|
GENERAL
AEGON is exposed to a variety of risks. Some risks are related to the international nature of AEGON’s business, such as currency translation risk. Other risks include insurance related risks, such as changes in mortality and morbidity. However, AEGON’s largest exposure is to changes in financial markets (e.g. interest rate, credit and equity market risks) that affect the value of the investments and technical provisions (including deferred policy acquisition costs).
AEGON continues to embed advanced risk management techniques in its capital management framework. This process is primarily aimed at achieving further efficiencies in capital management while sharing best risk management practices and improving consistency in internal risk reporting. Similar to 2003, this resulted in a more coordinated and proactive approach towards risk and capital management procedures. AEGON expects this trend to continue with the ongoing international development and advancement of risk management techniques. AEGON continues to stay abreast of regulatory developments, in particular Solvency II, which allows advanced internal risk management models as a basis for capital requirements.
AEGON’s financial risk management, part of the global risk management framework, is based on asset liability management (ALM) processes and models. These processes and models are in place in each country unit and are not only used to manage risk in each unit, but also for the Group. AEGON takes inventory of its current risk position across all risk categories. It also measures the sensitivity of net income and shareholders’ equity to stochastic and deterministic scenarios. AEGON’s management uses the insight gained through these ‘what if?’ scenarios to manage the Group’s risk exposure and capital position. The models, scenarios and assumptions used are reviewed and, if necessary, updated each year.
DAP-BASED SENSITIVITY ANALYSES
Results of AEGON’s sensitivity analyses are presented throughout this section to show the estimated sensitivity of net income and shareholders’ equity to various scenarios. These sensitivity analyses are presented on Dutch Accounting Principles (DAP) in order to permit a consistent comparison with historical financial data. AEGON ceased to apply DAP on January 1, 2005 when it changed its basis of accounting to International Financial Reporting Standards or IFRS. Because AEGON will report financial information for 2005 only under IFRS, the sensitivity analysis included in this section may not reflect the same sensitivities that would result from the application of IFRS. Among other things, the impact of the differences between DAP and IFRS on risk sensitivities is currently expected to be greatest for interest rate changes, equity market changes and relative currency rate movements.
These scenario results do not consider the actions that might be taken to mitigate losses inherent in AEGON’s risk management processes. As financial markets fluctuate, these actions may involve selling investments, changing investment portfolio allocation and adjusting interest rates or bonuses credited to policyholders. Also, the results do not take into account correlation between factors and assume unchanged conditions for all other assets and liabilities. Results of the analyses also cannot be extrapolated for wider variations since effects do not tend to be linear.
CURRENCY EXCHANGE RATE RISK
As an international group, AEGON is subject to currency risk. Also, currency risk exists for any policy denominated in currencies other than the policy’s local currency. In the Netherlands, AEGON invests the majority of its equity holdings in an internationally diversified portfolio, rather than solely in Dutch equities. Equity held in subsidiaries is kept in local currencies to the extent shareholders’ equity is required to satisfy regulatory and self-imposed capital requirements. Because of this, currency exchange rate fluctuations may affect the level of shareholders’ equity as a result of translation into euro. AEGON holds the remainder of its capital base (capital securities, subordinated and senior debt) in various currencies in amounts that are targeted to correspond to the book value of its country units. This balancing mitigates currency translation impacts to equity and leverage ratios. Currency risk in the investment portfolios is managed using asset liability matching principles. AEGON does not hedge the income streams from the main non-euro units and, as a result, earnings may fluctuate due to currency translation. As AEGON has significant business segments in the Americas and in the United Kingdom, the principal sources of exposure from currency fluctuations are from the differences between the US dollar and euro and between the UK pound and euro. AEGON may experience significant changes in net income and shareholders’ equity because of these fluctuations.
The five-year historical income before tax and capital in units for AEGON are shown in table 1.
Table 1
 |
|
|
|
|
|
|
Income before tax
(in millions) |
2000 |
2001 |
2002 |
2003 |
1 |
2004 |
AEGON Americas
(in USD) |
1,870 |
2,034 |
1,142 |
1,740 |
|
2,207 |
AEGON The Netherlands
(in EUR) |
840 |
924 |
659 |
771 |
|
720 |
| AEGON UK (in GBP) |
219 |
231 |
146 |
130 |
|
148 |
| Other countries (in EUR) |
57 |
72 |
64 |
79 |
|
123 |
|
|
|
|
|
|
Capital in units
(in millions) |
2001 |
2002 |
2003 |
|
2004 |
AEGON Americas
(in USD) |
13,920 |
16,518 |
17,491 |
|
18,132 |
AEGON The Netherlands
(in EUR) |
3,654 |
2,605 |
2,865 |
|
3,436 |
| AEGON UK (in GBP) |
1,771 |
2,028 |
2,173 |
|
2,222 |
| Other countries (in EUR) |
374 |
399 |
481 |
|
592 |
| 1 |
The 2003 figures have been adjusted to reflect changes in accounting principles implemented as of January 1, 2004. |
The exchange rates for US dollar and UK pound per euro for each of the last five year-ends are set forth in table 2.
