Transition to EEV
Lloyds TSB Group PLC
22 November 2006
LLOYDS TSB GROUP PLC
TRANSITION TO EUROPEAN EMBEDDED VALUE AT SCOTTISH WIDOWS
22 NOVEMBER 2006
CONTENTS
Page
1. Executive summary 1
2. EEV methodology 3
3. EEV assumptions 5
4. Summary of financial impact for Scottish Widows of adoption of EEV 7
for supplementary reporting
5. EEV supplementary reporting results for year to 31 December 2005 9
6. Sensitivity analysis 11
7. Traditional embedded value equivalent risk discount rate 12
8. Additional information 13
9. Directors' attestation 15
10. Pro-forma impact of EEV on Lloyds TSB Group statutory accounts 15
11. Audit opinion 16
12. Glossary of terms 18
13. Contacts for further information 21
FORWARD LOOKING STATEMENTS
This announcement contains forward looking statements with respect to the
business, strategy and plans of the Lloyds TSB Group, its current goals and
expectations relating to its future financial condition and performance. By
their nature, forward looking statements involve risk and uncertainty because
they relate to events and depend on circumstances that will occur in the future.
The Group's actual future results may differ materially from the results
expressed or implied in these forward looking statements as a result of a
variety of factors, including UK domestic and global economic and business
conditions, risks concerning borrower credit quality, market related risks such
as interest rate risk and exchange rate risk in its banking business and equity
risk in its insurance businesses, changing demographic trends, unexpected
changes to regulation or regulatory actions, changes in customer preferences,
competition and other factors. Please refer to the latest Annual Report on Form
20-F filed with the US Securities and Exchange Commission for a discussion of
such factors.
TRANSITION TO EUROPEAN EMBEDDED VALUE AT SCOTTISH WIDOWS
1. EXECUTIVE SUMMARY
Introduction
In May 2004, the Chief Financial Officers Forum ('CFO Forum') published its
European Embedded Value ('EEV') Principles (the 'Principles') and Guidance which
set out a series of agreed standards for embedded value reporting. These
Principles establish a consistent treatment for the financial information
provided for insurance and investment contracts and, in our view, allow a fuller
recognition of the economic value being created. Compared with 'Traditional
Embedded Value' ('TEV'), EEV Principles also provide a more appropriate
valuation of in-force business which explicitly takes into account the cost of
financial options and guarantees, and required capital, as well as non-market
risks, such as mortality. Since the publication of these EEV Principles, a
number of companies have adopted EEV.
Lloyds TSB will continue to report under International Financial Reporting
Standards ('IFRS') in its statutory accounts. However, in line with industry
best practice, the Group intends to introduce supplementary financial reporting
relating to Scottish Widows Group ('Scottish Widows') on an EEV basis from the
2006 year end. In addition, the accounting for those products which are
recognised on an embedded value basis under IFRS will also move to a basis
consistent with relevant EEV Principles.
Clearly, because the adoption of EEV Principles is purely a reporting change, it
has no impact on the business fundamentals, economics or cash flows. The total
profit recognised over a contract's lifetime is the same as that recognised
under the IFRS basis of accounting, however the timing of profit recognition is
different. EEV provides for improved clarity, transparency and comparability of
financial information disclosures. The Group believes that EEV represents the
most appropriate measure of long-term value creation in the life assurance and
investment businesses.
The EEV results included in this document have been prepared in accordance with
the CFO Forum's EEV Principles and Guidance. The methodology adopted by
Scottish Widows has been developed in conjunction with consulting actuaries,
Tillinghast, who have made the following statement:
'We have worked closely with Scottish Widows to develop their European Embedded
Value methodology and are satisfied that the approach is robust and is based on
market consistent principles.'
This document describes the EEV methodology adopted and provides details of the
2005 results, together with a reconciliation to TEV.
