The financial activities of insurance companies

The financial activities of insurance companies Photo credit: Scott Olson/Reportage In line with stock market appreciation and further cuts in interest rates, unrealized capital gains on insurance company assets increased in 2004. As in 2003, the relative weight of equity securities in new investments increased, partly due to the high level of policyholder investment in life insurance unit-linked policies. 39

ECONOMIC HIGHLIGHTS FRANCE EURO ZONE UNITED STATES 2003 2004 2003 2004 2003 2004 GDP growth rate 0.8 2.3 0.5 1.8 3.0 4.4 Inflation (annual average) 2.1 2.1 2.1 2.1 2.3 2.7 Interest rate (annual average) Ten-year government bonds 4.1 4.1 4.1 4.1 4.0 4.3 Three-month euro rate Euribor Inter-bank rate 2.3 2.1 1.2 1.6 Stock price CAC 40 Stoxx 50 Nasdaq (% change at 12/31/04, In local currency) + 7.4 + 6.9 + 8.6 Exchange rate: 1 euro = 1.26 dollar end 2003 1.36 dollar end 2004 Sources: Comptes de la nation, Eurostat. CHANGE IN INSURANCE COMPANY INVESTMENTS In billions of euros 1,200 1,000 800 600 400 200 0 861.0 73.6 787.4 893.7 54.0 839.7 2000 2001 2002 2003 2004 Balance sheet carrying value Unrealized capital gains Source: Commission de contrôle des assurances, des mutuelles TOTAL INSURANCE COMPANY INVESTMENTS1 921.2 46.7 874.5 1,015.8 62.8 953 1,129.6 90.7 1,038.9 2004 CHANGE 2003-2004 TOTAL INVESTMENT STRUCTURE INCREASE STRUCTURE % IN BILLIONS OF EUROS IN % IN BILLIONS OF EUROS IN % CHANGE Bonds 716.6 69.0 57.5 66.9 8.7 Equities 251.6 24.2 28.5 33.2 12.8 Real estate 37.6 3.6 1.2 1.4 3.3 Loans and deposits 25.7 2.5 1.3 1.5 4.8 Others 7.4 0.7 0.0 0.0 0 Total 1,038.9 100.0 85.9 100.0 9.0 Of which : Life and insurance investment 922.0 88.7 78.3 91.2 9.3 Property and casualty 116.9 11.3 7.6 8.8 7.0 1. Balance sheet carrying value. Source: Commission de contrôle des assurances, des mutuelles ANALYSIS OF INSURANCE COMPANY INVESTMENTS IN EUROPE IN 2003 (as a % of total investments market value) REAL ESTATE EQUITIES BONDS LOANS OTHER AND EQUIVALENT AND DEPOSIT European Union 4.3 32.8 41.5 14.7 6.7 France 4.4 23.4 68.7 2.7 0.7 Germany 2.4 37.1 9.7 50.5 0.3 United Kingdom 6.2 43.3 36.9 3.7 8.9 Economic and financial environment highlights In 2004, the French economy got back on the growth track. After advancing by 16% in 2003, the CAC 40 rose by 7.4% in 2004. The appreciation of the euro against the US dollar, from USD 1.26 at the end of December 2003 to 1.36 in December 2004, reduced the book value of premium income for highly international businesses, particularly those with interests in the US. This includes not only reinsurance, but also marine, aviation and transport (MAT) insurance, for which coverage is generally contracted in dollars. Insurance company investments Boosted by an increase in life and health insurance premium income, investments rose in 2004 to reach 1,039 billion euros (balance sheet carrying value). NEW INVESTMENTS In 2004, the net flow of investments increased by 9.4% over the previous year, reflecting higher net life insurance inflows. New investments pursued the trend observed in 2003, with the percentage of monies invested in equities (balance sheet value) increasing from 26.8% to 33.2%, reflecting the significant policyholder payments into unit-linked contracts, mainly invested in equities and mutual funds. The share of real-estate investments rose in 2004 from 1.2% to 1.4%. INSURANCE COMPANY ASSETS Overall, the value of funds invested by insurance companies increased by 9% in 2004, reflecting growth of 9.3% in life insurance and capital redemption and 7% in property and casualty insurance. These financial and real-estate assets primarily correspond to obligations to policyholders and shareholders equity. Stock market appreciation and further declines in yields resulted in higher unrealized capital gains in 2004. Globally, unrealized capital gains rose by 44.4% (54.4% for equities, 47.7% for bonds, and 11.5% for real-estate assets). The global investment structure evolved little in 2004. In most European countries, the portion of funds invested in equity securities is substantially higher than in France. Source: Comité européen des assurances. 40

