AEGON - Annual Report 2002
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Financial highlights
Amounts in millions
2002 2001 2002 2001
USD USD % EUR EUR %
   
      INCOME BY PRODUCT SEGMENT      
1,379 1,394 –1 Traditional life 1,457 1,557 –6
165 321 –49 Fixed annuities 174 358 –51
257 193 33 GICs and funding agreements 272 215 27
351 566 –38 Life for account policyholders 371 632 –41
–437 107 Variable annuities –462 120
2 84 –98 Fee business 2 94 –98
— 307   Book profit Mexico — 343  
   
1,717 2,972 –42 Life insurance 1,814 3,319 –45
263 187 41 Accident and health insurance 278 209 33
59 60 –2 General insurance 62 67 –7
   
2,039 3,219 –37 TOTAL INSURANCE 2,154 3,595 –40
8 40 –80 BANKING ACTIVITIES 8 45 –82
–296 –355 –17 INTEREST CHARGES AND OTHER –313 –397 –21
   
1,751 2,904 –40 Income before tax 1,849 3,243 –43
–334 –822 –59 Corporation tax –353 –918 –62
48 64 –25 Transamerica Finance Corporation 51 72 –29
1,465 2,146   –32   Net income 1,547 2,397 –35
 
    INCOME GEOGRAPHICALLY      
1,142 2,034 –44 Americas 1,206 2,272 –47
624 827 –25 The Netherlands 659 924 –29
221 333 –34 United Kingdom 233 372 –37
60 65 –8 Other countries 64 72 –37
2,047 3,259 –37 Income before tax business units 2,162 3,640 –41
–296 –355 –17 Interest charges and Other –313 –397 –21
 
1,751 2,904 –40 Income before tax 1,849 3,243 –43
–334 –822 –59 Corporation tax –353 –918 –62
48 64 –25 Transamerica Finance Corporation 51 72 –29
1,465 2,146 –32 NET INCOME 1,547 2,397 –35
6,686 7,000 –4 Gross margin 7,061 7,817 –10
4,935 4,096 20 Commissions and expenses 5,212 4,574 14
     
Amounts per common share of EUR 0.12  
1.02 1.58 –35 Net income1 1.08 1.76 –39
1.02 1.57 –35 Net income fully diluted1 1.08 1.75 –38
As at As at As at As at
31 Dec. 31 Dec. 31 Dec. 31 Dec.
2002 2001 2002 2001
   
8.99 10.06 –11 Shareholders’ equity2 8.57 11.41 –25
9.54 10.50 –9 Shareholders’ equity after full conversion2 9.10 11.91 –24
NUMBER OF EMPLOYEES 26,659 25,663 4
 
Outstanding common shares:  
— Number of common shares (millions) 1,445 1,422 3
— Weighted average number (millions) 1,402 1,357 3

1  Based on the weighted average number of common shares, adjusted for repurchased own shares.
2  Based on the number of common shares outstanding at the end of the period, adjusted for repurchased own shares.


FINANCIAL RELATIONS
AEGON’s international business activity is matched with a geographically diverse investor base. AEGON’s common shares are listed on the stock exchanges in Amsterdam, New York, London, Frankfurt, Zurich and Tokyo. Its common shares are also included in many major indices.

AEGON has an active investor relations program focusing on providing investors around the world with information required to make appropriate investment decisions. Much attention is given to ensuring that the information provided is consistent, coherent and comprehensive, and disclosed on a non-selective basis and in a timely fashion. Current and evolving industry disclosure practices as well as feedback from the financial community are closely monitored to keep AEGON attuned to changes in the markets. Clear communications on the complexities and dynamics of our business activities and the related financial issues are important.

Along with periodic news releases and shareholder reports, investor and analyst briefing materials, financial interviews and our corporate website, mainstays of our investor relations program include management ‘road shows’ and investor days, as well as web casts and teleconferencing. In addition, investor relations’ staff are available to answer questions and to maintain an open dialogue between AEGON and the financial community, including its investors.

Selected results of our sensitivity analyses are presented throughout this annual report to show the estimated sensitivity of net income and shareholders’ equity to various scenarios in 2003. It should be noted, however, that the results should be read as indicative only, as they are derived from static analyses which are performed without taking into account correlation between factors and assuming unchanged conditions for all other assets and liabilities and only limited management responsive actions. Results of the analyses also cannot be extrapolated for wider variations since effects do not tend to be linear.

