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Chesnara PLC (CSN)

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Thursday 30 April, 2009

Chesnara PLC

Annual Financial Report


 
Chesnara plc (the 'Company')

ANNUAL FINANCIAL REPORT 

*   Financial Statements for the year ended 31 December 2008

*   Notice of Annual General Meeting

*   Form of Proxy for the Annual General Meeting

Copies of the above documents which were issued to shareholders on 14 April
2009 have been submitted to the UK Listing Authority and will be available for
inspection at the UK Listing Authority's Document Viewing Facility, which is
situated at: The Financial Services Authority, 25 The North Colonade, Canary
Warf, London E14 5HS. The Company's Financial Statements and Notice of Annual
General Meeting  may also be found on its websire at www.chesnara.co.uk.    

The Company announced its preliminary results for the year ended 31 December
2008 on 31 March 2009 which included audited financial statements and a fair
review of business. The Company today provides the following additional
regulated information, included within its Financial Statements, in full
unedited text as required to be made public under the disclosure and
transparency rules. 

STATEMENT OF DIRECTORS' RESPONSIBILITIES IN RESPECT OF THE FINANCIAL
STATEMENTS.


The Directors are responsible for preparing the Group and Parent Company
financial statements in accordance with applicable law and regulations.

Company law requires the Directors to prepare Group and Parent Company
financial statements for each financial year. Under that law they are required
to prepare the Group financial statements in accordance with IFRSs as adopted
by the EU and applicable law and have elected to prepare the Parent Company
financial statements on the same basis.

The Group and Parent Company financial statements are required by law and IFRSs
as adopted by the EU to present fairly the financial position of the Group and
the Parent Company and the performance for the period; the Companies Act 1985
provides in relation to such financial statements that references in the
relevant part of that Act to financial statements giving a true and fair view
are references to their achieving a fair presentation.

In preparing each of the Group and Parent Company financial statements, the
Directors are required to:   

*  select suitable accounting policies and then apply them consistently;

*  make judgements and estimates that are reasonable and prudent;

*  state they have been prepared in accordance with IFRSs as adopted by the EU;

and

*  prepare the financial statements on the going concern basis unless it is
   inappropriate to presume that the Group and Parent Company will continue in
   business.

The Directors are responsible for keeping proper accounting records that
disclose with reasonable accuracy at any time the financial position of the
Parent Company and enable them to ensure that the financial statements comply
with the Companies Act 1985. They have general responsibility for taking such
steps as are reasonably open to them to safeguard the assets of the Group and
detect fraud and other irregularities.

Under applicable law and regulations, the Directors are also responsible for
preparing a Directors' Report, Directors' Remuneration Report and the Corporate
Governance Statement that comply with that law and those regulations.

The Directors are responsible for the maintenance and integrity of the
corporate and financial information included on the Company's website.
Legislation in the UK governing the preparation and dissemination of financial
statements may differ from legislation in other jurisdictions.

We confirm that, to the best of our knowledge:

*  the financial statements, prepared in accordance with the applicable set of
   accounting standards, give a true and fair view of the assets, liabilities,
   financial position and profit or loss of the Company and the undertakings
   included in the consolidation taken as a whole; and

*  the Directors' Report includes a fair review of the development and performance
   of the business and the position of the issuer and the undertakings included in
   the consolidation taken as a whole, together with a description of the
   principal risks and uncertainties that they face.

This responsibility statement was approved by the Board of Directors on 30
March 2009 and was signed by Peter Mason, Chairman and Graham Kettleborough,
Chief Executive

 
PRINCIPAL RISKS AND UNCERTAINTIES


The Group's management of insurance risk is a critical aspect of the business.
The primary insurance activity carried out by the Group comprises the
assumption of the risk of loss from persons that are directly subject to the
risk. Such risks in general relate to life, accident, health and financial
perils that may arise from an insurable event, with the majority of the Group's
exposure relating to mortality risk on individual lives, predominantly in the
UK. As such, the Group is exposed to the uncertainty surrounding the timing and
severity of claims under the related contracts.

The Group is also exposed to a range of financial risks through its life
assurance contracts, financial assets, financial liabilities, including
investment contracts and borrowings, and its reinsurance assets. In particular,
the key financial risk is that in the long-term its investment proceeds are not
sufficient to fund the obligations arising from its insurance and investment
contracts. The most important components of this financial risk are market risk
(interest rate risk and equity price risk), and credit risk, including the risk
of reinsurer default. The Group has procedures for setting and monitoring the
Group's assets and liability position with the objective of ensuring that the
Group can always meet its obligations without undue cost and in accordance with
the Group's internal and regulatory capital requirements.

Detailed information on the characteristics and management of insurance and
financial risks borne by the Group is provided in Notes 4 and 5 respectively of
the Company's published financial statements for the year ended 31 December
2008 and included below under Management of Insurance Risk and Management of
Financial Risk.

In addition, detailed information on accounting estimates and judgements is
included in Note 3 of the Company's published consolidated financial statements
for the year ended 31 December 2008 and included below under the heading
Accounting Estimates and Judgements.

There have been no changes in the nature and incidence of the principal risks
and uncertainties, referred to above, during the twelve months ended 31
December 2008, except in relation to volatility in global investment markets.
The impact of this on reported results for the twelve months ended 31 December
2008 is set out in the commentary under 'IFRS Result' and 'EEV Result' in the
Operating and Financial Review in the financial statements. Clearly there is
continuing significant uncertainty with regard to the direction of investment
markets and attention is drawn particularly to the sensitivity of the reported
embedded value of the Company to investment market and interest rate movements
set out in Note 7 to the European Embedded Value Basis Supplementary
Information in the financial statements.
 

ACCOUNTING ESTIMATES AND JUDGEMENTS
 

The Group makes estimates and assumptions that affect the reported amounts of
assets and liabilities and also makes critical accounting judgements in
applying the Group's accounting policies. Such estimates and judgements are
continually evaluated and are based on historical experience and other factors,
including expectations of future events that are believed to be reasonable. The
more critical areas where accounting estimates and judgements are made are
described below. 


(a) Classification of long-term contracts

The Group has exercised judgement in its classification of long-term business
as between insurance and investment contracts, which fall to be accounted for
differently in accordance with the policies set out in Note 2 of the financial
statements, Accounting Policies. Insurance contracts are those where
significant risk is transferred to the Group under the contract and judgement
is applied in assessing whether the risk so transferred is significant,
especially with regard to pensions contracts, which are predominantly, but not
exclusively, created for investment purposes.


(b) Estimates of future benefits payments arising from long-term insurance
contracts

The Group makes estimates of the expected number of deaths for each of the
years that it is exposed to risk. These estimates are based on either standard
mortality tables or reinsurers' rate tables as appropriate, adjusted to reflect
the Group's own experience. For contracts without fixed terms the Group has
assumed that it will be able to increase charges to policyholders in future
years, in line with emerging mortality experience.

The Group has offered guaranteed annuity options within certain contracts.
Estimates have been made of the number of contract holders who will exercise
these options, in order to measure their value. Changes in investment
conditions could result in significantly more contract holders exercising their
options than the Group has assumed in determining the liabilities arising from
these contracts.

The Group makes estimates of future deaths, voluntary contract terminations,
investment returns and administration expenses at the inception of long-term
insurance contracts with fixed and guaranteed terms. These estimates, which are
reconsidered annually, form the assumptions used to calculate the liabilities
arising from these contracts.

The assumptions used to establish insurance contract liabilities and
appropriate sensitivities relating to variations in critical assumptions are
disclosed in Note 25 of the financial statements.


(c) Fair value of investment contracts

Guaranteed income and guaranteed growth bonds

The fair value of investment contract liabilities, in respect of guaranteed
income and guaranteed growth bonds, (which are fully described in Note 5 of the
financial statements and below in Management of Financial Risk) is established
using a valuation technique, which approximates the following methodology:

 

The fair value of the contract, measured at inception, is the purchase price
paid for it. This price implies a retail market rate of interest prevailing at
the inception of the contract, which is used to equate the contractual cash
flows payable under the bond to the purchase price, including an allowance for
expenses incurred in managing the contract; and

Subsequent measurement of the liability at fair value reflects the impact of
changes in retail market interest rates for these products: this is
accomplished in practice by tracking movements in the less-than-5-year gilt
index as the bonds are predominantly less than 5 years in term.

Fair value measurement has been adopted to reduce volatility in reported
earnings in the income statement as the liabilities so determined are measured
in a way which is consistent with the fair value of the underlying invested
financial assets.

