White paper Consolidation policy and business activities at Danica Pension Unaudited Version VI April 2008 April 2008 1
White paper Profit policy and business activities at Danica Pension Contents Page Management summary 3 1. Introduction 4 2. Danica group overview 5 3. Danica s business profile 6 4. Danske Bank s profit from the Danica group 10 5. Importance of financial guarantees and insurance guarantees 12 6. Earnings of Danica Pension 14 7. European Embedded Value in Danica Pension I, Denmark 19 Appendix A. The Danica group in the statutory accounts of Danske Bank 34 Appendix B. Changes in 2007 35 Appendix C. Frequently asked questions 36 Appendix D. Contact persons 38 April 2008 2
Management summary The Danica group offers life insurance and pension products in Denmark, Sweden, Norway and is licensed to operate in the Republic of Ireland. In Denmark, Danica offers traditional policies, market products and health and accident products, while the product ranges in Sweden and Norway cover market products and health and accident products. Danica expects to enter the Irish market in the first half of 2008 with a range of market and mortgage protection products. In 2007, the Danish activities accounted for 90% of total sales, and with a market share of 31%, Danica is the largest pension company in Denmark. During the past five years, the Danica group has seen a rise in gross premiums, including premiums on investment contracts, of 6.3% per annum. The main growth driver is sales of the market products Danica Balance and Danica Link, which allow customers to choose their own risk profile. Earnings contributed by the Danica group to the Danske Bank Group consist of risk allowance, insurance results from market products and health and accident products, as well as the investment return on assets allocated to the shareholders. The accounts presented by the Danske Bank Group s business areas include a financing result that consists of interest paid for shareholders equity and interest received on allocated capital. The risk allowance, which is a share of the technical provisions from the traditional business, etc., is the Danske Bank Group s main source of income from the Danica group. The company Danica Pension contributes to the Danske Bank Group s profit for the Danica group primarily via the risk allowance and the investment return on shareholders equity. The risk allowance can be booked as income only if it does not exceed the technical basis for risk allowance, which is calculated mainly as the investment return on customer funds less the technical rate of interest and value adjustments of provisions. The company Danica Pension I contributes to the Danske Bank Group s profit from the Danica group primarily through the insurance result on market products. The results and equity of Danica Pension I are based on IFRS and Danish accounting standards, under which the present value of insurance contracts can be no less than the surrender value of the contracts. The statutory accounts tend to underestimate the value of market products, and the fact that market products account for an increasing share of total premiums has highlighted the need for more value-based methods as a supplement to conventional accounting methods. With market products now accounting for more than 40% of gross premiums, Danica Pension has decided to introduce European Embedded Value for Danish unit-linked business. At the end of 2007, European Embedded Value amounted to DKr1,979m, which represents an increase of DKr 432m compared with the level at a year earlier. The increase is driven mainly by new business. At the same time, the European Embedded Value of existing business decreased because Danica lowered its prices in 2007. The European Embedded Value of DKr1,979m covers shareholders net assets of DKr 349m, certaintyequivalent present value of future profits of DKr1,740m and other components of a negative DKr110m. Thus, the Embedded Value calculated shows an additional value of DKr1,630m compared with the carrying amount at the end of 2007. April 2008 3
1. Introduction The purpose of this White Paper is to inform investors, analysts and other stakeholders of Danica Pension s activities and profit policy. This White paper is intended to give an overview of the main factors that affect the Danica group s annual accounts and not least to describe their relation to the annual accounts of the Danske Bank Group. The rules on preparing the income statement and balance sheet of a life insurance company are highly complex and sometimes very technical. This White paper is therefore not intended to give a comprehensive description of every aspect of the Danica group s accounts. It is important to understand which parts of the Danica group these issues concern. Section 2 gives an overview of the group and describes which parts of the Danica group the subsequent analysis refers to. In section 3, we present a business profile of the Danica group, focusing on products, markets, distribution channels and so on. In section 4 we describe the Danica group s performance based on an explanation of how the results of the Danica group affect the accounts of the Danske Bank Group. This is followed in section 5 by a description of the financial and insurance guarantees employed by Danica. In section 6 we review Danica Pension s earnings, including the relationship between the size of the investment return and Danske Bank s possibility of booking the life insurance risk allowance on its income statement. Finally, in section 7 we describe value creation from unit-linked business in addition to the conventional statutory accounts by introducing European Embedded Value in Danica Pension I, Denmark. April 2008 4
