L&G Full Year Results 2015 Part 3

RNS Number : 0691S

Legal & General Group Plc

15 March 2016

Legal & General Group Plc

Full Year Results 2015 Part 3

Capital and Investments 65

4.01 Group regulatory capital - Insurance Groups Directive (IGD)


The group is required to measure and monitor its capital resources on a regulatory basis and to comply with the minimum capital requirements of regulators in each territory in which it operates. At a group level, Legal & General had to comply with the requirements of the European Insurance Groups Directive (IGD) at the balance sheet date. The table below shows the total group capital resources, group capital resources requirement and the group surplus on an IGD basis. These results are not audited.

	2015	2014
	£bn	£bn


Core tier 1 capital	7.0	6.4
Innovative tier 1 capital	0.6	0.6
Tier 2 capital¹	1.8	1.7
Deductions	(1.2)	(1.0)


Group capital resources	8.2	7.7


Group capital resources requirement²	3.8	3.8


IGD surplus	4.4	3.9


Group capital resources requirement coverage ratio³	217%	201%


1. The group redeemed €0.6bn Euro subordinated notes in June 2015 and issued £0.6bn subordinated notes in October 2015, both constituting Lower Tier 2 capital.
2. Group capital resources requirement includes a With-profits Insurance Capital Component (WPICC) of £0.4bn (2014: £0.4bn).
3. Coverage ratio is calculated on unrounded values.

A reconciliation of the capital and reserves attributable to the equity holders of the company on an IFRS basis to the group capital resources on an IGD basis is given below.


	2015	2014
	£bn	£bn


Capital and reserves attributable to equity holders on an IFRS basis	6.4	6.0
Innovative tier 1 capital	0.6	0.6
Tier 2 capital	1.8	1.7
Unallocated divisible surplus (UK only)	0.9	0.7
Proposed dividends	(0.6)	(0.5)
Intangibles	(0.4)	(0.4)
Other regulatory adjustments¹	(0.5)	(0.4)


Group capital resources	8.2	7.7


1. Other regulatory adjustments include differences between accounting and regulatory bases.

The table below demonstrates how the group's net cash generation reconciles to the IGD capital surplus position.

						2015
						£bn


IGD surplus at 1 January						3.9
Net cash generation						1.3
Dividends						(0.8)
New business capital deployed						(0.2)
Existing business capital release						0.2
Repayment of Euro subordinated debt						(0.5)
New Sterling subordinated debt issued						0.6
Other variances and regulatory adjustments						(0.1)


IGD surplus at 31 December¹						4.4


1. All IGD amounts are estimated, unaudited and after accrual of the 2015 final dividend of £592m (2014: £496m).

Capital and Investments 66

4.02 Group regulatory capital - Solvency II Directive

From 1 January 2016, the group is required to measure and monitor its capital resources on a new regulatory basis and to comply with the requirements established by the Solvency II Framework Directive, as adopted by the Prudential Regulation Authority (PRA) in the UK.

In December 2015, the group received approval to calculate its Solvency II capital requirements using a Partial Internal Model. The vast majority of the risk to which the group is exposed is assessed on the Internal Model basis approved by the PRA. Capital requirements for a handful of smaller entities are assessed using the Standard Formula basis on materiality grounds. The group's US insurance businesses are valued on a local statutory basis, following the PRA's approval of the group's application to use the Deduction and Aggregation method of including these businesses in the group solvency calculation.

The tables below show the estimated Group Eligible own funds, Solvency Capital Requirement (SCR) and Surplus own funds based on the Internal Model, Matching Adjustment and Transitional Measures on Technical Provisions (TMTP) approved by the PRA in December 2015.

(a) Capital position

As at 31 December 2015 the group had a Solvency II surplus of £5.5bn over its Solvency Capital Requirement, corresponding to a coverage ratio of 169%. The Solvency II capital position is as follows:
					2015
					£bn


Eligible own funds¹					13.5
Solvency capital requirement (SCR)					8.0
Solvency capital requirement (SCR)

Surplus					5.5


SCR coverage ratio²					169%


1. Eligible own funds do not include an accrual for the 2015 final dividend of £592m declared in 2016.
2. Coverage ratio is calculated on unrounded values.

The Solvency II results are estimated and unaudited. Further explanation of the underlying methodology and assumptions is set out in the sections below.

(b) Methodology

Eligible own funds comprise the excess of the value of assets over the liabilities, as valued on a Solvency II basis. Subordinated debt issued by the group is considered to be part of available capital, rather than a liability, as it is subordinate to policyholder claims. Eligible own funds includes deductions in relation to fungibility and transferability restrictions, where the surplus own funds of a specific group entity cannot be freely transferred around the group due to local legal or regulatory constraints.

Assets are valued at IFRS fair value with adjustments to remove intangibles, deferred acquisition costs and to value reassurers' share of technical provisions on a basis consistent with the liabilities on the Solvency II Balance Sheet. The economic value of assets which are excluded from the IFRS Balance Sheet is also included.

Liabilities are valued on a best estimate market consistent basis, with the application of a Solvency II Matching Adjustment for valuing annuity liabilities and include recognition of the benefit relating to the TMTP for firms moving from the Solvency I to the Solvency II regime. The TMTP has been calculated on a basis approved by the PRA which seeks to encapsulate the difference between the total Financial Resources Requirement under the previous Solvency I regime and the new Solvency II regime as at 31 December 2015.

The liabilities include the Risk Margin which represents allowance for the cost of capital for a purchasing insurer taking on the portfolio of liabilities and residual risks that are deemed to be not hedgeable under Solvency II, following the 1-in-200 stress event. This is calculated using a cost of capital of 6% as prescribed by EIOPA.

The Solvency Capital Requirement is the amount of capital required to cover the 1-in-200 worst projected future outcome in the year following the valuation, allowing for realistic management and policyholder actions and the impact of the stress on the tax position of the group. This allows for diversification between the different firms within the group and between the risks to which they are exposed.

All material EEA insurance firms, including Legal & General Assurance Society, Legal & General Insurance, and Legal & General Pensions Management Company (PMC) (LGIM's insurance subsidiary) are incorporated into the group's Solvency II Internal Model assessment of required capital, assuming diversification of the risks between and within those firms. These firms contribute over 95% of the group SCR.

Firms which are not regulated but which carry material risks to group solvency are modelled in the Internal Model on the basis of applying an appropriate stress to their net asset value.

Firms for which the capital requirements are less material, for example Legal & General Netherlands, are valued on a Solvency II Standard Formula basis.

Capital and Investments 67

4.02 Group regulatory capital - Solvency II Directive (continued)

(b) Methodology (continued)

Legal & General America's Banner Life and its subsidiaries are incorporated into the calculation of group solvency using a Deduction and Aggregation basis. All risk exposure in these firms is valued on a local statutory basis, with capital requirements set to a multiple of local statutory Risk Based Capital (RBC) and further restrictions on the surplus contribution to the group. The US regulatory regime is considered to be equivalent to Solvency II by the European Commission. The contribution to group SCR is 150% of the local RBC Capital Adequacy Level (CAL). The contribution to Eligible own funds is the SCR together with any surplus capital in excess of 250% of RBC CAL.

All non-insurance regulated firms are included using their current regulatory surplus, allowing for any restrictions on fungibility or transferability, without allowing for any diversification with the rest of the group.

Allowance is made within the Solvency II Balance Sheet for the group's defined benefit pension scheme using results on the IFRS basis. Allowance is made within the SCR by stressing the IFRS result position using the same Internal Model basis as for the insurance firms.

The calculation of the Solvency II Balance Sheet and associated capital requirement requires a number of assumptions, including:

(i) assumptions required to derive the present value of best estimate liability cash flows. Non market assumptions are broadly the same as those used to derive the group's EEV disclosures. Future investment returns and discount rates are those defined by EIOPA, which means that the risk-free rates used to discount liabilities are market swap rates, with a 12 basis point deduction to allow for a credit risk adjustment. For annuities that are eligible, the liability discount rate includes a Matching Adjustment;

(ii) assumptions regarding management actions and policyholder behaviour across the full range of scenarios. The only management actions allowed for are those that have been approved by the Board and are in place at the balance sheet date;

(iii) assumptions regarding the volatility of the risks to which the group is exposed are used to calculate the Solvency Capital Requirement. Assumptions have been set using a combination of historic market, demographic and operating experience data. In areas where data is not considered robust, expert judgement has been used; and

(iv) assumptions on the dependencies between risks, which are calibrated using a combination of historic data and expert judgement.

(d) Reconciliation of IFRS Shareholders' equity to Solvency II Eligible own funds

The table below gives a reconciliation of the group's IFRS shareholders' equity to the Eligible own funds on a Solvency II basis.


					2015
					£bn


IFRS Shareholders' equity at 31 December					6.4
Remove DAC, goodwill and other intangible assets and liabilities					(2.0)
Add subordinated debt treated as economic available capital¹					2.5
Insurance contract valuation differences²					7.5
Add value of shareholder transfers					0.2
Increase in value of net deferred tax liabilities (resulting from valuation differences)					(0.5)
Other					(0.2)
Adjustment - Basic own funds to Eligible own funds³					(0.4)


Eligible own funds at 31 December					13.5


1. Treated as available capital on the Solvency II Balance Sheet as the liabilities are subordinate to policyholder claims. 2. Differences in the measurement of liabilities between IFRS and Solvency II, offset by the inclusion of the Risk Margin net of Transitional Measures on Technical Provisions (TMTP). 3. Eligibility restrictions relating to the own funds of non-insurance regulated entities. The figures that appear in this note are all pre-accrual for the 2015 final dividend of £592m, declared in 2016.

Capital and Investments 68

4.02 Group regulatory capital - Solvency II Directive (continued)
(e) Sensitivity analysis The following sensitivities are provided to give an indication of how the group's Solvency II surplus as at 31 December 2015 would have changed in a variety of adverse events. These are all independent stresses to a single risk. In practice the balance sheet is impacted by combinations of stresses and the combined impact can be larger than adding together the impacts of the same stresses in isolation. It is expected that, particularly for market risks, adverse stresses will happen together.

	Impact on	Impact on
	net of tax	Solvency II
	capital	coverage
	surplus	ratio
	2015	2015
	£bn	%


Credit spreads widen by 100bps using the same 100bps addition to all ratings¹	(0.3)	(1)
Credit spreads widen by 100bps assuming an escalating addition to ratings^1,2	(0.6)	(8)
Credit spreads tighten by 100bps using the same 100bps deduction to all ratings¹	0.2	1
Credit spreads tighten by 100bps assuming an escalating deduction to ratings^1,2	0.6	7
A worsening in our expectation of future default and downgrade to 115% of our assumed best estimate level	(0.5)	(11)
20% fall in equity markets	(0.4)	(4)
40% fall in equity markets	(0.7)	(8)
20% rise in equity markets	0.5	5
15% fall in property markets	(0.3)	(3)
100bps increase in risk free rates³	0.6	19
100bps fall in risk free rates³	(0.4)	(11)
1% reduction in annuitant base mortality	(0.1)	(2)
1% increase in annuitant base mortality	0.1	2

1. All spread sensitivities apply to Legal & General's corporate bond (and similar) holdings, with no change in the firm's long term default expectations. 2. The stress for AA bonds is twice that for AAA bonds, for A bonds it is three times, for BBB four times and so on, such that the weighted average spread stress for the portfolio is 100bps. 3. Interest rate sensitivities allow (on an approximate basis) for the recalculation of TMTP.
The above sensitivity analysis does not reflect all management actions which could be taken to reduce the impacts. In practice, the group actively manages its asset and liability positions to respond to market movements. The impacts of these stresses are not linear therefore these results should not be used to extrapolate the impact of a smaller or larger stress. The results of these tests are indicative of the market conditions prevailing at the balance sheet date. The results would be different if performed at an alternative reporting date.

