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 – 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 – the possibility of incurring loss as a result of changes in the valuation of unquoted shares;
• property risk – 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 – 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 – 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 – the risk of being unable to realize investments and other assets without affecting their market prices in order to settle financial liabilities when they fall due;
• interest rate risk – 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 – 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 – 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 – 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;
• credit spread risk –  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  – the possibility of incurring loss 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.

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 – generating material exposure to interest rate risk.

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

Risk units take part in the risk identification process, measure, monitor and report on the risks. Market risk is measured using the model of calculating market risk economic capital based on the value at risk method (VaR) or the standard formula in accordance with the principles defined by the Solvency II Directive. 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 individual 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 risk is restricted by the system of periodically updated limits introduced by the resolution of the supervisory board or the Capital, Asset and Liability Management Committee, covering all risk measures the level of which is monitored and reported by Alior Bank’s organizational units that are independent of the business division. 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 limiting potential adverse changes in economic value of equity.

Exposure to market risk

The following table presents financial assets of banks and at client’s risk, by the item in which they are classified in the consolidated financial statements:

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 PZU Group’s exposure to derivatives is presented in section 35.

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

Exposure to debt securities issued by corporations and local government units

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. An analysis of effect of a change in technical rate on measurement of insurance contracts is presented in sections 7.5.2.1 and 7.5.2.2.

The table below presents the contractual level of sensitivity of net interest income (NII) to a 100 bp change in interest rates and sensitivity of the economic value of equity (EVE) of PZU Group’s banks to a 200 bps change in interest rates. The measure (NII) is used for managing interest rate risk in order to reduce variations in net interest income. 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 sensitivity, for deposits from retail customers, the declines in interest rates are limited to the zero interest rate level, but not down to negative figures, while for EVE sensitivity the zero-based limitation of interest rate decreases applies to all liabilities. Also, in the case of EVE sensitivity for PLN-denominated current deposits, a model that ensures realistic revaluation is used.

Reform of interest rate indicators

On 1 January 2018, a new standard took effect in the European Union for the development of benchmarks, based on the BMR, defining the principles of operation and duties of benchmark administrators and entities making use of these benchmarks. The purpose of the new rules is to increase the credibility, transparency and reliability of benchmarks. As a result of the reform, the benchmarks were adjusted to the new rules (including WIBOR and EURIBOR) or ceased to exist (such as LIBOR) having been replaced with alternative indicators. The largest impact of the reform on the PZU Group stems from loans and advances to customers. The principal risks associated with the reform pertain to the need to update contractual terms and systems and review various control mechanisms related to the reform and regulatory risk. The impact of this development on the overall risk is limited largely to the interest rate risk.

As at 31 December 2021, the IBOR reform affecting the currencies covered by the PZU Group’s exposure was largely completed. The table below presents the status of the transition to new benchmarks under the IBOR reform.

The PZU Group has a portfolio of loan agreements and derivative transactions based on the USD LIBOR benchmark with maturities extending beyond June 2023. In respect of these loan agreements, the PZU Group is considering reaching out to the borrowers with a proposed annex in which any reference to the USD LIBOR benchmark will be removed. Some derivatives are registered with the Central Counterparty Clearing House, while the rest contain effective fallback clauses.

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 investment (deposit) financial assets of the PZU Group and derivative financial assets denominated in foreign currencies.

7.5.3.3. Equities prices risk

Level of risk exposure

The value of the portfolio of equity financial instruments is presented in section 36.2.

Sensitivity analysis

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