B. FIG Analyst Training - Partie I

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FIG EMEA training
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December 2007
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Table of contents
SECTION 1 Banking _____________________________________________________________________________ 1

1.A Accounting
1.B Capital
1.C Valuation
1.D Financial effects
SECTION 2 Insurance ____________________________________________________________________________ 6
2.A Insurance capital
2.B Life accounting and valuation
2.C Non-life accounting and valuation
SECTION 3 Asset Management________________________________________________________________ 10
SECTION 4 Financial Markets and Technology _______________________________________________ 11
SECTION 5 Fixed income and DCM ___________________________________________________________ 12
SECTION 1
Banking
1
SECTION 1.A
Banking
Accounting
2
Accounting and financial analysis for banks

FIG EMEA training
26 November 2007
06060H227_Banking accounting.ppt
Table of contents
SECTION 1 Introduction and business models 2

SECTION 2 Key ratios and performance indicators 11
SECTION 3 Accounting issues 19
SECTION 4 Risk management 25
APPENDIX A Banking business model—additional materials 31
1
SECTION 1
Introduction and business models

Representative product offering
♦ A bank’s product mix Retail banking Corporate banking

has various ♦ Secured lending ♦ Lending
implications for the
♦ Unsecured lending ♦ Deposits
profile of the business
♦ Savings and term deposits ♦ Cash management
– growth
♦ Credit cards ♦ Project finance
– profitability
♦ Debit cards ♦ Trade finance
– cost of risk
– capital ♦ Payments ♦ Securities services
requirements ♦ Payments
♦ A bank’s products Complementary businesses

appear on both sides ♦ Insurance
of the balance sheet,
♦ Asset management
and off-balance sheet
♦ Private banking
♦ Investment banking
♦ Leasing
♦ Custody and settlement
3
The banking model
Capital intermediation
A business centred
on intermediation Investment Bank Investment
Capital Capital
needs resources
A bank acts as a link Yield Yield
between available capital ♦ Customer loans ♦ Deposit from
(asking for a yield) and (mortgage, auto, retail customers
capital needs consumer finance)
♦ Bonds subscribed by
♦ Corporations funding institutional investors
A bank also provides
♦ Leverage in
advice and act on behalf of investment funds
its customers, on the basis
of its knowledge of
financial markets and its Intermediation with financial markets
capacity to act on them ♦ Provide financial advice
♦ Execute trades
♦ Manage assets
Knowledge of
the market ♦ Safekeep assets
Bank
Financial markets
♦ Investment Clients
opportunities
♦ Retail
♦ Sector trends and
outlook for specific ♦ Corporates
companies
Ability to act ♦ Pay fees and commissions

on the market
♦ Give their assets for
administration/management/
custody 4
A bank’s financial statements
A simplified “Spread”
balance sheet
Interest income Interest expense
A bank’s balance sheet
reflects its capital
intermediation role.
Important volumes of
financial instruments and
loans on the assets side,
and deposits and debt on Interest bearing
the liabilities side, mean liabilities
that banking balance sheet Interest yielding assets
can reach very high sizes Deposits from
customers,
The overall volume and funding of the
risk profile of this activity Other liabilities banking assets,
will determine the level of short positions
capital the bank will need on securities
to hold Other assets Equity (driven by
regulatory capital)
Loans to
customers, Regulatory need
investments in to hold capital
securities, above a
inventories of minimum level
securities determined by
risk exposure
5
A bank’s financial statements
A simplified net income Interest income Reflection of the spread

between cost of funding
and lending rates
(Interest expense)
A banks earns money
through a combination of:
Net interest income
Arising from advisory,
‐ net interest income, trading on behalf of
arising from the spread Net fee and commission income customers and other
between the interest financial services
paid on interest bearing Propriety trading and

Trading income gains on bid/ask spreads
liabilities, and the
interest earned from
Net banking income
interest yielding assets
Including staff costs and
‐ trading income from the other administration
(Operating expenses) expenses (note this does
purchase and sale of not include interest and
various assets fee expenses)
(Amortisation and depreciation)
‐ fees and commissions
earned from trading and Operating profit
securities services on Net movement in
provisioning of doubtful
behalf of third parties, loans and other assets
(Cost of risk)
and advisory services (i.e. impairment for the
year net of
Operating expenses Profit before tax potential revenues)
and cost of risk drive
the profitability of (Tax and minority interests)
the business
Net income
6
A representative example
Société Générale’s 2006 2005

Balance sheet (€m) (€m) Income statement (€m)
2006 accounts
Cash and balances at central bank 9,358 6,186 Net interest income 3,112
Due from banks 68,157 53,451 Net commission income 6,853
SG is a French Universal Customer loans 263,547 227,195 Trading income 11,257
bank; its accounts are Trading portfolio 419,185 372,376 Other operating income 1,195
published under IFRS Investment portfolio 142,944 129,360 Net banking income 22,417
Intangible assets 6,044 4,233 Operating expenses (12,985)
Other assets 47,606 42,333 Depreciation (718)
Total assets 956,841 835,134 Operating profit 8,714
Bank deposits 129,835 113,207 Provisions (679)
Customer deposits 267,397 222,544 Other income 43
Trading liabilities 281,853 263,896 Profit before tax 8,078
Other interest bearing liabilities 124,364 101,183 Corporate tax (2,293)
Other liabilities 108,447 95,021
Net profit 5,785
Subordinated debt 11,513 12,083
Minority interests 564
Minority interests 4,378 4,157
Net profit, group share 5,221
Share capital & reserves 29,054 23,043
Total liabilities and equity 956,841 835,134
7
Other key features of banks
A highly regulated industry

♦ Capital requirements
♦ Loan provisions
Financing generates value

♦ EV/EBITDA, EV/EBIT multiples not applicable
A different perspective on cash

♦ Focussing on conventional free cash flows to shareholders ignores regulatory constraints (DDM rather
than DCF)
♦ Easy access to funding
Limited visibility over some key business drivers

♦ Complex financial instruments
♦ Asset quality of loan portfolio
8
The banking business models

Investment
Business model Universal banking Retail Private banking
The breakdown in asset

and liability losses, as Total balance sheet (€bn) 1,440.3 635.7 833.9 22.4
well as the revenue split, Total revenues (€m) 27,943.0 28,563.0 22,940.0 1,765.0
Net income (€m) 7,308.0 7,127.0 7,596.0 418.0
differs significantly from Cost income ratio (%) 2 57.7 61.3 44.6 59.6
one business model to Tier I ratio (%) 7.4 na 7.4 12.7
another RoAE (%) 16.2 29.5 18.0 10.3
% of balance sheet total 100%

80%
60%
40%
20%
0%
Customer loans Trading portfolio Other interest yielding assets Other assets
100%
80%
60%
40%
20%
0%
Customer deposits Trading liabilities
Other interest bearing liabilities Other liabilities
Equity
% of total revenues
100%
80%
60%
40%
20%
0%
Net interest income Net fee and commission income
Trading income Other revenues¹
Source: 2006 company financials
Notes:
1 Includes insurance net income and income from property development for BNP Paribas
2 Excluding D&A
9
RoE decomposition in banking
RoE is driven by the Net interest

return on risk assets, net income/RWA (bp)
of expenses (reflected in + Income/RWA (bp)
115
the cost income ratio) 830 x
Net commission
and cost of risk, and the income/RWA (bp)
Cost-income
capitalisation levels 100% –
254 ratio (%)
required by regulators + RoRWA (bp)
61.1%
and rating agencies Trading income/RWA
(bp)
299
LLP/RWA (bp)
417 /10,000
Other operating (25) +
income/RWA (bp) Extraordinary
items & other / RoE before tax (%)
44 items /RWA (bp)
2 36.8%
Average Tier I
ratio (%)
Adjusted
7.7% +
equity/RWA (%)
Other adjusted 8.1%
equity/RWA (%)
0.4%
Note: In italics: Société Générale 2006 figures, based on average RWA of €270,139 million
10
SECTION 2
Key ratios and performance indicators

Net banking income analysis
Net interest income Net interest margin (NIM) Net interest margin/spread benchmarking 2006
analysis highlights Net interest income/average interest earning assets
differences in business 1.10
3,112 SG
= 0.60% 0.60
models or economic
Avg (552,170; 482,716) Northern 0.75
environment
♦ Measures the efficiency of the bank’s capital Rock 0.93
intermediation activity
3.39
BNP Paribas
♦ A low number can reflect: 1.58
– Adverse funding rates, or low interest yield on loan 3.47
portfolio; or Santander
2.42
– High ratio of interest bearing liabilities/interest
Bank of 2.36
earning assets (as is the case for SG)
America 2.83
♦ Need to exclude from financial assets equity securities,
leasing arrangements (usually income on leasing is 3.39
Citi
accounted in other income), trading derivatives 2.99
3.73
HSBC
Net interest spread 3.10
Interest income/average interest earning assets – 3.70

Akbank
4.68
Interest expense/average interest bearing liabilities
6.70
30,056 26,944 Sberbank
- 7.54
Avg (552,170; 482,716) Avg (615,308; 529,106)
- 2 4 6 8 10
= 5.81% - 4.71% = 1.10% (%)
♦ Measures the efficiency of funding Source: Annual reports 2006, UBS Research
♦ Is distinct from Net Interest Margin in that it does not
factor in the absolute volumes of lending and funding
on the balance sheet
12
Net banking income analysis
Non interest income Net interest income/Net banking income

components are usually
3,112
viewed as higher quality, = 14%
in particular commission 22,417
income
♦ Highlights the level of diversification of income
within a bank
♦ High level denotes a focus on traditional
capital intermediation rather than fee business
♦ Net banking income is often called operating income (in
contrast to operating expenses – see cost-income ratio)
13
Operating efficiency
The cost income ratio is a Cost—income ratio Cost income ratio benchmarking 1
key measure to assess Operating expenses (including or excluding
the profitability of a depreciation)/net banking income
ABN Amro 76.3
bank’s revenue 12,985
generation = 57.9% (excluding D&A)
22,417 Citi 58.0
♦ Depreciation and amortisation can be either

included or excluded, but this needs to be SG 57.9
footnoted to ensure consistency
♦ Especially for the analysis of investment banks, BNP Paribas 57.7
the cost income ratio can be split between a
“compensation” cost-income ratio including HSBC 51.3
only personnel expenses and a “non-
compensation” cost income ratio Bank of
48.7
America
Santander 44.6
0 25 50 75 100
(%)
Source: Annual reports 2006
Note:
1 Excluding depreciation and amortisation
14
Asset composition and quality
Asset quality is a point Loan portfolio mix and concentration

of focus; a bank needs to
♦ Mix between corporate, consumer unsecured and secured lending
find a balance between
yield and cost of risk ♦ Concentration to specific sectors and regions can be a concern
Credit quality
♦ Nonperforming asset trends
♦ Reserve adequacy
Growth rates
♦ Outsized growth in loan type, relative to peers
♦ Lack of loan growth
Loan yields
♦ Loan portfolio yields by product compared to peers
♦ Risk versus return
Investment portfolio mix and concentration

♦ Exposure to interest rate risk/prepayment speeds
♦ Focus for balance sheet leverage
15
Asset composition and quality
Cost of risk is an indictor Cost of risk (or loan loss ratio) European markets cost of risk (bps)
of the P&L impact of Bad and doubtful debt (loan loss) provisions/
quality of the loan average customer loans (gross) Benelux 38
portfolio
679
The coverage ratio = 0.29% = 29bp Switzerland 38
measures the level of Average (253,272; 222,655)
prudence UK 56
♦ Should be interpreted in conjunction with
the business mix and provisioning policy of
the bank France 63
♦ Differs from "coverage ratio" which focuses on

general provisions stock divided by NPLs in Germany 65
excess of collateral
Coverage ratio Italy 72
Total allowances for loans & advances put on

Spain 76
non accrual basis/loans & advances put on non
accrual basis
Greece 86
6,197+ 235 + 45
= 61%
9,888+ 688 + 46 Portugal 86
♦ Can be calculated including or excluding

estimated value of collaterals: needs to Emerging Europe 135
be footnoted
♦ Total allowances exclude portfolio impairment 0 50 100 150
provision (pre-IFRS: general provisions or Fund
for General Banking Risks) Source: UBS Research
16
Loans to deposits balance
The bank’s operational Loans/deposits ratio (transformational ratio) Loans/deposits ratio benchmarking
performance will be Customer loans/customer deposits
impacted by its funding 263,547 ICBC 55.6
model, which is reflected = 98.6%
267,397
by the loans/deposits Citi 72.0
ratio ♦ Interpretation
– too high funding cost may be too SG 98.6
high with low reliance on deposits (since
deposits are typically a low cost Sberbank 124.2
funding instrument); may also reflect a too
high reliance on financial markets which are BNPP 131.6
considered as a less stable source of
funding deposits Santander 146.4
– too low balance sheet may be yielding
relatively low level of interest income (since HBOS 177.9
loans typically generate higher gross returns
than most other assets) Northern Rock 322.6
– either way, net interest margin will be
impacted adversely 0 100 200 300 400
(%)
Source: Company financials (2006)
17
Summary of key ratios and indicators
Profitability Capital adequacy Liquidity

♦ Net interest margin ♦ Retained earnings/last period's ♦ Cash and cash reserves +
♦ Net interest spread equity (internal capital interbank lending + investment
generation) securities (liquid assets)/deposits
♦ Interest income/average
♦ Equity/total assets and money market funding
interest-earnings assets
♦ Core tier 1 capital/RWAs ♦ Loans/deposits and money
♦ Interest expense/average
market funding
interest-bearing liabilities ♦ Tier 1 capital/RWAs
♦ Loans/customer deposits
♦ Return on average equity ♦ Total capital/RWAs
♦ Loans/total deposits
♦ Return on average assets ♦ Shareholders' equity —fixed
assets—equity in affiliates (free ♦ Liquid assets/total assets
♦ Cash earnings on average
tangible equity capital)/ shareholders' equity ♦ Customer deposits/
♦ Dividend payout total deposits
♦ Return on average risk-
weighted assets ♦ Customer deposits/
shareholders' equity
♦ Pre-provision income/
average assets ♦ Due from banks/due to banks
♦ Pre-tax profit/average assets
♦ Net interest income/ Asset quality Efficiency and business mix
average assets
♦ Loan loss provisions (P&L)/ ♦ Net interest income/total income
♦ Net interest income/
average loans (cost of risk or ♦ Net fee and commission
average RWAs
loan loss ratio) income/total income
Risk ♦ Loan loss provisions (BS)/ ♦ Cost to income ratio
ending loans
♦ Value-at-Risk ♦ Personnel expenses/
♦ Loan loss provisions (BS)/NPLs average assets
(coverage ratio)
♦ Personnel expenses/
♦ Loan loss provisions/profit operating income
before tax and provisions
♦ Personnel expenses/non
♦ Loan loss provision expenses/ interest expense
pre-provision income
♦ Net income/employee
♦ Pre-provision Income/net loans
♦ Personnel expense/employee
18
SECTION 3
Accounting issues
Financial instruments under IFRS
IFRS have introduced Description Accounting effects

principles of recognition
♦ Loans and receivables from customers and
of fair value for a large Loans and banks which are neither held for trading
proportion of the assets receivables nor intended for sale ♦ Accounted for at amortised cost using the
(L&R) effective interest method for premiums and
held by a bank discounts
♦ Non derivative instruments with a fixed ♦ Impairment (with P&L impact) to be
Impacts of periodic Held to maturity and fixed or determinable
Maturity (HTM) recorded if necessary
revaluations are either payments, with a demonstrated intention
to hold until maturity
directly accounted for in
the income statement (HFT, Held for Trading
♦ Assets acquired to generate a profit in
FVO assets) or delayed (HFT) the near term through price fluctuations
with the accounting in a ♦ Derivatives not designated as hedging
specific equity account instruments
(AFS assets) ♦ Option given to elect assets which would ♦ Accounted for at fair value
Fair value ♦ Changes in fair value booked in the
have fallen into another category to be
Only loans, receivables and option (FVO) income statement
accounted at fair value through profit
assets which are
and loss
undoubtedly intended for
♦ This designation needs to be done at the
holding until maturity are time of initial recognition of the assets,
still accounted under the and cannot be reversed
amortised cost method
♦ Financial assets which are neither HTM, ♦ Accounted for at fair value
Available for
or accounted at fair value through P&L ♦ Changes in fair value booked in equity
Sale (AFS)
(i.e. HFT or FVO) (unrealised capital gains & losses) without
any P&L impact until the sale of the assets
♦ Derivatives hedging fair value, cash ♦ Fair value hedge: gains & losses in P&L
Hedging
flows, or the investment in a foreign ♦ Cash flow hedge: gains & losses in equity
instruments
operation, with appropriate ♦ Hedge foreign investment: gains & losses
documentation on the hedging in equity
relationship ♦ Ineffective portion of hedges: gains &
losses in P&L
20
Financial instruments under IFRS
Although these two Illustration: Available for Sale asset

instruments have
experienced the same 22/11/N 31/12/N 31/12/N+1
evolution in value, the Assets Equity Assets Equity Assets Equity
timing of P&L impacts is Cash (100) 0 Asset 120 Unrealised 20 Cash 115 Unrealised 0
distinct Asset 100 capital gains capital gain
P&L 0 Asset 0 P&L 20-5 =15
The AFS asset’s changes in
value do not impact the
P&L until the sale
P&L impact Purchase of Asset for 100 Asset gains 20 in value Sale of Asset for 115
N 0
N+1 15
The changes in value of

the Held for Trading asset Illustration: Held for Trading asset
are immediately reflected
in the P&L
22/11/N 31/12/N 31/12/N+1
P&L impact
N 20
Assets Equity Assets Equity Assets Equity
N+1 (5)
Cash (100) 0 Asset 120 P&L 20 Cash 115 P&L (5)
Asset 100 Asset 0 Reserves 20
Purchase of Asset for 100 Asset gains 20 in value Sale of Asset for 115
21
Hedge accounting under IFRS