(d) Liability for future redress in respect of mortgage endowment misselling
complaints

Included within insurance contract liabilities is a liability in respect of
amounts anticipated to be payable as redress for upheld mortgage endowment
misselling complaints. In establishing this liability the Group makes estimates
about the number of future upheld complaints (taking into account the number of
complaints received, the number of complaints time-barred and the number of
complaints which are admitted) and about the average cost of redress per upheld
complaint. These estimates are determined, taking into account historical
experience and investment return projections. Variations in these estimates
could result in higher or lower than expected numbers of upheld complaints and
higher or lower than expected amounts of redress per upheld complaint. The
impact of variations in these assumptions is disclosed in Note 25 of the
financial statements.


(e) Deferred acquisition costs and deferred income

The Group applies judgement in deciding the amount of direct costs that are
incurred in acquiring the rights to provide investment management services in
connection with the issue of investment contracts. Judgement is also applied in
establishing the amortisation of the assets representing these contractual
rights and the recognition of initial fees received in respect of these
contracts. The assets are amortised on a straight-line basis over the expected
lifetime of the investment management service contracts and deferred income is
amortised on a straight-line basis over the expected period over which it is
earned. Estimates are applied in determining the lifetime of the investment
management service contracts and in determining the recoverability of the
contractual rights assets by reference to expected future income and expense
levels. This test for recoverability is performed using best estimates of
future cash flows, using a market consistent estimate of future investment
returns.

 
(f) Amortisation of acquired value of in-force business

The Group applies accounting estimates and judgement in determining the fair
value, amortisation and recoverability of acquired in-force business relating
to insurance and investment contracts. The acquired value of in-force business
has been amortised on a basis that reflects the expected profit stream arising
from the business acquired at the date of acquisition. This profit stream is
estimated from the experienced termination rates, expenses of management and
age of the individual contract holders as well as global estimates of
investment growth, based on recent experience at the date of acquisition.
Acquired value of in-force business is tested for recoverability by reference
to expected future income levels.

 

MANAGEMENT OF INSURANCE RISK 

Introduction

The Group's management of insurance risk is a critical aspect of the business.
The primary insurance activity carried out by the Group comprises the
assumption of the risk of loss from persons that are directly subject to the
risk. Such risks in general relate to life, accident, health and financial
perils that may arise from an insurable event, with the majority of the Group's
exposure relating to mortality risk on individual lives, predominantly in the
UK. As such, the Group is exposed to the uncertainty surrounding the timing and
severity of claims under the related contracts.

The Group manages its insurance risk through underwriting limits, approval
procedures for new products or for policies that exceed set limits, pricing
guidelines, reinsurance and monitoring of emerging issues. The Group is
substantially closed to new insurance business and, in practice, only sells a
limited amount of new insurance business to existing policyholders: the
assumption of new insurance risks is, accordingly, limited.

The principal risk is that the frequency and severity of claims is adverse to
that expected. The theory of probability is applied to the pricing and
provisioning for a portfolio of insurance contracts. Insured events are, by
their nature, random, and the actual number and size of events during any one
year may vary from those estimated using established statistical techniques.
The risk under assurance policies is partly naturally hedged by risks under
annuity policies where the exposure is to the risk of longevity.
 

Underwriting strategy

The aim of the underwriting strategy is to avoid the assumption of undue
concentration of risk on any one life and there are defined underwriting
procedures embracing the limits on cover for individual policies.


Reinsurance strategy

The aim of the reinsurance strategy is to reinforce the underwriting strategy
by avoiding the retention of undue concentration of risk on any one life.
Accordingly, there is a policy on reinsurance, which limits the total exposure
on any one policy. However, there are a small number of policies which breach
these limits due to historical reasons.

The Group holds a wide range of reinsurance treaties, including wholly
reinsured business and risk premium reinsurance which includes original terms
reinsurance and facultative reinsurance.

Ceded reinsurance contains credit risk, and such reinsurance recoverables are
reported after deductions for known insolvencies and uncollectable items. The
Group monitors the financial condition of reinsurers on an ongoing basis and
reviews its reinsurance arrangements periodically.

The Group has a policy in place of only entering into new reinsurance contracts
with reinsurers rated A and above.
 

Terms and conditions of insurance contracts

The terms and conditions of insurance contracts that have a material effect on
the amount, timing and uncertainty of future cash flows arising from insurance
contracts are set out in the product analyses below, which give an assessment
of the Group's main products and the ways in which it manages the associated
risks.

 

                                    Sums assured - gross and net of reinsurance   
                                     31 December 2008          31 December 2007    
                                     Gross        Net          Gross        Net       
                                      £000       £000           £000       £000      
                                                                                                 
Annuities-immediate (per             4,568      4,514          4,200      4,108     
annum)                                                                          
                                                                                
Long-term with DPF                  72,728        204         75,697        204       
                                                                                
Long-term without DPF            5,024,349  3,632,144      5,233,417  3,712,227 
                                                                                
                                ---------- ----------     ---------- ----------
                                                                                
Total                            5,101,645  3,636,862      5,313,314  3,716,539 
                                                                                
                                ========== ==========     ========== ==========
                                                                                

Long-term insurance contracts - immediate annuities

Product features

This type of annuity is purchased with a single premium at outset, and is paid
to the policyholder for the remainder of his/her lifetime. Annuities may be
level or escalate at a fixed rate.

There are two types of immediate annuities: retirement and voluntary. Voluntary
annuities are made at the discretion of the policyholder. Policyholders of
personal pensions may have to purchase an immediate annuity on retirement.
Other variations (joint life annuities) are to continue the annuity (at the
same level or lower) to the surviving spouse or partner.

Payments are often guaranteed to be paid for a minimum term regardless of
survival (e.g. 5 or 10 years).

Profit on existing contracts arises when mortality and investment experience
are better than expected. All risks and rewards associated with this type of
product accrue to shareholders.


Management of risks

The main risks associated with this product are longevity and investment risks.
Longevity risks arise as the annuities are paid for the lifetime of the
policyholder, and this risk is managed through the initial pricing of the
annuity. Investment risk depends on the extent to which the annuity payments
under the contracts have been matched by suitable assets. The Group regularly
monitors the asset matching for these contracts as explained in the Market Risk
Management section of Note 5 of the financial statements and included below
under Management of Financial Risks.

The key risks are managed through appropriate pricing and product design.
Reinsurance is not generally used for this product, although there is a small
number of reinsured policies. Underwriting is not used for this product.

In respect of mortality risk (longevity), the pricing assumption is based on
both historic in-house and industry available information on mortality
experience for the population of policyholders, including allowances for future
mortality improvements. 

In respect of investment risk, with this type of product the lump sum premium
is available for the Group to invest at the start of the contract. The asset
mix will consist of fixed interest securities, including gilts, with varying
redemption dates. The income earned on the investment will not usually be
sufficient to cover the annuity and the expense outgo, so each year part of the
lump sum will be disinvested, which is taken account of in the asset mix, in
order to balance the fund. If annuitants die as expected the assets referred to
above would be appropriate. However, in most cases annuitants will not die as
expected and, therefore, the Group will need to buy and sell assets as
necessary throughout the term of the policies to minimise the risk of mismatch.
This position is monitored on a regular basis. Details of default risk on the
fixed interest securities are set out in the Credit Risk Management section of
Note 5 of the financial statements and included below under Management of
Financial Risks.

 
Concentration of insurance risks

The tables for immediate annuity contracts set out below illustrate the
concentration of risk based on two bands of contracts grouped by the annuity
payable each year for each annuity policy insured.

Annuity payable each year for each life      Total annuities payable each year 
insured                                                                        
                                                       Before             After
                                                  reassurance       reassurance
As at 31 December 2008                            £000      %       £000      %      
                                                                               
£0 - £25,000                                     4,523   99.0      4,505   99.8   
                                                                               
More than £25,000                                   45    1.0          9    0.2    
                                                                               
                                                 4,568  100.0      4,514  100.0  
                                                                               
As at 31 December 2007                                                         
                                                                               
£0 - £25,000                                     4,155   98.9      4,099   99.8   
                                                                               
More than £25,000                                   45    1.1          9    0.2    
                                                                               
                                                 4,200  100.0      4,108  100.0  
                                                                               


Long-term insurance contracts - with discretionary participation features

Product features

The Group historically wrote with-profits business in the UK, where the
policyholder benefits comprise a guaranteed sum assured payable on death or at
maturity, to which may be added a discretionary annual bonus and a
discretionary terminal bonus.

