A. Introduction To FIG For New Joiners

STRICTLY CONFIDENTIAL
Introduction to FIG
New joiner training
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26 September 2007
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Financial institutions overview

Five sub-sectors across the globe
Largest sub sectors ‘Other financials’
Asset Financial Markets Specialty

Banks Insurance
Management & Technology Finance
Brokers &
Bancassurance
advisers
Selected examples
1
Table of contents
SECTION 1 Insurance—accounting and financials 2

SECTION 2 Banks—accounting and financials 10
SECTION 3 Valuation considerations 23
SECTION 4 Acquisition impacts 35
2
SECTION 1
Insurance—accounting and financials

What does an insurance company do?

Non-allocated risk exposure Allocated risk exposure
Premiums
paid by all
policyholders
Insurance
company
Claim payment
On average, a certain percentage of the An insurance company allocates the risk

population will incur the cost of adverse exposure of each policyholder to the other
events policyholders versus the payment of a
premium
• Human life (Life)
• Other risks (Non-Life)
4
What does an insurance company do?

Premiums Claims payments
Insurance company
Investment management
Balance sheet
Other assets Other liabilities
Shareholders'
equity
Shareholders'
Policyholders and Policyholder
policyholders' Provisions for
money potential claims
= investments from
policyholders
5
Accounting basics
What typically happens when a policy is written?
A simplified example (e.g. home insurance)
Pay premium
Insurance
Customer
Pay any claims
company
Profit and loss Balance sheet

1. Contract written ♦ Premiums received ♦ Premiums invested in
♦ Initial costs incurred assets / securities
(acquisition / admin)
2. During life of contract ♦ Payment / reserving ♦ Liability / reserve created

of claims
♦ Ongoing admin costs
♦ Investment income on
premiums invested
6
A non-life insurer’s financial statements

Simplified example .
Total insurance contracts written during the period

Profit and loss account (€m)
Gross written premiums 9,000 .
.
Premiums payable to reinsurers for cession of risk

Premiums ceded to reinsurers (2,000) .
Net written premiums (of reinsurance) 7,000

. .
for which the company has retained a liability
Net change in provision for unearned premiums (200)
.
Net premiums earned 6,800

.
Reserve for net premiums / unexpired periods of

.
Net investment return 1,350 .
policies at year end

Total income 8,150
The proportion of NWP applicable for the period
.
Claims incurred (6,000) .
Acquisition and administrative costs (2,000) .
Includes return on investment of capital

Net other operating income/(expenses) (50)
Total expenses (8,050) .
Claims outstanding
Finance costs (50) . (net of losses covered by reinsurers)
Profit before tax 50 .
Interest paid on outstanding debt

Balance sheet extracts (n-1) (n)
1 year policy premium=120
Invested assets 15,500 16,500
Unearned premium
Technical reserves 13,500 14,000 GEP=30 reserve=90
Shareholders’ funds 3,000 3,150 GWP=120
J F MA M J J A S O N D J F MA M J J A S O N D
n-1 n
7
Key operational / profitability ratios

Underwriting analysis
♦ There are two main sources of potential profit
–1 the difference between the premiums received and the claims and expenses
incurred, known as the underwriting result
–2 the return on investments
♦ Key ratios can help understand the company’s underwriting performance

Ratio analysis (net of reinsurance) Net premiums / gross premiums written
(7,000 / 9,000)
(%)
Retention ratio 78 Claims incurred / premiums earned
(6,000 / 6,800)
Claims ratio 88
Operating expense / net premiums
Expense ratio 29 (2,000 / 7,000)
Combined ratio 117 Claims ratio + expense ratio
(88%+29%)
– Written / Earned: Standard definition uses written premiums for expense

ratio—we often use earned for both claims and expense ratios
– Gross / Net: Usually done net of reinsurance to reflect the retained part, but
gross basis will better reflect underlying dynamics of the portfolio
8