Fair value hedge Cash flow hedge Foreign investment hedge
Description ♦ Derivative covering ♦ Derivative covering ♦ Changes in the value in
Derivatives are eligible changes in the fair value of changes in future expected reporting currency of the
assets or liabilities due to cash flows arising from net investment in a foreign
for hedge accounting fluctuations of interest financial assets assets, operation
providing the company rates or exchange rates for liabilities commitments, or
maintains sufficient instance highly probable future
transactions
documentation
Example ♦ Instrument hedged: 10y ♦ Instrument hedged: 10y ♦ Investment in a subsidiary
The link between specific bond yielding 5.2% bond yielding EURIBOR 3M operating in US$, with a
derivatives and specific ♦ Hedging instrument: 10y + 50bp book value of $400m
assets, liabilities or swap paying 5.2% and ♦ Hedging instrument: 10y ♦ Hedging instrument: FX
receiving EURIBOR 3M swap paying EURIBOR 3M swap paying a nominal
transactions must be +50bp +50bp and receiving a amount of US$400m and
evidenced ♦ With the hedge in place, fixed rate of 5.2% receiving the equivelent
the company is ♦ With the hedge in place, amount in Euros (providing
The efficiency of the synthetically investing in a the company is the company has issued
hedge, i.e. the proportion bond paying EURIBOR 3M synthetically investing in a debt in Euros for this
+50bps -> the fair value of bond paying 5.2% -> the amount)
of changes in value
the instrument is protected cash flows from the ♦ With the hedge in place, the
covered by the derivative, from changes in interest instrument are protected company has transformed
must be tested and fall rates (but its cash flows are from changes in interest part of its debt in Euros into
within a band of 80-125% not) rates (but its fair value is synthetic debt issued for
not) $400m, which protects the
net value in Euros of the
foreign investment.
Accounting ♦ Changes in fair value of ♦ Changes in fair value of ♦ Changes in fair value of the
effects the hedging instruments the hedging instruments hedging instruments are
are accounted for in the are accounted for in equity accounted for in equity
income statement under the line “unrealised ♦ During the life of the hedge
♦ The company can elect gains and losses” amounts are transferred
the hedged assets for the ♦ During the life of the from unrealised gains and
Fair Value Option if they hedge amounts are losses to the income
transferred from unrealised statement when the
are not HFT, implying
gains and losses to the corresponding foreign
changes in FV in income income statement when exchange gains and losses
statement as well the corresponding hedged are realised
♦ Ineffective part of the cash flows are realised ♦ Ineffective part of the hedge
hedge accounted in ♦ Ineffective part of the accounted in income
income statement hedge accounted in statement 22
income statement
Loan portfolio
The loan book Specific provisions for credit Risks An illustrative internal classification:
RBS rating category
Annual
♦ Non performing ("non-accrual", "doubtful", profitability of
default (%)
etc) loans & advances to customers can
Asset quality S&P RBS 2006
be either grade Min Mid Max equivalent exposure
– un-secured or
AQ1 0.0 0.1 0.2 AAA to BBB-
– secured by collateral (security/asset)
♦ Loan loss provisions are taken (via the P&L) to AQ2 0.2 0.4 0.6 BB+ to BB
cover new estimated loss on each individual

AQ3 0.6 1.1 1.5 BB- to B+
loan, are released when the loss materialises,
and taken back when the loss is smaller
AQ4 1.5 3.3 5.0 B+ to B
than anticipated
♦ These provisions will be based on a bank's AQ5 5.0 52.5 100.0 B and below
assumption on the probability of recovery and

0 10 20 30 40 50
realisation of value of collateral (%)
♦ Therefore, total allowances (stock of provisions) Illustration of NPL coverage: HVB’s doubtful
are supposed to cover estimated loss on NPL loans portfolio (€m)
not covered by collaterals
– these provisions and allowances will be 16,000
Estimated
subject to market scrutiny and can 14,000 value of
be criticised 12,000 collateral
Portfolio-based provisions 10,000 Unsecured
♦ In addition, banks may book collective 8,000 Loan loss

allowances
provisions, based on groups of receivables 6,000
identified as sensitive and with homogenous 4,000 Secured
sensitivity to risk factors 2,000
0
NPL Allowances Unprovisioned risk
23
Loan portfolio
Illustrative credit quality flow chart

Development of
provisions for bad and Loans 90+ days
Loans accruing interest Charge-offs Recoveries
doubtful debts past due
If interest is past If not accruing interest, If recover a previously As net charge-offs

30 days due, move to move to charged-off loan, add to rise, increase
Loans 30–90 days

Non-accruing status Net charge-offs Provision
past due
(affects earnings)
If interest is past If likelihood of not Charge-offs plus

90 days due, move to collecting interest is recoveries equals
increasing, move to
RBS—annual provision movement

5,000 1,877 (142)
3,887 (61) (1,841) 3,935
4,000
(GBP m)
3,000 215
2,000
1,000
0
Balance Currency Amounts Recoveries of New Discount Balance
1-Jan-06 translation written off amounts provisions unwind 31-Dec-06
and other previously income
adjustments written off statement
change
24
SECTION 4
Risk management
Risk management basics
A deeper look into the Banks are typically working the yield curve ♦ “Credit risk”
black box – the credit risk determines the level of
Interest remuneration embedded in the lending
rate risk curve
“Lending
9 curve” – the bank’s funding rates depend on its
spread over base rates, which depends on
“Funding its own credit quality
curve”
8 Credit ♦ “Interest rate risk” = mismatch in assets
risk and liability maturities
“Base
7 Funding curve” – exposure to changes in the shape of the
Interest rate (%)
spread yield curve substantially impact the margin

6 – the bank’s “risk appetite” on the shape of
the yield curve can not be analysed due to
insufficient disclosure
5 – open positions in banking book are not
Base covered in Basel II capital requirements
4 rate ♦ “Base rate risk”
risk
– general increases in interest rates (i.e. a
translation upwards of the Base curve) will
3
compress margins if they are not reflected
3 months 5 years 10 years on lending rates)
Maturity
26
Risk management basics
Banks use various Maturity gap analysis: Fortis Duration of equity: Fortis
metrics to assess their 36
36 26.3 ♦ ∆ Value
exposure to 26 26.3 = – Duration · ∆ i
26 Value
interest rates 16 9.7 10.2 11.8
11.8
16 9.7 10.2 4.3
(€bn)
6 4.3
(€bn)
6 ♦ Fortis 2006 Duration of equity = 5 years
(4) (0.7)
(4)
(60) (0.7) ♦ Duration >0 means that an increase in interest rates has an
(14)
(60)
(14)
(80) (61.0) overall negative impact on Fortis’ value of equity
(24)
(80) (61.0)
(24)
<1m 1–3m 3–12m 1–3y 3–5y 5–10y >10y
<1m 1–3m 3–12m 1–3y 3–5y 5–10y >10y
Source: Fortis annual report 2006
Earnings at Risk: ING
♦ Measure of the impact on earnings of an upward shock

in interest rates of 1% over a period of one year
♦ Result by business line:
50 20
(50) (19)
(150) (107)
(€m)
(250)
(260)
(350)
(364)
(450)
ING Retail ING ING Total
wholesale banking Direct Bank
banking corporate line
Source: ING annual report 2006
27
Value at Risk
Trading risk assessment: ♦ Definition: amount (e, £, etc.) such that there is a given probability (called the confidence
Value at Risk (VaR) level) of not losing more than this amount in a given time period of trading activity
♦ Time period is generally 1 day (alternatively 10 day), confidence level 99% (95%)
♦ Other differences: calculation method (variance/covariance, historical simulation, Monte Carlo),
reporting method (end-of-period VaR or average VaR)
♦ Allows to calculate risk-adjusted return
♦ Allows to calculate capital requirement: expected default frequency (EDF) is the annualised probability
of default. An EDF of 2.5bp translates to an S&P rating of AA+; the Basle Committee requires banks to
hold a minimum 4x VaR as reserve capital against trading losses
♦ Allows regulator to supervise risk policy: A bank expects to lose more than the VaR (1-confidence
level)% of the time. Losses exceeding VaR are called “exceptions”
♦ Adjusting reported VaR figures

– from 95% confidence to 99% confidence: multiply by 1.41
– from 99% confidence to 95% confidence: multiply by 0.71 (= 1/1.41)
– from 1-day to 10-day: multiply by 3.16 (=10^(1/2))
– from 10-day to 1-day: multiply by 0.32 (=1/3.16)
– for example, a 1-day, 95% confidence level VaR of EUR50m is equivalent to
– 1-day, 99% confidence level VaR of 50 x 1.41 = 70.50m
– 10-day, 99% confidence level VaR of 70.50 x 3.16 = 222.78m
– These adjustment factors are for quick illustrative comparison, as they are based on simplified
models. The true conversion rates are neither constant over time nor easy to determine from an
external point of view
28
Value at Risk
VaR is an indication of Société Générale’s historical daily trading P&L and VaR (99%, 1 day)
risk appetite
However it needs to be
put in perspective with
capital employed
Source: Société Générale’s annual report
Benchmark of year end 2006 VaR (99%, 1 day)1
140 127
120
100 91
74
80
(€m)
58 56
60
40 33 31
22 20
20
0
Goldman Morgan Citi Lehman Merrill RBS Bank of Société BNP Paribas
Sachs Stanley Brothers Lynch America² Générale
Source: Company financials

Note:
1 Adjusted when disclosed on another basis; converted into Euro at year end 2006 rate
2 Average 2006
29
Further reference
♦ “Banking basics… and beyond” UBS Research, 19 February 2002
♦ “The basics of banks stocks” Deutsche Bank, August 2001
♦ The first notes to financial statements in a bank’s annual report always detail accounting principles for the main lines
♦ Central banks websites: for statistics, sizes of market for different products (loans, deposits, funds) and market shares
30
APPENDIX A
Banking business model—additional materials

The banking models
Retail banks Main products/business lines Largest European retail banks (m. cap in €bn)
♦ Personal banking (current accounts, savings,
HSBC 142
overdrafts, etc)
Santander 93
♦ Consumer finance (revolving loans, credit
cards, etc) UniCredit 73
♦ Mortgage lending UBS 67
♦ General/non-life/P&C insurance Intesa Sanpaolo 66
Sberbank 66
Key differentiating factors BNP Paribas 65
♦ NIM by countries/products RBS 62
♦ Cost/income ratio BBVA 62
♦ Cost of risk by countries/products ING 61
♦ RWA growth Barclays 48
Crédit Suisse 48
♦ Distribution channels
SocGen 48
♦ Status: State-owned, listed, private,
co-operative, mutual, savings banks, etc Deutsche Bank 44
HBOS 42
Crédit Agricole 40
Lloyds TSB 39
Fortis 39
Standard Chartered 34
KBC 32
32
The banking models
Asset gatherers Main business lines Largest European asset gatherers (m. cap in €bn)
♦ Asset management (mutual funds, wholesale) HSBC 142
♦ Private banking (tailor-made, onshore, offshore) Santander 93
♦ Life insurance (protection, savings, pensions) UniCredit 73
UBS 67
Key differentiating factors Intesa Sanpaolo 66
♦ Gross margin Sberbank 66
♦ Fee income/NBI BNP Paribas 65
♦ AuMs growth/net inflows RBS 62
♦ Distribution channels BBVA 62
♦ Asset allocation ING 61
♦ Investment performance Barclays 48
Crédit Suisse 48
SocGen 48
Deutsche Bank 44
HBOS 42
Crédit Agricole 40
Lloyds TSB 39
Fortis 39
KBC 32
33
The banking models
Corporate and Main business lines Largest European C&I banks (m. cap in €bn)
Investment Banking ♦ Corporate banking (cash management, HSBC 142
custody etc)
Santander 93
♦ Wholesale lending (plain vanilla)
UniCredit 73
♦ Structured lending
UBS 67
♦ Corporate Finance/Advisory
Intesa Sanpaolo 66
♦ Capital Markets
Sberbank 66
♦ Trading (equity, FI, FX, derivatives, swaps, other)
BNP Paribas 65
♦ Brokerage (incl. prime)
RBS 62
BBVA 62
Key differentiating factors
ING 61
♦ Revenues
Barclays 48
♦ Cost-income
Crédit Suisse 48
♦ VaR
SocGen 48
♦ Relationships and brand name
Deutsche Bank 44
HBOS 42
Crédit Agricole 40
Lloyds TSB 39
Fortis 39
KBC 32
34
The banking models
Alternative models Main business lines

♦ Custodians banks
♦ Central banks
♦ Clearing houses
Mixed models
♦ Bancassurance
♦ Allianz
♦ UBS
35
A mixed model—UBS
Wealth management
Client needs
and investment banking
support each other
Wealth UBS Global
Management Asset
US 1 Management
Wealthy
clients Corporate
Wealth globally &
Management Corporate & institutional
Advice & institutional Advice &
tailored tailored clients 2
clients
products Retail & products
globally
affluent
Private clients in
& Switzerland Third party
Corporate products
Clients
Client-
World class
centred
content
advice
Products
Notes:
1 Ex-PaineWebber
2 UBS Investment Bank, ex- UBS Warburg
36
A mixed model—Allianz
The rationale behind the

creation of a new
bancassurer Distribution channels
Individual clients Agents Planners Branches
in Germany Remote (telephone and online)
Protection products
♦ P&C
♦ Health
♦ Term life
Allianz
Customers’ financial needs

Long-term savings Financial
♦ Life (whole, unit linked)
Allianz Planners
♦ Mutual funds
♦ Corporate pensions
Credit/financing Dresdner
♦ Mortgages
♦ Loans Bank
Dresdner
♦ Consumer credit Vermögens-
beratung
Transaction/services
♦ Brokerage Advance
♦ Credit cards Bank
♦ Current account
37
SECTION 1.B
Banking
Capital
3
Bank capital
FIG EMEA training
26 November 2007
06060H227_Bank capital.ppt
Table of contents
SECTION 1 Bank capital 2

SECTION 2 Basel II 14
SECTION 3 Rating agency analysis 29
APPENDIX A Further reading
1
SECTION 1
Bank capital
Current news flow
“ Bank capital is precious again. Expect an unusual amount of investor attention to be lavished on
balance sheet measures, such as capital ratios, as the markets assimilate the knock-on effects of the
credit crisis
November 20, 2007
Investors are worried about RBS's capital position. The bank's core Tier 1 ratio, by its own estimate,
has dropped to 4.25 per cent following its acquisition of ABN Amro's wholesale division
,
November 11, 2007

”
“ In our view, already squeezed capital ratios at Citi get squeezed further in the fourth quarter, notably
from incremental losses on the warehouse. While Citi is a very cash generative company with earnings
Investment Research around $5 billion a quarter over the past 2 years, the payout ratio has been creeping up there (never
mind the fact that they didn’t earn the dividend this quarter) and we think they’ll need to take a breath
and rebuild capital ratios over the next few quarters.
Unfortunately, if the CDO warehouse and SIV issues are even bigger than we’re anticipating, Citi could
find itself in a situation where a capital raise would be its best alternative
November 5, 2007 ”
“ We believe there is another leg down for bank stocks as investors shift their focus from the massive write-
downs due to credit-related exposure to the severe impact that these write-downs and securities-related
downgrades will have on many of the banks' risk-weighted assets and capital ratios. The optics for the
group are not good at the moment, but they are poised to get worse because of the interconnectivity of
the rating agencies, RWAs, and regulatory capital ratios.
We expect Tier 1 ratios to drop materially in the fourth quarter. We continue to believe that C is at
precariously low capital levels that will force the company to sell assets, raise capital, and cut its
dividend. Our concern over C and the probability of its stock falling below $30 a share mounts by the day
November 11, 2007
3
”
Bank capital
Introduction ♦ Banks are heavily regulated entities – from a supervisory perspective, capital requirements
attempt to ensure that the assets of the depositors are protected (i.e., that their assets will be
returned despite any financial hardships that may arise)
– from a bank’s perspective, capital requirements need to be met while maximising returns
to shareholders (by minimising the equity base) and retaining a flexible funding approach
♦ Capital is held to support the activities of the bank

– Tier 1 and Tier 2 capital to support the banking book
– Tier 3 capital to support the trading book
♦ The regulatory picture is complicated: capital adequacy guidelines are set forth from a number
of bodies
– domestic national regulators
– European Union (by way of EU Directives)
– the Bank for International Settlements/BASEL Committee (by way of the Basel Capital
Accord)
4
Bank regulation over time
Basel II has become

mandatory in the EU
with many other Timeline 1988 1996 1998 2006 2008
countries across the
world following suit Basel I
Capital
BIS issues Tier 1 Basel II Basel II
Adequacy
accord classification accord implementation
Directive
In the U.S., the Fed has ♦ Unification of ♦ Inclusion of ♦ Harmonisation ♦ Improvement of ♦ In the EU, it will
Comment
approved final rules to regulation and market risk and of Hybrid T1 measurement be implemented
implement Basel II “for avoidance of introduction of instruments of credit risks via the Risk
arbitrage Tier 3 and disclosure, Based Capital
large, internationally inclusion of Directive
active banking operational risk
organizations” this
month. Implementation
is expected in 2009
Credit risk
Market risk
Operational risk
5
Key capital ratios
Tier 1 and total ♦ The Basel Committee decided in 1988 to submit all banks to minimum capital adequacy constraints,
capital ratio with the objectives of:
– raising overall capital levels in the banking system
– creating a level playing field for banks competing internationally (although this is difficult given that
a) implementation varies across markets and b) capital securities markets price capital inconsistently
♦ These constraints are expressed in terms of ratios of capital to a measure of risk undertaken by
the bank
“Confidence in the tier-1

capital ratio favoured by
European regulators seems
to have evaporated. […] Tier 1 capital Total capital
Investors seem to pay
Tier 1 ratio = Total capital ratio/BIS/CAR ratio =
closer attention to more
cautious capital measures Risk weighted assets (“RWAs”) RWAs
such as the leverage ratio,
which does not allow for
any risk-weighted
adjustment to assets”,
November 22, 2007
6
Bank capital components
Tier 1 ♦ Main components Deductions ♦ Investments in unconsolidated subsidiaries

capital – shareholder’s equity of total ♦ Holdings of other financials institutions’
– minority interests capital capital instruments, although certain
– hybrid tier 1 instruments (preference concessions apply
shares, etc.) up to certain limits
♦ Deduct intangibles—treasury stock, positive
goodwill Total ♦ Tier 1 capital + tier 2 capital + tier 3
capital capital – deductions
♦ Watch out for unrealised gains/losses!
Tier 2 ♦ Main components Risk ♦ Different balance sheet assets have

capital – upper tier 2 Weighted different risk profiles (e.g. an unsecured
Assets consumer loan is inherently more risky than
– lower tier 2
(RWA) US T-Bills)
♦ Deductions
♦ Also risk weighted off balance sheet assets
– loan loss reserves (e.g. letter of credit)
♦ Limits ♦ At UBS we do not calculate RWA, but …
– lower tier 2 < 50% tier 1
– we should understand the risk profile
– total tier 2 < 100% tier 1 of a bank
– apply previous RWA/assets to latest
♦ Held against market risk in trading book reported assets as a proxy
Tier 3
capital ♦ In some jurisdictions—amortised lower tier 2
(e.g., France)
7
Capital structure chart
Sub debt “Hybrids” debt and equity features Equity