2. Danica group overview The corporate structure of the Danica group is described in figure 1 below. FIGURE 1: THE DANICA GROUP Forsikringsselskabet Danica Parent company, whose main activities are sales of health care and critical illness policies. Danica Pension Sales of conventional life and pension business (Danica Traditionel) as well as health and accident insurance. These activities are subject to the profit policy announced to the Danish Financial Supervisory Authority. Further information is provided below Danica Pension I Sales of market products (Danica Balance and Danica Link) to the Danish and Norwegian markets. The company also writes health and accident insurance. From 2008 only to the Danish market. 1) Danica Liv III Covers guaranteed annuities without bonus entitlement. No new policies have been written since 1982. 2) Danica Pension AB Sales of market products to the Swedish market. The company also writes health and accident insurance. 3) Danica Pensjon Sales of market products and risk insurance, etc. to the Norwegian market. 1) Danica Life Ltd. Sales of market products and risk insurance, etc. to the Irish market. 1) 1) 2) 3) The results of these companies are included in the return on investment of equity funds. The result of Danica Liv III is included in the return on customer funds in Danica Pension. In 2007, the result of Danica Pension AB is included in the return on customer funds in Danica Pension. From 2008 the result is included in the equity funds in Danica Pension. It is particularly the activities of Danica Pension that are relevant to the profit policy. Danica Pension I, Danica Pensjon, Danica Pension AB and Danica Life Ltd. are owned by Danica Pension, and their results are recognised directly in the results of the Danica group. The earnings of Danica Pension I (domestic Life business) are described in section 7. April 2008 5
3. Danica s business profile The Danica group offers life insurance and pension-based insurance schemes. In addition to activities in its primary market, Denmark, the Danica group has activities in Sweden, Norway and the Republic of Ireland. In 2007, the Danica group s gross premium amounted to DKr18.9bn, of which the Danish activities accounted for 90%. Since 2003, the Danica group has seen a rise in gross premiums including investment contracts of 6.3% p.a., driven primarily by organic growth and mainly in the corporate market. From 2006 to 2007, regular premiums rose by 10% for corporate pension plans, while they dropped slightly for personal pension plans. Personal pension plans are primarily sold through Danske Bank. The market products Danica Balance and Danica Link were introduced in 2005 and 2001, respectively. These products share of total premiums in Denmark rose from 30% in 2006 to 42% in 2007. TABLE 1: PREMIUMS INCLUDING INVESTMENT CONTRACTS (DKr bn) 2007 2006 2005 2004 2003 Danica Balance and Danica Link 7.1 6.0 3.2 1.8 1.8 Danica Traditionel 10.2 10.7 11.4 11.0 11.7 Internal transfers -1.4-1.6-0.6-0.2-0.2 Health and accident etc. 1.2 1.1 1.1 1.0 0.9 International 1.8 2.0 1.8 1.1 0.6 Total premiums 18.9 18.2 16.9 14.7 14.8 Its financial strength of DKr26.2bn and an excess capital base of DKr12.8bn make Danica one of the financially strongest groups in the industry. This provides policyholders with a high degree of security in their savings. Danica has been assigned an AA-rating in the Insurer financial strength category by Standard & Poor s. Danica is committed to providing high-quality customer service based on accessibility, short processing times and customer care. Danica regularly conducts customer satisfaction surveys, and is the only Danish company to post its processing times on the Internet. Therefore, it is important to Danica to maintain a competent and committed staff. 3.1 Activities in Denmark In the Danish market, the Danica group offers insurance-based pension schemes, life insurance and health care products to employers and private individuals. These include both traditional policies based on the payment of interest on savings and market products in which the customers select the risk profiles themselves including the option of a benefit guarantee. Danica s business volume has risen in recent years, making Danica Denmark s largest pension company in terms of gross premiums with a market share of 31% of the market on which the company competes. April 2008 6
DKr bn 18 FIGURE 2: GROSS PREMIUMS IN DENMARK - GROUPS (including investment contracts and health and accident) 15 12 9 6 3 0 Danica PFA Nordea Liv & Pension SEB Pension 2003 2004 2005 2006 2007 Topdanmark Livsforsikring Danica uses several distribution channels. It has a large number of sales persons and advisers who primarily address the corporate segment. They are associated with a number of regional offices around Denmark. In addition, Danica works with many insurance agents who also operate in the market for corporate schemes. Most sales of policies to private individuals take place through Danske Bank s extensive branch networks. Danica Traditionel Customers with Danica Traditionel are not required to make any decisions themselves as to how their money is to be invested, as the money is invested collectively. In return, pension savings in Danica Traditionel have guaranteed benefits, calculated on the basis of technical interest rates of 4.5%, 2.5% or 1.5%, respectively. New business is written on the basis of 1.5% only and the average guarantee was 2.8% in 2007. Danica Balance & Danica Link (Market products) The figure below shows the development of gross premiums on market products in Denmark. DKr bn 8 6 4 2 FIGURE 3: GROSS PREMIUMS - MARKET PRODUCTS, DANISH BUSINESS Gross premiums - market products Market products of total premiums % 50 40 30 20 10 0 2003 2004 2005 2006 2007 0 April 2008 7
Danica s market products comprise Danica Balance and Danica Link. Danica Balance is a lifecycle product launched in May 2005, which combines the advantages of collective investment with individual adjustment. The result is a simple product, allowing the customer to choose a larger equity share than normally available in conventional products. Danica Link gives customers the opportunity to influence the way in which their pension savings are invested. This means that the returns accruing to the pension account are a direct reflection of the investments chosen. Customers can choose either to be active investors or to leave the investment decisions to Danica. In Denmark, Danica Link customers can invest their pension savings in securities and at the same time insure themselves against capital loss, as Danica Link is available both with and without a payment guarantee. The payment guarantee ensures customers benefits equal to at least 95% of their contributions. At the end of 2007, approximately 97,000 of Danica s customers have opted for market products, against some 72,000 at the beginning of the year. Insurance cover Customers are able to buy extra insurance cover against disability and death; these covers are mainly requested under corporate schemes. In addition, Danica offers cover against critical illness and healthcare insurance. 3.2 International activities The figure below shows the development of gross premiums on market products abroad. DKr bn 2,0 FIGURE 4: GROSS PREMIUMS - MARKET PRODUCTS, INTERNATIONAL BUSINESS 1,5 1,0 0,5 0,0 2003 2004 2005 2006 2007 Gross premiums decreased by DKr239m from 2006 to 2007, which is mainly attributable to the Swedish market. New business hence ceased for the product Kapitalpension, which in 2006 accounted for 50% of the total premiums of the business, as a result of new legislation entering into force in the first quarter of 2007. Danica set up its activities in Sweden in 1999 and offers pension products to employers as well as to private individuals. Both market products and health and accident products are provided. In Sweden, Danica s gross premiums from market products amounted to DKr1,288m in 2007. Danica collaborates closely with Danske Bank Sweden and a number of the largest brokers in Sweden. April 2008 8