DISCLOSURE
AEGON is committed to providing information on key factors that drive its business and affect its financial condition, results and value. Our disclosure practices have been developed over many years with due consideration of the needs and requirements of our stakeholders, including regulators, investors and research analysts. We have substantive supplemental information in our annual and quarterly accounts to provide transparency of our financial results. We have provided insight into the methodologies we apply to manage both risk and accounting practices for deferred policy acquisition costs and guaranteed minimum benefits. In the summer of 2003 we will begin reporting our embedded value and will also provide a detailed analysis of the sensitivity of our embedded value to various factors, such as equity market returns, interest rates, discount rates and lapse rates. This additional disclosure will be provided in order to give the financial community increased understanding of AEGON’s value now and in the future.

RESULTS
Net income for 2002 of EUR 1,547 million was 35% lower than last year. Results were adversely affected by additions to the provision for bond defaults (EUR 817 million), accelerated amortization of deferred policy acquisition costs (EUR 450 million) and increased provisions for products with guaranteed minimum benefit (EUR 482 million). Comparison with the prior year’s result is positively influenced by the additional earnings from the acquired J.C. Penney direct marketing insurance operations (EUR 94 million). The 2001 gain on the sale of operations in Mexico (EUR 343 million) and the loss of earnings on these divested operations (EUR 81 million) negatively influences the comparison with the prior year. Adjusting for the above items, pre-tax earnings would have been marginally higher in 2002 than in 2001. The influence of currency exchange rates on net income was minus 2%.

Total revenues were 2% lower (1% higher, excluding currency influence) and gross margin was 10% lower (excluding currency influence 6% lower). The decline in gross margin is due primarily to lower investment returns, higher bond default provisions and provisions for guaranteed minimum benefits. Commissions and expenses were 14% above last year (19% excluding currency influence), which includes the higher DPAC amortization and the expenses of acquired operations. Excluding the acquired operations and the additional DPAC amortization, commissions and expenses were 3% higher.

The effective tax rate for 2002 was 19% compared to 28% for 2001. The lower effective tax rate is largely due to a reduction of the deferred tax liability, favorable adjustments resulting from the filing of the 2001 corporate tax returns in the US, lower taxable income relative to tax preferred investments and tax-exempt income in the Netherlands and the US, and a tax loss in the UK.

Results for Transamerica Finance Corporation were USD 48 million as compared to USD 64 million last year. This reflects lower asset balances for 2002 as well as tax benefits and investment gains included in 2001 results, which are non-recurring.

LINE OF BUSINESS

The Americas
Traditional life results of USD 813 million, up 3%, include USD 160 million of bond defaults compared to USD 157 million for 2001. Fixed annuity results of USD 165 million , down 49%, include USD 401 million of bond defaults compared to USD 229 million for 2001. Fixed annuity results also include a net reduction of DPAC amortization of USD 34 million compared to a positive unlocking of USD 20 million for 2001. GICs and funding agreement results of USD 257 million, up 33%, include bond defaults of USD 174 million compared to USD 159 million for 2001. Life for the account of policyholders results were USD 106 million, up 14%, reflecting lower expense levels. Variable annuity reported a loss of USD 437 million compared to a profit of USD 107 million in 2001. Due to declining equity markets and the adjustment of our equity return assumptions, additional DPAC amortization of USD 327 million and CAD 31 million and guaranteed minimum benefit provisions of USD 199 million and CAD 88 million were charged against results. Fee business results were USD 5 million, USD 69 million lower than 2001. The 2001 results included earnings from divested pension operations in Mexico. Accident and health results increased 60% to USD 233 million due to the acquired direct marketing insurance operations of J.C. Penney.

The Netherlands
Traditional life results of EUR 552 million were 10% lower than 2001 results, due to lower interest results and higher lapse rates. Life for the account of policyholders results were EUR 49 million, down from EUR 192 million the prior year. This is primarily due to the provisions for guaranteed minimum benefits of EUR 209 million. Accident and health results of EUR 26 million were EUR 10 million lower than in 2001 and reflect higher claims as well as lower investment returns. General insurance results were EUR 24 million, down EUR 13 million from the prior year, due to the October storm claims and lower investment returns. Banking activities were EUR 8 million, down EUR 37 million from 2001, reflecting lower production and investment spreads, as well as increased provisions for credit risk.

United Kingdom
Life for the account of policyholders results were GBP 75 million lower, mainly as a result of lower management and fund-related fees.

Other Countries
Net income from other countries was EUR 52 million, a 15% decrease from 2001. The lower result was due primarily to lower results in Spain and start-up activities in Asia. Taiwan showed a modest profit for the first time.

Capital gains
EUR 758 million was released as indirect return to income before tax compared with EUR 723 million for 2001. The revaluation account balance at December 31, 2002 was EUR 2,598 million, of which realized gains of EUR 2,056 million and unrealized gains of EUR 542 million.