Cheap[er] to issue Expensive to issue
Innovative
Lower Tier 2, and Non-innovative
preferred
Tier 3 (but of Upper Tier 2 non-equity Core Tier 1
securities (tax
limited use) securities
deductible)
Limited to 15% of Tier 1 Must be

“dominant” form of
Tier 1
i.e. at least 50%
Limited to 100% of Tier 1 “Preferred securities”
of Tier 1
Tier 2/Tier 1
Lower Tier 2 Upper Tier 2 Innovative Non-innovative Core Tier 1

♦ Minimum 5 ♦ Typically perpetual ♦ Typically ♦ Typically, noncumulative, ♦ Common/ordinary shares
years maturity debt (but minimum noncumulative, perpetual,
♦ Retained earnings
maturity of ten years perpetual, SPV-issued directly-issued preference
♦ Subordinate to
in Italy, Denmark) preference shares shares ♦ Foreign currency
senior creditors
translations
♦ Bank can withhold ♦ Tax deductibility is ♦ Not tax deductible
♦ Event of default for
interest when due often granted by (although some issues ♦ Fund for general banking
nonpayment of interest
under certain domestic tax can be) risk (optional in Europe)
when due
conditions authorities
♦ Retail targeted issues: no ♦ Minority interest (equity,
♦ Capital is amortised
♦ Also includes: ♦ Institutional targeted step ups, noncall period not preferred)
20% in last five years
– allowance for issues: step up in is typically five years
♦ Less: goodwill
♦ Typical product is 10 loan and coupon of 150 bps
♦ Noncall period can vary
years with 5 years lease losses after 10 years ♦ Less: other deductions
noncall period e.g. tax effect of
– unrealized gains ♦ Often recorded on
unrealised gains
♦ Step up in coupon on listed securities balance sheet as
allowed after (45% eligible) minority interest
noncall period in
some countries
Source: UBS research

8
Trading performance of bank capital
Spreads have widened Trading performance of Euro bank capital by type vs. benchmark
massively in the wake of
300
the sub prime fallout
250
200
(bps)
150
100
50
0
24-May-07 18-Jun-07 14-Jul-07 9-Aug-07 4-Sep-07 30-Sep-07 26-Oct-07 21-Nov-07
Lower Tier 2 Upper Tier 2 Tier 1
Source: Bloomberg
9
Tier 1 capital calculation
Included within Tier 1 Capital

capital are preferred
Permanent share capital and reserves
securities – instruments
issued by a bank directly Published interim retained profits
– or indirectly by a Minority interest Regulation varies slightly
consolidated subsidiary between jurisdictions
Hybrid capital (innovative/non-innovative)
or SPV
Goodwill and other intangible assets
Preferred security
holders have a right to
any residuals in Tier 1 capital
liquidation although will Hybrid capital
usually receive only a
tiny portion after Core T1 capital
insured depositors and
other senior debt
holders are paid out
Limit
Innovative tier 1 capital 15% of total tier 1
10
Tier 2 capital calculation
Tier 2, divided into two Revaluation reserves

classes, upper and lower,
represents a lesser form Perpetual subordinated debt
of capital than Tier 1
Upper tier 2
Portfolio impairment provisions
(maturity > five years)
Upper Tier 2 (typically
perpetual subordinated
Dated subordinated debt 1 Lower tier 2
debt) can absorb losses
by cutting interest
payments only when Tier 2 capital (prior to limits
solvency is threatened and restrictions)
Lower Tier 2 has an

inability to absorb losses
on a going concern basis
Limit
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)
11
SECTION 2
Basel II
Current news flow

“ Basel II is a modern, risk-sensitive capital standard that will protect the safety and soundness of our
large, complex, internationally active banking organizations. The new framework is designed to evolve
over time and adapt to innovations in banking and financial markets, a significant improvement from
the current system
”
Ben S. Bernanke, Federal Reserve Board Chairman, November 2, 2007
“ Transparency should undeniably be heightened“. She also said a review of the new Basel II capital
reserve requirements for banks needs to be conducted in relation to liquidity at financial institutions,
considering Northern Rock, the U.K. bank that had to be rescued by financing from the Bank of
England, was Basel II compliant
Christine Lagarde, Minister of Finance, French Republic, October 22, 2007, quoted in Dow Jones
”
“ Basel is the root of the banking crisis
It was the 1988 Basel Accord that first created the opportunity for regulatory arbitrage whereby banks
could shunt loans off the balance sheet. In effect, a new capital discipline designed to improve risk
management had the unintended consequence of creating a parallel banking system whose lack of
transparency explains the market seize-up since August
[…] The Basel II regime, which takes effect in January, makes securitisation less attractive to banks and
seeks to address contingent risk. Yet it is hard to believe it would have prevented the current mess. Basel
II relies on the modelling techniques that led to the sub prime disaster. The new rulebook also depends
heavily on the credit rating agencies in whom investors have lost confidence.
Financial Times, November 6, 2007

”
13
Basel II—built on 3 pillars
Basel II?
“International Basel committee on Banking Supervision

Convergence of Capital
Measurement and Pillar 1: Pillar 2: Pillar 3:
Minimum capital Supervisory review Market discipline
Capital Standards: A
requirements process
Revised Framework”
♦ 8% minimum capital ♦ Capital management ♦ Financial disclosure about
June 2006 (347 pages!) ratio maintained planning – capital structure
♦ RWA take into account ♦ National discretion for – risk exposures
– credit risk some charges – capital adequacy
Focus has been on Pillar 1,
– market risk ♦ Additional capital ♦ Allows investor community
but we consider Pillars 2
– operational risk requirements could be to assess a Bank’s risk
and 3 as important added by national profile under Basel II
♦ No change to definition of regulators as a result of requirements
tier 1, tier 2 and tier 3 stress testing
capital
Source: Basel Committee
14
Basel II must be viewed from a strategic vantage point
♦ The implementation of Basel II over the next few years will have significant implications for the
banking sector
– retail-oriented franchises will benefit in terms of lower capital requirements;
– low-quality corporate lenders may need to hold more capital (Pillar 1)
– today’s landscape of “winners and losers” will be altered by implementation date
– additional capital requirements under Pillar 2 set by domestic regulators will be an
important determinant of final Basel II capital levels
♦ Basel II is already happening: banks have set up project teams to implement Basel II to improve
credit and operational risk management
– banks are only now beginning to evaluate Basel II on a strategic basis
♦ Basel II thinking must run throughout the bank

– creates a new credit risk management culture
– creates a bias toward certain asset classes, and penalises others; portfolio management
skills will be at a premium
– forces increased disclosure to the investment community
– places a premium on stress testing, capital management and strategic planning
15
Business implications of Basel II
Likely beneficiaries: Change of business model
♦ Retail focused banks ♦ Potential shift of focus on products experiencing a reduction in capital requirements, such as residential
♦ Wholesale focused banks (with mortgages
significant retail business lines) ♦ Potential reconsideration of products experiencing an increase in capital requirements, such as sub-
♦ Bancassurance models (with prime lending
grandfathered insurance
Differentiation of players and consolidation
business)
♦ Depending on business models and risk appetite, banks could either come out as winners or losers
during the Basel II implementation
Likely neutral: ♦ This increased differentiation could serve as a catalyst for continued consolidation of the financial
markets
♦ Retail focused banks with a
below-average credit history Non-bank competitors
♦ Some non-Basel regulated firms will have a relative advantage compared to banks due to lower capital
constraints
Likely to be disadvantaged ♦ Banking-like activities by non-bank competitors might increase (such as direct commercial property
♦ Wholesale focused banks (with lending)
focus on corporate lending) Importance of insurance players
♦ Bancassurance franchises (if ♦ High-quality insurance companies benefit from lower risk weight as counterparties
double leverage from wholly
owned insurance business is ♦ Potential sale of insurance policies to mitigate operational risk charge
not being grandfathered by Profitability
local regulators)
♦ If many banks in the same market become risk aware (bias toward mortgage and retail lending),
♦ Asset managers
margins could collapse
– returns could fall faster than capital requirements
♦ Banks who are willing and able to take on more and adequately priced risk in the primary and/or
secondary credit markets could raise their return on capital
16
Disclosure example: Commerzbank
Source: Commerzbank Investor Day, September 21, 2006
17
Basel I to Basel II transition
Banks have to efficiently Basel I Transition from Basel I Basel II

manage their capital to Basel II
allocation with regard to ♦ Banks can continue to use Basel ♦ Banks can elect to use the ♦ Banks must be using either the
I till 31 December 2007 Standardized Approach or the Standardized or IRB Approaches
both Basel I and Basel II Foundation Internal Ratings by January 1st 2008
Approach (Foundation IRB)
from January 1st 2007
♦ Banks can at the earliest use the
advanced Internal Ratings Based
Application
approach (“Advanced IRB”)
from January 1st 2008
The capital usage calculation using
either IRB approach is subject to a
Basel I capital floor for the first three
years of usage:
♦ 2007: 95% of the capital using
Basel I
♦ 2008: 90%
♦ 2009: 80%
♦ Risk weighting not consistent ♦ Basel I floor effects delay ♦ Impact of rating agencies on
with economic risk for convergence between capital requirements
Issues
“corporate risk” (e.g. senior regulatory and economic capital

securitization exposures and
residential mortgages)
♦ Risk transfer mechanisms that ♦ Combination of Basel I solutions ♦ Re-tranching existing assets to
are capital efficient: to lower impact of capital floors reduce rating downgrade
– liquidity facility and Basel II solutions to impact
Solutions
optimize capital usage ♦ Leveraging exposure on highly

– tranching exposure
– re-tranching equity sec rated assets where equity
tranche is investment grade.
exposure by duration
♦ Re-tranching equity sec
exposure by duration
18
Disclosure example - Postbank
Example for capital

disclosure of a listed
bank
RWA
Capital
Source: Postbank IR Q3 2007 19

Basel II: Implication effects
Basel I simple rules- Risk Standardised approach under Basel II

based methodology Assets in the Basel I approach weighting (non exhaustive)
♦ Cash
♦ Cash
♦ Claims on OECD/other developed 0% ♦ Sovereign debt (AAA to AA-)
Sub-optimal reflection countries’ governments and
central banks
of true underlying risk
in some cases: a bank
♦ Corporate & bank debt (AAA to AA-)
in OECD Turkey with ♦ Bank loans 20%
♦ Sovereign debt (A+ to A-)
lower risk weighting
than AAA-rated
corporate such as GE / 35% ♦ Loans secured by residential property (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%
♦ Capital instruments of other banks ♦ Loans secured by commercial property
(unless a capital deduction) ♦ Unsecured loans
♦ Other assets
♦ Corporate debt (< BB-)

150% and ♦ Bank debt (< BB-)
above ♦ Equity investments
♦ Hedge funds
20
Basel II: different approaches
Standardised Approach Credit risk weighting requirements under standardised and Internal Ratings based
is ratings-driven approaches to Basel II
IRB (internal ratings- Basel I Basel II Probability Loss given

based) either foundation weighting standardised IRB range of default default
(%) (%) (%) (%) (%)
or advanced approach
(AIRB) Residential secured 50 35 12–60 0.50–1.50 15–35
Unsecured personal lending 100 75 60–115 0.50–2.50 85
Under advanced IRB banks
are allowed to use their own Commercial property 100 100 Na
models to quantify required SME lending (<€1m exposure) 100 75 55–75 1.50–10.00 45
capital for credit risk
SME lending (>€1m exposure) 100 Depends on credit
The foundation approach defined as a corporate grade (below)
uses some variables (LGD,
Corporate: AAA to AA- 100 20
EAD) as input from Basel II
Corporate: A+ to A- 100 50 For all
corporate 0.03–5.00 45
Corporate: BBB+ to BB- 100 100 15–150
Corporate: below BB- 100 150
Basel II—evolutionary approach to Pillar 1
21
Basel II: IRB parameters
Internal Ratings Based IRB is based on measures of … … and on classification of assets into
Approach is loss-driven five categories
and ratings-driven
To use the Internal Rating ♦ Probability of default (PD) ♦ Sovereign
Based (“IRB”) requires ♦ Loss given default (LGD) ♦ Bank
approval from the bank’s
regulator ♦ Exposure at default (EAD) ♦ Corporate
This usually involves one ♦ Effective maturity (M) ♦ Retail
year of model testing
reviewed by the regulator ♦ Unexpected losses (UL) ♦ Equity (treatment same as standardised
prior to implementation approach for EU countries risk weighting is
♦ Expected losses (EL) 290% listed/370% unlisted)
In addition to the above, securitisations have a specific treatment. If an asset is rated the Ratings-Based
Approach (“RBA”) must be used. If a rating (external or inferred) is not available the Supervisory Formula
or the Internal Assessment Approach (for exposures to ABCP conduits only) must be used
22
Pillar 1—operational risks
New charge: added to Operational risk

Pillar 1
♦ “the risk of loss resulting from inadequate or failed internal process, people and systems or from
external events”
Three different approaches proposed

♦ Basic indicator: gross income X factor (17 to 20%)
♦ Standard: separate business units use different indicators X factors
♦ Advanced measurement approach (AMA): uses bank’s internal modelling systems
♦ Use of insurance against operational risk will be permitted for advanced measurement approach, but
not to exceed 20% reduction in overall operational risk capital charge
♦ Basel Committee will provide for partial adoption of AMA
Percentages by lines of business
Corporate finance (18%) Payment & Settlement (18%)

Trading & sales (18%) Agency Services (15%)
Retail banking (12%) Asset management (12%)
Commercial banking (15%) Retail brokerage (12%)
Source: UBS based on Basel Committee
23
Disclosure example operational risks: Commerzbank
Source: Commerzbank Investor Day, September 21, 2006
24
The importance of Pillars 2 and 3
Too much attention has Pillar 2 supervisory review

focused on Pillar 1
♦ Additional capital requirements could be added by national regulators
models
♦ Capital management process
♦ National discretion for some charges
♦ May be more important than Pillar 1 Capital
How much information Pillar 3 market discipline

will we get?
♦ Capital structure
♦ Risk exposures
♦ Capital adequacy
♦ Allows investor community to assess a bank’s risk profile under Basel II requirements
♦ Could have important implications for shedding layers of opacity that have undermined traditional
bank price performance
25
Insurance companies owned by banks
The Capital ♦ Basel I allows double counting of capital through funding of insurance operations through banks’ tier II
Requirements Directive – applies to most European banking regulations (e.g. not Switzerland; France, Germany, Italy,
will require 50% of the Portugal and Spain have no regulatory
deduction to be made capital deduction)
from Tier 1 capital, but ♦ Basel II proposal to require 50% tier I funding implemented in some countries only
e.g. the FSA has chosen – technically this stems from an increase in risk weights from 100% to 1250% of stakes in
to delay implementation insurance companies
of this change until at ?
least 2012
50%
Different treatment, 100%

Total capital
depending on the
regulator
Tier II
50%
Full application “Basel I”: deduction “Basel II”: equal

postponed in most from total capital, deduction from
countries i.e. tier II funding tier I and tier II Tier I
Tier I capital Tier II capital Total capital Capital insurance

Capital "Basel
in insurance II": equal
subsidiary "Basel I"
“Basel I” capital "Basel II"
“Basel II” capital
subsidiary deduction from tier I position position
and tier II
Tier I Tier II
26
SECTION 3
Rating agency analysis

Rating agency methodology of analysing banks: S&P
Adjusted Common
equity (ACE) is S&P’s Reported shareholders'equity
equity
Reported shareholders’
measure of core capital
Minorities
Adjusted Total Capital
Dividends
(ATE) includes some
components of the Goodwill and nonservicing intangibles
capital structure with
Retirement benefit adjustments
features that make them
weaker than common TLCF
equity Other
Adjusted
Adjustedcommon
commonequity
equity
ACE and ATE/RWA ratios Preferred and hybrid (subject to limits)

(instead of Tier I) General reserves unrealised gains
Equity in unconsolidated subs
MACE to reflect large Capital for insurance comps

insurance subs
Adjustment for securitised assets
Adjustedtotal
Adjusted totalequity
equity
0 5 10 15
Source: S&P, indicative only
28
Rating agency methodology of analysing banks: Moody’s
Moody’s classifies
hybrids in a basket from
A to E on the debt— Reported
Reported shareholders'equity
shareholders’ equity
equity continuum
The basket assignments Minorities
capture how closely the
hybrid replicates the key
Preferred stock
features of common equity
– no maturity
– non-payment of Unrealised gains or losses from AFS securities
dividend/interest
does not trigger Adjustment for cash flow hedges
default
– loss absorption
Goodwill and all other intangibles Basket
A
B
Moody's equity credit for hybrid and preferred C
D
E
TangibleTangible
common common
equityequity
(TCE)
0 5 10 15 20
Source: Moody’s, indicative only
29
APPENDIX A
Further reading
Further reading
Author Title Date
Financial Institutions Group 26 April 2007
Provides More Transparency Into
Adjustments Made To Bank Data
Managing Capital under Basel 2 4 July 2007
Bank Financial Strength Ratings: February 2007

Global Methodology
The preferred quality of 27 October 2006

capital revisited
Basel II Capital Release 11 September 2006
International Convergence of June 2006

Capital Measurement and Capital
Standards: A revised Framework
Asset Securitization—Trying to 20 February 2006