Further analysis
Investment yield
Investment return on insurance reserves / average invested assets
“ 1,350
= 8.4%
– ”
The allocation between investment return on technical reserves and
capital is somewhat arbitrary and in some jurisdictions does not
even exist
(15,500+16,500) / 2
Remember to annualise P&L figures of
– Therefore, investment yield should capture both elements
Reserve ratio (non-life)

Technical reserves over net premiums earned
“ ”
interim reports!!
14,000 – Indicates “tail” (length of the reserves stay with insurer)

= 200%
of portfolio
7,000 – Will be distorted by high premium growth
Asset coverage
Invested assets / sum of technical reserves and capital
“ 16,500
= 96%
– ”
Describes share of yield-earning assets
(14,000+3,150)
Solvency ratio (non-life)

Shareholders funds / net premiums written
“ 3,150
= 45%
–
–
”
Simple but common measure for financial strength
Needs to be viewed in context of business model
7,000
9
A life insurer’s financial statements

Highlights
♦ Recognition of premiums: in general, in accordance with IFRS, policies of the
life segment are classified as insurance products (and therefore accounted as
life premiums) on the basis of the underlying insurance risk
– Investments products - mainly unit/index-linked policies - are recognised as
financial liabilities in the balance sheet and fees and commission income and
expenses are recognized through P&L
Comparing insurance companies productivity, unit/index-linked product

volume should be added to the GWP stated in the P&L!!
Such information is usually disclosed in the Director’s report
♦ Provisions (mathematical reserves for traditional and financial liabilities for

U/L products) are calculated on the basis of actuarial assumptions (i.e.
mortality rate)
10
A life insurer’s financial statements

Simplified example
.
(doesn’t include unit/index-linked products)
Profit and loss account (€m)
Gross written premiums 16,000 .
.
Premiums payable to reinsurers for cession of risk

Premiums ceded to reinsurers (1,000) .
Net written premiums (of reinsurance) 15,000 . .

for which the company has retained a liability
Net change in provision for unearned premiums (200) .
Net premiums earned 14,800 .
Reserve for net premiums / unexpired periods of

.
Investment income 17,900 .
policies at year end

Total income 33,800
The proportion of NWP applicable for the period
.
Net insurance benefits and claims (28,400)

o/w benefits paid to policyholders (15,900) .
.
Includes return on investment of capital
o/w change in provisions (12,500) .
and return of policyholders
Acquisition and administrative costs (5,200) Benefits paid to policyholders, including return on
Net other operating income/(expenses) 2,000 policyholders investments
.
(net of reinsurance share)

Total expenses (31,600)
Finance costs (200) .
Change in insurance provisions

Profit before tax 2,000
.
(net of reinsurance share)
Balance sheet extracts (n-1) (n) Interest paid on outstanding debt

.
Invested assets 199,800 192,400

Insurance provisions 145,200 144,300
Shareholders’ funds 5,600 5,300
11
Embedded value
An introduction to embedded value
Most companies active in life insurance employ some form of embedded value accounting
Appraisal value
Embedded value
Adjusted NAV VBIF Goodwill
“ Embedded value represents net assets plus the value of business in force
”
“ The value of business in force (“VBIF”) represents the best estimate of the present value
of future profits from existing life business
”
“ Appraisal value equals embedded value plus goodwill
”
“ The goodwill of an insurer is the estimated NPV of future profits from future new
business and is often expressed as a multiple of the value of one year’s new business
”
12
Embedded value
The debate over embedded value vs. more traditional
accounting methods is about the timing of the recognition of
profits, not the quantum of profits
Comments Profits recognition profile
♦ Closer relationship to cash accounting
Statutory basis
– one of the most conservative accounting

methodologies
♦ New business strain
♦ Profit recognised as it is released from the life fund
(releases based on solvency considerations)
♦ Acquisition costs are partially deferred and capitalised

(not set against first year profits)
– Deferred Acquisition Costs (DAC)
IFRS
♦ DAC amortised over lifetime of policy