With International Accounting Standards becoming AEGON’s reporting standard in 2005, it is AEGON’s intention to discontinue the indirect return system of accounting for capital gains after 2003. Beginning with the first quarter 2004 capital gains and losses will be reported as earnings in the income statement when realized. Based on current stock market levels, AEGON expects to recognize indirect income in 2003 of approximately EUR 450 million. The remaining realized portion of the revaluation reserve not recognized in 2003 will be transferred directly to the surplus fund at year-end 2003.

DIVIDEND
The Executive Board has proposed a dividend of EUR 0.74 per common share for the year 2002 (2001: EUR 0.83). After taking into account the interim dividend of EUR 0.37, this represents a final dividend of EUR 0.37 per common share. The final dividend will be paid entirely in stock. For every 25 shares held one new share will be paid. The stock fraction for the share dividend has been based upon the average price of the AEGON share on the Euronext Amsterdam Stock Exchange for the five trading days from February 27 up to and including March 5. AEGON shares will be quoted ex-dividend on April 23, 2003. The dividend will be payable as of May 13, 2003.

The Executive Board has proposed to pay the final 2002 dividend entirely in shares as a measure of prudence and to retain financial flexibility in uncertain political and economic times. Over the past years, approximately 45% of AEGON’s dividends have been paid in shares. AEGON recognizes the importance of offering its shareholders a stable and adequate dividend, which is supported by the company’s cash flow and capital position.

RISK MANAGEMENT
AEGON is exposed to a variety of risks. Some risks are related to the international nature of the Group, such as currency translation risk. Other risks include insurance-related risks, such as changes in mortality and morbidity. However, the largest part of our risk lies in our exposure to financial markets: changes which affect the value of our investments and provisions (including deferred policy acquisition costs) through our exposure to interest rate, credit and equity market risks. During the benign investment environment in the 1990s, AEGON’s earnings and capital benefited from rising equity markets, low credit defaults and relatively stable interest rates. However, more recently most segments of the financial markets have experienced unfavorable conditions, which have affected our earnings and our capital.

In 2002, particularly weak equity markets and a high level of corporate bond defaults adversely impacted AEGON’s net income and capital.

The table on this page sets forth certain information concerning trends in the performance of equity markets (as represented by certain major indices) and US Treasury and Dutch government bond yields for the period from 1998 through 2002.

AEGON performs sensitivity analyses for its most significant business risks to assess the variability of income and shareholders’ equity based on changes to the selected risk parameters and reviews the scenarios included in these analyses each year. The insights drawn from these analyses are used by AEGON’s management to consider actions that may be taken, if necessary.

CURRENCY RISK
AEGON manages its currency risk using established currency risk policies. For investments, these policies are based on asset liability matching principles. Equity held in subsidiaries is kept in local currencies to the extent shareholders’ equity is required to satisfy (local) regulatory and self-imposed capital requirements. As a result, currency fluctuations may affect the level of AEGON’s shareholders’ equity as a result of translation into euro. The remainder of AEGON’s capital base (capital securities and subordinated and senior debt) is held in or swapped into various currencies proportionally to the value of AEGON’s activities in those currencies such that AEGON’s debt-to-total-capital ratio is not materially affected by currency volatility. We also run a translation risk on earnings generated by the various country units. AEGON does not hedge these income streams. As a result, earnings may also fluctuate due to currency translation risk.

1998 1999 2000 2001 2002
S&P 500 1,229 1,469 1,320 1,148 880
Nasdaq 2,193 4,069 2,471 1,950 1,336
FTSE 100 5,883 6,930 6,222 5,217 3,940
AEX 538 671 638 507 323
10-year US Treasury 4.65 6.43 5.1 5.04 3.82
10-year Dutch government 3.95 5.47 4.99 5.11 4.23


As of December 31, 2002, shareholders’ equity declined by EUR 2,190 million as a result of currency translation, mainly caused by the effect that the decline of the US dollar had on the value of our US operations when expressed in euro. The lower average currency translation rate for both the US dollar and the UK pound had a negative effect of approximately 2% on reported earnings for 2002.

The sensitivity analysis table on this page shows the effect on net income and shareholders’ equity of movements in the exchange rates of AEGON’s most important currencies relative to the euro. The table shows that a decrease of 10% of the US dollar, Canadian dollar and UK pound exchange rates would result in a negative impact on net income of approximately 6% and on shareholders’ equity of approximately 10.5%. Conversely, an increase of 10% in these exchange rates would result in a positive impact on net income of the same magnitude.

