MIGDAL INSURANCE AND FINANCIAL HOLDINGS LTD. - BOARD OF DIRECTORS' REPORT AS OF SEPTEMBER 30 TH, 2004

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1 MIGDAL INSURANCE AND FINANCIAL HOLDINGS LTD. - BOARD OF DIRECTORS' REPORT AS OF SEPTEMBER 30 TH, 2004 The Board of Directors' Report for September 30 th, 2004 reviews the main changes in the activities of the Company in January-September 2004 (the report period ). The report makes the assumption that the reader also has the Directors' Report and the full Financial Statements for A. DESCRIPTION OF THE COMPANY 1. Organizational structure and areas of activity ( Migdal Holdings or the Company ) is a holding company that holds full control of the shares of Migdal Insurance Company Ltd. ( Migdal Insurance ) and Migdal Investments Management 2001 Ltd. ("Migdal Investments Management ). The principal shareholders of Migdal Holdings are Assicurazioni Generali S.p.A. ( Generali ), which, together with its subsidiaries, hold approximately 64% of the Company's shares, and Bank Leumi le-israel Ltd. ( Bank Leumi ) and its subsidiary which hold approximately 20% of the Company's shares. The shares of Migdal Holdings are listed for trading on the Tel Aviv Stock Exchange. The main areas of activity of the Migdal Holdings Group are the various kinds of life assurance, provident funds management, pension funds management, all branches of general insurance and health insurance. Along with these activities, the Group is also active in the management of various investments, including entry into the financial services and financial assets management sector for customers. The Group is the largest in the life assurance line in Israel, and fourth in general insurance. As per data published by the Israeli Insurance Association, in 2003, the Group's life assurance premium constituted approx. 32.5% of total premium in life assurance line, and the Group's general insurance premium constituted approx. 10% of total premium in general insurance. Migdal Insurance Group consists of insurance companies - Migdal Insurance Co. Ltd. ("Migdal"), and The Magen Insurance Co. Ltd. ("The Magen"), managed jointly on the operational level, with the exclusion of various limitations and restrictions; Managing companies of pension funds - Yozma Pension Fund for Self-employed (old fund), Migdal Pension Funds Management Ltd., which manages the pension funds New Yozma and Tnufa, and Te'utza Yield and Service Ltd. ("Te'utza") which manages Te'utza pension fund; as well as provident funds management companies that manage an educational fund, a provident fund for retirement benefits and severance pay, and an employer fund for severance pay. In light of the Group's policy to expand its activity in the market of pension settlements, during the report year the Company acquired Te'utza and it is about to acquire New Makefet Management of Pension and Provident Funds Ltd. ("Makefet") (see Articles 5a and c hereinafter). Migdal Insurance Group also includes insurance agencies, whose holdings are concentrated in the consolidated company Migdal Holdings and Management of Insurance Agencies Ltd. ("Migdal Agencies"). The Group includes companies active in investments, finance and credit, which are held by the consolidated company Migdal Eshkol Finansim B.M. ( Eshkol Finansim ). Migdal Investments Management, which concentrates the Group s financial, non-insurance activity, includes Migdal Capital Markets (1965) Ltd. ( Migdal Capital Markets ), which deals with management of investment portfolios and Stock Exchange services for customers, consulting, escorting and underwriting in issuances, as well as management of mutual funds and provident funds.

2 Migdal Investments Management signed a letter of intent for the sale of 50% of its holdings in Migdal Capital Markets to Bear Stearns Asset Management (BSAM) in order to expand the Company's businesses, in cooperation with an overseas company which deals with this field. Within the framework of concentrating financial activity in Migdal Capital Markets, Migdal Management of Provident Funds Ltd. shall be held by Migdal Capital Markets (see Article 5b hereinafter), so most of the Group's holdings in provident funds shall be concentrated within Migdal Capital Markets, accompanied by the operation, marketing and other services of Migdal Insurance and its distribution system. Migdal Holdings has an investment recorded as "permanent investment" in negotiable securities of an interested party, Bank Leumi. After the date of the balance sheets, the Company sold part of its holdings in these securities to IDB Development Corporation Ltd. ("IDB") (see Article 5d hereinafter). 2. Composition of revenues and insurance reserves Aggregate premium, including fees, from life assurance and general insurance amounted to approximately NIS 4.8 billion, similar to the same period in Insurance premiums from life assurance constituted approximately 71% of all premiums, and general insurance premiums accounted for approximately 29% of total premiums (similar to the same period in 2003). The Group's insurance reserves (including outstanding claims) before deduction of re-insurance as of September 30 th, 2004 amount to NIS 39.1 billion, of which, life assurance reserves are approximately NIS 35.8 billion (of which about NIS 19.8 billion profit participating life assurance policy reserves) and general insurance reserves are approximately NIS 3.3 billion. The Group's insurance reserves (including outstanding claims) before deduction of re-insurance as of September 30 th, 2003 were approximately NIS 36.1 billion, of which, life assurance reserves amounted to approximately NIS 33.0 billion (out of which NIS 16.8 billion profit participating life assurance policy reserves) and general insurance reserves were approximately NIS 3.1 billion. The reserves are invested mainly in "Hetz" designated government bonds, in negotiable and non-negotiable securities, in loans, deposits and other investments. 2

3 The composition of revenues in the report period is as per the following details: Premium composition in life assurance: Reported premium in business report 1-9/ /2003 NIS m. % NIS m % Current 3, , Single premium Total premium 3, , Premium composition including fees in general insurance: Property motorcar Compulsory motorcar bodily injury Liabilities Loss of property Health Other Total 1, , Premium composition including fees in general insurance net of re-insurance: Property motorcar Compulsory motorcar bodily injury Liabilities Loss of property Health Other Total 1, ,

