in USD millions, for the years ended December 31 2006 2005 Change 1
General Insurance combined ratio (in %) 2 94.2% 100.8% 6.6 pts
Global Life new business value, after tax 3 515 406 27%
Return on common shareholders’ equity (ROE) 6 19.0% 15.5% 3.5 pts
5 Excluding cash collateral received for securities lending. 6 German footnote
performance (indexed) since September 4, 2002 09/2002 12/2002 12/2003 12/2004 12/2005 12/2006
The information contained within the Financial Review is unaudited. This document should be read in conjunction with our audited Consolidated Financial Statements. Comparatives in the Financial Review are as of or for the year ended December 31, 2005, unless otherwise specified.
Group performance highlights in USD millions, for the years ended December 31 2006 2005 Change 1
Group investments return (as % of average invested assets) 5.1% 5.6% (0.5 pts)
2 The General Insurance combined ratio is calculated as the sum of net earned premiums and policy fees less the net underwriting result, divided by net earned premiums and policy fees.
• Farmers Management Services contributed USD 1.2 billion to the Group’s business operating profit as a net result of increased management fees and other related revenues and increased management and other related expenses associated with growth initiatives.
• Other Businesses business operating profit increased by USD 141 million to USD 554 million with solid contributions from Farmers Re and Centre.
• Corporate Functions business operating loss increased by USD 209 million largely due to increased interest expense driven by issuances of debt during 2005.
Net income before income taxes increased by USD 1.3 billion, or 23 percent, to USD 6.7 billion for the year ended December 31, 2006.
Gross written premiums and policy fees increased by 2 percent in General Insurance reflecting our diversified portfolio, while maintaining our underwriting discipline and improving profitability. While gross written premiums and policy fees in Global Life decreased by 3 percent, insurance deposits increased by 20 percent primarily due to growth initiatives in the unit-linked business. Management fees and other related revenues increased by 4 percent in Farmers Management Services basis reflecting an increase in gross premiums earned of 2 percent in the Farmers Exchanges, which we manage but do not own.
Diluted earnings per share increased by CHF 11.60 per share, or 43 percent, to CHF 38.71 per share for the year ended December 31, 2006, compared with CHF 27.11 per share for the same period in 2005.
Business operating profit reflects adjustments for net capital gains on investments and impairments (except for the capital markets and banking operations included in Other Businesses), policyholders’ share of investment results for the life business, non-operational foreign exchange movements, and significant items arising from special circumstances including gains and losses on divestments of businesses. Non-operational foreign exchange movements arise from intercompany foreign currency hedging and the corporate financing of subsidiaries which are not a reflection of local operating activities and are, therefore, not included in the calculation of business operating profit. Business operating profit is not a substitute for net income as determined in accordance with International Financial Reporting Standards (IFRS).
Policyholder allocation of net capital gains on investments and impairments 9,651 12,416
Business operating profit 5,861 3,947 1 Excluding capital markets and banking activities and certain securities held for specific economic hedging purposes. 2 Included in 2006 are the aforementioned legal settlements in the amount of USD 325 million.
Gross written premiums and policy fees increased by USD 777 million, or 2 percent, to USD 34.2 billion in 2006. While maintaining our underwriting discipline and focusing on profitable growth, we increased new business volumes and customer renewals.
Net underwriting result increased by USD 1.9 billion to USD 1.7 billion, which contributed to a 6.4 percentage point improvement to a loss ratio of 70.0 percent. Underlying improvements occurred across most regions. In addition, we experienced a relatively benign catastrophe season compared with 2005 where we reported a 4.6 percentage point impact. The expense ratio decreased by 0.2 percentage points to 24.2 percent.
Global Corporate in USD millions, for the years ended December 31 2006 2005 Change
Business operating profit increased by USD 754 million to USD 694 million for the year ended December 31, 2006, primarily driven by a USD 709 million improvement in the net underwriting result.
North America Commercial in USD millions, for the years ended December 31 2006 2005 Change
Gross written premiums and policy fees increased by USD 180 million, or 2 percent, to USD 11.9 billion. By using our segmentation techniques, we achieved overall rate increases compared with an overall decline in average rates in the US. Gross written premiums in our top-tier customer segments, i.e. those generating the highest levels of profitability and return, increased by 8 percent, while those in the least profitable customer segments decreased by 2 percent. The aggregate growth rate was achieved while we reduced our exposure in certain natural catastrophe prone areas.
Business operating profit increased by USD 178 million, or 12 percent, to USD 1.7 billion for the year ended December 31, 2006. This strong result was achieved due to an improved net underwriting result reflecting both an overall favorable loss development and our enhanced pricing methodologies in continuously challenging markets.
Net underwriting result increased by USD 218 million, or 30 percent, resulting in a 1.9 percentage points improvement in the combined ratio. The 1.7 percentage point improvement in the loss ratio demonstrates an overall favorable claims experience and enhanced pricing methodologies. Positive experience on natural catastrophes has been offset by higher claims frequency in our Italian motor book and a higher impact of large losses in commercial lines in Germany. The expense ratio benefited from underlying expense improvements related to the continuous operational transformation, which more than compensated for the ongoing investments in our Pan-European platform and led to an overall expense ratio decrease of 0.2 percentage points.
International Businesses in USD millions, for the years ended December 31 2006 2005 Change
Gross written premiums and policy fees increased by USD 93 million, or 3 percent, to USD 3.0 billion. Latin America, mainly Mexico and Chile, as well as South Africa contributed to this increase primarily resulting from higher volumes, but also increases in rates in certain regions.
Group Reinsurance in USD millions, for the years ended December 31 2006 2005 Change
Business operating profit increased by USD 171 million from a loss of USD 99 million to a profit of USD 72 million for the year ended December 31, 2006, driven by an increase in the net underwriting result.
Net underwriting result increased by USD 164 million, to USD 5 million from a loss of USD 159 million, primarily due to the lower number of large losses adversely affecting the 2005 result.
We measure the embedded value of our life insurance business in addition to the valuation in accordance with IFRS. Embedded value information takes into account the value of new business measured from the point of sale of the contract, a value which is not fully recognized under IFRS. Our methodology, developed in accordance with the European Embedded Value Principles, uses a “bottom-up” market consistent approach allowing explicitly for market risk. In particular, asset and liability cash flows are valued using risk discount rates consistent with those applied to similar cash flows in the capital markets, and options and guarantees are valued using market consistent models calibrated to observable market prices.
Present value of new business premiums (PVNBP) 3 19,487 18,816 4%
New business margin, after tax (as % of APE) 21.7% 17.7% 4.0 pts
Zurich Financial Services Group · Annual Report 2006 · Financial Report 10 Financial Review
Business operating profit increased by USD 83 million, or 8 percent, to USD 1.2 billion for the year ended December 31, 2006, primarily due to the change in business mix toward unit-linked products. The UK contributed USD 124 million to the increase in business operating profit which more than offset the decreases in Switzerland of USD 43 million and International Businesses of USD 36 million.
United States in USD millions, for the years ended December 31 2006 2005 Change
New business margin, after tax (as % of APE) 52.0% 64.4% (12.4 pts)
New business annual premium equivalent (APE) increased by 2 percent to USD 113 million as an increase in annual premium products offset a decrease in single premiums. New business margin, after tax (as a percentage of APE) decreased by 12.4 percentage points to 52.0 percent, following a review of cost allocations. Also contributing to the decrease was the effect of rising interest yields in the US, which result in higher discounting of future profits.
Business operating profit increased by USD 124 million, or 85 percent, to USD 270 million for the year ended December 31, 2006, primarily due to increased margins as a result of the change in product mix and profit development expectations. Other contributing factors include improved mortality, and one-off expenses in 2005 associated with the change in the UK Life model, such as Openwork, and a USD 34 million gain on pension plan changes in 2006, partially offset by a USD 56 million reduction in net investment income due to capital repatriation.
New business margin, after tax (as % of APE) 23.7% 16.5% 7.2 pts
Business operating profit increased by USD 29 million, or 21 percent, to USD 169 million for the year ended December 31, 2006, primarily due to the impact of lower policy acquisition expenses and a change in business mix. Insurance deposits doubled and gross written premiums and policy fees decreased primarily as a result of a large group pension contract, but also as a result of the continued shift from traditional products in favor of unit-linked products.
Zurich Financial Services Group · Annual Report 2006 · Financial Report 12 Financial Review
New business annual premium equivalent (APE) increased by 26 percent on a local currency basis, primarily due to changes in business mix, in addition to growth in emerging markets (written through the Isle of Man) and in Ireland. The increases were partially offset by Spain where fewer sales initiatives led to a decrease. New business margin, after tax (as a percentage of APE) increased 2.1 percentage points to 21.4 percent. This increase was primarily attributable to the regional mix of business, the repricing of two main products and revised persistency assumptions in the Isle of Man. These effects were partially offset by Spain where the initial costs associated with the shift to higher margin risk business were spread over lower sales than in 2005.
Other Businesses in USD millions, for the years ended December 31 2006 2005 Change
Headquarter expenses, after recharges to operating businesses and excluding foreign currency (188) (91) nm
Business operating loss increased by USD 209 million to USD 888 million for the year ended December 31, 2006. Interest expense increased by USD 184 million primarily as a result of debt issued in 2005. Headquarter expenses, after recharges to operating businesses and excluding foreign currency increased by USD 97 million, primarily as a result of expenses for our global branding campaign. Partially offsetting these factors was an increase of foreign currency gains for the Corporate Functions segment of USD 112 million.
The net investment return on Group investments decreased by 0.5 percentage points to 5.1 percent.
Net unrealized gains in total equity decreased by USD 1.6 billion for the year ended December 31, 2006, compared with a net decrease of USD 300 million for the same period in 2005, largely due to fixed maturity debt securities declining in value as interest rates rose. Net unrealized gains on available-for-sale equity securities partially offset losses from fixed maturity debt securities. The total return on Group investments was 4.3 percent for the year ended December 31, 2006, compared with 5.4 percent in 2005.
Net investment result, net of investment expenses 1 11,587 12,853 (10%)
Unit-linked investments are primarily invested in equity securities. Equity markets, particularly in the UK, increased at a stronger rate in 2005 compared with 2006. As a result, net capital gains on investments and impairments on unit-linked investments decreased by 15 percent for the year ended December 31, 2006.
of which: net capital gains on investments and impairments attributable to shareholders 1,088 966 13%
1 After deducting investment expenses of USD 726 million and USD 632 million for the years ended December 31, 2006 and 2005, respectively. 2 Excluding average cash received as collateral for securities lending of USD 4.2 billion and USD 4.9 billion in the years ended December 31, 2006 and 2005, respectively.
Performance of our total investments is the sum of the performance of our Group investments and unit-linked investments.
Insurance benefits and losses, net of reinsurance 7,845 7,414 7,183 7,764
Net income attributable to shareholders 1,274 1,296 1,172 785 1 Includes net investment income and net capital gains on investments and impairments.
in USD millions, for the three months ended 12/31/05 09/30/05 06/30/05 03/31/05
Net income attributable to shareholders 958 457 1,020 779 1 Includes net investment income and net capital gains on investments and impairments.
Zurich Financial Services Group · Annual Report 2006 · Financial Report 18 Financial Review
Selected balance variance over December 31, 2005, as of December 31, 2006 sheet items in USD millions in %
The weakening of the US dollar from December 31, 2005 to December 31, 2006 had a positive effect on balance sheet positions in US dollar terms, which are translated at closing exchange rates.
For the year ended December 31, 2006, the impact of foreign currency translation on the consolidated income statements was not significant.
Other reserves for insurance contracts, excluding unit-linked products 95,437 90,277 6%
Total investments increased by USD 32.7 billion, while on a local currency basis they increased by USD 8.2 billion, or 3 percent. Similarly, total reserves for insurance contracts increased by 9 percent, but on a local currency basis by 2 percent. Liabilities for investment contracts increased by 24 percent in reporting currency and 10 percent on a local currency basis. As of December 31, 2006, financial debt remained flat on a local currency basis compared with December 31, 2005, while total equity increased by 16 percent primarily due to the contribution of net income after taxes.