Sensitivity analysis of net income and shareholders' equity1 to currency markets2
Movement of markets Effects on net income Effects on shareholders' equity
Increase versus the euro
of USD, GBP and CAD of 10%		 between 5.5% and 6.5% between 10.0% and 11.0%
Decrease versus the euro
of USD, GBP and CAD of 10%		 between –5.5% and –6.5% between –10.0% and –11.0%


1  Basic assumptions: no correlation between markets and risks; unchanged conditions for all other assets and liabilities; limited management actions taken; all changes are relative to net income and shareholders' equity. Effects do not tend to be linear and therefore cannot be extrapolated for larger increases or decreases.
2  The effect of currency movements is reflected as a one-time shift in value of the US dollar, the Canadian dollar and the UK pound up or down on January 1. Movements of other currencies have a negligible influence on both net income and shareholders' equity.


ASSET LIABILITY RISK MANAGEMENT
The keys to AEGON’s risk management are the asset liability management (ALM) processes and procedures we perform in our country units. All of our country units have robust ALM models in place, which drive the risk management process of both the country units and the AEGON Group as a whole.

Over the past several years, we have been strengthening our global risk management framework. Capital management is a central function in the AEGON Group and we have been and will continue to closely align the AEGON Group’s capital management with the risk management performed by the country units. During 2003, we will further expand the AEGON Group’s risk management practices, aiming to further optimize risk and capital management on a group-wide basis.

LIABILITY RISKS

Technical provisions
Actuarial assumptions and their sensitivities underlie the calculation of technical provisions, which are based on generally accepted reserve valuation standards. In the ordinary course of business, AEGON makes assumptions such as estimates of premiums, mortality, morbidity, investment returns, lapses, surrenders and expenses. These assumptions are initially based on best estimates of future experience at the policy inception date, in some instances taking into account a margin for the risk of adverse deviation from these assumptions. The assumptions used are regularly reviewed, compared to actual experience and, if necessary, depending on the type of products, updated.

The AEGON Group is exposed to both mortality and longevity risk in its products. In the United States, we are on balance exposed to mortality risk as a result of AEGON USA’s large life insurance business, while in the Netherlands we are on balance exposed to longevity risk as a result of AEGON The Netherlands’ large defined benefit pension business. The AEGON Group maintains a well-balanced portfolio of businesses in terms of mortality and longevity risks. Therefore, we believe that changes to mortality and longevity factors are not a current concern relative to our reserving basis and our mix of business.

Assumptions are made regarding future investment yields for both the pricing and for the assessment of profitability of many general account and for account of policyholders products. Assumed yields are based on management’s best estimates. Periodically, AEGON assesses the impact of fluctuations of future investment yields on pricing and profitability. For products where AEGON offers explicit benefit guarantees to its clients, product pricing reflects these guarantees.

Embedded derivatives
The technical provision for life insurance includes provisions for guaranteed minimum benefits related to products for which the regular technical provision is included in technical provisions with investments for the account of policyholders. The main products are:

• guaranteed minimum benefits on variable products in the United States;
• guaranteed minimum accumulation benefits on segregated funds in Canada;
• guaranteed return on certain unit-linked products in the Netherlands.

Most provisions are calculated using stochastic models.

DEFERRED POLICY ACQUISITION COSTS
AEGON defers and amortizes a part of its acquisition costs. These policy acquisition costs are costs that are related to the sale of life insurance contracts. Policy acquisition costs are deferred to the extent that they are recoverable from future expense loadings in the premiums or from estimated gross profits, depending on the type of product. Deferred policy acquisition costs (DPAC) are deducted from the technical provision for life insurance.

DPAC are subject to recoverability testing at the end of each reporting period. DPAC related to insurance contracts with fixed premiums are amortized as a percentage of premiums over the life of the contracts. The assumptions are locked in at issue and additional amortization is recorded if loss recognition testing indicates unrecoverability. For flexible premium insurance and investment type contracts, variable annuities, unit-linked products and fixed annuities, the DPAC is amortized as a percentage of gross profits. For products in the Americas the assumptions are unlocked periodically and the amortization is adjusted over time as actual gross profits emerge. For flexible premium products in the Netherlands and the UK the amortization pattern established at issue is followed and recoverability testing is performed.

For separate account products in the Americas (for account of policyholders), such as variable annuities, variable universal life and segregated funds, estimated gross profits are computed based upon assumptions related to the underlying policies including mortality, lapse, expenses, and asset growth rates. Because equity market movements have a significant impact on the value of variable annuity accounts and the fees earned on these accounts, estimated future profits can increase or decrease with movements in the equity markets. AEGON USA currently assumes long-term equity returns of 9.0%, fixed income returns of 6% and money market returns of 3.5%. As equity markets do not move in a systematic manner, AEGON uses its best estimates giving consideration to the effect of short-term swings in the equity markets. As a result, a 12% equity growth rate has been assumed for the next five years reverting to 9% thereafter.