♦ Timing of profits brought forward
♦ Value based measure

– value of product sold estimated at time of sale and
booked in P&L
Embedded value
♦ Future profits discounted at risk free rate plus a risk

premium
– different for different products
♦ Aim to recognise profit as it is earned over the life of the
insurance policy
– profits recognised when earned, not when released
to shareholders
– same profit recognised over course of product life as
under more conservative accounting methods
Source: UBS IBD analysis
Note: Based on typical 10-year endowment policy
13
SECTION 2
Banks—accounting and financials

What does a (traditional) bank do?
"Net interest income"

"Net interest spread"
♦ Bank gives away loans and Bank ♦ Bank takes deposits from
charges interest, i.e. 5% on a customers and pays interest,
mortgage = interest income i.e. 3% on a savings account
Balance sheet
= interest expense
Lending money "Safekeeping" money

Deposits
Loans
Other liabilities
Investments
Shareholders'
Other assets equity
Customers Customers
15
A bank’s financial statements

Simplified balance sheet
Balance sheet Inter-bank lending. Source of liquidity
Cash and balances at central bank 5,000 Retail loans (Mortgages, consumer
Interbank and money market 5,000 credit), Corporate loans
Customer loans 60,000
Assets from trading activities
Trading portfolio 10,000
Investment portfolio 10,000 Financial investments or associates
Fixed assets 5,000
Prepayments and accrued
Other assets 5,000 income, debtors, etc.
Total assets 100,000
Bank deposits 15,000
Savings, current account balances,
Customer deposits 55,000 time deposits
Securities in issue 12,000
Other liabilities 12,000 Does not include loan loss provisions,
which are deducted from loans
Subordinated debt 2,000 and advances
Minority interests 1,000
Includes bank’s tier 2 and
Share capital & reserves 3,000 tier 3 capital
Total liabilities and equity 100,000
Including ordinary and sometimes
hybrid share capital
16

Simplified income statement Interest receivable less
Income statement interest payable
Net interest income 5,000

Fees & commissions revenues less
Net commission income 2,900 fees & commissions payable
Trading income 1,700
Other operating income 400 e.g. dividend income,
property rental income, etc.
Net banking income 10,000
Operating expenses (7,000)
Administrative expenses
Depreciation (500) and staff costs
Operating profit 2,500
Provisions (800) Fixed asset depreciation
Exceptional items (500)
Profit before tax 1,200 Loan-loss provisions and
Corporate tax (360) provisions for contingent liabilities
Net profit 840
Items of a ‘one-off’ nature
Minority interests 140
e.g. profit / loss on disposals,
Net profit, group share 700 write-downs on fixed asset
investments, restructuring costs
17

Ratios
Business mix and
Profitability Asset quality Capital adequacy Liquidity
efficiency
♦ Net interest ♦ Net interest ♦ Loan loss ♦ Core tier 1 ♦ Cash and cash
income / total margin provisions (P&L) capital/RWAs reserves +
income ♦ Net yield / average loans ♦ Tier 1 interbank lending
♦ Net fee and ♦ Interest income /
(cost of risk or capital/RWAs + investment
loan loss ratio) securities (liquid
commission average interest- ♦ Total
income / total earnings assets ♦ Loan loss capital/RWAs
assets) / deposits
income provisions (BS) / and money market
♦ Interest expense / ♦ Equity/total assets funding
♦ Cost to income average interest-
ending loans
♦
ratio bearing liabilities ♦ Loan loss
Shareholders' ♦ Loans / deposits
equity —fixed and money market
♦ Personnel ♦ Net interest
provisions (BS) /
assets—equity in funding
expenses / average NPLs (coverage
income / average affiliates (free
assets RWAs
ratio)
capital) /
♦ Loans / customer
♦ Personnel ♦ Return on
♦ Loan loss shareholders'
deposits
expenses / average equity
provisions / equity ♦ Loans / total
profit before tax deposits
operating
♦ Return on average ♦ Dividend payout
income
assets
and provisions
ratio ♦ Liquid assets / total
♦ Personnel ♦ Loan loss provision
♦ assets
expenses / non
♦ Return on average expenses / pre-
Dividend cover
♦ Customer deposits
risk-weighted provision income
interest expense / total deposits
assets
♦ Net income / ♦ Pre-provision ♦ Customer deposits/
employee
♦ Pre-provision income / net loans shareholders'
income / average
♦ Personnel expense assets
equity
/ employee
♦ Pre-tax profit /
♦ Due from banks /
due to banks
average assets
18