Common stock portfolios backing participating with-profit policyholder contracts 1,604 – 1,691 –
Trading equity portfolios in capital markets and banking activities 2,260 – 2,026 –
The total increase of equity securities of USD 18.7 billion was attributable to net purchases of USD 147 million, value appreciation in local currency and foreign currency movements of USD 9.8 billion.
All other positions remained broadly flat or slightly increased after adjusting for foreign currency movements.
We establish reserves for losses and loss adjustment expenses, which are estimates of future payments of reported and unreported claims for losses and related expenses, with respect to insured events that have occurred. These estimates are based on assumptions regarding the development of reserved claims, which may be different from the actual development of claims over time. Any changes in estimates are reflected in the income statement of the period in which estimates are changed.
Total net losses and loss adjustment expenses paid (18,907) (17,200) 10%
Development of Reserves for Life Insurance Contracts in USD millions Future life Policyholders’ policyholders’ contract deposits Reserves for benefits and other funds unit-linked contracts
Interest and bonuses credited to policyholders 2,973 2,708 876 1,217 6,184 6,897
Net reserves for future life policyholders’ benefits increased by 7 percent from January 1, 2006, primarily due to foreign currency translation; however, after adjusting for this effect, they decreased by 3 percent due to the transfer of group life contracts to independent foundations in Switzerland and maturities of traditional products in Germany.
After adjusting for foreign currency translation effects, net reserves for policyholders’ contract deposits and other funds decreased by 4 percent primarily due to the continued decline of endowments in Germany as those products are no longer tax deductible. In addition, net unrealized gains on investments charged to shareholders’ equity decreased.
After adjusting for foreign currency translation effects, our unit-linked contracts reserves increased by 8 percent due to an increase in unit-linked business, as well as gains on unit-linked investments being credited to policyholders, particularly in the UK due to the strength of the equity market.
The Group’s Euro Medium Term Note (EMTN) Programme allows for the potential issuance of up to USD 6 billion of senior and subordinated notes, of which USD 3.7 billion was issued as of December 31, 2006
Distributions to shareholders totaled USD 745 million, of which USD 701 million was distributed to common shareholders and USD 44 million to preferred shareholders. The distributions to common shareholders of CHF 7.00 per share comprised a gross dividend of CHF 4.60 per share and a payout of CHF 2.40 per share in the form of the nominal value reduction of each registered share. The total payout of CHF 7.00 per share was approved at the Annual General Meeting on April 20, 2006, and was paid to shareholders on July 4, 2006. The nominal value reduction was subject to the fulfillment of the necessary requirements and the registration of the share capital reduction in the Commercial Registrar of the Canton of Zurich. The nominal value of each registered share reduced from CHF 2.50 to CHF 0.10.
On March 30, 2006, and April 11, 2006, we redeemed the Series I and Series III of Trust Capital Securities (Zurich RegCaPS), respectively. The liquidation amounts totaled USD 425 million in aggregate.
On March 16, 2006, we redeemed 12,000,000 Series A Preference Shares issued by Zurich Financial Services (Jersey) Ltd., with a par value of EUR 25 per security for a total of USD 355 million, reducing minority interests.
For the year ended December 31, 2006, we recorded net unrealized losses on investments of USD 421 million, excluding translation adjustments, in total equity driven by lower values of debt securities due to an overall increase in interest rates in 2006 compared with 2005.
Cash and cash equivalents as of December 31, including cash received as collateral for securities lending 23,122 23,482
Net cash provided by operating activities was USD 743 million for the year ended December 31, 2006, lower than 2005 by USD 1.7 billion, mostly due to net losses and loss adjustment expenses paid as a result of the hurricanes which occurred in the second half of 2005 but have largely been paid out in 2006. Additionally, in line with our strategy, more cash was invested. The comparative differences were magnified by the effect of average exchange rates remaining relatively stable, while the closing rates of some of our major currencies changed significantly and in opposite directions for the two years presented.
Net cash used in financing activities was USD 2.0 billion for the year ended December 31, 2006, compared with net cash provided by financial activities of USD 853 million in 2005. In 2006 the cash was used to make distributions to shareholders of USD 701 million and redemptions of preferred securities of USD 780 million.
Debt related to capital markets and banking activities 22 1,889 2,139
Share of equity in income from investments in associates (85) (105)
Redemption of preferred securities and repayments to minority interests (802) 12
Net change of debt for capital markets and banking activities (219) (1,784)
Change in cash received as collateral for securities lending (751) (626)
Balance as of December 31, 2006 10 – 10,448 1 As approved by the Annual General Meeting on April 20, 2006, the share capital was reduced by a nominal value reduction of CHF 2.40 per share from CHF 2.50 to CHF 0.10 in respect of each registered share. The payment to shareholders was made on July 4, 2006. The nominal value reduction of share capital in USD is adjusted for cumulative translation adjustments.
The number of common shares issued was 144,749,399 as of December 31, 2006, and 144,006,955 as of both December 31, 2005 and 2004.
Net unrealized gains/(losses) Cumulative Common Total on invest- translation Retained shareholders’ Preferred shareholders’ Minority Total ments adjustment earnings equity securities equity interests equity
The format of the consolidated statements of cash flows has been changed from prior year. Cash flows relating to sales, maturities and purchases of debt and equity securities and other investments are now included in net cash provided by operating activities; these items were previously included in net cash used in investing activities. This change was made as the Group believes that the underlying transactions relate to principal revenue producing activities rather than to expenditures for resources intended to generate future income and cash flows. Without this adjustment the net cash provided by operating activities would be USD 3,996 million (2005: USD 6,055 million) and net cash used in investing activities would be USD 3,199 million (2005: USD 3,596 million).
The following balances are generally classified as non-current: equity securities, investments in associates, investments held by investment companies, real estate held for investment, deferred policy acquisition costs on life insurance contracts, deferred tax assets, goodwill, other intangible assets, reserves for unit-linked products, liabilities for investment contracts and deferred tax liabilities.
Maturity tables have been provided for the following balances: debt securities (table 7.3), derivative assets and derivative liabilities (tables 9.1 and 9.2), reserves for losses and loss adjustment expenses (table 11.9), future life policyholders’ benefits (table 11.9) and outstanding debt (table 22.3).
• Eagle Star Insurance Company Limited from General Insurance to Other Businesses
a) Consolidation principles The Group’s consolidated financial statements include the assets, liabilities, equity, revenues, expenses and cash flows of Zurich Financial Services and its subsidiaries. A subsidiary is an entity in which Zurich Financial Services owns, directly or indirectly, more than 50% of the outstanding voting rights, or which it otherwise has the power to control. The results of subsidiaries acquired are included in the consolidated financial statements from the date of acquisition. The results of subsidiaries that have been divested during the year are included up to the date control ceased. All significant intercompany balances, profits and transactions are eliminated in full.
Investments in associates and partnerships where the Group has the ability to exercise significant influence but not control, as well as joint ventures where there is joint control, are accounted for using the equity method. Significant influence is presumed to exist when the Group owns, directly or indirectly, between 20% and 50% of the outstanding voting rights.
Zurich Financial Services Group · Annual Report 2006 · Financial Report 36 Consolidated Financial Statements
Amounts collected as premiums from investment type contracts such as universal life, unit-linked and unitized with-profits contracts, are reported as deposits. Revenue from these contracts consists of policy fees for the cost of insurance, administration and surrenders during the period. Front-end fees are recognized over the estimated life of the contracts. Policy benefits and claims that are charged to expenses include benefit claims incurred in the period in excess of related policyholder contract deposits and interest credited to policyholder deposits.
Deferred policy acquisition costs The costs of acquiring new business, including commissions, underwriting and policy issue expenses, which vary with and are directly related to the production of new business, are deferred. Future investment income is taken into account in assessing recoverability.
Unamortized deferred policy acquisition costs associated with internally replaced contracts that are, in substance, contract modifications, continue to be deferred and amortized. Costs associated with internally replaced contracts that are, in substance, new contracts, are written off.
Future life policyholders’ benefits for other traditional life insurance policies are calculated using a net level premium valuation method based on actuarial assumptions as to mortality, persistency, expenses and investment return including a margin for adverse deviation.
Policyholders’ contract deposits represent the accumulation of premium received less charges plus declared dividends.
Where unrealized gains or losses on the revaluation of available-for-sale assets arise and are recorded directly in equity in accordance with the accounting policy for such assets, the corresponding adjustment to future life policyholder’s benefits and related assets is also recognized directly in equity.
The policyholders’ share of unrealized gains or losses, which may be paid in the future in respect of assets, is included in future life policyholders’ benefits.
For products containing discretionary participation features the amount of the discretionary participation feature is deemed to be the investment return on all related assets where the apportionment between the shareholder and the contract holder has not yet been determined. The liability includes certain elements of unrealized gains and portions of retained earnings attributable to the DPF, based on the mandated rates applied to these gains and earnings on the assumption that they had been realized at the balance sheet date.
Reinsurance The Group’s insurance subsidiaries cede risk in the normal course of business in order to limit the potential for losses arising from certain exposures. Reinsurance does not relieve the originating insurer of its liability. Certain Group insurance companies assume reinsurance business incidental to their normal business, as well as from the Farmers Exchanges. Reinsurance assets include balances due from reinsurance companies for paid and unpaid losses and loss adjustment expenses, ceded unearned premiums and ceded future life policy benefits. Amounts recoverable from reinsurers are estimated in a manner consistent with the claim liability associated with the reinsured policy. Reinsurance is recorded gross in the consolidated balance sheet unless a legal right of offset exists.
Liabilities for investment contracts (unit-linked) These represent portfolios maintained to meet specific investment objectives of policyholders who bear the investment risk. The assets are classified as fair value through profit or loss. The liabilities are carried at fair value. The costs of policy administration, investment management, surrender charges and certain policyholder taxes assessed against the policyholders’ account balances are included in policy fee revenue.
Measurement of investment contracts Valuation techniques are used to establish the fair value at inception and at each subsequent reporting date.
For investment contracts with fixed and guaranteed terms, the amortized cost basis is used. In this case, the liability is initially measured at its fair value minus transaction costs that are incremental and directly attributable to the acquisition or issue of the contract.
d) Other revenue recognition Fee revenue for the provision of non-claims related management services to the Farmers Exchanges is calculated primarily as a percentage of gross premiums earned by the Farmers Exchanges. Farmers Group, Inc. and its subsidiaries (FGI) provides the following non-claims related management services to the Farmers Exchanges: risk selection, preparation and mailing of policy forms and invoices, premium collection, management of the investment portfolios and certain other administrative and managerial functions. The Farmers Exchanges are responsible for their own claims functions, including the settlement and payment of claims and claims adjustment expenses. They are also responsible for the payment of agent commissions and bonuses and the payment of premium and income taxes.
The Group charges its customers for asset management and other related services using the following different approaches: • Front-end fees are charged to the customer at inception. This approach is used particularly for single premium contracts. The consideration received is deferred as a liability and recognized over the life of the contract on a straight-line basis.
• Regular fees charged to the customer periodically (monthly, quarterly or annually) either directly or by making a deduction from invested funds. Regular charges billed in advance are recognized on a straight-line basis over the period in which the service is rendered; fees charged at the end of the period are accrued as a receivable that is offset against the financial liability when charged to the customer.
Classification Financial assets are classified into the following categories: “held-to-maturity”, “fair value through profit or loss”, “available-for-sale”, or “loans and receivables”. The classification depends on the purpose for which the investments were acquired.
Loans and receivables, such as mortgage loans, policyholders’ collateral and other loans, include loans where money is provided directly to the borrower, other than those that are originated with the intent to be sold in the short term, which are recorded in the trading category.
The Group recognizes regular way purchases and sales of financial assets on trade date, which is the date on which the Group commits to purchase or sell the asset.
Loans and receivables are initially recorded at fair value and are subsequently measured at amortized cost using the effective interest rate method, less provision for impairment.