All returns quoted above are gross returns and hence are before any asset management or insurance management and expense fees are deducted. Such fees would be deducted from the assumed market returns when projecting the policyholders’ account values. Variable annuity fees range from approximately 1% to 2.5%.

Every year AEGON tests the recoverability of DPAC from the future profits and future premium loadings that are forecasted to emerge from in-force contracts. It should be noted that testing of the DPAC is focused on recoverability only for all products in the Netherlands and the United Kingdom and fixed premium products in the Americas. Flexible premium and investment type contracts in the Americas are tested for recoverability but also for the appropriateness of the proportional amortization. Additional amortization will occur for products in the Netherlands and the UK and for fixed premium products in the Americas only when DPAC is no longer deemed recoverable, while unlocking will occur for flexible premium insurance and investment type contracts in the Americas when long-term return assumptions and therefore expected future profit streams are changed. Recoverability for these products could still be ample when unlocking occurs. This page shows some sensitivity of net earnings to changes in long-term return assumptions.

Included in AEGON’s DPAC is a substantial amount of value of business acquired (VOBA) resulting from acquisitions, which in its nature is similar to DPAC and is subject to the same testing and amortization requirements. At year-end 2002, this amounted to approximately EUR 5.3 billion, 2001: EUR 7.2 billion.

PORTFOLIO COMPOSITION AND ASSET RISKS
AEGON country units are responsible for the management of their own investment portfolios. The asset liability management policies employed in the units specify the level of risk and exposure that can be assumed by the relevant country unit based on changes in interest rates, credit quality, equity markets and exchange rates. Those policies are also monitored at AEGON Group level. As mentioned in this review, during 2003 we will continue the ongoing process of integrating asset and liability risk management with capital management.

Portfolio composition
In 2002, AEGON’s general account investment assets decreased 5.8% from 2001 to EUR 123.1 billion. These assets represent 44.4% of AEGON’s total managed assets. On general account assets, AEGON carries the investment risk and earns a spread. The general account assets in the Americas and the Netherlands represented 97% of AEGON’s general account assets at December 31, 2002. The decrease during 2002 was mainly driven by currency exchange rate differences. In local currencies, the general account asset base of AEGON Americas grew 12.5% to USD 109 billion due to strong new production in traditional life products and fixed annuities. In the Netherlands, the total general account asset base decreased by 11.1%, mainly as a result of the decline of the value of our equity investments by 17.4% in 2002. In 2002, AEGON also rebalanced its portfolio from equities to fixed income investments while increasing slightly the credit quality of the fixed income portfolio despite the further deterioration of credit markets during the year by reinvesting at a slightly higher average credit quality.

One-time effect of changes in long-term assumptions
approx. USD 
Effect on net earnings of lowering long-term equity assumptions by 1% –110 million 
Effect on net earnings of eliminating the higher short-term equity growth rate assumptions –230 million 
Effect on net earnings of lowering long-term fixed income assumptions by 1% –30 million 


Investments for the account of policyholders (34.2% of AEGON’s total managed assets in 2002) decreased by 16.4% in 2002 to EUR 94.7 billion, driven by currency exchange rate changes and declines in equity markets. Strong new production in variable annuities in the Americas of USD 9.9 billion partially offset the impact of equity market declines. On investments for the account of policyholders, the investment risk is generally borne by the policyholders, in certain cases subject to minimum benefit guarantees provided by AEGON, and AEGON earns fee income through policy expense charges. For these investments, the shift toward fixed income allocations already apparent in the past two years continued in 2002, as the allocation in fixed income securities (49%) was brought almost equal to the allocation in equities (51%). Assets related to banking activities increased 1.7% in 2002 to EUR 7.2 billion.

Off balance sheet investments (third-party asset management, mutual funds and synthetic GICs), on which we also earn fees, represented 18.8% of total managed assets and declined slightly in 2002 to EUR 52 billion as a result of the lower USD exchange rate, more than offsetting increased new production in third-party asset management and synthetic GICs.

Interest rate risk
The general account fixed income portfolios of the Americas and AEGON The Netherlands accounted for 97.3% of the total general account fixed income portfolio of the AEGON Group at December 31, 2002. AEGON USA and AEGON The Netherlands are the only country units that actively manage their duration mismatch. Presently, the other country units target the duration of their assets to equal approximately the duration of their liabilities. Duration means essentially the weighted average life of all cash flows related to an investment or a liability.

For our AEGON USA business, the average duration of assets is approximately 3.8 years. This relatively low duration as compared to the long-term nature of AEGON USA’s business is driven by the asset liability management process applied to the institutional markets business in the United States (GICs and funding agreements). Both the assets and the liabilities for this business are managed on a floating rate basis, with extensive use of interest rate swaps. As a result, these assets and liabilities, which represent a little over a quarter of the total general account assets and liabilities of AEGON USA, have an average effective duration of less than one year. The maximum allowed duration mismatch between the assets and liabilities of AEGON USA is plus or minus one year.