Capital and Investments 69

4.02 Group regulatory capital - Solvency II Directive (continued)
(f) Analysis of Group Solvency Capital Requirement
The table below shows a breakdown of the group's SCR by risk type. The split is shown after the effects of diversification.

					2015
					%


Interest Rate					4
Equity					11
Property					5
Credit¹					48
Currency					3
Inflation					2
Total Market Risk²					73
Counterparty Risk					1
Life Mortality					-
Life Longevity³					11
Life Lapse					1
Life Catastrophe					2
Non-life underwriting					1
Health underwriting					-
Expense					-
Total Insurance Risk					15
Operational Risk					5
Miscellaneous⁴					6


Total SCR					100


1. Credit risk is Legal & General's most significant exposure, arising predominantly from the c£40bn portfolio of bonds and bond-like assets backing the group's annuity business. 2. In addition to credit risk the group also has significant exposure to other market risks, primarily due to the investment holdings within the shareholder funds but also the risk to fee income from assets backing unit linked and with-profit Savings business. 3. Longevity risk is Legal & General's most significant insurance risk exposure, arising from the annuity book on which the majority of the longevity risk is retained. 4. Miscellaneous includes the SCR for the pension scheme, LGA on a Deduction and Aggregation basis and the sectoral capital requirements for non-insurance regulated firms.

Capital and Investments 70

4.03 Group Economic Capital

Legal & General defines Economic Capital to be the amount of capital that the Board believes the group needs to hold, over and above its liabilities, in order to meet its strategic objectives. This is not the same as regulatory capital which reflects regulatory rules and constraints. The group's objectives include being able to meet its liabilities as they fall due whilst maintaining the confidence of our investors, rating agencies, customers and intermediaries.

Legal & General maintains a risk based capital model that is used to calculate the group's Economic Capital Balance Sheet and support the management of risk within the group. This modelling framework, suitably adjusted for regulatory constraints, also meets the needs of the Solvency II regime. Our Economic Capital model has not been reviewed by the Prudential Regulatory Authority (PRA), nor will it be.

Solvency II has elements which are considered to be inconsistent with the group's definition of economic capital, so there are differences between the two balance sheets. A reconciliation between the two bases is provided in section 4.03(h).

(a) Capital position

As at 31 December 2015 the group had an economic capital surplus of £7.6bn (2014: £7.0bn), corresponding to an economic capital coverage ratio of 230% (2014: 229%). The economic capital position is as follows:
	2015	2014
	£bn	£bn


Eligible own funds¹	13.5	12.5
Economic capital requirement	5.9	5.5


Surplus	7.6	7.0


1-in-200 coverage ratio²	230%	229%


1. Eligible own funds do not include an accrual for the 2015 final dividend of £592m (2014: £496m) declared after the balance sheet date.
2. Coverage ratio is calculated on unrounded values.

Further explanation of the underlying methodology and assumptions is set out in the sections below.

(b) Methodology

Eligible own funds are defined to be the excess of the value of assets over the liabilities. Subordinated debt issued by the group is considered to be part of available capital, rather than a liability, as it is subordinate to policyholder claims.

Assets are valued at IFRS fair value with adjustments to remove intangibles, deferred acquisition costs and to value reassurers' share of technical provisions on a basis consistent with the liabilities on the Economic Capital Balance Sheet. The economic value of assets excluded from the IFRS Balance Sheet is also included.

Liabilities are valued on a best estimate market consistent basis, with the application of an Economic Matching Adjustment for valuing annuity liabilities.

The Economic Capital Requirement is the amount of capital required to cover the 1-in-200 worst projected future outcome in the year following the valuation, allowing for realistic management and policyholder actions and the impact of the stress on the tax position of the group. This allows for diversification between the different firms within the group and between the risks that they are exposed to.

The liabilities include a Recapitalisation Cost to allow for the cost of recapitalising the balance sheet following the 1-in-200 stress in order to maintain confidence that our future liabilities will be met. This is calculated using a cost of capital that reflects the long term average rates at which it is expected that the group could raise debt and allowing for diversification between all group entities.

All material insurance firms, including Legal & General Assurance Society, Legal & General Insurance, Legal & General Pensions Management Company (PMC) (LGIM's insurance subsidiary) and Legal & General America (LGA) are incorporated into the group's Economic Capital model assessment of required capital, assuming diversification of the risks between those firms.

Firms for which the capital requirements are less material, for example Legal & General Netherlands, are valued on the Solvency II Standard Formula basis. Non-insurance firms are included using their current regulatory surplus, without allowing for any diversification with the rest of the group.

Allowance is made within the Economic Capital Balance Sheet for the group's defined benefit pension scheme based upon the scheme's funding basis, and allowance is made within the capital requirement by stressing the funding position using the same economic capital basis as for the insurance firms.

The results and the model are unaudited but certain elements of the methodology, assumptions and processes have been reviewed by PwC.

Capital and Investments 71

4.03 Group Economic Capital (continued)

The calculation of the Economic Capital Balance Sheet and associated capital requirement requires a number of assumptions, including:

(i) assumptions required to derive the present value of best estimate liability cash flows. Non market assumptions are broadly the same as those used to derive the group's EEV disclosures. Future investment returns and discount rates are based on market data where a deep and liquid market exists or using appropriate estimation techniques where this is not the case. The risk-free rates used to discount liabilities are market swap rates, with a 12 basis point deduction to allow for a credit risk adjustment. For annuities the liability discount rate includes an Economic Matching Adjustment;

(iii) assumptions regarding the volatility of the risks to which the group is exposed are used to calculate Economic Capital Requirement. Assumptions have been set using a combination of historic market, demographic and operating experience data. In areas where data is not considered robust, expert judgement has been used; and

(iv) assumptions on the dependencies between risks, which are calibrated using a combination of historic data and expert judgement.

For annuities the liability discount rate includes an Economic Matching Adjustment. The Economic Matching Adjustment is derived using the same approach as the Solvency II matching adjustment, but any constraints we consider economically artificial, such as capping the yield on assets with a credit rating below BBB and any ineligibility of certain assets and liabilities, have not been applied.

The other key assumption relating to the annuity business is the assumption of longevity. As for IFRS and EEV, Legal & General models base mortality and future improvement of mortality separately. For our Economic Capital assessment we believe it is appropriate to ensure that the balance sheet makes sufficient allowance to meet the 1 in 200 stress to longevity over the run off of the liabilities rather than just over a 1 year timeframe as required by Solvency II.

(d) Analysis of change

The table below shows the movement (net of tax) during the financial year in the group's Economic Capital surplus.


								Economic
								Capital
								surplus
								2015
Analysis of movement from 1 January to 31 December 2015								£bn


Economic solvency position as at 1 January 2015								7.0
Operating experience expected release¹								0.8
Operating experience new business								0.1
Other capital movements²								0.3
New Sterling subordinated debt issuance								0.6
Repayment of Euro subordinated debt								(0.5)
Dividends paid in the period								(0.7)
Economic solvency position as at 31 December 2015								7.6


1. Release of surplus generated by in-force business.
2. Other capital movements comprise model and assumption changes, changes in asset mix across the group (with corresponding increase in Economic Capital Requirement) and other market movements.

Capital and Investments 72

4.03 Group Economic Capital (continued)
(e) Reconciliation of IFRS Shareholders' equity to Economic Capital Eligible own funds

The table below gives a reconciliation of the group's IFRS Shareholders' equity to the Eligible own funds on an Economic Capital basis.


	2015	2014
	£bn	£bn


IFRS Shareholders' equity at 31 December	6.4	6.0
Remove DAC, goodwill and other intangible assets and liabilities	(2.0)	(2.0)
Add subordinated debt treated as economic available capital¹	2.5	2.4
Insurance contract valuation differences²	7.0	6.6
Add value of shareholder transfers	0.2	0.3
Increase in value of net deferred tax liabilities (resulting from valuation differences)	(0.5)	(0.6)
Other	0.2	0.1
Adjustment - Basic own funds to Eligible own funds³	(0.3)	(0.3)


Eligible own funds at 31 December	13.5	12.5


1. Treated as available capital on the Economic Capital balance sheet as the liabilities are subordinate to policyholder claims. 2. Differences in the measurement of liabilities between IFRS and Economic Capital, offset by the inclusion of the recapitalisation cost. 3. Eligibility restrictions relating to the own funds of US captive reassurers and the UK with-profits fund. The figures that appear in this note are all pre-accrual for the 2015 final dividend of £592m (2014: £496m).

(f) Sensitivity analysis The following sensitivities are provided to give an indication of how the group's economic capital surplus as at 31 December 2015 would have changed in a variety of adverse events. These are all independent stresses to a single risk. In practice the balance sheet is impacted by combinations of stresses and the combined impact can be larger than adding together the impacts of the same stresses in isolation. It is expected that, particularly for market risks, adverse stresses will happen together.

		Impact on
	Impact on	economic
	net of tax	capital
	capital	coverage
	surplus	ratio
	2015	2015
	£bn	%


Credit spreads widen by 100bps assuming an escalating addition to ratings^1,2	(0.4)	(8)
Credit spreads tighten by 100bps assuming an escalating deduction to ratings^1,2	0.4	8
A worsening in our expectation of future default and downgrade to 115% of our assumed best estimate level	(0.3)	(12)
20% fall in equity markets	(0.3)	(4)
40% fall in equity markets	(0.6)	(6)
20% rise in equity markets	0.4	5
15% fall in property markets	(0.2)	(3)
100bps increase in risk free rates³	-	10
100bps fall in risk free rates	0.1	(9)
1% reduction in annuitant base mortality	(0.1)	(2)
1% increase in annuitant base mortality	0.1	2


1. All spread sensitivities apply to Legal & General's corporate bond (and similar) holdings, with no change in the firm's long term default expectations. 2. The stress for AA bonds is twice that for AAA bonds, for A bonds it is three times, for BBB four times and so on, such that the weighted average spread stress for the portfolio is 100bps. 3. A 100bps increase in risk free rates would result in a significant reduction in Group own funds, which would be offset by a similar reduction in group ECR, resulting in net nil impact on surplus (when rounded to nearest £0.1bn).
The above sensitivity analysis does not reflect management actions which could be taken to reduce the impacts. In practice, the group actively manages its asset and liability positions to respond to market movements. The impacts of these stresses are not linear therefore these results should not be used to extrapolate the impact of a smaller or larger stress. The results of these tests are indicative of the market conditions prevailing at the balance sheet date. The results would be different if performed at an alternative reporting date.

Capital and Investments 73

4.03 Group Economic Capital (continued)
(g) Analysis of Group Economic Capital Requirement

The table below shows a breakdown of the group's Economic Capital Requirement by risk type. The split is shown after the effects of diversification.

	2015	2014
	%	%


Interest Rate	4	6
Equity	13	15
Property	6	4
Credit¹	48	44
Currency	-	3
Inflation	3	(2)
Total Market Risk²	74	70
Counterparty Risk	1	1
Life Mortality	-	-
Life Longevity³	4	10
Life Lapse	4	5
Life Catastrophe	4	3
Non-life underwriting	1	1
Health underwriting	-	1
Expense	1	1
Total Insurance Risk	14	21
Operational Risk	7	7
Miscellaneous⁴	4	1


Total Economic Capital Requirement	100	100


1. Credit risk is Legal & General's most significant exposure, arising predominantly from the c£40bn portfolio of bonds backing the group's annuity business. 2. In addition to credit risk the group also has significant exposure to other market risks, primarily due to the investment holdings within the shareholder funds but also the risk to fee income from assets backing unit linked and with-profits Savings business. 3. Longevity risk is Legal & General's most significant insurance risk exposure, arising from the annuity book on which the majority of the longevity risk is retained. 4. Miscellaneous includes the ECR for the pension scheme and the sectoral capital requirements for non-insurance regulated firms.

