Reconciliation in USD millions, for the years ended December 31 to business operating profit
in USD millions, for the years ended December 31 2006 2005 Change
Business operating profit increased by USD 1.9 billion to USD 3.8 billion for the year ended December 31, 2006, due to the underlying improvement in our net underwriting result, which increased across all divisions except International Businesses. The most significant contributors to the increase in business operating profit were North America Commercial and Global Corporate, which increased by USD 885 million and USD 754 million, respectively.
Zurich Financial Services Group · Annual Report 2006 · Financial Report 6 Financial Review
New business annual premium equivalent (APE) increased by USD 65 million, or 3 percent, to USD 2.4 billion. APE increased by 15 percent on a local currency basis driven by continued growth across most regions, particularly in Zurich International Solutions (based in the Isle of Man) where much of the increase arose from emerging markets, as well as in Ireland and Hong Kong. This growth is aided by the strong performance of the financial markets. New business margin, after tax increased by 4.0 percentage points to 21.7 percent due to the aforementioned growth, business model changes and the effect of rising interest rates.
Switzerland in USD millions, for the years ended December 31 2006 2005 Change
New business margin, after tax (as % of APE) 38.8% 5.8% 33.0 pts
Rest of Europe in USD millions, for the years ended December 31 2006 2005 Change
Business operating profit decreased by USD 36 million, or 26 percent, to USD 102 million, primarily due to a 2006 one-off charge for policy acquisition costs and a non-recurring benefit in Hong Kong in 2005. These decreases were partially offset by an increase in Latin America, particularly in Argentina, resulting from an increase in gross written premiums and policy fees as a consequence of higher volumes, in addition to favorable experience.
Corporate Functions in USD millions, for the years ended December 31 2006 2005 Change
We manage our diversified Group investments portfolio to optimize benefits for both shareholders and policyholders while ensuring compliance with local regulatory and business requirements under the guidance of our Asset/Liability Management and Investment Committee. Investments for unit-linked products are managed in accordance with the investment objectives of each unit-linked fund.
Performance of Group Investments in USD millions, for the years ended December 31 2006 2005 Change
Total investment result, net of investment expenses 1 7,880 9,994 (21%)
Total investments increased by USD 32.7 billion, or 12 percent, to USD 310.0 billion as of December 31, 2006. After adjusting for foreign currency translation effects, total investments increased by USD 8.2 billion as a result of increased inflows of funds into investments and positive revaluations of equities and real estate held for investment. These effects were partially offset by negative revaluations on our debt securities due to higher interest rates compared with 2005.
Divestments of companies and businesses, including transfer to liabilities held for sale (66) (37) nm
Total equity increased primarily as a result of net income after taxes of USD 4.6 billion, which more than offset redemptions of preferred securities, distributions to shareholders and net reductions of unrealized gains caused by higher interest rates.
2 Zurich RegCaPS Funding Trust I repaid USD 425 million of Trust Capital Securities I to investors on March 30, 2006 and on April 11, 2006, and Zurich Financial Services (Jersey) Ltd. repaid EUR 300 million of Series A Preference Shares to investors on March 16, 2006.
The Group’s balance sheet is not presented using a current/non-current classification. However, the following balances are generally classified as current: cash and cash equivalents, short-term investments, deferred policy acquisition costs on general insurance contracts, accrued investment income, receivables, reserve for premium refunds, and accrued liabilities.
Classification Insurance contracts are those contracts that transfer significant insurance risk. These contracts may also transfer financial risk. Significant insurance risk is defined as the possibility of paying significantly more in a scenario where the insured event occurs than in a scenario where the insured event does not occur. Scenarios considered include those which are deemed to be possible.
