Annual Financial Report - 25 of 41

RNS Number : 8666D

HSBC Holdings PLC

30 March 2011

Report of the Directors: Operating and Financial Review (continued)

Risk > Risk management of insurance operations > Overview of products / Nature and extent of risks / Insurance risk

Our manufacturing business concentrates on personal lines, e.g. contracts written for individuals. This focus on the higher volume, lower individual value personal lines contributes to diversifying risk.

Overview of insurance products

(Audited)

The main contracts we manufacture are listed below:

Life insurance business

· Life insurance contracts with discretionary participation features ('DPF');

· credit life insurance business;

· annuities;

· term assurance and critical illness policies;

· linked life insurance;

· investment contracts with DPF;

· unit-linked investment contracts; and

· other investment contracts (including pension contracts written in Hong Kong).

Non-life insurance business

Non-life insurance contracts include motor, fire and other damage to property, accident and health, repayment protection and commercial insurance.

Credit non-life insurance is concentrated in North America and Europe, and is originated in conjunction with the provision of loans. Following a decision taken to close the Consumer Lending network in the US, insurance products written in conjunction with this business are being run off.

In December 2007, we decided to stop selling payment protection insurance ('PPI') products in the UK and a phased withdrawal was completed across the HSBC, first direct and M&S Money brands during 2008. HFC ceased selling single premium PPI in 2008 and sales of regular premium PPI will reduce as HFC exits its remaining retail relationships. HSBC continues to distribute its UK short-term income protection ('STIP') product. In January 2009, the Competition Commission ('CC') published its report into the PPI market in which it stipulated that STIP products will also be subject to their remedies when sold in conjunction with or as a result of a referral following the sale of a loan or similar credit product. We have undertaken an analysis of the required changes to the STIP product and its sales processes resulting from the CC's remedies. Following an appeal to the Competition Appeal Tribunal, the CC had to reconsider whether a ban on firms selling PPI at the point of sale of the credit product was an appropriate and justified remedy for the deficiencies it identified in the PPI

market. On 14 October 2010, the CC confirmed that it intended to proceed with a point of sale ban. It is anticipated that the Order implementing the CC's remedies will be made in late March or early April, and that the point of sale ban will then come into effect 12 months after the date of the Order.

Nature and extent of risks

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The majority of the risk in our insurance business derives from manufacturing activities and can be categorised as insurance risk and financial risks. The following sections describe how these risks are managed. Financial risks include market risk, credit risk and liquidity risk. The assets of insurance manufacturing subsidiaries are included within the consolidated credit risk disclosures on pages 93 to 128, although separate disclosures in respect of insurance manufacturing subsidiaries are provided below. The consolidated liquidity risk and market risk disclosures focus on banking entities and disclosures specific to the insurance manufacturing subsidiaries are provided in the sections below. Operational risk is covered by the Group's overall operational risk management process.

The insurance manufacturers set their own control procedures in addition to complying with guidelines issued by the Group Insurance Head Office. The control framework for monitoring risk includes the Group Insurance Risk Committee, which oversees the status of the significant risk categories in the insurance operations. Five sub-committees of this Committee focus on products and pricing, market and liquidity risk, credit risk, operational risk and insurance risk, respectively. Similar risk committees exist at regional and entity levels. Any issues requiring escalation from the Group Insurance Risk Committee would be reported to the GMB via the Risk Management Meeting.

In addition, local ALCOs and Risk Management Committees monitor certain risk exposures, mainly for life business where the duration and cash flow matching of insurance assets and liabilities are reviewed.

All insurance products, whether manufactured internally or by a third party, are subjected to a product approval process. Approval is provided by the Regional Insurance Head Office or Group Insurance Head Office depending on the type of product and its risk profile. The approval process is formalised through the Product and Pricing Committee, which comprise the heads of the relevant risk functions within insurance.

Insurance risk

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Insurance risk is the risk, other than financial risk, of loss transferred from the holder of the insurance contract to the issuer (HSBC). The principal insurance risk we face is that, over time, the cost of acquiring and administering a contract, claims and benefits may exceed the aggregate amount of premiums received and investment income.

The cost of claims and benefits can be influenced by many factors, including mortality and morbidity experience, lapse and surrender rates and, if the policy has a savings element, the performance of the assets held to support the liabilities.

Life and non-life business insurance risks are controlled by high-level policies and procedures set centrally, taking into account where appropriate local market conditions and regulatory requirements. Formal underwriting, reinsurance and claims-handling procedures designed to ensure compliance with regulations are applied, supplemented with stress testing.

As well as exercising underwriting controls, we use reinsurance as a means of mitigating exposure to insurance risk, in particular to aggregations of catastrophe risk. When we manage our exposure to insurance risk through the use of third-party reinsurers, the associated revenue and manufacturing profit is ceded to them. Although reinsurance provides a means of managing insurance risk, such contracts expose us to credit risk, the risk of default by the reinsurer (see page 165).

The following tables analyse our insurance risk exposures by geographical region and by type of business.

Analysis of life insurance risk - liabilities to policyholders⁷⁴

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	Europe	Hong Kong	Rest of Asia- Pacific	North America	Latin America	Total
	US$m	US$m	US$m	US$m	US$m	US$m
At 31 December 2010
Life (non-linked) .........................................	1,679	17,989	789	1,004	2,122	23,583
Insurance contracts with DPF⁷⁵ ...............	327	17,203	278	-	-	17,808
Credit life ................................................	565	-	72	36	2	675
Annuities .................................................	471	-	31	760	1,622	2,884
Term assurance and other long-term contracts .............................................	316	786	408	208	498	2,216

Life (linked) ................................................	2,274	3,235	485	-	4,502	10,496

Investment contracts with DPF^75,76 .............	22,052	-	22	-	-	22,074

Insurance liabilities to policyholders ............	26,005	21,224	1,296	1,004	6,624	56,153

At 31 December 2009
Life (non-linked) .........................................	2,998	14,456	526	1,026	1,973	20,979
Insurance contracts with DPF⁷⁵ ...............	1,128	14,095	227	-	-	15,450
Credit life ................................................	953	-	20	50	-	1,023
Annuities .................................................	452	-	28	777	1,554	2,811
Term assurance and other long-term contracts .............................................	465	361	251	199	419	1,695

Life (linked) ................................................	2,125	2,896	437	-	3,528	8,986

Investment contracts with DPF^75,76 .............	20,979	-	35	-	-	21,014

Insurance liabilities to policyholders ............	26,102	17,352	998	1,026	5,501	50,979

For footnotes, see page 174.

Our most significant life insurance products are investment contracts with DPF issued in France, insurance contracts with DPF issued in Hong Kong and unit-linked contracts issued in Hong Kong, Latin America and the UK.

The principal drivers of our insurance risk are described below. The liabilities for long-term contracts are set by reference to a range of assumptions around these drivers. These typically reflect the issuers' own experiences. The type and quantum of insurance risk arising from life insurance depends on the type of business, and varies considerably.

· mortality and morbidity: the main contracts which generate exposure to these risks are term assurance, whole life products, critical illness and income protection contracts and annuities. The risks are monitored on a regular basis, and are primarily mitigated by underwriting controls and reinsurance and by retaining the ability in certain cases to amend premiums in the light of experience;

· lapses and surrenders: the risks associated with this are generally mitigated by product design, the application of surrender charges and management actions, for example, managing the level of bonus payments to policyholders. A detailed persistency analysis at a product level is carried out at least on an annual basis; and

· expense risk is mitigated by pricing, for example, retaining the ability in certain cases to amend premiums and/or policyholder charges based on experience, and cost management discipline.

Economic assumptions, such as investment returns and interest rates, are usually based on observable market data. Clearly, liabilities are affected by changes in assumptions (see 'Sensitivity of HSBC's insurance subsidiaries to risk factors' on page 165 and 'Sensitivity analysis' on page 171).

Analysis of non-life insurance risk - net written insurance premiums^74,77

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	Europe	Hong Kong	Rest of Asia- Pacific	North America	Latin America	Total
	US$m	US$m	US$m	US$m	US$m	US$m
2010
Accident and health .....................................	78	174	8	3	37	300
Motor .........................................................	-	15	28	-	267	310
Fire and other damage .................................	38	29	11	16	22	116
Liability ......................................................	-	20	4	-	2	26
Credit (non-life) ..........................................	25	-	-	53	2	80
Marine, aviation and transport ....................	3	10	4	-	18	35
Other non-life insurance contracts ..............	20	39	1	9	84	153

Total net written insurance premiums .........	164	287	56	81	432	1,020

Net insurance claims incurred and movement in liabilities to policyholders ....................	(169)	(117)	(25)	(13)	(201)	(525)

2009
Accident and health .....................................	94	160	7	3	23	287
Motor .........................................................	123	14	20	-	234	391
Fire and other damage .................................	72	22	8	16	22	140
Liability ......................................................	-	15	4	-	2	21
Credit (non-life) ..........................................	35	-	-	86	-	121
Marine, aviation and transport ....................	7	9	4	-	17	37
Other non-life insurance contracts ..............	24	32	1	12	58	127

Total net written insurance premiums .........	355	252	44	117	356	1,124

Net insurance claims incurred and movement in liabilities to policyholders ....................	(748)	(107)	(17)	(96)	(155)	(1,123)

2008
Accident and health .....................................	14	155	5	3	27	204
Motor .........................................................	350	15	14	-	273	652
Fire and other damage .................................	150	26	3	4	22	205
Liability ......................................................	-	14	4	-	34	52
Credit (non-life) ..........................................	99	-	-	144	-	243
Marine, aviation and transport ....................	-	11	4	-	24	39
Other non-life insurance contracts ..............	49	28	-	15	29	121

Total net written insurance premiums .........	662	249	30	166	409	1,516

Net insurance claims incurred and movement in liabilities to policyholders ....................	(553)	(121)	(13)	(98)	(176)	(961)

For footnotes, see page 174.

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Our motor business is written predominantly in Latin America. The run-off of the UK motor book continued in 2010. Accident and health is written in all regions but mainly in Hong Kong. We write fire and other damage to property contracts in all major markets, most significantly in Europe. Credit non-life insurance, which is originated in conjunction with the provision of loans, is concentrated in the US and Europe.

The main risks associated with non-life business are:

· underwriting: the risk that premiums are not appropriate for the cover provided; and

· claims experience: the risk that claims exceed expectations.

We manage these risks through pricing (for example, imposing restrictions and deductibles in the policy terms and conditions), product design, risk selection, claims handling, investment strategy and reinsurance policy. The majority of our non-life insurance contracts are renewable annually, providing added flexibility to the underwriting terms and conditions.

Balance sheet of insurance manufacturing subsidiaries

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A principal tool we use to manage our exposure to insurance risk, in particular for life insurance contracts, is asset and liability matching.

The tables below show the composition of assets and liabilities by contract and by geographical region and demonstrate that there were sufficient assets to cover the liabilities to policyholders in each case at the end of 2010.