Impact on the Lloyds TSB Group statutory accounts
Lloyds TSB Group will continue to report its statutory accounts under IFRS with
only insurance policies and discretionary participating investment business, as
defined in IFRS 4, being accounted for on an embedded value basis. The embedded
value basis will however move to a basis consistent with relevant EEV
Principles, although the impact on the Group's statutory accounts is minimal.
Under IFRS, the value of the Group's in-force business at 31 December 2005 was
£2,922 million. Had the Group been reporting on the basis consistent with EEV
the value of in-force business would have been £2,921 million, a reduction of £1
million (see section 10). There is no impact within the 2005 income statement,
and the impact at 31 December 2006 is not expected to be material.
Supplementary reporting - Impact of adopting EEV principles
For supplementary reporting purposes, in line with industry best practice,
Scottish Widows has adopted a market consistent, bottom-up approach which
incorporates an allowance for risk including the cost of financial options and
guarantees, non-market risk and, to comply with EEV Principles, the cost of
holding required capital. In addition, the covered business reported on an EEV
basis now includes the retail OEICs and managed fund business of Scottish
Widows, which were not covered under TEV.
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1. EXECUTIVE SUMMARY (continued)
The table below shows the overall impact of the transition from TEV to EEV
reporting on a supplementary basis. A detailed reconciliation of these numbers
is contained in section 4.
Year to 31 December 2005
Scottish Widows TEV EEV Change
£m £m %
New business profit before tax 224 254 13
Profit before tax* 616 727 18
Embedded value (year end) 6,334 6,386 1
Post-tax return on embedded value 6.8% 8.0%
*excluding volatility, the strengthening of reserves for annuitant mortality and other items (see section 5).
The overall impact of the move to EEV, including the changes in covered
business, on the 2005 supplementary results of Scottish Widows is to increase
new business profit before tax by 13 per cent to £254 million and profit before
tax, excluding volatility, the strengthening of reserves for annuitant mortality
and other similar items, by 18 per cent to £727 million. At 31 December 2005,
the embedded value of Scottish Widows on this basis totalled £6,386 million,
broadly unchanged from that under TEV. This reflects the reduction in embedded
value as a result of the inclusion of the cost of financial options and
guarantees and the cost of holding required capital being more than offset by
changes in the amount of covered business, primarily the retail sales of OEICs
(see section 4).
The table below highlights the difference between Lloyds TSB Group's reported
IFRS financial information relating to Scottish Widows, and that under
supplementary EEV reporting.
Year to 31 December 2005 Reported Supplementary
Scottish Widows IFRS EEV
£m £m
New business profit before tax 123 254
Profit before tax* 655 727
Embedded value (year-end) 5,478 6,386
*excluding volatility, the strengthening of reserves for annuitant mortality and other items
(see section 5).
Compared to Lloyds TSB Group's reported IFRS accounts for the year ended 31
December 2005, Scottish Widows' new business profit before tax under EEV is £131
million higher at £254 million, reflecting the earlier timing of profit
recognition. Profit before tax, excluding volatility, the strengthening of
reserves for annuitant mortality and other items, is £72 million higher at £727
million, as higher new business profit before tax is partially offset by the
consequent lower profit on existing business. Similarly, the embedded value is
£908 million higher at £6,386 million, largely reflecting the inclusion of
certain investment products under EEV. The Group believes that EEV reporting
better represents the economic value of Scottish Widows' in-force business.
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2. EEV METHODOLOGY
The EEV results included in this document have been prepared in accordance with
the CFO Forum's EEV Principles and Guidance.
In preparing this transition document, the directors of Scottish Widows have
applied the policies expected to be adopted when the first set of supplementary
financial information on an EEV basis for the year ended 31 December 2006 is
prepared.
The covered business reported on an EEV basis includes all of the life
insurance, retail OEICs and managed fund business of Scottish Widows. Retail
OEICs and the managed fund business were not covered under TEV reporting but are
included in the EEV definition of covered business. This inclusion is
consistent with this business being managed on an embedded value basis. A
similar approach to modelling OEIC business has been used as that employed for
life and pensions business.