Short-term investments are investments with original maturity between three months and twelve months. The carrying values of short-term investments approximate fair values.
The Group considers an available-for-sale equity for impairment when the fair value of the security has been not insignificantly below the weighted-average cost for more than 12 months. Additionally, the Group considers an available–for-sale equity for impairment when the fair value has been below the weighted-average cost by more than 50% for any period of time.
The fair value of available-for-sale debt securities may fall temporarily below their carrying value, but, provided there is no risk resulting from changes in financial standing, an impairment is not recorded for such securities.
Derivative financial instruments include interest rate, currency and total return swaps, futures, forwards and option contracts, all of which derive their value mainly from underlying interest rates, foreign exchange rates, commodity values or equity instruments. A derivative contract may be traded on an exchange or over-thecounter (OTC). Exchange-traded derivatives are standardized and include futures and certain option contracts. OTC derivative contracts are individually negotiated between contracting parties and include forwards, caps, floors and swaps. Derivative financial instruments are subject to various risks similar to those related to the underlying financial instruments, including market, credit and liquidity risk.
embedded derivatives are assessed at inception of the contract and, depending on their characteristics, are accounted for as separate derivative financial instruments pursuant to IAS 39.
The effective portion of gain or loss on the re-measurement of a cash flow hedging instrument is recognized directly in shareholders’ equity. The ineffective portion is recognized in current period income. When the hedged firm commitment results in the recognition of an asset or a liability, then, at the time the asset or liability is recognized, the associated gains or losses that had previously been recognized in shareholders’ equity are included in the initial measurement of the acquisition cost or other carrying amount of the asset or liability. For other cash flow hedges, the gains or losses that are recognized in shareholders’ equity are transferred to the income statement in the same period in which the item hedged affects the net profit and loss, for example, when the future sale actually occurs.
g) Securities lending Certain entities within the Group participate in securities lending arrangements whereby specific securities are loaned to other institutions, primarily banks and brokerage firms, for short periods of time. Under the terms of the securities lending agreements, the Group retains substantially all the risks and rewards of ownership of these loaned securities, and also retains contractual rights to cashflows therefrom. These securities are therefore not derecognized from the Group’s balance sheet.
i) Debt issued Debt issued by the Group is initially measured at cost, which is the fair value of the consideration received, net of transaction costs incurred. Subsequent measurement is at amortized cost, using the effective interest rate method to amortize cost at inception to the redemption value over the life of the debt.
Other intangibles Other intangible assets have a definite useful life and are carried at cost less accumulated amortization and consist primarily of acquired brand names and software costs that meet the recognition criteria for capitalization. The costs of these assets are amortized using the straight-line method over the following estimated economic lives: • brand names 20 years; • software three to five years.
Impairments Intangible assets that have an indefinite useful life are not subject to amortization and are tested annually for impairment. Assets that are subject to amortization are reviewed for impairment whenever events or changes in circumstances indicate that the carrying amount may not be recoverable. An impairment loss is recognized for the excess of the asset’s carrying value over its recoverable amount. The recoverable amount is the higher of an asset’s fair value less selling costs and value in use.
l) Income taxes The Group provides current tax expense according to the tax laws of each jurisdiction in which it operates. Deferred income taxes are recognized using the asset and liability method. Deferred income taxes are recorded for temporary differences, which are based on the difference between financial statement carrying amounts and income tax bases of assets and liabilities using enacted income tax rates and laws. Losses for tax purposes are treated as deferred tax assets to the extent it is probable that the losses can offset future taxable income and is allowed by the applicable local tax laws and regulations.
Taxes payable by either the company or its subsidiaries on expected distribution to the holding company of the profits of subsidiaries are recognized as deferred income taxes unless a distribution of those profits is not intended or would not give rise to a tax liability.
Retirement benefits The operating companies in the Group provide employee retirement benefits through both defined benefit plans providing specified benefits and defined contribution plans. The assets of these plans are generally held separately from the Group’s general assets in trustee-administered funds. Defined benefit plan obligations and contributions are determined annually by qualified actuaries using the projected unit credit method. The Group’s expense related to these plans is accrued over the employees’ service periods based upon the actuarially determined cost for the period. Actuarial gains and losses are recognized as income or expense when the net cumulative unrecognized actuarial gains and losses for each individual plan at the end of the previous reporting year exceeded 10% of the higher of the defined benefit obligation and the fair value of plan assets at that date. These gains or losses are then recognized over the expected average remaining working lives of the employees participating in the plans. Contributions to defined contribution pension plans are charged to the income statement as they become due.
n) Share-based compensation Under the Group’s equity-settled, share-based compensation plan, the fair value of the employee services received in exchange for the grant of shares and/or options is recognized as an expense in the consolidated income statement over the vesting period, with a corresponding amount recorded in additional paid-in capital.
The total amount to be expensed over the vesting period is determined by reference to the fair value of the shares and/or options granted, excluding the impact of any non-market vesting conditions (for example, profitability and premium income growth targets). Non-market vesting conditions are included in assumptions about the number of shares and/or options that are expected to be issued or become exercisable. At each balance sheet date, the Group revises its estimates of the number of shares and/or options that are expected to be issued or become exercisable. It recognizes the impact of the revision of original estimates, if any, in the income statement, and a corresponding adjustment to equity.
p) Leases Leases in which a significant portion of the risks and rewards of ownership are retained by the lessor are classified as operating leases. Payments made under operating leases are charged to the income statement on a straight-line basis over the lease term.
r) Treasury shares Zurich Financial Services shares held by the Group are classified as treasury shares and are deducted from equity at its nominal value. The differences between the nominal value and the amount paid for acquiring, or received for disposing of treasury shares, are recorded as an adjustment to additional paid-in capital in shareholders’ equity.
Balance sheets and cash flows as of for the years ended 12/31/06 12/31/05 12/31/06 12/31/05
Forthcoming changes in accounting standards In August 2005, the IASB released IFRS 7 “Financial Instruments: Disclosures”. IFRS 7 is effective January 1, 2007. IFRS 7 applies to all risks arising from all financial instruments, except those covered by another more specific standard such as interests in subsidiaries, associates and joint venture, post-employment benefits, sharebased payment and insurance contracts. IFRS 7 requires disclosure of: a) the significance of financial instruments for an entity’s financial position and performance. These disclosures incorporate many of the requirements previously in IAS 32.
Zurich Financial Services Group · Annual Report 2006 · Financial Report 48 Consolidated Financial Statements
The Group is in the process of assessing the impact of SOP 05-01 and the IFRICs on its financial position, results or disclosures.
2005 implementation of new accounting standards and adjustments The main restatement adjustments for the Group resulted from the adoption of IFRS 4, which relates to the definition of an insurance contract. They primarily affect the accounting treatment of the Group’s life business which impacts both the Group’s consolidated balance sheet and income statement. The (IASB) issued IFRS 4 “Insurance Contracts” on March 31, 2004. The standard applies to all insurance contracts (including reinsurance contracts) that an entity issues and to reinsurance contracts that it holds, except for specified contracts covered by other IFRS standards. The most significant change as a result of the adoption of the standard is the reclassification of certain contracts as financial instruments and hence application of IAS 39 to these contracts. IFRS 4 does not provide comprehensive guidance on the accounting treatment for insurance contracts and as such the Group will continue to apply US GAAP in certain circumstances where IFRS is silent.
IAS 36, “Impairment of Assets,” and IAS 38, “Intangible Assets,” were revised in March 2004 by the IASB as part of the Business Combinations project. Consistent with the group’s adoption of IFRS 3, the revised standards were adopted as of January 1, 2005.
All changes in accounting policies have been made in accordance with transitional provisions in the respective standards.
Zurich Financial Services Group · Annual Report 2006 · Financial Report 50 Consolidated Financial Statements
Changes in 2006 For the year ended December 31, 2006, the Group recorded the estimated loss of USD 66 million (pre-tax) on the envisaged disposal of certain run-off portfolios in four European countries. The loss was partially offset by a USD 23 million (pre-tax) gain resulting from a reorganization of our legal entity structure in Germany changing the minority interest share of the Group’s net assets.
On December 19, 2006, the Group announced the signing of an agreement for the purchase of all remaining shares in the insurance intermediary Endsleigh Limited in the United Kingdom. Since 2002 the Group has held 45% of Endsleigh’s stock. The transaction was closed on January 2, 2007. On December 22, 2006, the Group announced the signing of an agreement for the purchase of 100% of the Spanish surety writer ACC Seguros y Reaseguros de Danos, S.A. The transaction is expected to be closed in the first quarter 2007. As both transactions did not close in 2006, they did not have an impact on the scope of consolidation.
The time required to learn of and settle claims is an important consideration in establishing the Group’s reserves. Short-tail claims, such as for automobile and property damage, are normally reported soon after the incident and are generally settled within months following the reported incident. Long-tail claims, such as bodily injury, pollution, asbestos and product liability, can take years to develop and additional time to settle. For long-tail claims, information concerning the event, such as the required medical treatment for bodily injury claims and the measures and costs required to clean up pollution, may not be readily available. Accordingly, the reserving analysis of long-tail lines of business is generally more difficult and subject to greater uncertainties than for short-tail losses.
The Group uses a number of accepted actuarial methods to estimate and evaluate the amount of reserves recorded. The nature of the claim being reserved for and the geographic location of the claim influence the techniques used by the Group’s actuaries. Additionally, the Group’s Corporate Center actuaries perform periodic
b) Future life policyholders’ benefits and policyholders’ contract deposits The future life policyholders’ benefits and policyholders’ contract deposits liabilities contain a number of assumptions regarding mortality (or longevity), lapses, surrenders, expenses and investment returns. These assumptions are determined with reference to past experience adjusted for new trends, current market conditions and future expectations. As such the liabilities for future life policyholders’ benefits and policyholders’ contract deposits may not represent the ultimate amounts paid out to policyholders. For example: • The estimated number of deaths determines the value of the benefit payments. The main source of uncertainty arises because of the potential for pandemics and wide-ranging lifestyle changes, such as changes in eating, smoking and exercise habits, which could result in earlier deaths for age groups in which the Group has significant exposure to mortality risk.
c) Fair value of financial assets and liabilities Certain of the Group’s assets and liabilities are recorded at fair value on the balance sheet. Fair value determinations for financial assets and liabilities are based generally on listed market prices or broker or dealer price quotations. If prices are not readily determinable, fair value is based on either internal valuation models or management estimates of amounts that could be realized under current market conditions. Fair values of certain financial instruments, including over-the-counter (OTC) derivative instruments, are determined using pricing models that consider, among other factors, contractual and market prices, correlations, yield curves, credit spreads volatility factors and/or prepayment rates of the underlying positions. The use of different pricing models and assumptions could lead to different estimates of fair value.
d) Impairment of assets Assets are subject to regular impairment reviews under the relevant IFRS standard. Impairments are measured as the difference between the cost (or amortized cost) of a particular asset and the current fair value or the recoverable amount.
Refer to note 15 for further information on deferred policy acquisition costs.
f) Deferred taxes Deferred tax assets are recognized if sufficient future taxable income, including income from the reversal of existing taxable temporary differences and available tax planning strategies, are available for realization. The utilization of deferred tax assets arising from temporary differences depends on the generation of sufficient taxable profits in the period in which the underlying asset or liability is recovered or settled. As of each balance sheet date, management evaluates the recoverability of deferred tax assets and if it is considered probable, that all or a portion of the deferred tax asset will not be utilized, then a valuation allowance would be recognized.
Refer to note 25 for further information on defined benefit pension plans.
• Financial market and asset / liability (ALM) mismatch risk – risk associated with the Group’s investment portfolio, the relative duration of assets and liabilities and currency fluctuations.
There are other risks such as operational risk. Information regarding operational risk is contained in the risk management section of the Corporate Review.
The Group systematically and regularly assesses risks through its Total Risk Profiling® process, which allows the Group to evaluate the probability of a risk scenario occurring and the severity of the consequences should it occur. The Group then develops, monitors and implements appropriate improvement actions.
