Risk management
report of the executive board
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Home > Our Businesses - Report of the Executive Board > Risk management > Financial and insurance risks
Financial and insurance risks The information in this section has been prepared in accordance with IFRS 7 ‘Financial Instruments Disclosure’. GENERAL A description of AEGON’s risk management and control systems is given below on the basis of significant identified risks. Some risks, such as currency translation risk, are related to the international nature of AEGON’s business. Other risks include insurance related risks, such as changes in mortality and morbidity. However, the Group’s most significant exposures are to changes in financial markets (e.g. interest rate, credit and equity market risks) that affect the value of AEGON’s investments, liabilities from products AEGON companies sell, as well as deferred expenses and the value of business acquired. AEGON manages risk at local level where business is transacted, based on principles and policies established at Group level. AEGON’s integrated approach to risk management involves common measurement of risk and scope of risk coverage to allow the Group’s risk position to be aggregated. In addition, this integrated framework facilitates the sharing of best practices and the latest research on methodologies. Risk management functions are applied locally and are tied to the speed of business, while corporate oversight remains independent of business activity providing oversight and peer review. To manage its risk exposure, AEGON has risk policies in place. Many of these policies are group wide while others are specific to local businesses. The group level policies limit the company’s exposure to major risks such as equity, interest rates, credit and currency. The limits in these policies in aggregate remain within AEGON’s overall tolerance for risk as well as its financial resources. Operating within this policy framework, AEGON employs risk management programs including asset liability management (ALM) processes and models, hedging programs (which are largely conducted via the use of derivatives) and insurance programs (which are largely conducted through the use of reinsurance). These risk management programs are in place in each country unit. They are used not only to manage risk in each unit, but are also part of overall Group Risk Management. AEGON operates a Derivative Use Policy and a Reinsurance Use Policy to govern its use of derivatives and reinsurance. These policies establish the control, authorization, execution and monitoring requirements for the use of such instruments. In addition, these policies stipulate necessary mitigation of credit risk created through these derivatives and reinsurance risk management tools. For derivatives, credit risk is normally mitigated by requirements to post collateral via credit support annex agreements. For reinsurance, credit risk is normally mitigated by downgrade triggers allowing AEGON’s recapture of business, as well as funds withheld by treaties (when AEGON owns the assets) and assets held in trust for the benefit of the Group (in the event of reinsurer insolvency). As part of these risk management programs, AEGON takes inventory of its risk position across risk categories. AEGON also measures the sensitivity of net income and shareholders’ equity under both stochastic and deterministic scenarios. 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 regularly and updated as necessary. Results from AEGON’s sensitivity analyses are presented throughout this section to show the estimated sensitivity of net income and equity to various scenarios. For each type of market risk, the analysis shows how IFRS net income and equity would have been affected by changes in the relevant risk variable that were reasonably possible at the reporting date. For each sensitivity test the impact of a reasonably possible change in a single factor is shown. The analysis considers the interdependency between interest rates and lapse behavior for products sold in the Americas where there is clear evidence of dynamic lapse behavior. Management action is taken into account to the extent that it is part of AEGON’s regular policies and procedures, such as established hedging programs. However, incidental management actions that would require a change in policies and procedures are not taken into account. Each sensitivity analysis reflects the extent to which the shock tested would affect management’s critical accounting estimates and judgement in applying AEGON’s accounting policies1. Market-consistent assumptions underlying the measurement of non-listed assets and liabilities are adjusted to reflect the shock tested. The shock may also affect the measurement of assets and liabilities based on assumptions that are not observable in the market. For example, a shock in interest rates may lead to changes in the amortization schedule of deferred policy acquisition costs or to an increase in impairment losses on equity investments. Although management’s short-term assumptions may change, if there is a reasonable change in a risk factor, long-term assumptions will generally not be revised unless there is evidence that the movement is permanent. This fact is reflected in the sensitivity analyses provided below.