Comprehend Basel II
Bank Capital A–Z January 2003, update 2004
31
SECTION 1.C
Banking
Valuation
4
Bank valuation
FIG EMEA training
26 November 2007
06060h227_Bank valuation.ppt
Table of contents
SECTION 1 Bank valuation 2

SECTION 2 Multiples 7
SECTION 3 Gordon Growth 20
SECTION 4 Sum-of-the-parts valuation 24
SECTION 5 Dividend discount model 28
1
SECTION 1
Bank valuation
Valuing a bank
Valuation work is ♦ M&A transactions

performed in most of
the situations where ♦ Fairness opinions
corporate finance
♦ Restructuring
is involved
♦ IPOs
♦ Market advisory
3
Valuation methodologies should incorporate …
... the specific features of ♦ A regulated industry (capital requirements, loan provisions)
the banking sector
♦ Financing is at the core of the business
– EV/EBITDA, EV/EBIT multiples non applicable
♦ Easy access to funding
– limited use of conventional cash flows
♦ Limited visibility over some key business drivers
– complex financial instruments (in some cases)
– asset quality of loan portfolio
4
Essential preliminary analysis
A good understanding of Understanding the performance of a bank—selected features

the operating
performance of the bank ♦ Mix (businesses, geographical)
is key to any meaningful
valuation work ♦ Growth prospects/business cycle
♦ Revenue mix
♦ Margins
♦ Efficiency
♦ Asset quality
♦ Profitability
♦ Solvency/capital ratios
♦ Asset/liability mix
5
Key valuation methodologies
There are several major 1 Multiples

valuation methodologies
♦ Trading multiples (“Comps”)
♦ Transaction multiples (“Precedents”)
2 Gordon growth model (“GGM”)
3 Sum-of-the-parts valuation (“SOTP”)
4 Dividend discount model (“DDM”)
6
SECTION 2
Multiples
General methodology
Methodology follows Identify key comparable Determine

defined process to reach public companies / closest comps
transactions
judgement on likely
value of target
Principles are broadly

the same for trading
and transaction multiples Determine Calculate relevant Determine appropriate Determine likely value
key multiples multiple of comps multiple range of target range for target
Analyse financial Determine key drivers

performance of target of comps’ multiples
and comps (ratio analysis)
8
Using multiples in a valuation
Key considerations ♦ Select comparables carefully
– business mix
– geographical presence
– quality of the franchise
– profitability
– trading data (small capitalisation / thinly traded stocks)
♦ Be consistent
♦ Understand the accounting treatment and the potential differences it creates
♦ Document your work—to allow outlining and updating
9
Applying multiples to value a bank
Why do multiples There are good reasons why valuation multiples vary it is not enough to say
vary?—four factors that the value of a business should be automatically based upon the “sector”
average multiple
1 The quality of the business
♦ High quality businesses deserve higher valuation multiples
♦ Consider differences in value drivers
– growth
– quality of management
– new investment opportunities
– quality of franchise
– etc. …
♦ The problem is how to allow for those differences
– how much is growth worth?
– what is the impact of a higher return on capital?
2 Accounting differences
♦ IFRS vs. US GAAP vs. local GAAP
♦ Different application of optionalities
3 Fluctuations in profits
♦ Multiples are only meaningful if the profit used is representative of that “maintainable” in the future—
multiples vary if there are one-off profit fluctuations
♦ A multiple is only meaningful if the profit on which it is based is indicative of future profit potential
– exclude exceptional items
– use forecast rather than historical profits
♦ Where the current or subsequent years profits are still not representative of the longer term …
– consider using forward priced multiples
4 Mis-pricing
♦ A low multiple could indicate that the stock is simply underpriced rather than just poor quality
♦ If deserved differences in multiples are not fully explained by differences in
– business quality
– accounting policies
– fluctuations in profits
10
Multiples—trading comparables
Summary overview ♦ Apply selected valuation statistics of comparable companies to the relevant financial data of the bank
– P/E ratios
– P/BV ratios
Benefits Limits
♦ Simplicity ♦ Ability to find truly comparable company(ies)
♦ Widespread applicability ♦ Static valuation methodology
♦ Based on market views ♦ Influence of “irrational” market features
♦ Relative valuation tool
11
Price/earnings multiples
Calculating P/E multiples

Share price Market capitalisation
♦ P/E = or
EPS Net income

♦ P/AdjE = or
Adjusted EPS Adjusted net income
EPS calculation
Stated EPS: (Net attributable income including extraordinary items (net of tax))/weighted average
number of shares
Adjusted EPS: Stated EPS adjusted for extraordinary item, general provisions, other country
specific items
Source: UBS Research, Consensus (Datastream /I/B/E/S)

12
Price/book multiples
Calculating P/BV
multiples Share price Market capitalisation
♦ P/E = or
BVPS Book value

♦ P/AdjE = or
Adjusted BVPS Adjusted book value
BVPS calculation
Stated BVPS: Shareholder funds net of treasury shares and excluding minority interest)/Number
of shares
Adjusted BVPS: Stated BVPS adjusted for various items (see next page)
Source: UBS Research, Consensus (Datastream /I/B/E/S)

13
Adjusted book value definition
Certain standard Key items

adjustment should be
made, but there will Shareholders’ equity
typically be areas where
－ Minorities (if applicable)
judgement is required
－ Goodwill
－ Other intangibles
＋ Fund for general bank risk ?
(local statutory, shown as equity in IFRS)
＋ Unrealised capital gains (notes, other input) ?
＋ Cash flow hedge reserve deduction
± Other items ?
Source: Commerzbank 2006 annual report
14
Simple RoE, P/E and P/B considerations
♦ Zero earnings mean actual RoE=0 and hence the regression line should on the face of it cross the origin
♦ We typically take into account a longer-term expectation of reversion to CoE and also increase the fit
(R²) of the regression by allowing b 0
♦ Keep in mind that:
P/B E
= = RoE
P/E B
(if you disregard averaging equity and assume consistent adjustments)
– hence, in a way the value map is similar to P/E analysis
– use this relationship to sense check your comps tables or precedents (keep practical complications
from adjustments in mind though)
♦ Bear in mind that differences in capital structure have an impact on P/E
– leverage has a P/B of 1x and a P/E much in excess of typical valuations
♦ Be careful with conclusions of companies above the regression line being overvalued. This is a simple
model and many factors are at play
15
Correlation analysis
Correlation or regression
analysis (also called the 3.50 y = 0.0925x + 0.7326 Santander
value map approach) is a R2 = 0.894
BBVA
useful and visual tool for 3.00
BPI
justifying and
P/TBV 06A (x)

benchmarking valuation BCP Banco Popular
2.50 Banco Sabadell
multiples
BES
2.00 Banco Pastor

Banesto
1.50
10.0 15.0 20.0 25.0 30.0
RoTBV 07E (%)
♦ Occasionally used for EPS CAGR and P/E with a similar rationale
16
European banks trading multiples
Share price P/E P/TBV RoTBV EPS CAGR

A valuation Share Market
price¹ value YTD 12m high 2007E 2008E 2009E 2007E 2008E 2009E 2007E 2008E 2009E 2007E–09E
multiples output for Name Domicile (local) (€bn) (%) (%) (x) (x) (x) (x) (x) (x) (%) (%) (%) (%)
a cross section of BNP Paribas France 70.86 62.2 (14.3) 75.2 8.0 8.1 7.5 1.51 1.36 1.23 19.9 17.7 17.3 3.5
European banks Société Générale France 100.58 44.1 (21.8) 63.5 8.3 8.1 7.5 1.63 1.46 1.31 21.1 19.0 18.5 5.3
Crédit Agricole France 22.21 35.0 (29.2) 64.8 7.0 6.9 6.3 1.77 1.53 1.34 27.5 23.7 22.7 5.2
NatIxis France 11.79 13.8 (44.6) 51.8 6.6 6.5 5.8 0.91 0.85 0.80 14.2 13.6 14.1 6.5
Mean (27.5) 63.8 7.5 7.4 6.8 1.45 1.30 1.17 20.7 18.5 18.2 5.1
Median (25.5) 64.1 7.5 7.5 6.9 1.57 1.41 1.27 20.5 18.3 17.9 5.3
Deutsche Bank Germany 83.57 43.3 (17.5) 70.8 6.9 7.8 7.2 1.48 1.41 1.32 23.4 18.5 19.0 (1.6)
Commerzbank Germany 25.12 16.2 (12.9) 66.9 9.0 8.4 7.9 1.20 1.11 1.02 13.8 13.7 13.5 6.7
Deutsche Postbank Germany 54.72 9.2 (14.5) 76.1 12.4 10.8 9.7 2.41 2.05 1.75 19.8 20.5 19.6 13.5
Hypo Real Estate Germany 35.30 7.0 (26.1) 66.9 8.8 7.5 6.5 1.15 1.05 0.95 12.0 14.7 15.5 16.8
Aareal Germany 26.00 1.2 (26.3) 65.2 9.4 7.4 6.4 0.81 0.75 0.69 8.9 10.6 11.1 21.0
Mean (19.5) 69.2 9.3 8.4 7.5 1.41 1.27 1.15 15.6 15.6 15.7 11.3
Median (17.5) 66.9 9.0 7.8 7.2 1.20 1.11 1.02 13.8 14.7 15.5 13.5
Bank of Georgia Georgia 33.15 0.5 47.3 75.3 18.4 11.9 9.0 3.40 2.64 2.04 20.4 25.0 25.6 42.8
Sberbank Russia 4.17 61.7 21.5 0.1 20.9 16.7 13.1 3.47 2.93 2.45 17.9 19.0 20.4 26.5
Kazkommertsbank Kazakhstan 10.65 2.1 (53.9) 44.4 8.5 7.0 5.2 1.28 1.08 0.90 16.3 16.6 18.8 27.6
PKO Poland 52.20 14.0 11.1 88.5 20.0 16.9 14.6 4.86 4.19 3.63 26.1 26.6 26.7 17.2
Pekao Poland 254.80 11.5 12.3 93.8 20.1 17.3 14.9 4.90 4.60 4.28 25.0 27.4 29.7 16.0
OTP Hungary 8,580.00 9.1 (1.9) 78.4 11.3 9.9 8.5 3.55 2.81 2.28 35.6 31.8 29.6 15.1
Komercni Czech Rep. 4,133.00 5.7 33.4 91.7 15.4 13.9 12.8 2.89 2.63 2.37 19.6 19.8 19.5 9.6
Mean 10.0 67.5 16.4 13.4 11.2 3.48 2.99 2.57 23.0 23.7 24.3 22.1
Median 12.3 78.4 18.4 13.9 12.8 3.47 2.81 2.37 20.4 25.0 25.6 17.2
Source: Datastream, I/B/E/S, UBS Investment Research, broker notes
Note:
1 Share prices are closing prices as at 20 Nov 07
17
Multiples—precedent transactions
Summary overview
♦ Apply selected valuation statistics of comparable precedent transactions to the relevant financial data of
the bank
– P/E ratios
– P/BV ratios
Benefits Limits
♦ Realistic approach (includes ♦ Ability to find truly comparable transactions
M&A-related items) – geographical presence
♦ Control premium take into consideration – business mix
♦ Relative valuation tool – transaction-specific items
♦ Accepted and common measure ♦ Subject to market fluctuations
♦ Lack of disclosure limits visibility over key
features of any transaction
Understanding precedent transactions—a non exhaustive list

♦ Comparability of markets observed
– tax issues
– accounting rules
– takeover rules
♦ Specific circumstances of the transaction
– hostile vs. friendly
– negotiated vs. auction
– strategic merger
♦ Further transaction information
– control premium (to be determined)
– deferred payments
– management earn-out schemes
– reps and warranties
18
Summary
Multiples are a critical ♦ Trading multiples are equity market’s primary calculation measure
part of valuation— ♦ M&A market tries to reconcile transaction multiples with control premiums to determine
great care necessary transaction value
for robust result ♦ Multiple analysis should be conducted rigorously, like DDM
♦ Expert guidance should be sought on selection of comps, multiples and multiples ranges
Thorough use of multiples ♦ Must understand drivers of comps’ multiples and relative rankings
analysis should achieve ♦ Always check results against equivalent DDM—if done
virtually everything DDM
can do
19
SECTION 3
Gordon Growth
The Gordon Growth model
The Gordon Growth Gordon Growth formula Considerations

model is popular with
RoE – growth Advantages
equity analysts
P/BV =
CoE – growth Relatively easy and requires few inputs
Where: P = value Favoured by many equity analysts
BV = book value of equity

RoE = return on equity
Disadvantages
Growth = perpetual growth rate
CoE = Cost of Equity required by Very simplistic, only one stage in base case
marginal investor
Dispute over “correct” BV and earnings to
use as input
21
Derivation of the D1
formula from a P0 = one-stage dividend discount valuation
one-stage dividend CoE – g
discounting approach
D0
E0 x x (1 + g) BV0 x RoE x payout ratio
Key things to remember E0
P0 = =
♦ Discounting dividends, CoE – g CoE – g
not earnings
♦ Relationship between RoE,
E1 E0 (1 + g)
payout ratio and growth: in with D1 = D0 (1 + g) and RoE = =
a steady state the business
must grow in line with the BV0 BV0
“retained part of RoE”
P0 RoE – g
=
BV0 CoE – g
g
with g = RoE (1 – payout ratio) or payout ratio = 1 –
RoE
By the way, the same model can be used to derive
P0 Payout ratio
=
E0 CoE – g
22
Example P/B statistics Assumptions

and sensitivities
Return on equity 15%
(RoE)
Cost of equity 9%
(CoE)
Perpetual growth 2%
(g)
Implied multiple 1.86 (RoE-g)/(CoE-g)
Perpetual growth (g) = 2% Perpetual growth (g) = 3%

RoE (%) RoE (%)
10.0 12.5 15.0 17.5 20.0 22.5 25.0 10.0 12.5 15.0 17.5 20.0 22.5 25.0
7.5 1.45 1.91 2.36 2.82 3.27 3.73 4.18 7.5 1.56 2.11 2.67 3.22 3.78 4.33 4.89
8.0 1.33 1.75 2.17 2.58 3.00 3.42 3.83 8.0 1.40 1.90 2.40 2.90 3.40 3.90 4.40
8.5 1.23 1.62 2.00 2.38 2.77 3.15 3.54 8.5 1.27 1.73 2.18 2.64 3.09 3.55 4.00
CoE (%)
CoE (%)
9.0 1.14 1.50 1.86 2.21 2.57 2.93 3.29 9.0 1.17 1.58 2.00 2.42 2.83 3.25 3.67
9.5 1.07 1.40 1.73 2.07 2.40 2.73 3.07 9.5 1.08 1.46 1.85 2.23 2.62 3.00 3.38
10.0 1.00 1.31 1.63 1.94 2.25 2.56 2.88 10.0 1.00 1.36 1.71 2.07 2.43 2.79 3.14
10.5 0.94 1.24 1.53 1.82 2.12 2.41 2.71 10.5 0.93 1.27 1.60 1.93 2.27 2.60 2.93
11.0 0.89 1.17 1.44 1.72 2.00 2.28 2.56 11.0 0.88 1.19 1.50 1.81 2.13 2.44 2.75
23
SECTION 4
Sum-of-the-parts valuation
Summary overview ♦ Valuing each business activity separately according to its own business dynamics
♦ Strictly speaking, SOTP is not the actual valuation methodology but rather a way of organising
an approach
– still requires fundamental methodologies, usually multiples or Gordon growth models
Benefits Limits
♦ Detailed analysis of key business areas ♦ Limited information available
♦ Assists identification of hidden value (holding ♦ Static information analysis
company structures)
♦ Relies on market/precedent
♦ Provides insight into valuation weight of transaction multiples
various business areas
♦ Lack of real comparables
25
Understanding key Illustrative Valuation Indicative

Business capital allocation methodology multiple range
business drivers
Retail 7% RWAs P/E 10–15x
Wholesale 6% RWAs P/BV 1.0–1.5x
Asset management 2 x cost base P/AuM (or P/E) 1–2%
Private banking 4 x cost base P/AuM (or P/E) 2–3%
Life insurance 5% technical reserves P/EV 1–2x
(1.25% u/l)
Non-life insurance 40% GWP P/BV 1–2x
Corporate centre Balancing item P/BV 0.5–1x
Group Equity as reported Sum Implied P/E & P/B
Capital allocation
♦ The capital allocation to the business divisions 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 disclosure but
analysts will do their own allocation so as to harmonise between peers
26
Retail Asset Corporate and Investment Foreign Corporate Life

Illustration (€m) Banking management institutional banking subsidiaries centre insurance Group
Net profit 135 50 145 30 25 0 12 397
Allocated equity 750 3 670 150 110 10 74 1,767
Estimated EV 184
ROE (%) 18 >100 22 20 23 nm na 22
Cost / income ratio (%) 58 36 41 52 50 84 na 68
P / E (x) 11.3 14.0 11.0 8.0 11.0 nm 23 11.6
P / book (x) 2.0 nm 2.4 1.6 2.5 1.0 2.6
P / EV (x) 1.5
Value (€m) 1,525 700 1,595 240 275 10 ¹ 276 4,621
Target share price (€) 46
Market cap 4,265
Share price 43
Note:
1 Valued at par, or even sometimes below par if assumed to be excess capital
27
SECTION 5
Dividend discount model

Discounted cashflows/dividend discount model (“DDM”)
Summary overview ♦ Calculate the net present value of a bank based on a series of estimated cash flows and a
terminal value
Benefits Limits
♦ Identifies key valuation drivers and ♦ Significant sensitivity to a very limited number
sensitivity of the result of parameters
♦ Dynamic valuation approach ♦ Relies on ability to forecast future performance
♦ Reflects earning power ♦ Time consuming
♦ Can differentiate between value for

different buyers
29
Discounted cashflows/dividend discount model (“DDM”)
In a “dividend discount “Corporate world” Financial Institutions

model (DDM)“ we still Cash flow to the company Cash flow to the shareholder
discount cash flows, but
simply look at the
shareholder level
EBIT
- Tax
♦ Regulatory and rating = NOPAT
considerations drive target
capitalisation and earnings + D&A - Risk-weighted assets
retention
- Capex x Target regulatory capital ratio
♦ Enterprise value analysis not
WC = Required earnings retention
appropriate in a business
where the P&L starts with Other A/L + Available net income
the interest line
= Free cash flow = Dividends
Financial
Institutions Shareholders Debtholders
analysis
Equity value Net debt
“Corporate
world” Company
analysis
Operating assets
30
Forecasting cashflows
Key value drivers In depth historic analysis