At the end of 2007, the Swedish company was transferred from customer funds to assets attributable to shareholders equity in Danica Pension. The transfer was effected at fair value at December 31, 2007. The difference of DKr400m between fair value and carrying amount has been added to the collective bonus potential. In the Norwegian market, Danica offers pension products to employers as well as to private individuals. Both market products and health and accident products are provided. The products are sold through Danica s own corporate sales force and in close collaboration with Fokus Bank. In 2007, Danica s gross premium was DKr556m, primarily from market products in Norway. At December 31, 2007, Forsikringsselskabet Danica sold the Norwegian company Danica Pensjons-forsikring to the subsidiary Danica Pension. The selling price was DKr439m, corresponding to the net asset value at December 31, 2007 with the addition of DKr207m in goodwill, which has been capitalised in Danica Pension. The additional goodwill on disposal has been eliminated in the Danica group. The company has been allocated to assets attributable to shareholders equity in Danica Pension. The plan is to transfer the insurance portfolio of the Norwegian branch from Danica Pension I to Danica Pensjonsforsikring in the first quarter of 2008 effective from January 1, 2008. Danica Pension established a life insurance company in the Republic of Ireland in 2007. The concession has been filed and sales are expected to commence in the first half of 2008. Sales will be conducted through National Irish Bank, which is part of the Danske Bank Group. Both market products and mortgage protection will be provided. In the Republic of Ireland, a loss before tax of DKr7m was realised in 2007. As at December 31, 2007, Danica Pension acquired the Irish company from the parent company, Forsikringsselskabet Danica. The purchase price was DKr30m, equalling the equity value at December 31, 2007. The company has been allocated to assets attributable to shareholders equity in Danica Pension. April 2008 9
4. Danske Bank s profit from the Danica group The table below shows the earnings elements from Danica that are included in Danske Bank s annual accounts. TABLE 2: DANSKE BANKS CONTRIBUTION FROM THE DANICA GROUP Ref. (DKr m) 2007 2006 1 Share of technical provisions etc. 1,040 1,037 2 Insurance result, unit-linked business 6-53 3 Insurance result, health and accident -112-101 4 Investment return 710 772 5 Financing result -526-300 6 Deferred risk allowance 0 0 7 Net income from insurance business 1,118 1,355 1. Share of technical provisions etc. In 2007, the amount was calculated as a share of the average life insurance provisions and the collective bonus potential, excluding Forenede Gruppeliv. 2. Insurance result, unit-linked business Consists of the technical result of unit-linked activities (Danica Link and Danica Balance) in Denmark and Norway. 3. Insurance result, health and accident Comprises the technical result of Health and accident insurance and Health care products in Denmark and Norway excluding the investment return. A large part of Danica s life insurance and pension agreements includes disability cover. The customers pay for this cover, and the amount paid is a competitive parameter. In practice, the result of health and accident activities is calculated in the same way as the result of non-life activities. The calculation includes a computed technical rate of interest (corresponding to the rate of interest on policyholders savings) on the provisions, whereas the health and accident business share of the company s remaining return on investment is included in the investment return. The health and accident result is specified in the notes to the Danica group s annual accounts (note 8, page 47). 4. Investment return Comprises the return on assets allocated to the shareholders equity of all the companies in the Danica group that affect its profit as well as the portion of the investment return attributable to the health and accident business. The return on customer funds in Danica Pension is distributed proportionally between Life insurance and Health and accident insurance based on the size of the technical provisions (investment community). However, the return on the derivative financial instruments used to hedge guaranteed benefits is not distributed on Health and accident insurance. The return on assets allocated to shareholders equity corresponds proportionally to the return on customer funds as far as equities are concerned, while other investments of shareholders equity are made independently. April 2008 10