Management of risks

This business is wholly reassured to Guardian and hence the only risk retained
by the Group for this business is the risk of default by the reinsurer. This
risk is detailed in the Credit Risk Management section of Note 5 of the
financial statements and included below under Management of Financial Risks.

Long-term insurance contracts - without discretionary participation features

Product features

The Group has written both non-linked and unit-linked contracts, which include
death and morbidity benefits on a whole life, endowment and term assurance
basis.

For contracts where death is the insured risk, the most significant factors
that could increase risk are epidemics (such as AIDS, SARS or a flu pandemic)
or widespread changes in lifestyle, such as eating, smoking and exercise
habits, resulting in earlier or more claims than expected.

Management of risks

Unit-linked insurance contracts are contracts where monthly reviewable charges
are made for insurance risk and administration charges and consist mainly of
regular unit-linked endowments where the primary purpose is to provide an
investment return. In addition, the policyholder is insured against death and
serious injury. Unit-linked contracts operate by investing the policyholders'
premiums into pooled investment funds of the Group, the policyholders' share of
the fund being represented by units. The benefit is payable on death, or
maturity if earlier, the amount payable on death being subject to a guaranteed
minimum amount. Therefore, the Group is exposed only to insurance risk insofar
as the value of the unit-linked fund is lower than the guaranteed minimum death
benefit. The maturity or surrender value depends on the investment performance
of the underlying fund and on the level of charges levied by the Group for
policy administration fees, mortality and other charges. 

For contracts with fixed and guaranteed benefits and fixed future premiums,
there are no mitigating terms and conditions that reduce the insurance risk
accepted. This is the case for a small proportion (approximately 5% of total
sums assured) of the life assurance business sold by the Group.

For the remainder of the business, operated on a quasi-linked basis, the Group
charges for mortality risk on a monthly basis and has the right to alter these
charges based on its mortality experience and hence minimise its exposure to
mortality risk. The Group also reserves the right at regular intervals to
change the premium payable in the light of charges made for insurance risk and
administration services and the investment performance of the assets notionally
backing these contracts. Delays in implementing increases in charges and market
or regulatory restraints over the extent of the increases may reduce this
mitigating effect.

A number of these contracts also include Permanent Health Insurance (PHI)
benefits which have reviewable charges and the Group reserves the right to
alter these charges based on its morbidity experience and hence to minimise its
exposure to morbidity risk. Delays in implementing increases in charges and
market or regulatory restraints over the extent of the increases may reduce
this mitigating effect. 

Reinsurance is used extensively on the business described above to mitigate
concentrations of insurance risk. The insurance risk is further managed through
pricing, product design and, for non-linked and quasi-linked contracts,
appropriate investment strategy.

For units held under unit-linked contracts all of the investment risk is borne
by the policyholder with the exception of a small number of contracts which
provide for a minimum guaranteed rate of return, as investment performance
directly affects the value of the unit fund and hence the benefits payable.

Concentration of insurance risk

The tables for long term insurance contracts set out below illustrate the
concentration of risk based on five bands of contracts grouped by benefits
assured for each policy assured.


Benefits assured for each                 Total benefits assured                                                   
life assured                               
                              Before reinsurance        After reinsurance      
In £000's bands                  £m           %            £m           %         
                                                                               
As at 31 December 2008                                                         
                                                                               
0 - 250                       4,930        96.8         3,611        99.4      
                                                                               
250 - 500                       116         2.3            20         0.6       
                                                                               
500 - 750                        27         0.5             1           -         
                                                                               
750 - 1,000                      12         0.2             -           -         
                                                                               
More than 1,000                  12         0.2             -           -         
                                                                               
                         ----------  ----------    ----------  ----------
                                                                               
                              5,097       100.0         3,632       100.0     
                                                                               
                         ==========  ==========    ==========  ==========
                                                                               
                                                                               
                                                                               
As at 31 December 2007                                                         
                                                                               
0 - 250                       5,136        96.8         3,694        99.5      
                                                                               
250 - 500                       117         2.2            17         0.4       
                                                                               
500 - 750                        33         0.6             2         0.1       
                                                                               
750 - 1,000                      12         0.2             -           -         
                                                                               
More than 1,000                  12         0.2             -           -         
                                                                               
                         ----------  ----------    ----------  ----------
                                                                               
                              5,310       100.0         3,713       100.0     
                                                                               
                         ==========  ==========    ==========  ========== 
                                    
                                                                               

In addition to the above the Group has, at 31 December 2008, a total of
approximately £10.3m per annum of retained PHI sums assured (31 December 2007:
approximately £17m). The Group does not retain PHI sums assured on any one life
greater than £25,000 per annum.

Long-term insurance contracts - guaranteed annuity options

Product features

There are a small number of unit-linked deferred annuity policies with
guarantees regarding the rate at which the policyholder is able to convert the
unit fund into an annuity at retirement, which creates an insurance liability.
At retirement the fund available can either be transferred to another provider,
used to purchase an annuity with a Group company at the annuity rates then
applying, or used to purchase an annuity from a Group company at guaranteed
annuity rates written into the policy document. The guaranteed annuity rates
are only available in certain circumstances. Policyholders gain the benefit of
whichever of the then-current annuity rates and guaranteed annuity rates give
them the higher benefits.

Management of risks

The main risks associated with this product are longevity and market risks.
These were controlled through product design and pricing. However, the
guaranteed annuity rates were set during the 1960s and 1970s, when these
products were sold. As these rates are no longer suitable in current
conditions, appropriate technical provisions are held to reflect the risk
arising from the guarantees.

The longevity assumptions underlying the technical provisions are based on both
historic in-house and industry available information on mortality experience
for the population of policyholders, including allowances for future mortality
improvements.

Concentration of insurance risks

There are 292 such policies in force as at 31 December 2008 (as at 31 December
2007: 330). The underlying contracts have total unit funds of £2.6m (as at 31
December 2007: £4.1m), with the largest fund being less than £0.4m.

Other risks on insurance contracts

Apart from financial risks relating to the financial assets, which support life
assurance contracts, as set out in Note 5 of the financial statements and
included below under Management of Financial risks, there are other significant
types of risk pertaining to life insurance contracts, as follows:

Expense risk

The Group strategy is to outsource all operational activities to third party
administrators in order to reduce the significant expense inefficiencies that
would arise with fixed and semi-fixed costs on a diminishing policy base. There
are, however, risks associated with the use of outsourcing. In particular,
there will be a need in future to renegotiate the terms of the outsourcing
arrangements as the existing agreements expire. There is also a risk that, at
some point in the future, third party administrators could default on their
obligations. The Group monitors the financial soundness of third party
administrators and it has retained step-in rights on the more significant of
these agreements. There are also contractual arrangements in place which
provide for financial penalties in the event of default by the administration
service providers.


Mortgage endowment misselling complaints

The life businesses have experienced a significant level of complaints from
mortgage endowment policyholders since their first regulatory mailing programme
in 2000. In response to this, the Life business hold mortgage endowment
complaints redress provisions. The Group continues to monitor closely, among
other factors, the volume of complaints and the value of compensation paid to
policyholders in order to assess the continuing adequacy of the provisions.

There remains however a residual risk that at some point in future the levels
of complaints received may prove to be higher than those anticipated within the
provision.

 
Persistency risk

Persistency risk is the risk that the investor cancels the contract or
discontinues paying new premiums into the contract, thereby exposing the Group
to a loss resulting from an adverse movement in the actual experience compared
to that expected in the product pricing. Although changes in the levels of
persistency would not adversely affect the result in the short term they would
reduce future profits available from the contract.

 

MANAGEMENT OF FINANCIAL RISK 

Introduction

The Group's management of financial risk is a critical aspect of the business.
For a significant proportion of the Group's life insurance contracts, the cash
flows are linked, directly or indirectly, to the performance of the financial
assets which support those contracts. This gives rise to financial risk, which
also arises on the Group's investment contracts in relation to financial assets
which support these contracts. The Group has procedures for setting and
monitoring the Group's assets and liability position with the objective of
ensuring that the Group can always meet its obligations without undue cost and
in accordance with the Group's internal and regulatory capital requirements.

The Group is exposed to a range of financial risks through its life assurance
contracts, financial assets, financial liabilities, including investment
contracts and borrowings, and its reinsurance assets. In particular, the key
financial risk is that in the long-term its investment proceeds are not
sufficient to fund the obligations arising from its insurance and investment
contracts. The most important components of this financial risk are market risk
(interest rate risk and equity price risk), and credit risk, including the risk
of reinsurer default.