In accordance with the EEV Principles, Scottish Widows' EEV is the sum of
• the shareholders' net assets and
• the value of the in-force business taking account of the cost
of:
- financial options and guarantees
- non-market risk, and
- required capital.
The EEV shareholders' net assets are equal to the IFRS shareholders' net assets
adjusted for deferred income reserve, deferred acquisition costs and statutory '
sterling reserve' adjustments together with their associated deferred tax
balances.
The allowance for risk in shareholder cash flows is a key feature of the EEV
Principles and has been determined using a 'bottom-up' approach applied on a
market consistent basis. Accordingly, each cash flow is valued using the
discount rate consistent with that applied to such a cash flow in the capital
markets. For example, an equity cash flow is valued using an equity risk
discount rate, and a bond cash flow is valued using a bond risk discount rate.
In using cash flow specific discount rates, the EEV methodology differs from the
TEV approach which uses a single 'top down' risk discount rate.
In practice, where the cash flows are either independent of or move linearly
with market movements, a method has been applied known as the 'certainty
equivalent' approach whereby it is assumed that all assets earn the risk-free
rate and all cash flows are discounted using the risk-free rate. This gives the
same result as applying the method in the previous paragraph. The risk-free
rate assumption is consistent with the rates used by Scottish Widows for
reporting under the FSA's realistic reporting regime.
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2. EEV METHODOLOGY (continued)
- Financial options and guarantees
A market consistent approach has been adopted for the valuation of financial
options and guarantees, using a stochastic option pricing technique calibrated
to be consistent with the market price of relevant options at each valuation
date. The valuation and economic models used are the same as those used by
Scottish Widows for reporting under the FSA's realistic reporting regime and, in
accordance with FRS 27, in the Group's consolidated accounts.
The majority of Scottish Widows' financial options and guarantees are in the
With Profits Fund. If experience in the With Profits Fund is significantly
adverse then the shareholder will bear the full cost under the requirements of
the Scheme of Transfer. However, if the experience is positive, the benefit to
the shareholder is shared with policyholders. The cost of this asymmetry is
known as 'burn-through cost'.
- Non-market risk
An allowance for non-market risk is made through the appropriate choice of best
estimate experience assumptions relating to risks such as mortality, and through
the cost of the corresponding capital required. Generally, the best estimate
assumptions will give the mean expected financial outcome to shareholders, and
hence no further allowance for non-market risk is required. However, in the
case of operational risk and the With Profits Fund there are asymmetries in the
range of potential outcomes around the best estimates. These are allowed for in
the EEV provision for non-market risk.
Operational risk refers to the risk of direct or indirect loss resulting from
inadequate or failed internal processes, people and systems or external events.
The operational risk cost has been calculated by comparing the mean impact of
variations in operational risk, as modelled in the economic capital
calculations, with the existing allowance for operational risk in specific
accounting provisions and embedded value projection assumptions.
For the risk cost associated with the With Profits Fund non-economic
assumptions, the impact on burn-through cost of a range of risk events has been
considered.
- Required capital and cost of capital
An allowance is made in the valuation for the cost of holding required capital
for covered business and not therefore immediately available for distribution to
the shareholder. In determining the amount of required capital on both the
in-force business and on new business, allowance has been made for the highest,
determined at the entity level, of the following:
• The minimum amount of capital required to meet FSA capital
adequacy requirements, including the Individual Capital Assessment.
• The amount retained to satisfy the requirements of the Scheme
of Transfer.
• Management's view of the economic capital requirements of the
business.
The cost of capital is the difference between the amount of required capital and
the present value of future releases of that capital, allowing for the
investment expenses and taxation on the required capital until it can be
released. Whilst this cost of capital adjustment is made in the Scottish Widows
supplementary EEV financial information, for Lloyds TSB statutory reporting
purposes no adjustment is made in order to maintain consistency with the
required treatment of capital in the Group's banking businesses.