Balance sheet of insurance manufacturing subsidiaries by type of contract

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	Insurance contracts					Investment contracts
	With DPF	Unit- linked	Annu-ities	Term assur- ance⁷⁸	Non-life	With DPF⁷²	Unit- linked	Other	Other assets⁷⁹	Total
	US$m	US$m	US$m	US$m	US$m	US$m	US$m	US$m	US$m	US$m
At 31 December 2010
Financial assets........	17,665	9,763	2,615	2,671	2,231	21,511	8,338	3,927	7,157	75,878
- trading assets .....	-	-	-	-	11	-	-	-	-	11
- financial assets designated at fair value	1,206	9,499	413	523	180	5,961	7,624	1,486	1,452	28,344
- derivatives ........	53	-	1	6	-	229	7	1	4	301
- financial investments .......	14,068	-	1,847	1,661	692	14,465	-	1,804	4,495	39,032
- other financial assets .................	2,338	264	354	481	1,348	856	707	636	1,206	8,190

Reinsurance assets ...	10	760	400	263	432	-	-	-	79	1,944
PVIF⁸⁰ ....................	-	-	-	-	-	-	-	-	3,440	3,440
Other assets and investment properties ............	189	6	21	398	213	565	14	56	712	2,174

Total assets .............	17,864	10,529	3,036	3,332	2,876	22,076	8,352	3,983	11,388	83,436

Liabilities under investment contracts:
- designated at fair value ..................	-	-	-	-	-	-	8,321	3,379	-	11,700
- carried at amortised cost	-	-	-	-	-	-	-	439	-	439
Liabilities under insurance contracts .............................	17,808	10,496	2,884	2,891	2,456	22,074	-	-	-	58,609
Deferred tax ...........	11	-	20	4	6	-	-	1	793	835
Other liabilities .......	-	-	-	-	-	-	-	-	2,075	2,075

Total liabilities ........	17,819	10,496	2,904	2,895	2,462	22,074	8,321	3,819	2,868	73,658

Total equity ............	-	-	-	-	-	-	-	-	9,778	9,778

Total equity and liabilities⁸¹ ...........	17,819	10,496	2,904	2,895	2,462	22,074	8,321	3,819	12,646	83,436

Balance sheet of insurance manufacturing subsidiaries by type of contract (continued)

	Insurance contracts						Investment contracts
With DPF		Unit- linked	Annu- ities	Term assur- ance⁷⁸	Non-life	With DPF⁷⁶		Unit- linked	Other	Other assets⁷⁹	Total
	US$m	US$m	US$m	US$m	US$m		US$m	US$m	US$m	US$m	US$m
At 31 December 2009
Financial assets................	15,322	8,204	2,567	2,053	2,290		20,501	7,366	4,008	7,252	69,563
- trading assets ............	-	-	-	-	10		-	-	-	-	10
- financial assets designated at fair value	599	7,837	446	482	63		5,498	6,572	1,582	2,085	25,164
- derivatives ................	16	1	-	3	-		144	299	2	3	468
- financial investments	13,013	-	1,511	1,033	742		13,948	-	1,701	3,901	35,849
- other financial assets	1,694	366	610	535	1,475		911	495	723	1,263	8,072

Reinsurance assets ..........	6	831	376	389	467		-	-	-	60	2,129
PVIF⁸⁰ ............................	-	-	-	-	-		-	-	-	2,780	2,780
Other assets and investment properties ..	165	5	25	634	242		516	13	56	601	2,257

Total assets ....................	15,493	9,040	2,968	3,076	2,999		21,017	7,379	4,064	10,693	76,729

Liabilities under investment contracts:
- designated at fair value ..................................	-	-	-	-	-		-	7,347	3,518	-	10,865
- carried at amortised cost	-	-	-	-	-		-	-	417	-	417
Liabilities under insurance contracts ......	15,450	8,986	2,811	2,718	2,728		21,014	-	-	-	53,707
Deferred tax ...................	6	-	22	1	7		1	-	2	750	789
Other liabilities ...............	-	-	-	-	-		-	-	-	2,371	2,371

Total liabilities ...............	15,456	8,986	2,833	2,719	2,735		21,015	7,347	3,937	3,121	68,149

Total equity ...................	-	-	-	-	-		-	-	-	8,580	8,580

Total equity and liabilities⁸² ..................	15,456	8,986	2,833	2,719	2,735		21,015	7,347	3,937	11,701	76,729

For footnotes, see page 174.

Balance sheet of insurance manufacturing subsidiaries by geographical region⁷⁴

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	Europe	Hong Kong	Rest of Asia- Pacific	North America	Latin America	Total
	US$m	US$m	US$m	US$m	US$m	US$m
At 31 December 2010
Financial assets ............................................	36,233	26,278	1,651	2,548	9,168	75,878
- trading assets ........................................	-	-	-	-	11	11
- financial assets designated at fair value ..	16,133	5,550	1,106	-	5,555	28,344
- derivatives ............................................	238	50	12	-	1	301
- financial investments ............................	16,758	17,299	247	2,006	2,722	39,032
- other financial assets ............................	3,104	3,379	286	542	879	8,190


Reinsurance assets .......................................	974	770	33	23	144	1,944
PVIF⁸⁰ .........................................................	1,102	1,734	165	141	298	3,440
Other assets and investment properties .......	1,060	743	26	9	336	2,174

Total assets .................................................	39,369	29,525	1,875	2,721	9,946	83,436

Liabilities under investment contracts:
- designated at fair value ..........................	7,359	4,300	41	-	-	11,700
- carried at amortised cost .......................	-	-	-	-	439	439
Liabilities under insurance contracts ............	27,475	21,515	1,381	1,169	7,069	58,609
Deferred tax ................................................	375	298	39	-	123	835
Other liabilities ............................................	1,354	289	58	12	362	2,075

Total liabilities ............................................	36,563	26,402	1,519	1,181	7,993	73,658

Total equity ................................................	2,806	3,123	356	1,540	1,953	9,778

Total equity and liabilities⁸¹ .........................	39,369	29,525	1,875	2,721	9,946	83,436

	Europe	Hong Kong	Rest of Asia- Pacific	North America	Latin America	Total
	US$m	US$m	US$m	US$m	US$m	US$m
At 31 December 2009
Financial assets ............................................	35,704	22,337	1,330	2,582	7,610	69,563
- trading assets ........................................	-	-	-	-	10	10
- financial assets designated at fair value ..	14,756	4,758	877	-	4,773	25,164
- derivatives ............................................	446	18	3	-	1	468
- financial investments ............................	16,940	14,771	133	2,037	1,968	35,849
- other financial assets ............................	3,562	2,790	317	545	858	8,072


Reinsurance assets .......................................	1,100	849	25	19	136	2,129
PVIF⁸⁰ .........................................................	1,022	1,248	113	138	259	2,780
Other assets and investment properties .......	1,380	498	23	40	316	2,257

Total assets .................................................	39,206	24,932	1,491	2,779	8,321	76,729

Liabilities under investment contracts:
- designated at fair value ..........................	6,500	4,299	66	-	-	10,865
- carried at amortised cost .......................	-	-	-	-	417	417
Liabilities under insurance contracts ............	27,845	17,618	1,072	1,268	5,904	53,707
Deferred tax ................................................	334	220	27	82	126	789
Other liabilities ............................................	1,744	284	54	3	286	2,371

Total liabilities ............................................	36,423	22,421	1,219	1,353	6,733	68,149

Total equity ................................................	2,783	2,511	272	1,426	1,588	8,580

Total equity and liabilities⁸² .........................	39,206	24,932	1,491	2,779	8,321	76,729

For footnotes, see page 174.

Financial risks

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Our insurance businesses are exposed to a range of financial risks, including market risk, credit risk and liquidity risk. Market risk includes interest rate risk, equity risk and foreign exchange risk. The nature and management of these risks is described below.

Manufacturing subsidiaries are exposed to financial risks when, for example, the proceeds from financial assets are not sufficient to fund the obligations arising from non-linked insurance and investment contracts. In many jurisdictions, local regulatory requirements prescribe the type, quality and concentration of assets that these subsidiaries must maintain to meet insurance liabilities. These requirements complement Group-wide policies.

The following table analyses the assets held in our insurance manufacturing subsidiaries at 31 December 2010 by type of contract, and provides a view of the exposure to financial risk. For linked contracts, which pay benefits to policyholders which are determined by reference to the value of the investments supporting the policies, we typically designate assets at fair value; for non-linked contracts, the classification of the assets is driven by the nature of the underlying contract.

Financial assets held by insurance manufacturing subsidiaries (Audited)
	Life linked	Life non-linked		Non-life	Other
	contracts⁸³		contracts⁸⁴	insurance⁸⁵	assets⁷⁹	Total
	US$m		US$m	US$m	US$m	US$m
At 31 December 2010
Trading assets
Debt securities ......................................	-		-	11	-	11

Financial assets designated at fair value.....	17,123		9,589	180	1,452	28,344
Treasury bills .......................................	10		119	-	10	139
Debt securities ......................................	6,660		3,281	180	847	10,968
Equity securities ...................................	10,453		6,189	-	595	17,237

Financial investments
Held-to-maturity:
- debt securities ....................................	-		16,015	152	908	17,075

Available-for-sale: ...................................	-		17,830	540	3,587	21,957
- Treasury bills ....................................	-		10	-	31	41
- other eligible bills ..............................	-		36	140	217	393
- debt securities ....................................	-		17,776	391	3,210	21,377
- equity securities .................................	-		8	9	129	146

Derivatives ..............................................	7		290	-	4	301
Other financial assets⁸⁶ ............................	971		4,665	1,348	1,206	8,190

Total financial assets⁸¹ ............................	18,101		48,389	2,231	7,157	75,878

At 31 December 2009
Trading assets
Debt securities ......................................	-		-	10	-	10

Financial assets designated at fair value ....	14,409		8,607	63	2,085	25,164
Treasury bills .......................................	46		174	-	3	223
Debt securities ......................................	5,086		3,428	63	1,220	9,797
Equity securities ...................................	9,277		5,005	-	862	15,144

Financial investments
Held-to-maturity:
- debt securities ....................................	-		13,995	186	670	14,851

Available-for-sale: ...................................	-		17,211	556	3,231	20,998
- Treasury bills ....................................	-		-	211	86	297
- other eligible bills ..............................	-		26	127	126	279
- debt securities ....................................	-		17,169	199	2,787	20,155
- equity securities .................................	-		16	19	232	267

Derivatives ..............................................	300		165	-	3	468
Other financial assets⁸⁶ ............................	861		4,473	1,475	1,263	8,072

Total financial assets⁸² ............................	15,570		44,451	2,290	7,252	69,563

For footnotes, see page 174.

Approximately 65.1% of financial assets were invested in debt securities at 31 December 2010 (2009: 64.4%) with 22.9% (2009: 22.2%) invested in equity securities.

In life linked insurance, premium income less charges levied is invested in a portfolio of assets. We manage the financial risks of this product on behalf of the policyholders by holding appropriate assets in segregated funds or portfolios to which the liabilities are linked. These assets represented 23.9% of the total financial assets of our insurance manufacturing subsidiaries at the end of 2010 (2009: 22.4%).

Market risk

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Market risk arises when mismatches occur between product liabilities and the investment assets which back them. For example, mismatches between asset and liability yields and maturities give rise to interest rate risk.

Description of market risk

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The main features of products manufactured by our insurance manufacturing subsidiaries which generate market risk, and the market risk to which these

features expose the subsidiaries, are discussed below.

Long-term insurance or investment products may incorporate benefits that are guaranteed. The table below shows, in respect of each category of guarantee, the total liabilities to policyholders established for guaranteed products manufactured by our insurance subsidiaries. The table also shows the range of investment returns (net of operating costs) on the assets supporting these products and the implied investment returns that would enable the business to meet the guarantees.

Categories of guaranteed benefits

· annuities in payment;

· deferred/immediate annuities: these consist of two phases -the savings and investing phase and the retirement income phase;

· annual return: the annual return is guaranteed to be no lower than a specified rate. This may be the return credited to the policyholder every year, or the average annual return credited to the policyholder over the life of the policy, which may occur on the maturity date or the surrender date of the contract; and

· capital: policyholders are guaranteed to receive no less than the premiums paid plus declared bonuses less expenses.