Being based on IFRS, the accounting mismatch inherent in IFRS is also apparent in the reported sensitivities. A change in interest rates has an immediate impact on the carrying amount of assets measured at fair value. However, the shock will not have the same effect on the carrying amount of the related insurance liabilities that are measured using prudent assumptions or on management’s long-term expectations. Consequently, the different measurement bases for assets and liabilities leads to increased volatility in IFRS net income and equity. AEGON has classified a significant part of its investment portfolio as ‘Available for Sale’, which is one of the main reasons why the economic shocks tested have a different impact on net income than on equity. Unrealized gains and losses on these assets are not recognized in the income statement but are booked directly to the revaluation reserves in equity, unless impaired. As a result, economic sensitivities predominantly impact equity but leave net income unaffected. The effect of movements of the revaluation reserve on capitalisation ratios and capital adequacy are minimal. AEGON’s target ratio for the composition of its capital base is based on shareholders’ equity excluding the revaluation reserve. The sensitivities do not reflect what the net income for the period would have been had risk variables been different because the analysis is based on the exposures in existence at the reporting date rather than on those actually occurring during the year. Nor are the results of the sensitivities intended to be an accurate prediction of AEGON’s future equity or earnings. The analysis does not take into account the impact of future new business, which is an important component of AEGON’s future earnings. Neither does it consider all methods available to management to respond to changes in the financial environment, such as changing investment portfolio allocations or adjusting premiums and crediting rates. Furthermore, the results of the analyses cannot be extrapolated for wider variations since effects tend not to be linear. No risk management process can clearly predict future results. Currency exchange rate risk As an international group, AEGON is subject to foreign currency translation risk. Foreign currency exposure exists when policies are denominated in currencies other than the issuer’s functional currency. Currency risk in the investment portfolios backing insurance and investment liabilities are managed using asset liability matching principles. Assets allocated to equity are kept in local currencies to the extent shareholders’ equity is required to satisfy regulatory and self-imposed capital requirements. Therefore, currency exchange rate fluctuations may affect the level of shareholders’ equity as a result of translation of subsidiaries into euros, the Group’s presentation currency. 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 on equity and leverage ratios. 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 the euro and between the UK pound and the euro. AEGON may experience significant changes in net income and shareholders’ equity because of these fluctuations. AEGON operates a Currency Risk Policy under which direct currency speculation or program trading by country units is not allowed unless explicit approval has been granted by the Group Risk and Capital Committee. Assets should be held in the functional currency of the business written or hedged back to that currency. Where this is not possible or practical, remaining currency exposure is subject to documentation requirements and limits are placed on the total exposure at both group level and for individual country units. Information on AEGON’s three-year historical net income and equity in functional currency on an IFRS basis are shown in table 1. The exchange rates for US dollar and UK pound per euro for each of the last five year-ends are set forth in the table below.
AEGON group companies’ foreign currency exposure from transactions denominated in foreign currencies is not material. 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 as included in table 2 underneath, are due to the translation of subsidiaries and joint-ventures in the consolidated financial statements. Interest rate risk AEGON bears interest rate risk with many of its products. In cases where cash flows are highly predictable, investing in assets that closely match the cashflow profile of the liabilities can offset this risk. For some AEGON country units, local capital markets are not well developed. This prevents the complete matching of assets and liabilities for those businesses. For some products, cash flows are less predictable as a result of 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 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 by AEGON 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. This 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 accelerated amortization of deferred policy acquisition costs (DPAC), which in turn reduces net income. During periods of sustained low interest rates, AEGON may not be able to preserve margins as a result of minimum interest rate guarantees and minimum guaranteed crediting rates provided on policies. Also, investment earnings may be lower because the interest earnings on new fixed-income investments are likely to have declined with the market interest rates. 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. Accordingly, net income declines as a result of a decrease in the spread between returns on the investment portfolio and the interest rates either credited to policyholders or assumed in reserves. AEGON manages interest rate risk closely, taking into account all of the complexity regarding policyholder behavior and management action. AEGON employs sophisticated interest rate measurement techniques and actively uses derivatives and other risk mitigation tools to closely manage its interest rate risk exposure. All derivative use is governed by AEGON Derivative Use Policy. Table 3 shows interest rates at the end of each of the last five years. The sensitivity analysis in table 4 underneath shows an estimate of the effect of a parallel shift in the yield curve on net income and equity. Increases in interest rates have a negative effect on IFRS equity and net income in the current year because it results in unrealized losses on investments that are carried at fair value. The offsetting economic gain on the insurance and investment contracts is however not fully reflected in the sensitivities because many of these liabilities are not measured at fair value. Over time, the short-term reduction in net income due to rising interest rates would be offset by higher net income in later years, all else being equal. Therefore, rising interest rates are not considered a long-term risk to the company. The sensitivity analysis reflects the assets and liabilities held at year end. This does not necessarily reflect the risk exposure during the year as significant events do not necessarily occur on January 1. Changes in sensitivities between 2006 and 2007 arise primarily from the completion of the hedging program of guarantees valued at fair value of AEGON The Netherlands. 