In the Netherlands, the average duration of assets is approximately 5.4 years with a maximum allowed duration mismatch between assets and liabilities of plus or minus two years. The combined market value weighted duration mismatch of AEGON USA and AEGON The Netherlands was around 0.2 years at December 31, 2002.

AEGON conducts both interest rate sensitive and interest rate insensitive business. A simultaneous decrease of worldwide interest rates of 1% from the current levels would have a positive effect on AEGON’s net income of approximately EUR 25 million. Conversely, an increase of worldwide interest rates of 1% would have an approximately EUR 110 million negative influence on net earnings. The main driver for the asymmetric effects of an immediate change of interest rates up or down by 1% is the interest rate risk of AEGON USA. An immediate increase of 1% will have a negative effect on earnings mainly as a result of a sudden rise in lapse rates on fixed annuities. A sudden decrease of 1% will cause a positive effect as a result of lower lapse rates, which is largely offset by the compression of spreads. A gradual increase of interest rates would have a substantially more benign effect on earnings.

During 2002, interest rates decreased substantially, lowering the new money spreads on our traditional life insurance and causing initial crediting rates on fixed annuities to be as low as 2.7%. We have refiled products with the US state regulators allowing us to lower the crediting rate to 2% (subject to a 3% minimum guarantee on 90% of the original premium, consistent with current US non-forfeiture law). Many US states have approved this change to lower crediting rates on new sales to levels, which are more consistent with our profitability objectives. At the same time, we are leading an industry effort in the United States to tie the level of guarantees to actual interest rates. This effort is still in progress.

CREDIT RISK
AEGON is exposed to credit risk on its fixed income portfolio, which includes bonds, mortgages, over-the-counter derivatives and reinsurance contracts. Country units apply specific guidelines for the acceptable level of credit risk and provide for default losses.

AEGON monitors its aggregate exposure to credit counterparties at AEGON Group level. For that purpose AEGON aggregates exposures from its country units to assess overall credit risk. Most of the AEGON Group’s credit risk lies with AEGON USA. To manage its credit risk, AEGON USA applies exposure limits, including exposures from derivatives transactions, which depend on our assessment of the credit quality of a counterparty. The exposure limits are shown in the table elsewhere on this page.

AEGON USA assigns internal ratings to assess counterparty creditworthiness, based on both published ratings by rating agencies and in–house analyses. In general, the internal ratings tend to be in line with the ratings issued by the rating agencies. If an exposure exceeds the stated limits as a result of a downgrade, the exposure must be readjusted as soon as is practical to the limit for the rating category, which varies with the asset quality of the security. In all cases, exceptions to these limits can only be made after explicit approval in advance from AEGON senior management. Almost all of the AEGON Group’s general account securities rated BB or lower (below investment grade) are held by AEGON USA.

Rating category Exposure limit
on single name
(in USD millions)		 % of general account assets
AAA or AA 620  0.57% 
A 465  0.43% 
BBB 310  0.28% 
BB 155  0.14% 
B 93  0.09% 
CCC 31  0.03% 


Sensitivity analysis of net income to interest rates1,2
Movement of markets Effects on net income
Immediate parallel yield curve shift up of 100 basis points approx. EUR –110 million
Immediate parallel yield curve shift down of 100 basis points approx. EUR 25 million

1  Basic assumptions: no correlation between markets and risks; unchanged conditions for all other assets and liabilities; limited management actions taken; all changes are relative to net income. Effects do not tend to be linear and therefore cannot be extrapolated for larger increases or decreases.
2  The effect of interest rate movements is reflected as the effect of an immediate parallel shift up or down of all relevant yield curves on January 1.


Selected exposure reductions as per December 31, 2002

Amounts
reduced since
in USD
million		 Average
sales
price*
Airlines –241  84.5 
Auto –352  96.2 
Communications –1,124  86.3 
Utilities –1,002  88.7 
Other –928  97.5 
Total –3,647   
*per USD 100 face value


As markets deteriorated, AEGON USA expanded its credit risk modelling to reflect more closely current market circumstances. The modelling now takes into account increased market volatility and considers a wider range of outcomes before investment decisions are taken.

Under certain circumstances, AEGON uses credit derivatives, mainly in specific cases where synthetic corporate bonds are being created. The total underlying amount of these credit derivatives is small relative to the entire fixed income portfolio and amounted for the AEGON Group to approximately EUR 500 million at December 31, 2002.

