Exposure To Spanish Assets And The Economy Is Overshadowing Spanish Insurers' Sound Underwriting Earnings And Capital Adequacy

Primary Credit Analyst: Marco Sindaco, London (44) 20-7176-7095; marco.sindaco@standardandpoors.com Secondary Contacts: Peter McClean, London (44) 20-7176-7075; peter.mcclean@standardandpoors.com Lotfi Elbarhdadi, Paris (33) 1-4420-6730; lotfi.elbarhdadi@standardandpoors.com

Table Of Contents
Sovereign Risk Constrains The Scope For Higher Ratings Moderately Strong Capital, Notwithstanding Heightened Asset Credit Risk High P/C Profitability Could Potentially Weaken Over Coming Years Contracting Demand For Life Protection Products And Lower Interest Rates Could Weigh On The Life Segment's Strong Margins Related Criteria And Research

WWW.STANDARDANDPOORS.COM/RATINGSDIRECT

NOVEMBER 19, 2013 1

1219301 | 301967406

Exposure To Spanish Assets And The Economy Is Overshadowing Spanish Insurers' Sound Underwriting Earnings And Capital Adequacy
Heightened asset credit risk, and still-challenging economic prospects in Spain are weighing on Standard & Poor's Ratings Services' views of Spanish insurers' financial strength. Our assessment of the life and non-life insurance industry and country risk assessment as moderate, a level higher than the European average, is a constraint to business risk profiles, mostly due to our view on the country's economic prospects. Furthermore, the lower average rating of Spanish insurers' investment portfolios compared with western and northern European peers is weighing on our views on insurers' capital adequacy and risk position. Spanish insurance market practices feature strict asset-liability matching (ALM), the application of surrender penalties, and market value adjustments in case of surrenders. In our opinion, these features allow Spanish insurers to effectively manage their exposure to interest rate risk. Consequently, and despite record increases in yields on Spanish government bonds negatively affecting asset values, Spanish insurers have maintained sound solvency levels over the past two years. Overview Asset credit risk and exposure to a tough economic environment in Spain are the major constraints on Spanish insurers' creditworthiness, in our opinion. We believe domestic insurers are still maintaining moderately strong levels of capital adequacy on average, but remain subject to stable investment market conditions. Life insurers continue to post strong margins, benefiting from the profitable protection products and good yields on Spanish bonds. P/C insurers continue to post strong combined ratios, benefiting from stable reserving, absence of exposure to natural catastrophe risk, and an improved claims frequency resulting from weakened economic activity. Increasing competition could eventually lead insurers to aggressive pricing, in turn eroding P/C margins. Life margins could also suffer from a contraction in the demand for protection products and lower investment yields.

The relatively high yields on Spanish sovereign bonds also provides Spanish insurers with good investment margins compared with their western and northern European peers and enables life insurers in particular to retain relatively good margins above guaranteed life policy rates. Overall, the life insurance sector's profitability, which we view as strong, continues to be driven by the highly profitable protection products. In P/C business lines, lower economic activity and vehicle usage are also driving lower claims frequency, maintaining P/C companies' underwriting profitability at sound levels. As a consequence, capital, underwriting life, and non-life results are the main relatively positive features that we consider are supporting ratings in the Spanish market. However, protracted tough economic conditions could

WWW.STANDARDANDPOORS.COM/RATINGSDIRECT

NOVEMBER 19, 2013 2

1219301 | 301967406

Exposure To Spanish Assets And The Economy Is Overshadowing Spanish Insurers' Sound Underwriting Earnings And Capital Adequacy

ultimately result in a curtailing of premium volumes. This, in turn, could pressure cost management and weigh on earnings potential should insurers strive for volumes through aggressive pricing or guarantees. We believe life sector profitability could be negatively impacted by contracting volumes of the profitable protection products and lower interest rates, while improved claims frequency is likely to offset by pressure on motor insurance tariffs.

