Preliminary results - 12 months ended 31 December 2005
Appendix B
The following additional disclosures have been extracted from the Group's 2005 Report and Accounts.
Additional disclosures
Movements in insurance liabilities
(i) Movements in long-term business provisions
The long-term business provision is calculated separately for each of the Group’s life operations. The provisions for overseas subsidiaries have generally been included on the basis of local regulatory requirements, modified where necessary to reflect the requirements of the Companies Acts.
Material judgement is required in calculating the provisions and is exercised particularly through the choice of assumptions where there is discretion over these. In turn, the assumptions used depend on the circumstances prevailing in each of the life operations. Provisions are most sensitive to assumptions regarding discount rates and mortality/morbidity rates.
Bonuses paid during the year are reflected in claims paid, whilst those allocated as part of the bonus declaration are included in the movements in the long-term business provision, as detailed below.
The following movements have occurred in the long-term business provisions during the year:
| 2005 £m |
2004 £m |
|
|---|---|---|
| Carrying amount at 1 January | 106,491 | 96,228 |
| Provisions in respect of new business | 6,589 | 5,839 |
| Expected change in existing business provisions | (2,703) | (3,164) |
| Variance between actual and expected experience | 3,784 | 1,680 |
| Impact of operating assumption changes | (1,034) | 377 |
| Impact of economic assumption changes | 2,411 | 1,004 |
| Other movements | 340 | 227 |
| Change in liability recognised as an expense | 9,387 | 5,963 |
| Portfolio transfers, acquisitions and disposals | (360) | 924 |
| Foreign exchange rate movements | (684) | 289 |
| Effect of adjusting to FRS 27 realistic basis | - | 3,087 |
| Other movements | (404) | - |
| Carrying amount at 31 December | 114,430 | 106,491 |
(ii) Movements in general insurance and health claims provisions
Significant delays occur in the notification and settlement of claims and a substantial measure of experience and judgement is involved in assessing outstanding liabilities, the ultimate cost of which cannot be known with certainty at the balance sheet date. The reserves for general insurance and health are based on information currently available; however, it is inherent in the nature of the business written that the ultimate liabilities may vary as a result of subsequent developments.
The following changes have occurred in the general insurance and health claims provisions during the year:
| 2005 £m |
2004 £m |
|
|---|---|---|
| Carrying amount at 1 January | 12,750 | 12,378 |
| Impact of changes in assumptions | (6) | (30) |
| Claim losses and expenses incurred in the current year | 7,124 | 6,770 |
| Decrease in estimated claim losses and expenses incurred in prior years | (372) | (234) |
| Incurred claims losses and expenses | 6,746 | 6,506 |
| Less: | ||
| Payments made on claims incurred in the current year | (3,379) | (3,120) |
| Payments made on claims incurred in prior years | (3,407) | (3,244) |
| Recoveries on claim payments | 263 | 233 |
| Claims payments made in the year, net of recoveries | (6,523) | (6,131) |
| Other movements in the claims provisions | (9) | 27 |
| Changes in claims reserve recognised as an expense | 214 | 402 |
| Gross portfolio transfers, acquisitions and disposals | (153) | 2 |
| Foreign exchange rate movements | 146 | 32 |
| Other gross movements | 8 | (64) |
| Carrying amount at 31 December | 12,965 | 12,750 |
Long-term business investment liabilities
Investment contracts are those that do not transfer significant insurance risk from the contract holder to the issuer, and are therefore treated as financial instruments under IFRS.
Many investment contracts contain a discretionary participation feature in which the contract holder has a contractual right to receive additional benefits as a supplement to guaranteed benefits and are referred to as participating contracts. They are not measured at fair value as there is currently no agreed definition of fair valuation for discretionary features under IFRS. In the absence of such a definition, it is not possible to provide a range of estimates within which a fair value is likely to fall. The IASB has deferred consideration of participating contracts to Phase ll of its insurance contracts project.
For participating business, the discretionary participation feature is recognised separately from the guaranteed element and is classified as a liability, referred to as unallocated divisible surplus.
Investment contracts that do not contain a discretionary participation feature are referred to as non-participating contracts and the liability is measured at either fair value or amortised cost.