4 3. Dependence on clients or marketing factors Migdal operates through agents, and most of them work with other companies as well. The Group has one agency (a consolidated company) whose rate of sales out of total Group sales in life assurance, in the reported period, exceeds 10% (17%). In the Group there are no agents whose rate of sales out of Group sales in general insurance exceeds 10%. 4. Changes and developments in re-insurance In 2004 there is no significant change in re-insurance conditions compared with those of During , there was a decrease in the scope of re-insurance, due to the collapse of reinsurers or a significant downgrade of their credit rating, and due to a significant hike of tariffs and a decline in covers. As a result, the number of re-insurers with whom Migdal Insurance and The Magen work has decreased significantly, so the relative share of each of them in the companies' re-insurance portfolio increased. There are three re-insurers, including Generali, the Company's controlling shareholder, whose share in general insurance re-insurance premium in the reported period exceeds 10%. 5. Special issues a. On September 2 nd, 2004, Migdal was declared, together with an overseas company, Famfox Amsterdam Investments B.V. (Famfox) as the preferred offerer in a competitive process for the acquisition of all Makefet's shares, so that Migdal shall hold 50.9% of Makefet and Famfox shall hold 49.1% (Generali, the Company's controlling shareholder, has an interest in Famfox). The acquisition price is approx. NIS 201 million. Makefet manages the new pension funds: Makefet Personal, Makefet Complementary, as well as benefit provident funds. The execution of the acquisition is subject to the approval of the Anti-Trust Director General and a holding permit and a control permit by the Commissioner of Insurance. As of the date of the financial statements, the approval of the Anti-Trust Director General has been received and the permits of the Commissioner of Insurance have been received as well. b. Migdal Investments Management and Bear Stearns Asset Management (BSAM), an American investments management company, signed a letter of intent for the acquisition of 50% of Migdal Capital Markets shares by BSAM for $12.5 million. The companies are outlining a detailed agreement. After a detailed agreement is signed, the completion of the transaction will be subject to receiving the approvals required as per the regulatory arrangement. Subject to the completion of details as mentioned above, the sale may yield a capital profit of up to approx. NIS 11 million, net, to Migdal Investments. The objective of introducing BSAM as a partner in Migdal Capital Markets is to establish a large investment entity with expertise, products and financial services overseas, which will complete Migdal Capital Markets' wide array of products and services. c. On June 30 th, 2004, Migdal purchased all Te'utza's subscribed and issued share capital from its shareholders for approx. NIS 16.5 million. Teu'tza is a company managing Te'utza Pension Fund (a new comprehensive pension fund) and a general pension fund being established. In 2003, Te'utza's net contributions amounted to NIS 147 million (4.1% of new pension funds) and the scope of assets in respect of pension liabilities as of December 31 st, 2003 totaled NIS 829 million (4.3% of new pension funds). The number of members in the fund as of December 31 st, 2003 is approx. 21 thousand. d. In February 2004, the Company received a dividend from Bank Leumi in the amount of approx. NIS 26 million. In March 2004, the Company sold Bank Leumi shares which constitute 4.2% of the Bank's issued capital and voting rights, out of 8% of the Bank shares held by the Company as a permanent investment (see also Note 6 to Financial Statements). Net profit for the Company from the sale of shares amounted to NIS 20 million. Furthermore, in June 2004 the Company received approx. NIS 3 million as an additional dividend. After these shares were sold, the Group's holding in Bank Leumi shares decreased to below 5% and the Group is no longer an interested party in the Bank. On September 30 th, 2004, the Company's management decided to cancel the balance of the write down on Bank Leumi shares in the amount of approx. NIS 24 million, based on the updated valuation received and attached to the Financial Statements. 4

5 On October 20 th, 2004 (after the date of the balance sheets), an agreement was signed between Migdal Holdings and IDB Development Corporation Ltd. for the sale of a package of Bank Leumi shares held by Migdal Holdings, which constitutes approx. 2.4% of the Bank's issued capital and voting rights to IDB, for the amount of approx. NIS 313 million (at a price of NIS 9.25 per share). The cost of sold shares after the cancellation of provision for the write down is approx. NIS 293 million. Migdal Insurance and The Magen granted a loan in the amount of NIS 177 million to IDB for the partial finance of the acquisition. In addition to IDB's duty to pay the loan unconditionally, IDB put a lien on part of Bank Leumi shares it acquired in favor of the creditors (approx million shares of NIS 1 par value).the above loan was granted for years (subject to a right of early payment by IDB according to the conditions stated in the agreement), CPI-linked and bearing an annual interest of 5.5%. The Company is examining the appropriate accounting handling of this transaction. See also notes 7 and 10 to Financial Statements. The Company is examining the date of the accounting recognition of the sale. e. On October 8 th, 2003, Migdal Agencies signed an agreement with a shareholder in Amit Insurance Agencies Ltd. (hereinafter "Amit"). According to this agreement, Migdal Agencies will buy 40% of Amit shares for approx. $ 630 thousand. Another agreement was signed on December 30 th, 2003 between Ihud, Migdal Agencies and Amit. According to this agreement, Ihud will transfer to Amit part of Ihud activity against the allocation of Amit shares to Migdal Agencies. Should both transactions as mentioned above be completed, the Company will hold, directly and indirectly, 70% of Amit's share capital. All the approvals related with the execution of the above transactions have not been received yet, and the parties are examining other alternatives for