♦ Profitability ♦ Three to five years
♦ Net interest margin ♦ Assessing the quality (reliability) of
income streams
♦ Commission income to operating income
♦ Adjusting for non-recurring items
♦ Trading income to operating income
♦ Tax
♦ Efficiency Mid term forecast
♦ Cost/income ratio
♦ Forecast for three years based on management
♦ Solvency/capital ratio forecast/plan/targets
♦ Target tier 1 ratio ♦ Compare value drivers to a defined peer group
and clarify differences
♦ Asset quality
♦ Loan provision charge/loans
♦ Balance sheet growth Long term forecast
♦ Customer loans
♦ Reflect long term market changes over a
♦ Customer deposits period up to ten years by adjusting growth
rates and margins
♦ Total assets
♦ Risk weighted assets
31
How to build a DDM?
Assumptions
Tax rate 35.00% (€m) 2006 2007E 2008E 2009E 2010E 2011E
Interest forgone 5.000% Net income 300 250 325 420 500 540
on cash EURIBOR 3M
Adjustment for incremental dividends (26) (25) (24) (26)
Target Tier I 5.5%
Adjusted net income 250 299 395 476 514
ratio
Standalone 50% Core Tier I 2,500 2,700 2,000 2,200 2,500 2,700
payout ratio
RWA 32,600 32,000 34,100 36,900 39,700 42,000
LT growth rate 2.0% Core Tier I ratio (%) 7.7 8.4 5.9 6.0 6.3 6.4
Dividends 940 125 171 317 390

– of which additional vs. forecast dividends 815 (38) (40) 67 120
Adjusted Core Tier I 2,500 1,760 1,876 2,030 2,184 2,310
Adjusted Core Tier I ratio (%) 7.7 5.5 5.5 5.5 5.5 5.5
Time factor (x) 0.4 1.4 2.4 3.4 4.4

Discount factor (x) 0.97 0.89 0.81 0.75 0.69
Discounted dividends 907 110 139 237 268
Key assumptions Valuation (€m)

Risk-free rate (%) 4.4
Beta 0.90 Dividends 2007–11 1,661
Market risk premium (%) 5.0
Terminal value 3,978
Cost of capital (%) 8.9
Total value 5,640
LT growth (%) 2.0
390 x (100% + 2%)

x 0.69
(8.9% - 2%)
32
DDM methodologies and pitfalls
Discount factor ♦ CAPM approach suggests:
CoE = Rf + E * (Rm - Rf)
e.g. 4.8% 1 + 1.14 3 * 5%2 = 10.5%

Notes:
1 Risk free rate (EURO Bond 10-year) = 4.8%
2 Risk premium = 5.0%
3 Beta predictive = 1.14
Terminal value ♦ Gordon growth multiple (P/B)

methodology – remember “g” is perpetual nominal growth rate (hence must be in line with
economy and can hardly be zero or negative)
1
♦ Discounting dividends, not earnings when using CoE - g
♦ Timing for terminal cashflow and book value (t or t+1)
♦ Typically, TV represents 70–80% of value (depending on the modelled horizon, growth
and profit profile, etc.) so this is a crucial question that is all too often neglected
Beta ♦ CAPM requires forward looking beta, historical betas can be guidance but should not be
used blindly
♦ Leverage theoretically is an issue (levered/unlevered betas!) but is heavily regulated in FIG
and so often disregarded
♦ There is always a strong case for a bank beta of 1, given the fundamental exposure to the
entire economy
Capitalisation ♦ Target core tier I and hybrid capital

and leverage ♦ Interest on any capital and tax shield on interest to be included in financial forecasts
♦ Typically best to assume refinancing of existing instruments at call date
(easy to create circularities)
33
SECTION 1.D
Banking
Financial effects
5
FIG EMEA training

Financial effects
26 November 2007
06060h227_Financial effects.ppt
Table of contents
SECTION 1 Introduction 2
SECTION 2 Bank specifics 7
1
SECTION 1
Introduction
Why are merger models important?
Merger models don’t tell Overview

the whole story about a
♦ Show financial impact of a merger, acquisition or other business combination
deal, but they are an
important tool ♦ Analyse impact on
– earning per share (EPS)
– capital and balance sheet ratios (Tier 1, BVPS, EVPS)
– other items (RoE, RoI, RoRAC/EVA, etc.)
♦ Can be used to measure sensitivity to
– price paid
– transaction funding mix
– synergies
Possible transaction structures

♦ Standard case and focus for this session
100% acquisition and
full consolidation ♦ Consideration of dilution from options can be tricky
♦ Key change from above is minority interest

> 50% acquisition and
full consolidation with – need to investigate P&L and B/S accounting impacts
minority accounting
♦ Earnings effects not often considered

< 50% acquisition ♦ Capital impacts can differ depending on control framework and precise
stake acquired
3
A real life example
4
Funding mix
Three basic types of

funding instruments Relative impact Relative impact on
Type on capital EPS accretion Comments Cost
available
Trade-off between
capital and earnings ♦ Predominant considerations in Dilution
Equity ‘mergers’ and large transactions
effects
♦ More expensive than cash or Cost of issue

debt but limits dilution of
Hybrids stated T1 ratios
♦ Core capital or ACE ratio
unaffected
♦ "Cash" can be Opportunity cost or

– excess cash on cost of issue
Cash/ balance sheet
debt – raised through debt
– raised through issue of
other securities
5
Dilution from options in financial institutions analysis
Options and convertibles ♦ Buyer typically acquires

need to be considered in – outstanding common shares
financial analysis but – outstanding options
tend to be less distorting – convertible securities (rare in financial institutions)
in financial institution ♦ “Treasury stock method” is preferred way of computing the number of “common share equivalents” for a
given set of options
– this method assumes that proceeds from exercise received by the company are used to replace stock
– by definition, out of the money options are not considered
– the method is consistent with current IFRS rules
♦ If significant options outstanding, pay attention to whether they will be “rolled over” or cashed out (this may
affect funding structure)
Example 1 Example 2
Number of shares outstanding (#) 100 Same situation, but offer price raised to €20
Options (#) 5
Weighted average strike price (€) 10
Offer price (€) 15
How many shares are acquired? How many shares are acquired?
“Value” of one option (€) 15-10=5 “Value” of one option (€) 20-10=10
Number of options (#) 5 Number of options (#) 5
Total option value (€) 25 Total option value (€) 50
Deal price (€) 15 Deal price (€) 20
Common share equivalents (#) 1.67 Common share equivalents (#) 2.5
TOTAL DILUTED NUMBER OF SHARES 101.67 TOTAL DILUTED NUMBER OF SHARES 102.5
6
SECTION 2
Bank specifics
Earnings effects
Setting out a simple Input assumptions Funding mix and funding costs
Mix
numerical example
Buyer Target Costs 1 2 3 4
Forward earnings (€m) 150 40 Cash/debt (%) 5 0 20 70 100
NOSH (#) 120 80 Hybrid (%) 7 0 30 30 0
Share price 15 6 Equity (%) 100 50 0 0
Sum (%) 100 100 100 100
Offer price (€) 7.5
Share acquired (%) 100
Synergies (pre-tax, €m) 10

Tax rate (%) 30
Implications
Buyer Target
Forward EPS (€) 1.25 0.50
P/E (x) 12.0 12.0
Market cap (€m) 1,800 480
Purchase price (€m) 600
Premium to share price (%) 25.0
Post-tax synergies (€m) 7

Indicative value of synergies (€m)1 59.5
Note:
1 Assuming a valuation of 10x and implementation
costs of 150% of annual synergies
8
Earnings effects
Step 1 Step 2
Calculating pro forma Buyer's original EPS as benchmark + / - Earnings consolidation and adjustments for transaction
EPS
Forward earnings—buyer (€m) 150
Funding mix assumed to + Forward earnings—target (€m) 40
Forward earnings (€m) 150
be 100% equity NOSH (#) 120 + Post-tax synergies (€m) 7
- Funding costs—cash/debt (€m) 0.00
Forward EPS—buyer (€) 1.25
- Funding costs—hybrid (€m) 0.00
Forward earnings—pro forma (€m) 197
Step 4 Step 3
Buyer's pro forma EPS New shares issued in the transaction
Share component of offer (€m) 600

Forward earnings—pro forma (€m) 197 Buyer's share price 15
NOSH—pro forma (#) 160 NOSH issued as consideration (#) 40
Forward EPS—pro forma (€) 1.23 + NOSH—buyer (#) 120
NOSH—pro forma (#) 160
Step 5
EPS comparison
Forward EPS—buyer (€) 1.25

Forward EPS—pro forma (€) 1.23
EPS accretion/(dilution) (%) (1.5)
EPS accretion/(dilution) (€) (0.02)
9
Earnings effects
Key areas for ♦ IFRS has discontinued goodwill amortisation with an impairment test
consideration – cash vs stated distinction now obsolete
– some jurisdictions allow tax deductibility irrespective of accounting treatment
♦ Transaction costs and restructuring charges are usually excluded from calculations
– “one-off” costs
– accretion / dilution analysis looks at sustainable / run-rate earnings
– if equity raise through separate rights issue in cash offer, may need to consider underwriting
expenses
♦ EPS estimates usually based on average shares outstanding

– use of current shares outstanding is a short cut
– be careful if, e.g. significant stock buy backs or options outstanding
♦ Watch out for amortisation of identified intangibles, e.g.

– core deposits (US-GAAP allows accounting of a core deposit intangible “CDI”)
– distribution agreements
– value of business acquired (EV accounting “through the back door” in IFRS for insurance)
♦ Typically, several forward years are modelled, often incorporating at least one full run-rate year where
all synergies are realigned
♦ May use pro forma full run-rate synergies throughout
10
Capital effects
Expanding our simple Further input assumptions

example
Buyer Target
RWA 8,000 2,000
Core Tier 1 (for simplicity assuming = TNAV) 800 250
Hybrid Tier 1 80 50
Implications
Buyer Target
Tier 1 880 300
Core Tier 1 ratio (%) 10.0 12.5
Tier 1 ratio (%) 11.0 15.0
P/TNAV (x) 2.3 1.9

RoTNAV (x) 18.8 16.0
Goodwill (€m) 350
11
Capital effects
100% equity (Mix 1)

Looking at a 100% 20
equity and a 100% cash 16 (3.7)
funding mix for 7.5
(3.5) 0.5
12 1.0
Ratio (%)
0.0
illustrative purposes (1.3)
8
10.0 10.5
4
0
Core Tier 1—buyer Hybrid Tier Equity issued in Consolidation of Deduction of Consolidation of Hybrid Tier 1 issued Hybrid Tier 1—pro Core Tier 1—pro
1—buyer connection with target RWA goodwill generated target hybrid as part of funding forma forma
the transaction mix (€m)
Capital (€m) 800 80 600 0 (350) 50 0 (130) 1,050

Risk Assets (€m) 8,000 8,000 8,000 10,000 10,000 10,000 10,000 10,000 10,000
100% cash (Mix 4)

20
16
Ratio (%)
12
1.0 0.0
(2.2)
8 0.5
(3.5)
0.0 (1.3)
10.0
4
4.5
0
Core Tier 1—buyer Hybrid Tier Equity issued in Consolidation of Deduction of Consolidation of Hybrid Tier 1 issued Hybrid Tier 1—pro Core Tier 1—pro
1—buyer connection with target RWA goodwill generated target hybrid as part of funding forma forma
the transaction mix (€m)
Capital (€m) 800 80 0 0 (350) 50 0 (130) 450

Risk Assets (€m) 8,000 8,000 8,000 10,000 10,000 10,000 10,000 10,000 10,000
12
Capital effects
Key areas for ♦ In practice, considerations are usually more complex

consideration ♦ More “controls” must be satisfied
– may target Core Tier 1, Tier 1 and total capital ratios
– use of hybrids and prefs subject to regulatory and rating agency limits
♦ Goodwill calculation
– generally purchase price minus tangible book value of target (after assets and liabilities have been
revalued from carrying value to fair value)
♦ Must consider securities (other than common equity) on target’s balance sheet
– preferred securities
– other capital instruments
♦ There may be additional subtractions from Tier 1 or total capital (e.g. insurance holdings)
♦ Typical questions asked by clients

– how much capital do I need to raise / what share component do I need to meet a capital target of x?
– how much hybrid can I issue (to minimise dilution on EPS and stated Tier 1 ratios)?
– what goodwill hit can I afford?
13
Synergies
Cost synergies typically ♦ Synergies calculated in two basic ways

form the largest and – top-down (usually % of target or combined overlapping costs or revenues)
most tangible source of
– bottom-up (requires much more in-depth analysis)
value in M&A
♦ Synergies usually only accomplished with certain implementation costs
Strategic benefits and
revenue synergies are – rule of thumb: equal to 100–150% of run rate cost synergies
more elusive and harder – implementation costs can be subtraction from equity upfront or amortised, but are usually ignored
to quantify in pro forma EPS calculations
♦ Synergies usually realised over several years (“phasing”)

– for example, 30% in year 1, 70% in year 2, and 100% in years 3 and after
♦ Synergies are usually discussed in terms of pre-tax bottom line. You must “tax-effect” to use in
calculating pro forma EPS
♦ “Synergies to breakeven” (or “synergies for nil dilution”) is an important data point in many analyses. It
measures the synergies required for a given merger to be neither EPS accretive or dilutive
Dilution before synergies = Pro forma EPS -

Buyer EPS = €1.19 – €1.25 = €(0.06)
Dilution x
€10/(1–30%) = €14.3 of €10 more net income
New Shares
pre-tax earnings to breakeven/nil
Outstanding–pro forma =
needed to breakeven dilution needed
€(0.06) x 160 = €10
14
Return on investment
RoI is an instrument Continuing our example

often used by clients to
evaluate a proposal Forward earnings—target (€m) 40
+ Post-tax synergies (€m) 7
against other
Forward earnings—on investment (€m) 47
opportunities
Purchase Price (€m) 600
Analysts and the capital
market also look at it RoI (%) 7.8
and compare it with the

cost of funding
It is independent of the
funding mix (unlike EPS)
Source: Santander analyst presentation, 8 November 2007

15
"Tricks of the Trade"
Sensitivities to illustrate Earnings accretion/(dilution) (%) Observations

earnings and capital Funding mix ♦ Leverage improves earnings effects of the
effects 1 2 3 4 expense of capital ratios
6.00 3.7 7.1 13.4 15.3 ♦ With 100% equity funding the purchase price
Offer price (€)

7.00 0.2 3.6 10.4 12.7 does not impact capital dilution
7.50 (1.5) 1.9 8.9 11.3 – any increased goodwill hit is covered by
8.00 (3.1) 0.3 7.4 10.0 equity
9.00 (6.2) (3.0) 4.5 7.3
♦ Otherwise higher prices are dilutive
Core Tier 1 ratio impact (%-pts) ♦ Core Tier 1 impacts are worse than stated
Tier 1
Funding mix
1 2 3 4
6.00 0.5 (1.9) (4.3) (4.3)
Offer price (€)
7.00 0.5 (2.3) (5.1) (5.1)

7.50 0.5 (2.5) (5.5) (5.5)
8.00 0.5 (2.7) (5.9) (5.9)
9.00 0.5 (3.1) (6.7) (6.7)
Stated Tier 1 ratio impact (%-pts)

Funding mix
1 2 3 4
6.00 0.8 (0.2) (2.6) (4.0)
Offer price (€)
7.00 0.8 (0.3) (3.1) (4.8)

7.50 0.8 (0.4) (3.4) (5.2)
8.00 0.8 (0.5) (3.7) (5.6)
9.00 0.8 (0.6) (4.2) (6.4)
16
"Tricks of the Trade"
♦ How do you know if a 100% share transaction is accretive or dilutive pre-synergies

Quality of a financial without doing any calculation?
effects model is only as
– compare acquirer’s P/E to Target’s P/E; if acquirer’s P/E is higher than Target’s,
good as quality of the then its accretive, if its is lower, its dilutive
inputs EPS and P/E
♦ How do you know if a 100% cash transaction is accretive or dilutive without doing
arithmetics
Check your inputs any calculation?
carefully and cross – compare the “P/E of cash” to the Target’s P/E
reference different data – P/E of cash equals 1 / (Post-tax cost of cash)
sources – e.g. if pre-tax cost of cash is 5% and the tax rate is 30%, the “P/E” is 28.6
(100/3.5)
♦ Evaluating Tier 1 impacts in 100% equity deals
Capital
– weighted average Tier 1 of buyer and target should be a good approximation
arithmetics
♦ Back of the envelope approach in 100% cash deals
– look at RWA consolidation and goodwill
♦ Final tip: the best way to learn is to build from scratch a merger plan at least once
– some examples are saved in N:\FIG\models
– during the course of a deal these models get heavily customised
17
SECTION 2
Insurance
6
SECTION 2.A
Insurance
Insurance capital
7
Insurance capital
FIG EMEA training
3 December 2007
06060H227_Insurance capital.ppt
Table of contents
SECTION 1 Introduction 2
SECTION 2 Regulatory requirements 5
SECTION 3 Rating agency requirements 15
SECTION 4 Internal models 30
SECTION 5 Capital structure considerations 34
APPENDIX A Relevant publications and additional reading

APPENDIX B S&P—previous CAR model details
APPENDIX C Moody’s—scorecards details
1
SECTION 1
Introduction
Why capital requirements?
Capital serves as a risk A simplified insurer’s balance sheet

buffer and protects Assets Liabilities
policyholders
Volatile due to Invested Technical Volatile due to
♦ Market risks (stock assets reserves
♦ Being today’s estimate of
prices, interest future claims, and
rates, exchange therefore inherently
rates etc.) stochastic
♦ Credit risks (bond ♦ Market factors
issuer default etc.) (e.g. interest rates with
impact on guarantees or
discounted values)
Capital buffer
3
Sources of capital requirements
Insurance capital Internal