Liabilities to policyholders⁸⁷

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	2010			2009
	Amount of reserve	Investment returns implied by guarantee⁸¹	Current yields	Amount of reserve	Investment returns implied by guarantee⁸²	Current yields
	US$m	%	%	US$m	%	%

Annuities in payment ........................	1,491	0.0 - 8.5	1.5 - 16.2	1,299	0.0 - 7.5	1.3 - 16.7
Deferred annuities .............................	642	0.0 - 6.0	2.1 - 16.8	569	0.0 - 6.0	0.9 - 15.1
Immediate annuities ..........................	532	6.0 -- 9.0	5.5 - 5.5	553	6.0 - 9.0	5.4 - 5.4
Annual return ....................................	19,980	0.0 - 4.5	0.0 - 5.9	17,147	0.0 - 4.5	0.8 - 6.2
Annual return ....................................	841	4.5 - 6.0	6.1 - 8.5	497	4.5 - 6.0	5.1 - 6.5
Capital ..............................................	15,445	-	2.0 - 4.0	15,866	-	2.4 - 4.3

For footnotes, see page 174.

Interest rate risk arises to the extent that yields on the assets are lower than the investment returns implied by the guarantees payable to policyholders by insurance manufacturing subsidiaries. When this happens, we may discontinue products.

The proceeds from insurance and investment products with DPF are primarily invested in bonds with a proportion allocated to other asset classes in order to provide customers with the potential for enhanced returns. Subsidiaries with portfolios of such products are exposed to the risk of falls in market prices which cannot be fully reflected in the discretionary bonuses. An increase in market volatility could also result in an increase in the value of the guarantee to the policyholder.

Long-term insurance and investment products typically permit the policyholder to surrender the policy or let it lapse at any time. When the surrender value is not linked to the value realised from the sale of the associated supporting assets, the subsidiary is exposed to market risk. In particular, when customers seek to surrender their policies when asset values are falling, assets may have to be sold at a loss to fund redemptions.

A subsidiary holding a portfolio of long-term insurance and investment products, especially with DPF, may attempt to reduce exposure to its local market by investing in assets in countries other than that in which it is based. These assets may be denominated in currencies other than the subsidiary's local currency. It is often not cost effective for the subsidiary to hedge the foreign exchange exposure associated with these assets, and this exposes it to the risk that its local currency will strengthen against the currency of the related assets.

For unit-linked contracts, market risk is substantially borne by the policyholder, but we typically remain exposed to market risk as the market value of the linked assets influences the fees we earn for managing them.

Asset and liability matching

It may not always be possible to achieve a complete matching of asset and liability durations, partly because there is uncertainty over policyholder behaviour, which introduces uncertainty over the receipt of all future premiums and the timing of claims, and partly because the duration of liabilities may exceed the duration of the longest available dated fixed interest investments.

We use models to assess the effect of a range of future scenarios on the values of financial assets and associated liabilities, and ALCOs employ the outcomes in determining how the assets and liabilities should be matched. The scenarios include stresses applied to factors which affect insurance risk such as mortality and lapse rates. Of particular importance is matching the expected pattern of cash inflows with the benefits payable on the underlying contracts, which can extend for many years.

Our current portfolio of assets includes debt securities issued at a time when yields were higher than those observed in the current market. As a result, yields on extant holdings of debt securities exceed those which may be obtained on current issues. We reduced short-term bonus rates paid to policyholders on certain participating contracts to manage the immediate strain on the business. Should interest rates and yield curves remain low for prolonged periods, further such steps may be needed.

How market risk is managed

(Audited)

All our insurance manufacturing subsidiaries have market risk mandates which specify the investment instruments in which they are permitted to invest and the maximum quantum of market risk which they are permitted to retain. They manage market risk by using some or all of the techniques listed below, depending on the nature of the contracts they write.

Techniques for managing market risk

· for products with DPF, adjusting bonus rates to manage the liabilities to policyholders. The effect is that a significant portion of the market risk is borne by the policyholder;

· as far as possible, matching assets to liabilities;

· using derivatives to a limited extent;

· for new products with investment guarantees, considering the cost when determining the level of premiums or the price structure;

· periodically reviewing products identified as higher risk, which contain investment guarantees and embedded optionality features linked to savings and investment products;

· including features designed to mitigate market risk in new products, such as charging surrender penalties to recoup losses incurred when policyholders surrender their policies; and

· exiting, to the extent possible, investment portfolios whose risk is considered unacceptable.

In the product approval process, the risks embedded in new products are identified and assessed. When, for example, options and guarantees are embedded in new products, the due diligence process ensures that complete and appropriate risk management procedures are in place. For all but the simplest of guaranteed benefits the assessment is undertaken by Group Insurance Head Office. Management reviews certain exposures more frequently when markets are more volatile to ensure that any matters arising are dealt with in a timely fashion.

How the exposure to market risk is measured

(Audited)

Our insurance manufacturing subsidiaries monitor exposures against mandated limits regularly and report them to Group Insurance Head Office. Exposures are aggregated and reported on a quarterly basis to senior risk management forums in the Group, including the Group Insurance Market and Liquidity Risk Committee, Group Insurance Risk Committee and the Group Stress Test Review Group.

Standard measures for quantifying market risks

· for interest rate risk, the sensitivities of the net present values of asset and expected liability cash flows, in total and by currency, to a one basis point parallel shift in the discount curves used to calculate the net present values;

· for equity price risk, the total market value of equity holdings and the market value of equity holdings by region and country; and

· for foreign exchange risk, the total net short foreign exchange position and the net foreign exchange positions by currency.

The standard measures are relatively straightforward to calculate and aggregate, but they have limitations. The most significant one is that a parallel shift in yield curves of one basis point does not capture the non-linear relationships between the values of certain assets and liabilities and interest rates. Non-linearity arises, for example, from investment guarantees and product features which enable policyholders to surrender their policies. We bear the shortfall if the yields on investments held to support contracts with guaranteed benefits are less than the investment returns implied by the guaranteed benefits.

We recognise these limitations and augment our standard measures with stress tests which examine the effect of a range of market rate scenarios on the aggregate annual profits and total equity of our insurance manufacturing subsidiaries, after taking into consideration tax and accounting treatments where material and relevant. The results of these tests are reported to Group Insurance Head Office and risk committees every quarter.

The following table illustrates the effects of various interest rate, equity price, foreign exchange rate and credit spread scenarios on our profit for the year and total equity of our insurance manufacturing subsidiaries:

Sensitivity of HSBC's insurance manufacturing subsidiaries to risk factors (Audited)
	2010		2009
	Effect on profit for the year	Effect on total equity	Effect on profit for the year	Effect on total equity
	US$m	US$m	US$m	US$m

+ 100 basis points parallel shift in yield curves ...................	72	(132)	68	(82)
- 100 basis points parallel shift in yield curves ...................	(86)	131	(69)	92
10% increase in equity prices .............................................	76	76	19	19
10% decrease in equity prices .............................................	(76)	(76)	(20)	(20)
10% increase in US dollar exchange rate compared to all currencies ..............................................	21	21	20	20
10% decrease in US dollar exchange rate compared to all currencies ..............................................	(21)	(21)	(20)	(20)
Sensitivity to credit spread increases ..................................	(31)	(74)	(36)	(91)

Where appropriate, we include the impact of the stress on the PVIF in the results of the stress tests. The relationship between the values of certain assets and liabilities and the risk factors may be non-linear and, therefore, the results disclosed cannot be extrapolated to measure sensitivities to different levels of stress. The sensitivities are stated before allowance for the effect of management actions which may mitigate changes in market rates, and for any factors such as policyholder behaviour that may change in response to changes in market risk.

Credit risk

(Audited)

Description of credit risk

Credit risk can give rise to losses through default and can lead to volatility in our income statement and balance sheet figures through movements in credit spreads, principally on the US$43.3bn (2009: US$40.5bn) non-linked bond portfolio.

As tabulated above, the sensitivity of the net profit after tax of our insurance subsidiaries to the effects of increases in credit spreads is a fall of US$31m (2009: US$36m fall). This is small because 51.4% of the financial assets held by our insurance subsidiaries are classified as either held to maturity or available for sale, and consequently any changes in the fair value of these financial investments, absent impairment, would have no impact on the profit after tax. We calculate the sensitivity using simplified assumptions based on a one-day movement in credit spreads over a two-year period. A confidence level of 99%, consistent with our Group VAR, is applied. While credit spreads have generally widened from the levels observed at the end of 2009, the volatility experienced during 2010 was lower than that seen in 2009, leading to a reduction in our sensitivity to credit spread movements.

We used to sell certain unit-linked life insurance contracts which were reinsured with a third-party counterparty, who also underwrote market return guarantees. We are exposed to credit risk to the extent that the counterparty is unable to meet the terms of the guaranteed benefits. The cost to us of market return guarantees increases when interest rates fall, equity markets fall or market volatility increases. In addition, when determined by reference to a discounted cash flow model in which the discount rate is based on current interest rates, guarantee costs increase in a falling interest rate environment. The sale of these contracts ceased in 2008, reflecting our adjusted risk appetite.

How credit risk is managed

Our exposure to credit risk products is included in the tables showing exposures to life and non-life insurance risk on pages 157 to 159. Our insurance manufacturing subsidiaries are responsible for the credit risk, quality and performance of their investment portfolios. Our assessment of the creditworthiness of issuers and counterparties is based primarily upon internationally recognised credit ratings and other publicly available information.

Investment credit exposures are monitored against limits by our local insurance manufacturing subsidiaries, and are aggregated and reported to Group Credit Risk, the Group Insurance Credit Risk Meeting and the Group Insurance Risk Committee. Stress testing is performed by Group Insurance Head Office on the investment credit exposures using credit spread sensitivities and default probabilities. The stresses are reported to the Group Insurance Risk Committee.

We use a number of tools to manage and monitor credit risk. These include an Early Warning Report and a watch list of investments with current credit concerns which are circulated fortnightly to senior management in Group Insurance Head Office and the Regional Chief Risk Officers to identify investments which may be at risk of future impairment.

Credit quality

(Audited)

The following table presents an analysis of treasury bills, other eligible bills and debt securities within our insurance business by measures of credit quality. The five credit quality classifications are defined on page 114. Only assets supporting non-linked liabilities are included in the table as financial risk on assets supporting linked liabilities is predominantly borne by the policyholder. 90.5% (2009: 90.9%) of the assets included in the table are invested in investments rated as 'Strong'.