(h) Reconciliation from Economic Capital surplus to Solvency II surplus

The Economic Capital position does not reflect regulatory constraints. The regulatory constraints imposed by the Solvency II regime result in a lower surplus. The table below provides an analysis of the key differences between the two bases. The Solvency II results are reported net of Transitional Measures on Technical Provisions.

					2015
					£bn


Economic Capital surplus as at 31 December					7.6
Different matching adjustment¹					(1.4)
Risk margin vs Recapitalisation cost²					-
Longevity calibration³					(0.3)
Eligibility of Group own funds⁴					(0.5)
LGA on a D&A basis⁵					0.1


Solvency II surplus as at 31 December⁶					5.5


1. This is the difference between the Economic Matching Adjustment and the Solvency II Matching Adjustment. 2. The risk margin represents the amount a third party insurance company would require to take on the obligations of a given insurance company. It is equal to the cost of capital on the SCR necessary to support insurance risks that cannot be hedged over the lifetime of the business. The recapitalisation cost is an equivalent measure under economic capital, but represents the cost of recapitalising the balance sheet following a stress event. It also removes elements of its specification that are, in Legal & General's view, uneconomic. 3. Economic Capital and Solvency II balance sheets use different calibrations for longevity risk. 4. Deductions for regulatory restrictions in respect of fungibility and transferability restrictions. These do not apply to the Economic Capital balance sheet. 5. To ensure consistency of risk management across the group, L&G America remains within the Internal Model for Economic Capital purposes. 6. There are also differences in the valuation of with-profits business and the group pension scheme that have lower order impacts on the difference between the surpluses.

Capital and Investments 74

4.04 Investment portfolio

	Market	Market
	value	value
	2015	2014
	£m	£m


Worldwide total assets	747,944	710,554
Client and policyholder assets	(679,913)	(638,117)
Non-unit linked with-profits assets	(11,644)	(15,242)


Investments to which shareholders are directly exposed	56,387	57,195

Analysed by investment class:

			Other
			non profit		Other
		LGR	insurance	LGC	shareholder
		investments	investments	investments¹	investments	Total	Total
		2015	2015	2015	2015	2015	2014
	Note	£m	£m	£m	£m	£m	£m


Equities		149	-	1,987	116	2,252	2,265
Bonds	4.06	39,368	2,367	1,427	754	43,916	45,811
Derivative assets²		3,627	-	36	-	3,663	3,940
Property		2,157	-	186	4	2,347	2,030
Cash, cash equivalents, loans & receivables		1,053	534	1,988	593	4,168	3,018


Financial investments		46,354	2,901	5,624	1,467	56,346	57,064


Other assets		-	-	41	-	41	131


Total investments		46,354	2,901	5,665	1,467	56,387	57,195


1. Equity investments include CALA Group Limited and Peel Media Holdings Limited (MediaCityUK).
2. Derivative assets are shown gross of derivative liabilities of £2.7bn (2014: £2.7bn). Exposures arise from the use of derivatives for efficient portfolio management, especially the use of interest rate swaps, inflation swaps, credit default swaps and foreign exchange forward contracts for asset and liability management.

Capital and Investments 75

4.05 Direct Investments
(a) Analysed by asset class


	Direct¹	Traded²		Direct¹	Traded²
	Investments	securities	Total	Investments	securities	Total
	2015	2015	2015	2014	2014	2014
	£m	£m	£m	£m	£m	£m


Equities	432	1,820	2,252	318	1,947	2,265
Bonds	3,722	40,194	43,916	2,983	42,828	45,811
Derivative assets	-	3,663	3,663	-	3,940	3,940
Property	2,347	-	2,347	2,030	-	2,030
Cash, cash equivalents, loans & receivables	425	3,743	4,168	241	2,777	3,018
Other assets	41	-	41	131	-	131


	6,967	49,420	56,387	5,703	51,492	57,195


1. Direct Investments constitute an agreement with another party and represent an exposure to untraded and often less volatile assets. Direct Investments include physical assets, bilateral loans and private equity but exclude hedge funds.
2. Traded securities are defined by exclusion. If an instrument is not a Direct Investment, then it is classed as a traded security.

(b) Analysed by segment
	LGR	LGC	LGA	Insurance	Total
	2015	2015	2015	2015	2015
	£m	£m	£m	£m	£m


Equities	-	432	-	-	432
Bonds	3,336	93	293	-	3,722
Property	2,157	186	-	4	2,347
Cash, cash equivalents, loans & receivables	-	115	310	-	425
Other assets	-	41	-	-	41


	5,493	867	603	4	6,967



	LGR	LGC	LGA	Insurance	Total
	2014	2014	2014	2014	2014
	£m	£m	£m	£m	£m


Equities	-	318	-	-	318
Bonds	2,586	168	229	-	2,983
Property	1,879	147	-	4	2,030
Cash, cash equivalents, loans & receivables	-	54	187	-	241
Other assets	118	13	-	-	131


	4,583	700	416	4	5,703

(c) Movement in the period

	Carrying			Change in	Carrying
	value			market	value
	01.01.15	Additions	Disposals	value	2015
	£m	£m	£m	£m	£m


Equities	318	101	(31)	44	432
Bonds	2,983	1,001	(228)	(34)	3,722
Property	2,030	256	(8)	69	2,347
Cash, cash equivalents, loans & receivables	241	166	(4)	22	425
Other assets	131	22	(153)	41	41


	5,703	1,546	(424)	142	6,967

Capital and Investments 76

4.06 Bond portfolio summary
(a) LGR analysed by sector

					BB or
	AAA	AA	A	BBB	below	LGR	LGR
	2015	2015	2015	2015	2015	2015	2015
	£m	£m	£m	£m	£m	£m	%


Sovereigns, Supras and Sub-Sovereigns	956	4,774	64	154	30	5,978	14
Banks:
- Tier 1	17	35	-	-	26	78	-
- Tier 2 and other subordinated	-	-	92	138	2	232	1
- Senior	49	421	859	77	1	1,407	4
Financial Services:
- Tier 1	-	-	-	-	-	-	-
- Tier 2 and other subordinated	-	3	33	8	4	48	-
- Senior	63	396	106	140	-	705	2
Insurance:
- Tier 1	-	-	-	6	-	6	-
- Tier 2 and other subordinated	-	-	144	64	-	208	1
- Senior	-	14	316	118	-	448	1
Utilities	43	8	1,847	2,593	27	4,518	11
Consumer Services and Goods
& Health Care	136	969	1,572	1,830	130	4,637	12
Technology and Telecoms	48	138	409	1,940	129	2,664	7
Industrials¹	-	21	934	899	30	1,884	5
Oil and Gas	24	321	482	901	247	1,975	5
Property	-	516	269	868	-	1,653	4
Asset backed securities	46	222	53	32	38	391	1
Securitisations and debentures²	335	2,587	5,603	2,391	331	11,247	28
Lifetime mortgage loans³	-	-	-	207	-	207	1
CDOs⁴	-	552	469	14	47	1,082	3


Total £m	1,717	10,977	13,252	12,380	1,042	39,368	100


Total %	4	28	34	31	3	100


1. Included within Industrials is a £455m exposure to Basic Resources.
2. Securitisations and debentures have been reanalysed in note 4.06(c).
3. Lifetime mortgage loans have increased in value since inception predominantly due to the accrual of interest on the loans.
4. The underlying reference portfolio has had no reference entity defaults during the period ended 31 December 2015. The CDOs are termed as super senior since default losses on the reference portfolio have to exceed 27.5%, on average across the reference portfolio, before the CDOs incur any default losses. Assuming an average recovery rate of 30%, then over 39% of the reference names would have to default before the CDOs incur any default losses. The CDOs are valued using an external valuation which is based on observable market inputs. This is then validated against the market valuation.

Capital and Investments 77

4.06 Bond portfolio summary (continued)
(a) LGR analysed by sector (continued)

					BB or
	AAA	AA	A	BBB	below	LGR	LGR
	2014	2014	2014	2014	2014	2014	2014
	£m	£m	£m	£m	£m	£m	%


Sovereigns, Supras and Sub-Sovereigns	1,048	6,326	145	241	-	7,760	19
Banks:
- Tier 1	-	-	-	11	13	24	-
- Tier 2 and other subordinated	-	-	328	214	17	559	1
- Senior	12	416	1,105	109	25	1,667	4
Financial Services:
- Tier 1	-	-	-	-	-	-	-
- Tier 2 and other subordinated	-	-	47	49	-	96	-
- Senior	51	443	145	307	-	946	2
Insurance:
- Tier 1	-	4	19	105	-	128	-
- Tier 2 and other subordinated	-	-	207	156	-	363	1
- Senior	-	53	429	142	-	624	2
Utilities	-	47	3,283	2,184	47	5,561	14
Consumer Services and Goods
& Health Care	137	809	1,497	1,612	71	4,126	10
Technology and Telecoms	24	95	734	1,504	191	2,548	6
Industrials¹	-	200	883	1,016	21	2,120	6
Oil and Gas	19	342	608	1,211	6	2,186	5
Property	-	371	614	895	2	1,882	5
Asset backed securities	268	245	135	36	38	722	2
Securitisations and debentures²	377	2,032	3,969	1,714	213	8,305	20
CDOs³	-	539	477	55	49	1,120	3


Total £m	1,936	11,922	14,625	11,561	693	40,737	100


Total %	5	29	36	28	2	100


1. Included within Industrials is a £501m exposure to Basic Resources.
2. Securitisations and debentures have been reanalysed in note 4.06(c).
3. The underlying reference portfolio has had no reference entity defaults during the period ended 31 December 2014. The CDOs are termed as super senior since default losses on the reference portfolio have to exceed 27.5%, on average across the reference portfolio, before the CDOs incur any default losses. Assuming an average recovery rate of 30%, then over 39% of the reference names would have to default before the CDOs incur any default losses. The CDOs are valued using an external valuation which is based on observable market inputs. This is then validated against the market valuation.