Regulatory environment Rating agencies
requirements are models
established by
♦ Policyholders take credit risk, in particular for long tail lines: ratings used ♦ Vary by
regulators but in ♦ Historically excluded reinsurers (but now covered
following reinsurance directive) by intermediaries insurance
practice, rating agency ♦ Most insurers are rated, “mandatory” for reinsurers from a
company
requirements are more business perspective ♦ Usually more

detailed (e.g.
onerous and thus drive modelling
capital considerations correlations)
and specific
to business
Solvency I Solvency II National model
regulation
Shareholders typically ♦ Often less
onerous
favour higher returns results in
♦EU directives ♦Fundamental ♦EU framework ♦100+ insurance ♦~60 insurance ♦~100 insurance ♦35 insurance
(i.e. lower capital or from 1973 and wide- allows options analysts analysts analysts analysts particular
due to
increased leverage) (non-life) and ranging review and more
♦Most important ♦More ♦Dominant US ♦Important bank diversification
1979 (life) of insurance stringent
transformed regulation national rules European qualitative agency rating agency credit
into national initiated in agency with reasoning with quality
♦Local product transparent ♦Model based reputation
law January 2000
features require quantitative ♦Less important on NAIC
♦Subsequent ♦Expected to be specific approach in corporate approach ♦Growing but
development implemented in regulation finance context relatively still
♦Models and ♦Gives credit for weak in
to improve 2012
♦FSA has methodology diversification insurance;
group
♦Some regulators harmonised published benefits assigning
regulation
have introduced banking and unsolicited
♦Quantitative ♦Weak
♦Not very interim rules insurance ratings
approach European
stringent (FSA, FOPI etc.) capital rules
presence
Focus areas for purposes of this presentation
4
SECTION 2
Regulatory requirements
Overview of current EU requirements (‘Solvency I’)
Total solvency capital to Key building blocks—”Solvency I” approach

Solvency ratio
exceed the required
solvency margin … Up to 50% of the lower of
available and required
See following
pages
solvency margin
… with additional
restrictions applying to the
composition of capital
With initial maturity > 5 years

and up to 25% of the lower of
available and required solvency
margin, i.e. dated instruments
limited to 50% of
subordinated debt
50% credit for unpaid

share capital
Paid-up Reserves and Minority Intangibles Stakes in Dated Perpetual Free bonus Life items Available Non-life Life Required
share retained interest subsidiary subordinated subordinated reserves (acquisition solvency requirement requirement solvency
capital earnings post financial debt debt costs, future margin margin
dividends institutions profits) (RMM)
♦ Failure to meet the regulatory solvency margin will result in the regulator imposing additional reporting
requirements and ultimately taking management control in the interest of policyholders
♦ Emerging innovative Tier 1-style instruments currently count within the subordinated allowance, but
French insurers propose a new category of deeply subordinated debt subject to a maximum of 15% of
Tier 1 capital that would receive eligible capital treatment under Solvency I
6
Solvency I requirements—non-life
Minimum requirement is Premium-based Claims-based

broadly 16% of net
premiums written
18% of First €50m of GPW 26% of first €35m of three year average of
gross claims
In practice, the Solvency I
non-life requirements tend to
be disregarded in favour of a
a higher top-down solvency
ratio or a ratings-based 16% of amounts in excess of threshold 23% of amounts in excess of threshold
approach
Maximum of the
two approaches
Less: up to 50% reinsurance haircut
♦ Required margin can be increased by 50% for volatile lines (marine, aviation, general liability etc.)
♦ Thresholds increased from €10 million and respectively €7 million
♦ As a rule of thumb, the premium based approach will drive requirements for claims rations below 70% (assuming
no growth over the past three years)
♦ Also applies to non-life risks covered in life contracts and health insurance
♦ Life reinsurance is now also subject to the non-life (!) rules, such that capital arbitrage will remain a driver for the
use of life reinsurance
7
Solvency I requirements—life
Minimum requirement is Traditional life Unit-linked Mortality risk

usually 4–5% of net
technical reserves for 4% of Mathematical reserves 1% of Unit-linked reserves 0.3% of capital at risk
traditional business
In practice, companies often Mathematical reserves Unit-linked reserves Capital at risk
target a 150% coverage of = “Technical reserves in life = sum insured (i.e. maximum
Solvency I requirements. This = life technical reserves
insurance where the investment payment for policies
is also frequently used as + unearned premium reserves risk is borne by the policyholder” underwritten)
input in embedded value (net of expenses) (matching asset item exists)
analyses ./. mathematical reserves
Less: up to 50%
Less: up to 15% reinsurance haircut
reinsurance haircut
♦ Additional minimum guarantee fund of €3 million (negligible in most cases)

♦ Risks covered
– operational risk (1% of reserves)
– investment risk (3% of reserves)
– mortality risk (0.3% of capital at risk)
♦ 0.3% charge on capital at risk viewed as onerous but impact is insignificant for primary insurers
– S&P use between 0.08% and 0.2% in life reinsurance (C6)
♦ Non-life elements of life insurance contracts typically treated as such (i.e. premiums, or
claims-based requirement)
♦ No specific requirement for longevity risk
8
Insurance Group supervision
Single entity-based ♦ Pure use of “solo” solvency has pitfalls ♦ Group solvency calculations required following implementation
– structural leverage ( 1 ) in national law in 2000
requirements are
– multiple gearing ( 2 ) ♦ Group deduction larger than scope of consolidation (includes
insufficient from an – potential misuse of internal indirect participations of 20%+)
economic perspective … reinsurance ( 3 )
♦ Two main approaches
– based on consolidated accounts, or
– aggregation and deduction of single entity solvency filings
… hence, the EU requires A simplified example ¹
a group solvency
statement to be prepared “Solo” solvency Group solvency
1 Structural leverage
Insurance subsidiary—B 100% Parent company—A Group solvency margin

GPW 1,000 Participation in B 150 GPW of B 1,000
Ceded to D (200) Equity 100 GPW of C 400
NPW 800 Debt issued 50 GPW of D 200
Solvency capital 150 Not subject to solvency 16 Internal reinsurance (200)
requirement
2 Multiple Solvency margin 128 Ceded externally 0
gearing Excess/(deficit) 22 NPW 1,400

Participation in C 80 3 Internal reinsurance Solvency capital 100
Participation in D 10 Solvency margin 224
Excess/(deficit) (124)
100% 100%
Insurance subsidiary—C Reinsurance subsidiary—D

GPW = NPW (external) 400 GPW = NPW (from B) 200
Solvency capital 80 Equity 10
Solvency margin 64 Not subject to solvency
requirement ²
Excess/(deficit) 16
Notes:
1 Assumes pure non-life group, using 16% requirement for simplicity
2 Pre introduction of the reinsurance directive (RID)
♦ The European Financial Groups Directive (FGD) effective from 2005 adds additional rules regarding
non-insurance businesses
9
Financial Groups directive
The directive was Definition criteria for a financial conglomerate Allianz example
introduced in 2005 ♦ A group … 350
>300%
in order to – parent-subsidiary relationships or holding 300
improve supervision company models
250
– horizontal group structures without capital links >170%
200 >150%
♦ … with at least one regulated entity, …
150
♦ mainly financial activities …
100
♦ Improve solvency – >40% of group’s total assets in financial
50
calculation methods by sector entities
0
introducing a group-wide ♦ … and significant involvement in both the
meet-or-fail criterion IGD FGD Economic
banking & investment services sector and the
solvency¹
♦ Prevent double gearing insurance sector
Source: Roadshow presentation
and excessive leverage
Note:
♦ Include intra-group 1 According to internal risk capital model
transactions under An example
supervision
Parent holding
♦ Focus on group risk company
exposure
♦ Supervision of internal risk
management and Banking/
measurement systems Investment Insurance Non-financial
♦ Improve regulatory 35% 20% 45%

efficiency through single
co-ordinating supervisor Source: FSA
Note: Percentages indicate share of total assets
♦ Remove inconsistencies
between sectoral ♦ Not mainly banking (BCD—Banking Consolidation Directive)
regulations
♦ Not mainly insurance (IGD—Insurance Groups Directive)
10
Solvency II
A three pillar approach Pillar I—Quantitative Pillar II—Supervisory review Pillar III—Market discipline
similar to Basel II requirements
♦ Minimum capital requirements ♦ Own risk solvency assessment ♦ Disclosure

set for firms generally using a (ORSA) recommendations and
risk-based approach requirements to allow
♦ Assessment of the strength
market participants to assess
♦ Use of scenario approaches and effectiveness of risk
key information on capital, risk
and internal (stochastic) management systems and
exposures, risk assessment,
models internal controls including
management processes and
♦ Group solvency – review of exposures capital adequacy of the
♦ Solvency II is an ongoing (including the reinsurance
requirements taking account insurance
project of the European programme)
of additional risks at group
Commission (since 2000 and ♦ Disclosures on risks key
level – internal risk model stress
likely to take a few more years) sensitivities and scenario
testing of technical
aiming at a fundamental and ♦ Rules on technical provisions, analysis on assets and
provisions
wide-ranging review of the investment rules, ALM, etc. technical provisions
current regulatory regime in – qualifications of senior
the light of current management asset/liability
development in insurance, risk mismatch
management, finance MCR + SCR ♦ Additional capital add-ons in
techniques, financial reporting, individual cases
etc., in particular addressing
issues such as Source: Study into the methodologies to asses the overall financial position of an insurance undertaking from the perspective of prudential
– matching of assets supervision, KPMG for the European Commission, May 2002, PwC Insurance Digest
and liabilities
♦ Several European countries have already implemented regulations that anticipate many elements of Solvency II
– reinsurance arrangements
(e.g. UK, Netherlands and Switzerland)
– aggregation of risk
11
Solvency II
From Solvency I to Solvency II Pillar I and how it links to MCEV
Solvency I Solvency II
Inadmissible
assets/
Implicit and ineligible Free
intransparent capital Capital
degree of
conservation Pillar2 MCEV
Adjusted SCR
SCR
95% VAR
MCR
MV of assets 90% VAR
Risk
Market margin
MV of liabilities
value of
liabilities
Technical
BEL provisions
Technical Solvency I Best Risk Minimum Solvency

Other
provisions RMM estimate margin capital capital liabilities
liability requiremen requiremen
(BEL) t (MCR) t (SCR)
Source: PricewaterhouseCoopers research Source: Watson Wyatt
Timescale
2005 2006 2007 2008 2009 2010 2012
Draft
Framework Full
directive implementation
(July 2007)
QIS 1 QIS 2 QIS 3 QIS 4
Source: PricewaterhouseCoopers research. UBS-IBD

Note: QIS =quantitative impact study
12
Solvency II
Solvency II objectives Implications

Solvency II will lead to a
considerable Risk management ♦ Objective of Solvency II to cover all ♦ Greatly favours cross-border
improvement of sector and control quantifiable risks consolidation as regulatory capital
(Pillar I & II) requirements decline as a result of
risk management – Solvency II is broader than Basel II and
looks at the entire balance sheet, with a diversification benefits
particular focus on ALM ♦ Significantly elevates importance of risk
♦ Solvency II aims to fully recognise management and management
diversification benefits information systems
♦ Internal risk models key for – IT becomes at least as much of a
modelling risks strategic factor as under Basel II
♦ Should help improve competitive
conditions by favouring discipline and
economic value orientation in product
design, pricing and underwriting
Disclosure ♦ Extensive public and regulatory ♦ Improved level of disclosure and

(Pillar III) disclosure of risk profile comparability between insurers
(Pillar III) ♦ Potentially higher volatility of results and
capital requirements
Capital components ♦ More consistent classification of capital ♦ Likely to allow greater use of non-equity
(Pillar I) components across countries capital but with significant focus on
– alignment with banking capital; see qualitative aspects
UK interim capital rules
“Winners” and ♦ Key factors impacting insurers’ competitive ♦ Solvency II should favour:
“losers” position post Solvency II: – multinationals over single country
– captures all quantifiable risks insurers
– recognition of diversification benefits (or – insurers with sophisticated systems
absence thereof) and good databases
– heavy reliance on management systems – larger insurers given ability to spread
and risk modelling cost of implementation
– focus on expected loss anticipates trends – diversified business models
(traditional vs. unit-linked, composites)
13
The Financial Services Authority’s approach in the UK
The FSA has

implemented many
aspects of Solvency II
ahead of time
CP 190: CP 195: PS 04/20:
Non-life insurance Life insurance Financial conglomerates
♦ Anticipation of Solvency II features ♦ ‘Twin peaks’ approach: life insurers ♦ Early implementation of the EU
without delay are required to hold capital to cover Financial Groups Directive
the higher of two calculations
♦ Introduction of an ‘Enhanced ♦ Covering mixed financial holding
Capital Requirement’ (ECR) to apply ♦ Regulatory peak: essentially companies that are neither banking
for most insurers instead of the identical with the previous nor insurance group, e.g.
‘Solvency I’ rules (MCR) regulations (some relaxations as to
interest rate, expense and lapse
♦ Basic approach assumptions) Parent
♦ Realistic peak: based on realistic

Asset-related values x =X value of policy liabilities and
asset factors (%) including costs of guarantees and Banking/
Insurance Non-financial
options and a risk capital margin investment
Insurance-related values x (RCM) to cover stress scenarios
=X 35% 20% 45%
technical provisions factors (%)
♦ Excess of realistic over regulating
Net written premium x =X peak shown as with profits
♦ Imposes rules regarding group
premium factors (%) insurance capital component
risk controls and management,
(WPICC)
risk concentration and intra-
Total ECR (before equalisation X ♦ Subsequently codified (incl. few group transactions and group
adjustment) modifications) through PS04/16 capital adequacy
14
SECTION 3
Rating agency requirements

Financial strength rating scales
Rating agency language

translated
Secure Strong Secure Secure
The exact terminology AAA Extremely strong Aaa Exceptional A++, A+ Superior AAA Exceptionally strong
is very helpful in
Investment
AA Very strong Aa Excellent A, A- Excellent AA Very strong
grade
translating qualitative
agency statements A Strong A Good B++, B+ Very good A Strong
into quantitative BBB Good Baa Adequate BBB Good

rating categories
Vulnerable Weak Vulnerable Vulnerable
BB Marginal Ba Questionable B, B- Fair BB Moderately weak

Sub-investment grade
B Weak B Poor C++, C+ Marginal B Weak
CCC Very weak Caa Very Poor C, C- Weak CCC, CC, C Very weak
CC Extremely weak Ca Extremely poor D Poor DDD, DD, D Distressed
R Regulatory action C Lowest E Under regulatory

supervision
F In liquidation
S Rating suspended
+, - 1 High
Modifiers
2 Medium
“moderate” used to denote (see above) +, -
3 Low
“below expectations”, or
“below requirements”
Source: Sigma 4/2003
16
A primer on different types of ratings and notching
Insurance financial Exemplary group structure and typical notching

strength ratings (IFSR)
are intended to Senior rating
evaluate
1–2 notches
policyholder’s claims Holding
2–3 notches
company
There are many other Subordinated rating
ratings assigned to
different obligations
of different group
companies and Insurance Financial
it is important to Strength Rating
1 notch
distinguish these
Insurance
companies
Senior rating
1–2 notches
Subordinated rating
Other/
non-core
subsidiaries Stand-alone FSR
17
S&P—general methodology
Capital is only one Uniform rating criteria used

rating factor but clearly a
very important one
Financial flexibility Management and
which also allows corporate strategy
quantitative analysis Operating
performance
Individual criteria are Liquidity Capital

model
usually rated in “code Capitalisation
language” and can offer
Competitive
be benchmarked position
across components
Enterprise risk
Investments
management
18
S&P—group methodology
Only core subsidiaries or ♦ S&P generally consider the group’s position through a consolidated model
those with explicit – subsidiaries also considered, but do not drive group rating
guarantees are assigned ♦ Notching of subsidiaries
the group rating
Core Strategically important Non-strategic
♦ Integral business ♦ Most “core” characteristics ♦ Criteria for core or
♦ Usually group brand met, but strategically important not
– insufficient relative size met
♦ Significant (>5–10% of – insufficient capitalisation
capital) ♦ In particular
vs. group (but still BBB) – start-ups
♦ Strong commitment – operated more on a – run-offs
demonstrated stand-alone basis – undercapitalised
♦ Capital levels commensurate ♦ Sale unlikely – sale announced (!)
with group capitalisation
♦ Sale inconceivable
♦ >51% share of votes
Stand-alone rating plus uplift up