In addition to risk-specific monitoring and modeling the Group deploys a risk based capital (RBC) model to assess the economic capital consumption of its business. The Group defines risk-based capital as the capital needed to protect the Group’s policyholders against the worst-case loss (which the Group calibrates according to its financial strength target of AA at a one-in-2000 probability of occurring over a one year time horizon; this translates to a 99.95% confidence level). The Group continues to embed RBC modeling into its organization and decision-making, such as allocating capital to its General Insurance lines of business for pricing purposes. The Group is also building on the internal RBC model to fulfill new regulatory requirements regarding the Swiss Solvency Test, which establishes risk based economic solvency requirements.
a) Insurance risk The Group assumes certain customer risks, and therefore must manage that transfer of risk including the establishment of limits for underwriting authority and requirement for specific approvals for transactions involving new products or where established limits of size and complexity may be exceeded. The Group’s underwriting strategy is to exploit the diversification across industries and geographic regions in which the Group operates.
The Group uses a variety of reserving and modeling methods to address the various insurance risks inherent in its general and life insurance business.
The Group has centralized the management of treaty reinsurance for General Insurance and closely monitors emerging issues that may affect its overall risk exposures, such as new areas of liability. The Group models and estimates risk associated with natural catastrophes and monitors potential exposures to man-made catastrophes.
Direct written for the year ended December 31, 2006 premiums and policy fees by line of business and by region
Man-made catastrophes include such risks as train collisions, hotel fires and terrorism. Man-made catastrophe risks present challenges for the Group to assess due to the high degree of uncertainty about what events might actually occur. The Group monitors potential exposures by analyzing certain accumulations in some geographic areas, using a number of assumptions about the potential characteristics of the threat.
Zurich Financial Services Group · Annual Report 2006 · Financial Report 56 Consolidated Financial Statements
Life insurance risk The risks associated with life insurance include: • biometric risk, that is the reasonable possibility of significant loss due to uncertainty of rates of deaths and rates of disability among policyholders; • risk due to movements in financial markets, i.e. investment returns and interest rate risk. These are managed under the market and ALM risk; • risk due to financial policyholder behavior, for instance surrenders or lapses. This may be associated with the risks described above or may be independent; and
The table below shows the Group’s concentration of risk within the Global Life segment by region based on direct written premiums. The Group’s exposure to life insurance risks varies significantly by geographic region and may change over time.
Accident Individual 2 Group and Health Unit-Linked 3 1 Including intercompany eliminations.
In addition to the specific risks insured, all these lines expose the Group to lapse, surrender and expense risks.
Certain of the products above contain guarantees for which liabilities have been recorded for additional benefits and minimum guarantees, primarily in the subsidiary Kemper Investors Life Insurance Company which has written variable annuity contracts that provide annuitants with certain guarantees related to minimum death and income benefits. The determination of IFRS liabilities for these contracts is based on SOP 03-01 and involves a range of scenarios and assumptions, including those regarding expected market rates of return and volatility, contract surrender rates, annuitization elections and mortality experience. The assumptions used are consistent with those used in determining estimated gross profits for purposes of amortizing deferred policy acquisition costs.
Refer to note 11 for details of the carrying value of the liability relating to these products and its development.
b) Credit risk The Group has identified reinsurance assets and debt securities as its main sources of credit risk.
The Group typically cedes new business to authorized reinsurers that are rated at least BBB. The premiums ceded shown in the table below, that are below investment grade or not rated, relate mainly to former transactions, pools and captives.
Reinsurance in USD millions, for the year ended December 31, 2006 premiums ceded and assets by rating of reinsurer
Amounts Reinsurance ceded as % of total assets 1 as % of total
Zurich Financial Services Group · Annual Report 2006 · Financial Report 58 Consolidated Financial Statements
The Group is also exposed to credit risk from third party counterparties where the Group holds debt and/or equity in those companies. Counterparty concentrations are managed by issuer, industry, country, seniority and credit rating. Credit risks related to the debt issuers are assessed and monitored. The Group’s credit risk policy stipulates single counterparty limits and a minimum average rating of the debt portfolio as well. Credit exposure to counterparties rated below investment grade requires specific approval.
Debt securities by in USD millions, as of December 31, 2006 rating of issuer
In the case of derivatives, such as interest rate or currency swaps, forward contracts and purchased options, the replacement value of the outstanding derivatives represents a credit risk to the Group. The Group controls the credit risk of its outstanding positions with external counterparties through approval processes embedded in derivative programs.
In addition to reinsurance assets and debt securities, another source of credit risk for the Group is third party brokers, agents and other intermediaries. The Group’s credit risk exposures to third party brokers, agents and other intermediaries arises where those intermediaries collect premiums from customers to be paid to the Group or pay claims to customers on behalf of the Group. For details of the amounts receivable from brokers, agents and other intermediaries refer to note 16.
The Group regularly measures and manages its financial market and ALM risk exposure. The Group has limits in place on concentration in investments by single issuers and certain asset classes as well as on asset / liability mismatches. The Group’s Asset Liability Management and Investment Committee determines the Group’s Strategic Asset Allocation and manages the Group’s asset/liability exposure. The Group oversees the activities of local Asset Liability Management and Investment Committees and regularly assesses financial market and ALM
risks both on a Group and a local business level. Risk assessment includes quantification of the contributions to financial market and ALM risk from all major risk drivers. Risk reviews include the analysis of three aspects: management of the interest rate risk per major maturity bucket, efficiency of the asset allocation relative to the actual risk level and compliance of the aggregated positions with risk limits. The economic effect of extreme market moves is routinely examined and considered when setting the asset allocation.
1 Negative values indicate a decrease to the balance. Positive values indicate an increase to the balance.
In addition to the interest rate risk exposure for debt securities, the Group is exposed to interest rate risk on its reserves for insurance contracts, liabilities for investment contracts and floating rate borrowings.
General insurance reserves are not discounted other than for settled claims with fixed payment terms, therefore interest rate risks to the Group on these reserves are not significant.
Returns on unit-linked contracts, whether classified as insurance or investment contracts, are for the risk of the policyholder, therefore interest rate risks to the Group on these liabilities are not significant.
Most of the Group’s debt is subject to fixed interest rates, which may be adjustable during the course of the term. No adjustments are made to the principal value of the debt for changes in the yield curve. However, an increase in interest rates would result in an increase to the Group’s interest expense on floating rate debt.
Zurich Financial Services Group · Annual Report 2006 · Financial Report 60 Consolidated Financial Statements
Net gains and losses on foreign currency transactions included in the consolidated income statements for the years ended December 31, 2006 and 2005 are shown in note 2s.
Effective interest rates The table below shows the ranges for weighted average effective interest rates for selected balance sheet statement captions.
Effective interest for the years ended December 31 rates on selected assets and liabilities
A summary of net investment income and net capital gains, losses and impairments is given below: Table 7.1
Investments held by 1 Impairments on total investments amounted to USD 26 million and USD 64 million for the years ended December 31, 2006 and 2005, respectively. 2 Including net capital gains/(losses) on derivative financial instruments of USD (65) million and USD 56 million for the years ended December 31, 2006 and 2005, respectively.
Details of the investment balances as of December 31, 2006 and 2005 are given in the tables below by measurement category.
Debt securities: Fair value through profit or loss 17,572 5.7% 15,876 5.7%
Other investments: Investments held by investment companies 1,861 0.6% 1,928 0.7%
As of December 31, 2006 and 2005, investments included USD 11,512 million and USD 12,486 million, respectively, of loaned securities. Cash and cash equivalents included USD 3,820 million and USD 4,571 million of cash received as collateral for loaned securities as of December 31, 2006 and 2005, respectively. Non-cash collateral received for loaned securities was USD 7,654 million and USD 8,262 million as of December 31, 2006 and 2005, respectively.
Debt securities in USD millions, as of December 31 maturity schedule (total investments)
One year through five years 1,218 1,456 32,196 32,787 3,527 3,046
USD millions % of total USD millions % of total thereof: Trading equity portfolios in capital markets and banking activities 2,260 2.0% 2,026 2.1%
(losses) on fair value for the years ended December 31 through profit or loss debt and equity securities
Capital Z Financial Services Fund II 1 – 401 40 100 18.41% 29.43%
1 During 2006, the Group divested part of its interest in Capital Z Financial Services Fund II. As a result of this transaction, the Group no longer has significant influence over this associate. The remaining investment was reclassified as available-for-sale equity securities, common stock, as of December 31, 2006.
Unrealized in USD millions, as of December 31 net gains on investments included in shareholders’ equity
Less amount of net unrealized (gains) on investments attributable to: Life policyholder dividends and other policyholder liabilities (1,038) (2,131)
Zurich Financial Services Group · Annual Report 2006 · Financial Report 66 Consolidated Financial Statements
The methods and assumptions used by the Group in estimating fair value of the financial instruments and other investments are discussed below.
Investments held by investment companies: estimated fair values are determined by the investment managers and reviewed by management.
Total insurance benefits and losses 33,874 38,261 (3,668) (5,842) 30,206 32,419
11. Reserves for insurance contracts and reinsurers’ share of reserves for insurance contracts
Zurich Financial Services Group · Annual Report 2006 · Financial Report 72 Consolidated Financial Statements
Losses and loss adjustment expenses incurred: Losses and loss adjustment expenses paid: Divestments of companies and businesses (66) (47) – 10 (66) (37)
The Group establishes loss reserves, which are 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. Any changes in estimates are reflected in the consolidated income statement in the period in which estimates are changed.
The table below presents changes in the historical general insurance reserves net of reinsurance, that the Group established in 2001 and subsequent years. The top line of the table shows the estimated reserves for unpaid losses and loss adjustment expenses as of each balance sheet date, which represents the estimated amount of future payments for losses occurring in that year and in prior years. The upper, or paid, portion of the table presents the cumulative amounts paid through each subsequent year in respect of the reserves established at each year end. The lower or reserve re-estimated, portion of the table shows the re-estimation of the initially recorded reserve as of each succeeding year end. Changes to estimates are made as more information becomes known about the actual losses for which the initial reserves were established. The cumulative deficiency or redundancy is equal to the initial net reserves less the liability re-estimated as of December 31, 2006. Conditions and trends that have affected the development of our reserves for losses and loss adjustment expenses in the past may or may not necessarily occur in the future, and accordingly, conclusions about future results may not be derived from the information presented in the tables below.
The table below presents our consolidated loss and loss adjustment expense reserve development as of December 31 for the years indicated.
Zurich Financial Services Group · Annual Report 2006 · Financial Report 74 Consolidated Financial Statements
Reserves for losses in USD millions and loss adjustment expenses for asbestos and environmental claims
Management has considered environmental and latent injury claims and claims expenses in establishing the reserves for losses and loss adjustment expenses. The Group continues to be advised of claims asserting injuries from toxic waste, hazardous materials and other environmental pollutants and alleged damages to cover the clean-up costs of hazardous waste dump sites relating to policies written in prior years and indemnity claims asserting injuries from asbestos. Coverage and claim settlement issues, such as determination that coverage exists and the definition of an occurrence, together with increased medical diagnostic capabilities and awareness have often caused actual loss development to exhibit more variation than in other lines. Such claims require specialized reserving techniques and the uncertainty of the ultimate cost of these types of claims has tended to be greater than the uncertainty relating to standard lines of business.
Interest and bonuses credited to policyholders 3,040 2,758 (67) (50) 2,973 2,708
Interest and bonuses credited to policyholders 1,010 1,353 (134) (136) 876 1,217
Interest and bonuses credited to policyholders 6,184 6,897 – – 6,184 6,897
Zurich Financial Services Group · Annual Report 2006 · Financial Report 76 Consolidated Financial Statements
• USD 116 million related to a change in the United Kingdom pensions legislation.
As of January 1, 2006, the policyholders’ participation for the individual life business in Switzerland became subject to regulatory guidelines whereby the statutory policyholders’ dividend fund must be distributed to the policyholders at least in the amount of 20% of the account balance on the statutory accounts.