Table 2
|
|
|
|
|
|
|
| Closing rates |
2000 |
2001 |
2002 |
2003 |
|
2004 |
| USD |
0.93 |
0.88 |
1.05 |
1.26 |
|
1.36 |
| GBP |
0.62 |
0.61 |
0.65 |
0.70 |
|
0.71 |
The sensitivity analysis in table 3 shows the estimated approximate effects on net income and shareholders’ equity of movements in the exchange rates of AEGON’s non-euro currencies relative to the euro.
Table 3
SENSITIVITY ANALYSIS OF NET INCOME AND SHAREHOLDERS’ EQUITY TO CURRENCY EXCHANGE RATE MARKETS 1,2,3
|
|
|
| Movement of markets |
Estimated approximate
effects on net income |
Estimated approximate
effects on
shareholders' equity |
| Increase versus the euro |
increase between |
increase between |
| of non-euro currencies of 15% |
10% and 11% |
15% and 16% |
| Decrease versus the euro |
decrease between |
decrease between |
| of non-euro currencies of 15% |
10% and 11% |
15% and 16% |
| 1 |
The accounting basis used for this table is DAP. The effects should not be used as a guide in providing directional and approximate magnitude impact on net income and shareholders equity in 2005 since starting January 1, 2005 AEGON adopted IFRS, which differs in significant respects from DAP in its treatment of the consequences of certain events, including interest rate changes, equity market changes and relative currency rate movements. |
| 2 |
Basic assumptions: no correlation between markets and risks; unchanged conditions for all other assets and liabilities; limited management actions taken. All percentage 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. |
| 3 |
The effect of currency exchange rate movements is reflected as a one-time shift up or down in the value of the non-euro currencies versus the euro on December 31, 2004. |
INTEREST RATE RISK
AEGON bears interest rate risk in many of its products. In cases where cash flows are highly predictable, investing in assets that closely match the liabilities can mitigate this risk — a method that AEGON employs. However in some products, liability cash flows are less predictable. The uncertainty arises from policyholder actions that can be affected by the level of interest rates.
In periods of rapidly increasing interest rates, policy loans, surrenders and withdrawals may increase and usually do increase. Premiums in flexible premium policies may decrease as policyholders seek investments with higher perceived returns. This activity may result in cash payments requiring the sale of invested assets at a time when the prices of those assets are adversely affected by the increase in market interest rates, which may result in realized investment losses. These cash payments to policyholders result in a decrease in total invested assets and a decrease in net income. Among other things, early withdrawals may also require AEGON to accelerate amortization of policy acquisition costs, reducing net income.
During periods of sustained low interest rates, life insurance and annuity products may be relatively more attractive to consumers, resulting in increased premium payments on products with flexible premium features, and a higher percentage of insurance policies remaining in force from year to year. During such a period, investment earnings may be lower because the interest earnings on new fixed income investments will likely have declined with the market interest rates. In addition, mortgages and redeemable bonds in the investment portfolio are more likely to be repaid as borrowers seek to borrow at lower interest rates and AEGON may be required to reinvest the proceeds in securities bearing lower interest rates. Also, in a period of low interest rates, AEGON may not be able to reduce crediting rates on policies and still preserve margins as a result of minimum guaranteed crediting rates provided on policies. Accordingly, during periods of sustained low interest rates, net income may decline as a result of a decrease in the spread between either the interest rates credited to policyholders or the rates assumed in reserves and returns on the investment portfolio.
The general account fixed income portfolios of AEGON USA and AEGON The Netherlands accounted for 96% of the total general account fixed income portfolio of the AEGON Group at December 31, 2004. AEGON USA and AEGON The Netherlands manage their duration mismatch on the basis of their expectations for the future level of interest rates. Presently, the other country units target the duration of their assets to equal approximately the duration of their liabilities. In addition to point in time duration measurement, deterministic and stochastic scenarios are used to measure and manage interest rate risk.
In these models, policyholder behavior changes are anticipated. These models are used by all country units and aggregated at the group level.
