurring loss as a result of changes in the values of assets, liabilities and financial instruments caused by changes in the level or in the volatility of market prices of equities;
• unquoted equity risk is the possibility of incurring loss as a result of changes in the valuation of unquoted shares;
• property risk is the possibility of incurring loss as a result of changes in the values of assets, liabilities and financial instruments caused by changes in the level or in the volatility of market prices of real estate;
• commodity risk is the possibility of incurring loss as a result of changes in the values of assets, liabilities and financial instruments caused by changes in the level or in the volatility of market prices of commodities;
• inflation risk is the possibility of incurring loss associated with the level of information, especially inflation of prices  of goods and services as well as expectations as to the future inflation level, which affect the valuation of assets and liabilities;
• liquidity risk means the risk of being unable to realize investments and other assets without affecting their market prices in order to settle financial obligations when they fall due;
• interest rate risk is the possibility of incurring a loss as a result of changes in the value of financial instruments or other assets and a change in the present value of projected cash flows from liabilities, caused by changes in the term structure of market rates or in the volatility of risk-free market interest rates;
• basis risk is the possibility of incurring a loss as a result of changes in the value of financial instruments or assets and a change in the present value of projected cash flows from liabilities, caused by changes in the term structure of spreads between market interest rates and risk-free rates or in the volatility of such spreads, excluding credit spreads;
• foreign exchange risk is the possibility of incurring loss as a result of changes in the value of assets, liabilities and financial instruments, caused by changes in the level or in the volatility of currency exchange rates;
• credit spread risk is the possibility of incurring loss as a result of changes in the value of assets, liabilities and financial instruments, caused by changes in the level or in the volatility of credit spreads over the term structure of the interest rates on debt securities issued by the State Treasury;
• concentration risk is the possibility of incurring loss stemming either from lack of persification in the asset portfolio or from large exposure to default risk by a single issuer of securities or a group of related issuers.

Concentration risk and credit spread risk are regarded as an integral part of market risk when measuring risk for the purposes of risk profile, risk tolerance, and market risk ratio reporting. The process of managing the risks has however a different set of traits from the process of managing the other sub-categories of market risk and has been described in section 7.5.1.1 along with the process for managing counterparty insolvency risk.

The market risk in the PZU Group originates from three major sources:

• operations associated with asset and liability matching (ALM portfolio);
• operations  associated  with  active  allocation,  i.e.  designating  the  optimum  medium-term  asset   structure   (AA portfolios);
• banking operations in Pekao Alior Bank – in conjunction with them the PZU Group has materially increased its exposure to interest rate risk.

A number of documents approved by supervisory boards, management boards and dedicated committees govern investment activity in the PZU Group’s companies.

Risk units take part in the risk identification process, measure, monitor and report on the risks. Market risk is measured using the value at risk method (VaR). The total market risk value is calculated by aggregating the amounts of inpidual risks based on a pre-defined correlation matrix. In order to effectively manage market risk, risk limits are adopted  in     a form of a capital amount allocated to each market risk and limits for inpidual market risks.

In Pekao, the market risk management system forms the structural, organizational and methodological framework, which aims to maintain the balance sheet and off-balance sheet structure in line with the accepted strategic objectives. The market risk management process and the governing procedures include the separation into the banking and trading books.

In managing its trading book’s market risk, Pekao strives to optimize the financial performance and ensure the highest possible quality of service of the bank’s clients in respect to market-making, while remaining within the limits approved by the management board and the supervisory board.

When managing interest rate risk in its banking book, Pekao endeavors to secure the economic value of equity and to achieve its intended net interest income target within the accepted limits.

In Alior Bank, the exposure to market and liquidity risk is restricted by the system of periodically updated limits introduced by the resolution of the supervisory board or the management board that include all risk measures. In Alior Bank, there are three types of limits that differ in respect to their functioning - basic, supplementary and stress-test limits. Market risk management focuses on potential changes in economic result.

Exposure to market risk

The following table presents financial assets of banks and at client’s risk, by classification into their respective portfolios:

In its investing activities, the PZU Group uses derivatives as a tool to mitigate risk (with or without hedge accounting) and to facilitate efficient management of the investment portfolio.

The following tables present the PZU Group’s exposure to derivatives.

As at 31 December 2016, the PZU Group held no commodity derivatives.

Risk concentration

Exposure to debt securities issued by governments other than the Polish government

As at 31 December 2017

As at 31 December 2016

Exposure to debt securities issued by corporations and local government units

As at 31 December 2017

As at 31 December 2016

7.5.3.1. Interest rate risk

The following table presents the sensitivity test of the portfolio of financial instruments for which the PZU Group bears the risk (except for loan receivables from clients and deposit liabilities).