Most non-participating investment contracts measured at fair value are unit-linked in structure and the fair value liability is equal to the unit reserve plus additional non-unit reserves if required on a fair value basis. For this business, a deferred acquisition cost asset and deferred income reserve liability are recognised in respect of transaction costs and front-end fees respectively, that relate to the provision of investment management services, and which are amortised on a systematic basis over the contract term.
There is a small volume of annuity certain business for which the liability is measured at amortised cost using the effective interest method. The fair value of contract liabilities measured at amortised cost is not materially different from the amortised cost liability.
Movements in the year
The following movements have occurred in the year:
(i) Participating investment contracts
| 2005 £m |
2004 £m |
|
|---|---|---|
| Carrying amount at 1 January | 43,974 | 36,974 |
| Reserves in respect of new business | 3,467 | 3,284 |
| Expected change in existing business provisions | (1,720) | (1,340) |
| Variance between actual and expected experience | 2,034 | 1,400 |
| Impact of operating assumption changes | 5 | (18) |
| Impact of economic assumption changes | 513 | 47 |
| Other movements | (153) | 73 |
| Change in liability | 4,146 | 3,446 |
| Portfolio transfers and acquisitions | 4 | 2,030 |
| Foreign exchange rate movements | (856) | 304 |
| Effect of adjusting to FRS 27 realistic basis | - | 1,220 |
| Other movements | (10) | - |
| Carrying amount at 31 December | 47,258 | 43,974 |
(ii) Non-participating investment contracts
| 2005 £m |
2004 £m |
|
|---|---|---|
| Carrying amount at 1 January | 25,581 | 20,493 |
| Reserves in respect of new business | 5,247 | 3,872 |
| Expected change in existing business provisions | 936 | 769 |
| Variance between actual and expected experience | (1,732) | 160 |
| Impact of operating assumption changes | 2 | - |
| Impact of economic assumption changes | - | 5 |
| Other movements | 93 | 78 |
| Change in liability | 4,546 | 4,884 |
| Portfolio transfers and acquisitions | - | 194 |
| Foreign exchange rate movements | (76) | 10 |
| Carrying amount at 31 December | 30,051 | 25,581 |
Loss development tables
The following table presents the development of claim payments and the estimated ultimate cost of claims for the accident years 2001 to 2005. The upper half of the table shows the cumulative amounts paid during successive years related to each accident year. For example, with respect to the accident year 2001, by the end of 2005 £5,648 million had actually been paid in settlement of claims. In addition, as reflected in the lower section of the table, the original estimated ultimate cost of claims of £6,186 million was re-estimated to be £6,286 million at 31 December 2005. This increase from the original estimate is due to the combination of a number of factors, including claims being settled for larger amounts than originally estimated. The original estimates will also be increased or decreased, as more information becomes known about the individual claims and overall claim frequency and severity.
In the year of adoption of IFRS, only five years are required to be disclosed. This will be increased in each succeeding additional year, until ten years of information is included.
The Group aims to maintain strong reserves in respect of its non-life and health business in order to protect against adverse future claim experience and development. As claims develop and the ultimate cost of claims become more certain, the absence of adverse claims experience will then result in a release of reserves from earlier accident years, as shown in the loss development table below. However, in order to maintain strong reserves the Group transfers much of this release to current accident year (2005) reserves where the development of claims is less mature and there is much greater uncertainty attaching to the ultimate cost of claims. The release from prior accident year reserves during 2005 is also due to an improvement in the estimated ultimate cost of claims.
