Preliminary results year ended 31 December 2008
05 March 2009
Appendix A – Capital management
A3 – Sensitivity analysis and capital management
Sensitivity analysis
The sensitivity of the group’s shareholders’ funds on an MCEV basis and IFRS basis at 31 December 2008 to a 10% fall in global equity markets, a rise of 1% in global interest rates or a 0.5% increase in credit spreads is as follows:
| MCEV basis | ||||||
|---|---|---|---|---|---|---|
| 2007 £bn |
2008 £bn |
Equities down 10% | Interest rates up 1% £bn |
0.5% increased credit spread £bn |
||
| Direct £bn | Indirect £bn | |||||
| 22.4 | Long-term savings1 | 19.2 | (0.3) | (0.5) | (0.3) | (1.7) |
| 6.8 | General insurance and other | 4.4 | (0.3) | – | (0.2) | 0.3 |
| (5.5) | Borrowings2 | (6.5) | – | – | – | – |
| 23.7 | Shareholders’ funds | 17.1 | (0.6) | (0.5) | (0.5) | (1.4) |
| IFRS basis | ||||||
|---|---|---|---|---|---|---|
| 2007 £bn | 2008 £bn | Equities down 10% £bn | Interest rates up 1% £bn | 0.5% increased credit spread £bn | ||
| 14.6 | Long-term savings | 16.5 | (0.3) | (0.4) | (0.3) | |
| 6.8 | General insurance and other | 4.4 | (0.3) | (0.2) | 0.3 | |
| (5.5) | Borrowings | (6.5) | – | – | – | |
| 15.9 | Shareholders’ fund | 14.4 | (0.6) | (0.6) | – | |
- Assumes MCEV assumptions adjusted to reflect revised bond yields.
- Comprising internal, external and subordinated debt, net of corporate tangible net assets.
These sensitivities assume a full tax charge/credit on market value assumptions.
The tables above incorporates the effect on the value of the pension scheme assets and liabilities of a 10% decrease in equity markets, a 1% increase in fixed income bond yields and a 0.5% increase in credit spreads. The interest rate sensitivity also assumes an equivalent movement in both inflation and discount rate (i.e. no change to real interest rates) and therefore, incorporates the offsetting effects of these items on the pension scheme liabilities. A 1% increase in the real interest rate only has the effect of reducing the pension scheme liability by £1.4 billion thereby enhancing shareholders’ funds by £1.0 billion (after deducting tax).
Group IGD
The sensitivity of the group’s IGD surplus reflects the impact of the hedges we have put in place as part of our long-term strategy to protect the group from extreme market movements. At 31 December 2008 the sensitivity to a 10% fall in global equity markets or a rise of 1% in global interest rates is as follows:
| 2008 £bn |
Equities down 10% £bn |
Interest rates up 1% £bn |
|
|---|---|---|---|
| IGD Group surplus | 2.0 | (0.2) | (0.1) |
We continue to actively manage our equity risk exposures. The sensitivity of the group’s IGD surplus to falls in the global equity markets since 31 December 2008 is as follows:
| £bn | |
|---|---|
| Equities down 10% | (0.2) |
| Equities down 20% | (0.3) |
| Equities down 30% | (0.5) |
| Equities down 40% | (0.8) |
Risk management – Equity hedging
Our risk management processes ensure close and on-going monitoring of all our capital measures. The following table shows the material equity derivatives within the group’s shareholder funds at 31 December 2008 that are used as part of a long-term strategy to manage equity risk. It excludes derivatives used for portfolio management purposes:
| Derivative | Notional £bn1 |
Market fall below protection level £bn2,4 |
Market fall required before protection starts £bn3,4 |
Outstanding duration |
|---|---|---|---|---|
| (a) | 0.5 | 13% | – | < 3 months |
| (b) | 1.6 | 17% | – | 3-11 months |
| (c) | 1.9 | – | 17% | 12 months |
- The notional represents the notional amount of hedging as at 31 December 2008.
- The 'Market fall below protection level' shows the percentage the market has fallen below the protection level as at 31 December 2008. Both derivatives (a) and (b) are therefore in the money at this date.
- The 'Market fall required before protection starts' shows the percentage the market would have to fall from the 31 December 2008 positions before the derivative moves into the money.
- Derivatives (a), (b) and (c) each represent a collection of derivatives with different strike prices. The strike prices used in the above calculations are the weighted average strikes of the derivatives in each bucket.
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 its capital more efficiently. Primarily MCEV, 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) are used. Sensitivities to economic and operating experience are regularly produced on all of our financial performance measurements as part of our decision making and planning process, and as part of the framework for identifying and quantifying the risks that each of its business units, and the group as a whole are exposed to.
For long-term business in particular, sensitivities of MCEV performance indicators to changes in both economic and non-economic experience are continually used to manage the business and to inform the decision making process. More information on MCEV sensitivities can be found in the presentation of results in the MCEV section of this announcement.