For AEGON USA’s business, the average duration of assets is approximately 4.3 years. This relatively low duration, as compared to the long-term nature of most of AEGON USA’s businesses, is driven by the asset and 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 effective duration of close to two months. For AEGON The Netherlands, the average duration of assets is approximately 6.9 years. The combined market value weighted duration mismatch of AEGON USA and AEGON The Netherlands was approximately minus 1.0 year at December 31, 2004 (duration of assets is shorter than duration of liabilities).
Table 4 shows each of the last five year-end interest rates for the period from 2000 through 2004.
Table 4
|
|
|
|
|
|
|
| Closing rates |
2000 |
2001 |
2002 |
2003 |
|
2004 |
| 3 month US Libor |
6.40% |
1.88% |
1.38% |
1.15% |
|
2.56% |
| 3 month Euribor |
4.86% |
3.29% |
2.87% |
2.12% |
|
2.16% |
| 10-year US Treasury |
5.10% |
5.04% |
3.82% |
4.25% |
|
4.22% |
10-year Dutch
government |
4.99% |
5.11% |
4.23% |
4.29% |
|
3.68% |
The sensitivity analysis in table 5 shows an estimate of the effect on net income of movements in the interest rates.
Table 5
SENSITIVITY ANALYSIS OF NET INCOME TO INTEREST RATES 1,2,3
|
|
|
| Parallel movement of yield curve |
Estimated approximate effects on net income |
Estimated approximate effects on
shareholders equity |
| Shift up 100 basis points |
EUR (60) million |
EUR (60) million |
| Shift up 200 basis points |
EUR (248) million |
EUR (248) million |
| Shift down 100 basis points |
EUR (40) million |
EUR (40) million |
| Shift down 200 basis points |
EUR (65) million |
EUR (65) million |
| 1 |
The accounting basis used for this table is DAP. The effects should not be used as a guide in providing directional and approximate magnitude impact on net income and shareholders equity in 2005 since starting January 1, 2005 AEGON adopted IFRS, which differs in significant respects from DAP in its treatment of the consequences of certain events, including interest rate changes, equity market changes and relative currency rate movements. |
| 2 |
Basic assumptions: no correlation between markets and risks; unchanged conditions for all other assets and liabilities; limited management actions taken; changes are relative to net income. Effects do not tend to be linear and therefore cannot be extrapolated for larger increases or decreases. |
| 3 |
The effect of interest rate movements is reflected as the effect of a one-time parallel shift up or down of all relevant yield curves on December 31, 2004. |
The main driver for the asymmetric effects of an immediate change of interest rates up or down by 1% or 2% is the interest rate risk of AEGON USA. It is estimated that an immediate increase of 1% or 2% will have a negative effect on earnings mainly as a result of an expected sudden rise in lapse rates on fixed annuities. An immediate decrease of 1% or 2% is also expected to have a negative effect as a result of compression of spreads. It is estimated that a gradual increase of interest rates would have a substantially more benign effect on earnings. The sensitivities have a similar impact on shareholders’ equity. Accordingly, during periods of sustained low interest rates, net income may decline as a result of a decrease in the spread between either the interest rates credited to policyholders, due to the presence of minimum guarantees, or the rates assumed in reserves and returns on the investment portfolios.
CREDIT RISK
As premiums and deposits are received, these funds are invested to pay for future policyholder obligations. For general account products, AEGON typically bears the risk for investment performance — return of principal and interest. AEGON is exposed to credit risk on its general account fixed income portfolio (bonds, mortgages and private placements), over-the-counter derivatives and reinsurance contracts. Some issuers have defaulted on their financial obligations for various reasons, including bankruptcy, lack of liquidity, downturns in the economy or downturns in real estate values, operational failure and fraud. In the past, poor economic and investment climates in AEGON’s major markets resulted in significant investment impairments on AEGON’s investment assets due to defaults and overall declines in the securities markets. Although credit default rates were moderate in 2004, a reversion to excessive defaults, or other reductions in the value of these securities and loans, could have a material adverse effect on AEGON’s business, results of operations and financial condition.
AEGON actively manages its credit risk exposure by individual counterparty, sector and asset class. AEGON also employs deterministic and stochastic credit risk modeling in order to assess AEGON’s credit risk profile and associated earnings and capital implications due to various credit loss scenarios. The ratings distribution of general account portfolios of AEGON’s major country units are presented in table 6 by rating category.