Capital and Investments 78

4.06 Bond portfolio summary (continued)
(b) Total group analysed by sector

					BB or
	AAA	AA	A	BBB	below	Other	Total	Total
	2015	2015	2015	2015	2015	2015	2015	2015
	£m	£m	£m	£m	£m	£m	£m	%


Sovereigns, Supras and Sub-Sovereigns	1,981	5,022	112	367	62	5	7,549	16
Banks:
- Tier 1	68	139	5	10	26	-	248	1
- Tier 2 and other subordinated	22	-	100	146	3	1	272	1
- Senior	105	721	992	98	3	1	1,920	4
Financial Services:
- Tier 1	-	-	-	-	-	-	-	-
- Tier 2 and other subordinated	-	3	38	16	-	1	58	-
- Senior	65	415	172	198	7	-	857	2
Insurance:
- Tier 1	-	-	-	6	-	-	6	-
- Tier 2 and other subordinated	-	3	146	68	1	1	219	-
- Senior	1	18	326	126	-	-	471	1
Utilities	42	17	1,900	2,677	42	13	4,691	11
Consumer Services and Goods
& Health Care	170	1,004	1,707	1,993	210	4	5,088	12
Technology and Telecoms	61	169	472	2,027	151	1	2,881	7
Industrials¹	-	38	1,039	1,075	67	2	2,221	5
Oil and Gas	27	342	517	958	280	1	2,125	5
Property	-	516	287	912	9	81	1,805	4
Asset backed securities	434	237	50	32	42	-	795	2
Securitisations and debentures²	358	2,592	5,714	2,412	334	11	11,421	27
Lifetime mortgage loans³	-	-	-	207	-	-	207	-
CDOs⁴	-	552	469	14	47	-	1,082	2


Total £m	3,334	11,788	14,046	13,342	1,284	122	43,916	100


Total %	8	27	32	30	3	-	100


1. Included within Industrials is a £455m exposure to Basic Resources.
2. Securitisations and debentures have been reanalysed in note 4.06(d).
3. Lifetime mortgage loans have increased in value since inception predominantly due to the accrual of interest on the loans.
4. The underlying reference portfolio has had no reference entity defaults during the period ended 31 December 2015. The CDOs are termed as super senior since default losses on the reference portfolio have to exceed 27.5%, on average across the reference portfolio, before the CDOs incur any default losses. Assuming an average recovery rate of 30%, then over 39% of the reference names would have to default before the CDOs incur any default losses. The CDOs are valued using an external valuation which is based on observable market inputs. This is then validated against the market valuation.

Capital and Investments 79

4.06 Bond portfolio summary (continued)
(b) Total group analysed by sector (continued)

					BB or
	AAA	AA	A	BBB	below	Other	Total	Total
	2014	2014	2014	2014	2014	2014	2014	2014
	£m	£m	£m	£m	£m	£m	£m	%


Sovereigns, Supras and Sub-Sovereigns	1,930	6,592	198	457	60	12	9,249	20
Banks:
- Tier 1	-	-	-	13	13	-	26	-
- Tier 2 and other subordinated	13	-	344	245	19	-	621	1
- Senior	102	658	1,305	128	27	1	2,221	5
Financial Services:
- Tier 1	-	-	-	-	-	-	-	-
- Tier 2 and other subordinated	-	-	62	56	2	12	132	-
- Senior	62	490	222	353	3	8	1,138	3
Insurance:
- Tier 1	-	4	19	106	-	-	129	-
- Tier 2 and other subordinated	-	4	206	164	1	-	375	1
- Senior	1	76	447	154	-	26	704	2
Utilities	-	65	3,407	2,291	61	-	5,824	13
Consumer Services and Goods
& Health Care	160	893	1,753	1,786	130	4	4,726	10
Technology and Telecoms	42	137	838	1,607	211	1	2,836	6
Industrials¹	-	214	1,045	1,199	55	1	2,514	6
Oil and Gas	25	376	675	1,317	21	-	2,414	5
Property	-	373	630	947	8	168	2,126	5
Asset backed securities	710	297	142	43	42	-	1,234	3
Securitisations and debentures²	406	2,037	4,044	1,721	214	-	8,422	18
CDOs³	-	539	477	55	49	-	1,120	2


Total £m	3,451	12,755	15,814	12,642	916	233	45,811	100


Total %	8	28	34	27	2	1	100


1. Included within Industrials is a £501m exposure to Basic Resources.
2. Securitisations and debentures have been reanalysed in note 4.06(d).
3. The underlying reference portfolio has had no reference entity defaults during the period ended 31 December 2014. The CDOs are termed as super senior since default losses on the reference portfolio have to exceed 27.5%, on average across the reference portfolio, before the CDOs incur any default losses. Assuming an average recovery rate of 30%, then over 39% of the reference names would have to default before the CDOs incur any default losses. The CDOs are valued using an external valuation which is based on observable market inputs. This is then validated against the market valuation.

Capital and Investments 80

4.06 Bond portfolio summary (continued)
(c) Analysis of LGR securitisations and debentures

					BB or
	AAA	AA	A	BBB	below	LGR	LGR
	2015	2015	2015	2015	2015	2015	2014
	£m	£m	£m	£m	£m	£m	£m


Sovereigns, Supras and Sub-Sovereigns	-	678	4	-	-	682	151
Financial Services	-	449	1,263	341	113	2,166	1,348
Insurance	-	28	102	-	-	130	27
Utilities	-	83	1,569	113	-	1,765	826
Consumer Services and Goods
& Health Care	-	-	257	82	16	355	297
Technology and Telecoms	-	-	-	-	1	1	-
Industrials	-	38	390	283	-	711	591
Oil and Gas	-	-	14	32	19	65	64
Property	-	73	328	1	-	402	408
Infrastructure / PFI / Social housing	-	299	448	465	20	1,232	1,279
Covered Bonds¹	258	-	-	15	-	273	328
Whole Business Securitised	-	65	209	241	109	624	569
Residential Mortgage Backed Securities	77	435	114	42	-	668	670
Commercial Mortgage Backed Securities	-	333	321	438	-	1,092	577
Secured Bonds²	-	106	560	230	53	949	950
Other	-	-	24	108	-	132	220


Total	335	2,587	5,603	2,391	331	11,247	8,305


1. Covered bonds are typically issued by banks and are secured on pools of residential mortgages.
2. Secured bonds are typically issued by Special Purpose Vehicles and are secured on various assets and/or cashflows within the issuer's business.

Capital and Investments 81

4.06 Bond portfolio summary (continued)
(d) Analysis of total group securitisations and debentures

					BB or
	AAA	AA	A	BBB	below	Other	Total	Total
	2015	2015	2015	2015	2015	2015	2015	2014
	£m	£m	£m	£m	£m	£m	£m	£m


Sovereigns, Supras and Sub-Sovereigns	-	678	4	-	-	-	682	151
Banks	-	-	-	-	-		-	11
Financial Services	-	449	1,263	341	113		2,166	1,356
Insurance	-	29	103	-	-		132	27
Utilities	-	83	1,571	114	-	-	1,768	835
Consumer Services and Goods
& Health Care	-	-	300	97	19	-	416	297
Technology and Telecoms	-	-	-	-	1	-	1	-
Industrials	-	38	390	283	-	-	711	592
Oil and Gas	-	-	14	32	19	-	65	64
Property	-	73	329	1	-	-	403	408
Infrastructure / PFI / Social housing	-	299	448	465	20	2	1,234	1,280
Covered Bonds¹	264	-	-	15	-		279	328
Whole Business Securitised	-	65	210	242	109		626	569
Residential Mortgage Backed Securities	77	435	114	42	-	-	668	670
Commercial Mortgage Backed Securities	-	333	321	438	-		1,092	577
Secured Bonds²	-	107	560	230	53	9	959	961
Other	17	3	87	112	-	-	219	296


Total	358	2,592	5,714	2,412	334	11	11,421	8,422


1. Covered bonds are typically issued by banks and are secured on pools of residential mortgages.
2. Secured bonds are typically issued by Special Purpose Vehicles and are secured on various assets and/or cashflows within the issuer's business.

Capital and Investments 82

4.06 Bond portfolio summary (continued)
(e) Analysed by domicile

The tables below are based on the legal domicile of the security:
	LGR	Total	LGR	Total
	2015	2015	2014	2014
	£m	£m	£m	£m


Market value by region:
United Kingdom	20,387	21,073	20,055	21,021
USA	9,543	11,721	9,515	11,839
Netherlands	1,663	1,941	1,910	2,182
France	1,284	1,507	1,412	1,726
Germany	284	600	378	682
Greece	-	1	-	-
Ireland	334	360	276	303
Italy	172	286	301	429
Portugal	-	7	1	11
Spain	126	187	212	260
Russia	-	8	19	37
Rest of Europe	1,695	1,942	1,857	2,164
Brazil	91	102	139	157
Rest of World	2,707	3,099	3,542	3,880
CDOs	1,082	1,082	1,120	1,120


Total	39,368	43,916	40,737	45,811


1. £1,047m (2014: £1,043m) of the CDOs are domiciled in Ireland and £35m (2014: £77m) are domiciled in the rest of the world.

Additional analysis of sovereign debt exposures:

	Sovereigns, Supras and Sub-Sovereigns

	LGR	Total	LGR	Total
	2015	2015	2014	2014
	£m	£m	£m	£m


Market value by region:
United Kingdom	4,305	4,665	5,946	6,267
USA	459	792	536	772
Netherlands	34	237	5	153
France	6	90	1	138
Germany	144	322	204	417
Greece	-	1	-	-
Ireland	-	7	-	8
Italy	1	97	2	96
Portugal	-	7	-	9
Spain	-	31	-	10
Russia	-	8	19	28
Rest of Europe	609	739	765	922
Brazil	30	36	55	64
Rest of World	390	517	227	365


Total	5,978	7,549	7,760	9,249

Capital and Investments 83

4.06 Bond portfolio summary (continued)
(f) Analysed by credit rating
	Externally	Internally		Externally	Internally
	rated	rated¹	LGR	rated	rated¹	Total
	2015	2015	2015	2015	2015	2015
	£m	£m	£m	£m	£m	£m


AAA	1,711	6	1,717	3,328	6	3,334
AA	9,426	1,551	10,977	10,237	1,551	11,788
A	11,349	1,903	13,252	12,143	1,903	14,046
BBB	10,721	1,659	12,380	11,683	1,659	13,342
BB or below	1,022	20	1,042	1,264	20	1,284
Other	-	-	-	-	122	122


	34,229	5,139	39,368	38,655	5,261	43,916


1. Where external ratings are not available LGR bonds have been rated using an internal rating.


	Externally	Internally		Externally	Internally
	rated	rated¹	LGR	rated	rated¹	Total
	2014	2014	2014	2014	2014	2014
	£m	£m	£m	£m	£m	£m


AAA	1,936	-	1,936	3,451	-	3,451
AA	10,357	1,565	11,922	11,190	1,565	12,755
A	13,231	1,394	14,625	14,420	1,394	15,814
BBB	10,360	1,201	11,561	11,441	1,201	12,642
BB or below	630	63	693	853	63	916
Other	-	-	-	-	233	233


	36,514	4,223	40,737	41,355	4,456	45,811


1. Where external ratings are not available LGR bonds have been rated using an internal rating.

This page has been left intentionally blank.