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 a 1% increase or decrease. The test allows consistently for similar changes to investment returns and movements in the market value of backing fixed interest securities. |
| Equity/property market values | The impact of a change in equity/property market values by ± 10% |
| 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% |
Long-term businesses
| 2008 | |||||||
|---|---|---|---|---|---|---|---|
| Impact on profit before tax £m | Interest rates +1% |
Interest rates -1% |
Equity/ property +10% |
Equity/ property -10% |
Expenses +10% |
Assurance mortality +5% |
Annuitant mortality +5% |
| Insurance participating | (10) | (165) | 85 | (90) | (20) | (5) | (10) |
| Insurance non-participating | (25) | 135 | 90 | (90) | (20) | (25) | (310) |
| Investment participating | (35) | (55) | 25 | (20) | – | – | – |
| Investment non-participating | (10) | 10 | 20 | (20) | (5) | – | – |
| Assets backing life shareholders’ funds | (20) | 30 | 180 | (180) | – | – | – |
| Total | (100) | (45) | 400 | (400) | (45) | (30) | (320) |
| 2008 | |||||||
|---|---|---|---|---|---|---|---|
| Impact on shareholders' equity before tax | Interest rates +1% |
Interest rates -1% |
Equity/ property +10% |
Equity/ property -10% |
Expenses +10% |
Assurance mortality +5% |
Annuitant mortality +5% |
| Insurance participating | (30) | (135) | 85 | (90) | (20) | (5) | (10) |
| Insurance non-participating | (185) | 270 | 110 | (105) | (20) | (25) | (310) |
| Investment participating | (50) | (40) | 30 | (25) | – | – | – |
| Investment non-participating | (210) | 230 | 20 | (20) | (5) | – | – |
| Assets backing life shareholders’ funds | (80) | 95 | 190 | (190) | – | – | – |
| Total | (555) | 420 | 435 | (430) | (45) | (30) | (320) |
| 2007 | |||||||
|---|---|---|---|---|---|---|---|
| Impact on profit before tax £m |
Interest rates +1% |
Interest rates -1% |
Equity/ property +10% |
Equity/ property -10% |
Expenses +10% |
Assurance mortality +5% |
Annuitant mortality +5% |
| Insurance participating | 15 | (10) | – | – | (5) | – | – |
| Insurance non-participating | (205) | 165 | 45 | (35) | (5) | (20) | (295) |
| Investment participating | (5) | (25) | – | – | (5) | – | – |
| Investment non-participating | (35) | 40 | 65 | (60) | – | – | – |
| Assets backing life shareholders’ funds | (115) | 140 | 180 | (175) | – | – | – |
| Total | (345) | 310 | 290 | (270) | (15) | (20) | (295) |
| 2007 | |||||||
|---|---|---|---|---|---|---|---|
| Impact on shareholders' equity before tax | Interest rates +1% |
Interest rates -1% |
Equity/ property +10% |
Equity/ property -10% |
Expenses +10% |
Assurance mortality +5% |
Annuitant mortality +5% |
| Insurance participating | (5) | 20 | – | – | (5) | – | – |
| Insurance non-participating | (320) | 275 | 105 | (95) | (5) | (20) | (295) |
| Investment participating | (5) | (25) | – | – | (5) | – | – |
| Investment non-participating | (170) | 190 | 65 | (60) | – | – | – |
| Assets backing life shareholders’ funds | (165) | 190 | 460 | (455) | – | – | – |
| Total | (665) | 650 | 630 | (610) | (15) | (20) | (295) |
The impact on the group’s results from sensitivity to these assumptions can also be found in the MCEV sensitivities included in the alternative method of reporting long-term business profits section.
General insurance and health businesses
| 2008 | ||||||
|---|---|---|---|---|---|---|
| Impact on profit before tax £m |
Interest rates +1% |
Interest rates -1% |
Equity/ property +10% |
Equity/ property -10% |
Expenses +10% |
Gross loss ratios +5% |
| Net of reinsurance | (360) | 360 | 90 | (90) | (170) | (425) |
| 2008 | ||||||
|---|---|---|---|---|---|---|
| Impact on shareholders’ equity before tax £m |
Interest rates +1% |
Interest rates -1% |
Equity/ property +10% |
Equity/ property -10% |
Expenses +10% |
Gross loss ratios +5% |
| Net of reinsurance | (360) | 360 | 90 | (90) | (40) | (425) |
| 2007 | ||||||
|---|---|---|---|---|---|---|
| Impact on profit before tax £m |
Interest rates +1% |
Interest rates -1% |
Equity/ property +10% |
Equity/ property -10% |
Expenses +10% |
Gross loss ratios +5% |
| Net of reinsurance | (255) | 290 | 110 | (110) | (150) | (365) |
| 2007 | ||||||
|---|---|---|---|---|---|---|
| Impact on profit before tax £m |
Interest rates +1% |
Interest rates -1% |
Equity/ property +10% |
Equity/ property -10% |
Expenses +10% |
Gross loss ratios +5% |
| Net of reinsurance | (255) | 290 | 110 | (110) | (35) | (365) |
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.
Fund management and non-insurance businesses
| 2008 | ||||
|---|---|---|---|---|
| Impact on profit before tax £m |
Interest rates +1% |
Interest rates -1% |
Equity/ property +10% |
Equity/ property -10% |
| Total | 15 | (20) | 50 | (50) |
| 2008 | ||||
|---|---|---|---|---|
| Impact on shareholders’ equity before tax £m |
Interest rates +1% |
Interest rates -1% |
Equity/ property +10% |
Equity/ property -10% |
| Total | – | (10) | 130 | (130) |
| 2007 | ||||
|---|---|---|---|---|
| Impact on profit before tax £m |
Interest rates +1% |
Interest rates -1% |
Equity/ property +10% |
Equity/ property -10% |
| Total | (35) | 35 | 55 | (55) |
| 2007 | ||||
|---|---|---|---|---|
| Impact on shareholders’ equity before tax £m |
Interest rates +1% |
Interest rates -1% |
Equity/ property +10% |
Equity/ property -10% |
| Total | (35) | 35 | 55 | (55) |
Limitations of sensitivity analysis
The above tables demonstrate the effect of a change in a key assumption while other assumptions remain unchanged. In reality, there is correlation 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, our 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.