Table 6
GENERAL ACCOUNT FIXED INCOME
(in millions)
|
|
|
|
|
|
|
| Rating category |
AEGON
AMERICAS
(in USD) |
AEGON
THE NETHERLANDS
(in EUR) |
AEGON
UK
(in GBP) |
OTHER
COUNTRIES
(in EUR) |
|
TOTAL
(in EUR) |
| Treasuries/agencies |
8,814 |
6,137 |
233 |
1,529 |
|
14,468 |
| High quality (AAA) |
17,748 |
946 |
245 |
137 |
|
14,460 |
| High quality (AA) |
8,114 |
668 |
197 |
285 |
|
7,189 |
| Investment grade (A) |
31,674 |
1,180 |
903 |
429 |
|
26,145 |
| Investment grade (BBB) |
29,661 |
768 |
145 |
31 |
|
22,781 |
| High yield (BB and lower) |
7,088 |
97 |
0 |
6 |
|
5,307 |
| Mortgages |
14,395 |
3,782 |
0 |
7 |
|
14,357 |
| Other |
2,647 |
418 |
1 |
54 |
|
2,416 |
| Total investments fixed income |
120,141 |
13,996 |
1,724 |
2,478 |
|
107,123 |
Country units apply specific guidelines for the acceptable levels of credit risk and provide for default losses. AEGON monitors its aggregate exposure to credit counterparties at group level. For this purpose, AEGON aggregates exposures from its country units to assess overall credit risk. To manage its credit risk, AEGON has a single credit counterparty limit policy that is applied to all forms of credit risk. All forms of credit risk are aggregated by counterparty and measured for compliance against country unit credit limits and group-wide credit limits. The group-wide limits are shown in table 7.
Table 7
AEGON GROUP-WIDE WEIGHTED COUNTERPARTY EXPOSURE LIMIT 1
(in EUR millions)
|
|
| CREDIT RATING |
LIMIT |
| AAA |
1000 |
| AA |
1000 |
| A |
750 |
| BBB |
500 |
| BB |
250 |
| B |
125 |
| CCC |
50 |
| 1 |
The fixed income issuer rating is used when applying the credit counterparty limit exposure policy. |
If an exposure exceeds the stated limit as a result of a downgrade, the exposure must be readjusted as soon as practicable to the limit for that rating category. The limits vary 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.
AEGON establishes provisions for credit risk in the ordinary course of business. AEGON added EUR 195 million to its default provisions during 2004, while EUR 167 million was charged for defaults. Other movements had a positive impact of EUR 53 million on the provision, leaving a balance at year-end of
EUR 341 million (2003: EUR 260 million).
EQUITY MARKET RISK AND OTHER INVESTMENT RISKS
Fluctuations in the equity, real estate and capital markets have adversely affected AEGON’s profitability, capital position and sales of equity related products in the past and may continue to do so. Exposure to equity, real estate and capital markets exists in both assets and liabilities. Asset exposure exists through direct equity investment, where AEGON bears all or most of the volatility in returns and investment performance risk. Significant terrorist actions, as well as general economic conditions, have led to and may continue to result in significant decreases in the value of AEGON’s equity investments.
Liability exposure is present in equity-linked products whereby policyholder funds are invested in equities at the discretion of the policyholder, where most of the risk remains with the policyholder. Examples of these products include variable annuities, variable universal life, unit-linked products and mutual funds. AEGON typically earns a fee on the asset balance in these products and therefore has a risk related to the investment performance. In addition, some of this business has minimum return or accumulation guarantees, which are often life contingent or contingent upon policyholder persistency. AEGON is at risk if equity market returns do not exceed these guarantee levels and may need to set up additional reserves to fund these future guaranteed benefits. AEGON is also at risk if returns are not sufficient to allow amortization of deferred policyholder acquisition costs. It is possible under certain circumstances that AEGON would need to accelerate amortization of DPAC and to establish additional provisions for minimum guaranteed benefits, which would reduce net income and shareholders’ equity. Volatile or poor market conditions may also significantly reduce the popularity of some of AEGON’s savings and investment products, which could lead to lower sales and net income. AEGON’s general account equity holdings are shown in table 8 below.
The general account equity, real estate and other non-fixed income portfolio of AEGON Americas and AEGON The Netherlands accounted for 98% of the total general account equity, real estate and other non-fixed income portfolio of the AEGON Group. Of AEGON’s country units, AEGON The Netherlands holds the largest amount of 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.