5. Financing result Danske Bank s business area accounts are based on the principle that capital is allocated to the individual business areas in relation to their activities. For the other business areas, the required capital is fixed at 5.5% (6.5% in 2006) of risk-weighted assets. For Danica, the allocated capital is defined as the charge on the Danske Bank Group s capital equal to its ownership of Danica, i.e. the portion deducted from the Danske Bank Group s capital base. This largely corresponds to the solvency requirement for Danica minus external subordinated loan capital and plus capital tied up in assets allocated to shareholders equity. For Danica, this results in the following funding transactions: TABLE 3: FINANCING RESULT (DKr m) 2007 2006 Interest of Danica's shareholders equity -730-512 Interest on allocated capital 205 212 Financing result -526-300 It is important to note that this item is not included in Danica s group accounts, but only in Danske Bank s business area accounts. As shareholders equity exceeds the allocation of capital, overall net funding is negative. In October 2006, Danica raised external subordinated loan capital in the amount of EUR400m, which had a negative affect on net funding whereas the allocated capital has been reduced. 6. Change in shadow account balance The shadow account consists of risk allowances which could not be taken to income in previous accounting periods, see section 6.2. Change in shadow account balance constitutes income recognition of the shadow account balance, which stands at zero at the end of 2007. 7. Net income from insurance business The profit from the Danica group included in Danske Bank s Net income from insurance business. The profit deviates from, but is consistent with, the official profit of the Danica Pension group. 4.1 Risk allowance Danica Pension s traditional products are subject to the Executive Order on the Contribution Principle, which prescribes that earnings are to be distributed between customers and owners. Danica Pension prepares and notifies the authorities of the company s profit policy in accordance with these rules. The major component of the profit from Danica Pension is the risk allowance, which consists of a share of technical provisions etc. As shown in table 2, the risk allowance amounted to DKr1,040m in 2007. Overall, this risk allowance may be booked only if the so-called technical basis for risk allowance permits. See section 6 for a description of the technical basis for risk allowance. April 2008 11
5. Importance of financial guarantees and insurance guarantees The majority of customer funds relates to schemes to which financial or insurance guarantees are attached. To the extent that the customer funds are insufficient to cover the guarantees, a loss is posted on shareholders equity, reducing Danske Bank s profit from the Danica group. 5.1 Insurance guarantees Insurance risks are linked to trends in life expectancy and disability. For example, the increase in life expectancy affects the time during which benefits are payable under certain pension schemes, whereas the trends in mortality, sickness and recoveries affect the benefits of life insurance and disability insurance. In order to reduce insurance risks, Danica takes out reinsurance to cover a minor part of the risk relating to deaths and disability. Disaster risk is also covered by reinsurance for the entire portfolio. 5.2 Financial guarantees in market products Market rate products (Danica Balance and Danica Link) are individual schemes in which the results of interest rate and market value fluctuations directly affect the policyholders saved-up funds. Financial guarantees can be attached to these products. These guarantees are hedged in the financial markets in order to reduce the risk of their affecting shareholders equity. 5.3 Financial guarantees in Danica Traditionel Danica Traditionel is a collective scheme in which the financial guarantees are expressed through the technical rate of interest (see 2. in section 6.1). If the technical basis for risk allowance is insufficient to cover the risk allowance, tax on pension returns and bonuses, the excess is initially deducted in the collective bonus potential. The change in collective bonus potential is calculated as follows: TABLE 4: CHANGE IN COLLECTIVE BONUS POTENTIAL (DKr m) 2007 2006 Technical basis for risk allowance 2,120 5,824 - Share of technical provisions etc. -1,068-1,070 - Tax on pension returns -44-429 - Bonus etc. -1,410-1,728 Change in collective bonus potential -402 2,597 If this calculation results in a loss exceeding the current collective bonus potential, the excess may initially be deducted from the bonus on paid-up policies. Any losses in excess of the collective bonus potential and the bonus on paid-up policies are set off against shareholders equity. In practice, shareholders equity will be affected if the technical basis for risk allowance is negative in an amount that exceeds the collective bonus potential and the bonus on paid-up policies. The financial guarantees linked to Danica Traditional typically have very long durations and a large proportion is related to a technical interest rate of 4.5%. Danica uses its own risk management framework and hedging. The intention is that the company is able at any given time to withstand a 30% drop in share prices and a 50% drop or a 2.5 percentage point increase in interest rates. April 2008 12
Danica Pension s liabilities mainly comprise life insurance provisions, which are stated at market value by discounting the expected future cash flows. The value of the bond portfolio increases when the level of interest rates drops. The market value of the life insurance provisions also increases, but due to the greater interest rate sensitivity of these provisions, the value adjustment of the provisions is greater than the corresponding value adjustment of the bond portfolio. Overall, this means that Danica Pension experiences a negative value adjustment when the level of interest rates falls. Therefore, Danica Pension has purchased derivative financial instruments. The value of the bond portfolio is reduced by a greater amount than the value of life insurance provisions if interest rates rise, because provisions must equal, as a minimum, policyholders savings. Figure 5 illustrates the relationship between assets and liabilities. Please note that the figure is for illustrative purposes only. FIGURE 5: ILLUSTRATION OF MARKET VALUE ADJUSTMENT OF ASSETS AND LIABILITIES Provisions Bonds etc. Dkr. Interest rate change Financial instruments are used to hedge the difference between the two curves. In addition, funds are invested in assets with a view to maximising the return on investment, taking into account credit, currency and liquidity risks. April 2008 13
