LIQUIDITY RISK OTHER RISKS RATINGS GOVERNMENT REGULATION UNDERWRITING RISK AEGON GROUP ANNUAL REPORT 2003 39 Liquidity risk is inherent in much of AEGON’s business. Each asset purchased and liability sold has liquidity characteristics that are unique. Some liabilities are surrenderable, while some assets have low liquidity such as privately placed loans, mortgages loans, real estate, and limited partnership interests. If AEGON requires significant amounts of cash on short notice in excess of normal cash requirements, AEGON may have difficulty selling these investments at attractive prices, in a timely manner, or both. AEGON closely monitors and manages its liquidity position. AEGON employs a ‘source and use’ liquidity modeling technique that measures the degree of excess liquidity at various time frames over worsening catastrophic scenarios. Liability liquidity or cash needs are estimated over these catastrophic or ‘run on the bank’ scenarios throughout AEGON. Cash generation is then estimated over these same scenarios with the stipulation that a close to fair price is received on asset sales (that is, AEGON can not flood the market). The objective is for AEGON’s cash sources to exceed cash needs over all scenarios and time frames. Asset portfolios are constructed so that each country unit is self-supporting from a liquidity perspective. Future premiums, surplus assets, back-up liquidity lines and other contingent cash sources and management action are not utilized in the liquidity testing. This analysis is completed at each business unit, country unit and group level. AEGON’s earnings depend significantly upon the extent to which actual claims experience is consistent with the assumptions AEGON uses in setting the prices for products and establishing the technical provisions and liabilities for claims. To the extent that actual claims experience is less favorable than the underlying assumptions used in establishing such liabilities, net income would be reduced. Furthermore, if these higher claims were part of a trend, AEGON may be required to increase liabilities and this would further reduce net income. In addition, certain acquisition costs related to the sale of new policies and the purchase of policies already in force have been recorded on the balance sheet and are being amortized into income over time. If the assumptions relating to the future profitability of these policies (such as future claims, investment income and expenses) are not realized, the amortization of these costs could be accelerated and may even require write-offs due to unrecoverability. This could have a material adverse effect on AEGON’s business, results of operations and financial condition. Underwriting risk is first managed through the product pricing process where margins for adverse deviation and profit on expected claims are priced in. AEGON monitors claim trends and its own experience relative to expectations through experience studies. In addition, claims risk is diversified and managed through exclusions, exposure limits, such as through retention and cover limits through reinsurance. Of AEGON’s business containing mortality risk, AEGON has a significantly greater proportion of business in those products paying death benefits (life insurance) versus those making payment contingent on survivorship (life annuities). Therefore worsening mortality trends are a greater risk for AEGON compared to mortality improvement trends. Claims paying ability and financial strength ratings are factors in establishing the competitive position of insurers. A rating downgrade (or the potential for such a downgrade) could, among other things, materially increase the number of policy surrenders and withdrawals by policyholders, adversely affecting relationships with broker-dealers, banks, agents, wholesalers and other distributors of AEGON’s products and services. In addition, a downgrade may negatively impact new sales and adversely affect AEGON’s ability to compete and thereby have a material adverse effect on AEGON’s business, results of operations and financial condition. The current financial strength ratings for AEGON USA’s insurance companies are AA (very strong) with Standard & Poor’s and Aa3 (excellent) with Moody’s. Both agencies have a stable outlook on the ratings of AEGON USA companies. Negative changes in credit ratings may increase AEGON’s cost of funding. On April 8, 2003, Standard and Poor’s lowered its counterparty credit rating on AEGON’s senior debt from AA– to A+, with a stable outlook. During 2003, Moody’s maintained its rating on AEGON’s senior unsecured debt at A2 with a negative outlook. AEGON’s insurance business is subject to comprehensive regulation and supervision in all countries in which AEGON operates. The primary purpose of such regulation is to protect policyholders, not holders of AEGON’s securities. Changes in existing insurance laws and regulations may affect the way in which AEGON conducts its business and the products AEGON may offer. For example, AEGON expects sales in the United States to be affected by the new amendments to the Federal Trade Commission Telemarketing Sales Rule, as approximately 17% of AEGON USA new health insurance sales in 2002 were generated by telemarketing in the United States. The amendments to the rule, the majority of which went into effect on March 31, 2003, prevent telemarketers from targeting potential customers who have elected to be included in a national ’do not call’ list. Moreover, some states also have statewide ’do not call’ lists. In addition, changes in pension and employee benefit regulation, social security regulation, financial services regulation, taxation and the regulation of securities products and transactions, may also adversely affect AEGON’s ability to sell new policies or its claims exposure on existing policies. Additionally, the insurance laws or regulations adopted or amended from time to time may be more restrictive or may result in higher costs than current requirements.