the cooperation between them. Until the completion of the transactions, Ihud and Amit agreed to cooperate in the activity related with offering insurances for Leumi Card customers - Ihud's share in this activity will be 70%, and Amit's share 30%. f. In 3Q04, Migdal Agencies signed agreements with the shareholders of Shaham Insurance Agencies (1977) Ltd. (hereinafter "Shaham"), according to which Migdal Agencies shall acquire full control of Shaham Agencies as per the conditions specified in the agreement for approx. NIS 7 million. Migdal Agencies held approx % of Shaham shares before the acquisition. The completion of the transaction depends on several suspending conditions, including, inter alia, the approval of the Commissioner of Insurance and the Commissioner of the Capital Market. g. On June 30 th, 2004, 6.24% of Peltours Insurance Agencies Ltd. (Pettours) shares were allocated to Migdal Agencies for the amount of NIS 3,178 thousand. After the above allocation, Migdal Agencies holds 73.27% of Peltours shares. h. On April 25 th, 2004, the acquisition of approx. 16% of Sagi Yogev Insurance Agencies (1988) Ltd. shares was completed, and as a result, Migdal Agencies holds 100% of the agency's share capital. i. On June 14 th, 2004 the restrictive trade practices court approved the request to extend the approval granted to Data Car, a company which provides software and adjustment services, inter alia, to Migdal and The Phoenix which hold the company's shares, to continue Data Car's activity for two years, until June 14 th, 2006, subject to the conditions determined in the previous procedure for the approval of the agreement. In its ruling, the Court found that Data Car breached the court's conditions stated in the previous procedure for the approval of a tying agreement. The Court instructs that Data Car should amend the breach within 3 months after the ruling. In addition, the Court instructed Migdal and The Phoenix (the shareholders) to sign a commitment to pay NIS 1 million, each, in case there is a judiciary peremptory ruling stating that it breached the conditions stipulated in this approval. Furthermore, the Court instructed Data Car and the applicants to sign a letter of undertaking for the payment, jointly and severally (with Data Car and The Phoenix) of the amount of NIS 1 million, in case there is a judiciary peremptory ruling stating that Data Car breached the conditions imposed on it by the Court. j. On July 8 th, 2004, Migdal received the draft of an audit report prepared by Barlev & Co., CPAs, on Migdal, as per a letter of appointment by the Commissioner of Insurance from July 2 nd, 1998, regarding insurance policies entitled to designated Hetz bonds. According to the draft of the report which was submitted to the Company for comments, it seems that according to certain work assumptions included in the draft of the report, the 5

6 Company deviated from Hetz agreements provisions and the damage (nominal until the date of the draft of the report) caused to the Treasury, amounts to approx. NIS 41 million. According to Migdal, the assumptions on which the draft of the report was prepared are not founded, and it is clarifying this matter with those who wrote the report. B. THE COMPANY'S BUSINESS ENVIRONMENT General DEVELOPMENTS IN THE SECTOR During 2004, recovery in the economic activity on the market, continued, with a certain slowdown in 3Q04. According to Central Bureau of Statistics preliminary estimates, this year GDP is expected to increase by an annual rate of 4% (a 2.2% increase in GDP per capita), following a 1.3% increase last year (a 0.5% decrease in GDP per capita). Business GDP is expected to increase by 5.5%, compared with a 1.8% increase last year. The expansion in the economic activity stems mainly from the increase in export, which is supposed to increase by approx. 11.5% vs. a 6.1% increase last year, in light of the recovery in global economy, and mainly the higher growth rates in Western countries. Investment in fixed assets is expected to stabilize (a 0.3% decrease) after a continuous decline which began in 2Q01. Improved growth rates have not affected unemployment rates, and in January-August the number of employees was higher by only 1.4% compared with the same period in During 1H04, unemployment rate continued to be high, and reached 10.7% in August vs. 10.9% by the end of 2003 and 10.5% by the end of However, during January-August average salary in real terms (seasonally-adjusted data) increased by approx. 2.9% vs. the same period last year. Unemployment and salary rates impact the scope of insurance companies' life assurance businesses. INSURANCE SECTOR 1. Most of the Israeli insurance sector is concentrated in five main groups. In January-June 2004, life assurance premiums of these groups constituted approx. 95% of total premium in life assurance, and general insurance premium constituted approx. 72% of total premium in the general insurance line. Insurance companies sell similar products, therefore there is severe competition in general insurance as well as in life assurance and health insurance. In life assurance there is also competition from other entities which offer long term savings, such as pension and provident funds, and, to a certain extent, banks selling savings plans. Recently, further to the reform in pension funds, insurance companies increased their involvement in the pension market by acquiring new pension funds which used to be owned by old pension funds within the arrangement (see Life Assurance, Pension and Provident Funds, Article 2 hereinafter). 2. In November 2004, the inter ministerial committee regarding the reform in the capital market, appointed by the Minister of Finance, published its recommendations for the actions required in order to establish a competitive structure in the capital market. As per the committee's report, the Israeli capital market is characterized with an absolute dominance of the banking system, in "classic" banking areas (commercial banking) and in other brokering, while the banking system itself is centralistic and controlled almost exclusively by the two largest leading banking groups. In addition, the various activities handled by the banks create material conflict of interest between their business interest and the benefit of their customers. The solution recommended by the committee aims at decreasing significantly the centralization in the banking sector and reduce conflicts of interests included in it, with an emphasis on the prevention of centralization in other lines of the capital market. Enclosed please find the main recommendations: - Banking corporations shall not hold any means of control in a company for the management of provident funds or in provident funds ("provident fund") nor in a company which manages joint investments in trusteeship ("mutual fund"), nor be an interested party (holding of 5% or more of any means of control) in corporations which are interested parties in a provident fund or a mutual fund. Furthermore, controlling shareholders of a banking corporation, and anyone controlled by it, may not be 6