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3. EEV ASSUMPTIONS
This transition document has been prepared using the information available and
assumptions considered appropriate at 31 December 2005, and therefore
incorporates the assumptions applied within the financial statements for that
period. The additional assumptions required for EEV reporting reflect the
conditions that existed at 31 December 2005.
Economic assumptions
As outlined in section 2, a bottom-up approach is used to determine the economic
assumptions for valuing the business in order to determine a market consistent
valuation.
The risk-free rate assumed in valuing in-force business is 10 basis points over
the 15-year gilt yield. In valuing financial options and guarantees the
risk-free rate is derived from gilt yields plus 10 basis points, in line with
Scottish Widows' FSA realistic balance sheet assumptions. The table below shows
the range of resulting yields and other key assumptions.
31 December 31 December
2004 2005
% %
Risk-free rate (value of in-force) 4.67 4.22
Risk-free rate (financial options and guarantees) 4.3 to 4.7 3.9 to 4.3
Retail Price inflation 2.86 2.89
Expense inflation 3.76 3.79
While the market consistent methodology used does not involve the use of a
single TEV risk discount rate, equivalent risk discount rates are provided in
section 7.
In calculating the EEV total profit before tax, a set of expected investment
returns has been assumed. These are also used in calculating the equivalent
risk discount rate (see section 7). The expected investment returns are based
on prevailing market rates and published research into historic investment
return differentials. These are set out in the table below.
31 December 31 December
2004 2005
% %
Gilt yields (gross) 4.57 4.12
Equity returns (gross) 7.57 7.12
Dividend yields 3.00 3.00
Property returns (gross) 7.57 7.12
Corporate bonds (gross) 5.17 4.72
On adopting EEV the existing TEV expected investment returns were reviewed. The
only change is in the assumed equity and property returns which previously
exceeded the assumed gilt return by 2.6 per cent, now by 3.0 per cent. The
impact of this change on EEV reporting is not material.
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3. EEV ASSUMPTIONS (continued)
Non-economic assumptions
Future mortality, morbidity, lapse and paid-up rate assumptions are reviewed
each year and are based on an analysis of past experience and on management's
view of future experience. These assumptions are intended to represent a best
estimate of future experience as at 31 December 2005 and, for life and pensions
business, remain unchanged in the transition to EEV.
For OEIC business, the lapse assumption is based on experience which has been
collected over a 20 month period. To recognise that this is a shorter period
than that normally available for life and pensions business, and that this
period has coincided with favourable investment conditions, management have used
a best estimate of the long-term lapse assumption which is higher than indicated
by this 20 month experience. In management's view, the approach, and lapse
assumption, are both reasonable.
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4. SUMMARY OF FINANCIAL IMPACT FOR SCOTTISH WIDOWS OF ADOPTION OF EEV FOR
SUPPLEMENTARY REPORTING
The following tables set out in more detail the adjustments made to reconcile
TEV to EEV.
Impact of EEV on embedded value for supplementary reporting 31 December
2005
£m
TEV 6,334
Impact of revised allowance for risk Certainty equivalent valuation 103
Financial options and guarantees (193)
Non-market risk (70)
Cost of capital (262)
Changes to covered business - Pensions Management 18
Life and pensions 5,930
Changes to covered business - OEICs 456
EEV 6,386
Impact of EEV on profit before tax* for supplementary reporting 31 December
2005
£m
TEV 616
Impact of revised allowance for risk Certainty equivalent valuation (32)
Financial options and guarantees 32
Non-market risk (6)
Cost of capital 34
Tax grossing adjustment 13
Changes to covered business - Pensions Management 2
Life and pensions 659
Changes to covered business - OEICs 68
EEV 727
*excluding volatility and the strengthening of annuitant mortality reserves and other items (see section
5).