6. Earnings of Danica Pension The company Danica Pension primarily contributes to Danske Bank s profit from the Danica group through its investment return on shareholders equity and the risk allowance. For 2007, the contribution from the risk allowance was DKr1,040m, while the investment return was DKr710m. The risk allowance accounts for the main income from the Danica group. The calculation of the risk allowance and its sensitivity to various risks are described in the following. This is followed by a description of the investment return on shareholders equity. 6.1 Risk allowance The risk allowance for 2007 is DKr1,040m, which is in line with 2006. In 2006, the health and accident result was deducted from the risk allowance. In 2007, it is deducted directly from the profit for the year. The 2006 figures are adjusted in accordance with the principles used in 2007. Danica Pension s technical basis for risk allowance amounted to DKr2.1bn, and the risk allowance could therefore be booked in full in 2007. Danske Bank is permitted to book the risk allowance as income only to the extent that it does not exceed the technical basis for risk allowance. The technical basis for risk allowance is calculated mainly as the investment return on customer funds less the technical rate of interest (see 2. below) and the value adjustment of provisions. The calculation of the technical basis for risk allowance is illustrated in Table 5. TABLE 5: TECHNICAL BASIS FOR RISK ALLOWANCE Item (DKr m) 2007 2006 1 Return on investment securities 1,662 5,258 2 Average technical interest rate -5,231-5,272 3 Return on health and accident result -123-170 4 Cost and risk result before bonuses 243 260 5 Profit/loss on reinsurance -96-30 6 Value adjustment of provisions 5,665 5,777 7 Technical basis for risk allowance 2,120 5,824 1. Return on investment assets The total gross investment return on assets allocated to customers. Customers investment securities comprise bonds, equities and properties as illustrated in figure 6. FIGURE 6: DISTRIBUTION OF INVESTMENT ASSETS AT 31.12.2007 ALLOCATED TO DANICA PENSION CUSTOMERS Real property 10% Equi ti es 24% Bonds 66% April 2008 14
2. Average technical interest rate Contracts with customers are based on a technical interest rate, on which the guaranteed benefits offered to customers are based. During the last 14 years, the technical interest rate has dropped sharply owing to the general fall in interest rates. Until 1994, the technical rate was 4.5%. From 1994 to 1999, the rate was 2.5%. At present, new policies are written with a maximum rate of 1.5%. Table 6 shows the distribution of provisions according to the various technical rates at the end of 2007, compared with the distribution at the end of 2006. TABLE 6: LIFE INSURANCE PROVISIONS (DKr m) End 2007 End 2007 (%) End 2006 (%) Technical interest rate in % 0,0 1,145 1 1 1,5 44,145 29 26 2,5 28,814 19 20 4,5 78,425 51 53 8 to 20 189 0 0 Life insurance provisions 152,718 100 100 Without guarantee 10,795 Total life insurance provisions 163,513 As the table shows, the technical interest rates have generally become lower. 3. Return on health and accident result The health and accident business consists of disability insurance, for which reserves have been provided. Part of the total investment return is therefore attributable to the health and accident result. 4. Danske Bank Group before bonuses The calculation of guaranteed benefits is based on assumptions of future investment returns, costs and insurance risks (death and disability). These assumptions are conservative, and the difference between assumed and actual investment returns, costs and insurance risks are distributed to customers over time in the form of bonuses. The cost result before bonuses represents the difference between actual costs incurred and the costs assumed in the calculation of guaranteed benefits. The risk result before bonuses represents the difference between actual risk cover and the risk premium assumed in the calculation of guaranteed benefits. 5. Profit on reinsurance The profit on reinsurance is calculated as the reinsurance cover received less reinsurance premiums. 6. Value adjustment of provisions Life insurance provisions are stated at present value by discounting expected future cash flows using the swap yield curve prescribed by the Danish FSA. Value adjustment of the provisions constitutes the part of life insurance provisions exceeding the value of policyholders savings. April 2008 15
7. Technical basis for risk allowance If the technical basis for risk allowance is positive, Danica Pension can book the risk allowance to its income statement to the extent that it does not exceed the technical basis for risk allowance. If the risk allowance cannot be booked, in whole or in part, it can be deferred and booked in a year when the technical basis for risk allowance permits. 6.2 The shadow account The portion of the risk allowance for the period exceeding the technical basis for risk allowance is transferred to the shadow account. From this account, recognition in the profit of Danske Bank may be made at a later date when the technical basis for risk allowance permits. The shadow account accrues interest at the rate that applies to the bond portfolio allocated to shareholders equity. At the end of 2007, there is no deferred risk allowance in the shadow account. 6.3 Relationship between risk allowance, investment return and provisions If the investment return exceeds the technical interest rate and the value adjustment of provisions, the company may (other things being equal) book all or part of the risk allowance to the income statement as shown in the example in table 7 below. TABLE 7: RELATIONSHIP BETWEEN RETURN ON INVESTMENT AND RISK ALLOWANCE Scenario (in % of provisions) A B C D Return on investment assets 3.0 4.5 6.0 6.0 Technical interest rate -2.8-2.8-2.8-2.8 Cost and risk results and return on H&A -0.2-0.2-0.2-0.2 Profit on reinsurance 0.0 0.0 0.0 0.0 Value adjustment of provisions 0.0 0.0 0.0-3.0 Technical basis for risk allowance 0.0 1.5 3.0 0.0 Risk allowance may be recognised as income in whole or in part No Yes Yes No Risk allowance of provisions -0.6-0.6-0.6 0.0 Tax on pension returns (PAL) -0.5-0.7-0.9-0.9 Bonuses (difference between technical interest rate and interest on policyholders savings) -1.0-1.0-1.0-1.0 Change in collective bonus potential -1.5-0.8 0.5-1.9 In principle, the technical basis for risk allowance can be used to book all or part of the risk allowance for the period and the potential shadow account balance, as tax on pension returns and bonuses are covered by the collective bonus potential. The option of using this practice does, however, depend on the trend in the collective bonus potential. Scenario A The investment return is just large enough to cover the technical interest and the return on health and accident. Consequently, the risk allowance cannot be booked. The collective bonus potential is reduced by 1.5% of the provisions to cover obligations toward customers. Scenario B The investment return is larger than the technical interest etc., there is no value adjustment of provisions and the technical basis for risk allowance is positive. This means that the risk allowance may be booked in whole or in part. However, the technical basis for risk allowance does not cover the April 2008 16