Treasury bills, other eligible bills and debt securities in HSBC's insurance manufacturing subsidiaries

(Audited)

	Neither past due nor impaired
	Strong	Good	Satisfactory	Sub- standard	Impaired⁸⁸	Total
	US$m	US$m	US$m	US$m	US$m	US$m
At 31 December 2010

Supporting liabilities under non-linked insurance and investment contracts
Trading assets - debt securities ..................	9	-	2	-	-	11

Financial assets designated at fair value ......	3,126	88	330	36	-	3,580
- treasury and other eligible bills ............	118	-	1	-	-	119
- debt securities .....................................	3,008	88	329	36	-	3,461

Financial investments ................................	32,164	1,948	250	158	-	34,520
- treasury and other similar bills ............	-	-	10	-	-	10
- other eligible bills ................................	176	-	-	-	-	176
- debt securities .....................................	31,988	1,948	240	158	-	34,334


	35,299	2,036	582	194	-	38,111

Supporting shareholders' funds⁸⁹
Financial assets designated at fair value ......	492	286	75	4	-	857
- treasury and other eligible bills ............	10	-	-	-	-	10
- debt securities .....................................	482	286	75	4	-	847

Financial investments ................................	3,443	740	101	82	-	4,366
- treasury and other similar bills ............	-	-	31	-	-	31
- other eligible bills ................................	217	-	-	-	-	217
- debt securities .....................................	3,226	740	70	82	-	4,118


	3,935	1,026	176	86	-	5,223

Total⁸¹
Trading assets - debt securities ..................	9	-	2	-	-	11

Financial assets designated at fair value ......	3,618	374	405	40	-	4,437
- treasury and other eligible bills ............	128	-	1	-	-	129
- debt securities .....................................	3,490	374	404	40	-	4,308

Financial investments ................................	35,607	2,688	351	240	-	38,886
- treasury and other similar bills ............	-	-	41	-	-	41
- other eligible bills ................................	393	-	-	-	-	393
- debt securities .....................................	35,214	2,688	310	240	-	38,452


	39,234	3,062	758	280	-	43,334

	Neither past due nor impaired
	Strong	Good	Satisfactory		Sub- standard	Impaired⁸⁸	Total
	US$m	US$m		US$m	US$m	US$m	US$m
At 31 December 2009

Supporting liabilities under non-linked insurance and investment contracts
Trading assets - debt securities ..............................	8	-		2	-	-	10

Financial assets designated at fair value .................	2,812	80		704	69	-	3,665
- treasury and other eligible bills .......................	174	-		-	-	-	174
- debt securities .................................................	2,638	80		704	69	-	3,491

Financial investments ...........................................	30,126	1,509		130	148	-	31,913
- treasury and other similar bills ........................	211	-		-	-	-	211
- other eligible bills ...........................................	153	-		-	-	-	153
- debt securities .................................................	29,762	1,509		130	148	-	31,549


	32,946	1,589		836	217	-	35,588

Supporting shareholders' funds⁸⁹
Financial assets designated at fair value .................	527	506		180	10	-	1,223
- treasury and other eligible bills .......................	3	-		-	-	-	3
- debt securities .................................................	524	506		180	10	-	1,220

Financial investments ...........................................	3,335	312		16	6	-	3,669
- treasury and other similar bills ........................	82	-		4	-	-	86
- other eligible bills ...........................................	126	-		-	-	-	126
- debt securities .................................................	3,127	312		12	6	-	3,457


	3,862	818		196	16	-	4,892

Total⁸²
Trading assets - debt securities ..............................	8	-		2	-	-	10

Financial assets designated at fair value .................	3,339	586		884	79	-	4,888
- treasury and other eligible bills .......................	177	-		-	-	-	177
- debt securities .................................................	3,162	586		884	79	-	4,711

Financial investments ...........................................	33,461	1,821		146	154	-	35,582
- treasury and other similar bills ........................	293	-		4	-	-	297
- other eligible bills ...........................................	279	-		-	-	-	279
- debt securities .................................................	32,889	1,821		142	154	-	35,006


	36,808	2,407		1,032	233	-	40,480

For footnotes, see page 174.

Issuers of treasury bills, other eligible bills and debt securities in HSBC's insurance manufacturing subsidiaries

(Audited)

	Treasury bills	Other eligible bills	Debt securities	Total
	US$m	US$m	US$m	US$m
At 31 December 2010
Governments .....................................................................	170	121	9,401	9,692
Local authorities ................................................................	-	-	915	915
Asset-backed securities .......................................................	-	-	60	60
Corporates and other .........................................................	-	272	32,395	32,667

	170	393	42,771	43,334

At 31 December 2009
Governments .....................................................................	342	6	8,548	8,896
Local authorities ................................................................	-	-	886	886
Asset-backed securities .......................................................	-	-	54	54
Corporates and other .........................................................	132	273	30,239	30,644

	474	279	39,727	40,480

Credit risk also arises when part of the insurance risk we incur is assumed by reinsurers. The split of liabilities ceded to reinsurers and outstanding reinsurance recoveries, analysed by credit quality, is shown below. Our exposure to third parties under the reinsurance agreements described in the Credit Risk section above is included in this table.

Reinsurers' share of liabilities under insurance contracts

(Audited)

	Neither past due nor impaired				Past due
	Strong	Good	Satisfactory	Sub- standard	but not impaired	Total
	US$m	US$m	US$m	US$m	US$m	US$m

At 31 December 2010
Linked insurance contracts ..........................	44	716	-	-	-	760
Non-linked insurance contracts ...................	997	11	76	12	9	1,105

Total⁸¹ ........................................................	1,041	727	76	12	9	1,865

Reinsurance debtors .....................................	30	8	30	1	10	79

At 31 December 2009
Linked insurance contracts ..........................	27	804	-	-	-	831
Non-linked insurance contracts ...................	1,133	10	90	5	-	1,238

Total⁸² ........................................................	1,160	814	90	5	-	2,069

Reinsurance debtors .....................................	24	2	11	6	17	60

For footnotes, see page 174.

Liquidity risk

(Audited)

Description of liquidity risk

It is an inherent characteristic of almost all insurance contracts that there is uncertainty over the amount of claims liabilities that may arise and the timing of their settlement, and this creates liquidity risk.

There are three aspects to liquidity risk. The first arises in normal market conditions and is referred to as funding liquidity risk; specifically, the capacity to raise sufficient cash when needed to meet payment obligations. Secondly, market liquidity risk arises when the size of a particular holding may be so large that a sale cannot be completed around the market price. Finally, standby liquidity risk refers to the capacity to meet payment terms in abnormal conditions.

How liquidity risk is managed

Our insurance manufacturing subsidiaries primarily fund cash outflows arising from claim liabilities from the following sources of cash inflows:

· premiums from new business, policy renewals and recurring premium products;

· interest and dividends on investments and principal repayments of maturing debt investments;

· cash resources; and

· the sale of investments.

They manage liquidity risk by utilising some or all of the following techniques:

· matching cash inflows with expected cash outflows using specific cash flow projections or more general asset and liability matching techniques such as duration matching;

· maintaining sufficient cash resources;

· investing in good credit-quality investments with deep and liquid markets to the degree to which they exist;

· monitoring investment concentrations and restricting them where appropriate, for example, by debt issues or issuers; and

· establishing committed contingency borrowing facilities.

Each of these techniques contributes to mitigating the three types of liquidity risk described above.

Every quarter, our insurance manufacturing subsidiaries are required to complete and submit liquidity risk reports to Group Insurance Head Office for collation and review by the Group Insurance Market and Liquidity Risk Meeting. Liquidity risk is assessed in these reports by measuring changes in expected cumulative net cash flows under a series of stress scenarios designed to determine the effect of reducing expected available liquidity and accelerating cash outflows. This is achieved, for example, by assuming new business or renewals are

lower, and surrenders or lapses are greater, than expected.

The following tables show the expected undiscounted cash flows for insurance contract liabilities and the remaining contractual maturity of investment contract liabilities at 31 December 2010. A significant proportion of our non-life insurance business is viewed as short-term, with the settlement of liabilities expected to occur within one year of the period of risk. There is a greater spread of expected maturities for the life business where, in a large proportion of cases, the liquidity risk is borne in conjunction with policyholders (wholly in the case of unit-linked business).

The profile of the expected maturity of the insurance contracts as at 31 December 2010 remained comparable with 2009.

Expected maturity of insurance contract liabilities

(Audited)

	Expected cash flows (undiscounted)
	Within 1 year	1-5 years	5-15 years	Over 15 years	Total
	US$m	US$m	US$m	US$m	US$m
At 31 December 2010
Non-life insurance ...................................	1,140	1,157	83	76	2,456
Life insurance (non-linked) ......................	2,463	11,178	18,839	21,093	53,573
Life insurance (linked) .............................	485	2,557	6,366	10,724	20,132

Total⁸¹ ....................................................	4,088	14,892	25,288	31,893	76,161

At 31 December 2009
Non-life insurance ...................................	1,318	1,277	123	10	2,728
Life insurance (non-linked) ......................	2,393	10,098	17,253	18,231	47,975
Life insurance (linked) .............................	522	2,290	4,483	6,899	14,194

Total⁸² ....................................................	4,233	13,665	21,859	25,140	64,897

For footnote, see page 174.

Remaining contractual maturity of investment contract liabilities

(Audited)

	Liabilities under investment contracts by insurance manufacturing subsidiaries
	Linked investment contracts	Other investment contracts	Investment contracts with DPF	Total
	US$m	US$m	US$m	US$m
At 31 December 2010
Remaining contractual maturity:⁸¹
- due within 1 year .........................................................	391	446	11	848
- due between 1 and 5 years ............................................	940	-	11	951
- due between 5 and 10 years ..........................................	1,182	-	-	1,182
- due after 10 years ........................................................	2,133	-	-	2,133
- undated⁹⁰ .....................................................................	3,675	3,372	22,052	29,099

	8,321	3,818	22,074	34,213

At 31 December 2009
Remaining contractual maturity:⁸²
- due within 1 year .........................................................	477	443	14	934
- due between 1 and 5 years ............................................	904	-	20	924
- due between 5 and 10 years ..........................................	693	-	-	693
- due after 10 years ........................................................	2,093	-	-	2,093
- undated⁹⁰ .....................................................................	3,180	3,492	20,980	27,652

	7,347	3,935	21,014	32,296

For footnotes, see page 174.

Present value of in-force long-term insurance business

(Audited)

Our life insurance business is accounted for using the embedded value approach which, inter alia, provides a comprehensive risk and valuation framework. The present value of our in-force long-term ('PVIF') asset at 31 December 2010 was US$3.4bn (2009: US$2.8bn), representing the present value of the shareholders' interest in the profits expected to emerge from the book of in-force policies at that date.

The following table shows the movements recorded during the year in respect of total equity and PVIF of insurance operations:

Movements in total equity and PVIF of insurance operations

(Audited)

	2010		2009
	Total equity	PVIF included in total equity	Total equity	PVIF included in total equity
	US$m	US$m	US$m	US$m

At 1 January ......................................................................	8,580	2,780	7,577	2,033
Value of new business written during the year⁹¹ ...................	737	737	600	600
Movements arising from in-force business:
- expected return ...........................................................	(85)	(85)	(123)	(123)
- experience variances⁹² .................................................	20	20	(44)	(44)
- change in operating assumptions .................................	58	58	48	48
Investment return variances ...............................................	19	19	16	16
Changes in investment assumptions ...................................	(38)	(38)	19	19
Return on net assets ...........................................................	858	-	522	-
Exchange differences and other ..........................................	(222)	(51)	(83)	231
Capital transactions ...........................................................	(149)	-	48	-

At 31 December .................................................................	9,778	3,440	8,580	2,780

For footnotes, see page 174.

Key assumptions used in the computation of PVIF for main life insurance operations

	2010			2009
	UK	Hong Kong	France	UK	Hong Kong	France
	%	%	%	%	%	%

Risk free rate ................................................	3.46	3.10	3.15	3.50	2.58	3.46
Risk discount rate .........................................	7.00	11.00	8.00	7.00	11.00	8.00
Expenses inflation ........................................	3.76	3.00	2.00	3.50	3.00	2.00

The calculation of the PVIF is based upon assumptions that take into account risk and uncertainty. To project these cash flows, a variety of assumptions regarding future experience is made by each insurance operation which reflects local market conditions and management's judgement of local future trends. Some of the Group's insurance operations incorporate risk margins separately in the projection assumptions for each product, while others incorporate risk margins into the overall discount rate. Both factors are reflected in the wide range of risk discount rates applied.

Economic assumptions

(Audited)

The following table shows the effect on the PVIF of reasonably possible changes in the main economic
assumptions, namely the risk-free and risk discount rates, across all insurance manufacturing subsidiaries.

Due to certain characteristics of the contracts, the relationships may be non-linear and the results of the stress-testing should not be extrapolated to higher levels of stress. In calculating the various scenarios, all assumptions are held stable except when testing the effect of the shift in the risk-free rate, when resultant changes to investment returns, risk discount rates and bonus rates are also incorporated. The sensitivities shown are before actions that could be taken by management to mitigate effects and before resultant changes in policyholder behaviour.