Guarantees arising from minimum death benefits (GMDB), retirement income benefits (GRIB) and annuitization options (GAO) The Group sells products for which policyholders bear the full investment risk associated with the underlying invested funds selected by them. Certain of these products contain guarantees for which liabilities have been recorded for additional benefits and minimum guarantees, primarily in the subsidiary Kemper Investors Life Insurance Company which has written variable annuity contracts that provide annuitants with certain guarantees related to minimum death and income benefits. The determination of these liabilities is based on models that involve a range of scenarios and assumptions, including those regarding expected market rates of return and volatility, contract surrender rates, annuitization elections and mortality experience. The assumptions used are consistent with those used in determining estimated gross profits for purposes of amortizing deferred policy acquisition costs.
guarantee liabilities arising from minimum death benefits (GMDB), retirement income benefits (GRIB) as well as annuitization options (GAO)
Liabilities related in USD millions, as of December 31 to investment contracts
Farmers in USD millions, for the years ended December 31 management fees
million and USD 29 million for the years ended December 31, 2006 and 2005, respectively.
Expected and in USD millions, for the years ended December 31 actual income tax expense
Actual income tax expense attributable to shareholders 26.8% 1,692 29.1% 1,364
The expected weighted average statutory income tax rate for the Group is 30.2% and 32.3 % for the years ended December 31, 2006 and 2005, respectively. These rates were derived by obtaining a weighted average of the applicable statutory income tax rate in relation to the net income before income tax attributable to shareholders generated in the taxable territories in which the Group operates.
Deferred in USD millions, as of December 31 tax assets and liabilities
Deferred taxes – in USD millions, as of December 31 policyholders/ shareholders attribution
Zurich Financial Services Group · Annual Report 2006 · Financial Report 82 Consolidated Financial Statements
As of December 31, 2006 and 2005, the Group had income tax loss carryforwards of USD 4,790 million and USD 5,258 million, respectively, available (subject to various statutory restrictions) for use against future taxable income. After taking cumulative valuation allowances and current year utilizations into account, tax loss carryforwards for which deferred tax assests have been recognized amounted to USD 2,200 million and USD 3,150 million as of December 31, 2006 and 2005, respectively. The majority of the tax loss carryforwards expire in a period between five and fifteen years.
As of December 31, 2006 and 2005, the following taxpayer groups carry a net deferred tax asset position on their balance sheets.
Zurich Holding Company of America taxpayer group 1,500 1,381 1,224 1,252
Additions, capital improvements and transfers 5 71 19 79 109 283
Zurich Financial Services Group · Annual Report 2006 · Financial Report 84 Consolidated Financial Statements
Net carrying value as of January 1, 2005 457 1,105 116 129 309 2,116
Gross carrying value as of December 31 672 605 1 This intangible asset relates to insurance contracts only. 2 Other intangibles include internally generated capitalized software development costs and other costs.
When testing for impairment, the recoverable amount of a CGU is determined on the basis of value-in-use calculations. These calculations use cash flow projections based on financial budgets, which are approved by management, typically covering a five-year period. Cash flows beyond the five year period are extrapolated using the estimated growth rates. The estimated growth rate does not exceed the long-term average past growth rate for the insurance business in which the CGU operates. Discount rates may range from between 3.0% which is a market risk free rate where the cash flows have been adjusted for all possible outcomes, and 10.4% which is a risk adjusted discount rate.
The impairment test for attorney-in-fact relationships is based upon the business plans and the surplus development in the Farmers Exchanges. There is no indication that the value of the attorney-in-fact intangible asset is impaired.
Zurich Financial Services Group · Annual Report 2006 · Financial Report 86 Consolidated Financial Statements
Present value of profits of acquired insurance contracts 1 Other intangible assets 2 Attorney-in-fact relationships Total
Amounts due to reinsurers, agents and other insurance companies 1,771 2,942
Refer to note 9 for details on derivative financial instruments. Refer to note 25 for further details on the provision for defined post employment benefits.
Debt in USD millions, as of December 31 2006 2005 a) Debt related to capital markets and banking activities
Notes and loans payable in more than 1 year 44 543
Zurich Insurance Company 3.875% CHF 1,000 bond, due July 2011 822 763
Zurich Capital Trust I 8.376% USD 1,000 Capital Securities, due June 2037 990 1,000 2
a) Debt related to capital markets and banking activities In 2005, a restructuring was effected to combine the Zurich Bank and Dunbar Bank into a single banking unit under Zurich Financial Services EUB Holdings Limited. Debt relating to the new banking unit amounted to USD 739 million as of December 31, 2006, compared to USD 878 million as of December 31, 2005.
b) Senior debt The Group’s Euro Medium Term Note Programme (EMTN Programme) allows for the issuance of senior and subordinated notes up to a maximum of USD 6 billion. Issuing entities under the EMTN Programme are Zurich Finance (USA), Inc. and Zurich Finance (UK) p.l.c.
On December 9, 2005, ZFS Finance (USA) Trust I and ZFS Finance (USA) Trust II respectively issued 6.15% USD 600 million of Series I and 6.45% USD 700 million of Series II Fixed / Adjustable Rate Enhanced Capital Advantaged Preferred Securities (ECAPS), and on December 22, 2005, ZFS Finance (USA) Trust III issued USD 400 million of Series III Floating Rate ECAPS. These trust preferred securities were sold to a number of qualified institutional buyers and qualified purchasers under the exemption of rule 144A of the United States Securities Act (1933). Each Trust benefits from a subordinated support agreement of Zurich Financial Services and Zurich Group Holding. Distributions are payable quarterly or semi-annually in arrears but may at any time be deferred if certain conditions are met. Distributions will be mandatorily deferred if the Group fails to meet certain financial tests. If distributions are not paid in full after a certain period of time and during any mandatory deferral period, the Group must use commercially reasonable efforts to issue and/or sell share capital to fund accumulated and unpaid distributions. The Group has the option to call the securities after five or ten years from the issuance depending on the series. Each of the three Trusts will dissolve no later than December 15, 2065.
In 2005, under the EMTN Programme Zurich Finance (USA), Inc. issued 4.5% EUR 500 million bond due 2025 and callable in 2015, which is guaranteed by Zurich Insurance Company on a subordinated basis. The proceeds were swapped into six-month floating rate US dollars until the call date. The swap qualifies for hedge accounting under fair-value hedge accounting treatment.
The following is a summary of key contractual terms and conditions of the outstanding subordinated debt securities: Table 22.2
Redeemable in whole or in part at a price of 104.188% on or after June 1, 2007 and 8.376% decreasing annually to 100% USD 1,000 Capital At any time on on or after June 1, 2017, Securities, due June 2037 8.376% payable semi-annually or after June 1, 2007 plus any accrued interest.
6.625% payable annually Redeemable in whole 6.625% up to October 2, 2022 every five years GBP 450 bond, and then reset every 5 years Every five years on at par plus undated notes to the Reset Rate of Interest. 1 or after October 2, 2022 any accrued interest.
3-month LIBOR plus 1.15% Redeemable in whole Series III Floating Rate reset quarterly until At any time on or in part at par plus USD 400 ECAPS, December 15, 2010 and or after any accumulated and due December 2065 then 3-month LIBOR plus 2.15% December 15, 2010 unpaid distributions.
Credit facilities The Group has access to a syndicated revolving credit facility of USD 3 billion that terminates in 2011. Zurich Group Holding, together with Zurich Insurance Company and Farmers Group, Inc. are guarantors of the facility and can draw up to USD 1.25 billion, USD 1.5 billion and USD 250 million, respectively. No borrowings were outstanding under this facility as of December 31, 2006.
Issued share capital, CHF 0.10 and CHF 2.50 par value, respectively 144,749,399 144,006,955
Preferred securities in USD millions, as of December 31 2006 2005
Preferred securities, USD 1,000 par value 700 1,125 a) Issued share capital As of December 31, 2006, Zurich Financial Services had 144,749,399 issued and fully paid registered shares of CHF 0.10 par value, amounting to a share capital of CHF 14,474,939.90. As of December 31, 2005, the share capital amounted to CHF 360,017,387.50, divided into 144,006,955 fully paid registered shares of CHF 2.50 par value.
The Board is further authorized to restrict or withdraw the pre-emptive rights of shareholders and to allocate them to third parties if the shares are to be used for the take-over of an enterprise, or parts of an enterprise or of participations or if issuing shares for the financing including re-financing of such transactions; or for the purpose of expanding the scope of shareholders in connection with the quotation of shares on foreign stock exchanges.
Capital market instruments and option rights to shareholders The share capital of Zurich Financial Services may be increased by an amount not exceeding CHF 548,182.80 by the issuance of up to 5,481,828 fully paid registered shares with a nominal value of CHF 0.10 each (1) through the exercise of conversion and/or option rights which are granted in connection with the issuance of bonds or similar debt instruments by Zurich Financial Services or one of its Group companies in national or international capital markets; and/or (2) by the exercise of option rights which are granted to the shareholders. When issuing bonds or similar debt instruments connected with conversion and/or option rights, the pre-emptive rights of the shareholders will be excluded. The current owners of conversion and/or option rights shall be entitled to subscribe for the new shares. The conversion and/or option conditions are to be determined by the Board.
In the United States, restrictions on payment of dividends that apply to insurance companies may be imposed by the insurance laws or regulations of an insurer’s state of domicile. For general insurance subsidiaries, dividends are generally limited over a 12-month period to 10% of the previous year’s policyholders’ surplus or previous year’s net income. For life, accident and health insurance subsidiaries, dividends are generally limited over a 12-month period to 10% of the previous year’s policyholders’ surplus or the previous year’s net gain from operations. Dividends paid in excess of statutory limitations require prior approval from the Insurance Commissioner of the insurer’s state of domicile.
Meanwhile Zurich Financial Services continues to be subject to certain solvency requirements based on the decree concerning the placement of the Zurich Financial Services Group under the supervision of insurance conglomerates issued by FOPI on September 25, 2006. This decree has been issued based on the new Swiss insurance supervisory law mentioned above and replaces the decree issued by FOPI on April 23, 2001.
Earnings per share Net income attributable to common shareholders (in USD Number of Per share Per share millions) shares (USD) (CHF) 1
Effect of potentially dilutive shares related to share-based compensation plans – 814,490 (0.18) (0.22)
Diluted earnings per share 3,168 145,355,821 21.80 27.11 1 The translation from USD into CHF has been done for information purposes only at the Group’s average exchange rates for the years ended December 31, 2006 and 2005, respectively.
Minority interests 525 459 1 Zurich Financial Services (Jersey) Ltd. repaid EUR 300 million of Series A Preference Shares to investors on March 16, 2006.
Minority interests include third-party equity interests as well as preferred securities.
On March 16, 2006, Zurich Financial Services (Jersey) Limited redeemed its 12,000,000 perpetual non-voting, non-cumulative Series A Preference Shares which have a par value of EUR 25 each (EUR 300,000,000).
The Group had 52,286 and 52,010 employees (full-time equivalents) as of December 31, 2006 and 2005, respectively. Personnel and other related costs incurred for the year ended December 31, 2006 and 2005, were USD 4,757 million and USD 4,884 million, including wages and salaries of USD 3,954 million and USD 3,903 million, respectively.
Defined benefit pension plans Employees of the Group’s operating companies are covered under various pension plans, the largest ones of which are in the United Kingdom, United States, Germany and Switzerland. Certain companies run defined benefit plans, some of which provide benefits related to final pensionable earnings and others provide cash balance plans, where the participants receive the benefit of annual contributions made by both employer and employee and a credit for the investment return achieved on the assets. Eligibility for participation in the various plans is either based on completion of a specified period of continuous service or from the date of commencement of employment. Benefits are generally based on each employee’s years of credited service and average compensation in the years preceding retirement.
For the defined benefit plans, total contributions to funded plans and benefit payments by the Group are currently expected to be about USD 344 million in 2007.
Other defined post-employment benefits Certain of the Group’s operating companies provide post-employment benefit programs covering medical care and/or life insurance. Eligibility in the various plans is generally based on completion of a specified period of eligible service and reaching a specified age. The programs typically pay a stated percentage of medical expenses reduced by deductibles and other coverage. The cost of post-employment benefits is accrued during the employees’ service period. The method of accounting and the frequency of valuations are similar to those for defined benefit pension plans.