After the effect of reinsurance the loss development table is:
| All prior years | 2001 | 2002 | 2003 | 2004 | 2005 | Total | |
|---|---|---|---|---|---|---|---|
| Accident Year | £m | £m | £m | £m | £m | £m | £m |
| Net cumulative claim payments | |||||||
| At end of accident year | (2,970) | (2,913) | (2,819) | (2,870) | (3,281) | ||
| One year later | (4,624) | (4,369) | (4,158) | (4,378) | |||
| Two years later | (5,088) | (4,779) | (4,565) | ||||
| Three years later | (5,436) | (5,064) | |||||
| Four years later | (5,648) | ||||||
| Estimate of net cumulative claims | |||||||
| At end of accident year | 6,186 | 6,037 | 6,218 | 6,602 | 6,982 | ||
| One year later | 6,333 | 6,038 | 6,093 | 6,266 | |||
| Two years later | 6,321 | 5,997 | 6,037 | ||||
| Three years later | 6,329 | 5,973 | |||||
| Four years later | 6,286 | ||||||
| Estimate of cumulative claims | 6,286 | 5,973 | 6,037 | 6,266 | 6,982 | ||
| Cumulative payments | (5,648) | (5,064) | (4,565) | (4,378) | (3,281) | ||
| 2,417 | 638 | 909 | 1,472 | 1,888 | 3,701 | 11,025 | |
| Effect of discounting | (16) | (4) | (5) | (5) | (5) | (7) | (42) |
| Present value | 2,401 | 634 | 904 | 1,467 | 1,883 | 3,694 | 10,983 |
| Cumulative effect of foreign exchange | |||||||
| movements | - | - | 17 | 22 | 29 | - | 68 |
| Present value recognised in the balance sheet | 2,401 | 634 | 921 | 1,489 | 1,912 | 3,694 | 11,051 |
In the loss development table shown above, the cumulative claim payments and estimates of cumulative claims for each accident year are translated into sterling at the exchange rates that applied at the end of that accident year. The impact of using varying exchange rates is shown at the bottom of the table. Disposals are dealt with by treating all outstanding and IBNR claims of the disposed of entity as “paid” at the date of disposal.
The table also includes information on asbestos and environmental pollution claims provisions from business written before 2001. The claims provisions, net of reinsurance, in respect of this business were £289 million (2004: £224 million). These net provisions were strengthened during the year by £83 million (2004: £71 million).
Sensitivity analysis and capital management
The Group uses a number of sensitivity test based risk management tools to understand the volatility of earnings, the volatility of its capital requirements, and to manage our capital more efficiently. Primarily we use Financial Condition Reporting (a medium term projection of the financial health of the business under a variety of economic and operating scenarios), and increasingly Individual Capital Assessment (ICA). However sensitivities to economic and operating experience are regularly produced on all of the Group’s financial performance measurements as part of the Group’s decision making and planning process, and to set the framework for identifying and quantifying the risks that each of its business units, and the Group as a whole are exposed to.
For example, under ICA, an estimate of how much capital is needed to mitigate the risk of insolvency from events occurring within a selected remote level of probability is measured. This high level risk appetite parameter is then used to calibrate a series of core stresses and scenario tests of both an economic and operating nature to be examined by each business unit. Business units satisfy themselves that the range and level of these tests is appropriate to their local risk profile, and supplement the core tests where necessary. Business units also perform an assessment of the operational risk; this assessment is subject to central review and challenge by Group to verify consistency across business units and to identify aggregate exposures. The businesses are then able to assess the capital requirements within this risk appetite framework. The Group uses both the results at a business unit level and aggregated results to assess the benefits of diversification of risk within the Group, and to assess capital requirements of the types of risk it is exposed to. These results enable the Group to assess whether its risk appetite is appropriate and whether mitigating action is required.
Life insurance and investment contracts
The nature of long-term business is such that a number of assumptions are made in compiling the financial statements.
Assumptions are made about investment returns, expenses, mortality rates, and persistency in connection with the in-force
policies for each business unit. Assumptions are best estimates based on historic and expected experience of the business.
General insurance and health business
General insurance and health claim liabilities are estimated by using standard actuarial claims projection techniques. These
methods extrapolate the claims development for each accident year based on the observed development of earlier years. In
most cases, no explicit assumptions are made as projections are based on assumptions implicit in the historic claims
development on which the projections are based. As such, in the analysis below, the sensitivity of general insurance claim
liabilities is primarily based on the financial impact of changes to the reported loss ratio.