Sovereign Risk Constrains The Scope For Higher Ratings

As of end-October 2013, we rated nine Spanish insurers, representing approximately 23% of the market's 2013 gross premiums written. With the exception of HCC Europe Seguros & Reaseguros S.A. (AA-/Negative), our ratings on these insurers are all in the 'BBB' category (see table), with many of them limited at the 'BBB-' sovereign rating level, apart from Mapfre Re and Mapfre Global Risks, which derive a higher rating from their groups' international diversification under our criteria (see "Nonsovereign Ratings That Exceed EMU Sovereign Ratings," published June 14, 2011, on RatingsDirect). All our ratings on the sector carry negative outlooks. Rating Migration Of Spanish Insurers 2009-2013
--Year ended Dec. 31-Issuer Kingdom of Spain HCC Europe Seguros & Reaseguros Mapfre Global Risks Mapfre Re Nacional de Reaseguros S.A. CESCE FIATC Pelayo Fenix Directo S.A. AXA Seguros Generales *As of Nov. 19, 2013. 2009 2010 2011 2012 2013* BBB-/Negative AA-/Negative

AA+/Negative AA/Negative AA/Stable AA/Stable AA/Stable A+/Stable A-/Stable BBB-/Stable BBBpi BBBpi BBBpi AA/Stable AA/Negative AA/Negative A+/Stable A-/Positive

AA-/Watch Neg BBB-/Negative AA/Stable AA/Stable

AA-/Watch Neg BBB+/Negative BBB+/Negative AA-/Watch Neg BBB+/Negative BBB+/Negative A+/Watch Neg A-/Stable BBB-/Negative BBB-/Negative BBB-/Negative BBB-pi BBB-pi BBpi BBB-/Negative BBB-/Negative BBB-/Negative BBB-pi BBB-pi BBpi

BBB-/Positive BBB-/Positive BBBpi BBBpi BBBpi BBBpi BBBpi BBBpi

We generally view Spanish insurers' financial risk profiles, although weakened over the past two years, still as a relative rating strength, particularly when supported by sound earnings (see chart 1) and capital adequacy levels that on average are in our opinion moderately strong. Pressure on Spanish insurers' capital and earnings and risk position, resulting from difficult economic conditions and a decline in the credit risk associated with their assets, has weighed negatively on our opinion of Spanish insurers' financial risk profiles. Our assessment of insurers' business risk profiles, meanwhile, together with each insurer's specific competitive position, reflect our moderate view of Spanish P/C and life sector risks, as outlined in our Insurance Industry and Country Risk Assessments (IICRAs; see "Spanish Property/Casualty Insurance Sector Carries A Moderate Industry And Country Risk Assessment," published Nov. 12, 2013, and "Spanish Life Insurance Sector Carries A Moderate Industry And Country Risk Assessment," published Nov. 18, 2013). We base this opinion on our moderate view of Spain's country risk, which is negatively impacted by our view of economic and financial system risks, and our intermediate view of industry risk for both the life and P/C sectors.

WWW.STANDARDANDPOORS.COM/RATINGSDIRECT

NOVEMBER 19, 2013 3

1219301 | 301967406

Exposure To Spanish Assets And The Economy Is Overshadowing Spanish Insurers' Sound Underwriting Earnings And Capital Adequacy

Such features lead us to assess Spanish insurers' indicative stand-alone credit profiles (SACPs) at 'bbb/bbb+' on average, higher than the sovereign ratings and their average financial strength ratings of 'bbb-'.
Chart 1

Moderately Strong Capital, Notwithstanding Heightened Asset Credit Risk

The Spanish insurance sector continues to show levels of capital adequacy that we consider a relative rating strength. Over time, Spanish insurers have generally built capital buffers through retained earnings and/or members' direct contributions to mutual funds. On average, the sector covered comfortably its minimum regulatory capital requirements by 2.9x (2.2x for life and 3.7x for P/C) as of year-end 2012, compared with 2.6x at year-end 2011 and 2012 (see chart 2). We expect the overall level of capital adequacy in the industry to continue to benefit from net retained earnings and potentially lower capital requirements, resulting from lower business volumes.

WWW.STANDARDANDPOORS.COM/RATINGSDIRECT

NOVEMBER 19, 2013 4

1219301 | 301967406

Exposure To Spanish Assets And The Economy Is Overshadowing Spanish Insurers' Sound Underwriting Earnings And Capital Adequacy