tax on pension returns or the difference between the technical interest rate and the rate on policyholders savings. To cover these payments, the collective bonus potential will be reduced by 0.2% of the provisions. For the full risk allowance to be booked as income, an additional 0.6% reduction of the collective bonus potential is required. Scenario C The technical basis for risk allowance covers all customer obligations and leaves 3.0% of the provisions for additional profit allocation. This return also covers the tax on pension returns, bonuses and the risk allowance to Danske Bank with no reduction of the collective bonus potential. In scenarios B and C, it is possible to book the risk allowance for the year. In both scenarios it is also possible to book from the shadow account; this will, however, cause a (further) reduction of the bonus potential at a one-to-one ratio. Scenario D Assumptions as in C, but with a 3.0% value adjustment of provisions as a result of a reduction of interest rates. The technical basis for risk allowance is 0. Consequently, no risk allowance can be booked in the income statement. The relationship between risk allowance and investment return is illustrated further in figure 7, which shows the limit of when, with its balance sheet total at the end of 2007, Danica Pension will be able to book the full risk allowance one year ahead; the full risk allowance can be booked at share price and interest rate changes above the limit shown. For example as showed in figure 7, with an unchanged level of interest rates and a positive return on shares, it will be possible to book the risk allowance as income. This is based on an 8% return on properties. Negative share returns would require a fall in interest rates in order to obtain the full risk allowance. The asymmetric shape of the curve in figure 7 is due to Danica Pension s hedging strategy against interest rate changes (see page 12). FIGURE 7: LIMIT OF FULL RISK ALLOWANCE ONE YEAR AHEAD 70% 60% 50% Share price changes 40% 30% 20% 10% 0% -10% -20% -3% -2% -1% 0% 1% 2% 3% 4% 5% Interest rate changes April 2008 17
6.4 Investment return on shareholders equity Assets allocated to shareholders equity in Danica Pension are primarily invested in short-term bonds, equities and properties, as shown in figure 8. In addition, a minor portion of shareholders equity is invested in Danica Pension I, from which Danica s market products are sold. The profit generated by Danica Pension I is described in section 7. FIGURE 8: DISTRIBUTION OF DANICA PENSIONS ASSETS ALLOCATED TO SHAREHOLDERSEQUITY Equities 25% Bonds 64% Real property 11% April 2008 18
7. European Embedded Value in Danica Pension I, Denmark 7.1 Management summary The successful sale of market products (Danica Link and Danica Balance) at Danica Pension has significantly increased the demand for more value-oriented accounting methods as a supplement to conventional accounting methods. The market products now account for over 40 per cent of the gross premiums in Danica Pension, Denmark, as the figure below shows. DKr bn 14 FIGURE 9: GROSS PREMIUMS 12 10 8 6 4 2 0 Year 2003 2004 2005 2006 2007 Danica Traditionel, Denmark Market products, Denmark In this light, Danica Pension has decided to introduce European Embedded Value (EEV) in Danica Pension I, Denmark. The EEV methodology adopted by Danica Pension is a bottom-up market-consistent approach, and it covers the Danish unit-link life business. Hence, neither Health and Accident Insurance, nor the foreign activities is included. The calculations comply with the requirements of the CFO Forum (www.cfoforum.nl). The European Embedded Value covering Danica Link and Danica Balance is DKr1,979m as of December 31, 2007. Since this is Danica Pension s first EEV report, no historical comparisons are available. Instead, the year-end 2007 figures will be presented with a focus on explaining changes from year-end 2006 to year-end 2007. TABLE 8: EUROPEAN EMBEDDED VALUE (DKrm) 2006 Growth Movements in allocated capital 2007 Shareholders' net assets 297-6 58 349 Value of Business In-force 1,249 381 1,630 European Embedded Value 1,547 375 58 1,979 - hereof Value of New Business 325 EEV earnings 375 Return on EEV (excl. movements in allocated capital) 24% Shareholders net assets are defined as 125 per cent of statutory solvency requirements. These requirements are based on the consolidated accounts, which are presented in accordance with the International Financial Reporting Standards (IFRS) as adopted by the EU. In the annual report for Forsikringsselskabet Danica, the result for the covered business and shareholders net assets is shown in the segmental accounts. April 2008 19
The Value of Business In-force is the present value of future distributable earnings from the covered business. The components are represented as Certainty Equivalent Present Value of the Future Profits less Time Value of Options and Guarantees, Frictional Cost of Capital and Cost of Non-Market Risk. As shown in the table above, EEV as of year-end 2007 amounts to DKr1,979m, which represents an increase of DKr432m compared with the level at year-end 2006. This increase is due mainly to the value of New Business (VNB), higher capital requirements as a result of increased business volume and changes in the Danish tax legislation. At the same time, EEV of the in-force business decreased because of price reductions carried out during 2007. 