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Group capital structure

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The Group maintains an efficient structure from a combination of equity shareholders’ funds, preference capital, subordinated debt and borrowings, consistent with the Group’s risk profile and the regulatory and market requirements of its business. The achieved profit basis provides a more accurate reflection of the performance of the Group’s life operations year on year than results under the modified statutory basis. Accordingly, the Group’s capital structure is analysed on an embedded value basis.

The Group’s capital, from all funding sources, has been allocated such that the capital employed by trading operations is greater than the capital provided by its shareholders and its subordinated debtholders. As a result, the Group is able to enhance the returns earned on its equity capital.

Capital employed by segment

	30 June 2004 £m	31 December 2003 £m
Long-term savings	12,152	12,373
General insurance and health	4,505	4,481
Other business	581	725
Corporate	3,176	2,934
Total capital employed	20,414	20,513
Financed by
Internal debt	3,902	3,841
External debt	1,758	1,749
Subordinated debt	2,751	2,814
Shareholders’ funds and minority interests	12,003	12,109
	20,414	20,513

At 30 June 2004 the Group had £20.4 billion (31 December 2003: £20.5 billion) of total capital employed in its trading operations which is efficiently financed by a combination of equity shareholders’ funds, preference capital, subordinated debt and internal and external borrowings.

In the first half of 2004, the total capital employed in our long-term savings operations decreased due to the positive impact of retained earnings being offset by dividends paid to holding companies and the adverse effect of the Euro foreign exchange rate movement. The total capital employed in our general insurance businesses increased due to retained earnings partially offset by dividends paid to holding companies and foreign exchange losses.

In addition to its external funding sources, the Group has a number of internal debt arrangements in place. These have allowed assets supporting technical liabilities to be invested into the pool of central assets for use across the Group. They have also enabled the shareholders to deploy cash from some parts of the business to others in order to fund growth. Although intra-group loans in nature, they are counted as part of the capital base for the purpose of capital management. All internal loans satisfy arms length criteria and all interest payments have been made when due.

The ratio of the Group’s external debt to shareholders’ funds was 12% (31 December 2003: 12%). Interest cover, which measures the extent to which external interest costs, excluding the subordinated debt interest, are covered by achieved operating profit, was 30 times (31 December 2003: 19 times).

Deployment of equity shareholders' funds

	30 June 2004					31 December 2003
	Equities £m	Fixed income securities £m	Other invest- ments £m	Other net assets £m	Total £m	Total £m
Assets
Long-term savings	586	3,813	799	1,434	6,632	6,923
General insurance, health, corporate and other business	2,799	3,281	1,130	-	7,210	7,035
	3,385	7,094	1,929	1,434	13,842	13,958
Goodwill					1,263	1,323
Additional value of in-force long-term business					5,309	5,232
Assets backing total capital employed in continuing operations					20,414	20,513
External debt					(1,758)	(1,749)
Internal debt					(3,902)	(3,841)
Subordinated debt					(2,751)	(2,814)
					12,003	12,109
Minority interests					(949)	(944)
Preference capital					(200)	(200)
Equity shareholders' funds					10,854	10,965

Our exposure to equities has decreased from £3.6 billion at 31 December 2003 to £3.4 billion, which represents 17% of our capital employed. The Group has certain equity investments which are classified as strategic. The market values of these holdings and the percentage of issued share capital of these companies held by the Group, in both our shareholder and policyholder funds, is as follows.

	Market value		% of issued share capital
	30 June 2004 £m	31 December 2003 £m	30 June 2004 %	31 December 2003 %
Société Générale	224	233	1.1%	1.1%
Münchener Rückversicherungs-Gesellschaft	371	403	2.7%	2.6%
The Royal Bank of Scotland Group	848	854	1.7%	1.8%
UniCredito Italiano	487	536	2.8%	2.8%
	1,930	2,026

 

Return on capital employed

	6 months 2004			Full year 2003
	Normalised after-tax return £m	Opening equity capital £m	Return on capital (annualised) %	Return on capital %
Long-term savings	557	12,373	9.2%	10.4%
General insurance and health	419	4,481	19.6%	16.4%
Other business	1	725	0.3%	(7.9%)
Corporate	(23)	2,934	(1.6%)	(1.5%)
	954	20,513	9.5%	9.5%
Borrowings	(162)	(8,404)	3.9%	4.3%
	792	12,109	13.5%	12.9%
Minority interests	(70)	(944)	15.4%	17.6%
Preference capital	(9)	(200)	8.5%	8.5%
Equity shareholders' funds	713	10,965	13.4%	12.7%

The return on capital is calculated as the after-tax return on opening equity capital, based on operating profit, including life achieved profit, before amortisation of goodwill and exceptional items.