Stand-alone rating
to group rating in the best case
Group rating
or
Group rating based on explicit support
19
S&P—capital adequacy model overview (old version)
♦ Model initially introduced in October 1998 and substantially revised in April 2003
– modification of investment charges (“Nokia discount”, bond volatility)
CAR translated into rating categories
– introduction of “hard CAR” (removing soft capital components)
Rating CAR (%)
– refinement of VIF credit to avoid double-counting
AAA Extremely strong > 175
AA Very strong 150–175
– incorporation of life reinsurance methodology
A Strong 125–150 – life asset risk to be covered at multiple (rather than being a deduction from capital)
BBB Good 100–125 – goodwill credit removed, non-life DAC allowed
BB Marginal 75–100
B Weak 50–75
♦ Significant but evolutionary revision introduced in May 2007
<B Very weak, regulatory action etc. na
Model overview and terminology—available capital compared to required capital
Capital adequacy ratio (“CAR” or “soft CAR”)
Hard capital adequacy ratio (“hard CAR”)
Gross Net total C1: C2: C3: Risk- Soft Hard C4: C5: C6: C7: C8: Total
total adjusted Investment Other Non- adjusted capital risk- Non-life Non- Life Life Life capital
adjusted capital risk (non- credit insurance capital items1 adjusted premium life reinsurance reserve asset required
capital (Net life & risk risk (RAC) capital risk reserve risk risk risk (TCR)
(Gross TAC) shareholder) (Hard risk
TAC) RAC)
Non-life Life
Note:
1 Comprises hybrid capital, any remaining credit for loss reserve discounts or PVFP and 50% of non-life DAC as well as 50% of unpaid capital
20
S&P—revised capital model
The revised capital Overview of the proposed new criteria

model is an evolution, ♦ First fundamental update, where all asset and liability charges have been reviewed and updated
not a revolution
♦ The attempt to quantify part of the former qualitative analysis
However, the structure has ♦ Still a deterministic factor-based approach with no explicit credit for geographic diversification, but
changed such that the some consideration for diversification of risks
widely used capital ♦ Calculate the company specific redundancy or deficiency of target capital at varying confidence
adequacy ratio is replaced intervals—output is a figure, rather than a capital adequacy ratio and will not be disclosed—as before
with less comparable
absolute capital deficits to Leverage and coverage
the next voting level ♦ Under the proposed new criteria the amount of tolerated leverage will increase, because the new
broader economic capital available (ECA) will be used to calculate leverage. As a result S&P expects
Quantitative analysis in the fixed-change coverage to become the major limiting factor to issuance. The required levels of
context of M&A will be fixed-charge coverage will be in line with the current coverage requirements
significantly more cumbersome
but can probably be done using
the previous model while they Potential impact
run in parallel ♦ Higher capital requirements anticipated for ♦ Lower capital requirements anticipated for
– long-tail liability reserves – short-tail non-life reserves and non-life
– equity holdings premium risks
– large asset liability duration mismatch – property holdings
– longevity exposures – short term non-life bond investments
– natural peril catastrophic risks – life reserve-based charges in
certain markets
21
S&P—TAC and ECA in revised model
Capital definitions have Economic Capital Available (ECA) Total Adjusted Capital (TAC)
been slightly amended Reported shareholders equity/policyholder surplus ECA
and former “Gross TAC” + Equity minority interests – Remaining goodwill after S&P impairment
has been renamed
+ Equalisation/Catastrophe reserves – Investment in unconsolidated subsidiaries, associates
“Economic Capital and other affiliates
+ Prudential margins included in reserves
Available (ECA)”
– Investments in own shares/treasury shares
– Proposed shareholder dividends not accrued
– 50% haircut of VIF (post tax)
– S&P impairment of goodwill
– 50% haircut of life deferred acquisition costs (post tax)
– Other intangible assets
– 100% haircut of property/casualty deferred
– On-balance sheet unrealised gains/(losses) on life
acquisition costs
bonds (post tax)
– 50% haircut of property/casualty loss reserve surpluses
+ Off-balance sheet unrealised gains/(losses) on
investments other than life bonds (post tax) – 33% haircut of property/casualty loss reserve discount
– Off-balance sheet pension deficits (post tax) + Policyholder capital available to absorb losses
– On-balance sheet pension surpluses (post tax) +/– Analyst adjustments
+ Up to 100% of off-balance sheet life VIF (post tax)

TAC before hybrid capital adjustments
+ Property/Casualty loss reserve surpluses/(deficits)
+ Hybrid capital (subject to tolerance limits)
+ Property/Casualty loss reserve discount
– Excess over double leverage tolerances
+/– Analyst adjustments
Total Adjusted Capital (TAC)
Economic Capital Available (ECA)
22
S&P—some key life and non-life adjustments within TAC
Non-life loss reserve adjustment Life embedded value adjustment
Loss reserve redundancy/deficiency Present value of future profits
Discounting adjustment Components already recognised on balance sheet
Remove existing Compute uniform

discounts (usually discount as ♦ Basic aim is to accurately reflect the value of
allowed for annuities 1 in-force (VIF or PVFP) as a capital component
and known Reserves x 1–
payment patterns) (1+r)n – in practice, double-counting is a key concern
given EV is often calculated based on different
accounting frameworks (local statutory)
Legend:
r – 10 year government bond yield – care needs to be taken with respect to
n – mean term of claim liabilities
– cost of capital deduction (S&P allow VIF
♦ 100% credit in Gross TAC but 33% deducted in pre CoC)
arriving at Net TAC (see following page)
– treatment of bonus reserves
– life DAC already recorded
“Equity in the reserves”—a simple example
– acquired value of in-force (Value of
30 Business Acquired- VOBA) shown on
27 balance sheet
r = 5%
♦ When making a DAC adjustment, ensure that
only the shareholders’ element is deducted before
PVFP is added
10 10 10
♦ PVFP can be counted gross of cost of solvency
capital (CoC) due to the creditor perspective taken
by S&P (dividends to shareholders are subordinate
to any other claim)
Nominal Present Year 1 Year 2 Year 3
value value
23
M&A capital impact analysis
Real life example Available capital and required capital—based on old model
showing a composite Pre-transaction Acquisition adjustments Post-transaction
group acquiring a life Gross Total Adjusted Capital
insurance business at (Gross TAC)
a significant premium Net Total Adjusted Capital
(Net TAC)
to EV
C1—Investment risk
(non-life & shareholder)
C2—Other credit risk

Funding mix and price
(and hence goodwill
C3—Non-insurance risk
generated) are
obviously key to the Risk Adjusted Capital
(RAC)
result—essentially cash
in this example, hence Soft capital items
the reduction in net TAC
Hard Risk Adjusted Capital
(Hard RAC)
C4—Non-life premium risk
C5—Non-life reserve risk
C6—Life reinsurance risk
C7—Life reserve risk
C8—Life asset risk
Total Required Capital

(TRC)
Capital adequacy ratio 177% 156%

24
S&P—leverage and fixed charge cover
These are additional Leverage ratio Fixed charge cover

restrictions on Debt + “Excess” Hybrids EBITDA
Financial leverage = Fixed charge over =
debt capital under TAC + Total Debt & Hybrids Totality of actual and notional
S&P’s approach annual interest and preferred or
hybrid dividends
Maximum financial leverage ratios Minimum cover ratios
Rating Benchmark (%) Fixed charge cover (x) 1
Low rate High rate
AAA < 15 Rating environment environment
AA 25 AAA 10 8
AA 8 6
A 35
A 5 4
BBB 45 BBB 3 3
BB 65 BB 2 2
Note:
1 Requirements depend on classification of prevailing interest rate
environment as “low” or “high” (in recent times always defined
as “low”)
♦ Debt includes ♦ In the absence of any preferred stock elements the

– long and short-term debt ratio is commonly also called interest cover and
subject to the same criteria
– hybrid equity raised at an operating subsidiary
(as this will usually rank pari passu with or even ♦ Expected to become a key funding constraint and
senior to holding company debt) ratings driver
– hybrid capital reclassified as debt even if issued by ♦ Pro forma computations for capacity considerations
holding company – numerator: need to add interest on
♦ Certain components of TAC, such as policyholder bonus cash raised
reserves or reserve discounting, are not included in – denominator: add interest charge on potential
capital new issue
♦ Unfortunately, S&P is not always consistent across ♦ Hard interest cover is a coverage ratio where the
companies harvesting returns (realised and unrealised gains) are
excluded from the numerator—used
as appropriate
25
S&P—implied solvency ratios in non-life insurance
Capital requirements (%) Health Property A&H Motor Marine Liability Aviation Credit
vary by line European primary charges
of business Premium charge 1 16 24 20 13 29 30 42 99
Reserve charge 6 9 26 15 21 20 21 33
Reserve ratio (assumption) 2 60 100 60 150 100 300 230 60
It is easy to see that the
business mix is a
fundamental driver of the Simple solvency requirement for a rating of “A” 3
solvency ratio target
Nonetheless, as a practical 119
rule of thumb, solvency
ratios tend to be in a range
of 35% to 60%, depending 90 90
on mix and target rating
Capital/NPW (%)
50
33 36 36
20
Source: S&P, UBS investment Bank assumptions based upon ABI data
Notes:
1 On net premiums written
2 Net reserves over net premiums written
3 Expressed relative to net premiums written and calculated as premium charge + reserve charge x reserve ratio; this simple approach disregards
other requirements such as credit risk and capital components such as reserve discounting or any hybrid leverage
26
Moody’s—overview
Measurement
♦ Primarily uses regulatory capital ratios—no specific insurance capital model, but has introduced a
quantitative scorecard model in September 2006 in response to market criticism of lack of
transparency of their approach (see Appendix)
♦ Also uses basic analytical ratios, e.g. shareholders’ funds/net written premiums for P&C business and
debt/(debt + capital)
Summary of key financial metrics

Aaa Aa A Baa Ba
Financial leverage = Adjusted debt/ <20 20–30 30–40 40–50 >50
(Adjusted debt + Adjusted equity) (%)
Earnings coverage = Adjusted EBIT/ >12 8–12 4–8 2–4 <2
(Interest expense + preferred dividends) (x)
Note: Will be considered of ultimate parent level, coverage is 5-year average
♦ Moody’s revised hybrid methodology provides quantitative credit for

hybrid debt (according to basket definitions)
♦ Adjustments for operating leases and pension deficits (standard for corporates, recently added in non-
life as well)
27
A.M. Best
♦ Sophisticated P&C model similar to, but more onerous than the NAIC approach
Adjusted surplus
BCAR = (“Best’s Capital Adequacy Ratio”)
Net required capital
♦ Net Required Capital (NRC) components
– B1 fixed-income securities
– B2 equity securities
– B3 interest rate
– B4 credit
– B5 loss and LAE reserves
– B6 net written premium
– B7 off balance sheet
♦ Covariance benefit means A.M. Best is the only agency giving a diversification credit:
– NRC = (B1)2 + (B2)2 + (B3)2 + (1/2 B4)2 + [(1/2 B4) + B5]2 + (B6)2 + (B7)
Implied capital strength rating Absolute BCAR (%)

A++ > 175
A+ 160–175
A 145–160
A- 130–145
B++ 115–130
B+ 100–115
B-/B 80–100
C+/C++ 60–80
C-/C 40–60
♦ P&C criteria for cat losses significantly strengthened post Katrina
♦ Specific life methodology
28
Fitch
♦ Own stochastic insurance capital

model (“Prism”)
♦ Model not disclosed in detail Establishes Provides

minimum discussion
♦ First agency to introduce requirement insights
TailVAR in order to capture low Capital
probability-high severity risks adequacy
Regulatory Insurer’s internal

requirements capital models
Creates constant principles
Tail value of risk
Conditional
expected value
for tail
5%
Value at risk Change in

economic value
Tail value at risk
29
SECTION 4
Internal models
A real life example
All major insurers The concept The results

calculate and publish
their economic capital
model results
31
Diversification benefits
A key component of Diversification benefits of Recognition of diversification benefits: regulators and

internal models … CRO Forum member rating agencies
Level 1 Level 2 across Level 3 across entities within a Level 4 across geographies or
companies (anonymous) within risk types risk types given geography regulatory jurisdictions
Solvency I No No No No
♦ Ranging from 30% to 60% of Traffic lights Yes Not yet No No
… but increasingly risk-adjusted solvency capital, APRA Yes Yes Yes Yes
accepted by the total diversification benefits

GDV Yes Yes No No
are very large
other constituencies DNB (FTV) Yes Yes Implicit No
A 60 FOPI (SST) Yes Yes Undecided—talk in progress Undecided—talk in

progress
NAIC RBC Yes Yes No na
B 59 FSA Pillar 1 Yes Implicit No No
FSA Pillar 2 Yes Yes Discretionary Discretionary

C 58 Rating S&P Considering Considering Considering internal Considering internal
agency internal models internal models models models
Moody's Yes Yes Qualitative Qualitative
D 58
AM Best Yes Yes Qualitative Qualitative
Fitch Yes Yes Considering internal Considering internal

E 56 models models
Global Basel II Yes No Yes Undecided—talk in
progress
Source: CRO Forum
F 51
G 49 “ “Standard & Poor’s has recognized a qualitative benefit of

diversification, in its assessment of both competitive position and
earnings. For insurers that use models as part of risk management,
H 49 Standard & Poor’s will look to develop techniques that incorporate
quantitative results from insurers’ models into its own quantitative
interactive analysis. As we hold these ERM discussions with insurers,
I 32
we will be listening for the various ways that companies have chosen to
reflect credit for diversification in their own internal decision making
J 30 process. From our discussions with companies to date, we have
heard a very wide range of approaches and results. We will be
listening and learning as we discuss this with companies”
”
K 30
Standard & Poor’s
0 10 20 30 40 50 60 70 “Evaluating The Enterprise Risk Management Practices of Insurance
(%) of risk-adjusted solvency capital Companies”, 17 October 2005
Source: Cerulli Global Update, 2005
32
Diversification benefits
Diversification reduces Economic capital—as at 31/12/04, in € billion (unaudited internal measure)

AXA’s economic capital International insurance
by almost half, … 2.3
Total group
Geographic diversification benefits: (35%) diversification
11.2 benefits: (46%)
… highlighting competitive
benefits of large 1.6
P&C Segment diversification
multinational issuers benefits: (17%)
5.7
21.9
19.1
Life 15.5
Sum of economic capital Sum of segments' AXA Group

of local operations economic capital economic capital
Source: AXA—benefits of being global investor presentation 2005
♦ Required economic capital for the AXA Group was €19 billion at year-end 2004 (for a risk of default
equivalent to a AA company)
♦ The total diversification benefits (excluding diversification benefits within each local operation, which
are not measured) amounted to €16 billion), or 46%
♦ The geographic diversification benefit was high in life (30%) but particularly high in non-life (49%)
– additional benefits in no/low correlation of weather patterns, frequency, proportionately lower
sensitivity to capital markets
33
SECTION 5
Capital structure considerations

Harmonisation–the FSA rules and potentially solvency II rules
Harmonisation of capital Capital Maximum1 Term Instrument Step-up Deferral

requirements are likely
to lead to the application
Lower Tier 2 25% Dated 5 years+
of banking-type rules in 5 year
the insurance world as Subordinated
pioneered by the FSA in debt
the United Kingdom…
Upper Tier 2 25%
Cumulative
… but it is an ongoing 10 year

discussion Deeply
Innovative Tier
7.5% subordinated
1
debt
Perpetual
Perpetual
Preference
non-cumulative 17.5%
share Non-cumulative
preference shares
25% Ordinary
Equity
(minimum) share
Note:
1 Composition of regulatory capital base assuming maximum leverage
35
Hybrid capital for insurance companies
S&P’s view on quality Category Equity content Limit Examples

of capital 1 High (“Super Up to 35% of TAC ♦ Mandatory convertible securities that convert in three
hybrids”) or less years
♦ High quality hybrids with participating coupons
(= coupon that varies with the earnings of the issuer)—no
real life example yet
♦ Rabobank Nederland’s membership certificates
2 Intermediate– Up to 25% of TAC ♦ Perpetual preferred shares, most bank and insurer
strong undated deferrable Tier 1 instruments—examples include
the Allianz and Swiss Re hybrids
♦ Insurance long-dated hybrid instruments (residual maturity
of 20 years or more) with coupon deferability
2 Intermediate– Up to 25% of TAC ♦ European bank Upper Tier 2, limited life preferred shares
adequate ♦ Insurance hybrid instruments with a residual maturity of
less than 20 and coupon deferability
♦ Eligible funded contingent capital for insurers
3 Minimal Not included in TAC ♦ Dated hybrids with a residual maturity of five years or less
♦ Nondeferrable subordinated debt
♦ Instruments with put options
Instrument CAR model credit (%) Qualitative credit

30NC10 100
Perp, cumulative 100
Perp, non-cumulative 100
Perp, non-cumulative, deferral trigger 1
100
Mandatory-convertible security 100
+ 10% capacity
Note:
1 Moody’s Basket D-style instrument
36
Hybrid capital for insurance companies
Moody’s “Baskets” for Moody’s The Baskets

financial institutions Equity
♦ In February 2005 Moody’s published an Basket credit
updated hybrid methodology, effectively
making it easier for issuers to achieve higher ♦ Perpetual preferred non-
degrees of equity credit. Hybrids are assessed E cumulative in cash, with 100%
mandatory deferral trigger,
on their equity-like characteristics in terms of enforceable replacement capital
– no maturity ♦ Mandatory convertible
preferreds (3–years)
– no ongoing payments ♦ Common Equity
– loss absorption
♦ Perpetual preferred, non-
♦ Preferred securities will have 0% to 100% of D cumulative in cash 75%
(1) mandatory deferral
equity credit depending on issue characteristics trigger or
(2) optional deferral
♦ Moody’s have been relaxing their views on trigger, enforceable
fixed income hybrids. In the past Basket C was replacement capital
♦ Mandatory convertible with
difficult to achieve—however now Basket D or debt elements
E can be achieved
Perpetual preferreds, non- 50%
♦ No restriction on the amount of preferred cumulative in cash, with
shares that can have equity credit C (1) optional deferral and weak
replacement capital or
♦ Fitch introduced a similar basket system (2) mandatory deferral trigger
for hybrids
Perpetual preferreds, cumulative, 25%

B with optional deferral and weak
replacement capital
Dated preferreds
A Perpetual preferreds, no 0%
replacement capital
37
APPENDIX A
Relevant publications and additional reading

Relevant publications and additional reading
♦ Equity credit for Bank and Insurance Hybrid Capital, 16 February 2006
♦ Insurance criteria update: What makes an insurance or reinsurance subsidiary ’core’ under group rating
methodology?, 31 March 2005
♦ Property/casualty insurance criteria: Holding company analysis, 24 September 2004
♦ Capital adequacy at European bancassurers: The need to look beyond regulatory ratios, 23 July 2004
♦ Research: Evaluation European insurers’ capital adequacy, 24 April 2003 (accompanying the release of
the new capital model)
♦ Mandatory convertibles: New hybrid capital criteria for banks and insurers, 7 August 2002
♦ Revised financial services group methodology addresses increased willingness to sell underperforming
subsidiaries, 23 April 2002
♦ Insurance criteria update: Holding company analysis and consolidated groups, 13 November 2002
♦ The analysis of capital adequacy in the European and international insurance markets (unpublished
draft manuscript), January 1999
♦ Financial institution criteria (200 page handbook), January 1999
♦ Moody’s Global Rating Methodology for Life/Property and Casualty Insurers, September 2006
♦ Refinements to Moody’s tool kit: Evolutionary, not revolutionary!, February 2005
♦ Characteristics of a basket E mandatorily convertible security: For financial institutions and corporates,
November 2004
♦ Hybrid securities analysis: New criteria for adjustment of financial ratios to reflect the issuance for
hybrid securities, November 2003
♦ Moody’s tool kit: A framework for assessing hybrid securities, December 1999
♦ Insurance company ratings, No.4/2003