Managing insurance company investments The assets owned by insurance companies must match the obligations they have contracted with respect to their policyholders. The secure and effective management of these assets and liabilities determines the quality of the products offered by insurers. Insurance companies pursue a twofold objective: match assets, holding periods and returns to their contractual obligations (amounts, maturities, assumed interest/returns/benefits if applicable; protect their shareholders equity and solvency margin, thereby protecting their future earnings. In addition, since investment income and realized capital gains contribute to insurance company earnings, the management of investments must offer security, liquidity and yield. The French Insurance Code subjects insurance companies to a number of financial constraints, primarily concerning the types of assets that may back liabilities and solvency requirements. The selection of real-estate assets, which naturally have their place in the asset liability matching strategy of insurance companies, is made on the basis of a risk return trade-off whose aim is to harvest potential capital gains for policyholders. Their liquidity and their free valuation contribute to meeting this objective. Increasingly, insurance companies entrust the management of their investments to specialized financial services subsidiaries. These subsidiaries manage captive insurance assets, as well as funds entrusted by a variety of clients, ranging from individuals to institutions and groups (mandated management, third-party management, mutual funds). Through these specialized subsidiaries, the insurance industry plays a crucial role in investment management. LONG-TERM INVESTMENTS Insurance company obligations are generally long-term or even very long-term in particular those with respect to life insurance and retirement products. The ability to meet financial commitments over long periods is one of the key components of insurance company investment management. However, the duration of commitments is not the sole criterion guiding investment decisions. In reality, the financial management constraints faced by life insurers differ from those facing property and casualty insurers. Life insurance companies, which have longer liabilities, seek the stable rate of return they guarantee every year to holders of euro-based contracts. When held to maturity, government or corporate bonds provide the required degree of stability, which is why they predominate in life insurance investment portfolios. DEFINITIONS Allowance for other than temporary impairment in value (PDD) A valuation allowance that is established when the insurance company considers the depreciation of an asset to be other than temporary. Balance sheet value (or acquisition value) Total investments shown on insurance company balance sheets, carried at their purchase or cost price, less amortization and depreciation where applicable. Fair market value (or realizable value) Total market value of investments: the trading price of listed equity securities and the market or appraised value of real-estate assets. Financial futures Option or firm futures contract to buy or to sell financial products at some designated future date for a price that is agreed upon in advance. Insurance companies are authorized by law to use financial futures or derivatives to hedge the value of their assets. Investment reserve Reserve used to lessen the impact of fixed-income bond investments in the event of interest-rate fluctuations. Capital gains realized on the sale of bonds are allocated to this reserve. Capital losses realized are offset by withdrawals from this reserve, which is included in the calculation of capital adequacy (or solvency margin). Liquidity risk (or credit) reserve (PRE) An allowance that is established when the aggregate fair market value of equities and real-estate assets is lower than their book value. The amount of the allowance depends on the company s financial condition. Net investment flow Difference between the balance sheet value of total investments at the current year-end and at the preceding year-end. This difference is equal to new investment income flow less disposals and amortization or depreciation. Resilience reserve (PAF) An allowance established to cover the risk of asset liability mismatch in the event of adverse market movements that reduce the yield on assets invested to cover the insurer s guaranteed rate obligations on contracts other than unit-linked contracts. Unrealized capital gains and losses Difference, positive or negative, between realizable value and balance sheet value. Photo credit: Scott Olson/Reportage 41

Insurers committed to providing more funds to innovative SMES Photo credit: Jonathan Story/Stone French insurers have promised to increase their investments in small- and mid-sized businesses that show strong growth potential, particularly innovative ones. This commitment is subject to the proviso that the conditions under which insurers operate are globally stabilized and not subject to modification in both life and non-life insurance which means tax and legal stability. Insurers have jointly committed to step up the level of their investments in private equity or companies listed on unregulated markets, from 1.4% of all assets in 2003 to 2% in 2007. In addition, thanks to their own improved financial condition and better business conditions in general, insurers are able to return to the equity markets. By 2007, these investments will generate an additional 6 billion euros for small- and mid-sized