The above sensitivity tests do not include the effects of changes in interest rates for technical provisions and liabilities under investment contracts. The analysis of effect of a change in technical rate on measurement of insurance contracts is presented in section 7.5.2.

Interest rate risk in Pekao

The VaR model is the main tool for measuring interest rate risk of the trading book. This value reflects the level of ten- day loss that may be exceeded with a probability of no more than 1%. VaR is determined through historical simulation, based on a 2-year history of observation of the evolution of risks. The set of factors taken into account in the calculation of VaR includes all the relevant market factors that are taken into account in the valuation of financial instruments, except for the issuer’s and counterparty’s specific credit risk. The impact of changes in market factors on the current portfolio value is estimated using full revaluation (as a difference between the value of the portfolio after the change in market parameters, by the historically observed changes in those factors, and the present value of the portfolio). For such a set of probable changes in the portfolio's value (distribution function), VaR is determined as the 1% quantile.

The following table presents VaR for the interest rate risk in Pekao’s trading book.

When managing interest rate risk in its banking book, Pekao endeavors to secure the economic value of equity and to achieve its intended net interest income target within the accepted limits. The financial position in view of the changing interest rates is monitored by using interest rate gap (revaluation gap), duration analysis, sensitivity analysis, stress testing and VaR.

The table below presents the contractual level of sensitivity of net interest income (NII) to a 100 bp decline in interest rates and sensitivity of Pekao’s economic value of equity (EVE) to a 200 bps decline in interest rates as at the end of December 2017. EVE is defined as the present value of future cash flows that will be generated by the entity’s assets, less the present value of the future cash flows necessary to pay the entity’s liabilities. Both analyses assume an immediate change in market rates. The interest rate on bank products changes according to the contractual provisions, whereas in the case of contractual NII, for deposits from retail customers, the declines in interest rates are limited to the zero interest rate level (that is, the interest on customer deposits will not drop beneath zero). In the case of EVE sensitivity for PLN-denominated current deposits, a model that ensures realistic revaluation is used.

Interest rate risk in Alior Bank

The interest rate risk related to Alior Bank’s open positions is linked, first of all, to:

• revaluation date mismatch risk;
• basis risk, or the impact of non-parallel change in reference indexes with a similar revaluation date on the financial result;
• yield curve risk;
• client option risk.

One of the method of estimating exposure to interest rate risk is to calculate BPV, which provides information on the estimated change in the valuation of a transaction/item after a parallel shift in the yield curve by 1 basis point. The following tables present the BPV estimation for Alior Bank.

As at 31 December 2017 (thous. PLN)

As at 31 December 2016 (thous. PLN)

For the interest rate risk management purposes, Alior Bank distinguishes trading activity involving securities and derivatives concluded for trading purposes and banking activity involving other securities, own issues, loans, deposits, credits and derivative transactions used to hedge the risk of the banking book. Alior Bank uses the Value at Risk (VaR) model to estimate the level of interest rate risk. The following table presents the economic capital to cover interest rate risk measured using this method at the end of 2017 and 2016 (99% VaR with a 10-day horizon).

Alior Bank conducts scenario analysis that includes, among others, the impact of changes in interest rates on the future net interest income and economic value of equity. Within these scenarios internal limits are maintained, whose utilization is measured daily. Utilization of the limit of change in economic value of capital after a parallel shift of the percentage curve by +/-200 bps and non-parallel shifts in the +/- 100/400 bps scenarios (for 1M/10Y tenors, the shift between  them follows a linear interpolation) is presented in the following table:

7.5.3.2. Foreign exchange risk

Exposure to FX risk

To manage its FX risk, the PZU Group uses also derivatives which allows it to take a selected market exposure in a more efficient manner than by using cash instruments.

The following table presents the sensitivity test of the portfolio of PZU Group’s financial instruments (except for loan receivables from clients and deposit liabilities) in respect to financial instruments for which the PZU Group bears the risk.

Financial assets exposed to exchange risk include deposit transactions and debt securities used to hedge payments from technical provisions denominated in foreign currencies, exposures to equity instruments quoted on stock exchanges other than WSE, mutual fund units and certificates, exposures to derivatives denominated in foreign currencies and financial assets of consolidated international insurance companies.