Income analysis
Net interest margins ("NIM")

Net interest income / average interest bearing assets
“ 5,000
= 5.7%
– ”
Key measure of profitability for lending and borrowing business,
usually expressed as a percentage
(90,000+85,000)/ 2
Net interest spreads

Average interest rate receivable on assets less average interest rate payable on liabilities
“ – Similar to NIM, another way of analysing the funding efficiency of

a bank
”
– Alternative: "interest income / average interest-bearing assets less
interest expenses / interest-paying liabilities
Non interest income / net banking income

Non interest income / net banking income
“ (2,900+1,700+400)
= 50%
– ”
Highlights the diversification of income within a bank
10,000
19

Cost / profitability analysis
Cost / income ratio (efficiency ratio)

Operating expenses / net banking income
“ (7,000 + 500)
= 75%
– ”
No right and wrong way to calculate it (e.g. depreciation can be
included, other operating expense can be included in numerator in
which case other operating income should be included in
10,000 denominator. Alternatively, net other operating/expenses can be
included in numerator) but formula should be footnoted
Return on equity
Net profit / average shareholders' funds
“ 700
= 25%
–
–
”
Key value driver for bank measuring the shareholders' returns
Mostly net profit group share in which case shareholders' funds should
exclude minorities interests
(3,000+2,500) / 2
– If profit after tax before minorities, minorities should be included in
shareholders' funds
or
840
= 26%
(4,000+3,200) / 2
20

Balance sheet analysis (excluding capital ratios)
Customer Loans / deposits

Customer Loans / deposits
“ 60,000 ”
= 109%
– Measures liquidity via the extent by which lending activities are
funded through customer deposits
55,000
Cost of risk
Bad and doubtful debt (loan loss) provisions / average customer loans (gross)
“ 800
= 1.4% = 137bp
– ”
Shows the level of provisioning versus the loan assets. Should be read
in conjunction with the business mix and provisioning policy of
the bank
(60,000+57,000)/ 2
– Mortgages: low cost of risk; consumer credit: high cost of risk
– Differs from "coverage ratio" which focuses on general provisions
stock divided by NPLs in excess of collateral
21
Key capital ratios

Tier 1 and total capital ratio
♦ The Basel Committee decided in 1988 to submit all banks to minimum capital
adequacy constraints
♦ These constraints are expressed in terms of ratios of capital to a measure of risk

undertaken by the bank
Tier 1 capital
Tier 1 ratio =
Risk weighted assets (“RWAs”)
Total capital
Total capital ratio / BIS ratio =
RWAs
22
Tier 1 capital calculation

Key components and deductions to tier 1 capital
Capital
Permanent share capital and reserves Regulation varies
Published interim retained profits
slightly between
jurisdictions
Minority interest
Hybrid capital (innovative / non-innovative)
Goodwill and other intangible assets
Tier 1 capital
Limit
Innovative tier 1 capital ≤ 15% of total tier 1
23
Tier 2 capital calculation

Key components and limits to tier 2 capital
Revaluation reserves
Perpetual subordinated debt
Upper tier 2
Portfolio impairment provisions
(maturity > five years)
Lower tier 2
Dated subordinated debt 1
Tier 2 capital (prior to limits

and restrictions)
Limits
Limit 1: Tier 2 capital ≤ tier 1

Limit 2: Lower tier 2 ≤ 50% of tier 1
Note:
1 Gradually reduced during the last five years before repayment date (20% annual reduction)
24
FSA capital framework