Table 8
EQUITY, REAL ESTATE AND NON-FIXED INCOME EXPOSURE IN GENERAL ACCOUNT ASSETS
amounts in millions
|
|
|
|
|
|
|
| ASSETS |
AEGON
AMERICAS
(in USD) |
AEGON
THE
NETHERLANDS
(in EUR) |
AEGON
UK
(in GBP) |
OTHER
COUNTRIES
(in EUR) |
|
TOTAL
(in EUR) |
| Equity funds |
546 |
317 |
41 |
3 |
|
779 |
| Common shares1 |
629 |
2,541 |
15 |
30 |
|
3,054 |
| Preferred shares |
709 |
779 |
0 |
9 |
|
1,309 |
| Real estate |
783 |
1,675 |
0 |
50 |
|
2,300 |
| Hedge funds |
1,481 |
223 |
0 |
0 |
|
1,310 |
| Credit investment strategies |
306 |
0 |
0 |
0 |
|
225 |
| Total equity, real estate and other non-fixed income exposure |
4,455 |
5,534 |
56 |
92 |
|
8,977 |
Table 9
|
|
|
|
|
|
|
| Year-end |
2000 |
2001 |
2002 |
2003 |
|
2004 |
| S&P 500 |
1,320 |
1,148 |
880 |
1,112 |
|
1,112 |
| Nasdaq |
2,471 |
1,950 |
1,336 |
2,003 |
|
2,175 |
| FTSE 100 |
6,222 |
5,217 |
3,940 |
4,477 |
|
4,814 |
| AEX |
638 |
507 |
323 |
338 |
|
348 |
AEGON’s shareholders’ equity is directly exposed to movements in the equity and real estate markets. Starting in 2004, AEGON discontinued the indirect income method and instead recognizes realized gains and losses on equities and real estate in income, which may lead to increased sensitivity of net income to movements in equity and real estate markets. In addition, net income is sensitive to the fees earned on equity investments held for the account of policyholders as well as the amortization of deferred policy acquisition costs and provisioning for minimum product guarantees.
Sensitivity analysis of net income and shareholders’ equity to equity and real estate markets is presented in table 10 below.
The sensitivity of shareholders’ equity and net income to changes in equity and real estate markets reflects changes in the market value of AEGON’s portfolio, changes in DPAC amortization, contributions to pension plans for AEGON’s employees and the strengthening of the guaranteed minimum benefits, when applicable. The main reason for the non-linearity of results is that more severe scenarios can cause accelerated DPAC amortization and guaranteed minimum benefits provisioning, while moderate scenarios may not.
Table 10
SENSITIVITY ANALYSIS OF NET INCOME AND SHAREHOLDERS EQUITY TO EQUITY AND REAL ESTATE MARKETS1,2,3
|
|
|
| Immediate change in |
Estimated approximate
effects on net income |
Estimated approximate
effects on shareholders equity |
| Equity increase 10% |
EUR 126 million |
EUR 371 million |
| Equity decrease 10% |
EUR (96) million |
EUR (341) million |
| Equity decrease 20% |
EUR (287) million |
EUR (693) million |
| Real estate increase 10% |
EUR 0 million |
EUR 176 million |
| Real estate decrease 10% |
EUR (15) million |
EUR (176) million |
| Real estate increase 20% |
EUR (43) million |
EUR (352) million |
| 1 |
The accounting basis used for this table is DAP. The effects should not be used as a guide in providing directional and approximate magnitude impact on net income and shareholders equity in 2005 since starting January 1, 2005 AEGON adopted IFRS, which differs in significant respects from DAP in its treatment of the consequences of certain events, including interest rate changes, equity market changes and relative currency rate movements. |
| 2 |
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. The approximate effects on shareholders equity exclude the effects on net income, which is presented above separately. |
| 3 |
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 December 31, 2004. |
DERIVATIVES RISK
AEGON is exposed to currency fluctuations, changes in the fair value of its investments, the impact of interest rate and credit spread changes and changes in mortality and longevity. AEGON uses common financial derivative instruments such as interest rate swaps, options, futures and forward contracts to hedge some of the exposures related to both investments backing insurance products and company borrowings. AEGON may not be able to manage the risks associated with these activities successfully through the use of derivatives. In addition, a counter party may fail to honor the terms of its derivatives contracts with AEGON. AEGON’s inability to manage risks successfully through derivatives or counterparty’s failure to honor its obligations could have a material adverse effect on AEGON’s business, results of operations and financial condition.
LIQUIDITY RISK
Liquidity risk is inherent in much of AEGON’s business. Each asset purchased and liability sold has liquidity characteristics that are unique. Some liabilities are surrenderable while some assets have low liquidity such as privately placed loans, mortgage loans, real estate and limited partnership interests. If AEGON requires significant amounts of cash on short notice in excess of normal cash requirements, AEGON may have difficulty selling these investments at fair prices, in a timely manner, or both.