7 interested parties in a provident fund or a mutual fund and may not be interested parties in a corporation which is an interested party in the above corporation. - A permit for the acquisition of a provident fund or an insurer shall not be granted if after the acquisition, the market share of the buyers or their controlling shareholders and entities controlled by them, in the field of long term savings (provident funds, new pension funds and life assurance profit participating policies portfolio), exceeds 15%. Furthermore, a permit for the acquisition of a mutual fund shall not be granted if after the acquisition, the market share of the buyers or their controlling shareholders and entities controlled by them, in the field of mutual funds, exceeds 20%. - In the framework of legislation referring to the capital market, two occupations requiring training and licensing, and which are subject to regulation and supervision, shall be determined consulting and marketing, in financial products (including securities, mutual funds and structured banking deposits), as well as in pension products (including provident funds, profit participating life assurance and pension). Entities acting on the capital market, including in the field of insurance, will have to choose between marketing and consulting. - Entities dealing with consulting, those controlling them and controlled by them shall not be interested parties in an institutional entity, they shall not consult nor sell financial products or pension products of an institutional entity, which the entity itself, its controlling shareholders and those controlled by it are interested parties in those consulting entities. Furthermore, entities dealing with consulting, including banks, shall receive no consideration from the owners of the financial instrument or pension instrument in respect of the execution of activities in its products, including distribution fees. The above does not prevent the receipt of considerations in respect of other common trusteeship or banking services, paid within the framework of agreements between the consultant and the institutional entity, which are in the regular course of business, or whose terms are not different than what is common in similar agreements. - Banking corporations which completed the sale of all their holdings in provident funds and who are not interested parties in an insurer (including a pension fund), may consult or sell life assurance and pension products, subject to the above restrictions regarding those dealing with consulting. - Banking corporations, of whom the equity of the banking group to which it belongs exceeds NIS 10 billion may consult or sell life assurance and pension products, only after completing the sale of all its holdings in provident funds and it is not an interested party in an insurer as mentioned above, as well as after completing the sale of all its holdings in mutual funds. Moreover, permits to banking corporations to deal with this field shall be granted taking into consideration the development of competition in the field of consulting and sale of pension products by the banking system and particularly the relative size of banking corporations in the system. At this stage, it is difficult to evaluate whether the reform will be implemented and to what extent, and if it is implemented, what would be its impact on the businesses of insurance companies. DEVELOPMENTS IN LEGISLATIVE ARRANGEMENTS TAXATION 1. Insurance companies and Tax authorities signed a taxation agreement extending the 2002 agreement for Such an agreement for 2004 has not been signed yet. 2. On June 29 th, 2004, the Knesset approved an amendment to the Income Tax Ordinance (No. 140 and temporary order) 2004, which decreases gradually, as of January 1 st, 2004, tax rates imposed on companies from 35% (44.52% for financial institutions) in 2004 to 30% (40.17% for financial institutions) as of 2007 and afterwards. In 2Q04, the above amendment caused a one-time NIS 31.4 million decrease in expenses on income tax in respect of deferred taxes, and an addition of approx. NIS 1 million in capital fund due to a renewed real estate evaluation addition (see Note 9 to Financial Statements). 3. In a government bill in legislation stages, it is suggested to start comparing the tax rate applicable on foreign securities to tax rate on negotiable securities on the Tel Aviv Stock Exchange as of January 1 st, 2005 instead of January 1 st, As per this bill, as of January 1 st, 2005 individuals shall pay 15% tax rate on foreign securities instead of 7

8 35%, and provident funds will be totally exempt for tax on foreign securities, instead of paying 35% as they did up until now. The bill refers only to individuals and provident funds, and its aim is to cancel tax considerations in choosing investment tracks, which cause distortions and lack of efficiency on capital markets. If the bill is approved, individuals' and provident funds' investments on foreign markets are expected to increase in the upcoming years. It is impossible to estimate the impact on Migdal and on Migdal Capital Markets, which deals with brokering and the management of individuals' investments on capital markets. 