Capital management
In managing its capital, the Group aims to:

1. match the profile of its assets and liabilities, taking account of the risks inherent in each business. In the case of the Group's life operations, which have long-term liabilities, the majority of capital is held in fixed income securities. A significant proportion of the capital supporting the Group's general insurance and health operations is held in equities, reflecting the relatively low risk profile of these businesses;
2. maintain financial strength to support new business growth and satisfy the requirements of its policyholders, regulators and rating agencies;
3. retain financial flexibility by maintaining strong liquidity, including significant unutilised committed credit lines, and access to a range of capital markets;
4. allocate capital efficiently to support growth and repatriate excess capital where appropriate; and
5. manage exposures to movement in exchange rates by aligning the deployment of capital by currency with the Group’s capital requirements by currency.

An important aspect of the Group's overall capital management process is the setting of target risk-adjusted rates of return for individual business units, which are aligned to performance objectives and ensure that the Group is focused on the creation of value for shareholders.

Risk based capital
The Group uses risk based capital as one of several measures to assess its capital requirements for its general insurance businesses. Financial modelling techniques enhance our practice of active capital management, ensuring sufficient capital is available to protect against unforeseen events and adverse scenarios, and risk management. Our aim continues to be the optimal usage of capital through appropriate allocation to our businesses.

The introduction of FSA’s Prudential Source Book includes the requirement to calculate the realistic capital needed to meet adverse situations, the Internal Capital Assessment (ICA). Based on this we will agree specific risk adjusted capital requirements with our regulator for both our life and general insurance businesses. Our risk based capital model underpins our ICA modelling, and will form the basis of our discussions with the regulator in agreeing such capital requirements, along with our strong risk management processes. We continue to develop our risk based capital modelling capability for both our life and general insurance businesses as part of our longer-term development programme for more complex risk modelling techniques, and increasingly operate our business by considering economic and risk based capital requirements.

Our current risk based capital methodology for general insurance business assesses insurance, market and credit risks and makes prudent allowance for diversification benefits. We look at the level of capital necessary to enable the general insurance business to meet the statutory minimum solvency margin over a five year period with 99% probability of not requiring further capital. We consider risks over a five year period allowing for planned levels of business growth. Based on our model, our risk based capital requirement may be expressed as 34% of net written premiums.

Capital employed in our general insurance and health business after goodwill and adding back the claims equalisation reserve was £4.6 billion at 30 June 2004 and required capital on a risk basis was £3.3 billion, giving a surplus capital position of £1.3 billion.

Sensitivity analysis
The sensitivity of the Group’s shareholders’ funds at 30 June 2004 to a 10% fall in global equity markets or a rise of 1% in global interest rates is as follows:

31 December 2003 £bn		30 June 2004 £bn	Equities down 10% £bn	Interest rates up 1% £bn
12.4	Long-term savings(1)	12.2	11.7	12.2
8.1	General insurance and other	8.2	8.0	7.9
(8.4)	Borrowings(2)	(8.4)	(8.4)	(8.4)
12.1	Shareholders’ funds	12.0	11.3	11.7

⁽¹⁾ Assumes achieved profit assumptions adjusted to reflect revised bond yields.
⁽²⁾ Comprising internal, external and subordinated debt.
⁽³⁾ These sensitivities assume a full tax charge/credit on market value appreciation/falls.

Shareholders’ funds, including minority interests

		30 June 2004 Closing shareholders' funds			31 December 2003 Closing shareholders’ funds
		MSSB net assets (note 1)	Internally generated AVIF	Embedded value	MSSB net assets (note 1)	Internally generated AVIF	Embedded value
	Note	£m	£m	£m	£m	£m	£m
Life assurance
United Kingdom		2,748	2,765	5,513	2,844	2,829	5,673
France		1,017	483	1,500	1,068	381	1,449
Ireland		332	204	536	338	216	554
Italy		354	74	428	386	56	442
Netherlands (including Belgium and Luxembourg)		1,520	833	2,353	1,621	777	2,398
Poland		118	229	347	146	250	396
Spain		268	210	478	266	189	455
Other Europe		168	36	204	174	26	200
International		565	17	582	568	20	588
		7,090	4,851	11,941	7,411	4,744	12,155
Participating interests	2	211	-	211	218	-	218
		7,301	4,851	12,152	7,629	4,744	12,373
General insurance and health	3
United Kingdom	4	2,370		2,370	2,448		2,448
France		396		396	414		414
Ireland		380		380	333		333
Netherlands		370		370	250		250
Other Europe		110		110	112		112
Canada		585		585	631		631
Other		294		294	293		293
		4,505	-	4,505	4,481	-	4,481
Other business		581		581	725		725
Corporate	4	3,176		3,176	2,934		2,934
External debt	5	(1,758)		(1,758)	(1,749)		(1,749)
Internal debt		(3,902)		(3,902)	(3,841)		(3,841)
Subordinated debt		(2,751)		(2,751)	(2,814)		(2,814)
		(4,654)	-	(4,654)	(4,745)	-	(4,745)
Shareholders' funds, including minority interests		7,152	4,851	12,003	7,365	4,744	12,109
Comprising
Equities		3,385		3,385	3,571		3,571
Debt and fixed income securities		7,094		7,094	7,129		7,129
Property		582		582	612		612
Deposits and other investments		1,347		1,347	1,179		1,179
Intangible assets	6	1,721	4,851	6,572	1,811	4,744	6,555
Other net assets		1,434		1,434	1,467		1,467
Borrowings		(8,411)		(8,411)	(8,404)		(8,404)
		7,152	4,851	12,003	7,365	4,744	12,109