The Group manages these risks within an asset liability management (ALM)
framework that has been developed to achieve long-term investment returns at
least equal to its obligations under insurance and investment contracts, with
minimal risk. Within the ALM framework the Group periodically produces reports
at legal entity and asset and liability class level, which are circulated to
the Group's key management.  The principal technique of the Group's ALM
framework is to match assets to the liabilities arising from insurance and
investment contracts by reference to the type of benefits payable to
policyholders, with separate portfolios of assets being maintained for each
distinct class of liability.

For unit-linked contracts the Group's objective is to match the liabilities,
both insurance and investment contract liabilities, with units in the fund to
which the value of the liability is linked. For other business, the Group's
objective is to match the timing of cash flows from insurance and investment
contract liabilities with the timing of cash flows from assets subject to
identical or similar risks. By matching the cash flows of liabilities with
those of suitable assets, market risk is managed effectively, whilst liquidity
risk is minimised. These processes to manage the risks, which the Group has not
changed from previous periods, ensure that the Group is able to meet its
obligations under its contractual liabilities as they fall due.

Terms and conditions of investment contracts

The terms and conditions of insurance contracts that have a material effect on
the amount, timing and uncertainty of future cash flows arising from insurance
contracts are set out in Note 4 of the financial statements and included above
under Management of Insurance Risk. The terms and conditions of investment
contracts that have a material effect on the amount, timing and uncertainty of
future cash flows arising from investment contracts are set out in the product
analyses below.

The Group provides three types of investment contract which are predominantly
written in the UK.

Unit-linked savings

These are typically single premium contracts, with the premiums invested in a
pooled investment fund (usually an internal fund of the life assurance
company), where the policyholder's investment in the fund is represented by
units. There is a small additional benefit payable on death which does not
transfer significant insurance risk to the Group for these contracts. The
benefits payable at maturity or surrender of the contract are the bid value of
these units less surrender penalties, where applicable. The key variables
affecting the timing and uncertainty of future cash flows are investment
performance, persistency and expense inflation.

Unit-linked pensions

The contractual features are similar to unit-linked savings, except they may be
single or regular premium contracts. The benefits payable on retirement
purchase an open market pension annuity.

The key variables affecting the timing and uncertainty of future cash flows are
investment performance, interest risks, persistency and expense inflation.

Guaranteed Income and Growth Bonds

Guaranteed Income bonds are mainly single premium contracts for a fixed term
offering, either monthly or annually, fixed payments together with a return of
premium at the maturity date.  A guaranteed growth bond variant has also been
issued which offers no income but a higher guaranteed payment at the maturity
date.

The key variables affecting the timing and uncertainty of cash flows are
expense inflation, interest rates, persistency and mortality.

Risks associated with investment contracts

The risks associated with investment contracts are expense risk, persistency
risk and market risk. Market risk is the risk that the fair value of future
cash flows will fluctuate because of a change in interest or foreign currency
exchange rates or in equity prices and the consequent effect that this has on
the value of charges earned by the Group and on any guarantees in the
contracts. Expense risk is of the same nature as described under other risks on
insurance contracts in Note 4 (see page 59). Persistency risk is the risk that
the investor cancels the contract or discontinues paying new premiums into the
contract, thereby exposing the Group to a loss resulting from an adverse
movement in the actual experience compared to that expected in the product
pricing. Although changes in the levels of persistency would not adversely
affect the result in the short term they would reduce future profits available
from the contract.

Market risk management

The notes below explain how market risks are managed using the categories
utilised in the Group's ALM framework. In particular, the ALM framework
requires the management of interest risk, equity price risk, and liquidity risk
at the portfolio level, so that the appropriate risks for each portfolio may be
managed in an effective way. The Group is not significantly exposed to foreign
exchange risk as the only assets denominated in foreign currencies are matched
by corresponding insurance contract provisions and financial liabilities. To
reflect the Group risk management approach the required disclosures for
interest rate, equity price and liquidity risks, as appropriate, are given
separately for each portfolio of the ALM framework. The following tables
reconcile the balance sheet to the classes and portfolios used in the Group's
ALM framework.
 

31 December                                                                        
2008                                                                               
                                                                     
                                 Insurance                               Other              
                   Guaranteed    contracts  Unit-linked  Annuities  Non-linked           
             Total      bonds     with DPF    contracts in payment   contracts    Other     
Assets        £000       £000         £000         £000       £000        £000     £000      
                                                                                                      
Intangible                                                                                            
assets                                                                                                
                                                                                                      
Deferred                                                 
acquisition                                                                                           
costs        8,590          -            -            -          -           -    8,590     
                                                                                                      
Acquired                                                                                              
value of                                                                                              
in-force                                                                                              
business                                                                                              
                                                                                                      
                                                            
Insurance                                                                                             
contracts   16,866          -            -            -          -           -   16,866    
                                                                                                      
                                                             
Investment                                                                                            
contracts   11,610          -            -            -          -           -   11,610    
                                                                                                      
Reinsurers'                                                                                           
share of                                                                                              
insurance                                                                                             
contract                                                                                              
provisions 182,693          -       79,484      100,093          -       3,116        -         
                                                                                                      
Amounts                                                                                               
deposited                                                                                             
with                                                       
reinsurers  22,181          -            -       22,181          -           -        -         
                                                                                                      
Investment                                                 
properties   3,432          -            -        2,932          -           -      500       
                                                                                                       
Financial                                                                                             
assets                                                                                                
                                                                                                      
Equity                                                                                              
securities                                                                                            
at fair                                                   
value                                                                                                 
through                                                                                               
income     363,879          -            2      363,872          -           5        -         
                                                                                                      
Holdings                                                                                            
in                                                                                                    
collective                                                                                            
investment                                                                                            
schemes at                                               
fair value                                                                                            
through                                                                                               
income     576,502          -        2,578      554,817          -       8,041   11,066    
                                                                                                      
Debt                                                                                                
securities                                                                                            
at fair                                                 
value                                                                                                 
through                                                                                               
income     279,104     51,360            -      129,517     70,957      21,392    5,878     
                                                                                                      
Insurance                                                                                           
and other                                                                                             
receivables 11,056      2,127            -            -          -       1,423    7,506     
                                                                                                      
Prepayments  1,600          -            -            -          -           -    1,600     
                                                                                                      
Derivative                                                                                          
financial                                                                                             
instruments  5,570          -            -        5,570          -           -        -         
                                                                                                      
        ---------- ----------   ----------   ---------- ----------  --------- ---------
                                                                                                      
Total                                                   
financial                                                                                             
assets   1,237,711     53,487        2,580    1,053,776     70,957     30,861    26,050    
                                                                                                      
        ---------- ----------   ----------   ---------- ----------  --------- ---------
                                                                                                      
Reinsurers'                                                                                           
share of                                                                                              
accrued                                                  
policyholder                                                                                          
claims       4,100          -            -            -          -      1,192     2,908     
                                                                                                      
Cash and                                                
cash                                                                                                  
equivalent 192,381      3,031          368       50,257      7,260     13,135   118,330   
                                                                                                      
        ---------- ----------   ----------   ----------  ---------  --------- --------- 
                                                                                                      
Total    1,679,564     56,518       82,432    1,229,239     78,217     48,304   184,854
Assets                                                                                                      
        ========== ==========   ==========   ========== ========== ========== =========
                                                                                                      

 

 

                                                                                       
                                Insurance                              Other            
                    Guaranteed  contracts Unit-linked  Annuities  non-linked               
              Total      bonds   with DPF   contracts in payment   contracts   Other     
Liabilities    £000       £000       £000        £000       £000        £000    £000      
                                                                                                     
Bank                                  
overdraft     1,094          -          -          38          -         822     234       
                                                                                                     
Insurance                                                                                            
contract                                                                                             
provisions  923,506          -     82,432     728,179     78,217      34,678       -         
                                                                                                     
Financial                                                                                            
liabilities                                                                                          
                                                                                                     
                                                                                                     
Investment                                                                                           
contracts   558,542     55,119          -     494,449          -       8,974       -         
                                                                                                     
Borrowings    8,358          -          -           -          -           -   8,358     
                                                                                                     
Derivative                                                                                           
financial                                                                                            
instruments      70          -          -          70          -           -       -         
                                                                                                     