4. In the Economic Arrangements bill submitted within the budget law for 2005, there is an obligation regarding the payment of wage tax on social allocations, compensation for severance and deposits to provident funds, pension funds and educational funds. EFFECTIVE PROVISIONS 1. In May 2004, the Finance Committee of the Knesset approved amendments to the Regulations Regarding the Supervision on Insurance, whose main points are: A. As of January 1 st, 2004, financial statements will no longer be adjusted, see Note 1 c to Financial Statements. When Financial Statements are not adjusted in periods in which CPI increases, this will have the following impact compared with the adjustment method: - A decrease in comparison data of the same period last year (stated in terms of 12/03 CPI) by full increase in CPI in the reported period. - In business reports there was a change in the composition of costs, with no material change in profit, mainly an increase in investment profits against increased growth in outstanding claims and insurance reserves. - The impact on net profit depends on the composition on assets and liabilities. In the reported period, impact on Company's profits is not material. B. A change in the revaluation method of bonds, loans, deposits and non-negotiable commercial certificates of debt, from a revaluation based on adjusted cost to a revaluation based on fair value. As per the new method, cashflows expected from each of the above assets will be capitalized with interest rates determined by a company which will be chosen for this purpose by the Ministry of Finance. Furthermore, the method for calculating other non-negotiable securities (non-negotiable shares, non-negotiable options and futures) was changed from a revaluation based on adjusted cost to a revaluation based on fair value. The regulation will apply as of January 1 st, 2005, mainly for assets standing mostly against profit participating policies which were purchased starting from August 1 st, It seems that this method will increase volatility in yields of profit participating policies portfolios, thus volatility in insurance companies profitability. C. - DAC in respect of life assurance and health insurance policies issued since January 1 st, 2004 are added in full to insurance companies capital requirements, vs. part of DAC which were added to capital requirements in the existing situation. Due to structural changes in the new life assurance products which are marketed as of 2004 and in remuneration of agents in respect of these products (see Life Assurance, Pension Funds and Provident Funds, Developments in the Sector hereinafter) it is difficult to estimate how material will be the impact of the expected changes on future capital requirements. - DAC in life assurance in respect of policies issued as of January 1 st, 2004 will not stand against life assurance reserves. - Loans to agents working with insurance companies will not stand against life assurance profit participating reserves. 2. On September 2 nd, 2004, the Commissioner of Insurance published a circular detailing the restrictions and conditions for granting loans to insurance agents by insurers as of November 1 st, Insurers may continue and hold loans legally given to insurance agents prior to the effectiveness of the circular's provisions, up until their final repayment as per the terms of the loan. 8

9 LEGISLATIVE ARRANGEMENTS DRAFTS 1. On May 9 th, 2004, the Commissioner of Insurance published a draft regarding granting housing loans by an insurer. Pursuant to the provisions, the provisions which apply on banks in Israel regarding housing loans will apply, as instructed by the Commissioner and with the amendments set by him. The provisions of the draft are supposed to apply on housing loans which will be granted by insurance companies as of September 1 st, Insurance companies and the Commissioner of Insurance are negotiating this issue. 2. In August, the Commissioner of insurance published a proposal for the arrangement of insurance policies sale to borrowers of mortgage banks. According to this proposal, as of January 1st, 2005, the sale of insurance policies will be through a licensed designated insurance agency, which may be owned by the bank, with extended disclosure to insureds. Insurance companies and the Commissioner are discussing this issue. LIFE ASSURANCE, PENSION AND PROVIDENT FUNDS DEVELOPMENTS IN THE SECTOR 1. In 2004, significant changes in new life assurance plans, whose main points are a lower component of premium designated for covering general and administrative expenses, commissions for agents and profits, as well as a change in collected management fees from insureds from variable to fixed, became effective. The decrease of premium component for expenses changed commission agreements with agents, whose main points are longer commission spreads and a significant decrease in commissions paid to agents in the policy's first year. At this stage, the changes in commission agreements with agents reduced new sales, especially in 1Q04, with an improvement in 2Q04 and 3Q04. However, there is a significant decrease in policy cancellation rates and a decrease of premium in existing policies, due to the change in the way commissions are paid to agents, as well as due to the instructions of the Commissioner of Insurance to insurers and insurance agents regarding changing policies for insureds (see Developments in Legislative Arrangements, Effective Provisions, Article 1 hereinafter). 2. In 2003 a pension funds reform was introduced, aimed at financing the actuarial deficit in Trade Union pension funds in deficit. As per the settlement there were changes, among other things, in the way pension funds in deficit are managed, in members' rights, in the rate of management fees collected from members, in the determining retirement age for pension and in the way determining wages are calculated. In addition, there were changes in investment regulations of old and new funds, so that designated bonds are no longer issued for old funds as of September 2003, and for new funds as of January 2004, until the rate of designated bonds out of total funds' assets is 30%, and the rest will be diverted mainly to investment on the capital market. Furthermore, by the end of 2003, the State took over the pension funds from the Trade Union, and now they are managed by managers licensed by the State. During June-July 2004, the Commissioner of Insurance issued instructions regarding the sale of new pension funds owned by the old pension funds in the arrangement. As per these instructions, the Group's insurance companies were not allowed to participate in the purchase of a controlling share in Mivtachim pension fund (Mivtachim), but they were able to participate in the purchase of a controlling share in Makefet, as long as they joined an overseas company. There were no restrictions on the purchase of a controlling share in Meitavit Pension Funds Management Company Ltd. (hereinafter: "Meitavit"). As already mentioned, Migdal, together with an overseas company in which Generali has an interest, won controlling stake in Makefet (see Company Description, Special Issues, Article a above). Mivtachim pension fund was acquired by Menorah Holdings Ltd. and Meitavit was acquired by Clal Insurance Enterprises Holdings Ltd. 9