UNDERWRITING RISK
AEGON’s earnings depend significantly upon the extent to which actual claims experience is consistent with the assumptions used in setting the prices for products and establishing the technical provisions and liabilities for claims. To the extent that actual claims experience is less favorable than the underlying assumptions used in establishing such liabilities, income would be reduced. Furthermore, if these higher claims were part of a trend, AEGON may be required to increase liabilities, which may reduce income. In addition, certain acquisition costs related to the sale of new policies and the purchase of policies already in force have been recorded as assets on the balance sheet and are being amortized into income over time. If the assumptions relating to the future profitability of these policies (such as future claims, investment income and expenses) are not realized, the amortization of these costs could be accelerated and may even require write-offs due to unrecoverability. This could have a material adverse effect on AEGON’s business, results of operations and financial condition.
Sources of underwriting risk include policy lapses, policy claims such as mortality, and expenses. In general, AEGON is at risk if policy lapses increase as sometimes AEGON is unable to fully recover up front expenses in selling a product despite the presence of commission recoveries or surrender charges and fees. For mortality risk, AEGON sells certain types of policies that are at risk if mortality increases, such as term insurance, and sells certain types of policies that are at risk if mortality decreases such as annuity products. AEGON is also at risk if expenses are higher than assumed by management.
AEGON actively monitors and manages its underwriting risk by each underwriting risk type. Attribution analysis is performed on earnings and reserve movements in order to understand the source of any material variation in actual results from what was expected. AEGON’s units also perform experience studies for underwriting risk assumptions, comparing AEGON’s experience to industry experience as well as combining AEGON’s experience and industry experience based on the depth of the history of each source to AEGON’s underwriting assumptions. Where policy charges are flexible in products, AEGON uses these analyses as the basis for modifying these charges, maintaining a balance between policyholder and shareholder interests. AEGON also has the ability to reduce expense levels thus mitigating unfavorable expense variation.
Sensitivity analysis of net income and shareholders’ equity to various underwriting risks is shown in table 11.
Table 11
|
|
|
| SENSITIVITY ANALYSIS OF NET INCOME AND SHAREHOLDERS EQUITY TO VARIOUS UNDERWRITING RISKS1,2,3 |
| Underwriting risk sensitivity |
Estimated approximate effects on net income |
Estimated approximate effects on shareholders equity |
| Lapses increase 20% |
EUR (62) million |
EUR (62) million |
| Mortality increases 20% |
EUR (58) million |
EUR (58) million |
| Mortality decreases 10% |
EUR 59 million |
EUR 59 million |
| Expenses increase 10% |
EUR (95) million |
EUR (95) million |
| 1 |
The accounting basis used for this table is DAP. The effects should not be used as a guide in providing directional and approximate magnitude impact on net income and shareholders equity in 2005 since starting January 1, 2005 AEGON adopted IFRS, which differs in significant respects from DAP in its treatment of the consequences of certain events, including interest rate changes, equity market changes and relative currency rate movements. |
| 2 |
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 mortality sensitivities assume that mortality increases or decreases for all products regardless of whether one product produces a gain or loss on the directional change. |
NEW PRODUCTS
Regardless of the suitability of products for AEGON’s customers, or the adequacy of the disclosure provided to its customers by AEGON and by the intermediaries who distribute AEGON’s products, AEGON may face claims from customers and adverse negative publicity if these products result in losses or fail to result in expected gains. New products that are less well understood and that have less of a historical performance track record may be more likely to be the subject of such claims. Any such claims could have material adverse affect on AEGON’s results of operation, corporate reputation and financial condition.
TAX CHANGES
Insurance products enjoy certain tax advantages, particularly in the United States and the Netherlands, which permit the tax-deferred accumulation of earnings on the premiums paid by the holders of annuities and life insurance products under certain conditions and within limits. Taxes, if any, are payable on accumulated tax-deferred earnings when earnings are actually paid. The US Congress has, from time to time, considered possible legislation that would eliminate the deferral of taxation on the accretion of value within certain annuities and life insurance products. In addition, the United States Congress passed legislation in 2001 that provided for reductions in the estate tax and the possibility of permanent repeal of the estate tax continues to be discussed, which could have an impact on insurance products and sales in the United States. Recent changes in tax laws in the Netherlands have reduced the attractiveness of certain of AEGON’s individual life products.
The current administration in the Netherlands has indicated that it is contemplating further changes in law that would eliminate the tax advantages of certain other products, including group savings products. Any changes in United States or Dutch tax law affecting products could have a material adverse effect on AEGON’s business, results of operations and financial condition.