Features of FSA regulatory capital Interest
Capital Term Instrument Step-up deferral Maximum
Dated
Lower Tier 2 None 25%
5 years+ 5 year
Subordinated
debt
Upper Tier 2 Cumulative 25%
Deeply 10 year
Innovative
subordinated 7.5%
Tier 1
debt
Perpetual
Perpetual
non-cumulative Preference Non-
preference 17.5%
shares cumulative
shares
Ordinary shares
Equity 25%
(Core Tier 1)
Retained
(minimum)
earnings
♦ Variations in other countries
– dated UT2 allowed outside UK (BIS rules only require 10+ years)
– no innovative Tier 1 in Spain (regulator does not allow step-up)
– dated T1 in Germany (silent partnerships do not need to be perpetual)
– no traditional LT2 in Denmark (T2 needs to be perpetual and have deferral)
25
Basle II—Built on 3 Pillars

Focus has been on Pillar 1, but we consider Pillars 2 and 3
as important
Pillar 1 Pillar 2 Pillar 3

Minimum capital
requirements Supervisory review Market discipline
♦ 8% minimum maintained ♦ Additional capital ♦ Financial disclosure

requirements could be
♦ Tier 1, Tier 2 & Tier 3: no – capital structure
added by national
change in definition regulators, as a result of – risk exposures
stress testing – capital adequacy
♦ RWA to take into account
credit, market and ♦ Capital management ♦ Allows investor community
operational risk; three planning to assess a bank’s risk
possible approaches:
♦ National discretion for profile under Basle II
– Standard approach requirements
some charges (e.g.,
– Internal ratings based
excessive interest rate risk) ♦ Could have important
approach (IRB foundation)
– Internal ratings based ♦ May be more important implications for shedding
approach (IRB advanced) than Pillar 1 Capital layers of opacity that have
undermined traditional
bank price performance
26
Risk weighted assets calculation

From the Basel I “simplistic” approach to Basel II
Risk
Standardised approach under Basel II
Assets in the Basel I approach weighting
(non exhaustive)
♦ Cash
♦ Cash
♦ Claims on OECD / other
developed countries’
0% ♦ Sovereign debt (AAA to AA-)
governments and central banks
♦ Corporate & bank debt (AAA to AA-)
♦ Bank loans 20% ♦ Sovereign debt (A+ to A-)
♦ Loans secured by residential property

/ 35% (mortgages)
♦ Loans secured by property ♦ Corporate debt (A+ to BBB-)

(mortgages) 50% ♦ Bank debt (A+ to BBB-, non rated)
♦ Sovereign debt (BBB+ to BBB-)
♦ Corporate debt (BB+ to BB-, non rated),
♦ Customer loans ♦ Bank debt (BB+ to B-)
♦ All other assets (incl fixed assets) ♦ Sovereign debt (< BB+)
100% ♦ Loans secured by commercial property
♦ Capital instruments of other
banks (unless a capital deduction) ♦ Unsecured loans
♦ Other assets
♦ Corporate debt (< BB-)
150% and ♦ Bank debt (< BB-)
above ♦ Equity investments
♦ Hedge funds
27
SECTION 3
Valuation considerations
Key valuation methodologies

There are five major valuation methodologies
1 Trading multiples
2 Precedent transactions
3 Dividend Discount Model for banks & non-life, Embedded Value for life
4 Sum of the parts
5 Adjusted net asset value (“liquidation value”)
29
Valuation methodologies
Key valuation
methodologies Banks Life insurers Non-life insurers
DDM / DCF
Appraisal value
Trading comparables
Precedent transaction
Gordon growth model
Adjusted net assets 1
Sum-of-the-parts
Market prices 2
Notes:
1 In particular circumstances
2 If listed
We use similar methodologies

for valuing banks and insurance companies
30
Using multiples in a valuation

Key considerations
♦ Select comparables carefully

– business mix
– geographical presence
– quality of franchise
– profitability
– trading data (small capitalisation / thinly traded stocks)
♦ Be consistent
♦ Understand the accounting treatment and the potential differences
it creates
♦ Document your work
31
Price earnings multiples