10 DEVELOPMENTS IN LEGISLATIVE ARRANGEMENTS EFFECTIVE PROVISIONS 1. In April 2004, the Commissioner of Insurance distributed an update of a circular, which came into effect in the beginning of the year, regulating the activities of insurers and insurance agents as far as switching or changing life assurance and health insurance policies are concerned, in order to provide insureds with comprehensive information regarding the above mentioned insurance products. 2. On February 19 th, 2004, the Commissioner distributed a circular, effective as of January 1 st, 2005, forcing insurance companies to provide comprehensive information regarding covers, premium breakdown into various components as well as management fees and expenses, in life assurance plans which include a savings component while giving an insurance proposal and while producing policies. 3. On March 24 th, 2004, the Knesset approved Amendment No. 12 to the Law of Supervision on Insurance Businesses, in the framework of which the Income Tax Ordinance was amended, according to it the Income Tax Regulations were amended on November 8 th, 2004 (rules for the approval and management of provident funds 1964). Further to these amendments, the following changes will be effective as of January 1 st, 2005: a. The ceiling entitling for provision for capital for employees was reduced, and is NIS 7,000 per month (instead of NIS 9,900). b. The ceiling for provisions for capital and annuity in managers' insurance (in respect of all employee's employers) will be 4 times the average salary in Israel, including the capital part (in the past, the ceiling was similar to the income entitling for capital plus 4 times the average salary for annuity). c. Employer's provision to benefits may be up to 7.5% of the employee's salary (previously only up to 5%), and the provision for covering occupational disability may be included in the provision for benefits. If employers choose to make provisions for occupational disability beyond their provisions to benefits, they may increase provisions to benefits to a rate not exceeding 7.5%, together with the provision to occupational disability. Employee's provision to benefits may be up to 7% of his wage. d. Provisions of the employer's compensation component for annuity may be only in the same provident fund account to which he makes his provisions to annuity (in the past, the condition was employers' provisions to retirement benefits for annuity in the provident fund). e. The recognition of individual insureds' provisions to article 45a was reduced to death risk premium only (in the past, it could include the savings component in individual policies), as of January 1 st, At this stage, it is impossible to estimate the impact of changes on insurance companies. 4. On March 2004, the Commissioner of Insurance distributed instructions regarding the presentation of assets and liabilities in life assurance plans. According to these instructions, Hetz designated bonds issued in the years will be presented according to their nominal value and will not be revalued with the negative CPI accumulated since they were issued. However, insurance reserves standing against these bonds will be revalued as per the changes in the CPI as required by the policies conditions. As a result, Migdal recorded an NIS 33 million profit in the life assurance businesses report, an addition of NIS 18 million to net profit in 2003, and NIS 4 million profit in life assurance, an NIS 2 million addition to net profit in 1Q04. In 2Q04, due to CPI increase, life assurance business report recorded a loss of approx. NIS 37 million, an NIS 20 million decrease in net profit. In 3Q04 there was no change in CPI and as a result, no profits/losses were recorded due to the revaluation of designated Hetz. 5. On April 2004, an amendment to the Income Tax regulations (rules for the approval and management of provident funds) 1964, was approved, as follows. a. A change in the revaluation method for non-negotiable assets held by provident and pension funds, similar to the rules applicable for insurance companies (see General, Effective Provisions, Article 2 above). 10

11 b. Management fees that a company managing a new comprehensive pension fund may collect should not exceed 6% of premium, as well as up to 0.5% of the fund's assets balance, instead of management fees of 8% of premium (6% in order to cover expenses and 2% for reserves) up until now. 6. On April 2004, the Commissioner of Insurance distributed provisions determining insurers' obligation to provide an insurance continuity to insureds in collective LTS policies sold or renewed as of April 1 st, 2004, by providing the possibility to shift to an individual policy without renewed underwriting or a qualification period for insureds who were insured by the group policy for at least one year. 7. On July 2004, an amendment to the Income Tax regulations (rules for the approval and management of provident funds) 1964, was approved, as follows: a. There will be an obligation to revaluate assets on a daily basis, calculate annual yields based on daily data, along with canceling cashier interest rate. The above amendment will prevent cross subsidizing of investment profit between members. b. A change in the rules for withdrawing money from provident funds for retirement benefits. The amendment will allow, among other things, to withdraw money from provident funds for retirement benefits when members reach retirement age, with no additional conditions. Furthermore, the proposed amendment cancels the possibility to withdraw funds belonging to a salaried member from provident funds for retirement benefits before retirement age, unless there is a severe economic or health problem. c. A change in the reporting method to members in pension funds and an expansion of reports to members in new pension funds. d. Setting arrangements for transfer of money between provident funds. e. Setting arrangements regarding investment tracks in provident funds. f. Additional changes in arrangements determined in regulations regarding related parties. The amendment's