7.2 Introduction Danica Pension reports its results using statutory accounting as set out by IFRS issued by the International Accounting Standards Board (IASB) as adopted by the EU and with relevant interpretations issued by the International Financial Reporting Interpretation Committee (IFRIC). Furthermore, the consolidated accounts comply with the Danish FSA s disclosure requirements for annual reports of issuers of listed bonds. Statutory accounting often tends to underestimate the value of the insurance business, especially when it comes to market products with high growth. For Danica Pension, the results and equity in Danica Pension I have been negatively affected by the relatively high acquisition costs in the first year of a typical contract, whilst the income generated by sales is distributed over the term of the contract. With the successful introduction of Danica Balance in 2005 and the growth in Danica Pension s market products in general, this issue has become even more pronounced. Both investors and analysts have addressed this issue, and this has resulted in an increased focus on using more value-generating accounting methods. In May 2004, the CFO Forum developed requirements for EEV reporting, and since then a number of additional guidelines have been published. The EEV principles were designed with the intention of creating guidelines to improve comparability and transparency in financial reporting for insurance companies across Europe. In the figure below, the profits based on the statutory accounting method and the European Embedded Value method respectively are shown. The figure shows profits generated from a single contract, and illustrates the difference over time using IFRS accounting and European Embedded Value accounting. FIGURE 10: ILLUSTRATION OF THE REALISATION OF PRODUCTS Year Statutory/IFRS profits European Embedded Value earnings April 2008 20
Danica Pension has decided to conduct EEV reporting in accordance with these EEV principles, which in this context can work as a tool for estimating the value generated by Danica Pension I. The primary purpose of introducing EEV is to give analysts, investors and other stakeholders a more thorough view of the value creation of Danica Pension s market products. It is important in this context to stress that the EEV results must be seen not as the actual value to investors of the market product business but as a supplement to the existing accounting. Policies that the company expects to sell in the future are not part of the EEV calculations and constitute an important difference between EEV and the actual value of the business to investors. The reason for focusing on market products only and leaving out the conventional life and pension business (Danica Traditionel) is that the difference between the statutory result and estimated value creation is highest for these products. Hence, the results for the market products have been negative due to high growth rates and thus high acquisition costs. In the statutory accounts concerning the conventional business, the result primarily consists of risk allowance and investment return, while it is not directly influenced by the acquisition costs. Thus the accounting of the conventional business creates a more transparent result compared to the results of the market product business. In the chart below, the corporate structure of the Danica Group is shown together with the shareholders equity for the individual units. Danske Bank is the owner of Forsikringsselskabet Danica. FIGURE 11: CORPORATE STRUCTURE OF THE DANICA GROUP Forsikringsselskabet Danica (Shareholders equity: DKr 17,716m) Danica Pension (DKr 15,982m) Danica Life Ltd. ( 4m) Danica Pension I (Dkr 654m) Danica Liv III (DKr 743m) Danica Pension Försäkringsaktiebolag (SEK 114m) Danica Pensjonsforsikring (NOK 243m) Covered business (DKr 349m) DP I, excl. Covered Bus. (DKr 305m) EEV as of December 31, 2006, and December 31, 2007, as well as the new business value, the analysis of the change and the sensitivities have been developed in collaboration with the consulting actuary Tillinghast. Tillinghast has also conducted a sign-off process resulting in the attestation found at the end of this chapter. 7.3 METHODOLOGY AND DEFINITIONS Embedded Value is a measure used to estimate the shareholders interest in the covered business and is determined by calculating the present value of expected future distributable earnings. Danica Pension has decided to disclose the EEV of its market products in Danica Pension I, Denmark, in compliance with the requirements of the CFO Forum. For this, Danica Pension has decided to use the Market-Consistent Embedded Value (MCEV) approach. From 2002 to 2005, Danish Financial Reporting regulations allowed insurance companies to include the present value of the future profits on the balance sheet - a practice which was adopted by Danica Pension as Unrealised Market Value Correction. It was a simplified calculation of 10 years expected results, April 2008 21
where cost of capital and costs related to options and guarantees were not taken into account. Consequently, the results are not comparable to EEV results. In 2006, the Financial Reporting regulations were changed, so that from 2006 and onwards, the value of future results would not be recognised on the balance sheet and accordingly can no longer be found in Danica Pension s accounts. The approach that Danica Pension has adopted for the EEV calculation is a bottom-up market-consistent approach, where asset and liability cash flows are valued consistent with similar cash flows in the capital markets. The time value of options and guarantees are valued using market consistent valuation approaches calibrated to observable market prices. In order to obtain market-consistency, projected cash flows must be discounted using cash flow specific risk discount rates e.g. a projected symmetric risk-free cash flow should be discounted using the risk-free yield curve and a projected symmetric risky cash flow earning the market rate should be discounted using the market rate. The Present Value of Future Profits (PVFP) is calculated using a certainty equivalent technique, which is a deterministic method. The certainty equivalent value of in-force business is the present value of bestestimate distributable earnings discounted with the risk free rate consistent with the current yield curve. The best-estimate distributable earnings are determined under the assumption that the future investment returns on all asset classes will be equal to the forward rates implied by the risk free interest rates. In theory, when valuing cash flows depending on volatile assets e.g. charges depending on fund value, these assets need to be projected at returns reflecting these volatile assets. But as the resulting cash flows are volatile they should also be discounted taking the risk into account. These two effects cancel out and it is therefore sufficient to project volatile cash flows at the risk-free rate and discount using the same