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 equaling the 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. In the past, some issuers have defaulted on their financial obligations for various reasons, including bankruptcy, lack of liquidity, downturns in the economy, 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 the Group’s investment assets due to defaults and overall declines in the securities markets. Impairments on bonds held by AEGON have been low in recent years. However, a return to excessive defaults or other reductions in the value of these securities and loans could have a materially adverse effect on AEGON’s business, results of operations and financial condition. Table 5 underneath shows the Group’s maximum gross credit exposure from investments (credit protection not taken into account) in general account financial assets, as well as general account derivatives and reinsurance assets. Please refer to notes 46 and 47 to AEGON’s consolidated financial statements for further information on capital commitments and contingencies and on collateral given, which may expose the Group to credit risk. AEGON has entered into free-standing credit derivative transactions (Single Tranche Synthetic CDOs and Single Name Credit Default Swaps). The positions outstanding at the end of the year can be summarized as shown in table 6. For a fee, AEGON USA takes credit exposure on a credit index, i.e. super-senior tranches of a CDX index, via a synthetic collateralized debt obligation program (synthetic CDO’s). This index is composed of a reference portfolio of 125 investment grade corporate credits. Eighty-four percent of the exposure is to the most senior of the super-senior tranches. i.e. the 30% - 100% tranche. That means that losses to AEGON would only occur if cumulative net losses on the CDX index exceeded 30%, where cumulative net loss is defined as bond defaults net of recoveries. AEGON considers the probability of losses at these levels to be extremely remote and hence does not expect any cash losses to occur from these synthetic CDO positions. The average duration of the outstanding transactions is 4.7 years. As these derivatives are marked to market through earnings, they may cause substantial operational earnings volatility prior to maturity due to credit spread volatility. Assuming there are no cash losses from the positions, any mark to market effect on operating earnings will be reversed by maturity. At December 31, 2007, the notional amount of this program was EUR 4.5 billion with a negative market value of EUR 30 million.
AEGON manages credit risk exposure by individual counterparty, sector and asset class. Normally, it mitigates credit risk in derivative contracts by entering into collateral agreements where practical and in International Swaps and Derivatives Association (ISDA) master netting agreements for each of the Group’s legal entities to facilitate AEGON’s right to offset credit risk exposure. Main counterparties to these transactions are investment banks and are typically rated AA or higher. The credit support agreement will usually dictate the threshold over which collateral needs to be pledged by AEGON or its counterparty. Transactions requiring AEGON or its counterparty to post collateral are typically the result of over-the-counter derivative trades, comprised mostly of interest rate swaps, currency swaps, and credit swaps. Collateral received is mainly cash (USD and EUR). The Credit Support Agreements that outline acceptable collateral require high quality instruments to be posted. Nearly all securities received as collateral are US Treasuries or US Agency bonds. In 2007 and 2006, AEGON did not take possession of collateral or called on other credit enhancements. The credit risk associated with financial assets subject to a master netting arrangement is eliminated only to the extent that financial liabilities due to the same counterparty will be settled after the assets are realized. The extent to which the exposure to credit risk is reduced through a master netting agreement may change substantially within a short period of time because the exposure is affected by each transaction subject to the arrangement. AEGON may also mitigate credit risk in reinsurance contracts by including downgrade clauses that allow the recapture of business, retaining ownership of assets required to support liabilities ceded or by requiring the reinsurer to hold assets in trust. For the resulting net credit risk exposure, AEGON employs deterministic and stochastic credit risk modeling to assess the Group’s credit risk profile, associated earnings and capital implications due to various credit loss scenarios. AEGON operates a Credit Name Limit Policy under which limits are placed on the aggregate exposure that the Group has to any one counterparty. Limits are placed on the exposure at both group level and for individual country units. The limits also vary by a rating system, which is a composite of the main rating agencies (Fitch, Moody’s and S&P) and AEGON’s internal rating of the counterparty. If an exposure exceeds the stated limit then the exposure must be reduced to the limit for the country unit and rating category as soon as possible. Exceptions to these limits may only be made after explicit approval from AEGON’s Group Risk and Capital Committee. This policy is reviewed regularly. AEGON group-wide counterparty exposure limits at the end of 2007 are:
The limits were not changed for 2007 and there were no other material changes to the policy. There were no violations of the group-wide limits at year end 2007. Credit rating The ratings distribution of general account portfolios of AEGON’s major country units are presented in table 7 underneath, organized by rating category and split by assets that are valued at fair value and those valued at amortized cost.
Table 8 shows the credit quality of the gross balance sheet positions for general account reinsurance assets:
Credit risk concentration The tables 9 - 11 present specific credit risk concentration information for general account financial assets. Included in the bonds and money market investments are EUR 1,846 million in assets classified as held-to maturity and are therefore carried at amortized cost (2006: EUR 1,502 million). Of the EUR 1,846 million assets held-to-maturity, EUR 1,579 million are government bonds (2006: EUR 1,294 million), EUR 8 million is ABS exposure (2006: EUR 8 million) and EUR 259 million is Corporate exposure (2006: EUR 200 million).
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