The Group applies the same accounting policies for the recognition and measurement of obligations arising from insurance contracts and from investment contracts with DPF. These recognition and measurement criteria apply to obligations arising from the contract, deferred acquisition costs and other related intangible assets. The Group developed its accounting policies for insurance contracts before the adoption of IFRS 4 and in the absence of a specific standard for insurance contracts. Management used its judgment in developing a set of accounting policies for the recognition and measurement of rights and obligations arising from insurance contracts issued and reinsurance contracts held that provide the most useful information to users of the Group’s financial statements. In making this judgment, Management primarily considered the pronouncements of the Financial Accounting Standards Board (US GAAP) on insurance and reinsurance contracts.
Reserves for losses and loss adjustment expenses Losses and loss adjustment expenses are charged to income as incurred. Reserves for losses and loss adjustment expenses represent the accumulation of estimates for ultimate losses and include provisions for losses incurred but not yet reported (IBNR). The reserves represent estimates of future payments of reported and unreported claims for losses and related expenses with respect to insured events that have occurred. Reserving is a complex process dealing with uncertainty, requiring the use of informed estimates and judgments. The Group does not discount its loss reserves, other than for settled claims with fixed payment terms. Any changes in estimates are reflected in results of operations in the period in which estimates are changed.
Derivative financial instruments used for hedging For the purpose of hedge accounting, hedging instruments are classified as either fair value hedges where they hedge the exposure to changes in the fair value of a recognized asset or liability, or cash flow hedges where they hedge exposure to variability in cash flows that is either attributable to a particular risk associated with a recognized asset or liability or a forecast transaction.
Hedge accounting is discontinued when the hedging instrument expires or is sold, terminated or exercised, or no longer qualifies for hedge accounting.
Zurich Financial Services Group · Annual Report 2006 · Financial Report 44 Consolidated Financial Statements
Changes in 2005 The Group completed the following sales: 100% of the share capital of Claims Management Group Limited, the Group’s equity stake in ZC Sterling Corporation, 10% of the total issued share capital of South African Eagle Insurance Company Limited (SA Eagle) and the Group’s interest in Zurich National Life Assurance Company Limited in Thailand. Additionally, the Group acquired the life business portfolio of ING Insurance Argentina.
Refer to notes 10 and 11 for further information on future life policyholders’ benefits and policyholders’ contract deposits and other funds.
e) Deferred policy acquisition costs Deferred policy acquisition costs generally consist of commissions, underwriting expenses and policy issuance costs. The amount of acquisition costs to be deferred is dependent on management’s judgment as to which issuance costs are directly related to and vary with the acquisition. Further, once the costs are deferred, the related asset is amortized over the estimated life of the contract.
As a major, global insurance carrier, the Group helps customers around the world to manage a broad range of business and personal risks. In turn, the Group faces a number of risks. These risks include, but are not limited to: • Insurance risk – risk transferred to us by customers through the underwriting process.
In addition to the specific risks insured, the lines of business expose the Group to losses that could arise from natural and man-made catastrophes.
2 Including individual annuity and individual life. 3 Including policy fees of USD 2,060 million (North America USD 256 million, Europe USD 1,681 million and International Businesses USD 123 million).
The reinsurance assets in the table below include USD 8,974 million for which the Group has collateral. Included in the collateral are credit default swaps that the Group bought to mitigate credit risk with some of its large reinsurers. The Group only accepts high quality collateral such as cash or letters of credit from banks rated A and above. The average credit quality of the net reinsurance assets (including Receivables but after the deduction of collateral) was A- at December 31, 2006.