general implementation was set to 30 days after the publication of the amendments, except for a few material amendments (mainly clause a. above) whose implementation was postponed to January 2 nd, In September 2004, the Commissioner of Insurance distributed a circular detailing rules for the ways for transferring members' money between new comprehensive pension funds, whose main points are: - At least two years elapsed since the shifting insured joind the fund or the insured changes his work place, at least 3 years should elapse for shifting groups of employees. A money transfer shall not be performed in respect of employees receiving a pension from the transferring fund. - No benefits shall be granted by the receiving fund, except a permitted brokering commission for licensed insurance agents, provided the brokering commission or part of it is nit transferred to the employer, employers' association or workers organization. - The transferring fund shall transfer the accumulated amount to the receiving fund so that the rate of designated bonds equals their rate in the assets of the transferring fund, and the balance is transferred in assets agreed upon by both funds or in cash. 9. On October 2004, the Commissioner of Insurance distributed instructions stating that a management company of a pension fund may not grant any benefit to those not insureds in a pension fund, including through "commissions" or "reimbursement of expenses". LEGISLATIVE ARRANGEMENTS DRAFTS 1. Insurance companies and the Commissioner of Insurance are negotiating the possible separation in the financial reporting between the savings component and the risk component in life assurance policies, and the savings component in insurance policies shall be recorded in balance sheets only, and only the balance shall be recorded as an income in the business report, similar to the rules stated in the new international accounting standard regarding insurance contracts. 11

12 Recently, the Commissioner of Insurance appointed a professional committee for examining the implementation of the international standard in accounting regarding insurance contracts (IFRS4). The committee is supposed to refer, inter alia, to the possibility of separating policy components, as mentioned above. 2. After the Commissioner of Insurance appointed a think tank in order to set general rules regarding management fees paid by the profit participating policies and provident funds for investment funds, mutual funds and similar financial instruments, the Commissioner issued a decision according to which management fees in respect of investment funds will be considered as commissions (therefore from the insured's/member's account), while management fees in respect of mutual funds in Israel and abroad will be considered as management fees (therefore will be from the management fees collected by the insurer/managing company). As per the above decision, all management fees paid to related parties will be considered as management fees and not as commissions. Procedures (changes of regulations) in order to implement the above decision have not been prepared yet and insurance companies are discussing this matter with the Commissioner of Insurance. 3. In the Economic Arrangements bill submitted within the budget law for 2005, the following amendments are included, inter alia: - Cancellation of exempt on retirement compensation accumulated as of 2005 This amendment, if approved, may have an impact of transferring the compensation component from capital sum policies to annuity policies. - A significant decrease in the maximum tax exemption in educational funds, from NIS 15,400 to NIS 7,000 only. At the same time, the maximum deposit recognized for tax purposes on interest will decrease from NIS 14,760 to NIS 5,880. This amendment, if approved, may decrease significantly deposits in educational funds. - Cancellation of the tax exemption as per article 45a to the Order regarding deposits to provident funds for insureds in pay as you go pension. This amendment, if approved, will decrease significantly insureds' deposits in pay as you go pension to provident funds. GENERAL INSURANCE DEVELOPMENTS IN THE SECTOR 1. According to data of the Israel Insurance Association, premium volumes remained unchanged in 1H04 compared with the same period last year (a 0.2% decrease). 2. According to the data of the Israeli Police, the number of car thefts in January-August 2004 increased to 80, vs. a daily average of 67 car thefts in the same period last year, and a daily average of 69 in the entire According to data published by the Central Bureau of Statistics, the number of house and commercial burglaries in January-August 2004 increased by approx. 3.6% compared with the same period in Health Ministry informed insurance companies that it intends to significantly increase maximum hospitalization tariffs. This increase would somewhat increase the cost of claim in CMBI line. Until the publication date of this report, hospitalization tariffs were not increased. DEVELOPMENTS IN LEGISLATIVE ARRANGEMENTS EFFECTIVE PROVISIONS 1. On March 3 rd, 2004, the Commissioner of Insurance issued instructions regarding recording expenses stemming from issuing new policies in the disease and hospitalization line in general insurance as DAC, similar to the rules common in life assurance policies. The instructions apply to policies issued as of January 1 st, 2004, starting from the date in which insurers' liability in disease and hospitalization line is presented in financial statements as per an actuarial evaluation. Insurance companies and the Commissioner of Insurance are discussing the implementation of actuarial evaluations in disease and hospitalization insurance. Regarding this matter, on November 7 th, 2004 a draft of a circular regarding rules for the appointment 12