risk-free rate. As many customers have a maturity guarantee attached to their market product, these guarantees need to be valued as well. The value of the guarantees has been divided into two parts: intrinsic and time value. The intrinsic value is the value of the guarantee, if there were no volatility in the capital markets, and is included in PVFP. As of December 31, 2007, this value is insignificant. The remainder, Time Value of Options and Guarantees (TVOG), depends on the exposure to volatile cash-flows, and therefore a market-consistent stochastic model has been applied to determine the TVOG. This value is calculated using an advanced option-pricing approach calibrated to be consistent with the prices of quoted options with similar characteristics. While the financial cash-flows are adjusted for any financial risks, other risks such as operational and insurance risks are adjusted for by including a Cost of Non-Market Risk. This is described in section 7.3.4. Total EEV is calculated as the sum of shareholders net assets and PVFP less TVOG and Cost of Capital (CoC), where CoC covers Frictional Cost of Capital (FCOC) and Cost of Non-Market Risk (CNMR). These elements will all be described in section 7.3.4. April 2008 22
7.3.1 Covered business The covered business in Danica Pension s EEV calculation comprises the market products sold in Denmark (Danica Balance and Danica Link), also referred to as Danica Pension I, Denmark, excluding Health and Accident Insurance. Conventional life and pension business (Danica Traditionel) and market products sold outside Denmark, as well as the result from Health and Accident Insurance, are not covered. In the tables below, the gross premiums, the annual premiums and provisions concerning covered business are shown to illustrate the size. TABLE 9: COVERED BUSINESS (DKrm) 2006 2007 Change Gross premiums Regular premiums 2,521 3,597 43% Single premiums 3,329 3,508 5% Total gross premiums 5,850 7,106 21% TABLE 10: COVERED BUSINESS (DKrm) Dec. 31, 2006 Dec. 31, 2007 Change Annual premiums - with guarantee 599 607 1% - without guarantee 2,237 3,302 48% Total annual premiums 2,836 3,908 38% Provisions - with guarantee 5,228 5,723 9% - without guarantee 10,534 16,028 52% Total provisions 15,763 21,751 38% Statutory profit before tax 9.0 7.4-18% In comparison, the total provisions in Danica Pension Group were DKr222,514m as of year-end 2007, which means that covered business accounts for approximately 10 per cent of the total business in Danica Pension Group. Any revenues generated by covered business in other parts of the Danske Bank Group are not included in the EEV. This includes, for example, income generated in Danske Bank by selling Danica Pension s market products and likewise, income generated in Danske Capital by managing customers investments. Danica Pension has thus decided not to follow the look-through principle, which is part of the EEV-principles. It should be noted that valuation of revenues in other units of Danske Bank Group are included in the valuation of these business areas. 7.3.2 Calculation of value of future results The calculations of Danica Pension s EEV are performed by using a model developed to reflect the actual products and cash-flows in the covered business. The cash-flows are projected over 40 years using the riskfree interest rate as growth rate for all assets and then discounted using the risk-free discount rate. The chart below shows how the expected future results are spread out over the period of 40 years. On the basis of this chart, it is evident that a projection period of 40 years is sufficient approximately 40 per cent of the value is generated during the first five years. April 2008 23
DKr m 700 FIGURE 12: REALISATION OF EXPECTED FUTURE RESULTS 600 500 400 300 200 100 0 2007-2011 2012-2016 2017-2021 2022-2026 2027-2031 2032-2036 2037-2041 2042- Year 2046 The pre-tax profit of the covered business can be divided into the following elements: Income consists primarily of the fees paid by policyholders and the commissions received by the company from the fund managers investing policyholders savings. Costs consist of acquisition costs and administrative expenses. The result from the risk cover sold in relation to pension savings and the profit from the financial guarantees that policyholders can opt to buy. Return on investment of the assets allocated to shareholders equity. The income is generated from the assets over the term of the agreements, whereas the costs are highest in the first year due to acquisition costs. In years with a sharp increase in the business volume, the accounts are negatively affected by major acquisition costs. Thus, the profit does not reflect the value creation during such a year, and this is one of the main reasons for introducing EEV reporting. 7.3.3 Options and guarantees As stated in section 3, Danica Pension I has two different kinds of products; Danica Link and Danica Balance and each with financial options and guarantees. The guarantee attached to Danica Link secures the customer with at least 95 per cent of the payments (after charges and payment for insurance coverage). The guarantee is raised once a year to 95 per cent of the funds value, if and only if this constitutes an increase. The guarantee linked to Danica Balance, guarantees 0 % return on premiums (after charges and payment for insurance coverage). The options and guarantees connected to Danica Link products are partly hedged on an ongoing basis through the purchase of financial instruments, financed by guarantee premium payments from policyholders. In the EEV-context, these options and guarantees are valued using a market-consistent stochastic pricing model. Furthermore, the value of the guarantees has been divided into intrinsic and time value. The options and guarantees embedded in Danica Balance products are managed in Danica Pension I using a CPPI-strategy (Constant Proportion Portfolio Insurance Strategy). The CPPI strategy is a strategy which aims at ensuring that each portfolio is managed in such a way that its value at a certain point in time always exceeds the present value of guaranteed amounts. This is conducted by investing in a combination of risk free and risky assets, such that following a low or negative return of the equity component, a reallocation into risk free assets would be sufficient to make certain that the value of the embedded option is not substantial. April 2008 24