OTHER RISKS
RATINGS
Claims paying ability and financial strength ratings are factors in establishing the competitive position of insurers. A rating downgrade (or the potential for such a downgrade) of AEGON or any of its rated insurance subsidiaries could, among other things, materially increase the number of policy surrenders and withdrawals by policyholders of cash values from their policies. This may result in cash payments requiring the sale of invested assets, including illiquid assets, at a price that may result in realized investment losses. These cash payments to policyholders result in a decrease in total invested assets and a decrease in net income. Among other things, early withdrawals may also cause AEGON to accelerate amortization of policy acquisition costs, reducing net income.
In addition, a downgrade may adversely affect relationships with broker-dealers, banks, agents, wholesalers and other distributors of AEGON’s products and services, which may negatively impact new sales and adversely affect AEGON’s ability to compete and thereby have a material adverse effect on AEGON’s business, results of operations and financial condition. Negative changes in credit ratings may also increase AEGON’s cost of funding.
During 2004, Standard and Poor’s maintained the credit ratings of AEGON N.V. at A+ with a stable outlook. Moody’s Investor Service maintained the senior debt rating of AEGON N.V. at A2, and changed the negative outlook to stable. In July 2004, Standard and Poor’s changed the outlook on Scottish Equitable’s AA rating from negative to stable.
The current S&P and Moody’s insurance financial strength ratings and ratings outlook are in shown in table 12.
Table 12
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| RATINGS |
| |
S & P rating |
S & P outlook |
Moody's rating |
Moody's outlook |
| AEGON USA |
AA |
Stable |
Aa3 |
Stable |
| AEGON The Netherlands |
AA |
Stable |
Not rated |
Not rated |
| Scottish Equitable |
AA |
Stable |
A1 |
Stable |
INFORMATION TECHNOLOGY
While systems and processes are designed to support complex transactions and to avoid systems failure, fraud, information security failures, processing errors and breaches of regulation, any failure could lead to a material adverse effect on AEGON’s results of operation and corporate reputation.
CATASTROPHIC EVENTS
Natural disasters, terrorism and fires could disrupt AEGON’s operations and result in significant loss of property, key personnel and information about AEGON and its clients.
If AEGON’s business continuity plans have not included effective contingencies for such an event, this could adversely affect AEGON’s business, results of operations, corporate reputation and financial condition for a substantial period of time.
GOVERNMENT REGULATION
AEGON’s insurance business is subject to comprehensive regulation and supervision in all countries in which AEGON operates. The primary purpose of such regulation is to protect policyholders, not holders of securities. Changes in existing insurance laws and regulations may affect the way in which AEGON conducts business and the products offered. Changes in pension and employee benefit regulation, social security regulation, financial services regulation, taxation and the regulation of securities products and transactions may adversely affect AEGON’s ability to sell new policies or claims exposure on existing policies. Additionally, the insurance laws or regulations adopted or amended from time to time may be more restrictive or may result in higher costs than current requirements.
LITIGATION
AEGON faces significant risks of litigation and regulatory investigations and actions in connection with activities as an insurer, securities issuer, employer, investment advisor, investor and taxpayer. Lawsuits, including class actions and regulatory actions, may be difficult to assess or quantify, may seek recovery of very large and/or indeterminate amounts, including punitive and treble damages, and their existence and magnitude may remain unknown for substantial periods of time. A substantial legal liability or a significant regulatory action could have a material adverse effect on AEGON’s business, results of operations and financial condition.
CHANGES IN ACCOUNTING PRINCIPLES
AEGON’s 2004 financial statements have been prepared and presented in accordance with Dutch Accounting Principles. Any change in these accounting principles, such as the conversion to IFRS as of January 1, 2005, may have a material impact on AEGON’s reported results, financial condition and shareholders’ equity, including the level and volatility of reported results and shareholders’ equity.
LIQUIDITY AND CAPITAL RESOURCES
GENERAL
The AEGON Group conducts its capital management processes at various levels in the organization. The main goal of AEGON’s capital management is to manage the capital adequacy of its operating companies to high standards within leverage tolerances consistent with strong capitalization.
CAPITAL ADEQUACY
AEGON manages capital adequacy at the level of its country units and their operating companies. AEGON seeks to maintain its internal capital adequacy levels at the higher of local regulatory requirements, 165% of the relevant local Standard & Poor’s capital adequacy models or internally imposed requirements. During 2004, the capital adequacy of AEGON’s operating units continued to be strong. All of AEGON’s units were capitalized within these tolerances. In the United States, at December 31, 2004, AEGON held 370% of the minimum capital required by the National Association of Insurance Commissioners.