Sensitivity of PVIF to changes in economic assumptions

(Audited)

	PVIF at 31 December
	2010	2009
	US$m	US$m

+ 100 basis point shift in risk-free rate ............	231	212
- 100 basis point shift in risk-free rate ............	(190)	(145)
+ 100 basis point shift in risk discount rate ......	(179)	(140)
- 100 basis point shift in risk discount rate ......	205	162

Non-economic assumptions

(Audited)

We determine the policyholder liabilities and PVIF by reference to non-economic assumptions which include, for non-life manufacturers, claims costs and expense rates and, for life manufacturers, mortality and/or morbidity, lapse rates and expense rates. The table below shows the sensitivity of profit for 2010 and total equity at 31 December 2010 to reasonably possible changes in these non-economic assumptions at that date across all our insurance manufacturing subsidiaries, with comparatives for 2009.

The cost of claims is a risk associated with non-life insurance business. An increase in claims costs would have a negative effect on profit. Our main exposures to this scenario are in the UK, Hong Kong, Latin America and Bermuda.

Mortality and morbidity risk is typically associated with life insurance contracts. The effect on profit of an increase in mortality or morbidity depends on the type of business being written. Our largest exposures to mortality and morbidity risk exist in France, Hong Kong, the UK and the US.

Sensitivity to lapse rates depends on the type of contracts being written. For insurance contracts, claims are funded by premiums received and income earned on the investment portfolio supporting the liabilities. For a portfolio of term assurance, an increase in lapse rates typically has a negative effect on profit due to the loss of future premium income on the lapsed policies. France, Hong Kong, the UK and the US are where we are most sensitive to a change in lapse rates.

Expense rate risk is the exposure to a change in expense rates. To the extent that increased expenses cannot be passed on to policyholders, an increase in expense rates will have a negative impact on our profits.

Sensitivity analysis

(Audited)

	Effect on profit for the year to 31 December			Effect on total equity at 31 December
	Life	Non-life	Total	Life	Non-life	Total
	US$m	US$m	US$m	US$m	US$m	US$m

2010
20% increase in claims costs ........................	-	(211)	(211)	-	(211)	(211)
20% decrease in claims costs .......................	-	211	211	-	211	211
10% increase in mortality and/or morbidity rates ........................................................	(55)	-	(55)	(55)	-	(55)
10% decrease in mortality and/or morbidity rates ........................................................	66	-	66	66	-	66
50% increase in lapse rates ..........................	(203)	-	(203)	(203)	-	(203)
50% decrease in lapse rates ..........................	363	-	363	363	-	363
10% increase in expense rates .....................	(63)	(11)	(74)	(63)	(11)	(74)
10% decrease in expense rates .....................	63	11	74	63	11	74

2009
20% increase in claims costs ........................	-	(191)	(191)	-	(191)	(191)
20% decrease in claims costs .......................	-	190	190	-	190	190
10% increase in mortality and/or morbidity rates ........................................................	(51)	-	(51)	(51)	-	(51)
10% decrease in mortality and/or morbidity rates ........................................................	62	-	62	62	-	62
50% increase in lapse rates ..........................	(162)	-	(162)	(162)	-	(162)
50% decrease in lapse rates ..........................	408	-	408	408	-	408
10% increase in expense rates .....................	(52)	(11)	(63)	(52)	(11)	(63)
10% decrease in expense rates .....................	52	11	63	52	11	63

Other material risks

Reputational risk

(Unaudited)

The safeguarding of our reputation is of paramount importance to our continued prosperity and is the responsibility of every member of staff.

We regularly review our policies and procedures for safeguarding against reputational and operational risks. This is an evolutionary process which takes account of relevant developments and industry guidance such as The Association of British Insurers' guidance on best practice when responding to environmental, social and governance ('ESG') risks.

We have always aspired to the highest standards of conduct and, as a matter of routine, take account of reputational risks to our business. Reputational risks can arise from a wide variety of causes, including ESG issues and operational risk events. As a banking group, our good reputation depends upon the way in which we conduct our business, but it can also be affected by the way in which clients, to whom we provide financial services, conduct themselves. The training of Directors on appointment includes reputational matters.

Group functions with responsibility for activities that attract reputational risk are represented at the Group Reputational Risk Committee ('GRRC'), which is chaired by the Group Chairman. The primary role of the GRRC is to consider areas and activities presenting significant reputational risk and, where appropriate, to make recommendations to the Risk Management Meeting and the GMB for policy or procedural changes to mitigate such risk. Reputational Risk Committees have been established in each of the Group's regions. These committees are required to ensure that reputational risks are considered at a regional as well as Group level. Minutes from the regional committees are tabled at GRRC.

Standards on all major aspects of business are set for HSBC and for individual subsidiaries, businesses and functions. Reputational risks, including ESG matters, are considered and assessed by the Board, the GMB, the Risk Management Meeting, subsidiary company boards, Board committees and senior management during the formulation of policy and the establishment of our standards. These policies, which form an integral part of the internal control system (see page 202), are communicated through manuals and statements of policy and are promulgated through internal communications and training. The policies cover ESG issues and set out operational procedures in all areas of reputational risk, including money laundering deterrence, counter-terrorist financing, environmental impact, anti-corruption measures and employee relations. The policy manuals address risk issues in detail and co-operation between GMO departments and businesses is required to ensure a strong adherence to our risk management system and our sustainability practices.

Pension risk

(Unaudited)

We operate a number of pension plans throughout the world, as described in Note 7 on the Financial Statements. Some of them are defined benefit plans, of which the largest is the HSBC Bank (UK) Pension Scheme ('the principal plan').

In order to fund the benefits associated with these plans, sponsoring Group companies (and, in some instances, employees) make regular contributions in accordance with advice from actuaries and in consultation with the scheme's trustees (where relevant). The defined benefit plans invest these contributions in a range of investments designed to meet their long-term liabilities.

The level of these contributions has a direct impact on HSBC's cash flow and would normally be set to ensure that there are sufficient funds to meet the cost of the accruing benefits for the future service of active members. However, higher contributions will be required when plan assets are considered insufficient to cover the existing pension liabilities as a deficit exists. Contribution rates are typically revised annually or triennially, depending on the plan. The agreed contributions to the principal plan are revised triennially.

A deficit in a defined benefit plan may arise from a number of factors, including

· investments delivering a return below that required to provide the projected plan benefits. This could arise, for example, when there is a fall in the market value of equities, or when increases in long-term interest rates cause a fall in the value of fixed income securities held;

· the prevailing economic environment leading to corporate failures, thus triggering write-downs in asset values (both equity and debt);

· a change in either interest rates or inflation which causes an increase in the value of the scheme liabilities; and

· scheme members living longer than expected (known as longevity risk).

A plan's investment strategy is determined after taking into consideration the market risk inherent in the investments and its consequential impact on potential future contributions. The long-term

investment objectives of both HSBC and, where relevant and appropriate, the trustees are:

· to limit the risk of the assets failing to meet the liabilities of the plans over the long-term; and

· to maximise returns consistent with an acceptable level of risk so as to control the long‑term costs of the defined benefit plans.

In pursuit of these long-term objectives, a benchmark is established for the allocation of the defined benefit plan assets between asset classes. In addition, each permitted asset class has its own benchmarks, such as stock market or property valuation indices and, where relevant, desired levels of out-performance. The benchmarks are reviewed at least triennially within 18 months of the date at which an actuarial valuation is made, or more frequently if required by local legislation or circumstances. The process generally involves an extensive asset and liability review.

Ultimate responsibility for investment strategy rests with either the trustees or, in certain circumstances, a Management Committee. The degree of independence of the trustees from HSBC varies in different jurisdictions. For example, the principal plan, which accounts for approximately 70% of the obligations of our defined benefit pension plans, is overseen by a corporate trustee who regularly monitors the market risks inherent in the scheme.

The principal plan holds a diversified portfolio of investments to meet future cash flow liabilities arising from accrued benefits as they fall due to be paid. The trustee of the principal plan is required to produce a written Statement of Investment Principles which governs decision-making about how investments are made.

The DBS principal plan - asset allocation

	2010	2006
	%	%

Equities ...................................	15.5	15.0
Bonds ......................................	56.5	50.0
Alternative assets⁹³ .................	10.5	10.0
Property .................................	9.0	10.0
Cash ........................................	8.5	15.0

	100.0	100.0

For footnote, see page 174.

In 2006, HSBC and the trustee of the principal plan agreed to change the investment strategy in order to reduce the investment risk. The target asset allocations for this strategy at that time and as revised in 2010 are shown above. The strategy is to hold the majority of assets in bonds, with the remainder in a more diverse range of investments, and includes a commitment to undertake a programme of swap arrangements (see Note 45 on the Financial Statements) by which the principal plan makes LIBOR-related interest payments in exchange for the receipt of cash flows which are based on projected future benefit payments to be made from the principal plan.

Sustainability risk

(Unaudited)

Assessing the environmental and social impacts of providing finance to our customers has been firmly embedded into our overall risk management processes.

Sustainability risks arise from the provision of financial services to companies or projects which run counter to the needs of sustainable development; in effect this risk arises when the environmental and social effects outweigh economic benefits. Within GMO, a separate function, Group Corporate Sustainability, is mandated to manage these risks globally working through local offices as appropriate. Sustainability Risk Managers have regional or national responsibilities for advising on and managing environmental and social risks.

Group Corporate Sustainability's risk management responsibilities include:

· formulating sustainability risk policies. This includes oversight of our sustainability risk standards, management of the Equator Principles for project finance lending, and sector‑based sustainability policies covering those sectors with high environmental or social impacts (forestry, freshwater infrastructure, chemicals, energy, mining and metals, and defence-related lending); undertaking an independent review of transactions where sustainability risks are assessed to be high, and supporting our operating companies to assess similar risks of a lower magnitude;

· building and implementing systems-based processes to ensure consistent application of policies, reduce the costs of sustainability risk reviews and capture management information to measure and report on the effect of our lending and investment activities on sustainable development; and

· providing training and capacity building within our operating companies to ensure sustainability risks are identified and mitigated consistently to either our own standards, international standards or local regulations, whichever is higher.

Residual value risk

(Unaudited)

A significant part of a lessor's return from operating leases is dependent upon its management of residual value risk. This arises from operating lease transactions to the extent that the values recovered from disposing of leased assets or re-letting them at the end of the lease terms (the 'residual values') differ from those projected at the inception of the leases.

The sale of our rail finance business 'Eversholt Rail Group' during the year has significantly reduced our exposure to residual value risk.

Footnotes to Risk

Credit risk

1 The amount of the loan commitments reflects, where relevant, the expected level of take-up of pre-approved loan offers made by mailshots to personal customers. In addition to those amounts, there is a further maximum possible exposure to credit risk of US$220.2bn (2009: US$62.3bn), reflecting the full take-up of such irrevocable loan commitments. The take-up of such offers is generally at modest levels.

2 A change in the write-off period in North America during 2009 resulted in an acceleration of write-offs which reduced residential mortgages by US$1.9bn, other personal loans by US$1.3bn and total personal lending by US$3.3bn, with a corresponding reduction in impairment allowances. There was no significant effect on net loans and advances or loan impairment charges.

3 Residential mortgages include Hong Kong Government Home Ownership Scheme loans of US$3.5bn at 31 December 2010 (2009: US$3.5bn). Where disclosed, earlier comparatives were 2008: US$3.9bn; 2007: US$3.9bn; 2006: US$4.1bn.

4 Other personal loans and advances include second lien mortgages and other property-related lending.

5 Other commercial loans and advances include advances in respect of agriculture, transport, energy and utilities.

6 Included within 'Total gross loans and advances to customers' ('TGLAC') is credit card lending of US$62bn (2009: US$68bn). Where disclosed, earlier comparatives were 2008: US$75bn; 2007: US$83bn; 2006: US$75bn.