         ---------- ---------- ----------  ---------- ----------  ---------- -------
                                                                                                     
Total                                                   
financial                                                                                            
liabilities 566,970     55,119          -     494,519          -       8,974   8,358     
                                                                                                     
         ---------- ---------- ----------  ----------   --------  ---------- -------
                                                                                                     
Provisions    3,397          -          -           -          -         179   3,218     
                                                                                                     
Deferred                                                  
tax                                                                                                  
liabilities  10,798         90          -           -          -         147  10,561    
                                                                                                     
Reinsurance                                              
payables      1,397          -          -           -          -         253   1,144     
                                                                                                     
Payables                                                                                             
related to                                                                                           
direct                                                                                               
insurance                                                                                            
and                                                      
investment                                                                                           
contracts    23,891      1,309          -           -          -         942  21,640    
                                                                                                     
Deferred                                                   
income       14,575          -          -           -          -           -  14,575    
                                                                                                     
Income                                                     
taxes         1,074          -          -           -          -           -   1,074     
                                                                                                     
Other                                                   
payables      6,494          -          -           -          -       2,309   4,185     
                                                                                                     
         ---------- ---------- ----------  ---------- ----------  ---------- -------
                                                                                                     
Total                                                  
liabil-
ities     1,553,196     56,518     82,432   1,222,736     78,217      48,304  64,989    
                                                                                                     
         ========== ========== ==========  ========== ==========  ========== =======
                                                                                                     

 

31 December                                                                        
2007                                                                             
                                                                     
                                 Insurance                               Other              
                   Guaranteed    contracts  Unit-linked  Annuities  Non-linked           
             Total      bonds     with DPF    contracts in payment   contracts    Other     
Assets        £000       £000         £000         £000       £000        £000     £000      
                                       
Intangible                                                                                            
assets                                                                                                
                                                                                                      
Deferred                                                                                            
acquisition                                                                                           
costs        9,542          -            -            -          -           -    9,542     
                                                                                                      
Acquired                                                                                              
value of                                                                                              
in-force                                                                                              
business                                                                                              
                                                                                                      
                                                                                                      
Insurance                                                                                             
contracts   19,427          -            -            -          -           -   19,427    
                                                                                                      
                                                                                                      
Investment                                                                                            
contracts   12,627          -            -            -          -           -   12,627    
                                                                                                      
Reinsurers'                                                                                           
share of                                                                                              
insurance                                                                                             
contract                                                                                              
provisions 212,353          -       87,279      122,327          -       2,747        -         
                                                                                                      
Amounts                                                                                               
deposited                                                                                             
with                                                                                                  
reinsurers  27,558          -            -       27,558          -           -        -         
                                                                                                      
Investment                                                                                            
properties   4,983          -            -        4,483          -           -      500       
                                                                                                      
Financial                                                                                             
assets                                                                                                
                                                                                                      
  Equity                                                                                              
securities                                                                                            
at fair                                                                                               
value                                                                                                 
through                                                                                               
income     743,670          -        1,020      740,105          -       2,545        -         
                                                                                                      
Holdings                                                                                            
in                                                                                                    
collective                                                                                            
investment                                                                                            
schemes at                                                                                            
fair value                                                                                            
through                                                                                               
income     508,857          -        2,093      467,916          -       5,224   33,624    
                                                                                                      
Debt                                                                                                
securities                                                                                            
at fair                                                                                               
value                                                                                                 
through                                                                                               
income     247,152     80,844            -       84,424     59,589      18,727    3,568     
                                                                                                      
Insurance                                                                                           
and other                                                                                             
receivables 15,131      2,750            -            -          -         874   11,507    
                                                                                                      
Prepayments    284          -            -            -          -           -      284       
                                                                                                      
Derivative                                                                                          
financial                                                                                             
instruments  9,525          -            -        9,525          -           -        -         
                                                                                                      
        ---------- ----------   ----------   ---------- ----------  ---------- --------
                                                                                                      
Total                                                                                                 
financial                                                                                             
assets   1,524,619     83,594        3,113    1,301,970     59,589      27,370   48,983    
                                                                                                      
        ----------  ---------   ----------   ---------- ----------  ---------- --------
                                                                                                      
Reinsurers'                                                                                           
share of                                                                                              
accrued                                                                                               
policyholder                                                                                          
claims       4,661          -            -            -          -       1,109    3,552     
                                                                                                      
Cash and                                                                                              
cash                                                                                                  
equivalent 225,127      2,834          399      104,291      2,965      17,107   97,531    
                                                                                                      
        ---------- ----------   ----------   ---------- ----------  ---------- --------
                                                                                                      
Total    2,040,897     86,428       90,791    1,560,629     62,554      48,333  192,162   
assets                                                                                                      
        ========== ==========   ==========   ========== ==========  ========== ========
                                                                                                      

 

                                 Insurance                              Other            
                     Guaranteed  contracts Unit-linked  Annuities  non-linked               
               Total      bonds   with DPF   contracts in payment   contracts   Other     
Liabilities     £000       £000       £000        £000       £000        £000    £000   
                                                                                                     
Bank                                                                                                 
overdraft      1,229          -          -           -          -           -   1,229     
                                                                                                     
Insurance                                                                                            
contract                                                                                             
provisions 1,110,848          -     90,791     922,419     62,554      35,084       -         
                                                                                                     
Financial                                                                                            
liabilities                                                                                          
                                                                                                     
                                                                                                     
Investment                                                                                           
contracts    726,503     85,367          -     630,844          -      10,292       -         
                                                                                                     
Borrowings    12,469          -          -           -          -           -  12,469    
                                                                                                     
Derivative                                                                                           
financial                                                                                            
instruments      265          -          -         265          -           -       -         
                                                                                                     
          ---------- ---------- ----------  ---------- ----------  ---------- -------
                                                                                                     
Total                                                                                                
financial                                                                                            
liabilities  739,237     85,367          -     631,109          -      10,292  12,469    
                                                                                                     
          ---------- ---------- ----------  ---------- ----------  ---------- -------
                                                                                                     
Provisions     3,575          -          -           -          -         159   3,416     
                                                                                                     
Deferred                                                
tax                                                                                                  
liabilities   11,847       (250)         -           -          -          25  12,072    
                                                                                                    
Reinsurance                                              
payables       1,622          -          -           -          -         372   1,250     
                                                                                                     
Payables                                                                                             
related to                                                                                           
direct                                                                                               
insurance                                                                                            
and                                                                                                  
investment                                                                                           
contracts     22,859      1,311          -           -          -         504  21,044    
                                                                                                     
Deferred                                                    
income        16,362          -          -           -          -           -  16,362    
                                                                                                     
Income                                                     
taxes            743          -          -           -          -           -     743       
                                                                                                     
Other                                                   
payables       6,791          -          -           -          -       1,897   4,894     
                                                                                                     
          ---------- ---------- ----------  ---------- ----------  ---------- -------
                                                                                                     
Total                                                  
liab-
ilities    1,915,113     86,428     90,791   1,553,528     62,554      48,333  73,479    
                                                                                                     
          ========== ========== ==========  ========== ==========  ========== =======
                                                                                                     

 

Guaranteed bonds

These contracts are for a fixed term with financial benefits that are fixed and
guaranteed at the inception of the contract. The Group manages its market risk,
its only material risk on these products, by matching closely contracts written
with fixed interest debt securities of a suitable duration and quality, as
indicated by their credit rating.  The result is that, for these contracts, the
Group's primary financial risk is the risk that interest income and capital
redemptions from the financial assets backing the liabilities are insufficient
to fund the guaranteed benefits payable. By using fixed interest debt
securities, there is no exposure to equity price risk for this portfolio.

Regular monitoring of the interest rate risk is carried out by analysis of
expected cash flows from the financial assets held with those for the
liabilities.  Cash flows for the liabilities are determined assuming all
contracts continue until their expected maturity date. This analysis also
enables the Group to control its liquidity risk for this portfolio.

The following tables indicate the amount and timing of the cash flows arising
from the liabilities in this category of the Group's ALM framework.