European Embedded Value 85

Group embedded value - summary

	Covered business
		Insurance		Non-
	UK	overseas		covered
	business	business	LGA	business	Total
For the year ended 31 December 2015	£m	£m	£m	£m	£m


At 1 January 2015
Value of in-force business (VIF)	6,118	147	518	-	6,783
Shareholder net worth (SNW)	3,519	325	209	139	4,192


Embedded value at 1 January 2015	9,637	472	727	139	10,975
Exchange rate movements	-	(31)	36	(6)	(1)
Operating profit/(loss) after tax for the year	1,046	11	(56)	92	1,093
Non-operating profit/(loss) after tax for the year	270	(35)	(18)	26	243


Profit/(loss) for the year	1,316	(24)	(74)	118	1,336
Intra-group distributions¹	(692)	(201)	(54)	947	-
Dividend distributions to equity holders of the company	-	-	-	(701)	(701)
Transfer to non-covered business²	(25)	-	-	25	-
Other reserve movements including pension deficit³	56	-	(34)	(49)	(27)


Embedded value at 31 December 2015	10,292	216	601	473	11,582


Value of in-force business^4,5	5,802	81	399	-	6,282
Shareholder net worth^6,7	4,490	135	202	473	5,300


Embedded value per share (p)⁸					195



Additional value of LGIM⁹

				2015	2015
Indicative valuation including LGIM				p per share	£bn


EEV as reported				195	11.6
LGIM VIF				26	1.6


Total including LGIM				221	13.2




				2015	2015
Estimated LGIM discounted cash flow valuation				p per share	£bn


Look-through value of profits on covered business				5	0.3
Net asset value				14	0.8


Current value of LGIM in group embedded value				19	1.1


LGIM VIF				26	1.6


Alternative discounted value of LGIM future cash flows				45	2.7


1. UK intra-group distributions primarily reflect a £700m (2014: £675m) dividend from Society to group and a £20m (2014: £nil) dividend from LGRe to group, partially offset by dividends of £28m (2014: £29m) from LGN to Society. Dividends of £54m (2014: £46m) from LGA and £1m (2014: £2m) from LGF were paid to group. The Insurance overseas business intragroup distribution also includes the impact of the LGF disposal and other related impacts.
2. The transfer to non-covered business represents the IFRS profits arising in the year from the provision of investment management services by LGIM to the UK covered business, which have been included in the operating profit of the covered business on the look-through basis.
3. The other reserve movements primarily reflect movement in the pension deficit, the effect of reinsurance transactions between UK and US covered business, and movements in the share options scheme and employee scheme treasury shares.
4. Value of in-force business is shown net of cost of capital, which consists of £497m (2014: £545m) from UK covered business, £8m (2014: £60m) from Insurance overseas business and £14m (2014: £11m) from LGA.
5. The time value of the options and guarantees deduction included in value of in-force business is £36m (2014: £43m).
6. Shareholder net worth of Insurance overseas business is made up of £94m (2014: £90m) of free surplus and £41m (2014: £235m) of required capital.
7. Shareholder net worth of LGA is made up of £145m (2014: £161m) of free surplus and £57m (2014: £48m) of required capital.
8. The number of shares in issue at 31 December 2015 was 5,948,788,480 (2014: 5,942,070,229).
9. Excludes workplace savings results, which are reflected in the UK covered business.

Further analysis of the UK covered business can be found in Note 5.01.

European Embedded Value 86

Group embedded value - summary (continued)
	Covered business
		Insurance		Non-
	UK	overseas		covered
	business	business	LGA	business	Total
For the year ended 31 December 2014	£m	£m	£m	£m	£m


At 1 January 2014
Value of in-force business (VIF)	4,693	197	699	-	5,589
Shareholder net worth (SNW)	3,249	315	234	199	3,997


Embedded value at 1 January 2014	7,942	512	933	199	9,586
Exchange rate movements	-	(30)	44	(16)	(2)
Operating profit/(loss) after tax for the year	1,264	31	(68)	107	1,334
Non-operating profit/(loss) for the year	709	(11)	(11)	(5)	682


Profit /(loss) for the year	1,973	20	(79)	102	2,016
Intra-group distributions¹	(641)	(30)	(46)	717	-
Dividend distributions to equity holders of the company	-	-	-	(580)	(580)
Transfer to non-covered business²	(26)	-	-	26	-
Other reserve movements including pension deficit³	389	-	(125)	(309)	(45)


Embedded value at 31 December 2014	9,637	472	727	139	10,975


Value of in-force business^4,5	6,118	147	518	-	6,783
Shareholder net worth^6,7	3,519	325	209	139	4,192


Embedded value per share (p)⁸					185


Additional value of LGIM⁹

				2014	2014
Indicative valuation including LGIM				p per share	£bn


EEV as reported				185	11.0
LGIM VIF				27	1.6


Total including LGIM				212	12.6



				2014	2014
Estimated LGIM discounted cash flow valuation				p per share	£bn


Look-through value of profits on covered business				6	0.4
Net asset value				8	0.5


Current value of LGIM in group embedded value				14	0.9


LGIM VIF				27	1.6


Alternative discounted value of LGIM future cash flows				41	2.5


1. UK intra-group distributions primarily reflect a £675m dividend paid from Society to group, and dividends of €35m from LGN and £5m from Nationwide Life paid to Society. Dividends of $76m from LGA and €2m from LGF were paid to group.
2. The transfer to non-covered business represents the IFRS profits arising in the year from the provision of investment management services by LGIM to the UK covered business, which have been included in the operating profit of the covered business on the look-through basis.
3. The other reserve movements primarily reflect the effect of reinsurance transactions between UK and US covered business, pension deficit movement, movement in the savings related share options scheme and an intragroup capital contribution.
4. Value of in-force business is shown net of cost of capital, which consists of £545m from UK covered business, £60m from Insurance overseas business and £11m from LGA.
5. The time value of the options and guarantees deduction included in value of in-force business is £43m.
6. Shareholder net worth of Insurance overseas business is made up of £90m of free surplus and £235m of required capital.
7. Shareholder net worth of LGA is made up of £161m of free surplus and £48m of required capital.
8. The number of shares in issue at 31 December 2014 was 5,942,070,229.
9. Excludes workplace savings results, which are reflected in the UK covered business.

Further analysis of the UK covered business can be found in Note 5.01.

European Embedded Value 87

5.01 UK covered business embedded value reconciliation

	Shareholder net worth				Total
	Free	Required		Value of	embedded
	surplus	capital	Total	in-force	value
For the year ended 31 December 2015	£m	£m	£m	£m	£m


At 1 January 2015	887	2,632	3,519	6,118	9,637

Operating profit/(loss) after tax:
- New business contribution¹	(175)	214	39	316	355
- Expected return on VIF	-	-	-	346	346
- Expected transfer from VIF to SNW²	936	(182)	754	(754)	-
- Expected return on SNW	76	131	207	-	207
Generation of embedded value	837	163	1,000	(92)	908
- Experience variances	162	(272)	(110)	18	(92)
- Operating assumption changes³	686	86	772	(521)	251
- Development costs	(21)	-	(21)	-	(21)
Variances	827	(186)	641	(503)	138


Operating profit/(loss) after tax	1,664	(23)	1,641	(595)	1,046
Non-operating profit/(loss) after tax:
- Economic variances	62	(71)	(9)	184	175
- Effect of tax rate changes and other taxation impacts⁴	-	-	-	95	95
Non-operating profit/(loss) after tax	62	(71)	(9)	279	270


Profit/(loss) for the year	1,726	(94)	1,632	(316)	1,316
Intra-group distributions⁵	(692)	-	(692)	-	(692)
Transfer to non-covered business⁶	(25)	-	(25)	-	(25)
Other reserve movements including pension deficit	56	-	56	-	56


Embedded value at 31 December 2015	1,952	2,538	4,490	5,802	10,292


1. The UK free surplus reduction of £175m to finance new business primarily reflects £214m additional required capital in relation to new business.
2. The increase in UK free surplus of £936m from the expected transfer from the in-force non profit business includes £754m of operational cash generation and a £182m reduction in required capital. The £1,117m operational cash generation from Insurance, Savings, LGR and LGIM reported in Note 2.01 also includes £28m of dividends from LGN, £1m dividend from LGF and £334m reflecting profit from non-covered business.
3.The release from Value of in-force to Shareholder net worth within Operating assumption changes is primarily driven by the extension of PS06/14 realistic reserving to unit linked business, to enable negative non-unit regulatory reserves for linked business.
4.This primarily reflects the implementation of the UK planned future reductions in the corporation tax rate to 18% on 1 April 2020.
5. Intra-group distributions primarily reflect a £700m dividend from Society to group and a £20m dividend from LGRe to group, partially offset by dividends of £28m from LGN to Society.
6. The transfer to non-covered business represents the IFRS profits arising in the year from the provision of investment management services by LGIM to the UK covered business, which have been included in the operating profit of the covered business on the look-through basis.

The value of in-force business of £5,802m is comprised of £5,484m of non profit business and £318m of with-profits business.

European Embedded Value 88

5.01 UK covered business embedded value reconciliation (continued)

	Shareholder net worth				Total
	Free	Required		Value of	embedded
	surplus	capital	Total	in-force	value
For the year ended 31 December 2014	£m	£m	£m	£m	£m


At 1 January 2014	1,107	2,142	3,249	4,693	7,942

Operating profit/(loss) after tax:
- New business contribution¹	(340)	343	3	607	610
- Intra-group transfer from with-profit to non profit fund	-	-	-	80	80
- Expected return on VIF	-	-	-	317	317
- Expected transfer from VIF to SNW²	901	(213)	688	(688)	-
- Expected return on SNW	55	116	171	-	171
Generation of embedded value	616	246	862	316	1,178
- Experience variances	175	(83)	92	(6)	86
- Operating assumption changes	171	(109)	62	(36)	26
- Development costs	(26)	-	(26)	-	(26)
Variances	320	(192)	128	(42)	86


Operating profit after tax	936	54	990	274	1,264
Non-operating profit/(loss) after tax:
- Economic variances	(359)	219	(140)	851	711
- Effect of tax rate changes and other taxation impacts³	(12)	-	(12)	10	(2)
Non-operating profit/(loss) after tax	(371)	219	(152)	861	709


Profit for the year	565	273	838	1,135	1,973
Intra-group distributions⁴	(641)	-	(641)	-	(641)
Transfer to non-covered business⁵	(26)	-	(26)	-	(26)
Other reserve movements including pension deficit⁶	(118)	217	99	290	389


Embedded value at 31 December 2014	887	2,632	3,519	6,118	9,637


1. The UK free surplus reduction of £340m to finance new business reflects £343m additional required capital in relation to new business.
2. The increase in UK free surplus of £901m from the expected transfer from the in-force covered business includes £688m of operational cash generation and a £213m reduction in required capital. The £1,026m operational cash generation from Insurance, Savings, LGR and LGIM per Note 2.01 also includes £29m dividend from LGN, £2m dividend from LGF and £307m primarily reflecting profit from non-covered business.
3. Reflects the implementation of the UK planned future reductions in the corporation tax rate to 20% on 1 April 2015.
4. Intra-group distributions primarily reflect £675m dividends paid from Society to group and dividends of €35m from LGN and £5m from Nationwide to Society.
5. The transfer to non-covered business represents the IFRS profits arising in the year from the provision of investment management services by LGIM to the UK covered business, which have been included in the operating profit of the covered business on the look-through basis.
6. The other reserve movements reflect the pension deficit movement, the effect of reinsurance transactions between UK and US covered business and an intra-group capital contribution.

The value of in-force business of £6,118m is comprised of £5,778m of non profit business and £340m of with-profits business.

European Embedded Value 89

5.02 Reconciliation of shareholder net worth

	UK		UK
	covered		covered
	business	Total	business	Total
	2015	2015	2014	2014
	£m	£m	£m	£m


SNW of long-term operations (IFRS basis)	4,897	5,931	4,693	5,889
Other assets/(liabilities) (IFRS basis)	-	473	-	139


Shareholders' equity on the IFRS basis	4,897	6,404	4,693	6,028
Purchased interest in long term business	(38)	(39)	(46)	(49)
Deferred acquisition costs/deferred income liabilities	(294)	(1,435)	(201)	(1,255)
Deferred tax¹	(117)	367	(16)	444
Other²	42	3	(911)	(976)


Shareholder net worth on the EEV basis	4,490	5,300	3,519	4,192


1. Deferred tax represents all tax which is expected to be paid under legislation in force at the balance sheet date. 2. Other primarily relates to the different treatment of annuities and the LGA Triple X securitisation between the EEV and IFRS basis, as well as profit transfer from the long-term fund to shareholder funds.