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4. SUMMARY OF FINANCIAL IMPACT FOR SCOTTISH WIDOWS OF ADOPTION OF EEV FOR
SUPPLEMENTARY REPORTING (continued)
Impact of EEV on new business profit before tax for supplementary reporting 31 December
2005
£m
TEV 224
Impact of revised allowance for risk Certainty equivalent valuation 25
Financial options and guarantees -
Non-market risk (10)
Cost of capital (13)
Changes to covered business - Pensions Management 5
Life and pensions 231
Changes to covered business - OEICs 23
EEV 254
There are no material unhedged financial options and guarantees in new business.
Present value of new business premiums ('PVNBP')
The PVNBP is calculated as the value of single premiums plus the discounted
present value of future expected regular premiums, allowing for lapses and other
assumptions made under EEV. Previously new business margins were calculated as
the new business profit before tax divided by the Annual Premium Equivalent ('
APE'), where the APE was the value of regular premiums plus 10 per cent of
single premiums. For comparison purposes, EEV margin as a percentage of APE is
also provided.
Year to 31 December 2005 EEV new business New business Margin
profit before tax volume PVNBP PVNBP
£m £m %
Life and Pensions 231 6,627 3.5
OEICs 23 1,215 1.9
Total 254 7,842 3.2
Year to 31 December 2005 New business New business New business
profit before tax volume APE margin APE
£m £m %
TEV Life and pensions
(excluding Pensions Management) 224 754 29.7
EEV Life and pensions 231 804 28.7
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5. EEV SUPPLEMENTARY REPORTING RESULTS FOR YEAR TO 31 DECEMBER 2005
This section provides further details of the Scottish Widows' EEV financial
information.
Composition of EEV balance sheet
Life and
Pensions OEICs Total
£m £m £m
Value of in-force business (certainty equivalent) 3,214 252 3,466
Value of financial options and guarantees (193) - (193)
Cost of capital (262) - (262)
Non-market risk (70) - (70)
Total value of in-force business 2,689 252 2,941
Shareholders' net assets 3,241 204 3,445
Total EEV of covered business 5,930 456 6,386
Reconciliation of opening EEV balance sheet to closing EEV balance sheet on
covered business
Value of
Shareholders' in-force Total
net assets
business
£m £m £m
As at 1 January 2005 3,880 2,581 6,461
Total profit after tax 565 360 925
Dividends (1,000) - (1,000)
As at 31 December 2005 3,445 2,941 6,386
Analysis of shareholders' net assets on an EEV basis on covered business
Required Free Shareholders'
capital surplus net assets
£m £m £m
As at 1 January 2005 3,058 822 3,880
Total profit after tax (105) 670 565
Debt issued (560) 560 -
Dividends - (1,000) (1,000)
As at 31 December 2005 2,393 1,052 3,445
The table above shows the shareholders' required capital needed to support the
covered business has reduced from £3,058 million to £2,393 million over the
year.
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5. EEV SUPPLEMENTARY REPORTING RESULTS FOR YEAR TO 31 DECEMBER 2005 (continued)
Detailed Scottish Widows EEV balance sheet 31 December
2005
£m
Investments 75,299
Value of in-force business 2,941
Debtors 463
Other assets 1,310
Total assets 80,013
Technical provisions net of reinsurance 59,190
Other creditors 14,181
Net tax payable 77
Net creditors with other Lloyds TSB Group entities 179
Total liabilities 73,627
Total equity 6,386
Total equity and liabilities 80,013
2005 summary income statement on an EEV basis
Year to 31 December 2005 Life and
Pensions OEICs Total
£m £m £m
New business profit 231 23 254
Existing business profit
Expected return 359 31 390
Experience variances 5 7 12
Assumption changes (147) - (147)
Expected return on shareholders' net assets 211 7 218
Profit before tax, excluding volatility and
other items 659 68 727
Volatility 584
Strengthening of annuitant mortality assumptions (162)
Other items 172
Total profit before tax 1,321
Attributed shareholder tax (396)
Total profit after tax 925
The assumption changes above largely reflect the impact of changes in financial
options and guarantee modelling and lapse assumptions. Other items comprise the
capitalisation impact of a lower cost of capital following debt issuance during
2005, the benefit of an intra-Group transfer of a portfolio of OEICs and an
increase in the value of deferred tax assets, recognised in profit before tax
under EEV. These items have been separately identified in order to provide a
fairer representation of the underlying performance of the business.