Calculating P / E multiples
Share price
♦P/E=
EPS
Share price
♦ P / AdjE =
Adjusted EPS
EPS calculation
Stated EPS: (Net attributable income including extraordinary items
(net of tax)) / Weighted average number of shares
Adjusted EPS: Stated EPS adjusted for goodwill amortisation,
extraordinary item, general provisions, other country
specific items
Sources
UBS Research, Consensus (Datastream / I/B/E/S)
32
Price book multiples

Calculating P / BV multiples
Share price
♦ P / BV =
BVPS
Share price
♦ P / AdjBV =
Adjusted BVPS
BVPS calculation
Stated BVPS: Shareholder funds net of treasury shares and

excluding minority interest) / Number of shares
Adjusted BVPS: Stated BVPS adjusted for goodwill and intangibles,
general banking risks reserves, unrealised capital
gains and other country specific items
Sources
UBS Research, Consensus (Datastream)
33
So how do I actually do it?

Market valuation
P/E RoEV P/EV VNB
05E 06E 07E 06E 07E 04A 05E 06E multiple
Name (x) (x) (x) (%) (%) (x) (x) (x) (x)
Aviva 9.4 9.3 10.0 13.5 11.7 1.42 1.39 1.27 11.5
Prudential 11.5 11.0 10.5 12.5 12.1 1.55 1.39 1.27 10.0
Aegon 10.2 10.5 10.1 11.2 10.8 1.24 1.14 1.14 7.0
Legal & General 10.8 10.9 10.4 9.2 9.3 1.08 1.05 0.99 10.5
Friends Provident 11.4 11.2 10.7 10.8 10.8 1.25 1.18 1.12 9.0
Mean 10.7 10.6 10.3 11.4 10.9 1.31 1.23 1.16 9.6
Median 10.8 10.9 10.4 11.2 10.8 1.25 1.18 1.14 10.0
Value map Calculation

1.5 y = 0.0902x + 0.1965
Prudential Slope 0.0902
R2 = 0.9021
1.4 Intercept 0.1965
1.3 Friends Aviva RoEV 2006E (%) 8 10 12
P/EV 2005E (x)
Provident
1.2 Impl. multiple (x) 0.92 1.10 1.28
Aegon
1.1 EV 2005E (€m) 2,000
1.0 Legal & Valuation (€m) 1,836 2,197 2,558

General
0.9
9 10 11 12 13 14
RoEV 2006E (%)
34
Dividend discount model

Calculate the net present value of future dividends based on a
series of estimated dividend flows and a terminal value
Key value drivers In depth historic analysis
Bank Non-life insurance ♦ Three to five years
♦ Assessing the quality (reliability) of
Profitability income streams
♦ Net interest margin ♦ Premium growth ♦ Adjusting for non-recurring items
♦ Growth in commission ♦ Claims ratio Mid term forecast
and trading income
♦ Forecast for three years based on
♦ Cost / income ratio ♦ Expense ratio management forecast / plan / targets
♦ Cost of risk ♦ Investment return ♦ Compare value drivers to a defined peer
group and clarify differences
♦ Tax rate ♦ Tax rate
Long term forecast
Balance sheet
♦ Reflect long term market changes over
♦ Cust. loans & deposits ♦ Reserve ratio a period of up to ten years by adjusting
growth growth rates and margins
♦ Total assets, RWAs ♦ Asset coverage
Discount rate and terminal value
growth ratio
(RoE-g) ♦ WACC methodology drives discount rate
Capital adequacy
(CoE-g)
*AdjBV ♦ Terminal value calculation using
♦ Target Tier 1 ratio ♦ Solvency ratio “gordon growth” multiple
35
Sum of the parts valuation