Chart 2

However, the decline in the credit quality of Spanish securities over the past three years has weighed negatively on our view of Spanish insurers' capital adequacy. Spanish investments accounted for an estimate 70% of Spanish insurers' total investment portfolio in 2012. We estimate that Spanish bonds currently account for 45% of Spanish insurers' investments, or 3x their total capital. Therefore, we expect any developments in average ratings on Spanish securities to have an impact on our capital requirements for asset risk, and accordingly our views on capital adequacy. Spanish bonds, particularly domestic government bonds (which accounted for an estimated 26% of insurers' invested assets in 2012; see chart 3), match insurers' liquidity requirements and offer attractive yields, especially in light of the high demand for guarantees from Spanish life policyholders. This exposure is likely to remain also because of favorable regulatory treatment. In 2012, the Spanish regulator lowered the minimum credit ratings that securities backing reserves should carry, particularly in relation to sovereign debt. Prospectively, under the EU's Solvency II Directive, government bonds will likely benefit from the absence of a capital charge for default risk. Meanwhile, low interest rates in western and northern Europe reduce the alternative choices for investments.

WWW.STANDARDANDPOORS.COM/RATINGSDIRECT

NOVEMBER 19, 2013 5

1219301 | 301967406

Exposure To Spanish Assets And The Economy Is Overshadowing Spanish Insurers' Sound Underwriting Earnings And Capital Adequacy

Chart 3

More specifically, we believe the P/C players in general face lower asset credit risk than their life peers, owing to stronger solvency levels, lower exposure to Spanish bonds proportionally and shorter average asset duration. That said, this difference is partially offset by our view that P/C insurers are proportionally more exposed to the real estate sector than their life counterparts. Life insurers' higher exposure to Spanish bonds is largely due to their need to closely match cash flows, as they rely on the bonds' relatively high return to offer guaranteed rates (up to 5%) to their policyholders. Close matching of assets to liabilities should in our view continue to mitigate guarantee risks, since insurers typically match their liabilities with fixed-income securities, mostly domestic sovereign bonds. Life insurers mostly retain the credit risk associated with the assets backing their traditional policies. However, guarantees at maturity only act as a mitigant to interest rate risk, unlike the situation in many other continental European markets. This shelters Spanish insurers from realizing losses relating to market movements in the event of a sharp rise in bond yields and policy lapses. A further mitigant is the close, regulatory driven, ALM in the Spanish insurance market, which limits the negative effect that spikes in yields may have on capital. Spanish insurers' exposure to equity market risk is relatively manageable, in our view, since equities and participations

WWW.STANDARDANDPOORS.COM/RATINGSDIRECT

NOVEMBER 19, 2013 6

1219301 | 301967406

Exposure To Spanish Assets And The Economy Is Overshadowing Spanish Insurers' Sound Underwriting Earnings And Capital Adequacy

in investment funds account for less than 11% of insurers' total invested portfolio.

High P/C Profitability Could Potentially Weaken Over Coming Years

We estimate that the P/C insurance sector in Spain will contract by 3.0% in 2013 (following a 0.2% contraction in 2012) versus an estimated GDP decline of 1.5%. We expect volumes to continue to contract by about 1%-2% in 2014 and 2015 (versus GDP growth of 0.5% and 1.1%, respectively), while lower pricing, particularly in motor insurance, will likely continue to erode margins. Contraction in industrial activity could reduce the demand for commercial insurance covers, particularly in transport and property. We also believe that increasing price sensitivity among motor policyholders and reduced vehicle use will lead to a contraction of more than 6% in motor insurance in 2013 (in line with 2012), which accounts for about one-third of total P/C business. In our opinion, the Spanish P/C insurance sector benefited from several years of hard pricing, sound reserving, and good expense management. The insurers' struggle to maintain volumes is likely to exacerbate price competition, which could weigh on insurers' combined (loss and expense) ratios both in personal and commercial P/C lines. Our expectation is that pressure on tariffs, in particular motor, will remain an inherent feature of the Spanish insurance market over the next three years, fuelled by increasingly price-sensitive customers. In parallel, we anticipate that personal lines, especially the health insurance segment, will post stable growth as the need and demand for personal covers increase and state-provided covers decrease. Earnings should hold up well in 2013. Our estimate of the market's overall combined ratio is 95% in 2013 versus 93.4% in 2012 (see chart 4). We believe insurers' lack of exposure to catastrophe risk (which is covered by the state-backed Consorcio de Compensacin de Seguros), and the presence of the Baremo index for bodily injury claims (which makes claims settlement more predictable), continue to support sound underwriting profitability in the Spanish P/C market. Furthermore, investment returns, notably due to the relatively high yields on Spanish government bonds, have benefitted Spanish P/C insurers' operating results more than their northern and western European counterparts. Over the next two years, we expect any reduction in claims frequency to be more than offset by premium declines due, in particular, to downward trends in tariffs. Our base-case assumption for the Spanish market's underwriting profitability factors in a market's average combined ratio to a still-strong level of 96%-97% in 2014 and 2015. Earnings disparities are likely to be maintained, however, because insurers with sophisticated pricing and risk selection tools should be better placed to manage their exposures and tariffs due to more refined customer segmentation compared with peers. Although not in our base-case scenario, a potential strong recovery in economic activity would, on the one hand, have a positive impact on volumes. On the other hand, it would likely drive an increase in claims frequency, in our opinion. Such a scenario could likely lead to a spike in combined ratios for those insurers unable to adapt their pricing quickly to reflect the increased risk. In our opinion, the insurers most likely to preserve their profitability will be those applying risk-adjusted pricing and flexible terms and conditions.