businesses, excluding the insurance companies in the relevant groups, through direct investment or via French regulated mutual funds (FCPI, FCPR), local investment funds (FIP), venture capital firms (SCR), and so on. A total of nearly 14 billion euros is currently invested in small-and mid-sized businesses. Investments will be selected by Individual insurers and reflected in the life insurance policies they sell. To facilitate such investments, the Decree of November 8, 2004 doubled the maximum regulatory amount that could be invested (see page 43), while the 2005 Finance Act authorized a new life insurance policy invested in equities. Insurers are still waiting for changes to prudential regulations to take investments of this type into account. Life insurance invested assets: equities account for half More than half of the invested assets of French insurers finance businesses, of which about half are based in France and half abroad mainly in Europe. LIFE INSURANCE AND COMPOSITE COMPANY ASSETS MARKED TO MARKET, BY ASSET CLASS French equities 9% French corporate bonds 14% TOTAL SECURITIES ISSUED BY FRENCH BUSINESSES 23% Foreign equities 6% Foreign corporate bonds 21% TOTAL SECURITIES ISSUED BY NON-FRENCH BUSINESSES 27% French government bonds 19% Foreign government bonds 18% TOTAL GOVERNMENT BONDS 37% Real estate 4% Other (money market, commercial paper, etc.) 10% Source: FFSA. In fact, life insurance companies in France invest 9% of their assets* in French equities, either directly or via mutual funds, and 14% in corporate bonds issued by French firms. Overall, one-fourth of their assets are comprised of securities issued by French businesses. Not all of them issue shares of stock, however. Stateowned enterprises, in particular, issue only bonds and they also have financing and development needs that must be met. Insurers also fund foreign businesses, primarily those operating within the eurozone, by investing 27% of their assets in equities and bonds issued by non- French players. * Estimates based on the marked-to-market values in the quarterly statements of life insurance and composite company investments through the third quarter of 2004. Mutual fund investment information is provided by the AFG (Association Française de Gestion Financière) and the French central bank (Banque de France). 42

By developing unit-linked and euro-based contracts that guarantee the initial investment only, life insurers can free themselves from some constraints, which explains the growing percentage from equities in the life insurance investment portfolio. This figure nevertheless remains lower than for property and casualty from insurers. Conversely, property and casualty insurers hold a higher percentage of equity and real-estate assets, which deliver value over the longer term. Their assets have a longer total duration (average weighted duration of financial flows) than the assets of life insurers, for a shorter duration of corresponding obligations, but largely renewed from one year to the next. MITIGATING MARKET FLUCTUATIONS: ASSET-LIABILITY MANAGEMENT Both the asset and liability sides of insurance company balance sheets are sensitive to the impact of fluctuations in interest rates and stock market valuations. On the asset side of the balance sheet, interest-rate fluctuations directly impact the bond portfolio. Since many life insurance products contain contractual guarantees with respect to rates, participation in profits, and early surrender clauses, the liability side of the balance sheet is also sensitive to fluctuations in interest rates. To protect themselves from these risks, insurers have developed highly elaborate asset liability matching techniques. Among other things, since 2001, insurers conduct modeling for the Commission de Contrôle des Assurances, des Mutuelles et des Institutions de Prévoyance aimed at periodically testing their asset-liability match against various financial market trend hypotheses. Insurance companies make use of sophisticated investment instruments and techniques, particularly derivatives, which they use to protect themselves against future changes in the financial markets. The new financial instruments now available would help insurance companies enhance their financial management, such as the securitization of insurance risks and the issue of supersubordinated securities and non-cumulative preferred stock. It is the industry s wish that these instruments be fully integrated into the set of prudential regulations governing insurance. ACCOUNTING FRAMEWORK AND PRUDENTIAL MANAGEMENT Accounting regulations require insurance companies to adopt a conservative approach to the valuation of the assets they manage (see opposite, this page). Investments are also subject to prudential rules governing allocation, diversification and matching designed to spread risks (see opposite, this page). Investments must