The tables below show the funded status of the Group’s plans; this being the pension plan assets at fair value less the pension liability based on the present value of the obligation. Plans that are wholly unfunded are shown separately from funded plans.
Zurich Financial Services Group · Annual Report 2006 · Financial Report 96 Consolidated Financial Statements
For several of the Group’s wholly unfunded defined benefit plans there are assets within the Group that are designated, but not legally isolated, to meet the liabilities in those plans. Consequently, in accordance with IAS 19 these are not yet recognized as plan assets. However, to arrive at an economic net liability these assets would have to be netted against the present value of obligations. This is predominantly relevant for Germany where we carry a defined benefit obligation of USD 767 million as of December 31, 2006 without presenting any benefit for assets designated to support the liability.
Fair value of assets in USD millions, as of December 31 held in defined benefits plans – funded plans
As a matter of policy plan assets do not include equity securities issued by the Group, other financial instruments issued by the Group or property occupied by, or other assets used by the Group.
Effect of business combinations and other transfers (337) (18) – –
Zurich Financial Services Group · Annual Report 2006 · Financial Report 98 Consolidated Financial Statements
Effect of business combinations and other transfers 320 7 (4) –
Fair value of plan assets as of December 31 11,071 8,597 10 13
Weighted average as of December 31 assumptions used in determining the actuarial liabilities for defined benefit pension plans
The expected long-term rate of return on assets assumption is derived separately for each of the Group’s benefit plans. Each major asset class is assigned an expected long-term rate of return, net of investment expenses, appropriate for the environment in which that plan is invested. The overall expected long-term rate of return on assets for a plan is calculated as the weighted average of the expected return for each asset class, weighted by the plan’s target allocation to each asset class.
The actuarial assumptions of the healthcare cost trends rates have a significant impact on the amounts recognized. A one percentage point change in the health care cost trend rate would have the following effects on amounts recognized in 2006: Table 25.11
b) Defined contribution pension plans Certain of the Group’s operating companies sponsor defined contribution plans. Eligibility for participation in such plans is either based on completion of a specified period of continuous service or date of commencement of employment. The plans provide for voluntary contributions by employees and contributions by the employer which typically range from 3% to 15% of annual pensionable salary, depending on the employees’ years of service. The Group’s contributions under these plans amounted to USD 34 million and USD 11 million in 2006 and 2005, respectively.
Zurich Financial Services Group · Annual Report 2006 · Financial Report 100 Consolidated Financial Statements
b) Share-based compensation plans for employees The Group encourages employees to own shares of Zurich Financial Services and has set up a framework based on the implementation of either share options and/or performance share programs. Actual plans are tailored to meet local market requirements.
c) Share-based compensation plans for executives The Group operates long-term incentive plans for selected executives. These plans comprise the allocation of a target number of share grants and/or share option grants with the vesting of these share and option grants being subject to the achievement of specific financial performance goals. The Group can also make restricted share grants to selected employees, which provide share awards if the individual remains employed with the Group on selected dates in the future.
Executive long-term performance share plans Each year, selected executives are granted performance shares which vest over a period of three years, either on an annual basis or at the end of the three year period. Specific performance parameters are established for each of the Business Divisions and include, for example, return on equity or business operating profit objectives. The actual number of performance shares granted at the beginning of the performance period is determined such that the economic value is a defined percentage of the annual salary in the year of allocation. Actual awards under these plans are made fully in shares of Zurich Financial Services, of which 50% are sales-restricted for a further period of three years. There were a total of 640 and 787 participants in this plan as of December 31, d) Further information on performance share and option plans
Zurich Financial Services Group · Annual Report 2006 · Financial Report 102 Consolidated Financial Statements
Certain plan participants elected in 2002 to take their option award in the form of Share Appreciation Rights. Included in the number of shares under option in the table above are 67,801 and 70,902 shares as of December 31, 2006 and 2005, respectively, which will be settled through cash payments rather than through delivery of shares.
Options granted during the period 1 706,773 705,882 67 44 1 Number of options granted is shown as the number of shares under option granted during the period.
The risk-free interest rate was determined by using the seven year CHF swap rate applicable in 2006 and 2005. The fair value of any other share options granted during the year has been determined using the same methodology.
In the normal course of business, the Group enters into various transactions with related companies, including various reinsurance and cost-sharing arrangements. These transactions are not considered material to the Group, either individually or in aggregate. Parties are considered to be related if one party has the ability to control or exercise significant influence over the other party in making financial or operational decisions. The table below sets forth related party transactions reflected in the consolidated income statements and consolidated balance sheets.
Related party in USD millions transactions included in the consolidated financial statements
Related party in USD millions, for the years ended December 31 transactions – key personnel
No provision for non-repayment has been required in 2006 and 2005 for the loans or guarantees made to members of the Group Executive Committee.
Surplus Notes in USD millions, as of December 31 2006 2005 6.15% surplus note, due December 2013 88 88 6.15% certificates of contribution, due December 2013 523 524 6.15% certificates of contribution, due August 2014 296 296 6.00% certificates of contribution, due September 2006 – 107
Conditions governing payment of interest and repayment of principal are outlined in the surplus note and certificates of contribution. Generally, repayment of principal may be made only when the issuer has an appropriate amount of surplus, and then only after approval is granted by the issuer’s governing Board and the appropriate state insurance regulatory department in the US. In addition, payment of interest may generally be made only when the issuer has an appropriate amount of surplus and then only after approval is granted by the appropriate state insurance regulatory department in the US.
b) Quota share reinsurance treaties with the Farmers Exchanges The Farmers Exchanges cede risk through quota share reinsurance treaties to Farmers Reinsurance Company (”Farmers Re’’), a wholly owned subsidiary of FGI, and, to Zurich Insurance Company (”ZIC”).
Effective January 1, 2004, Farmers Re assumes annually USD 200 million and ZIC assumes USD 800 million of gross written premiums under an Auto Physical Damage (APD) Quota Share reinsurance agreement with the Farmers Exchanges. In addition, Farmers Re and ZIC assume a quota share percentage of ultimate net losses sustained by the Farmers Exchanges in their APD lines of business. The agreement, which can be terminated after 30 days notice by any of the parties, also provides for the Farmers Exchanges to receive a ceding commission of 18% of premiums, with additional experience commissions that depend on loss experience. This experience commission arrangement limits Farmers Re and ZIC’s potential underwriting gain on the assumed business to 2.5% of premiums assumed.
Effective January 1, 2006, the Farmers Exchanges modified the terms of the APD agreement with Farmers Re and ZIC. The new agreement provides for annual ceded premiums of USD 1 billion of gross written premiums with 20% assumed by Farmers Re and 80% assumed by ZIC, a 25.8% ceding commission for acquisition expenses, and an 8.2 % ceding commission for unallocated loss adjustment expense. The agreement also includes provisions for additional experience commissions that will depend on loss experience and recoveries below a specified ratio for each year. This experience commission arrangement limits Farmers Re and ZIC’s potential underwriting gain on the assumed business to 2.0% of premiums assumed plus 20% of the underwriting gain resulting from a combined ratio under 98%. The agreement, which can be cancelled after 90 days notice by any of the parties, has a termination date of December 31, 2008.
Exchanges’ catastrophe losses are subject to a maximum of USD 800 million. Farmers Re and ZIC assumed USD 19.2 million and USD 76.8 million, respectively, of maximum annual catastrophe losses. This reinsurance agreement, which can be terminated after 60 days notice by any of the parties, also provides for the Farmers Exchanges to receive a provisional ceding commission of 22% of premiums for acquisition expenses, 8.8% of premiums for unallocated loss adjustment expenses and 5.3% of premiums for other expenses with additional experience commissions potentially payable depending on loss experience.
Effective December 31, 2005, the 12% All Lines agreement was amended and the quota share participation ratio was reduced to 6%. As a result, Farmers Re and ZIC assume a 1.2% and 4.8% respective quota share of the premiums written and the ultimate net losses sustained in all lines of business written by the Farmers Exchanges after the APD reinsurance agreement has been applied. In addition, under this treaty the Farmers Exchanges’ catastrophe losses are subject to a maximum of USD 800 million. Farmers Re and ZIC may assume USD 9.6 million and USD 38.4 million, respectively, of the maximum Farmers Exchanges’ catastrophe losses subject to under this treaty.
For the year ended December 31, 2006, Group companies assumed USD 740 million of gross written premiums (USD 1,153 million in the prior year) from the Farmers Exchanges under the All Lines Quota Share reinsurance agreement.
Zurich Financial Services Group · Annual Report 2006 · Financial Report 106 Consolidated Financial Statements
Future rent commitments The Group has entered into various operating leases as lessee for office space and certain computer and other equipment. Lease expenses totaled USD 163 million and USD 155 million for the years ended December 31, 2006 and 2005, respectively.
Future payments in USD millions under non-cancelable operating leases with terms in excess of one year
In common with other groups with life assurance businesses in the UK, the Group remains exposed to a number of Conduct of Business issues, some of which are currently under review by the Financial Services Authority in the UK. While provisions are maintained which reflect management’s best evolving estimate of the probable costs and expenses of resolving these matters, significant uncertainty regarding the ultimate cost remains. The main area of uncertainty concerns sales advice related complaints. The key assumptions used to derive the complaint provision are the volume of complaints, both those already recorded and an assumption as to the level of future complaints, the percentage of complaints which will be successful (the uphold rate), the average redress payable per complaint and the expenses of reviewing each case or complaint. The assumptions used to set the provision have been based on actual experience over the past three years weighted towards more recent experience.
In 2003, the Group completed the divestment of various asset management operations. As part of these agreements, the Group has guaranteed certain minimum levels of “assets under management” to the acquirers. The guarantees provide that if the “assets under management” fall below those defined levels under certain conditions, the Group may be required to compensate for these shortfalls. The compensation is limited to the considerations received and the Group does not believe any such compensation to be probable.
The Group has entered into previously announced regulatory settlements (Multi-State and Three-State Agreements) in connection with investigations in the US concerning certain business practices involving insurance brokers and insurance companies. In July 2006, the Group also entered into a settlement agreement to resolve consolidated class-action litigation concerning those matters. The class-action settlement agreement, including plaintiffs’ attorney fees, is subject to final approval by the court. In addition, the Group and its subsidiaries are involved in investigations in the US regarding certain reinsurance transactions engaged in by the Group and its subsidiaries. Other Group subsidiaries are also involved in industry-wide legal proceedings regarding financing hedge funds engaged in mutual-fund market-timing activities. The Group continues to cooperate with all remaining regulatory investigations. Furthermore, Zurich Financial Services is a defendant in private class-action securities litigation relating to its divestiture of its interest in Converium Holding AG. On December 28, 2006, the Court granted Zurich Financial Services’ motion to dismiss all claims filed against it in that litigation. Plaintiffs moved for reconsideration on January 12, 2007. Zurich Financial Services intends to defend this litigation vigorously.
The outcome of unresolved current legal proceedings, claims, litigation and investigations could have a material effect on operating results and/or cash flows when resolved in a future period. Management is, however, not aware that these matters would materially affect the Group’s consolidated financial position.
Losses and loss adjustment expenses, net of reinsurance 19,860 20,963 88 109
Underwriting and policy acquisition costs, net of reinsurance 4,941 4,506 1,448 1,561
Significant non-cash expenses: Depreciation and impairments of fixed assets 76 83 47 42
Reserves for losses and loss adjustment expenses, gross 59,251 54,715 131 130
Reserves for losses and loss adjustment expenses, net 47,396 42,195 103 110
Policyholders’ contract deposits and other funds, net 914 846 13,999 13,741
Reserves for insurance contracts, net 60,798 54,505 136,813 120,455 1 Other related intangible assets consists of the present value of profits of acquired insurance contracts and attorney-in-fact relationships.