WWW.STANDARDANDPOORS.COM/RATINGSDIRECT

NOVEMBER 19, 2013 7

1219301 | 301967406

Exposure To Spanish Assets And The Economy Is Overshadowing Spanish Insurers' Sound Underwriting Earnings And Capital Adequacy

Chart 4

Contracting Demand For Life Protection Products And Lower Interest Rates Could Weigh On The Life Segment's Strong Margins
We expect profitability in the life sector to decline but remain strong in 2013-2015, absent major negative economic developments or impairments. According to our estimate, average new business margins are likely to fall to just above 3% of present value of new business premiums (PVNBP) over 2013-2015, from 3.5% in 2012, mostly driven by a likely contraction in the demand for the higher-margin protection products. These products benefit from favorable mortality experience, long duration, and regular premiums. As demand for protection mostly track trends in the wider economy, the prolonged contraction in bank and mortgage lending could impair growth prospects for these products. We also believe investment margins over 2013-2015, although remaining positive, will likely suffer from declining interest rates, which will in part be offset by lower levels of asset impairment compared with 2011 and 2012. The market growth patterns over the past five years have been very volatile, ranging between annual growth of 15% and contraction of 12%. We anticipate that the Spanish life market will contract by about 5% in terms of premiums in 2013, after a 10% fall in 2012. However, we see some growth returning in 2014-2015, partly mirroring GDP. We believe that lower competition from government bonds and bank deposits, and the pick-up in equity markets, are

WWW.STANDARDANDPOORS.COM/RATINGSDIRECT

NOVEMBER 19, 2013 8

1219301 | 301967406

Exposure To Spanish Assets And The Economy Is Overshadowing Spanish Insurers' Sound Underwriting Earnings And Capital Adequacy

spurring a pick-up in sales of savings (mostly participating with minimum guarantees) and unit-linked products, which accounted for 87% of total life premiums in 2012 (see chart 5).
Chart 5

On the in-force business, we estimate more than three-quarters of the Spanish market's life portfolio has guaranteed interest rates. Consequently, declining interest rates could dampen the long-term margin potential of savings products and increasingly put the emphasis on insurers' ability to adapt their products and guarantees should they wish to safeguard their margins. We expect, however, insurers to continue to benefit from positive, albeit weakened margins on these products, owing to cash flow matching, adjusted surrender values, and still relatively high yields on Spanish government bonds.

Related Criteria And Research

The articles listed below are available on RatingsDirect. Spanish Life Insurance Sector Carries A Moderate Industry And Country Risk Assessment, Nov. 18, 2013 Spanish Property/Casualty Insurance Sector Carries A Moderate Industry And Country Risk Assessment, Nov. 12, 2013

WWW.STANDARDANDPOORS.COM/RATINGSDIRECT

NOVEMBER 19, 2013 9

1219301 | 301967406

Exposure To Spanish Assets And The Economy Is Overshadowing Spanish Insurers' Sound Underwriting Earnings And Capital Adequacy Ratings On Spain Affirmed At 'BBB-/A-3'; Outlook Negative, June 14, 2013 S&P's Insurance Industry And Country Risk Assessments Offer A Global View Of The Forces Shaping Insurance Markets, May 22, 2013 Insurers: Rating Methodology, May 7, 2013 Methodology And Assumptions: Request For Comment: Ratings Above The Sovereign--Corporate and Government Ratings, April 12, 2013 Banking Industry Country Risk Assessment: Spain, March 14, 2013 Nonsovereign Ratings That Exceed EMU Sovereign Ratings, June 14, 2011 Refined Methodology And Assumptions For Analyzing Insurer Capital Adequacy Using The Risk-Based Insurance Capital Model, June 7, 2010
Additional Contact: Insurance Ratings Europe; InsuranceInteractive_Europe@standardandpoors.com