Both Pekao and Alior Bank use the VaR model to measure currency risk. It allows them to calculate potential loss on currency positions kept by the Bank caused by changes in exchange rates, while maintaining the assumed confidence level (99%) and the period in which the position is kept. The following table presents VaR determined for the trading book FX risk in both banks:

7.5.3.3. Equity risk

Level of risk exposure

The value of the portfolio of financial instruments available for sale and measured at fair value through profit or loss is presented respectively in sections 33.3 and 33.4.

Sensitivity analysis

The following table presents the sensitivity test of PZU Group’s equity to the portfolio of quoted equity instruments for which the PZU Group bears the risk.

7.5.3.4. Liquidity risk

Insurance activity

Financial liquidity risk of the PZU Group may result from three types of events:

• shortage of liquid cash compared to current needs;
• illiquidity of financial instruments held;
• structural maturity mismatch between assets and liabilities.

In the liquidity risk management process, liquidity is controlled in the short, medium and long term, i.e.:

• short-term liquidity – the balance of funds in the liquidity portfolio is maintained at no more than the limit specified for them. Conditional sell-buy-back transactions are also used to manage liquidity;
• medium-term liquidity – investment portfolios with appropriate liquidity are maintained;
• long-term liquidity and risk of structural mismatch between the maturity of assets and liabilities – Asset Liability Management (ALM) involves matching the structure of financial investments, which provide coverage for technical provisions, to the character of such provisions.

Another objective of the ALM process is to ensure the capability to pay claims and benefits, also in unfavorable economic conditions. The level of liquidity risk is measured by estimating the shortages of cash required to pay liabilities. The estimate is made using a set of analyzes, including among others a liquidity gap analysis (a mismatch of net cash flows) and an analysis of the distribution of expenditures relating to operating activity.

Pekao

The objective of liquidity risk management is to:

• ensure and maintain the ability to meet both current and future liabilities, taking into account the costs of raising liquidity and return on equity;
• prevent a crisis situation, and
• identify the arrangements for overcoming a crisis when and if it occurs.

Pekao has a centralized liquidity risk management system in place, which includes regular liquidity management and first level control exercised by responsible units, second level control exercised by a dedicated unit responsible for risk management and independent audit.

Liquidity management in the Pekao Group is planned within the following time horizons:

• intraday – applicable to intra-day flows;
• short-term – including a liquidity measurement system within a one-year horizon;
• long-term – covering a period of more than one year.

Due to the specific nature of the liquidity risk management tools and techniques used, the Pekao Group manages its current and medium-term liquidity together with short-term liquidity.

Alior Bank

The liquidity risk management policy at Alior Bank consists in maintaining liquidity positions so that it is possible to satisfy payment obligations at all times using the available cash in hand, proceeds from transactions with specified maturity dates or through the sale of transferable assets, while minimizing the costs of maintaining liquidity.

Alior Bank manages its liquidity by using ratios and related limits of the following types of liquidity:

• payment liquidity – capacity to finance assets and pay liabilities on a timely basis in the ordinary course of business or in other foreseeable circumstances, without a need to incur loss. In payment liquidity management, special emphasis is placed on the analysis of immediate and current liquidity (up to 7 days);
• short-term liquidity – capacity to pay  all cash liabilities as they become due and payable, in the period of next 30 days;
• medium-term liquidity – capacity to pay all liabilities with maturity dates from 1 to 12 months;
• long-term liquidity – monitoring the capacity to pay all cash liabilities as they become due, in the period of more than 12 months.

Risk exposure

The following table presents future undiscounted cash flow from assets and liabilities as at 31 December 2017.

The following table presents future undiscounted cash flows from banks’ off-balance sheet liabilities (by contractual terms)

7.5.4. Operational risk

Operational risk is the risk of suffering loss resulting from improper or erroneous internal processes, human activities, system failures or external events.

Operational risk management has the purpose of optimizing the level of operational risk and operating efficiency in the PZU Group’s operations, leading to a reduction of losses and costs arising from such risks and ensuring adequate and effective controls. Operational risk is managed in accordance with defined guidelines which take into account external conditions and information on operational risk levels is regularly reported to relevant internal authorities.

7.5.5. Compliance risk

Compliance risk is the risk of legal sanctions, financial losses or loss of reputation or credibility arising from a failure of PZU Group companies, their employees or entities acting on their behalf to comply with the law, internal regulations or standards of conduct, including ethical standards.

The demarcation of responsibilities with respect to systemic and ongoing compliance risk management is based on internal regulations.

Systemic management entails in particular: developing solutions for implementing compliance risk management principles, monitoring the compliance risk management process and promoting and monitoring compliance with internal regulations and standards of conduct in respect to compliance.

Ongoing compliance risk management entails: identifying, assessing and measuring and adaptation to regulatory requirements.