39
APPENDIX B
S&P—previous CAR model details

S&P—capital adequacy model overview
What the previous

model looks like
Server location—
N:\FIG\German
desk\Insurance\Rating
agencies\S&P’s \Models\
EU capmod_version 2004-
09-30 (unlocked).xls
41
S&P—gross TAC
Aiming to identify Key building blocks

economic capital
See next page
irrespective of
accounting standards
No credit for tax claims

unless cash benefit
sufficiently imminent (N.B.
DTL excluded from equity
anyway, see deferred tax
adjustment for URCG)
Including deferred tax

(if long-term buffer with
capital character is allowed,
the related tax shield should
be included as well)
Unless included in
equity, net of
deferred tax
possible at 10%
Resulting credit:
♦ Unconsolidated subsidiaries 0%
Limited to 25% of Net TAC ♦ Non-strategic affiliates at 85% of excess
excluding the allowable share of market value (i.e. net of a 15%
unallocated life funds for groups, volatility charge)
higher limits ♦ Core/strategically important affiliates at
stand-alone depend on rating 25% of excess market value
Reported Dividends and Equalisation Minorities Financial Deferred tax Hybrid equity Excess market Stakes in Goodwill and Non-life loss Life embedded Gross TAC
stakeholders' other proposed reserves reinsurance asset capital credit values (URCG) subsidiaries other reserve value
equity/ allocations (surplus relief) intangibles adjustments adjustments
policyholders' not accrued in
surplus balance sheet
Equity adjustments Asset value adjustments
Source: S&P, UBS Investment Bank
42
S&P—net TAC
Prudent adjustments to Key building blocks

gross TAC plus credit for
free policyholder reserves Net of deferred tax, Aims to reflect tax etc.,
result is 50% credit result— including 100% Fund for future Hybrid capital
in Net TAC credit in Gross TAC—is appropriations limit1, i.e.
67% credit in (FFA) or allowing
Net TAC uncommitted leverage of
bonus reserves reserve discount,
(“free RFB”) VIF, etc.
Ultimate goal only to etc.—excluded
include 50% of value of from hybrid Hybrid tolerance
in-force capital limit in % of
unleveraged
modified net
TAC is
25
– 33%
100–25
Gross TAC 50% of non-life 50% of non-life 33% of non-life 50% of present Capital in banking Modified net TAC Allowable share of Net TAC
DAC reserve redundancy computed reserve value of future subsidiaries unallocated life
discount profits (PVFP) funds
Note:
1 Applies to holding company analysis, can be higher for operating companies, additional 10% allowed for mandatory convertible securities
43
S&P—C1: investment risk
For shareholder
business only,
i.e. excluding C1 = Size factor
Default risk + Volatility risk + Concentration risk x adjustment
participating life
♦ For bond ♦ For all invested ♦ Investment in own ♦ “Penalty” for lack of
investments assets excluding shares diversification in
cash, unless hedged + small businesses
(<€1.2 billion
♦ Deduction for risk
invested assets)
concentrations in
one entity
Charge Charge Charge Size factor
Category (%) Category (%) % of TAC (%)
“A” or better 0.4 Bonds <10 0 2.5x
<1yr 1 2.5
“BBB” 3.3 10–25 20
1–2 yrs 2 1.5x
“BB” 7.5 25–50 40
Factor (×)
“B” 13.7 2–5 yrs 4 50–75 60 2.0
0.8x
“CCC” 20.2 5–10 yrs 6 75–100 80
>10 yrs 8 1.0
Other rated bonds 30.0 >100 100
Mortgages— Preference shares 6
performing 2.0 Property 1 18
0.1 0.2 1.2
Mortgages—
Equities Total invested assets (€bn)
nonperforming 14.0
15
20
25
30
40
55
Note:
1 Excluding property used by the group
44
S&P—C2: other credit risk
Essentially reinsurer
default risk
Reinsurance recoverable
C2 = default risk
+ Other asset risk
♦ On reinsurance recoverables, i.e. ♦ 3% high-level charge to reflect risks

– ceded claims reserves in balance sheet items not
(outstanding and IBNR) specifically captured by the model
– reinsurance debtors (amounts – receivables
currently due) – deferrals and accruals
– but excluding those secured by – property for own use
deposits or letters of credit – etc.
♦ Unearned premium reserve excluded
Category Charge (%)

“AAA” 0.5
“AA” 1.2
“A” 1.9
“BBB” 4.7
“BB” 9.6
“B” 23.8
“CCC” 49.7
“R” 50.0
Unrated reinsurers 25.0
45
S&P—C3: non-insurance risk
Mainly related to
asset management
Asset
operations … C3 = management charge
+ Other off balance items
… as capital tied up ♦ Requirement based on overall ♦ Individual analyst adjustments for

in banking subsidiaries funds under management – guarantees and
is deducted from TAC
♦ Bracketed by size – other contingent liabilities
0.5% 0.3% 0.2% 0.1%
70
65
Capital required (€m)
35
12.5
2.5 10 25 30
FuM (€bn)
> e.g. 0.35%
e.g. 0.26%
46
S&P—C4: non-life premium risk
Based on a bottom-up
approach by line
Proportional Non-proportional
of business C4 = Direct business + reinsurance
+ reinsurance
♦ Primary insurance ♦ External reinsurance ♦ Written on treaty or

premiums written on facultative basis
proportional basis
♦ Generally much higher
underwriting risk relative
to premium volume due to
“excess of loss” structure
Category Charge (%)
Health—based on morbidity tables 12
Accident & health—other 18 Charge
Motor 12 Category (%)
Marine, aviation and transport (“MAT”) 17 Health—based on
Property 19 morbidity tables 18
Liability 27 Accident & health—other 27
Pecuniary 18 Motor 18
Credit 75 MAT 26
Property other 30
Liability 29
Pecuniary 27
♦ Charges vary according to the estimated variability of Credit 115
losses and pricing risks across lines Finite 4
♦ Charge based on net premiums written, i.e. giving ♦ Property catastrophe charge
unlimited credit for reinsurance cover – in reinsurance
– premiums are often disclosed on different – net capital cost
bases (e.g. gross or earned) requiring a (including reinstatement
top-down adjustment premiums) of a 1 in 100
year loss event
47
S&P—C5: non-life reserve risk

Based on a bottom-up
approach by line
Proportional Non-proportional
of business C5 = Direct business + reinsurance
+ reinsurance
♦ Primary insurance ♦ External reinsurance ♦ Reserves, as opposed to

premiums written on than premiums, do not
proportional basis carry higher
underwriting risks
♦ Property (both catastrophe
and other) receives
increased charge
Category Charge (%)

Health—based on morbidity tables 5
Accident & health—other 28
Motor 12
Marine, aviation and transport 16
Property 22 (28 in XL)
Liability 10
Pecuniary 28
Credit 25
♦ Charges vary according to the perceived risk of deviations of ultimate losses from the
initial reserve estimates, but take into account the tails of the business, i.e. the period
over which investment return can be earned
♦ Charge based on net loss reserves, i.e. again giving credit for reinsurance
– unearned premium reserves do not yet represent insurance risk and are thus excluded
♦ Public disclosure is usually very limited which means top-down assumptions (e.g. reserve
rates are required)
♦ There can be some inconsistencies between countries from different treatment of claims
handling costs (reserving vs charge through P&L)
48
S&P—C6–C8: life risk

Primary life charges
modelled on the back
C8—Life insurance asset
of EU rules C6—Life reinsurance risk + C7—Life insurance risk + risk
Sum at risk-based charge ♦ General idea: 125% of ♦ Similar to non-life and

(between 0.08% and 0.2%) EU Required Minimum shareholder charge
Margin (RMM) (covered under C1) with
+
♦ For groups to be the exception that
Reserve-based charge
Proportional business
calculated as matched bonds do
Annuities and pensions 3% not carry a
5% of net non-linked reserves volatility charge
Linked business
(positive/zero – duration matching of
+
EU RMM) 1.25%/0.5% assets and liabilities
1.25% of net linked reserves removes interest rate
Other proportional risk on that part of
business 0.5% +
the portfolio, hence
+ 0.375% of net sums at risk no capital charge
– you can usually
Premium-based charge assume that at least
♦ Adjustment for linked
(2% of net premiums written) the component of
business with zero RMM
+ of 0.5% bonds that is
designated as ‘held
Non-proportional business
to maturity’ (HTM)
(52% of net premiums written)
for accounting
+ purposes is regarded
Financial reinsurance business as matched bonds
(individual assessment) ♦ Unlike C1, life asset risk
needs to be covered at a
multiple corresponding
to the target rating
49
APPENDIX C
Moody’s—scorecards details
Moody’s—rating scorecards
Generic Moody’s scorecard for the rating of insurance companies
Life (8 factors) P&C (7 factors)
Factor score (%) Metric score (%) Factor score (%) Metric score (%)
Factor 1: Market position and brand 15 25
Market share ratio 30 25
Relative market share ratio 70 50
Distribution efficiency 0 25
Business profile
Factor 2: Distribution 10 na
Distribution control 50
Diversity of distribution 50
Factor 3: Product focus and diversification 15 10
Product risk 60 40
Life insurance product diversification 40 0
P&C product diversification 0 40
Regulatory diversification 0 20
Factor 4: Asset quality 5 5
High risk assets % of invested assets 75 20
Reinsurance recoverables % equity 0 60
Goodwill % equity 25 20
Factor 5: Capital adequacy 10 15
Capital as % total assets 100 0
Gross underwriting leverage 0 100
Financial profile
Factor 6: Profitability 15 15
Return on equity 50 50
Sharpe ratio of growth in net income 50 50
Factor 7: Liquidity and asset/liability management 10 na
Liquid assets divided by policyholder reserves 100 0
Factor 8: Reserve adequacy na 10
Loss reserve developments % reserves 60
A&E funding ratio 40
Factor 9: Financial flexibility 20 20
Financial leverage 40 40
Cash flow coverage 30 30
Earnings coverage 30 30
51
Moody’s—life scorecard summary criteria

Aaa Aa A Baa Ba
Factor 1 Market share ratio 1 >10% 5–10% 2–5% 1–2% <1%
Relative market share ratio 2 >3x average 1.5–3.0x average 0.5–1.5x average 0.25–0.5x average <0.25 average
Factor 2 Distribution control Owned captive or Blend of controlled distribution Blend of controlled distribution Unaffiliated independent third Unaffiliated independent third
controlled distribution and preferred positions and unaffiliated distribution party distribution party distribution
(no preferred position) (marginalised position)
Diversity of distribution Greater than five distinct Four distinct distribution Three distinct distribution Dependence on two distinct Dependence on a single
distribution channels each channels with>10% of channels with>10% of distribution channels; vulnerable distribution channel for all
with>10% of premiums; no premiums; no significant premiums; more dependence to disruption and changes in premiums; very vulnerable to
concentration in any one dependence on any one on a few sources of distribution; distribution channels disruption and changes in
channel for sourcing of business distributor for sourcing position within third-parties distribution channels
of business is modest
Factor 3 Product risk Low Risk Reserves are>50% of Low Risk Reserves are 25–50% Low Risk Reserves are 10–25% Low Risk Reserves are 0–10% of Low Risk Reserves = zero % of
Total Reserves; majority of of Total Reserves; significant of Total Reserves; moderate Total Reserves; limited amount Total Reserves; no risk sharing
liabilities have high ability to portion of liabilities have above- amount of liabilities have ability of liabilities have ability to share with policyholders
share risk with policyholders average ability to share risks to share risks with policyholders risks with policyholders
with policyholders
Life insurance product Five or more distinct lines of Four distinct lines of business Three distinct lines of business Two distinct lines of business One distinct line of business
diversification business each produce at least each produce at least 10% of each produce at least 10% of each produce at least 10% of produces more than 90% of
10% of total life total life premiums/deposits total life premiums/deposits total life premiums/deposits total life premiums/deposits
premiums/deposits
Factor 4 High risk assets % of invested <10% 10–20% 20–30% 30–40% >40%
assets
Goodwill % equity <15% 15–25% 25–35% 35–50% >50%
Factor 5 Capital as % of total assets >12% 8–12% 6–8% 4–6% <4%
Factor 6 Return on equity >15% 10–15% 5–10% 0–5% <0%
Sharpe ratio of growth in >100% 100–67% 67–33% 33–0% <0%
net income 3
Factor 7 Liquid assets as % of >80% 60–80% 40–60% 20–40% <20%
policyholder reserve
Factor 9 Financial leverage 4 <20% 20–30% 30–40% 40–50% >50%
Cash flow coverage 5 >7x 5–7x 3–5x 1.5–3x <1.5x
Earnings coverage 6 >12x 8–12x 4–8x 2–4x <2x
Notes:
1 Premiums & deposits as % of industry’s premiums & deposits
2 Premiums & deposits relative to the average industry premiums & deposits by country
3 Absolute value of the mean of the company’s growth in net income divided by the standard deviation of growth in net income over a 5-year period (Ba in case of any loss)
4 Adjusted debt divided by (adjusted debt + adjusted equity)
5 Dividend capacity from subsidiaries divided by interest expense and preferred dividends (5-year average)
6 Adjusted earnings before interest and taxes divided by interest expense and preferred dividends (5-year average)
52
Moody’s—P&C scorecard summary criteria

Aaa Aa A Baa Ba
Factor 1 Market share ratio 1 >10% 5–10% 2–5% 1–2% <1%
Relative market share ratio 2 >3x average 1.5–3.0x average 0.5–1.5x average 0.25–0.5x average <0.25 average
Distribution efficiency 3 <20% 20–24% 24–28% 28–34% >34%
Factor 3 Product risk Very granular exposures; short- Granular exposures; short and Policies may have high gross Longer-tailed lines are majority Combination of size of in-force
tail lines; very low risk of medium-tailed lines represent limits relative to equity; risk of of premiums and/or policies portfolio and size of individual
estimating ultimate claim costs more than 2/3rd of premiums estimating ultimate claim have high gross limits relative to policies limits application of
costs is meaningful; longer- equity; risk of estimating "law of large numbers"; loss
tailed lines estimation risk high;
catastrophe risk substantial
Product diversification Five or more distinct lines of Four distinct lines of business Three distinct lines of business Two distinct lines of business One distinct line of business
business each produce at least each produce at least 10% of each produce at least 10% of each produce at least 10% of produces more than 90% of
10% of total net P&C total net P&C premiums written total net P&C premiums written total net P&C premiums written total net P&C premiums written
premiums written
Regulatory diversification No single regulated region No single regulated region No single regulated region No single regulated region One regulated region generates
generates more than 10% of generates more than 20% of generates more than 30% of generates more than 40% of more than 40% of total net
total net P&C premiums written total net P&C premiums written total net P&C premiums written total net P&C premiums written P&C premiums written
Factor 4 High risk assets % of <10% 10–20% 20–30% 30–40% >40%
invested assets
Reinsurance recoverables as % <35% 35–70% 70–100% 100–150% >150%
of equity
Goodwill as % of equity >15% 15–25% 25–35% 35–50% <40%
Factor 5 Gross underwriting leverage <2x 2–3x 3–5x 5–7x >7x
Factor 6 Return on equity >15% 10–15% 5–10% 0–5% <0%
Sharpe ratio of growth in >100% 100–67% 67–33% 33–0% <0%
net income
Factor 8 Loss reserve development as % <0% 0–2% 2–5% 5–7% >7%
of reserves
A&E funding ratio 4 >15x or not applicable 12–15x 10–12x 8–10x <8x
Factor 9 Financial leverage 5 <20% 20–30% 30–40% 40–50% >50%
Cash flow coverage 6 >7x 5–7x 3–5x 1.5–3x <1.5x
Earnings coverage 7 >12x 8–12x 4–8x 2–4x <2x
Notes:
1 Premiums & deposits as % of industry’s premiums & deposits
2 Premiums & deposits relative to the average industry premiums & deposits by country
3 Underwriting expenses as % of net premiums written
4 A&E net reserves over average payments payments (5-year average)
5 Adjusted debt divided by (adjusted debt + adjusted equity)
6 Dividend capacity from subsidiaries divided by interest expense and preferred dividends (5-year average)
7 Adjusted earnings before interest and taxes divided by interest expense and preferred dividends (5-year average)
53
SECTION 2.B
Insurance
Life accounting and valuation

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FIG EMEA training

SECTION 1 Banking _____________________________________________________________________________ 1

Accounting and financial analysis for banks

SECTION 1 Introduction and business models 2

APPENDIX A Banking business model—additional materials 31

Introduction and business models

Representative product offering

♦ A bank’s product mix Retail banking Corporate banking

♦ A bank’s products Complementary businesses

The banking model

Ability to act ♦ Pay fees and commissions

A bank’s financial statements

A bank’s financial statements

A simplified net income Interest income Reflection of the spread

paid on interest bearing Propriety trading and

Société Générale’s 2006 2005

Other key features of banks

A highly regulated industry

Financing generates value

A different perspective on cash

Limited visibility over some key business drivers

The banking business models

The breakdown in asset

% of balance sheet total 100%

RoE decomposition in banking

RoE is driven by the Net interest

Key ratios and performance indicators

Net banking income analysis

Interest income/average interest earning assets – 3.70

Net banking income analysis

Non interest income Net interest income/Net banking income

♦ Depreciation and amortisation can be either

Source: Annual reports 2006

Asset composition and quality

Asset quality is a point Loan portfolio mix and concentration

Investment portfolio mix and concentration

Asset composition and quality

♦ Differs from "coverage ratio" which focuses on

Coverage ratio Italy 72

Total allowances for loans & advances put on

♦ Can be calculated including or excluding

Loans to deposits balance

Source: Company financials (2006)

Summary of key ratios and indicators

Profitability Capital adequacy Liquidity

Financial instruments under IFRS

IFRS have introduced Description Accounting effects

Financial instruments under IFRS

Although these two Illustration: Available for Sale asset

The changes in value of

Hedge accounting under IFRS

cover new estimated loss on each individual

assumption on the probability of recovery and

Portfolio-based provisions 10,000 Unsecured

♦ In addition, banks may book collective 8,000 Loan loss

Illustrative credit quality flow chart