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6. SENSITIVITY ANALYSIS
The table below shows the sensitivity of the EEV and the new business profit
before tax to movements in some of the key assumptions. The impact of a change
in the assumption has only been shown in one direction. The impact can be
assumed to be reasonably symmetrical.
Impact on new
Impact business profit
on EEV before tax
£m £m
2005 EEV/new business profit before tax 6,386 254
(1) 100 basis points reduction in risk-free rates 173 6
(2) 10% reduction in market values of equity and property assets (240) n/a
(3) 10% reduction in maintenance expenses 76 34
(4) 10% reduction in lapses 75 14
(5) 5% reduction in annuitant mortality (115) (4)
(6) 5% reduction in mortality and morbidity (excluding annuitants) 39 4
(7) 100 basis points increase in equity and property returns nil nil
(1) In this sensitivity the impact takes into account the change in the value
of in-force, financial options and guarantee costs, statutory reserves and asset
values.
(2) The reduction in market values is assumed to have no corresponding change
in dividend or rental yields. The impact on EEV of £(240) million comprises a
£192 million reduction in the value of in-force and a £48 million reduction in
the shareholders' net assets.
(3) This sensitivity shows the impact of reducing maintenance expenses to 90
per cent of the expected rate.
(4) This sensitivity shows the impact of reducing lapse and surrender rates to
90 per cent of the expected rate.
(5) This sensitivity shows the impact on annuity and deferred annuity business
of reducing mortality rates to 95 per cent of the expected rate.
(6) This sensitivity shows the impact of reducing mortality and morbidity
rates on non-annuity business to 95 per cent of the expected rate.
(7) Under a market consistent valuation, changes in assumed equity and
property returns have no impact on the EEV.
In scenarios (3) to (6) assumptions have been flexed on both the realistic basis
and the statutory reserving basis. A change in risk discount rates is not
relevant as the risk discount rate is not an input to a market consistent
valuation.
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7. TRADITIONAL EMBEDDED VALUE EQUIVALENT RISK DISCOUNT RATE
The following comparison shows that new business products sold are considerably
less risky than in-force products; the equivalent risk discount rate before
deducting a cost of capital is significantly lower on new business than on
in-force business. This is primarily driven by the negligible cost of financial
options and guarantees on new business.
There is a smaller difference between the equivalent risk discount rates on the
in-force business and the new business, after allowing for the cost of capital.
This reflects the fact that the total return on the in-force business includes
the expected return on the large amount of capital required by the in-force
business. The large amount of capital required arises principally from the
Scheme of Transfer and allowing for the expected return on this capital has the
effect of lowering the equivalent risk discount rate.
End 2005 2005
In-force New
business business
% %
Risk free rate 4.2 4.2
Allowance for market risk 2.5 2.0
Allowance for financial options and guarantees 0.9 0.0
Allowance for non-market risk 0.3 0.3
Equivalent risk discount rate (pre cost of capital) 7.9 6.5
Allowance for cost of capital (1.4) (0.5)
Equivalent risk discount rate 6.5 6.0
The traditional embedded value risk discount rates shown were derived by
calculating the risk discount rate which, when used within a traditional
approach (net of the traditional cost of capital and with no allowance for the
time value cost of financial options and guarantees), gives the same value as
that arising from the market-consistent approach (net of the time value cost of
financial options and guarantees, the additional allowance for non-market risk
and the frictional cost of capital).
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8. ADDITIONAL INFORMATION
Definition of new business
New business encompasses both insurance and investment contracts and includes:
• Premiums from the sale of new contracts, and increments to
existing contracts.