Maturity profile of in USD millions, as of December 31 notional principal amounts and market values of derivative financial instruments (excluding ZCM)
Losses and loss adjustment expenses 24,505 28,124 (3,276) (5,518) 21,229 22,606
Future life policyholders’ benefits increased by USD 293 million after reinsurance (USD 585 million in 2005) due to the recognition of changes in assumptions. In particular, the 2006 net changes include the following significant movements: • USD 150 million related to changes in interest rate assumptions; and
Income tax in USD millions, for the years ended December 31 expense – current/deferred split
The net deferred tax liabilities increased from USD 1,924 million to USD 2,468 million during the year ended December 31, 2006. The change can be explained as follows: • increase of USD 342 million charged to income statement; • decrease of USD 72 million credited to equity; • increase of USD 299 million resulting from foreign exchange differences; and
Debt related to capital markets and banking activities 1,889 2,139 b) Senior debt
Zurich Finance (USA), Inc. 2.75% CHF 500 bond, due July 2006 – 381
ZCM`s debt was reduced from USD 1,196 million as of December 31, 2005 to USD 1,094 million as of December 31, 2006, which is attributable to the ongoing wind-down of ZCM’s business.
c) Subordinated debt Subordinated debt securities are obligations of the Group which, in case of liquidation, rank junior to all present and future senior indebtedness and certain other obligations of the Group.
Zurich Financial Services Group · Annual Report 2006 · Financial Report 92 Consolidated Financial Statements
coupon (6.58%) and three have a floating rate coupon (between LIBOR +53 bps and +71 bps). These coupon rates step up after the first call dates. Payments are at management’s discretion. The Group has the option to call the fixed rate securities in 2008 and the floating rate securities in 2011.
Insurance enterprises in European Union member countries are required to maintain minimum solvency margins. The required minimum solvency margin for general insurers is the greater of 16% of premiums written for the year or 23% of a three-year average of claims, subject to the first tranche (EUR 50 million) of premiums being at 18% and the first tranche (EUR 35 million) of claims at 26%. Life insurance companies are required to maintain a minimum solvency margin generally of 4% of insurance reserves (up to 1% of “insurance reserves for life insurance where the investment risk is carried by policyholders”) plus 0.3% of the amount at risk under insurance policies. The same minimum capital requirements are applicable for insurance enterprises operating in Switzerland. In addition, in certain European countries further requirements may apply.
As of December 31, 2006, the Group and its subsidiaries were substantially in compliance with applicable regulatory capital adequacy requirements.
Effect of business combinations and other transfers 5 – – –
Share Incentive Plan for employees in the UK The Group established an Inland Revenue approved Share Incentive Plan and launched the partnership shares element of this plan in 2003. This plan enables participating employees to make monthly purchases of Zurich Financial Services shares at the prevailing market price out of their gross earnings. There were 494 and 422 participants in the partnership element of the plan as of December 31, 2006 and 2005 respectively. The Group also operates the profit-sharing element of the Share Incentive Plan (reward shares) which was launched in 2004 with annual share allocations being made in May each year subject to business performance. The awards are based on the performance of the participating employee’s business unit for the year, subject to a maximum award of 5% of participant’s base salary (before any flexible benefit adjustments) or GBP 3,000. The total number of participating employees in the reward share element of the plans as of December 31, 2006 and 2005 was 6,620 and 6,680, respectively.
Zurich Financial Services Group · Annual Report 2006 · Financial Report 108 Consolidated Financial Statements
Net capital gains/(losses) on investments and impairments 444 327 8,888 11,518
Debt related to capital markets and banking activities – – – –
Allied Dunbar Assurance p.l.c. Swindon, England Life Insurance 100.00 100.00 GBP 0.05
Expected return on in-force business and shareholders’ net assets, after tax 228 490 718
• 10% decrease in voluntary discontinuance rates (e.g. a base assumption of 5% p.a. would decrease to 4.5% p.a.); • 10% decrease in maintenance expenses (e.g. a base assumption of USD 30 p.a. would decrease to USD 27 p.a.); • 10% decrease in initial expenses and commissions (new business values only); • 5% improvement in mortality and morbidity assumptions for assurances (e.g. if the base mortality assumption for assurances was 90% of a particular table this would decrease to 85.5%); • 5% improvement in mortality assumptions for annuities (e.g. if the base mortality assumption for annuities was 90% of a particular table this would decrease to 85.5%); • Frictional costs applied to 150% of minimum solvency margin, rather than to total capital for in-force business or minimum solvency margin for new business.