7 The above numbers for North America include a reclassification within the corporate and commercial lending category to reflect a more accurate presentation of lending in the region.

8 The impairment allowances on loans and advances to banks relate to the geographical regions, Europe, Middle East and North America.

9 These balances were between 0.75% and 1% of total assets. All other balances were above 1%.

10 We do not have material retail exposures in any of the eurozone countries listed in this table.

11 Includes balances at central banks. Lending to banks comprises non-trading loans and advances to banks including reverse repurchase transactions.

12 Derivative assets net of collateral and derivative liabilities for which a legally enforceable right of offset exists.

13 Includes residential mortgages of HSBC Bank USA and HSBC Finance.

14 Comprising Hong Kong, Rest of Asia-Pacific, Middle East and Latin America.

15 Negative equity arises when the value of the property used to secure a loan is below the balance outstanding on the loan, generally based on values at the balance sheet date.

16 Loan-to-value ratios are generally based on values at the balance sheet date.

17 HSBC Finance lending is shown on a management basis and includes loans transferred to HSBC USA Inc. which are managed by HSBC Finance.

18 Interest-only (affordability mortgages) are loans which are classified as 'interest only' for initial period before reverting to repayment. As a consequence, in the table 'Mortgage lending products' on page 109 these balances are included in the category 'Affordability mortgages, including ARMs'.

19 Stated income lending forms a subset of total mortgage services lending across all categories.

20 By states which individually account for 5% or more of HSBC Finance's US customer loan portfolio.

21 The average loss on sale of foreclosed properties is calculated as cash proceeds after deducting selling costs, commissions and other ancillary costs, minus the book value of the property when it was moved to assets held for sale, divided by the book value of the property when it was moved to assets held for sale.

22 The average total loss on foreclosed properties sold includes both the loss on sale (see footnote 21) and the cumulative write-downs recognised on the loans up to and upon classification as assets held for sale. This average total loss on foreclosed properties is expressed as a percentage of the book value of the property prior to its transfer to assets held for sale.

23 Percentages are expressed as a function of the relevant loans and receivables balance.

24 At 31 December 2010 and 2009, real estate secured delinquency included US$4.2bn and US$3.3bn, respectively, of loans that we carried at the lower of cost on net realisable value.

25 We observe the disclosure convention that, in addition to those classified as EL9 to EL10, retail accounts classified EL1 to EL8 that are delinquent by 90 days or more are considered impaired, unless individually they have been assessed as not impaired (see page 117, 'Past due but not impaired gross financial instruments').

26 The EL percentage is derived through a combination of PD and LGD, and may exceed 100% in circumstances where the LGD is above 100% reflecting the cost of recoveries.

27 Impairment allowances are not reported for financial instruments whereby the carrying amount is reduced directly for impairment and not through the use of an allowance account.

28 Impairment is not measured for assets held in trading portfolios or designated at fair value as assets in such portfolios are managed according to movements in fair value, and the fair value movement is taken directly to the income statement. Consequently, we report all such balances under 'Neither past due nor impaired'.

29 Loans and advances to customers includes asset-backed securities that have been externally rated as strong (2010: US$4.1bn; 2009: US$5.7bn), good (2010: US$627m; 2009: US$881m), satisfactory (2010: US$452m; 2009: US$311m), sub-standard (2010: US$669m; 2009: US$468m) and impaired (2010: US$29m; 2009: US$460m).

30 Impaired loans and advances are those classified as CRR 9, CRR 10, EL 9 or EL 10 and all retail loans 90 days or more past due, unless individually they have been assessed as not impaired (see page 117, 'Past due but not impaired gross financial instruments').

31 Collectively assessed loans and advances comprise homogeneous groups of loans that are not considered individually significant, and loans subject to individual assessment where no impairment has been identified on an individual basis, but on which a collective impairment allowance has been calculated to reflect losses which have been incurred but not yet identified.

32 Collectively assessed loans and advances not impaired are those classified as CRR1 to CRR8 and EL1 to EL8 but excluding retail loans 90 days past due.

33 Net of repo transactions, settlement accounts and stock borrowings.

34 As a percentage of loans and advances to banks and loans and advances to customers, as applicable.

35 Includes movement in impairment allowances against banks.

36 See table below 'Net loan impairment charge to the income statement by geographical region'.

37 Collectively assessed impairment allowances are allocated to geographical segments based on the location of the office booking the allowances or provisions. Consequently, the collectively assessed impairment allowances booked in Hong Kong may cover assets booked in branches located outside Hong Kong, principally in Rest of Asia-Pacific, as well as those booked in Hong Kong.

38 Total includes holdings of ABSs issued by Freddie Mac and Fannie Mae.

39 'Directly held' includes assets held by Solitaire where we provide first loss protection and assets held directly by the Group.

40 Impairment charges allocated to capital note holders represent impairments where losses would be borne by external third-party investors in the structures.

41 Mortgage-backed securities ('MBS's), asset-backed securities ('ABS's) and collateralised debt obligations ('CDO's).

42 High grade assets rated AA or AAA.

43 Gains or losses on the net principal exposure (footnote 49) recognised in the income statement as a result of changes in the fair value of the asset.

44 Fair value gains and losses on the net principal exposure (footnote 49) recognised in other comprehensive income as a result of the changes in the fair value of available-for-sale assets.

45 Realised fair value gains and losses on the net principal exposure (footnote 49) recognised in the income statement as a result of the disposal of assets or the receipt of cash flows from assets.

46 Reclassified from equity on impairment, disposal or payment. This includes impairment losses recognised in the income statement in respect of the net principal exposure (footnote 49) of available-for-sale assets. Payments are the contractual cash flows received on the assets.

47 The gross principal is the redemption amount on maturity or, in the case of an amortising instrument, the sum of the future redemption amounts through the residual life of the security.

48 A credit default swap ('CDS') gross protection is the gross principal of the underlying instrument that is protected by CDSs.

49 Net principal exposure is the gross principal amount of assets that are not protected by CDSs. It includes assets that benefit from monoline protection, except where this protection is purchased with a CDS.

50 Carrying amount of the net principal exposure.

51 Net exposure after legal netting and any other relevant credit mitigation prior to deduction of the credit risk adjustment.

52 Cumulative fair value adjustment recorded against exposures to OTC derivative counterparties to reflect their creditworthiness.

53 Funded exposures represent the loan amount advanced to the customer, less any fair value write-downs, net of fees held on deposit. Unfunded exposures represent the contractually committed loan facility amount not yet drawn down by the customer, less any fair value write-downs, net of fees held on deposit.

Liquidity and funding

54 2009 comparative data have been re-presented in line with the classification used in 2010. This resulted in an increase in the 'On demand' time band of US$273,078m for 'Loan and other credit-related commitments' and US$10,450m for 'Financial guarantees and similar contracts'. There was an equivalent reduction across the other time bands.

55 Figures provided for HSBC Bank plc and The Hongkong and Shanghai Banking Corporation incorporate all overseas branches. Subsidiaries of these entities are not included unless there is unrestricted transferability of liquidity between the subsidiaries and the parent.

56 This comprises our other main banking subsidiaries and, as such, includes businesses spread across a range of locations, in many of which we may require a higher ratio of net liquid assets to customer liabilities to reflect local market conditions.

57 Unused committed sources of secured funding for which eligible assets were held.

58 Client-originated asset exposures relate to consolidated multi-seller conduits (see page 363). These vehicles provide funding to our customers by issuing debt secured by a diversified pool of customer-originated assets.

59 HSBC-managed asset exposures relate to consolidated securities investment conduits, primarily Solitaire and Mazarin (see page 362). These vehicles issue debt secured by ABSs which are managed by HSBC. Of the total contingent liquidity risk under this category, US$8.1bn was already funded on-balance sheet at 31 December 2010 (2009: US$7.6bn) leaving a net contingent exposure of US$17.5bn (2009: US$21.5bn).

60 Other conduit exposures relate to third-party sponsored conduits (see page 364).

61 The five largest committed liquidity facilities provided to customers other than facilities to conduits.

62 The total of all committed liquidity facilities provided to the largest market sector, other than facilities to conduits.

Market risk

63 The structural foreign exchange risk is monitored using sensitivity analysis (see page 351). The reporting of commodity risk is consolidated with foreign exchange risk and is not applicable to non-trading portfolios.

64 The interest rate risk on the fixed-rate securities issued by HSBC Holdings is not included in the Group VAR. The management of this risk is described on page 148.

65 Credit spread sensitivity is reported separately for insurance operations (see page 165).

66 The standard deviation measures the variation of daily revenues about the mean value of those revenues.

67 The effect of any month-end adjustments, not attributable to a specific daily market move, is spread evenly over the days in the month in question.

68 Trading intent portfolios include positions arising from market-making and position taking.

69 Trading credit spread VAR was previously reported in the Group trading credit VAR. See page 148.

70 The total VAR is non-additive across risk types due to diversification effects. It incorporates credit spread VAR.

71 Investments in private equity are primarily made through managed funds that are subject to limits on the amount of investment. Potential new commitments are subject to risk appraisal to ensure that industry and geographical concentrations remain within acceptable levels for the portfolio as a whole. Regular reviews are performed to substantiate the valuation of the investments within the portfolio.

72 Investments held to facilitate ongoing business include holdings in government-sponsored enterprises and local stock exchanges.

73 Instead of assuming that all interest rates move together, HSBC groups its interest rate exposures into currency blocs whose rates are considered likely to move together.

Risk management of insurance operations

74 HSBC has no insurance manufacturing subsidiaries in the Middle East.

75 Insurance contracts and investment contracts with discretionary participation features ('DPF') can give policyholders the contractual right to receive, as a supplement to their guaranteed benefits, additional benefits that may be a significant portion of the total contractual benefits, but whose amount and timing are determined by HSBC. These additional benefits are contractually based on the performance of a specified pool of contracts or assets, or the profit of the company issuing the contracts.

76 Although investment contracts with DPF are financial investments, HSBC continues to account for them as insurance contracts as permitted by IFRS 4.

77 Net written insurance premiums represent gross written premiums less gross written premiums ceded to reinsurers.

78 Term assurance includes credit life insurance.

79 Other assets comprise shareholder assets.

80 Present value of in-force long-term insurance contracts and investment contracts with DPF.

81 Does not include associated insurance companies, Ping An Insurance, SABB Takaful Company and Bao Viet, or joint venture insurance companies, Hana Life and Canara HSBC Oriental Bank of Commerce Life Insurance Company Limited.

82 Does not include associated insurance companies, Ping An Insurance and SABB Takaful Company or joint venture insurance companies, Hana Life and Canara HSBC Oriental Bank of Commerce Life Insurance Company Limited.

83 Comprise life linked insurance contracts and linked long-term investment contracts.

84 Comprise life non-linked insurance contracts and non-linked long-term investment contracts.

85 Comprises non-life insurance contracts.

86 Comprise mainly loans and advances to banks, cash and intercompany balances with other non-insurance legal entities.

87 The table excludes contracts where the risk is 100% reinsured.

88 Impairment is not measured for debt securities held in trading portfolios or designated at fair value, as assets in such portfolios are managed according to movements in fair value, and the fair value movement is taken directly to the income statement. Consequently, we report all such balances under 'neither past due nor impaired'.

89 Shareholders' funds comprise solvency and unencumbered assets.

90 In most cases, policyholders have the option to terminate their contracts at any time and receive the surrender values of their policies. These may be significantly lower than the amounts shown above.

91 Value of net new business during the year is the present value of the projected stream of profits from the business.

92 Experience variances include the effect of the difference between demographic, expense and persistency assumptions used in the previous PVIF calculation and actual experience observed during the year.

Pension risk

93 In 2010, alternative assets included ABSs, MBSs and infrastructure assets. In 2006, alternative assets included loans and infrastructure assets.