 

31 December 2008                                      Contractual cash flows
                                                               (undiscounted)
Carrying        Carrying     0-1 year    1-2 years    2-3 years    3-4 years     
values and       amounts                                                          
cash flows                                                                     
arising                                                                        
from:                                                                          
                    £000         £000         £000         £000         £000       
                                                                               
Assets                                                                         
backing                                                                        
liabilities:                                                                   
                                                                               
Debt              51,360       35,498       12,455        6,907            -    
securities                                                                     
at fair                                                                        
value                                                                          
through                                                                        
income                                                                         
                                                                               
Insurance          2,127        2,127            -            -            -    
and other                                                                      
receivables                                                                    
                                                                               
Cash and           3,031        3,031            -            -            -    
cash                                                                           
equivalents                                                                    
                                                                               
              ----------   ----------   ----------   ----------   ----------    
                                                                               
Total             56,518       40,656       12,455        6,907            -    
                                                                               
Liabilities       56,518       36,628       13,982        7,135            -    
                                                                               
              ----------   ----------   ----------   ----------   ----------    
                                                                               
Difference             -        4,028       (1,527)        (228)           -    
in expected                                                                     
cash flows                                                                     
                                                                               
              ==========   ==========   ==========   ==========   ==========    
                                                                               

 

 

31 December 2007                        Contractual cash flows (undiscounted)
Carrying        Carrying     0-1 year    1-2 years    2-3 years    3-4 years     
values and       amounts                                                          
cash flows                                                                     
arising                                                                        
from:                                                                          
                    £000         £000         £000         £000         £000       
                                                                               
Assets                                                                         
backing                                                                        
liabilities:                                                                   
                                                                               
Debt              80,844       36,480       35,126       11,899        5,691    
securities                                                                     
at fair                                                                        
value                                                                          
through                                                                        
income                                                                         
                                                                               
Insurance          2,750        2,750           --           --           --    
and other                                                                      
receivables                                                                    
                                                                               
Cash and           2,834        2,834           --           --           --    
cash                                                                           
equivalents                                                                    
                                                                               
              ----------   ----------   ----------   ----------   ----------    
                                                                               
Total             86,428       42,064       35,126       11,899        5,691    
                                                                               
Liabilities       86,428       38,137       35,480       12,579        5,068    
                                                                               
              ----------   ----------   ----------   ----------   ----------    
                                                                               
Difference            --        3,927         (354)        (680)         623    
in expected                                                                    
cash flows                                                                     
                                                                               
              ==========   ==========   ==========   ==========   ==========    
                                                                               

 

These contracts can be surrendered before maturity for a cash surrender value.
For these contracts the Group is not required to separately measure this
embedded derivative at fair value. The terms are such that the surrender value
will broadly change in line with changes in the market value of the matching
assets, and so there is no significant risk of mismatch.

Sensitivity analysis - interest rate risk

The sensitivity analysis for interest rate risk illustrates how changes in the
fair value or future cash flows of a financial instrument will fluctuate
because of changes in market rates at the reporting date.

The carrying amount of both the liabilities and the assets, which are fixed
interest debt securities valued at fair value, will be sensitive to changes in
the level of interest rates.  By reviewing the matching of the cash flows by
term, on a quarterly basis, management aim to minimize the impact of a change
in values due to a parallel movement in all yield curves.

A 100 basis point increase or decrease in interest yields would not have a
material effect on either profit for the year ended 31 December 2008 and for
the year ended 31 December 2007 or shareholder equity as at those dates. 


Insurance contracts with discretionary participation features

The Group historically wrote with-profits business in the UK, where the
policyholder benefits comprise a discretionary annual bonus and a discretionary
terminal bonus.  The with-profits business is wholly reinsured to Guardian and
hence the only risk retained by the Group for this business is the risk of
default by the reinsurer. This risk is detailed under 'Credit Risk Management'
below.

With-profits business can be surrendered before maturity for cash surrender
specified in the contractual terms and conditions. The impact on the Group's
current year results would be minimal as any payments to policyholders are
matched by payments from Guardian under the reinsurance contract  For all these
contracts the Group is not required to separately measure this embedded
derivative at fair value.

A maturity analysis based on the earliest contractual repayment date would
present all the liabilities as due in the earliest period of the table because
these options can be exercised immediately by all policyholders.

For a small element of the with-profits business, policyholders have the option
to invest a portion of their investment in unit-linked funds as an alternative
to the with-profits fund.  In this case a portion of the business is retained,
with the management of financial risks of this portion being the same as
described under 'Unit-linked Contracts' below.

Unit-linked contracts

For unit-linked contracts, which may be insurance or investment contracts, the
Group matches all the financial liabilities, which are linked to units in the
insurance company funds, with assets on which the unit prices are based.  This
approach results in the Group having no significant market risk (being interest
rate, equity price and currency risks) or credit risk on these contracts. Its
primary exposure to market risk is the risk of volatility in asset management
fees due to the impact of interest rate and equity price movements on the fair
value of the assets held in the linked funds, on which investment management
fees are based.

In practice, there remain a number of areas where there is a residual risk as
follows:

Surplus units

Market risk arises from the existence of surplus units (over and above
requirements to match policyholder unit liabilities) in the insurance company
funds. Such surplus units (which effectively back surplus carried forward in
the long-term insurance funds) arise because the number of units in the funds
are in decline.

Mortgage endowment misselling redress provision

Market risk arises in two ways in respect of the redress provisions for
mortgage endowment misselling. The first is that a fall in equity prices
directly increases the cost of future redress payments. In addition it is also
likely that a large fall in equity prices would increase the propensity for
policyholders to make a complaint about their mortgage endowment policies.  The
sensitivity of the redress provision to equity price changes is disclosed in
Note 26 of the financial statements.

Guaranteed annuity options

For a small number of unit-linked contracts guarantees exist regarding the rate
at which the policyholder is able to convert the unit fund into an annuity at
retirement, as described above. As the policyholders gain the benefit of
whichever of the then-current annuity rates and guaranteed annuity rates give
them the higher benefits, this creates an interest rate risk, in that yields
available at the time the option is taken may be lower than those assumed in
the guaranteed rates. A provision is held for the cost of this guarantee.  

Guarantees in Timed Investment Funds

Investment guarantees have been made in respect of policies invested in the
Group's Timed Investment Funds whereby the price paid to policyholders for
their units on death or maturity will always be the highest price that the
units have reached during their period of investment in the funds. Although
there is a charge paid by policyholders for this guarantee there is a risk to
shareholders that this will be insufficient to meet the full cost of this
guarantee: this risk is managed within the investment strategy of the fund (see
Note 25(f) of the financial statements for more details). A provision is held
for the cost of this guarantee.

The key assumption in determining this provision is the level of potential
future fall in equities. An increase in this assumption, from 25% to 30%, would
result in a £0.2m decrease in profit for the year ended 31 December 2008 and to
shareholder equity as at 31 December 2008 (the increase would not have had a
material effect for the year ended 31 December 2007 and as at 31 December 2007)

Change in insurance contract provisions

When calculating insurance contract provisions for the non-unit component of
liabilities under linked contracts, allowance is made for both future
investment management charges and investment expenses as a proportion of unit
funds. As investment charges are generally in excess of investment expenses
this surplus is used to offset future administration expenses on the contracts.
In a falling market the absolute amount of the surplus of investment charges
over investment expenses would reduce and hence this might lead to an increase
in insurance contract provisions.

Bonus units

Certain contracts (primarily investment contracts) contain a condition that
bonus units are allocated at fixed dates in the future, essentially as a rebate
of a portion of the management fees charged during the period since the last
such bonus allocation. Financial assets are held to back the units that will be
allocated, so as to remove the risk of adverse market price movements. This
results in an apparent excess of financial assets over liabilities with an
exposure to market risk.

Unit-linked contracts can be surrendered before maturity for cash surrender
specified in the contractual terms and conditions.  The terms are such that the
surrender value will either be equal to the carrying amount of the contract
liability, or in some cases lower due to surrender penalties specified in the
contract terms and conditions.  The impact on the Group's current year results
would therefore be minimal. For all these contracts the Group is not required
to separately measure this embedded derivative at fair value.

A maturity analysis based on the earliest contractual repayment date would
present all the liabilities as due in the earliest period of the table because
these options can be exercised immediately by all policyholders.

Sensitivity analysis - equity risk

A decrease of 10% in the value of the assets would reduce asset management
fees, which would result in a £0.8m decrease in profit for the year ended 31
December 2008 and to shareholder equity as at 31 December 2008 (year ended 31
December 2007 and as at 31 December 2007: £0.9m decrease).

Annuities in payment

These are contracts which pay guaranteed financial benefits, generally monthly,
for the lifetime of the policyholder, and in some cases of their spouse. For
certain contracts payments are guaranteed to be paid for a minimum term
regardless of survival (e.g. for 5 or 10 years). The terms are guaranteed at
the inception of the contract. The financial component of these contracts is a
guaranteed fixed interest rate and hence the Group's primary financial risk on
these contracts is the risk that interest income and capital redemptions from
the financial assets backing the liabilities are insufficient to fund the
benefits payable.