Zurich Financial Services Group · Annual Report 2006 · Financial Report 114 Consolidated Financial Statements
To the General Meeting of Zurich Financial Services, Zurich As auditors of the Group, we have audited the consolidated financial statements (income statement, balance sheet, statement of cash flows, statement of changes in equity and notes on pages 27 to 114) of Zurich Financial Services for the year ended December 31, 2006.
Significant subsidiaries as of December 31, 2006 Book value of common stock (in Voting Ownership local currency
ZG Investments II Ltd. Hamilton Corporate Functions 100.00 100.00 USD 0.01
ZG Investments IV Ltd. Hamilton Corporate Functions 100.00 100.00 USD 0.01
Zurich International (Bermuda) Ltd. Hamilton Other Businesses 100.00 100.00 USD 9.9
Zürich Beteiligungs-Aktiengesellschaft (Deutschland) Frankfurt / Main General Insurance 100.00 100.00 EUR 152.9
as of December 31, 2006 Book value of common stock (in Voting Ownership local currency
Zurich Financial Services EUB Holdings Limited Dublin Other Businesses 100.00 100.00 GBP 0.001
Zurich Life Insurance Italia S.p.A. Milan Life Insurance 100.00 100.00 EUR 25.9
Zurich - Companhia de Seguros S.A. Lisbon General Insurance 100.00 100.00 EUR 10.0
Eagle Star Holdings Limited Swindon, England Corporate Functions 100.00 100.00 GBP 553.7
ZPC (Construction) Company Limited Fareham, England General Insurance 100.00 100.00 GBP 54.0
Zurich Assurance Ltd Swindon, England Life Insurance 100.00 100.00 GBP 236.1 2) Listed on the Johannesburg Stock Exchange. On December 31, 2006, the company had a market capitalization of ZAR 1,906.1 m (ISIN Number 000006243).
Zurich Financial Services (UKISA) Limited Swindon, England Corporate Functions 100.00 100.00 GBP 1,492.1
Zurich International (UK) Limited Portsmouth, England General Insurance 100.00 100.00 GBP 40.0
Zurich Invest (Jersey) Ltd. Jersey, Channel Islands General Insurance 100.00 100.00 CHF 0.1
Centre Reinsurance Holdings (Delaware) Limited Wilmington, DE Other Businesses 100.00 100.00 USD 0.00002
Crown Management Services Limited Wilmington, DE Other Businesses 100.00 100.00 USD 0.00003
The EV methodology adopted by Zurich is based on a “bottom-up” market consistent approach to allow explicitly for market risk. In particular: • asset and liability cash flows are valued using risk discount rates consistent with those applied to similar cash flows in the capital markets; and
• options and guarantees are valued using market consistent models calibrated to observable market prices.
In line with the European Embedded Value Principles, the EV is broken down into the following components: • shareholders’ net assets, including free surplus and required capital allocated to covered business; and
The adoption of the European Embedded Value Principles does not affect the basis of reporting the statutory results, the regulatory capital position or the dividend paying capacity of Zurich. EV is derived from the local statutory, regulatory and IFRS financial statements of Zurich’s Global Life entities and is presented net of minority interests. However new business value is shown before deduction of minorities.
EV information in this supplement includes: • Summary of Embedded Value results; • Geographical analysis of Embedded Value results; • Embedded Value methodology; • Embedded Value assumptions.
EV as of December 31, 2006 and the previous year comparatives, as well as the new business value, the analysis of movement and the sensitivities have been subject to external review by Deloitte & Touche LLP. Their Statement of External Review is set out in section 6.
2. Summary of Embedded Value results a) Embedded Value of Global Life
The shareholders’ net assets are based on local statutory accounting adjusted to reflect shareholders’ interest in the market value of net assets after the exclusion of goodwill and other necessary actuarial adjustments.
A breakdown of the EV results by geographical region is set out in section 3 below. A definition of the EV components is given in section 4.
b) New business New business value is the value added by new business written, calculated at the point of sale, without any value from future new business sales. It is calculated consistently with Zurich’s EV methodology and assumptions as explained for the value of business in-force in section 4.
New business 1 in USD millions, for the years ended December 31 volumes
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 mostly relates to subsidiaries in Germany.
Present value of new business premiums (PVNBP) 18,589 18,017 c) Analysis of movement in Embedded Value The following table provides an analysis of the movement in the EV for the covered business from December 31, 2005 (opening EV) to December 31, 2006 (closing EV). The analysis is shown separately for shareholders’ net assets and the value of business in-force, and includes amounts transferred between these components.
Expected transfer from value of business in-force to shareholders’ net assets, after tax 956 (956) 0
The other components of the movement in EV are: Economic variance, after tax arises from the differences between the actual investment returns in the period and the expected investment returns based on economic assumptions as at the start of year, and allows for the change in future economic assumptions between the start and end of the period. It also includes the impact of legal and regulatory changes in the period.
Foreign currency translation effects represent the impact of currency movements over the year. Closing EV before foreign currency translation effects is based on beginning of year exchange rates.
d) Reconciliation of IFRS net assets to Embedded Value for covered life business
Embedded Value 14.1 1 Intangible assets are defined as deferred policy acquisition and origination costs and other intangible assets less front end fees.
Zurich Financial Services Group · Annual Report 2006 · Financial Report 126 Embedded Value Report
e) Sensitivities A number of sensitivities have been produced to indicate the sensitivity of the EV and the new business value to changes in certain assumptions. These are in line with the CFO Forum’s Additional Guidance on European Embedded Value Disclosures issued in October 2005.
Economic sensitivities 100 basis points increase in risk free yield curve (271) 16 100 basis points decrease in risk free yield curve (481) (62)
10% increase in implied volatilities for equities and properties (213) (33)
• 100 basis points increase and decrease in the risk free yield curve across all durations; • 10% fall in equity and property market values (EV only, this is not applicable for new business); • 100 basis points increase in the discount rates (e.g. a discount rate of 6% p.a. would increase to 7% p.a.); • 10% increase in implied equity and property volatilities (e.g. 15% p.a. would increase to 25% p.a.); • 10% increase in implied risk free volatilities (e.g. 15% p.a. would increase to 25% p.a.); Operating sensitivities
In each sensitivity calculation, all other assumptions remain unchanged except where they are directly affected by the revised conditions. The results include any impact of the assumption change on the time value of options and guarantees.
A decrease in yield curve creates an increase in the cost of options and guarantees which outweighs the improvement in value of products with fixed cash flows.
Zurich has estimated the EV of these businesses based on the same principles as the covered business, including deductions for time value of options and guarantees, frictional costs and cost of non market risks, but using more approximate models. The results are set out as follows: Table 2.10
Geographical In USD millions, analysis of value as of December 31, 2006 of business in-force – 2006
Cost of non market risk (115) (248) (30) (49) (83) (64) (589)
Geographical In USD millions, analysis of value as of December 31, 2005 of business in-force – 2005
Time value of options and guarantees The change in the time value of options and guarantees from 2005 to 2006 reflects the following: • In the US, the reduction was mainly related to the higher market yield curve in 2006, which reduced the overall exposure to market risk on interest and surrender guarantees from universal life and interest sensitive deferred annuity business.
• In the UK, the increase was due to significant unit linked business with guarantees on death written during 2006, partially offset by good investment performance. For with profits business, management has in place an investment matching strategy which includes the use of derivative hedging and which mitigates the time value of options and guarantees for 2006 and the prior year.
• In Germany, the significant reduction reflects the increase in the risk free yield curve and the reduction of interest rate implied volatilities over the period. The average interest guarantee in respect of the conventional business remains at 3.5% while the ten year risk free rate increased from 3.6% in 2005 to 4.2% for 2006. The time value of options and guarantees is mainly related to guaranteed minimum interest rates as well as guaranteed surrender values and annuity options.
• In Rest of Europe, the reduction is mainly due to the lower implied volatilities for the Euro interest rates and the increase in the risk free rates. Most of the countries have profit sharing rules with guarantees on maturity and surrender similar to those in Germany, or in the case of Ireland, similar to those in the UK.
Cost of non market risk The change in the cost of non market risk from 2005 to 2006 reflects the following: • In the US, the cost of non market has increased due to the mortality risk associated with the significant portion of term assurance business and the higher market yield curve in 2006.
• In the UK, the slight increase is mainly due to a revision of expense allocations which has an impact on the operational risk allowance.
• In International Businesses, the increase was broadly in line with the growth in business in-force. Our Japanese business writes mainly cancer and critical illness protection products and our Chilean business is a significant writer of immediate annuities.
New business In USD millions, volumes for the years ended December 31
New business In USD millions, for the years ended December 31 value, after tax
New business 1 In USD millions, for the years ended December 31 value, before tax
New business value, as % APE as % PVNBP before tax 1 In certain countries particularly the UK, where life insurance companies pay tax in respect of both policyholders and shareholders, the results shown in the above table are before shareholders’ tax and after allowing for policyholders’ tax.
Geographical In USD millions, analysis of for the year ended December 31, 2005 new business value, after tax – 2005
Cost of non market risk (10) (6) (8) (4) (14) (7) (49)
Zurich Financial Services Group · Annual Report 2006 · Financial Report 132 Embedded Value Report
• In Germany, there was an increase in new business value, mainly driven by a reduction in time value of options and guarantees. The new business written in 2006 has reduced the time value of options and guarantees for the business written in prior years and this produces the positive time value for new business. Additionally, synergies following the merger of the life entities and the revision of lapse and mortality assumptions improved the new business value.
c) Analysis of movement in Embedded Value from December 31, 2005 to December 31, 2006
InterUnited United Switzer- Rest of national States Kingdom Germany land Europe Businesses
New business value, after tax 59 94 126 33 151 52
Closing Embedded Value before foreign currency translation effects 2,327 4,515 1,163 1,457 2,374 1,089
• In the US, operating profit includes a significant contribution from new business value and the benefit of improvements in the mortality experience assumption. Actual mortality and persistency experience was also favorable during 2006. Economic variance reflects a change in the shape and level of the risk free yield curve offset by actual investment returns on shareholders’ net assets.
• In Switzerland, operating profit includes a significant contribution from new business value. Positive effects include the clarification of the Bonus Fund requirements, the allowance for asset management fees, and the implementation of an interest rate hedge. The economic variance reflects the impact of the increase in the risk free yield curve at short to medium durations as well as a strong increase in unrealized gains on equity and property.
• In Rest of Europe, principally the Isle of Man, Ireland, Italy and Spain, operating profits include a significant contribution from new business value. A review of mortality assumptions in Ireland, and a reduction in the lapse assumption for the Isle of Man, increased the operating profit. This has been offset by expense increases in Italy and an update of the persistency assumptions for Ireland. Economic variance reflects the reduction in the corporate tax rate for Spain and the increase of the risk free yield curve for the Euro zone. This was partly offset by exchange rate movement in the Isle of Man.
• In International Businesses, operating profit includes a significant contribution from new business value in particular from Hong Kong. The revision of the persistency assumptions for Chile and Australia in line with improved experience also enhanced the operating profit. Economic variance reflects the reduction in the risk free yield curve in Chile from 2005.
a) Covered business Covered business includes all business written by companies that are included in Global Life, in particular: • life and critical illness insurance; • savings business (with profit, non-profit and unit-linked); • pensions and annuity business; and,
b) Calculation of Embedded Value EV presented in this document is derived through calculations which are performed separately for each business unit. Enhanced models to produce market consistent valuations have been developed by each of our life businesses.
Zurich Financial Services Group · Annual Report 2006 · Financial Report 134 Embedded Value Report
d) Shareholders’ net assets Shareholders’ net assets represent the market value of net assets held in respect of the covered business, and consist of the required capital and free surplus. The level of required capital reflects the amount of capital considered by the Directors to be appropriate to manage the business. The free surplus comprises the market value of shareholders’ net assets allocated to the covered business in excess of the assets backing the required capital.
The shareholders’ net assets are based on local statutory and regulatory accounting. Adjustments are made to shareholders’ net assets where appropriate, for example in respect of any unrealized gains attributable to shareholders. Any such adjustments are made consistently with the calculation of the value of business in-force.