Capital

Capital management

(Audited)

Our approach to capital management is driven by our strategic and organisational requirements, taking into account the regulatory, economic and commercial environment in which we operate.

It is our objective to maintain a strong capital base to support the development of our business and to meet regulatory capital requirements at all times. To achieve this, our policy is to hold capital in a range of different forms and from diverse sources, and all capital raising is agreed with major subsidiaries as part of their individual and the Group's overall capital management processes.

Our policy is underpinned by a capital management framework, which enables us to manage our capital in a consistent and aligned manner. The framework, which is approved by the GMB, incorporates a number of different capital measures including market capitalisation, invested capital, economic capital and regulatory capital.

Capital measures

· market capitalisation is the stock market value of the company;

· invested capital is the equity capital invested in HSBC by our shareholders;

· economic capital is the internally calculated capital requirement which we deem necessary to support the risks to which we are exposed at a confidence level consistent with a target credit rating of AA; and

· regulatory capital is the capital which we are required to hold in accordance with the rules established by the FSA for the consolidated Group and by our local regulators for individual Group companies.

The following risks managed through the capital management framework have been identified as material: credit, market, operational, interest rate risk in the banking book, pension fund, insurance and residual risks.

We incorporate stress testing in the capital management framework, and it is important in understanding the sensitivities of the core assumptions in our capital plans to the adverse effect of extreme, but plausible, events. Stress testing allows us to formulate our response, including risk mitigation actions, in advance of conditions starting to exhibit the stress scenarios identified. The actual market stresses which occurred throughout the financial system during recent years have been used

to inform our capital planning process and further develop the stress scenarios we employ.

In addition to our internal stress tests, others are carried out, both at the request of regulators and by the regulators themselves using their prescribed assumptions. We take into account the results of all such regulatory stress testing when undertaking our internal capital management assessment.

The responsibility for global capital allocation principles and decisions rests with the GMB. Through our structured internal governance processes, we maintain discipline over our investment and capital allocation decisions and seek to ensure that returns on investment are adequate after taking account of capital costs. Our strategy is to allocate capital to businesses on the basis of their economic profit generation, regulatory and economic capital requirements and cost of capital.

Our capital management process is articulated in the annual Group capital plan which is approved by the Board. The plan is drawn up with the objective of maintaining both an appropriate amount of capital and an optimal mix between the different components of capital. HSBC Holdings and its major subsidiaries raise non-equity tier 1 capital and subordinated debt in accordance with our guidelines on market and investor concentration, cost, market conditions, timing, effect on composition and maturity profile. Each of the subsidiaries manages its own capital to support its planned business growth and meet its local regulatory requirements within the context of the approved annual Group capital plan. In accordance with our capital management framework, capital generated by subsidiaries in excess of planned requirements is returned to HSBC Holdings, normally by way of dividends.

HSBC Holdings is the primary provider of capital to its subsidiaries and these investments are substantially funded by HSBC Holdings' own capital issuance and profit retention. As part of its capital management process, HSBC Holdings seeks to maintain a prudent balance between the composition of its capital and that of its investment in subsidiaries.

The tier 1 ratio (unaudited) increased to 12.1% at 31 December 2010 (2009: 10.8%). It is our belief that this enhanced ratio is appropriate in light of our current evolution of the regulatory framework.

Capital measurement and allocation

(Unaudited)

The FSA supervises HSBC on a consolidated basis and therefore receives information on the capital adequacy of, and sets capital requirements for, the Group as a whole. Individual banking subsidiaries are directly regulated by their local banking supervisors, who set and monitor their capital adequacy requirements.

We calculate capital at a Group level using the Basel II framework of the Basel Committee on Banking Supervision. However, local regulators are at different stages of implementation and local reporting may still be on a Basel I basis, notably in the US. In most jurisdictions, non-banking financial subsidiaries are also subject to the supervision and capital requirements of local regulatory authorities.

Basel II is structured around three 'pillars': minimum capital requirements, supervisory review process and market discipline. The Capital Requirements Directive ('CRD') implemented Basel II in the EU and the FSA then gave effect to the CRD by including the latter's requirements in its own rulebooks.

Regulatory capital

Our capital is divided into two tiers:

· tier 1 capital is divided into core tier 1 and other tier 1 capital. Core tier 1 capital comprises shareholders' equity and related non-controlling interests. The book values of goodwill and intangible assets are deducted from core tier 1 capital and other regulatory adjustments are made for items reflected in shareholders' equity which are treated differently for the purposes of capital adequacy. Qualifying capital instruments such as non-cumulative perpetual preference shares and hybrid capital securities are included in other tier 1 capital; and

· tier 2 capital comprises qualifying subordinated loan capital, related non-controlling interests, allowable collective impairment allowances and unrealised gains arising on the fair valuation of equity instruments held as available for sale. Tier 2 capital also includes reserves arising from the revaluation of properties.

To ensure the overall quality of the capital base, the FSA's rules set limits on the amount of hybrid capital instruments that can be included in tier 1 capital relative to core tier 1 capital, and also limits overall tier 2 capital to no more than tier 1 capital.

Regulatory and accounting consolidations

The basis of consolidation for financial accounting purposes is described on page 251 and differs from that used for regulatory purposes. Investments in banking associates are equity accounted in the financial accounting consolidation, whereas their exposures are proportionally consolidated for regulatory purposes. Subsidiaries and associates engaged in insurance and non-financial activities are excluded from the regulatory consolidation and are deducted from regulatory capital. The regulatory consolidation does not include SPEs where significant risk has been transferred to third parties. Exposures to these SPEs are risk-weighted as securitisation positions for regulatory purposes.

Pillar 1 capital requirements

Pillar 1 covers the capital resources requirements for credit risk, market risk and operational risk. Credit risk includes counterparty credit risk and securitisation requirements. These requirements are expressed in terms of risk-weighted assets ('RWA's).

Credit risk capital requirements

Basel II applies three approaches of increasing sophistication to the calculation of pillar 1 credit risk capital requirements. The most basic, the standardised approach, requires banks to use external credit ratings to determine the risk weightings applied to rated counterparties and group other counterparties into broad categories and apply standardised risk weightings to these categories. The next level, the internal ratings-based ('IRB') foundation approach, allows banks to calculate their credit risk capital requirements on the basis of their internal assessment of the probability that a counterparty will default ('PD'), but subjects their quantified estimates of exposure at default ('EAD') and loss given default ('LGD') to standard supervisory parameters. Finally, the IRB advanced approach allows banks to use their own internal assessment in both determining PD and quantifying EAD and LGD.

The capital resources requirement, which is intended to cover unexpected losses, is derived from a formula specified in the regulatory rules, which incorporates these factors and other variables such as maturity and correlation. Expected losses under the IRB approaches are calculated by multiplying PD by EAD and LGD. Expected losses are deducted from capital to the extent that they exceed accounting impairment allowances.

For credit risk, with the FSA's approval, we have adopted the IRB advanced approach for the majority of our business, with the remainder on either IRB foundation or standardised approaches.

For consolidated group reporting, the FSA's rules permit the use of other regulators' standardised approaches where they are considered equivalent. The use of other regulators' IRB approaches is subject to the agreement of the FSA. Under our Basel II rollout plans, a number of our Group companies and portfolios are in transition to advanced IRB approaches. At December 2010, portfolios in much of Europe, Hong Kong, Rest of Asia-Pacific and North America were on advanced IRB approaches. Others remain on the standardised or foundation approaches under Basel II, pending definition of local regulations or model approval, or under exemptions from IRB treatment.

Counterparty credit risk

Counterparty credit risk arises for OTC derivatives and securities financing transactions. It is calculated in both the trading and non-trading books and is the risk that the counterparty to a transaction may default before completing the satisfactory settlement of the transaction. Three approaches to calculating counterparty credit risk and determining exposure values are defined by Basel II: standardised, mark-to-market and internal model method. These exposure values are used to determine capital requirements under one of the credit risk approaches: standardised, IRB foundation and IRB advanced.

We use the mark-to-market and internal model method approaches for counterparty credit risk. Our longer-term aim is to migrate more positions from the mark-to-market to the internal model method approach.

Securitisation

Basel II specifies two methods for calculating credit risk requirements for securitisation positions in the non-trading book, being the standardised and IRB approaches. Both approaches rely on the mapping of rating agency credit ratings to risk weights, which range between 7% and 1,250%. Positions that would otherwise be weighted at 1,250% are deducted from capital.

Within the IRB approach, we use the Ratings Based Method for the majority of our non-trading book securitisation positions, and the Internal Assessment Approach for unrated liquidity facilities and programme-wide enhancements for asset-backed securitisations. We use the IRB approach for the majority of our non-trading book securitisation positions, while those in the trading book are treated like other market risk positions.

Market risk capital requirement

The market risk capital requirement is measured, with FSA permission, using VAR models, or the standard rules prescribed by the FSA.

We use both VAR and standard rules approaches for market risk. Our aim is to migrate more positions from standard rules to VAR.

Operational risk capital requirement

Basel II includes a capital requirement for operational risk, again utilising three levels of sophistication. The capital required under the basic indicator approach is a simple percentage of gross revenues, whereas under the standardised approach it is one of three different percentages of gross revenues allocated to each of eight defined business lines. Both these approaches use an average of the last three financial years' revenues. Finally, the advanced measurement approach uses banks' own statistical analysis and modelling of operational risk data to determine capital requirements.

We have adopted the standardised approach in determining our operational risk capital requirements.

Pillar 2 capital requirements

The second pillar of Basel II (Supervisory Review and Evaluation Process) involves both firms and regulators taking a view on whether a firm should hold additional capital against risks not covered in pillar 1. Part of the pillar 2 process is the Internal Capital Adequacy Assessment Process which is the firm's self assessment of the levels of capital that it needs to hold. The pillar 2 process culminates in the FSA providing firms with Individual Capital Guidance ('ICG'). The ICG is set as a capital resources requirement higher than that required under pillar 1. In 2011, this will be supplemented by an additional Capital Planning Buffer, set by the FSA, to cover capital demand should economic conditions worsen considerably against the current outlook.

Pillar 3 disclosure requirements

Pillar 3 of Basel II is related to market discipline and aims to make firms more transparent by requiring them to publish specific, prescribed details of their risks, capital and risk management under the Basel II framework. Our pillar 3 disclosures for the year ended 31 December 2010 are published as a separate document on the Group Investor Relations website.