In 2002, AEGON USA reinvested at a slightly higher average credit quality, increasing the average credit quality of its portfolio. In addition, it actively reduced exposures in certain sectors, reallocating credit risk to the consumer non-cyclical and energy sectors. For more detail on our exposure reductions, please refer to the table on this page, which includes the average prices at which we sold these securities.

The fixed income portfolio of AEGON The Netherlands is of very high average credit quality. More than 80% of the portfolio is invested in AAA/AA-rated securities while of the remainder (excluding mortgages) around 5% is BBB-rated and less than 1% is below investment grade or not rated. With respect to the portion of AEGON The Netherlands’ fixed income portfolio composed of residential mortgages, the actual default experience is very low, corresponding to an annual effect of approximately 0.02% on the total return of the fixed income portfolio. AEGON establishes provisions for credit risk in the ordinary course of business. AEGON USA added USD 774 million to its default provisions during 2002 while USD 791 million was released, leaving a balance at year-end of USD 281 million.

US Corporate bonds by sector

Sector Year end 
2002 
% 		 Year end 
2001 
% 
Financials 29  33 
Industrials – Basic industry 6  6 
•  Capital goods 6  5 
•  Communications 10  12 
•  Consumer cyclical 7  8 
•  Consumer non-cyclical 14  9 
•  Energy 7  4 
•  Technology 3  1 
•  Transportation 5  6 
Foreign 2  1 
Utilities 11  15 
Total 100  100 


DERIVATIVES
AEGON uses derivaive financial instruments, such as interest rate swaps, options, credit derivatives, futures and foreign exchange contracts, to manage its exposures related to investments and borrowings. AEGON does not hold or issue derivative instruments for speculative trading purposes.

We plan to use AEGON Derivatives N.V., a wholly owned subsidiary, as the counterparty for all over-the-counter derivatives transactions executed by AEGON Group units and guaranteed by AEGON N.V. enabling centralized monitoring and netting of exposures with derivatives counterparties. This subsidiary will also facilitate collateral management of derivative transactions.

During 2002, AEGON Derivatives N.V. began acting as counterparty in some derivatives transactions. In 2003, we plan to transfer most of our outstanding over-the-counter derivatives transactions to AEGON Derivatives N.V., and will start to use collateral agreements, which are being put in place with our derivative counterparties. AEGON’s derivative policy states that AEGON entities may only engage in medium- and long-term over-the-counter uncollateralized derivative contracts if the rating of the counterparty is at least double A. AEGON Derivatives N.V. will employ collateralization to limit counterparty exposure, which will allow transactions with single A rated counterparties.

Sensitivity analysis of net income and shareholders' equity to Equity and real estate markets1,2
Movement of markets Effects on net income Effects on shareholders' equity
Increase of equity and
real estate markets of 10%		 approx. EUR 180 million approx. EUR 715 million
Decrease of equity and
real estate markets of 10%		 approx. EUR –280 million approx. EUR –750 million

1  Basic assumptions: no correlation between markets and risks; unchanged conditions for all other assets and liabilities; limited management actions taken; all changes are relative relative to net income and shareholders’ equity. Effects do not tend to be linear and therefore cannot be extrapolated for larger increases or decreases.
2  The effect of movements in equity and real estate markets is reflected as a one-time increase or decrease of worldwide equity and real estate markets on January 1.


EQUITY MARKET RISK
The general account equity portfolios of the Americas and AEGON The Netherlands accounted for 96.3% of the total general account equity portfolio of the AEGON Group of EUR 6,325 million at December 31, 2002.

Of our country units, AEGON The Netherlands holds the largest amount of investments classified as equities, both in absolute terms and expressed as a percentage of total general account investments. The largest part of the equity portfolio of AEGON The Netherlands consists of a diversified portfolio of global equities and 5% equity holdings in Dutch companies which include non-redeemable preferred shares. Convertible bonds and alternative investments are also included under equities, with common equity investments accounting for 15%.

AEGON’s shareholders’ equity is directly exposed to movements in the equity markets. Beginning in 2004, AEGON will change its accounting policy to recognize in income realized gains and losses on equities and real estate, which may lead to increased sensitivity of earnings to movements in equity markets. In addition, as 51% of investments held for the account of policyholders is currently allocated to equity securities, net income is sensitive to the fees earned on these assets as well as the amortization of deferred policy acquisition costs and provisioning for minimum product guarantees. The sensitivity analysis on this page shows that net income would be approximately EUR 280 million lower and shareholders’ equity approximately EUR 750 million lower in the event of a decrease of 10% in equity and real estate markets. Conversely, an increase of 10% in these markets would result in a positive impact on net income of approximately EUR 180 million and on shareholders’ equity of approximately EUR 715 million.