European Embedded Value 90

5.03 Profit/(loss) for the year
		Covered business
			Insurance		Non-
		UK	overseas		covered
		business	business	LGA	business	Total
For the year ended 31 December 2015	Note	£m	£m	£m	£m	£m


Business reported on an EEV basis:
Contribution from new business after cost of capital	5.04	432	13	84	-	529
Contribution from in-force business:
- expected return¹		414	8	52	-	474
- experience variances²		(100)	(11)	6	-	(105)
- operating assumption changes^3,4		306	6	(238)	-	74
Development costs		(25)	-	-	-	(25)
Contribution from shareholder net worth⁵		192	1	9	-	202


Operating profit/(loss) on covered business		1,219	17	(87)	-	1,149

Business reported on an IFRS basis⁶		-	-	-	161	161


Total operating profit/(loss)		1,219	17	(87)	161	1,310
Economic variances⁷		245	7	(27)	(44)	181
Other variances⁸		-	(41)	-	-	(41)
Gains on non-controlling interests		-	-	-	19	19


Profit/(loss) before tax		1,464	(17)	(114)	136	1,469
Tax (expense)/credit on profit from ordinary activities		(243)	(7)	40	(18)	(228)
Effect of tax rate changes and other taxation impacts⁹		95	-	-	-	95


Profit/(loss) for the year		1,316	(24)	(74)	118	1,336



Operating profit on covered business before tax attributable to:
LGR		463
LGIM¹⁰		103
LGC		192
Insurance		311
Savings		150


Total		1,219



						p


Earnings per share
Based on profit attributable to equity holders of the company						22.25

Diluted earnings per share
Based on profit attributable to equity holders of the company						22.10


1. The expected return on in-force for UK covered business is based on the unwind of the risk discount rate on the opening, adjusted base value of in-force (VIF). The opening base VIF of the UK covered business was £6,118m in 2015 (2014: £4,693m). This is multiplied by the opening risk discount rate of 5.5% (2014: 6.8%) and the result grossed up at the notional attributed tax rate of 18% (2014: 20%) to give a return of £414m (2014: £397m). The same approach has been applied for Insurance overseas business.
2. UK covered business experience variances primarily reflect the impact from reduction of annuities in relation to reinsurance of bulk annuity transactions.
3. UK covered business operating assumption changes primarily reflect a change in mortality reserving assumptions in relation to unreported deaths of deferred annuitants; and the impact of release of prudence margin in the Sterling reserves, mainly in the Savings business; partially offset by enhancements to reinsurance modelling in our UK protection business, where recent contracts have been written on a risk premium basis (as opposed to level premium). The model change ensures that, for these treaties, sufficient prudence is being held in later years.
4. LGA operating assumption changes primarily reflect the impact of more conservative long-term assumptions on Post-Level Term mortality and shock lapse rates. This completes the assumption review exercise initiated in the US in 2014 after changes in industry-wide mortality tables.
5. Contribution from shareholder net worth reflects the investment returns on shareholder assets within covered businesses.
6. Non-covered business operating profit primarily reflects: LGIM business excluding workplace savings, general insurance, LGC and group non-covered business, which comprises group debt costs, investment projects and group expenses, partly offset by investment returns from non-covered shareholder assets.
7. The positive variance on UK covered business has resulted from a number of factors including favourable default experience, higher long term investment return rate (mainly in LGR), and the impact of reducing gilt holdings.
8. Other variances primarily reflects the recognition of the loss arising from the disposal of LGF.
9. This primarily reflects the implementation of the UK planned future reductions in the corporation tax rate to 18% on 1 April 2020.
10. LGIM figures represent the workplace savings results. Other areas of LGIM are not included within covered business.

European Embedded Value 91

5.03 Profit/(loss) for the year (continued)

		Covered business
			Insurance		Non-
		UK	overseas		covered
		business	business	LGA	business	Total
For the year ended 31 December 2014	Note	£m	£m	£m	£m	£m


Business reported on an EEV basis:
Contribution from new risks after cost of capital:
- contribution from new business	5.04	753	7	90	-	850
- intra-group transfer from with-profit to non profit fund		100	-	-	-	100
Contribution from in-force business:
- expected return¹		397	27	66	-	490
- experience variances²		32	(11)	(23)	-	(2)
- operating assumption changes³		42	16	(241)	-	(183)
Development costs		(32)	-	-	-	(32)
Contribution from shareholder net worth		184	7	3	-	194


Operating profit / (loss) on covered business		1,476	46	(105)	-	1,417

Business reported on an IFRS basis⁴		-	-	-	164	164


Total operating profit / (loss)		1,476	46	(105)	164	1,581
Economic variances⁵		863	(18)	(17)	(38)	790
Gains on non-controlling interests		-	-	-	7	7


Profit / (loss) before tax		2,339	28	(122)	133	2,378
Tax (expense)/credit on profit from ordinary activities		(364)	(8)	43	(31)	(360)
Effect of tax rate changes and other taxation impacts⁶		(2)	-	-	-	(2)


Profit / (loss) for the year		1,973	20	(79)	102	2,016



Operating profit on covered business before tax attributable to:
LGR		1,011
LGIM⁷		27
LGC		184
Insurance		232
Savings		22


Total		1,476



						p


Earnings per share
Based on profit attributable to equity holders of the company						34.07

Diluted earnings per share
Based on profit attributable to equity holders of the company						33.73

1. The expected return on in-force for UK covered business is based on the unwind of the risk discount rate on the opening, adjusted base value of in-force (VIF). The opening base VIF of the UK covered business was £4,693m in 2014. This is adjusted for the effects of opening model changes of £(30)m to give an adjusted opening base VIF of £4,663m. This is then multiplied by the opening risk discount rate of 6.8% and the result grossed up at the notional attributed tax rate of 20% to give a return of £397m. The same approach has been applied for the Insurance overseas businesses.
2. UK covered business variance primarily reflects UK cost of capital unwind and favourable mortality experience for bulk annuities. LGA experience variance primarily relates to adverse mortality experience within term assurance and universal life products respectively.
3. UK covered business operating assumption change primarily reflects mortality assumption changes for non profit annuities. LGA operating assumption changes primarily incorporates an adjustment to our mortality assumptions to reflect the changes in industry-wide mortality tables (which were issued in the second half of 2014).
4. Non-covered business operating profit primarily reflect LGIM business excluding workplace savings, general insurance and LGC non-covered business.
5. The UK covered business positive variance has resulted from a number of factors including lower risk discount rate, favourable default experience and enhanced yield on annuity assets, offset by a lower risk free rate. Non-covered variance primarily reflects lower equity return from shareholder funds.
6. Other taxation impacts reflects the change in the treatment of deferred tax on in-force business to align with IFRS by removing the effect of discounting.
7. LGIM figures represent the workplace savings results, other areas of LGIM are not included in covered business.

European Embedded Value 92

5.04 New business by product¹

		Present				Contri-
		value of	Capital-			bution
	Annual	annual	isation	Single		from new
	premiums	premiums	factor²	premiums	PVNBP	business³	Margin
For the year ended 31 December 2015	£m	£m		£m	£m	£m	%


UK Insurance⁴	231	1,306	5.7	-	1,306	130	9.9
Overseas Insurance	40	313	7.8	384	697	13	1.9


Insurance	271	1,619	6.0	384	2,003	143	7.1


Savings	54	170	3.1	1,507	1,677	1	0.1


LGR⁵	n/a	-	n/a	2,721	2,721	266	9.8


LGIM⁶	1,068	4,148	3.9	1,219	5,367	35	0.6


LGA	70	692	9.9	-	692	84	12.1


Total new business	1,463	6,629	4.5	5,831	12,460	529	4.2
Cost of capital						49


Contribution from new business before cost of capital						578


1. Covered business only.
2. The capitalisation factor is the present value of annual premiums divided by the amount of annual premiums.
3. The contribution from new business is defined as the present value at the point of sale of assumed profits from new business written in the period and then rolled forward to the end of the financial period using the risk discount rate applicable at the end of the reporting period.
4. The UK Insurance margin reflects the benefits of stronger commercial focus and disciplined expense control during 2015.
5. LGR for 2015 includes bulk annuities' single premiums and contribution from new business on a net of quota share reinsurance basis to provide a more representative margin figure.
6. LGIM figures represent the workplace savings results, other areas of LGIM are not included in covered business.

		Present				Contri-
		value of	Capital-			bution
	Annual	annual	isation	Single		from new
	premiums	premiums	factor²	premiums	PVNBP	business³	Margin
For the year ended 31 December 2014	£m	£m		£m	£m	£m	%


UK Insurance	230	1,336	5.8	-	1,336	112	8.4
Overseas Insurance	41	300	7.3	394	694	7	1.0


Insurance	271	1,636	6.0	394	2,030	119	5.9


Savings	63	171	2.7	1,678	1,849	9	0.5


LGR	n/a	-	n/a	6,578	6,578	614	9.3


LGIM⁴	591	2,277	3.9	1,060	3,337	18	0.5


LGA	91	907	10.0	-	907	90	9.9


Total new business	1,016	4,991	4.9	9,710	14,701	850	5.8
Cost of capital						108


Contribution from new business before cost of capital						958


1. Covered business only.
2. The capitalisation factor is the present value of annual premiums divided by the amount of annual premiums.
3. The contribution from new business is defined as the present value at the point of sale of assumed profits from new business written in the period and then rolled forward to the end of the financial period using the risk discount rate applicable at the end of the reporting period.
4. LGIM figures represent the workplace savings results, other areas of LGIM are not included in covered business.

European Embedded Value 93

5.05 Sensitivities
In accordance with the guidance issued by the European Insurance CFO Forum in October 2005, the table below shows the effect of alternative assumptions on the long term embedded value and new business contribution.

Effect on embedded value as at 31 December 2015

		1%	1%			1%
		lower	higher	1%	1%	higher
	As	risk	risk	lower	higher	equity/
	pub-	discount	discount	interest	interest	property
	lished	rate	rate	rate	rate	yields
	£m	£m	£m	£m	£m	£m


Insurance, Savings and LGR¹	10,508	796	(709)	722	(444)	183
LGA	601	55	(45)	(19)	13	-


Total covered business	11,109	851	(754)	703	(431)	183




					5%	5%
		10%	10%		lower	lower
		lower	lower	10%	mortality	mortality
	As	equity/	main-	lower	(UK	(other
	pub-	property	tenance	lapse	annu-	busi-
	lished	values	expenses	rates	ities)	ness)
	£m	£m	£m	£m	£m	£m


Insurance, Savings and LGR¹	10,508	(186)	116	95	(412)	65
LGA	601	-	13	(9)	n/a	209


Total covered business	11,109	(186)	129	86	(412)	274



Effect on new business contribution for the year

		1%	1%			1%
		lower	higher	1%	1%	higher
	As	risk	risk	lower	higher	equity/
	pub-	discount	discount	interest	interest	property
	lished	rate	rate	rate	rate	yields
	£m	£m	£m	£m	£m	£m


Insurance, Savings and LGR¹	445	67	(61)	50	(33)	21
LGA	84	6	(5)	2	(2)	-


Total covered business	529	73	(66)	52	(35)	21




					5%	5%
		10%	10%		lower	lower
		lower	lower	10%	mortality	mortality
	As	equity/	main-	lower	(UK	(other
	pub-	property	tenance	lapse	annu-	busi-
	lished	values	expenses	rates	ities)	ness)
	£m	£m	£m	£m	£m	£m


Insurance, Savings and LGR¹	445	(7)	19	22	(37)	4
LGA	84	-	1	2	n/a	13


Total covered business	529	(7)	20	24	(37)	17


1. Includes LGC and workplace savings.

Opposite sensitivities are broadly symmetrical.