The Group manages the interest rate risk by matching closely new contracts
written with fixed interest debt securities of a suitable duration and quality,
as indicated by their credit rating. By using fixed interest debt securities,
there is no exposure to equity price risk for this portfolio.

Regular monitoring of the interest rate risk is carried out by analysis of
expected cash flows from the financial assets held with those for the
liabilities.  Cash flows for the liabilities are determined by means of
projecting expected cash flows from the contracts using prudent estimates of
mortality.


The following tables indicate the estimated amount and timing of the cash flows
arising from the liabilities in this category of the Group's ALM framework.

 

31 December 2008                                      Contractual cash flows
(undiscounted)
Carrying         Carrying    0-5 years   5-10 years        10-15        15-20    >20 years
values and        amounts                                  years        years             
cash flows                                                                                
arising                                                                                   
from:                                                                                     
                     £000         £000         £000         £000         £000         £000
                                                                                          
Assets                                                                                    
backing                                                                                   
liabilities:                                                                              
                                                                                          
Debt               70,957       21,085       19,958       16,581       22,341       41,035
securities                                                                                
at fair                                                                                   
value                                                                                     
through                                                                                   
income                                                                                    
                                                                                          
Cash and            7,260        7,260            -            -            -            -
cash                                                                                      
equivalents                                                                               
                                                                                          
Total              78,217       28,345       19,958       16,581       22,341       41,035
                                                                                          
Liabilities        78,217       22,488       20,513       18,228       15,705       45,216
                                                                                          
               ----------   ----------   ----------   ----------   ----------   ----------
                                                                                          
Difference              -        5,857         (555)      (1,647)       6,636       (4,181)
in expected                                                                               
cash flows                                                                                
                                                                                          
               ==========   ==========   ==========   ==========   ==========   ==========
                                                                                          

 

31 December 2007                                      Contractual cash flows
(undiscounted)
Carrying         Carrying    0-5 years   5-10 years        10-15        15-20    >20 years
values and        amounts                                  years        years             
cash flows                                                                                
arising                                                                                   
from:                                                                                     
                     £000         £000         £000         £000         £000         £000
                                                                                          
Assets                                                                                    
backing                                                                                   
liabilities:                                                                              
                                                                                          
Debt               59,589       21,176       17,538       16,929       21,677       34,469
securities                                                                                
at fair                                                                                   
value                                                                                     
through                                                                                   
income                                                                                    
                                                                                          
Cash and            2,965        2,965           --           --           --           --
cash                                                                                      
equivalents                                                                               
                                                                                          
               ----------   ----------   ----------   ----------   ----------   ----------
                                                                                          
Total              62,554       24,141       17,538       16,929       21,677       34,469
                                                                                          
Liabilities        62,554       20,434       18,611       16,541       14,258       39,078
                                                                                          
               ----------   ----------   ----------   ----------   ----------   ----------
                                                                                          
Difference             --        3,707       (1,073)         388        7,419       (4,609)
in expected                                                                               
cash flows                                                                                
                                                                                          
               ==========   ==========   ==========   ==========   ==========   ==========
                                                                                          


Sensitivity analysis - interest rate risk

The sensitivity analysis for interest rate risk illustrates how changes in the
fair value or future cash flows of a financial instrument will fluctuate
because of changes in market rates at the reporting date.

The carrying amount of both the liabilities and the assets, which are debt
securities valued at fair value, will be sensitive to changes in the level of
interest rates.  By reviewing the matching of the cash flows by term, on a
quarterly basis, management aim to minimize the impact of a change in values
due to a parallel movement in all yield curves.

An increase of 100 basis points in interest yields of the matching assets would
result in a decrease of £0.3m in profit for the year ended 31 December 2008 and
in shareholder equity as at 31 December 2008 (year ended 31 December 2007 and
as at 31 December 2007: £0.4m decrease).

An increase or decrease of 100 basis points in interest yields would result in
a decrease of £1.7m in profit for the year ended 31 December 2008 and in
shareholder equity as at 31 December 2008 (year ended 31 December 2007 and as
at 31 December 2007: £0.5m decrease).

Other non-linked contracts

This category consists of two groups of contracts.  The first group,
representing £10.1m of liabilities out of the total of £48.3m as at 31 December
2008 (£10.9m out of the total of £48.3m as at 31 December 2007) is operated on
a quasi-linked basis; these are contracts for which, while not classed as
unit-linked due to the fact that there is no surrender value which depends on
unit values, all other aspects of the risk management of these contracts are
the same as for unit-linked contracts. As a result the Group operates the same
risk management processes as described under 'Unit-linked Contracts' above.

The following is a maturity analysis of the contractual liabilities for this
group of contracts, prepared on an estimated basis using estimates of
mortality. The analysis represents the gross liabilities, before taking into
account offsetting linked assets that are scheduled to mature in a similar
profile.

                                          Contractual cash flows (undiscounted)

                          0-5        5-10       10-15       15-20         >20 
                        years       years       years       years       years        
                                                                               
                         £000        £000        £000        £000        £000   
                                                                               
As at 31 December      22,686      24,813      21,543      10,105       4,080  
2008                                                                           
                                                                               
                    =========   =========   =========   =========   =========
                                                                                                        
                                                                               
                                                                               
As at 31 December      24,427      28,028      27,378      15,352       6,580  
2007                                                                           
                                                                               
                    =========   =========   =========   =========   =========
                            
                                                                               

 

Sensitivity analysis - equity risk

An increase or decrease of 10% in the value of the assets which back this group
of contracts would not have a material effect on either profit for the year
ended 31 December 2008 and the year ended 31 December 2007 or shareholder
equity as at those dates.

The second group of contracts comprises contracts which pay guaranteed benefits
on death or other insurance event, the terms being guaranteed at the inception
of the contract. The financial component of these contracts is a guaranteed
fixed interest rate, and hence, the Group's primary financial risk on these
contracts is the risk that interest income and capital redemptions from the
financial assets backing the liabilities are insufficient to fund the benefits
payable.

The Group manages the interest rate risk for this group by closely matching new
contracts written with financial assets of a suitable duration and quality, as
indicated by their credit rating. By using fixed interest debt securities there
is no exposure to equity price risk. Regular monitoring of the interest rate
risk is carried out by analysis of expected cash flows from the financial
assets held with those for the liabilities.  Cash flows for the liabilities are
determined by means of projecting expected cash flows from the contracts using
prudent estimates of mortality.

The following tables indicate the estimated amount and timing of the cash flows
arising from the liabilities in the second group of this category of the
Group's ALM framework.

31 December 2008                           Contractual cash flows
(undiscounted)
Carrying     Carrying      0-5    5-10    10-15      15-20    >20 
values and    amounts    years   years    years      years  years             
cash flows                                                                              
arising                                                                                 
from:                                                                                   
                 £000     £000    £000     £000       £000   £000
                                                                                        
Assets                                                                                  
backing                                                                                 
liabilities:                                                                            
                                                                                        
Reinsurers'     6,072      411     760    1,124      1,429  6,487
share of                                                                                
insurance                                                                               
contract                                                                                
provisions                                                                              
                                                                                        
Debt           17,724    4,929   4,300    2,702      3,126  9,953
securities                                                                              
at fair                                                                                 
value                                                                                   
through                                                                                 
income                                                                                  
                                                                                        
Insurance       1,423    1,423       -        -          -      -
and other                                                                               
receivables                                                                             
                                                                                        
Cash and       12,967   12,967       -        -          -      -
cash                                                                                    
equivalents                                                                             
                                                                                        
           ========== ======== =======  =======  ========= ======
                                                                                        
Total          38,186   19,730   5,060    3,826      4,555 16,440
                                                                                        
Liabilities    38,186   15,022   7,048    6,211      6,182 20,601
                                                                                        
           ---------- -------- ------- --------  --------- ------
                                                                                        
Difference          -    4,708  (1,988)  (2,385)    (1,627)(4,161)
in expected                                                                             
cash flows                                                                              
                                                                                        
           ========== ======== ======= ========  ========= ======
                                                                                        


31 December 2007                           Contractual cash flows
(undiscounted)
Carrying     Carrying      0-5    5-10    10-15      15-20    >20 
values and    amounts    years   years    years      years  years             
cash flows                                                                              
arising                                                                                 
from:                                                                                   
                 £000     £000    £000     £000       £000   £000
                                                                                         