The sensitivity of shareholders’ equity and earnings to changes in equity and real estate markets reflects changes in market value of our portfolios, indirect return, changes in DPAC amortization, contributions to pension plans for our employees and guaranteed minimum benefits strengthening, when applicable. The main reason for the difference in effects of an additional immediate change up or down of 10% is that a change down will cause additional DPAC amortization and guaranteed minimum benefits provisioning while an increase of 10% will not. AEGON is not directly exposed to commodity markets.

Ratings Standard & Poor’s Moody’s
Credit ratings
Commercial paper		 A-1+* P-1*
Senior debt AA-* A2*
Subordinated debt A+* A3*
Insurance financial strength
AEGON The Netherlands		 AA+*  
AEGON USA AA+* Aa3
Scottish Equitable AA+* A1
* Outlook negative


Capital base 2002
EUR million		 % 2001
EUR million		 %
Shareholders' equity 14,231 70.9 15,923 70.2
Capital securities 2,008 10.0 2,101 9.3
Subordinated debt 616 3.1 670 3.0
Senior debt related to insurance activities 3,203 16.0 3,982 17.5
Total capital base 20,058 100.0 22,676 100.0


CAPITAL MANAGEMENT
During 2002, AEGON’s capital position improved slightly. Shareholders equity was EUR 14,231 million compared to EUR 15,923 million at December 31, 2001. The EUR 1,692 million decrease is primarily due to negative exchange rate differences of EUR 2,190 million, unrealized investment losses of EUR 1,560 million, net income of EUR 1,517 million after preferred dividend and paid-in capital on preferred stock of EUR 2,064 million contributed on our existing preferred shares by Vereniging AEGON, our largest shareholder, as part of the capital realignment effected in September 2002. As a result, shareholders’ equity as a percentage of the capital base increased from 70% at December 31, 2001 to 71% at December 31, 2002.

In September 2002, AEGON effected a non-dilutive capital realignment whereby Vereniging AEGON sold 350 million of the common shares, of which 143.6 million common shares were sold directly by Vereniging AEGON in a secondary offering outside the United States and 206.4 million common shares were purchased by AEGON from Vereniging AEGON. AEGON subsequently sold these common shares in a global offering. The purchase price for the 206.4 million common shares sold by Vereniging AEGON to AEGON was EUR 2,064 million which amount Vereniging AEGON contributed as additional paid-in capital on AEGON’s existing preferred shares, all held by Vereniging AEGON. Through these transactions AEGON was able to raise equity capital without ownership dilution and to increase the free-float of AEGON’s common shares substantially. This has had a positive effect on AEGON’s weightings in equity indices.

In 2002, AEGON only accessed the term debt markets through the issuance of approximately EUR 600 million in notes in several small tranches under its USD 6 billion Medium Term Note Program, all through private placements. Funding needs were largely driven by operational financing, which almost entirely consisted of refinancing of maturing funding of the Transamerica Finance Corporation (TFC) businesses.

AEGON maintains access to the debt capital markets through its Medium Term Note Program and its existing shelf registration in the United States, while its EUR 2 billion Commercial Paper Program facilitates access to international and domestic money markets when required.

AEGON also maintains back-up credit facilities, with more than USD 4.5 billion (EUR 4.3 billion) of facilities committed by banks of excellent standing and credit quality. In addition, AEGON enjoys an extensive amount of additional credit lines, while TFC has secured USD 3.25 billion (EUR 3.1 billion) of back-up facilities for its own Commercial Paper Program.

During 2002, Standard and Poor’s maintained AEGON’s ratings at AA level with a negative outlook, while Moody’s Investors Service lowered AEGON’s long-term credit ratings. AEGON’s senior debt is now rated A2 by Moody’s, while the important financial strength rating of the AEGON USA companies remained unchanged at Aa3 with a stable outlook.

AEGON is committed to a strategy of continued financial strength as reflected by the development of AEGON’s capital base, which has kept leverage within our prescribed tolerances. At December 31, 2002, equity capital represented 71% of our capital base, while senior and dated subordinated debt raised to support insurance operations comprised 19% of our capital base. The remaining 10% comprised capital securities, consisting primarily of perpetual subordinated securities.

The capital adequacy of our operating units continues to be strong. AEGON manages its capital adequacy to a higher standard than required by the regulators, and as of December 31, 2002, solvency for AEGON N.V. was more than double the minimum EU capital requirement. Relative to the National Association of Insurance Commissioners requirements in the United States, we held in excess of 350% of the minimum required capital. Other indicators we use to monitor levels of capitalization include capital adequacy models developed by rating agencies.

The Hague, March 5, 2003
The Executive Board
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