cover obligations to VALUATION RULES FOR INSURANCE COMPANY ASSETS (Excluding IFRS) European Community legislation provides for the double valuation of assets, on the basis of historical cost and market or realizable value. While insurance companies must disclose both of these valuations, they may select the value to be recorded in the balance sheet. In the United Kingdom, assets are recorded at their market value, while in Germany they are recorded at their acquisition cost. In France, the situation is as follows: General guideline Insurance company assets are recorded in the balance sheet at their acquisition value or cost price, after deduction of any amortization and depreciation. This holds for all assets, both those that cover obligations to policyholders (underwriting reserves) and those that represent shareholders equity. Disclosure of realizable value All assets are also valued at their market values: trading price on the inventory date; redemption price for mutual funds; for real-estate assets, appraisal by an expert approved by the Commission de Contrôle des Assurances, des Mutuelles et des Institutions de Prévoyance. Insurance companies disclose such values in a special note to the financial statements. Valuation allowances No allowances are established for securities that may be written down (bonds, equity securities, negotiable debt securities) in the event of an unrealized capital loss (realizable value less than the acquisition value net of amortization or depreciation). Conversely, for all other assets, an allowance must be recorded in the balance sheet when the total realizable value is an overall capital loss (see Definitions, page 41). REGULATIONS GOVERNING INSURANCE COMPANY INVESTMENTS Underwriting reserves, which are estimated using the rules provided for in the French Insurance Code, must be evidenced at all times by assets that are admissible under the Code. Admissible assets First, the French Insurance Code specifies which types of assets may be matched against insurance liabilities. They fall into the following categories: bonds and other interest-rate related instruments; equities and equivalent securities; realestate assets; and loans and deposits. The asset portfolio must also satisfy certain criteria intended to limit the impact of market or liquidity risk for each type of asset. Within the category of assets that may be matched against liabilities, the balance sheet carrying value of equities may not exceed 65%, while the upper thresholds for real-estate and loans are 40% and 10%, respectively. Finally, assets matching liabilities to policyholders must also meet requirements concerning the counterparty risk spread. Insurance companies may not place more than 5% of their assets matched to policyholder liabilities with a single counterparty, although in certain cases this threshold may rise to 10%. The risk spread ratio is 10% for real-estate assets. A decree enacted in November 2004 raised the ratio from 0.5% to 1% for unlisted securities. A qualitative approach In addition to these quantitative regulations, current discussion is focused on two areas: the importance of considering asset quality, which should be an important complement to quantitative yardsticks; the need for insurance companies to demonstrate that they have set up effective internal control and audit mechanisms with individual responsibilities clearly defined. French regulators have already made an initial set of decisions on this issue, requiring issuers to publish an annual solvency report and practice asset/liability management. 43

Implementing international accounting standards for the insurance industry Publicly-traded insurance companies are required to present their 2005 consolidated financial statements in conformity with the new international accounting standards. Three of these standards apply particularly to insurers: IAS 32, IAS 39 and IFRS 4. IAS 32 (Financial Instruments: disclosure and presentation) seeks to enhance the understanding of financial statement users of the significance of financial instruments to an entity s financial position, cash flows and performance. Financial instruments are classified and recorded as a financial asset, a financial liability, or as equity. The standard also prescribes the conditions under which assets and liabilities can be offset in the balance sheet, and requires the disclosure of information concerning the use of these financial instruments by an entity, as well as their economic purpose, the related risks and their recognition. The basic principles that underlie this standard supplement those that apply to the recognition and measurement of financial assets and liabilities, which are set forth in IAS 39 (Financial Instruments: recognition and measurement). This standard was the subject of protracted debate in 2004 between the IAS Board and the European Commission. A new