• Escalation on existing regular premiums, which is counted as
new business when the escalation is received. Escalation on
existing regular premiums is not anticipated in advance of
being received.
• New entrants to existing corporate pension schemes who have
joined during the reporting period.
• Department of Work and Pensions (DWP) rebates received during
the reporting period. Future DWP rebates are not anticipated
in advance of being received.
This approach is consistent with our previous TEV approach.
Pensions Management new business sales were excluded from reported APE under
TEV. Under EEV this business is treated as covered business and is now included
within new business.
Definition of total profit before tax
Total profit before tax is the sum of the new business profit, the existing
business profit, the expected return on shareholders' net assets and volatility.
New business profit is defined as the contribution to total profit from writing
new business. New business profit is calculated as at the end of the reporting
period, based on the start period economic and non-economic assumptions, and
allows for all direct costs from writing new business, and an appropriate
allocation of overheads.
Existing business profit comprises the expected return on business written
before the start of the reporting period, experience variations and the impact
of non-economic assumption changes.
The expected return on shareholders' net assets is the investment return on the
assets in question assuming that they earn the expected returns as detailed in
section 3.
Volatility is defined to be the impact on profit from changes in economic
assumptions and market movements in excess of, or shortfall to, the expected
investment return. This includes the shortfall or excess return on the
shareholders' net assets, and the VIF (including the cost of financial options
and guarantees and the cost of capital). To provide a clearer representation of
the underlying performance of the business, the effect of excess or shortfall
from market movements is separately analysed as volatility.
Valuation of debt issued by Scottish Widows
During September 2005 Scottish Widows plc issued £560 million of step-up
perpetual subordinated notes. Redemption of these notes is at the option of the
company and is generally not allowable prior to the first call date on 24
September 2015. This debt is valued at cost adjusted for the gain or loss
attributable to the hedged risks.
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8. ADDITIONAL INFORMATION (continued)
Pension schemes
The defined benefit pension scheme deficits calculated in accordance with IAS 19
are recognised within the TEV and EEV balance sheet amounts. Pension scheme
assets are included at their fair value and scheme liabilities are measured on
an actuarial basis using the projected unit credit method. The liabilities are
discounted using rates equivalent to the market yields at the balance sheet date
on high-quality corporate bonds that have terms to maturity approximating to the
terms of the related pension liability.
Treatment of expenses
Allocations of expenses are based on detailed activity-based assessments of
costs. These involve the allocation of costs between new business, existing
business and where appropriate non-recurring development costs. All of the
costs of the life and pensions business are considered on a look-through basis.
This treatment is unchanged from the previous treatment of expenses.
The disclosed EEV profit before tax is net of development costs.
Tax
EEV profits are calculated net of tax and then grossed up at the effective rate
of shareholder tax. The full standard rate of UK corporation tax has been used
to gross up profits.
Deferred tax has been recognised, where appropriate, in respect of all
differences where transactions or events resulting in an obligation to pay more
tax in the future or a right to pay less tax in the future have occurred before
the period end. Where appropriate, deferred tax balances have been discounted
at the risk-free rate over the total period in which it is estimated that the
timing difference to which they relate will reverse.
Dividend recognition
Consistent with the treatment under IFRS, dividends are recognised when paid,
and not when declared.
With-profits bonuses
Future bonus rates on participating business are set at levels which would fully
utilise the assets supporting the with-profits business.
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9. DIRECTORS' ATTESTATION
The Directors of Scottish Widows Group acknowledge their responsibility for the
preparation of the supplementary information in accordance with the twelve EEV
Principles and the assumptions underpinning the 2005 results. Scottish Widows
Group and Lloyds TSB Group approved the EEV supplementary information on 21
November 2006.
