THG 2018 Annual Report

QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK INTEREST RATE SENSITIVITY Operations are subject to risk resulting from interest rate fluctuations, which may adversely impact the valuation of the investment portfolio. In a rising interest rate environment, the value of the fixed maturity sector, which comprises approximately 74% of our investment portfolio, may decline as a result of decreases in the fair value of the securities. Our intent is to hold securities to maturity and recover the decline in valuation as prices accrete to par. However, our intent may change prior to maturity due to changes in the ILQDQFLDO PDUNHWV RXU DQDO\VLV RI DQ LVVXHU¶V FUHGLW PHWULFV and prospects, or as a result of changes in cash flow needs. Interest rate fluctuations may also reduce net investment income and as a result, profitability. The portfolio may realize lower yields and therefore lower net investment income on securities because securities with prepayment and call features may prepay at a different rate than originally projected. Also, funds may not be available to invest at higher interest rates. In a declining interest rate environment, prepayments and calls may increase as issuers exercise their option to refinance at lower rates. The resulting funds would be reinvested at lower yields. The following table, which excludes assets relating to Chaucer, illustrates the estimated impact on the fair value of our fixed maturity portfolio at December 31, 2018 and 2017 of hypothetical changes in prevailing interest rates, defined as changes in interest rates on U.S. Treasury debt. It does not reflect changes in credit spreads, liquidity spreads and other factors that also affect the value of securities. Since changes in prevailing interest rates are often accompanied by changes in these other factors, the reader should not assume that an actual change in interest rates would result in the values illustrated. (dollars in millions) INVESTMENT TYPE +300bp +200bp +100bp 0 -100bp -200bp -300bp Residential mortgage-backed securities $ 600 $ 635 $ 675 $ 715 $ 750 $ 770 $ 770 Municipal securities 790 820 855 885 920 950 985 All other fixed maturity securities 3,980 4,165 4,355 4,560 4,770 4,990 5,220 Total December 31, 2018 $ 5,370 $ 5,620 $ 5,885 $ 6,160 $ 6,440 $ 6,710 $ 6,975 Total December 31, 2017 $ 4,970 $ 5,215 $ 5,480 $ 5,750 $ 6,020 $ 6,285 $ 6,550 nt income with credit and interest rate risk, while maintaining sufficient liquidity and the opportunity for capital growth. The asset allocation process takes into consideration the types of business written and the level of surplus required to support our different businesses and the risk return profiles of the underlying asset classes. We look to balance the goals of capital preservation, net investment income stability, liquidity and total return. The majority of our assets are invested in the fixed income markets. Through fundamental research and credit analysis, with a focus on value investing, our investment professionals seek to identify a portfolio of stable income-producing higher quality U.S. government, foreign government, municipal, corporate, residential and commercial mortgage-backed securities and asset-backed securities. We have a general policy of diversifying investments both within and across major investment and industrial sectors to mitigate credit and interest rate risk. We monitor the credit quality of our investments and our exposure to individual markets, borrowers, industries, sectors and, in the case of commercial mortgage-backed securities and commercial mortgage loan participations, property types and geographic locations. In addition, we currently carry debt that is subject to interest rate risk, which was issued at fixed interest rates between 4.50% and 8.207%. Current market conditions, in light of our risk tolerance, restrict our ability to invest fixed income assets at similar rates of return; therefore, earnings on a similar level of assets are not sufficient to cover current debt interest costs. EQUITY PRICE RISK Our equity securities portfolio is exposed to equity price risk arising from potential volatility in equity market prices. Portfolio characteristics are analyzed regularly and price risk is actively managed through a variety of techniques. A hypothetical increase or decrease of 10% in the market price of our equity securities would have resulted in an increase or decrease in the fair value of the equity securities portfolio of approximately $46 million at December 31, 2018 and $58 million at December 31, 2017. 59 2018 ANNUAL REPORT | THE HANOVER INSURANCE GROUP