Understanding key business drivers
Illustrative capital Valuation Indicative multiple
Business allocation methodology range
Retail 7% RWAs P/E 10.0–15.0×
Wholesale & IB 6% RWAs + 4 × VaR P/BV 1.0–1.5×
Asset management 2 × cost base P/AuM (or P/E) 1.0–2.0%
Private banking 4 × cost base P/AuM (or P/E) 2.0–3.0%
Life insurance 6% technical reserves P/EV 1.0–2.0×
(1.5% u/l) or GW/VNB 8.0–15.0×
Non-life insurance 40% GWP P/BV 1.0–2.0×
Corporate centre Balancing item P/BV 0.5–1.0×
Group Equity as reported Sum Implied P/E and P/B
Capital allocation
♦ The capital allocation to the business division should reflect the risk the segment is
exposed, e.g. retail-low, wholesale-high (regulatory capital vs. economic capital)
♦ In most cases the allocation is disclosed by the company as part of the segmental
disclose but analysts will do their own allocation so as to harmonise between peers
36
Appraisal value and market cap
Appraisal value … … Market cap
VNB x multiple
Good- Good- VNB x multiple
will will
Market
AV
cap
EV EV
EV + Goodwill = AV Market cap - EV = Goodwill

Goodwill / VNB = Implied market multiple
VNB x
multiple
Input Result
37

Illustration
Retail Asset Corporate Investment Foreign Corporate Life
( million) & Estate gathering customers banking subsidiary centre insurance Group
Net profit 94 58 100 64 25 0 na 341
Allocated equity 960 0.4 781 371 110 10 64 2,292
Estimated EV 129
ROE (%) 10 >100 13 17 23 nm na 22
Cost/income ratio (%) 79 43 41 52 50 84 na 68
P/E (x) 9.0 14.0 9.0 7.6 11.0 nm 9.8
P/Book (x) 0.9 nm 1.1 1.3 2.5 1.0 1.6
P/EV (x) 2.2
Value (€m) 864 812 859 482 275 0 289 3,581
Target share price () 71.0
Market cap 3,125
Share price 62.0
38
Adjusted net asset value—key potential adjustments

Understanding domestic accounting standards to assess
excess / deficit in capital position
♦ Calculation of the adjusted net asset value of a company

considering all hidden assets and liabilities
♦ Current year’s unpublished ♦ Current year’s unpublished

profits losses
♦ Unrealised capital gains after tax ♦ Goodwill and other intangibles
in investment portfolio (equities, ♦ Treasury shares
real estate, bonds)
♦ Pension fund deficits
♦ Equity-like reserves (e.g. FGBR or
equalisation reserve) ♦ Deficit in loan-loss reserves
39
SECTION 4
Acquisition impacts
Acquisition impacts
Bank A acquires Bank B—key assumptions
€m Bank A Bank B
Price
Market cap 1,000 800
NOSH (m) 1,000 500
♦ Expressed as premium to market cap or
share price
P/E 04 10x 9x ♦ 10% premium
P/E 05 9x 7x
P/E 06 8x 6x Financing
Tier 1 capital 450 350
♦ Mix of shares and cash
NAV 500 300 ♦ Issue of shares dilutes
RWAs 7,500 5,000 pro forma EPS but increases Tier 1
Tier 1 ratio 6% 7% ♦ Use of cash lowers proforma T1 ratio
but replacement of low yield in cash by
130 target bank’s earnings usually accretive
110
120 120 ♦ 90% shares / 10% cash
100
90
Synergies
Net income forecast
(Global Estimates, ♦ Justification for offering a premium:
UBS Research) 1+1>2
(€m) ♦ Often expressed as % of target cost
base or combined cost base
♦ Implementation takes time
2004 05 06 2004 05 06
41
EPS impact of the acquisition