Capital structure at 31 December

	2010	2009
	US$m	US$m
Composition of regulatory capital
(Audited)
Tier 1 capital
Shareholders' equity ................................................................................................................	142,746	135,252
Shareholders' equity per balance sheet¹ ................................................................................	147,667	128,299
Preference share premium ...................................................................................................	(1,405)	(1,405)
Other equity instruments .....................................................................................................	(5,851)	(2,133)
Deconsolidation of special purpose entities² ........................................................................	2,335	10,491

Non-controlling interests ........................................................................................................	3,917	3,932
Non-controlling interest per balance sheet ..........................................................................	7,248	7,362
Preference share non-controlling interests ..........................................................................	(2,426)	(2,395)
Non-controlling interest transferred to tier 2 capital ...........................................................	(501)	(678)
Non-controlling interest in deconsolidated subsidiaries .........................................................	(404)	(357)

Regulatory adjustments to the accounting basis .......................................................................	1,794	164
Unrealised losses on available-for-sale debt securities³ ..........................................................	3,843	906
Own credit spread ................................................................................................................	(889)	(1,050)
Defined benefit pension fund adjustment⁴ ............................................................................	1,676	2,508
Reserves arising from revaluation of property and unrealised gains on available-for-sale equities .................................................................................................	(3,121)	(2,226)
Cash flow hedging reserve ....................................................................................................	285	26

Deductions ..............................................................................................................................	(32,341)	(33,088)
Goodwill capitalised and intangible assets .............................................................................	(28,001)	(28,680)
50% of securitisation positions ............................................................................................	(1,467)	(1,579)
50% of tax credit adjustment for expected losses .................................................................	241	546
50% of excess of expected losses over impairment allowances ............................................	(3,114)	(3,375)

Core tier 1 capital ...............................................................................................................	116,116	106,260

Other tier 1 capital before deductions ......................................................................................	17,926	15,798
Preference share premium ...................................................................................................	1,405	1,405
Preference share non-controlling interests ..........................................................................	2,426	2,395
Hybrid capital securities .......................................................................................................	14,095	11,998

Deductions ..............................................................................................................................	(863)	99
Unconsolidated investments⁵ ...............................................................................................	(1,104)	(447)
50% of tax credit adjustment for expected losses .................................................................	241	546

Tier 1 capital ........................................................................................................................	133,179	122,157

Tier 2 capital
Total qualifying tier 2 capital before deductions ......................................................................	52,713	50,075
Reserves arising from revaluation of property and unrealised gains on available-for-sale equities .................................................................................................	3,121	2,226
Collective impairment allowances⁶ ......................................................................................	3,109	4,120
Perpetual subordinated debt .................................................................................................	2,781	2,987
Term subordinated debt .......................................................................................................	43,402	40,442
Non-controlling interest in tier 2 capital .............................................................................	300	300

Total deductions other than from tier 1 capital .......................................................................	(18,337)	(16,503)
Unconsolidated investments⁵ ...............................................................................................	(13,744)	(11,547)
50% of securitisation positions ............................................................................................	(1,467)	(1,579)
50% of excess of expected losses over impairment allowances ............................................	(3,114)	(3,375)
Other deductions .................................................................................................................	(12)	(2)


Total regulatory capital ......................................................................................................	167,555	155,729

Risk-weighted assets
(Unaudited)
Credit risk ...............................................................................................................................	890,696	903,518
Counterparty credit risk ..........................................................................................................	50,175	51,892
Market risk .............................................................................................................................	38,679	51,860
Operational risk ......................................................................................................................	123,563	125,898

Total ......................................................................................................................................	1,103,113	1,133,168

	2010	2009
	%	%
Capital ratios
(Unaudited)
Core tier 1 ratio ......................................................................................................................	10.5	9.4
Tier 1 ratio .............................................................................................................................	12.1	10.8
Total capital ratio ...................................................................................................................	15.2	13.7

For footnotes, see page 182.

Source and application of tier 1 capital

	2010 US$m	2009 US$m
Movement in tier 1 capital
(Audited)
Opening tier 1 capital .............................................................................................................	122,157	95,336
Contribution to tier 1 capital from profit for the year .........................................................	13,218	10,247
Consolidated profits attributable to shareholders of the parent company .............................	13,159	5,834
Removal of own credit spread net of tax .............................................................................	59	4,413

Net dividends ..........................................................................................................................	(3,827)	(3,969)
Dividends ............................................................................................................................	(6,350)	(5,639)
Add back: shares issued in lieu of dividends ...........................................................................	2,523	1,670

Decrease/(increase) in goodwill and intangible assets deducted ..................................................	679	(1,819)
Ordinary shares issued .............................................................................................................	180	18,399
Rights issue (net of expenses)⁷ .............................................................................................	-	18,326
Other ..................................................................................................................................	180	73
Hybrid capital securities issued net of redemptions ..................................................................	2,368	-
Foreign currency translation differences ..................................................................................	(526)	4,837
Other ......................................................................................................................................	(1,070)	(874)

Closing tier 1 capital ...............................................................................................................	133,179	122,157

Movement in risk-weighted assets
(Unaudited)
At 1 January ...........................................................................................................................	1,133,168	1,147,974
Movements .............................................................................................................................	(30,055)	(14,806)

At 31 December ......................................................................................................................	1,103,113	1,133,168

For footnotes, see page 182.

Movement in tier 1 capital

(Audited)

HSBC complied with the FSA's capital adequacy requirements throughout 2010 and 2009. Profits attributable to shareholders of the parent company increased capital by US$13.2bn, offset by net dividends of US$3.8bn after taking account of shares issued in lieu of dividends. Hybrid capital securities issued, net of redemptions, increased tier 1 capital by US$2.4bn.

Movement in risk-weighted assets

(Unaudited)

RWAs decreased by US$30.1bn or 3% in 2010. Of this reduction, US$12.8bn was due to credit risk, reflecting decreases in North America and Europe offset by increases in Asia and Latin America. There has been a decline in some North American retail portfolio exposures as a result of run off. However, the deterioration in the US economy and housing market in recent years has resulted in increases in the average risk weighting applicable to those portfolios as we progressively captured the effects of these events within the various Basel II model parameters. Market risk RWAs decreased by US$13.2bn, primarily due to reduced market volatility and continuing exposure management.

Future developments

(Unaudited)

The regulation and supervision of financial institutions continues to undergo significant change in response to the global financial crisis. In December 2010, the Basel Committee issued final rules in two documents: A global regulatory framework for more resilient banks and banking systems and International framework for liquidity risk measurement, standards and monitoring, which together are commonly referred to as 'Basel III'. The new minimum capital requirements will be phased in from 1 January 2013, with full implementation required by 1 January 2019. The minimum common

equity tier 1 requirement of 4.5% and additional capital conservation buffer requirement of 2.5% will be phased in sequentially from 1 January 2013, becoming fully effective on 1 January 2019. Any additional countercyclical capital buffer requirements will also be phased in, starting in 2016, in parallel with the capital conservation buffer to a maximum level of 2.5% effective on 1 January 2019, although individual jurisdictions may choose to implement larger countercyclical capital buffers. The leverage ratio will be subject to a supervisory monitoring period, which commenced on 1 January 2011, and a parallel run period which will run from 1 January 2013 until 1 January 2017. Further calibration of the leverage ratio will be carried out in the first half of 2017, with a view to migrating to a pillar 1 requirement from 1 January 2018. The Basel Committee has increased the capital requirements for the trading book and complex securitisation exposures which are due to be implemented on 31 December 2011. They will continue to conduct the fundamental review of the trading book, which is targeted for completion by the end of 2011. In addition to the reforms discussed above, institutions designated as G-SIFIs may be subjected to additional requirements, which have yet to be proposed by regulators. The Basel Committee will provide the approach to defining G‑SIFIs by the end of 2011. On 13 January 2011, the Basel Committee issued further minimum requirements to ensure that all classes of capital instruments fully absorb losses at the point of non-viability before taxpayers are exposed to loss. Instruments issued on or after 1 January 2013 may only be included in regulatory capital if the new requirements are met. The capital treatment of securities issued prior to this date will be phased out over a 10-year period commencing 1 January 2013.

Impact of Basel III

(Unaudited)

In order to provide some insight into the possible effects of the new Basel III rules on HSBC, we have estimated the pro forma common equity tier 1 ratio of the Group on the basis of our interpretation of those rules, as they would apply at 1 January 2019, but based on the position at 31 December 2010.

We have estimated that the application of the full Basel III rules on a pro forma basis would result in a common equity tier 1 ratio which is lower than the Basel II core tier 1 ratio by some 250-300 basis points. However, as the new rules will be phased in between 1 January 2013 and 1 January 2019, their impact will be gradual over that period. This estimate does not, however, take account of any future retained earnings, nor any management actions to reduce RWAs. The Basel III changes relate to increased capital deductions, new regulatory adjustments and increases in RWAs. The majority of the increase in RWAs relates to Basel III changes which are scheduled to come into effect on 1 January 2013, in particular to changes to counterparty credit risk capital charges and amounts for securitisation positions that were previously deducted from capital that will now be risk-weighted instead. Other increases in RWAs will begin to be phased in from 1 January 2014, including the majority of the unconsolidated investments that were previously deducted from capital. The remainder of the RWA increase arises from increases in trading book capital requirements which take effect on 31 December 2011, primarily relating to changes in market risk.

The estimated impact of Basel III is subject to change as regulators develop their requirements around the practical application and interpretation of the new rules, in particular the counterparty credit risk capital charge. Further uncertainty remains regarding any capital requirements which may be imposed on the Group over the period to 1 January 2019 in respect of the countercyclical capital buffer and any additional regulatory requirements for G‑SIFIs. Under the Basel III rules as they will apply from 1 January 2019, we believe that ultimately the level for the common equity tier 1 ratio of the Group may lie in the range 9.5% to 10.5%. This exceeds the minimum requirement for common equity tier 1 capital plus the capital conservation buffer. HSBC has a strong track record of capital generation and actively manages its RWAs. Before these new rules come into force, we will take appropriate management action over the implementation period to 1 January 2019 to reduce the quantum of increase in RWAs that would have occurred if the new rules had been in effect at 31 December 2010.

Footnotes to Capital

1 Includes externally verified profits for the year to 31 December 2010.

2 Mainly comprises unrealised losses on available-for-sale debt securities within special purpose entities which are excluded from the regulatory consolidation.

3 Under FSA rules, unrealised gains/losses on debt securities net of tax must be excluded from capital resources.

4 Under FSA rules, the defined benefit liability may be substituted with the additional funding that will be paid into the relevant schemes over the following five year period.

5 Mainly comprise investments in insurance entities.

6 Under FSA rules, collective impairment allowances on loan portfolios on the standardised approach are included in tier 2 capital.

7 Rights issue excludes US$493m of losses arising on derivative contracts and certain fees, which are recognised in the income statement.

This information is provided by RNS

The company news service from the London Stock Exchange

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Annual Financial Report - 25 of 41

(Audited)

Life insurance business

Non-life insurance business

Nature and extent of risks

Insurance risk

Europe

Hong Kong

Rest of Asia- Pacific

North America

Latin America

Total

US$m

Investment contracts with DPF75,76 .............

Investment contracts with DPF75,76 .............

Analysis of non-life insurance risk - net written insurance premiums74,77

Europe

Hong Kong

Rest of Asia- Pacific

North America

Latin America

Total

US$m

Unit-

Other

US$m

US$m

Total assets .............

Total liabilities ........

Unit-

Other

US$m

US$m

Total assets ....................

Total liabilities ...............

Hong Kong

Rest of Asia- Pacific

North America

Latin America

Total

US$m

Hong Kong

Rest of Asia- Pacific

North America

Latin America

Total

US$m

Life linked

Trading assets

Financial assets designated at fair value.....

Financial investments

Held-to-maturity:

Available-for-sale: ...................................

Derivatives ..............................................

Other financial assets86 ............................

Total financial assets81 ............................

Trading assets

Financial assets designated at fair value ....

Financial investments

Held-to-maturity:

Available-for-sale: ...................................

Derivatives ..............................................

Other financial assets86 ............................

Total financial assets82 ............................

Credit risk

Credit quality

Neither past due nor impaired

Neither past due nor impaired

Treasury

Debt

securities

Total

Liquidity risk

(Audited)

Within 1 year

At 31 December 2010

Non-life insurance ...................................

Total81 ....................................................

At 31 December 2009

Non-life insurance ...................................

North
America

Latin
America

Investment contracts with DPF^75,76 .............

Investment contracts with DPF^75,76 .............

Analysis of non-life insurance risk - net written insurance premiums^74,77

North
America

Latin
America

Hong
Kong

Rest of
Asia- Pacific

North
America

Latin
America

Hong
Kong

Rest of
Asia- Pacific

North
America

Latin
America

Other financial assets⁸⁶ ............................

Total financial assets⁸¹ ............................

Other financial assets⁸⁶ ............................

Total financial assets⁸² ............................

Total⁸¹ ....................................................

Total⁸² ....................................................

PVIF
included in
total equity

PVIF
included in
total equity