The above sensitivity analyses do not reflect management actions which could be taken to reduce the impacts. Sensitivity to changes in assumptions may not be linear, and as such, they should not be extrapolated to changes of a much larger order. A 2% higher risk discount rate would result in a £1,194m negative impact on UK embedded value and a £107m negative impact on UK new business contribution for the year.

European Embedded Value 94

5.06 Assumptions

UK assumptions

The assumed future pre-tax returns on fixed interest and RPI linked securities are set by reference to the portfolio yield on the relevant backing assets held at market value at the end of the reporting period. The calculated return takes account of derivatives and other credit instruments in the investment portfolio. Indicative yields on the portfolio, excluding annuities within LGR, but after allowance for long term default risk, are shown below.

For LGR, separate returns are calculated for new and existing business. An indicative combined yield, after allowance for long term default risk and the following additional assumptions, is also shown below. These additional assumptions are:

i. Where cash balances and debt securities are held at the reporting date in excess of, or below strategic investment guidelines, then it is assumed that these cash balances or debt securities are immediately invested or disinvested at current yields.

ii. Where interest rate swaps are used to reduce risk, it is assumed that these swaps will be sold before expiry and the proceeds reinvested in corporate bonds with a redemption yield of 0.7% p.a. (0.7% p.a. at 31 December 2014) greater than the swap rate at that time (i.e. the long-term credit rate).

iii. Where reinvestment or disinvestment is necessary to rebalance the asset portfolio in line with projected outgo, this is also assumed to take place at the long-term credit rate above the swap rate at that time.

The returns on fixed and index-linked securities are calculated net of an allowance for default risk which takes account of the credit rating, outstanding term of the securities. The allowance for corporate securities expressed as a level rate deduction from the expected returns for annuities was 22bps at 31 December 2015 (21bps at 31 December 2014).

UK covered business

i. Assets are valued at market value.

ii. Future bonus rates have been set at levels which would fully utilise the assets supporting the policyholders' portion of the with-profits business in accordance with established practice. The proportion of profits derived from with-profits business allocated to shareholders amounts to almost 10% throughout the projection.

iii. The value of in-force business reflects the cost, including administration expenses, of providing for benefit enhancement or compensation in relation to certain products.

iv. Other actuarial assumptions have been set at levels commensurate with recent operating experience, including those for mortality, morbidity, persistency and maintenance expenses (excluding the development costs referred to below). These are normally reviewed annually.

An allowance is made for future mortality improvement. For new business, mortality assumptions may be modified to take certain scheme specific features into account.

v. Development costs relate to investment in strategic systems and development capability that are charged to the covered business.

Overseas covered business

Other actuarial assumptions have been set at levels commensurate with recent operating experience, including those for mortality, morbidity, persistency and maintenance expenses.

European Embedded Value 95

5.06 Assumptions (continued)

Economic assumptions


		As at	As at
		2015	2014
		% p.a.	% p.a.
	Risk margin	3.1	3.3
	Risk free rate¹
	- UK	2.4	2.2
	- Europe	0.8	0.6
	- US	2.3	2.2
	Risk discount rate (net of tax)
	- UK	5.5	5.5
	- Europe	3.9	3.9
	- US	5.4	5.5
	Reinvestment rate (US)	5.1	5.0
Other UK business assumptions
	Equity risk premium	3.3	3.3
	Property risk premium	2.0	2.0

Investment return (excluding annuities in LGR )
	- Fixed interest:
	-Gilts & non gilts	2.0 - 2.7	1.7 - 2.4
	- Equities	5.7	5.5
	- Property	4.4	4.2

	Long-term rate of return on non profit annuities in LGR	4.2	3.6

	Inflation²
	- Expenses/earnings	3.8	3.7
	- Indexation	3.3	3.2

1. The risk free rate is the gross redemption yield on the 15 year gilt index. The Europe risk free rate is the 10 year ECB AAA-rated Euro area central government bond par yield. The LGA risk free rate is the 10 year US Treasury effective yield.

2. The LGR inflation rate has been set with reference to a curve.

Tax

The profits on the covered business, except for the profits on the shareholder capital held outside the long- term fund, are calculated on an after tax basis and are grossed up by the notional attributed tax rate for presentation in the income statement. For the UK, the after tax basis assumes the annualised current rate of 20.25% and subsequent planned future reductions in corporation tax to 18% from 1 April 2020. The tax rate used for grossing up is the long term corporate tax rate in the territory concerned, which for the UK is 18% (31 December 2014: 20%). The profits on the shareholder capital held outside the long-term fund are calculated before tax and therefore tax is calculated on an actual basis.

US, Netherlands and France covered business profits are also grossed up using the long term corporate tax rates of the respective territories i.e. the US is 35% (31 December 2014: 35%), France is 34.43% (31 December 2014: 34.43%) and the Netherlands is 25% (31 December 2014: 25%).

European Embedded Value 96

5.06 Assumptions (continued)

Stochastic calculations

The time value of options and guarantees is calculated using economic and non-economic assumptions consistent with those used for the deterministic embedded value calculations.

A single model has been used for UK and international business, with different economic assumptions for each territory reflecting the significant asset classes in each territory.

Government nominal interest rates are generated using a LIBOR Market Model projecting full yield curves at annual intervals. The model provides a good fit to the initial yield curve.

The total annual returns on equities and property are calculated as the return on 1 year bonds plus an excess return. The excess return is assumed to have a lognormal distribution. Corporate bonds are modelled separately by credit rating using stochastic credit spreads over the risk free rates, transition matrices and default recovery rates. The real yield curve model assumes that the real short rate follows a mean-reverting process subject to two normally distributed random shocks.

The significant asset classes are:

- UK with-profits business - equities, property and fixed rate bonds of various durations;

- UK annuity business - fixed rate and index-linked bonds of various durations; and

- International business - fixed rate bonds of various durations.

The risk discount rate is scenario dependent within the stochastic projection. It is calculated by applying the deterministic risk margin to the risk free rate in each stochastic projection.

Sensitivity calculations

A number of sensitivities have been produced on alternative assumption sets to reflect the sensitivity of the embedded value and the new business contribution to changes in key assumptions. Relevant details relating to each sensitivity are:

· 1% variation in discount rate - a one percentage point increase/decrease in the risk margin has been assumed in each case (for example a 1% increase in the risk margin would result in a 4.1% risk margin).

· 1% variation in interest rate environment - a one percentage point increased/decreased parallel shift in the risk free curve with consequential impacts on fixed asset market values, investment return assumptions, risk discount rate, including consequential changes to valuation bases.

· 1% higher equity/property yields - a one percentage point increase in the assumed equity/property investment returns, excluding any consequential changes, for example, to risk discount rates or valuation bases, has been assumed in each case (for example a 1% increase in equity returns would increase assumed total equity returns from 3.3% to 4.3%).

· 10% lower equity/property market values - an immediate 10% reduction in equity and property asset values.

· 10% lower maintenance expenses, excluding any consequential changes, for example, to valuation expense bases or potentially reviewable policy fees (for example a 10% decrease on a base assumption of £10 per annum would result in a £9 per annum expense assumption).

· 10% lower assumed persistency experience rates, excluding any consequential changes to valuation bases, incorporating a 10% decrease in lapse, surrender and premium cessation assumptions (for example a 10% decrease on a base assumption of 7% would result in a 6.3% lapse assumption).

· 5% lower mortality and morbidity rates, excluding any consequential changes to valuation bases but including assumed product repricing action where appropriate (for example if base experienced mortality is 90% of a standard mortality table then, for this sensitivity, the assumption is set to 85.5% of the standard table).

The sensitivities for covered business allow for any material changes to the cost of financial options and guarantees but do not allow for any changes to reserving bases or capital requirements within the sensitivity calculation, unless indicated otherwise above.

European Embedded Value 97

5.07 Methodology

Basis of preparation

The supplementary financial information has been prepared in accordance with the European Embedded Value (EEV) Principles issued in May 2004 by the European Insurance CFO Forum.

From 1 January 2016, the group is required to comply with the requirements established by the EU Solvency II Directive. The Solvency II reporting framework incorporates a best estimate of cash flows in relation to insurance assets and liabilities and consequently has replaced EEV reporting in the management information used internally to measure and monitor capital resources. Therefore, from 2016 the group will no longer be reporting EEV information.

In accordance with the October 2015 CFO Forum guidance on Solvency II, the Group has not reflected Solvency II requirements within the EEV results. Allowing for Solvency II could have had a significant impact on the EEV results, the impact of which has not been quantified.

The supplementary financial information has been audited by PricewaterhouseCoopers LLP.

Covered business

The group uses EEV methodology to value individual and group life assurance, pensions and annuity business written in the UK, Europe and the US. The UK covered business also includes non-insured self invested personal pension (SIPP) business.

The managed pension funds business has been excluded from covered business and is reported on an IFRS basis.

All other businesses are accounted for on the IFRS basis adopted in the primary financial statements.

There is no distinction made between insurance and investment contracts in our covered business as there is under IFRS.

European Embedded Value 98

5.07 Methodology (continued)

Description of methodology

The objective of EEV is to provide shareholders with realistic information on the financial position and current performance of the group.

The methodology requires assets of an insurance company, as reported in the primary financial statements, to be attributed between those supporting the covered business and the remainder. The method accounts for assets in the covered business on an EEV basis and the remainder of the group's assets on the IFRS basis adopted in the primary financial statements.

The EEV methodology recognises profit from the covered business as the total of:

i. cash transfers during the relevant period from the covered business to the remainder of the group's assets; and

ii. the movement in the present value of future distributable profits to shareholders arising from the covered business over the relevant reporting period.

Embedded value

Shareholders' equity on the EEV basis comprises the embedded value of the covered business plus the shareholders' equity of other businesses, less the value included for purchased interests in long-term business.

The embedded value is the sum of the shareholder net worth (SNW) and the value of the in-force business (VIF). SNW is defined as those amounts, within covered business (both within the long-term fund and held outside the long term fund but used to support long term business), which are regarded either as required capital or which represent free surplus.

The VIF is the present value of future shareholder profits arising from the covered business, projected using best estimate assumptions, less an appropriate deduction for the cost of holding the required level of capital and the time value of financial options and guarantees (FOGs).

Service companies

All services relating to the UK covered business are charged on a cost recovery basis, with the exception of investment management services provided to Legal & General Assurance Society Limited (Society). Profits arising on the provision of these services are valued on a look-through basis.

As the EEV methodology incorporates the future capitalised cost of these internal investment management services, the equivalent IFRS profits have been removed from the investment management (LGIM) segment and are instead included in the results of the Insurance, Savings and LGR segments on an EEV basis.

The capitalised value of future profits emerging from internal investment management services are therefore included in the embedded value and new business contribution calculations for the Insurance, Savings and LGR segments. However, the historical profits which have emerged continue to be reported in the shareholders' equity of the LGIM segment on an IFRS basis. Since the look-through into service companies includes only future profits and losses, current intra-group profits or losses must be eliminated from the closing embedded value, and in order to reconcile the profits arising in the financial period within each segment with the net assets on the opening and closing balance sheet, a transfer of IFRS profits for the period from the UK SNW is deemed to occur.

New business

New business premiums reflect income arising from the sale of new contracts during the reporting period and any changes to existing contracts, which were not anticipated at the outset of the contract.

In-force business comprises previously written single premium, annual premium, recurrent single premium contracts and payments in relation to existing longevity insurance. The longevity insurance product comprises the exchange of a stream of fixed leg payments for a stream of floating payments, with the value of the income stream being the difference between the two legs. New business annual premiums have been excluded for longevity insurance due to the unpredictable deal flow from this type of business.