Proforma net income calculation (€m)
Bank A Bank B Net synergies New debt Proforma
interests &
restructuring 307
charge
267
130
120 120
110
100 90 137
60
40
10
(3) (3) (3)
2004 05 06 2004 05 06 2004 05 06
(60)
€m Bank A New A Bank A
shares proforma Impact on Bank A’s EPS
Market cap 1,000 + 41.7%
0.20 + 36.4% 0.17
NOSH (m) 1,000 792 1,792 (20.0)% 0.15
0.15 0.11 0.12
EPS 2004E 0.10 0.08 0.10
e 0.10 0.08
EPS 2005E 0.11 0.15
EPS 2006E 0.12 0.17 0.05
0.00
2004 2005 2006
EPS as forecasts Proforma EPS
42
Capital adequacy impact of an acquisition

Understanding the key drivers
Impact on tier 1 ratio of acquiror
Shortcut!
18 Tier 1 capital A
+ Tier 1 capital B
16
– Cash outflow (cash component) RWA A
14 + RWA B
12
10
(%)
8
6.0%
6 4.8%
0
Initial tier 1 Issue of new Consolidation Consolidation Goodwill New minority Restructuring Proforma tier
ratio shares of target's of target's incurred interest (if less charges 1 ratio
RWAs minority than 100%
interest / FGBR acceptance)
/ GW &
intangibles
43

A. Introduction To FIG For New Joiners

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A. Introduction To FIG For New Joiners

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STRICTLY CONFIDENTIAL

Financial institutions overview

Asset Financial Markets Specialty

SECTION 1 Insurance—accounting and financials 2

Insurance—accounting and financials

What does an insurance company do?

On average, a certain percentage of the An insurance company allocates the risk

What does an insurance company do?

Other assets Other liabilities

A simplified example (e.g. home insurance)

Profit and loss Balance sheet

2. During life of contract ♦ Payment / reserving ♦ Liability / reserve created

A non-life insurer’s financial statements

Total insurance contracts written during the period

Premiums payable to reinsurers for cession of risk

Net written premiums (of reinsurance) 7,000

Net premiums earned 6,800

Reserve for net premiums / unexpired periods of

Net investment return 1,350 .

policies at year end

Claims incurred (6,000) .

Acquisition and administrative costs (2,000) .

Includes return on investment of capital

Profit before tax 50 .

Interest paid on outstanding debt

Key operational / profitability ratios

♦ Key ratios can help understand the company’s underwriting performance

– Written / Earned: Standard definition uses written premiums for expense

Key operational / profitability ratios

– Therefore, investment yield should capture both elements

Reserve ratio (non-life)

14,000 – Indicates “tail” (length of the reserves stay with insurer)

Solvency ratio (non-life)

A life insurer’s financial statements

Comparing insurance companies productivity, unit/index-linked product

♦ Provisions (mathematical reserves for traditional and financial liabilities for

A life insurer’s financial statements

Premiums payable to reinsurers for cession of risk

Net written premiums (of reinsurance) 15,000 . .

Net premiums earned 14,800 .

Reserve for net premiums / unexpired periods of

Investment income 17,900 .

policies at year end

Net insurance benefits and claims (28,400)

(net of reinsurance share)

Change in insurance provisions

(net of reinsurance share)

Balance sheet extracts (n-1) (n) Interest paid on outstanding debt

Invested assets 199,800 192,400

Adjusted NAV VBIF Goodwill

– one of the most conservative accounting

♦ Acquisition costs are partially deferred and capitalised

♦ DAC amortised over lifetime of policy

♦ Value based measure

♦ Future profits discounted at risk free rate plus a risk

Banks—accounting and financials

What does a (traditional) bank do?

"Net interest income"

Lending money "Safekeeping" money

A bank’s financial statements

A bank’s financial statements

Net interest income 5,000

A bank’s financial statements