Zurich’s approach to the cost of non market risk is based on a valuation of the potential impacts on shareholder value of variance in certain best estimate assumptions to allow explicitly, at product level, for insurance (mortality, longevity and morbidity), business and operational risk.
The mortality, morbidity and expense assumptions used to calculate the value of business in-force and new business value are best estimates based on recent past experience. To the extent that the impact on shareholder value of variations in experience around the best estimate is symmetrical (for example, where the loss on a 10% increase in expenses is equal and opposite to the profit on a 10% reduction), and not correlated with investment markets, no further allowance for non market risk would be required. In such circumstances, the risk is considered to be diversifiable, and financial markets do not charge a risk premium for diversifiable risks.
The new business is valued as at point of sale. Explicit allowance is made for frictional costs, time value of options and guarantees and cost of non market risk.
The value generated by new business written during the period is the present value of the projected stream of after tax distributable profits from that business. It has been calculated on the same market consistent approach as used for in-force business, using the same economic and operating assumptions as used to determine the EV as of the end of the year.
• Germany has used initial asset and liability data as of September 30, which have been projected to December 31 allowing for expected investment performance, new business, and policy movements. Adjustments have been made to the projected data to reflect actual positions such as policyholder bonus reserves as of December 31. New business value has been adjusted to allow for all business written to December 31.
h) Market consistent discounting Zurich has adopted a “bottom-up” market consistent approach for the projection and discounting of future cash flows in the calculation of the EV. As a result, the risks inherent in the cash flows are allowed for in a way that is consistent with the way the market is expected to allow for such risks.
The risk free yield curve assumptions are based on the swap curve in each major currency (US dollars, Euros, British pounds sterling and Swiss francs).
The calculations of the time value of options and guarantees are based on stochastic simulations using an Economic Scenario Generator (“ESG”) provided by Barrie & Hibbert. The outputs (“simulations”) have been calibrated to conform to the economic parameters specified by Zurich. The approaches used to prepare these simulations are described below.
• For US, UK, Germany, Switzerland and Ireland, the simulations used for calculation of time value of options and guarantees reflect the actual yield curves observable as of December 31, 2006 and implied volatilities quoted by a number of investment banks as of November 30.
j) Corporate Center costs Corporate Center costs that relate to covered business have been allocated to the relevant companies and included in the projected expenses. These are fully taken into account in the EV.
In the UK, a multi-tie distribution company called Openwork has replaced the former tied distribution network. This is included in the EV on a “look through” basis. After allowance for certain one-off expenses, profits and losses are attributed to new business value. Certain future revenue streams, mainly renewal commissions on business sold, are discounted and contribute to the new business value and to the value of business in-force.
In Switzerland, an investment management company provides asset management services to external pension schemes written in foundations and other pension funds. The present value of the net asset management fees, after tax, is included in the EV and the new business value.
q) Change in legislation or solvency regime. The impacts of changes in legislation or solvency regime are generally included in economic variance for the purpose of the analysis of movement.
• the way that different asset returns are correlated with each other.
Choice of “risk free yield curve” The risk free yield curve is derived from mid-market swap rates applicable to each economy as of December 31, 2006. This curve was used to extract forward reinvestment yields that are used for all asset classes.
These yield curves are consistent with the assumptions used by investment banks to derive their option prices, and hence their use ensures consistency with the derivation of implied volatilities. They also have the advantage that they are available for most of the markets in which Zurich operates.
Risk free yield as of December 31, 2006 curves – Annualised spot rates 1 Year 2 Year 5 Year 10 Year 20 Year 40 Year
Domestic yield curves are also used for businesses in other countries, except Hong Kong and Argentina which use US dollar, as their liabilities are principally US dollar denominated.
Implied asset volatility The volatility statistics shown below are based on analysis of the ESG output data, and hence show the economic projection assumptions produced by the ESG for the four main currencies.
Interest volatility can be described by the implied volatility of interest rate swaptions. Swaption implied volatilities vary both by the term of the option and also the term of the underlying swap contract. The following tables show swaption implied volatilities, based on the simulations used for the EV calculation: Table 5.2
Implied volatility as of December 31, 2006 of at-the-moneyforward interest rate swaptions 1 year 2 year 5 year 10 year 20 year 40 year option option option option option option
At-the-moneyas of December 31, 2006 forward equity implied volatility (capital index)
At-the-money- as of December 31, 2006 forward property implied volatility (capital index)
Exchange rates EV for December 31, 2006 and 2005 have been translated using the respective balance sheet exchange rates. The analysis of movements, including new business, has been translated at December 31, 2005 balance sheet exchange rates.
Demographic assumptions The assumed future mortality, morbidity and lapse rates have been derived from recent operating experience. Where appropriate, surrender and option take-up rate assumptions that vary according to the investment simulation under consideration have been used, based on our assessment of likely policyholder behavior.
The maintenance expense assumptions allow for the expected cost of providing future service benefits in respect of the Group staff pension schemes. Consistent with the treatment of not including any past service pension scheme surpluses within the EV, no allowance is made in the expense assumptions for any contributions as a result of past service benefits.
Where service companies have been valued on a look through basis, the value of profits or losses arising from these services have been included in the EV and the new business value.
In many life businesses, policyholders can exercise an option against the life company in certain circumstances, such as to surrender a policy. This then leads to an increase in the assumed lapse rates when interest rates rise (or a corresponding reduction when interest rates fall). This dynamic effect in relation to lapse rates has been allowed for in the stochastic models.
As investment conditions change, where a business unit’s investment policy indicates that Management would expect to alter the investment portfolio (e.g. the mix between equities and fixed interest for profit sharing subfunds ), this expected action has been included in the stochastic models.
• Zurich’s Embedded Value and New Business Value have been properly compiled on the basis of the methodology and assumptions chosen by Zurich and are compliant with the CFO Forum Principles.
New business premiums including deposits, of which: 185 192 5,540 5,036
Present value of new business premiums (PVNBP) 1,039 1,070 6,729 6,987
Embedded value information: Operating profit expected from in-force business and shareholders’ net assets, after tax 152 176 269 398
Closing Embedded Value before foreign currency translation effects 2,327 2,167 4,515 5,145
Closing Embedded Value after foreign currency translation effects, of which: 2,327 2,167 5,133 4,619
Operating return expected from in-force business and net assets, after tax 7.0% 8.8% 5.8% 7.4%
New business margin, after tax (as % of APE) 52.0% 64.4% 12.2% 9.9%
New business margin, after tax (as % of PVNBP) 5.7% 6.7% 1.4% 1.1%
New business margin, after tax (as % of PVNBP) 2.3% 1.9%
Zurich Financial Services Group · Annual Report 2006 · Financial Report 146 Embedded Value Report
Zurich Financial Services was incorporated on April 26, 2000, with a share capital of CHF 100,000. As of December 31, 2006, the shareholders’ equity totaled CHF 16,779,678,184 (December 31, 2005: CHF 16,472,848,630).
Its principal activity is the holding of subsidiaries. Revenues consist mainly of dividends and interest. The net income of Zurich Financial Services was CHF 1,187,995,724 for 2006 (CHF 781,121,406 for 2005).
in CHF thousands, for the years ended December 31 Notes 2006 2005
Total liabilities and shareholders’ equity 16,807,019 16,519,714 1 Dividends paid in the year, proposed in association with the 2005 result
1. Basis of Presentation Zurich Financial Services presents its financial statements in accordance with Swiss law.
4. Taxes The tax expense consists of income, capital and other taxes.
5. Investments in subsidiaries Investments in subsidiaries include a 57% interest in Zurich Group Holding with a carrying value of CHF 6,064,302,120 (prior year CHF 6,064,302,120) and a 100% interest in Allied Zurich p.l.c., with a carrying value of CHF 4,595,865,096 (prior year CHF 4,595,865,096). Allied Zurich p.l.c. holds the remaining 43% interest in Zurich Group Holding. Additionally, Zurich Financial Services holds 49,000 shares of Zurich Insurance Company with a book carrying value of CHF 2,750,190 (prior year CHF 2,750,190).
Average selling price, in CHF 281 204 1 in CHF thousands 9. Shareholders The shares registered in the share ledger as of December 31, 2006, were owned by 112,662 shareholders of which 106,839 were private individuals holding 20.1% of the shares (or 11.8% of all outstanding shares), 2,226 were foundations and pension funds holding 8% of the shares (or 4.7% of all outstanding shares), and 3,597 were other legal entities holding 71.9% of the shares (or 42% of all outstanding shares).
Zurich Financial Services Group · Annual Report 2006 · Financial Report 154 Zurich Financial Services Holding Company – Financial Statements
The Board of Directors proposes a dividend of CHF 11.00 per share to the Annual General Meeting on April 3, 2007.
Manfred Gentz 1 These figures are based on the issued and outstanding share capital on July 3, 2006. The proposed dividend published in the Annual Report 2005 was CHF 662,432 thousand resulting in a balance carried forward of CHF 780,785 thousand. The change was due to a resolution by the Board of Directors on February 15, 2006, according to which, out of contingent share capital, up to 1,000,000 shares could have been allocated for issuance to share based incentive plans. As of July 3, 2006, 558,300 shares have been issued out of the contingent capital.
To the General Meeting of Zurich Financial Services, Zurich As statutory auditors, we have audited the accounting records and the financial statements (income statements, balance sheets and notes on page 150 to 154) of Zurich Financial Services for the year ended December 31, 2006.
In our opinion, the accounting records and financial statements and the proposed appropriation of available earnings on page 155 comply with Swiss law and the company’s articles of incorporation.
Effective October 2, 2006, Zurich Financial Services cancelled its secondary listing of Zurich Financial Services shares on the London Stock Exchange and such shares were de-listed from the Official List of the United Kingdom Listing Authority. Following the de-listing, Zurich Financial Services shares will no longer be traded on the London Stock Exchange’s market for listed securities but will continue to be listed on the SWX EU-Compatible Segment.
Zurich Financial Services shareholders registered in the share ledger Private individuals20%
According to the information available to us on December 31, 2006, no shareholder of Zurich Financial Services held 5 percent or more of the voting rights of the issued share capital.
To CDI holders within the Zurich Financial Services Corporate Nominee Service with Lloyds TSB Registrars: payable within the week following April 22, 2007
Hard of hearing (text phone, domestic): 0121 415 7028 Web site: www.shareview.co.uk
American Depositary Receipts Zurich Financial Services has an American Depositary Receipt program with The Bank of New York (BNY). For more information call BNY’s ADR Services Center in the USA +1-888-BNY-ADRs (1-888-269-2377) or outside the USA on +1-212-815-3700.
The Corporate Review contains a description of the Group’s performance as well as risk management report, corporate governance and remuneration reports. The Corporate Review is published in English, German and French.
Business segment We have primary and secondary segments. Our primary segments are General Insurance, Global Life, Farmers Management Services, Other Businesses and Corporate Functions. Our secondary segments are geographic: North America, Europe, International Businesses and Central Region.
Business division We have four General Insurance business divisions: Global Corporate; Europe General Insurance; North America Commercial; International Businesses. Each focuses on specific customer segments, giving the Group a broad footprint across a diverse range of geographies, customers and insurance needs.
Income Statement Zurich’s financial statement that summarizes revenues and expenses for a specific period. Also known as an operating statement or profit and loss statement.
Net Underwriting Result The remaining profit/(loss) after deducting insurance losses and other technical expenses from net earned premiums.
New Business Margin The value added by new business at point of sale, divided by the new business premiums written over the period (measured on an Annual Premium Equivalent basis (APE).
Zurich Basics Zurich’s core values and basic principles, constituting our Group’s code of conduct.
The offer to repurchase securities of Zurich Financial Services is not made in the United States of America and to US persons and may be accepted only by non-US persons and outside the United States. Offering materials with respect to this offer may not be distributed in or sent to the United States and may not be used for the purpose of solicitation of an offer to purchase or sell any securities in the United States.
Printed end of February 2007 by St Ives Westerham Press Ltd., England
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