Assets                                                                                  
backing                                                                                 
liabilities:                                                                            
                                                                                        
Reinsurer's     6,784      459     849    1,256      1,596  7,248
share of                                                                                
insurance                                                                               
contract                                                                                
provisions                                                                              
                                                                                        
Debt           15,970    4,811   4,819    3,322      3,908 11,508
securities                                                                              
at fair                                                                                 
value                                                                                   
through                                                                                 
income                                                                                  
                                                                                        
Insurance         874      874      --       --         --     --
and other                                                                               
receivables                                                                             
                                                                                        
Cash and       13,805   13,805      --       --         --     --
cash                                                                                    
equivalents                                                                             
                                                                                        
           ----------  -------  ------   ------  --------- ------
                                                                                        
Total          37,433   19,949   5,668    4,578      5,504 18,756
                                                                                        
Liabilities    37,433   19,688   5,572    5,151      5,253 19,617
                                                                                        
           ----------  -------  ------ --------   -------- ------
                                                                                        
Difference         --      261      96     (573)       251   (861)
in expected                                                                             
cash flows                                                                              
                                                                                        
           ========== ======== ======= ========   ======== ======
                                                                                        

 

Sensitivity analysis - interest rate risk

The sensitivity analysis for interest rate risk illustrates how changes in the
fair value or future cash flows of a financial instrument will fluctuate
because of changes in market rates at the reporting date.

The carrying amount of both the liabilities and the assets, which include debt
securities valued at fair value, will be sensitive to changes in the level of
interest rates.  By reviewing the matching of the cash flows by term, on a
quarterly basis, management aim to minimize the impact of a change in values
due to a parallel movement in all yield curves.

An increase of 100 basis points in interest yields would result in a decrease
of £0.6m in profit for the year ended 31 December 2008 and in shareholder
equity as at 31 December 2008 (year ended 31 December 2007 and as at 31
December 2007: £0.2m increase).

A decrease of 100 basis points in interest yields would result in an increase
of £0.5m in profit for the year ended 31 December 2008 and in shareholder
equity as at 31 December 2008 (year ended 31 December 2007 and as at 31
December 2007: decrease of £0.2m).

Certain of the contracts in this second group of contracts are invested in the
Guaranteed Growth Fund which provides a return to policyholders which is linked
to the average mortgage rate. This creates a risk due to a mismatch of assets
and liabilities as there are no suitable assets available to back this
guarantee and hence the assets are held in cash. This means that the return on
assets held is lower than the return given to policyholders. Provisions are
held to meet this shortfall, on appropriate assumptions as to future levels of
return on assets and return given to policyholders. There is a risk that the
return given to policyholders will increase by more than the return on assets
due to inability to match the guarantee - that is, that the spread between
mortgage rates and cash deposit rates will increase.

 
Other

This category represents assets and liabilities other than for insurance and
investment contracts, relating, principally, to surplus net assets representing
shareholder equity.

Borrowings issued at variable rates of interest expose the Group to cash flow
interest risk.  Information on borrowings is provided in Note 28 on page 87.  A
1% increase in interest rates would result in a decrease of £0.1m in profit for
the year ended 31 December 2008 and in shareholder equity as at 31 December
2008 (year ended 31 December 2007 and as at 31 December 2007: £0.1m decrease).

Credit risk management

The Group has exposure to credit risk, which is the risk that a counterparty
will be unable to pay amounts in full when due. Key areas where the Group is
exposed to credit risk are:

*  Reinsurers' share of insurance liabilities;

*  Amounts deposited with reinsurer in relation to investment contracts;

*  Amounts due from reinsurers in respect of claims already paid; and

*  Counterparty risk with respect to corporate bond, deposits and debt securities.


In addition there will be some exposures to individual policyholders, on
amounts due on insurance contracts.  These are tightly controlled, with plans
being terminated or benefits amended if amounts owed are for more than 3
months, so there is no significant risk to the results of the Group.

The Group structures the levels of credit risk it accepts by placing limits on
its exposure to a single counterparty, or group of counterparties. Such risks
are subject to at least an annual review.

By far the largest credit risk to the Group is in relation to its reinsurance
assets. Although the Group holds a significant proportion of its financial
assets in securities, the risk of default on these is mitigated to the extent
that any losses arising in respect of unit-linked funds backing the insurance
and investment contracts the Group issues, would effectively be passed on to
policyholders and investors through the unit-linked funds backing the insurance
and investment contracts.

The Group retains some residual risks on assets which support annuities,
guaranteed investment bonds and shareholder's equity. These risks are
monitored: a key aspect of this is the Group's current policy of investing new
monies only in high-quality bonds of supra-national corporations and in
government-backed debt. The Group has never purchased assets rated below AA by
Standard and Poors.

The Group's objective is to earn competitive relative returns by investing in a
diversified portfolio of securities. Watch lists are maintained for exposures
requiring additional review and all credit exposures are reviewed monthly.

The Group's exposure to credit risk in relation to its debt securities and cash
balances is summarised below: 

                                                                        Cash                
                         Credit rating-debt securities              balances        Total     
                  AAA           AA            A      Unrated                             
As at 31         £000         £000         £000         £000            £000         £000      
December                                                                                   
2008                                                                                      
                                                                                          
Debt                                                                                      
securities,                                                                               
deposits and                                                                              
cash                                                                                      
balances                                                                                  
with credit                                                                               
institutions                                                                              
                                                                                          
  Linked       40,507          137            -            -          45,046       85,690    
                                                                                          
  Non-linked   44,937       15,385        3,520            -         147,335      211,177
                                                                                          
Government                                                                                
or pseudo                                                                                 
Government                                                                                
deposits                                                                                  
                                                                                          
  Linked       72,999            -            -            -               -       72,999    
                                                                                          
  Non-linked  101,619            -            -            -               -      101,619   
                                                                                          
                                                                                          
                                                                                          
           ----------   ----------   ----------   ----------      ----------   ----------
                                                                                          
Total debt,                                                                               
deposits and                                                                              
cash                                                                                      
balances      260,062       15,522        3,520            -         192,381      471,485   
                                                                                          
           ==========   ==========   ==========   ==========      ==========   ==========
                                                                                          

 

 

                                                                   Cash                
                         Credit rating-debt securities         balances        Total     
                AAA           AA            A      Unrated                             
As at 31       £000         £000         £000         £000         £000         £000      
December                                                                                  
2007                                                                                      
                                                                                          
Debt                                                                                      
securities,                                                                               
deposits and                                                                              
cash                                                                                      
balances                                                                                  
with credit                                                                               
institutions                                                                              
                                                                                          
  Linked      3,098          647           86            -      110,146      113,977   
                                                                                          
  Non-linked 50,531       36,843        3,755          151      114,981      206,261
                                                                                          
Government                                                                                
or pseudo                                                                                 
Government                                                                                
deposits                                                                                  
                                                                                          
  Linked     62,137            -            -            -            -       62,137    
                                                                                          
  Non-linked 89,904            -            -            -            -       89,904    
                                                                                          
         ----------   ----------   ----------   ----------   ----------   ----------
                                                                                          
Total debt,                                                                               
deposits and                                                                              
cash                                                                                      
balances    205,670       37,490        3,841          151      225,127      472.279   
                                                                                          
         ==========   ==========   ==========   ==========   ==========   ==========
                                                                                          

 

Reinsurance credit risk

Reinsurance is used to manage insurance risk. This does not however discharge
the Group's liability as primary insurer. If a reinsurer fails to pay a claim
for any reason, the Group remains liable for the payment to the policyholder.
The creditworthiness of major reinsurers is considered on an annual basis by
reviewing their financial strength.

It should be noted that for historical reasons the Group has a significant
exposure of £200.6m as at 31 December 2008 (31 December 2007: £236.9m) to
Guardian, which does not have a published credit rating. Of this amount £182.5m
(31 December 2007: £212.0m) is in respect of currently guaranteed benefits. The
exposure which relates to reinsured insurance contract liabilities, and which
relates to amounts deposited with Guardian in respect of investment contract
liabilities, was mitigated during 2006 when Guardian granted to Countrywide
Assured plc a floating charge over related investment assets, which ranks that
company equally with Guardian policyholders.

In addition the Group also has an exposure on a number of its risk premium
reinsurance contracts, although in general the premiums payable under these
contracts in any period will be higher than the claims payments received.


For further information please contact


Graham Kettleborough
Chief Executive, Chesnara plc                    

                                                                                    
01772 840001
07799 407519