WWW.STANDARDANDPOORS.COM/RATINGSDIRECT

NOVEMBER 19, 2013 10

1219301 | 301967406

Copyright 2013 by Standard & Poor's Financial Services LLC. All rights reserved. No content (including ratings, credit-related analyses and data, valuations, model, software or other application or output therefrom) or any part thereof (Content) may be modified, reverse engineered, reproduced or distributed in any form by any means, or stored in a database or retrieval system, without the prior written permission of Standard & Poor's Financial Services LLC or its affiliates (collectively, S&P). The Content shall not be used for any unlawful or unauthorized purposes. S&P and any third-party providers, as well as their directors, officers, shareholders, employees or agents (collectively S&P Parties) do not guarantee the accuracy, completeness, timeliness or availability of the Content. S&P Parties are not responsible for any errors or omissions (negligent or otherwise), regardless of the cause, for the results obtained from the use of the Content, or for the security or maintenance of any data input by the user. The Content is provided on an "as is" basis. S&P PARTIES DISCLAIM ANY AND ALL EXPRESS OR IMPLIED WARRANTIES, INCLUDING, BUT NOT LIMITED TO, ANY WARRANTIES OF MERCHANTABILITY OR FITNESS FOR A PARTICULAR PURPOSE OR USE, FREEDOM FROM BUGS, SOFTWARE ERRORS OR DEFECTS, THAT THE CONTENT'S FUNCTIONING WILL BE UNINTERRUPTED, OR THAT THE CONTENT WILL OPERATE WITH ANY SOFTWARE OR HARDWARE CONFIGURATION. In no event shall S&P Parties be liable to any party for any direct, indirect, incidental, exemplary, compensatory, punitive, special or consequential damages, costs, expenses, legal fees, or losses (including, without limitation, lost income or lost profits and opportunity costs or losses caused by negligence) in connection with any use of the Content even if advised of the possibility of such damages. Credit-related and other analyses, including ratings, and statements in the Content are statements of opinion as of the date they are expressed and not statements of fact. S&P's opinions, analyses, and rating acknowledgment decisions (described below) are not recommendations to purchase, hold, or sell any securities or to make any investment decisions, and do not address the suitability of any security. S&P assumes no obligation to update the Content following publication in any form or format. The Content should not be relied on and is not a substitute for the skill, judgment and experience of the user, its management, employees, advisors and/or clients when making investment and other business decisions. S&P does not act as a fiduciary or an investment advisor except where registered as such. While S&P has obtained information from sources it believes to be reliable, S&P does not perform an audit and undertakes no duty of due diligence or independent verification of any information it receives. To the extent that regulatory authorities allow a rating agency to acknowledge in one jurisdiction a rating issued in another jurisdiction for certain regulatory purposes, S&P reserves the right to assign, withdraw, or suspend such acknowledgement at any time and in its sole discretion. S&P Parties disclaim any duty whatsoever arising out of the assignment, withdrawal, or suspension of an acknowledgment as well as any liability for any damage alleged to have been suffered on account thereof. S&P keeps certain activities of its business units separate from each other in order to preserve the independence and objectivity of their respective activities. As a result, certain business units of S&P may have information that is not available to other S&P business units. S&P has established policies and procedures to maintain the confidentiality of certain nonpublic information received in connection with each analytical process. S&P may receive compensation for its ratings and certain analyses, normally from issuers or underwriters of securities or from obligors. S&P reserves the right to disseminate its opinions and analyses. S&P's public ratings and analyses are made available on its Web sites, www.standardandpoors.com (free of charge), and www.ratingsdirect.com and www.globalcreditportal.com (subscription) and www.spcapitaliq.com (subscription) and may be distributed through other means, including via S&P publications and third-party redistributors. Additional information about our ratings fees is available at www.standardandpoors.com/usratingsfees.

WWW.STANDARDANDPOORS.COM/RATINGSDIRECT

NOVEMBER 19, 2013 11

1219301 | 301967406