Notes

1. Includes acquired additional value of in-force long-term business of £458 million (31 December 2003: £488 million).
2. The net assets represent the £211 million of goodwill on the RBSG joint venture (31 December 2003: £218 million).
3. The capital employed in the Group's general insurance operations includes £262 million of goodwill (31 December 2003: £392 million).
4. Assets available to shareholders are held by the Group's UK general insurance operations and are available to finance future growth of the Group. Accordingly, for the purposes of preparing this note, these assets have been reclassified as Corporate.
5. The external borrowings reported in the summary consolidated balance sheet of £1,769 million (31 December 2003: £1,760 million) comprise £11 million, (31 December 2003: £11 million) of general insurance borrowings (reported within the general insurance and health net assets) and £1,758 million (31 December 2003: £1,749 million) of borrowings by holding companies of the Group not allocated to operating companies (shown as external debt).
6. Comprises £458 million of acquired additional value of in-force long-term business (31 December 2003: £488 million), £1,052 million of goodwill arising on acquisitions (31 December 2003: £1,105 million) and £211 million of goodwill on the RBSG joint venture (31 December 2003: £218 million).

30 June 2004		Normalised return (Note 1)		Opening shareholders’ funds including minority interests	Annualised return on capital
	Note	Before tax £m	After tax £m	£m	%
Life assurance
United Kingdom	2	356	249	5,891	8.6%
France		114	74	1,449	10.5%
Ireland		18	16	554	5.9%
Italy		34	21	442	9.7%
Netherlands (including Belgium and Luxembourg)		129	93	2,398	7.9%
Poland		33	27	396	14.1%
Spain		78	50	455	23.2%
Other Europe		7	5	200	5.1%
International		31	22	588	7.6%
		800	557	12,373	9.2%
General insurance and health
United Kingdom	3	345	236	2,448	20.2%
France		15	11	414	5.4%
Ireland		68	60	333	39.3%
Netherlands		51	40	250	34.6%
Other Europe		18	13	112	24.6%
Canada		59	40	631	13.1%
Other		24	19	293	13.4%
		580	419	4,481	19.6%
Other business		2	1	725	0.3%
Corporate	3, 4	(28)	(23)	2,934	(1.6%)
External debt		(40)	(33)	(1,749)	3.8%
Internal debt		(100)	(70)	(3,841)	3.7%
Subordinated debt		(84)	(59)	(2,814)	4.2%
		1,130	792	12,109	13.5%
Notes 1. The normalised return is based upon operating profit, including life achieved profit, before amortisation of goodwill and exceptional items. 2. Shareholders’ funds includes £211 million of goodwill on RBSG joint venture. 3. Assets available to shareholders are held by the Group’s UK general insurance operations and are available to finance future growth of the Group. Accordingly, these assets together with their associated pre-tax investment return of £66 million (post-tax £46 million) have been reclassified as Corporate. 4. The return before tax of £(28) million comprises investment return of £66 million and corporate costs of £(94) million.

31 December 2003		Normalised return (Note 1)		Opening shareholders’ funds including minority interests (Note 2)	Return on capital
	Note	Before tax £m	After tax £m	£m	%
Life assurance
United Kingdom	3	659	461	5,243	8.8%
France		220	142	1,221	11.6%
Ireland		65	57	472	12.1%
Italy		70	42	349	12.0%
Netherlands (including Belgium and Luxembourg)		189	140	1,806	7.8%
Poland		104	76	352	21.6%
Spain		158	102	350	29.1%
Other Europe		9	6	176	3.4%
International		81	56	410	13.7%
		1,555	1,082	10,379	10.4%
General insurance and health
United Kingdom	4	608	416	2,052	20.3%
France		44	33	481	6.9%
Ireland		91	78	236	33.1%
Netherlands		74	55	275	20.0%
Other Europe		32	24	63	38.1%
Canada		12	8	535	1.5%
Other		30	27	275	9.8%
		891	641	3,917	16.4%
Other business		(54)	(44)	554	(7.9%)
Corporate	4, 5	(79)	(38)	2,475	(1.5%)
External debt		(109)	(86)	(2,053)	4.2%
Internal debt		(196)	(138)	(3,671)	3.8%
Subordinated debt		(101)	(71)	(1,190)	6.0%
		1,907	1,346	10,411	12.9%
Notes 1. The normalised return is based upon operating profit, including life achieved profit, before amortisation of goodwill and exceptional items. 2. Restated for the effect of a change in accounting policy in respect of the treatment of shares held by employee trusts as a deduction from shareholders’ capital. 3. Shareholders’ funds include £231 million of goodwill on RBSG joint venture. 4. Assets available to shareholders are held by the Group’s UK general insurance operations and are available to finance future growth of the Group. Accordingly, these assets together with their associated pre-tax investment return of £81 million (post-tax £57 million) have been reclassified as Corporate. 5. The return before tax of £(79) million comprises investment return of £81 million and corporate costs of £(160) million.

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