13 of actuaries in health insurance, the scope of actuarial estimation he is supposed to execute and the declaration he should sign. According to the draft of the circular, the provisions of this circular will be effective as of financial statements of March 31 st, On March 15 th, 2004, the Supreme Court ruled regarding the estate of Michael Ettinger (Ettinger affair) which overruled a rule which was effective for years (Gavriel ruling). The old ruling stated that an injured person's estate is not compensated for the loss of ability to earn money in the years his life expectancy was shortened ("the lost years"). In Ettinger affair, the Supreme Court states that in the case of an injured person who is alive, and whose life expectancy was shortened, as well as his estate, are entitled for a compensation for his loss of ability to earn money in respect of the lost years as well, in the amount of the difference between the lost income and the expenses which were saved. The Supreme Court returned the case to the District Court for continued discussions regarding compensation. At this point, the implications of the ruling on the cost of claims in CMBI and liabilities lines may not be assessed (Ettinger affair). 3. In May 2004, the amendment to the Regulations of the Supervision on Insurance Businesses (conditions of contracts regarding private vehicles) (amendment) 2003, regarding changes in standard motorcar policies, whose aim is, among other things, having more flexible policies, came into effect. 4. The Commissioner of Insurance set principles for the approval of homeowners insurance tariffs for borrowers in mortgage banks, as of 2004, so that a minimal rate of damages (rate of claims out of premium) was determined. The implementation of these principles will be gradual till THE CAPITAL MARKET General 3Q04 was characterized with an opposite trend to 1H04. Growth rate decreased, stock market indices declined, and there was higher volatility on bond markets. Inflation in July, August, September was 0.0%, -0.2% and 0.2%, respectively (based on known index), therefore by the end of the third quarter, CPI was similar to the beginning of the quarter. Since the beginning of the year, CPI increased by approx. 1.2%. Monetary interest rate which decreased from 5.2% in the beginning of the year remained unchanged compared with 2Q04, at 4.1%. Bonds Non-linked bonds During January-September 2004, yield to maturity on long term bonds increased from approx. 6.9% to 7.5% by the end of 2Q04 and 7.6% by the end of 3Q04, with significant volatility during 3Q04. In short term bonds, yield to maturity decreased from 4.7% in the beginning of the year to 4.6% by the end of 3Q04. The high volatility in the long term non-linked channel was due mainly to volatility in American bonds for 10 years and to volatility in long term inflation expectations. In 3Q04, the non-linked channel recorded an average real yield of 1.8%, and since the beginning of the year, an average real yield of approx. 1.7%. CPI-linked bonds During January-September, yields to maturity on short term CPI-linked bonds decreased from 4.2% to 3.7% by the end of 2Q04 and 3.2% by the end of 3Q04, in medium term bonds yields decreased from 4.0% in the beginning of the year to 3.3% by the end of 2Q04 and increased to 3.6% by the end of 3Q04. In long term ones, yield increased from 4.1% in the beginning of the year to 4.5% by the end of 2Q04, and remained unchanged by the end of 3Q04. The CPI-linked bonds market was impacted by the cut in monetary interest rate, along with expectations for interest rate hikes in the long term, and by an increase in inflation expectations for the upcoming year from 1% to approx. 1.9% by the end of 3Q04. In 3Q04, the CPI-linked bond channel yielded approx. 1.8% in real terms on average, and 2.8% real yield since the beginning of

14 Shares In Israel The domestic stock market recorded a negative trend in 3Q04, following peaks recorded by the end of 2Q04 and in the beginning of 1Q04. Sharp decreases were recorded in July and August, when Maof index decreased by approx. 2.9% and 3.7%, respectively. In September, markets improved a bit and Maof index increased by approx. 1.9%. By the end of 3Q04, Maof index decreased (in real terms) by approx. 4.8%, and since the beginning of the year, it increased by approx. 4.1%. TA 75 index decreased by approx. 7.1% in 3Q04 and since the beginning of the year it increased by approx. 3.2%. Yeter index decreased by approx. 7.2% in 3Q04, but since the beginning of the year it recorded the highest increase 21.9%. Foreign markets In January-September 2004, leading foreign markets were characterized with high volatility, with price increases in 1H04 and declines in 3Q04. MSCI recorded a nominal yield of 1.29% in January-September (0.08% in real terms), out of which 1.0% negative yield in 3Q04 (in real and nominal terms). S & P recorded a nominal yield of 0.24% in January-September (negative 0.95% in real terms), out of which 2.3% negative yield in 3Q04 (in real and nominal terms). The Dow Jones recorded a negative yield of 3.6% in the date of the report (4.72% in real terms), out of which 3.4% negative yield in 3Q04 (in real and nominal terms). Nasdaq recorded a negative yield of 3.76% in reported period (negative 4.9% in real terms), out of which a significant decrease of 6.9% in 3Q04 (in real and nominal terms). Price decreases in leading markets in 3Q04 were mainly influenced by a hike in oil prices and tepid macro data from the USA and China. However, share prices increased on markets which are commodity-biased, including oil, such as England, Australia, Canada and South Africa. On the other hand, the American bond market was positive in 3Q04, due to the continued decrease in long term interest rates. For example, interest rate decreases on American government bonds for 10 years decreased from 4.6% in the beginning of the quarter, to approx. 4.1% occurred in spite of three interest rate hikes by the Feds, each by 25 basis points, in June, August and September. The main explanation for these decreases is weakness in macro data during the quarter, which brought about expectations for a slowdown in the American economy towards the end of 2004 and into These concerns moderated inflation worries due to sharp increases in oil prices. Foreign currency During January-September, the Shekel depreciated by approx. 2.3% against the USD in nominal terms (1.1% in real terms). Compared with the Euro, the Shekel appreciated by 0.15% in nominal terms (1.3% in real terms) since the beginning of the year, and compared with the Yen, the Shekel appreciated by 1.5% in nominal terms (2.7% in real terms). During 3Q04 the Shekel appreciated by approx. 0.1% against the currency basket. Most of the appreciation is attributed to the Dollar, whose rate decreased from NIS 4.497/$ to approx. NIS 4.482/$, a nominal appreciation of approx. 0.4%. The Yen rate decreased by 2.3%. The Euro rate was NIS /Euro in the beginning of the quarter, and it increased by 1.1% to NIS /Euro. 14