New business contribution arising from the new business premiums written during the reporting period has been calculated on the same economic and operating assumptions used in the embedded value at the end of the financial period. This has then been rolled forward to the end of the financial period using the risk discount rate applicable at the end of the reporting period.

The present value of future new business premiums (PVNBP) has been calculated and expressed at the point of sale. The PVNBP is equivalent to total single premiums plus the discounted value of annual premiums expected to be received over the term of the contracts using the same economic and operating assumptions used for the embedded value at the end of the financial period. The discounted value of longevity insurance regular premiums and quota share reinsurance single premiums are calculated on a net of reinsurance basis to enable a more representative margin figure.

The new business margin is defined as new business contribution at the end of the reporting period divided by the PVNBP. The premium volumes and projection assumptions used to calculate the PVNBP are the same as those used to calculate new business contribution.

Intra-group reinsurance arrangements are in place between the US and UK businesses, and it is expected that these arrangements will be periodically extended to cover recent new business. LGA new business premiums and contribution reflect the groupwide expected impact of LGA directly-written business.

European Embedded Value 99

5.07 Methodology (continued)

Projection assumptions

Cash flow projections are determined using best estimate assumptions for each component of cash flow and for each policy group. Future economic and investment return assumptions are based on conditions at the end of the financial period. Future investment returns are projected by one of two methods. The first method is based on an assumed investment return attributed to assets at their market value. The second, which is used by LGA, where the investments of that subsidiary are substantially all fixed interest, projects the cash flows from the current portfolio of assets and assumes an investment return on reinvestment of surplus cash flows. The assumed discount and inflation rates are consistent with the investment return assumptions.

Detailed projection assumptions including mortality, morbidity, persistency and expenses reflect recent operating experience and are normally reviewed annually. Allowance is made for future improvements in annuitant mortality based on experience and externally published data. Favourable changes in operating experience are not anticipated until the improvement in experience has been observed.

All costs relating to the covered business, whether incurred in the covered business or elsewhere in the group, are allocated to that business. The expense assumptions used for the cash flow projections therefore include the full cost of servicing this business.

Tax

The projections take into account all tax which is expected to be paid, based on best estimate assumptions, applying current legislation and practice together with known future changes.

Allowance for risk

Aggregate risks within the covered business are allowed for through the following principal mechanisms:

i. setting required capital levels with reference to both the group's internal risk based capital models, and an assessment of the strength of regulatory reserves in the covered business;

ii. allowing explicitly for the time value of financial options and guarantees within the group's products; and

iii. setting risk discount rates by deriving a group level risk margin to be applied consistently to local risk free rates.

Required capital and free surplus

Regulatory capital for the UK covered businesses is provided by assets backing the with-profits business or by the SNW. The SNW comprises all shareholders' capital within Society, including those funds retained within the long-term fund (collectively Society shareholder capital).

Society shareholder capital is either required to cover the EU solvency margin or is free surplus as its distribution to shareholders is not restricted.

For UK with-profits business, the required capital is covered by the surplus within the with-profits part of the fund and no effect is attributed to shareholders except for the burn-through cost, which is described later. This treatment is consistent with the Principles and Practices of Financial Management for this part of the fund.

For UK non profit business, the required capital will be maintained at no less than the level of the EU minimum solvency requirement. This level, together with the margins for adverse deviation in the regulatory reserves, is, in aggregate, in excess of internal capital targets assessed in conjunction with the Individual Capital Assessment (ICA) and the with-profits support account.

The initial strains relating to new non profit business, together with the related EU solvency margin, are supported by releases from existing non profit business and the Society shareholder capital. As a consequence, the writing of new business defers the release of capital to free surplus. The cost of holding required capital is defined as the difference between the value of the required capital and the present value of future releases of that capital. For new business, the cost of capital is taken as the difference in the value of that capital assuming it was available for release immediately and the present value of the future releases of that capital. As the investment return, net of tax, on that capital is less than the risk discount rate, there is a resulting cost of capital which is reflected in the value of new business.

For LGA, the Company Action Level (CAL) of capital has been treated as required capital for modelling purposes. The CAL is the regulatory capital level at which the company would have to take prescribed action, such as submission of plans to the state insurance regulator, but would be able to continue operating on the existing basis. The CAL is currently twice the level of capital at which the regulator is permitted to take control of the business.

For LGN, required capital has been set at 104% of EU minimum solvency margin for all products without FOGs. For those products with FOGs, capital of between 104% and 563% of the EU minimum solvency margin has been used. These capital requirements have been scaled up by a factor of 1.042 at the total level to ensure the total requirement meets the 160% Solvency I from the capital policy for the EEV, for the NBVA no scaling is applied. The level of capital has been determined using risk based capital techniques.

The contribution from new business for our international businesses reflects an appropriate allowance for the cost of holding the required capital.

European Embedded Value 100

5.07 Methodology (continued)

Financial options and guarantees

Under the EEV Principles an allowance for the time value of FOGs is required where a financial option exists which is exercisable at the discretion of the policyholder. These types of option principally arise within the with-profits part of the fund and their time value is recognised within the with-profits burn-through cost described below. Additional financial options for non profit business exist only for a small amount of deferred annuity business where guaranteed early retirement and cash commutation terms apply when the policyholders choose their actual retirement date.

Further financial guarantees exist for non profit business, in relation to index-linked annuities where capped or collared restrictions apply. Due to the nature of these restrictions and the manner in which they vary depending on the prevailing inflation conditions, they are also treated as FOGs and a time value cost is recognised accordingly.

The time value of FOGs has been calculated stochastically using a large number of real world economic scenarios derived from assumptions consistent with the deterministic EEV assumptions and allowing for appropriate management actions where applicable. The management action primarily relates to the setting of bonus rates. Future regular and terminal bonuses on participating business within the projections are set in a manner consistent with expected future returns available on assets deemed to back the policies within the stochastic scenarios.

In recognising the residual value of any projected surplus assets within the with-profits part of the fund in the deterministic projection, it is assumed that terminal bonuses are increased to exhaust all of the assets in the part of the fund over the future lifetime of the in-force with-profits policies. However, under stochastic modelling, there may be some extreme economic scenarios when the total projected assets within the with-profits part of the fund are insufficient to pay all projected policyholder claims and associated costs. The average additional shareholder cost arising from this shortfall has been included in the time value cost of FOGs and is referred to as the with-profits burn-through cost.

Economic scenarios have been used to assess the time value of the financial guarantees for non profit business by using the inflation rate generated in each scenario. The inflation rate used to project index-linked annuities will be constrained in certain real world scenarios, for example, where negative inflation occurs but the annuity payments do not reduce below pre-existing levels. The time value cost of FOGs allows for the projected average cost of these constrained payments for the index-linked annuities. It also allows for the small additional cost of the guaranteed early retirement and cash commutation terms for the minority of deferred annuity business where such guarantees have been written.

LGA FOGs relate to guaranteed minimum crediting rates and surrender values on a range of contracts, as well as impacts on no-lapse guarantees (NLG). The guaranteed surrender value of the contract is based on the accumulated value of the contract including accrued interest. The crediting rates are discretionary but related to the accounting income for the amortising bond portfolio. The majority of the guaranteed minimum crediting rates are between 3% and 4%. The assets backing these contracts are invested in US Dollar denominated fixed interest securities.

LGN separately provides for two types of guarantees: interest rate guarantees and maturity guarantees. Certain contracts provide an interest rate guarantee where there is a minimum crediting rate based on the higher of 1-year Euribor and the policy guarantee rate. This guarantee applies on a monthly basis. Certain other linked contracts provide a guaranteed minimum value at maturity where the maturity amount is the higher of the fund value and a guarantee amount. The fund values for both these contracts are invested in Euro denominated fixed interest securities.

Risk free rate

The risk free rate is set to reflect both the pattern of the emerging profits under EEV and the relevant duration of the liabilities where backing assets reflect this assumption (e.g. equity returns). For the UK, it is set by reference to the gross redemption yield on the 15 year gilt index. For LGA, the risk free rate is the 10 year US Treasury effective yield, while the 10 year ECB AAA-rated Euro area central government bond par yield is used for LGN.

European Embedded Value 101

5.07 Methodology (continued)

Risk discount rate

The risk discount rate (RDR) is a combination of the risk free rate and a risk margin, which reflects the residual risks inherent in the group's covered businesses, after taking account of prudential margins in the statutory provisions, the required capital and the specific allowance for FOGs.

The risk margin has been determined based on an assessment of the group's weighted average cost of capital (WACC). This assessment incorporates a beta for the group, which measures the correlation of movements in the group's share price to movements in a relevant index. Beta values therefore allow for the market's assessment of the risks inherent in the business relative to other companies in the chosen index.

The WACC is derived from the group's cost of equity and debt, and the proportion of equity to debt in the group's capital structure measured using market values. Each of these three parameters is forward looking, although informed by historic information and appropriate judgements where necessary. The cost of equity is calculated as the risk free rate plus the equity risk premium for the chosen index multiplied by the company's beta. Forward-looking or adjusted betas make allowance for the observed tendency for betas to revert to 1 and therefore a weighted average of the historic beta and 1 tends to be a better estimate of the company's beta for the future period. We have computed the WACC using an arithmetical average of forward-looking betas against the FTSE 100 index.

The cost of debt used in the WACC calculations takes account of the actual locked-in rates for our senior and subordinated long term debt. All debt interest attracts tax relief at a rate of 18.5% (2014: 20.1%).

Whilst the WACC approach is a relatively simple and transparent calculation to apply, subjectivity remains within a number of the assumptions. Management believes that the chosen margin, together with the levels of required capital, the inherent strength of the group's regulatory reserves and the explicit deduction for the cost of options and guarantees, is appropriate to reflect the risks within the covered business.

Analysis of profit

Operating profit is identified at a level which reflects an assumed longer term level of investment return.

The contribution to operating profit in a period is attributed to four sources:

i. new business;

ii. the management of in-force business;

iii. development costs; and

iv. return on shareholder net worth.

Further profit contributions arise from actual investment return differing from the assumed long term investment return, and from the effect of economic assumption changes. These are shown below operating profit.

The contribution from new business represents the value recognised at the end of each period from new business written in that period, after allowing for the actual cost of acquiring the business and of establishing the required technical provisions and reserves and after making allowance for the cost of capital. New business contributions are calculated using closing assumptions.

The contribution from in-force business is calculated using opening assumptions and comprises:

i. expected return - the discount earned from the value of business in-force at the start of the year;

ii. experience variances - the variance in the actual experience over the reporting period from that assumed in the value of business in-force as at the start of the year; and

iii. operating assumption changes - the effects of changes in future assumptions, other than changes in economic assumptions from those used in valuing the business at the start of the year. These changes are made prospectively from the end of the period.

Development costs relate to investment in strategic systems and development capability.

The contribution from shareholder net worth comprises the increase in embedded value based on assumptions at the start of the year in respect of the expected investment return on the Society shareholder capital.

Further profit contributions arise from investment return variances and the effect of economic assumption changes.

Economic variances represent:

i. the effect of actual investment performance and changes to investment policy on SNW and VIF business from that assumed at the beginning of the period; and

ii. the effect of changes in economic variables on SNW and VIF business from that assumed at the beginning of the period, which are beyond the control of management, including associated changes to valuation bases to the extent that they are reflected in revised assumptions.

This information is provided by RNS

The company news service from the London Stock Exchange

END

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Legal & General Group (LGEN)

Thursday, 23rd May 2024

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HL. QQ. AJB

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