draft proposal concerning the fair value option, which was submitted by the Board in March 2005, is on the verge of being ratified. In its final version, the standard specifies the conditions under which the value of a financial asset or liability can be measured based on fair market value. The option may be used to reduce or eliminate the problem of asset-liability mismatch or, if it is already being used, to measure the performance of the entity s portfolio of assets or liabilities. IAS 39 defines four types of financial assets on the basis of the purpose for which they are held: loans and debt, financial instruments held to maturity, financial instruments in the trading portfolio, and assets held for sale. In addition, the classification and recognition of contracts as insurance contracts or investment contracts is made on the basis of two standards: IAS 39 and IFRS 4. Insurance contracts are defined in terms of a minimum insurance risk threshold (IFRS 4). This definition pertains to personal protection and life insurance contracts with a dominant savings component and participation in profits. Savings contracts that do not share profits, and which do not account for a significant portion of insurance reserves, are considered to be investment contracts, and as such are subject to IAS 39. Insurers are obliged to accept a difference in the way assets are treated recognized in accordance with IAS 39 at their fair value and insurance liabilities, which are carried at their amortized cost. This mismatch is attenuated by the use of interim options, such as mirror accounting or the adjustment of discount rates, both of which are authorized under IFRS 4 during the transition period before the final standard is devised for insurance contracts. One of the major challenges for the future insurance standard will be to ensure consistent accounting treatment for insurance assets and liabilities. In the meantime, the Board s decision to leave options open in the application of these standards may create differences in terms of actual accounting practices from one insurer to the next that will contribute very little to the goal of harmonization across Europe. 44

policyholders at all times, as evidenced by underwriting reserves recorded as liabilities. In addition to these rules, an investment reserve is set aside (see Definitions, page 41). The contribution of investment results The chart of accounts applicable to insurance companies clearly distinguishes the contribution of investment income to earnings from that attributable to insurance underwriting results. Overall, investment income totaled 40.1 billion euros in 2004 (+8.4% versus 2003), of which 36.9 billion euros in net investment income and 3.2 billion euros in net gains on the sale of marketable securities held for short-term purposes, which accounted for 3.5% of the average level of unrealized capital gains for the period. LIFE INSURANCE COMPANIES For life, capital redemption and composite insurance companies (life insurance companies authorized to cover bodily injury and health risks), where assets under management mainly correspond to obligations to policyholders, underwriting results include total investment income and realized capital gains, except the portion that corresponds to shareholders equity. Underwriting results thus include all resources premiums and investment income used to finance amounts credited or paid to policyholders. In all, the investments of life insurance companies generated resources of 35.2 billion euros, up by 7.3% from the previous year, of which 32.7 billion euros in net investment income and 2.5 billion euros in net gains on the sale of marketable securities held for short-term purposes, versus 1.2 billion in 2003. PROPERTY-CASUALTY INSURANCE COMPANIES In property and casualty insurance (which covers property damage, liability, accidents resulting in bodily injury and those related to illness), the portion of investment income and capital gains corresponding to established underwriting and claims reserves are recorded as operating income or loss, and the rest as non-operating income or loss (mainly shareholders equity). In 2004, investment income included in property and casualty underwriting results came to 3.8 billion euros, up 18% from the 2003 level. Under non-operating income, net investment income was 1.1 billion euros, versus 1 billion one year prior. CHANGE IN INVESTMENT INCOME AND CAPITAL GAINS, life insurance, investment and composite companies 40 35 30 25 20 15 10 5 0 CHANGE IN INVESTMENT INCOME AND CAPITAL GAINS, property and casualty companies In billions of euros 8 7.1 7 6 5 4 3 2 1 0 in billions of euros 34.6 2000 2000 32.1 2001 Sources: FFSA, Commission de contrôle des assurances, des mutuelles 5.8 2001 29.8 2002 3.6 2002 32.8 2003 4.2 2003 35.2 2004 4.9 2004 Sources: FFSA, Commission de contrôle des assurances, des mutuelles 45