Some results of sensitivity testing for long-term business and general insurance and health business are set out below. For each sensitivity test the impact of a change in a single factor is shown, with other assumptions left unchanged.
| Sensitivity Factor | Description of sensitivity factor applied |
|---|---|
| Interest rate & investment return | The impact of a change in market interest rates by ± 1% (e.g. if a current interest rate is 5%, the impact of an immediate change to 4% and 6%). The test allows consistently for similar changes to investment returns and movements in the market value of backing fixed interest securities. |
| Expenses | The impact of an increase in maintenance expenses by 10% |
| Assurance mortality/morbidity (life insurance only) | The impact of an increase in mortality/morbidity rates for assurance contracts by 5% |
| Annuitant mortality (life insurance only) | The impact of a reduction in mortality rates for annuity contracts by 5% |
| Gross loss ratios (non-life insurance only) | The impact of an increase in gross loss ratios for general insurance and health business by 5% |
The above sensitivity factors are applied using actuarial and statistical models, with the following pre-tax impacts on profit and shareholders’ equity at 31 December 2005:
Long-term business – impact on profit before tax (£m)
| Interest rates | Interest rates | Expenses | Assurance mortality | Annuitant mortality | |
|---|---|---|---|---|---|
| +1% | -1% | +10% | +5% | -5% | |
| Insurance participating | 5 | (35) | (5) | - | - |
| Insurance non-participating | 60 | (350) | (5) | (30) | (295) |
| Investment participating | 10 | (50) | - | - | - |
| Investment non-participating | - | - | - | - | - |
| Total | 75 | (435) | (10) | (30) | (295) |
Long-term business – impact before tax on shareholders’ equity (£m)
| Interest rates | Interest rates | Expenses | Assurance mortality | Annuitant mortality | |
|---|---|---|---|---|---|
| +1% | -1% | +10% | +5% | -5% | |
| Insurance participating | (10) | (20) | (5) | - | - |
| Insurance non-participating | 20 | (305) | (5) | (30) | (295) |
| Investment participating | (10) | (25) | - | - | - |
| Investment non-participating | (5) | - | - | - | - |
| Total | (5) | (350) | (10) | (30) | (295) |
The sensitivity to a reduction in market interest rates relates primarily to the effect of interest rate guarantees in the Netherlands, with smaller impacts in the UK and other countries. The different impacts of interest rate changes on shareholders’ equity and profit arise from the classification of fixed interest securities as available for sale in some business units, for which movements in unrealised gains would be taken directly to shareholders’ equity.
The mortality sensitivities relate primarily to the UK and Irish business units.
General insurance and health business – impact on profit before tax (£m)
| Interest rates | Interest rates | Expenses | Gross loss ratios | |
|---|---|---|---|---|
| +1% | -1% | +10% | +5% | |
| Gross and net of reinsurance | (275) | 285 | (115) | (305) |
General insurance and health business – impact before tax on shareholders’ equity (£m)
| Interest rates | Interest rates | Expenses | Gross loss ratios | |
|---|---|---|---|---|
| +1% | -1% | +10% | +5% | |
| Gross and net of reinsurance | (275) | 285 | (30) | (305) |
The sensitivity to a 5% increase in gross loss ratios is the same for both net and gross of reinsurance because this increase does not result in any material excess of loss reinsurance limits being reached. For general insurance, the impact of the expense sensitivity on profit also includes the increase in ongoing administration expenses, in addition to the increase in the claims handling expense provision.
Limitations of sensitivity analysis
The above tables demonstrate the effect of a change in a key assumption while other assumptions remain unchanged. In reality,
such an occurrence is remote, due to correlations between the assumptions and other factors. It should also be noted that these
sensitivities are non-linear, and larger or smaller impacts should not be interpolated or extrapolated from these results.
The sensitivity analyses do not take into consideration that the Group’s assets and liabilities are actively managed. Additionally, the financial position of the Group may vary at the time that any actual market movement occurs. For example, the Group’s financial risk management strategy aims to manage the exposure to market fluctuations. As investment markets move past various trigger levels, management actions could include selling investments, changing investment portfolio allocation, adjusting bonuses credited to policyholders, and taking other protective action.
A number of the business units use passive assumptions to calculate their long-term business liabilities. Consequently, the actual impact of a change in the assumptions may not have any impact on the liabilities, whereas assets are held at market value on the balance sheet. In these circumstances, the different measurement bases for liabilities and assets may lead to volatility in shareholder equity. Similarly, for general insurance liabilities, the interest rate sensitivities only affect profit and equity where explicit assumptions are made regarding interest (discount) rates or future inflation.
Other limitations in the above sensitivity analyses include the use of hypothetical market movements to demonstrate potential risk that only represent the Group’s view of possible near-term market changes that cannot be predicted with any certainty; and the assumption that all interest rates move in an identical fashion.