CAPITAL BASE
AEGON applies leverage tolerances to its capital base. The capital base reflects the capital employed in core activities and consists of shareholders’ equity, capital securities and dated subordinated and senior debt. AEGON has managed its capital base to comprise at least 70% shareholders’ equity, at least 5% capital securities, and a maximum of 25% dated subordinated and senior debt. At December 31, 2004, AEGON’s leverage was within these prescribed tolerances: equity capital represented 72% of its total capital base, while senior and dated subordinated debt comprised 12% of its total capital base. Capital securities accounted for the remaining 16%. In the second half of 2004, AEGON N.V. issued Junior Perpetual Capital Securities in separate tranches of EUR 950 million and USD 500 million to refinance maturing debt and strengthen its capital base. The ratio of shareholders’ equity to total capital remains stable at approximately the same level as it was over the year.
In the future, AEGON’s capital base may be subject to regulatory requirements arising out of current legislation drafted by the Dutch Government. Under IFRS accounting rules, the composition of reported equity will change and be subject to higher volatility. AEGON will monitor the development of its capital ratios under IFRS, and review the definitions to remain consistent with historical tolerances, if necessary, in an effort to ensure continued strong capitalization.
SHAREHOLDERS’ EQUITY
Shareholders’ equity was EUR 14,413 million at December 31, 2004, compared to EUR 13,947 million at December 31, 2003. The increase of EUR 466 million is largely due to the net income of EUR 1,663 million, offset by amongst others, currency translation losses of EUR 775 million and cash dividends of EUR 351 million.
DEBT FUNDING AND LIQUIDITY
AEGON’s funding strategy continues to be based on assuring excellent access to international capital markets at low costs. As part of this strategy, AEGON aims to offer institutionally targeted debt securities in amounts that are eligible for benchmark inclusion and supports maintenance of liquid secondary markets in these securities. AEGON also aims to maintain excellent access to retail investors, as witnessed by the successful issuance of the Junior Perpetual Capital Securities. AEGON’s focus on the fixed income investor base will continue to be supported by an active investor relations program to keep investors well informed on AEGON’s strategy and results.
Most of AEGON’s external debt is issued by the parent company, AEGON N.V., as well as two companies whose securities are guaranteed by AEGON N.V.
AEGON N.V. has employed its regular access to the capital markets through private placements issued under its USD 6 billion Euro Medium Term Notes Program and under a separate US shelf registration. AEGON’s USD 2 billion Euro Commercial Paper Program and AEGON Funding Corp.’s USD 4.5 billion Euro Commercial Paper Program (guaranteed by AEGON N.V.) facilitate access to international and domestic money markets, when required. Additionally, AEGON N.V. utilizes a USD 300 million Euro Commercial Paper Program. AEGON maintains back-up credit facilities to support outstanding amounts under its Commercial Paper programs. Its committed credit facilities, provided by banks with strong credit standing, exceed USD 3 billion. AEGON also has additional credit lines. At December 31, 2004, AEGON N.V. had EUR 2.0 billion outstanding under its Medium Term Notes Program and EUR 95 million under its Commercial Paper Programs.
Operating leverage is not part of the capital base. At December 31, 2004, operating leverage was EUR 1.0 billion (2003: EUR 2.9 billion). Operating debt was reduced during 2004 due to cash proceeds from the sale of the TFC commercial finance and container leasing businesses. This was partially offset by the issuance of EUR 500 million of ten-year fixed-rate notes and EUR 75 million of 15-year fixed-rate notes to finance collateral reserve relief for the AEGON USA reinsurance business, as alternatives to current letter of credit requirements. The remaining operating debt activities primarily relate to the financing of TFC and its subsidiaries.
Internal sources of liquidity include distributions from operating subsidiaries on the basis of excess capital or cash and cash equivalents. Internal distributions may be subject to (local) regulatory requirements. Each business unit further manages its liquidity through closely managing the liquidity of its investment portfolio.
The duration profile of AEGON’s capital debt and interest rate structure is managed in line with the duration of surplus assets related to its investments in its subsidiaries, subject to liquidity needs, capital and other requirements. Of AEGON’s total capital debt at December 31, 2004, approximately EUR 0.7 billion matures within three years, EUR 0.9 billion between three and five years, and EUR 1.4 billion thereafter. AEGON believes its working capital, backed by the external funding programs and facilities, is amply sufficient for the group’s present requirements.
The Hague, March 2, 2005
The Executive Board |