Cost of non market risk (104) (215) (55) (44) (69) (50) (537)
• In the UK, there was an increase in new business value, mainly as a result of a lower cost base due to the revised business model, more favorable reinsurance conditions for term business and the revised operating assumptions offset by the change in economic basis. This increase was also partially offset by the time value of options and guarantees arising from death guarantees on certain investment contracts sold in 2006.
Closing Embedded Value after foreign currency translation effects 2,327 5,133 1,296 1,570 2,656 1,110
For liabilities where payouts are either independent or move linearly with markets, deterministic techniques (referred to as “certainty equivalent”) have been used. In such cases, the projection and discounting are based on the same risk free yield curve.
EV is shown net of minority holdings. Where Zurich has a majority interest in a subsidiary company, the new business value and the premium information are shown gross of minority holdings. The minorities’ share of new business value is eliminated through “operating variance, after tax”.
An adjustment has been made to the expense assumptions for each life business to include expected pension scheme costs in respect of future service entitlements.
The model also makes assumptions regarding the volatility of property investments, estimated from relevant historic return data. Based on the actual simulations used, the following implied volatilities arise: Table 5.4
Embedded value before foreign currency translation effects 12.3% 16.9% 1.3% 6.6%
Zurich Financial Services is the holding company of the Group with a listing on the SWX Swiss Exchange. On October 2, 2006, Zurich Financial Services delisted its secondary listing from the London Stock Exchange.
b) Investments in subsidiaries Investments in subsidiaries are equity interests, which are held on a long-term basis for the purpose of the holding company’s business activities. They are carried at a value no higher than their cost price less adjustments for impairment.
On February 15, 2006, the Board of Zurich Financial Services approved the issuance of a maximum of 1,000,000 dividend-paying shares from the contingent share capital to employees. At the Annual General Meeting on April 20, 2006, shareholders approved a share capital reduction in the form of a nominal value reduction of each registered share from CHF 2.50 to CHF 0.10. At the effective date of the nominal value reduction on July 3, 2006 Zurich Financial Services had 144,565,255 issued and fully paid shares, including 558,300 shares issued out of the contingent capital. As a result of this reduction, the share capital was reduced by CHF 346,956,612 from CHF 361,413,137.50 to a new total of CHF 14,456,525.50. Until December 31, 2006, a total of 742,444 shares were issued to employees from contingent share capital. As a consequence, 144,749,399 fully paid shares with a nominal value of CHF 0.10 were issued as of December 31, 2006, amounting to a share capital of CHF 14,474,939.90.
According to the information available to us on December 31, 2006, no shareholder of Zurich Financial Services held more than 5% of the voting rights of the issued share capital.
Nominal value reduction 2002 1.00 July 15, 2003 1 Proposed gross dividend, subject to approval by shareholders at the Annual General Meeting 2007; expected payment date is on April 10, 2007.
Share trading Zurich Financial Services shares are listed on the SWX Swiss Exchange and traded on the EU Regulated Market Segment of virt-x; ticker symbol: ZURN; the Swiss security number (Valorennummer) is 1107539. Trading in Zurich Financial Services shares on virt-x is conducted in Swiss francs. 100 percent of the shares are in free float.
ADR holder assistance may also be obtained from BNY at www.adrbny.com.
Distribution Channel A way of delivering products and services to target customers, as part of a chosen market strategy. Our distribution channels include our own sales force, independent financial advisers, franchisees, brokers, banks, affinity groups and direct marketing.
Net Income After Tax (NIAT) Generally defined, this is total revenues (primarily premiums earned, fee revenue and investment result) less total benefits, losses and expenses less income tax.
Return on Equity (ROE) ROE tells shareholders how effectively their money is being used. It also shows how a company compares with its competitors. ROE is the amount, expressed as a percentage, of the net income for a given period available to common stock shareholders, divided by the shareholders’ equity.