10. PRO-FORMA IMPACT OF EEV ON LLOYDS TSB GROUP STATUTORY ACCOUNTS
The table below reconciles the 31 December 2005 published value of in-force
business ('VIF') on a TEV basis, which is reported in the Lloyds TSB Group
statutory accounts, to the equivalent value on a market consistent basis
applying relevant EEV Principles.
Pro-forma as at 31 December 2005
£m
Gross VIF for insurance and participating investment
business (TEV basis) 2,922
IAS 12 tax (including policyholder tax) (934)
Total net VIF (TEV basis) 1,988
Impact of allowance for risk Certainty equivalent valuation 52
Financial options and guarantees (8)
Non-market risk (45)
Total net VIF (EEV consistent basis) 1,987
IAS 12 tax grossing adjustment 934
Total gross VIF (EEV consistent basis) 2,921
The cost of capital is not reflected in the Lloyds TSB Group accounts to
maintain consistency with the required treatment of capital in the Group's
banking business.
The pro-forma value of the in-force insurance business at 31 December 2005 on a
basis consistent with the relevant EEV Principles was £2,921 million, compared
to the reported figure of £2,922 million. As this reflects a change in
methodology rather than a change in accounting policy, the Group's financial
statements will not restate 2005 comparatives; the impact of this change will be
reported within the 2006 income statement. The impact at 31 December 2006 is
also not expected to be material.
Page 15 of 21
TRANSITION TO EUROPEAN EMBEDDED VALUE AT SCOTTISH WIDOWS
11. AUDIT OPINION
Special Purpose Audit Report of PricewaterhouseCoopers LLP to the directors of
Scottish Widows Group Limited on its European Embedded Value ('EEV')
Supplementary Financial Information for year ended 31 December 2005
We have audited the accompanying consolidated EEV balance sheet of Scottish
Widows Group Limited as at 31 December 2005, the related consolidated EEV income
statement for the year then ended and the related notes (hereinafter referred to
as 'the EEV supplementary financial information') set out in sections 2 to 6 and
8 to 9.
Respective responsibilities of directors and PricewaterhouseCoopers
The directors of the Scottish Widows Group are responsible for the preparation
of the EEV supplementary financial information which have been prepared as part
of the Scottish Widows Group's conversion to EEV.
Our responsibilities, as independent auditors, in relation to the supplementary
financial information are, as set out in our letter of engagement agreed with
you dated 27 October 2006, to report to you our opinion as to whether the
supplementary financial information has been properly prepared in accordance
with the European Embedded Value basis. We also report to you if we have not
received all the information and explanations we require for our audit of the
supplementary financial information. This report, including the opinion, has
been prepared for and only for the Scottish Widows Group in accordance with our
letter of engagement dated 27 October 2006 and for no other purpose. We do not,
in giving this opinion, accept or assume responsibility for any other purpose or
to any other person to whom this report is shown or in to whose hands it may
come save where expressly agreed by our prior consent in writing.
We also read the other information in the transition document and consider the
implication for our report if we become aware of any apparent misstatements or
material inconsistencies with the supplementary financial information.
The maintenance and integrity of the Scottish Widows Group Limited website is
the responsibility of the directors; the audit work does not involve
consideration of these matters and, accordingly, we accept no responsibility for
any changes that may have occurred to the supplementary financial information
since it was initially presented on the website.
Legislation in the United Kingdom governing the preparation and dissemination of
supplementary financial statements may differ from legislation in other
jurisdictions.
Page 16 of 21
TRANSITION TO EUROPEAN EMBEDDED VALUE AT SCOTTISH WIDOWS
11. AUDIT OPINION (continued)
Basis of opinion
We conducted our audit in accordance with International Standards on Auditing ('
ISA') (UK and Ireland) issued by the Auditing Practices Board. Our audit
included examination, on a test basis, of evidence relevant to the amounts and
disclosures in the supplementary financial information. This evidence included
an assessment of the significant estimates and judgements made by the directors
in the preparation of the supplementary financial information, and of whether
the EEV methodology is appropriate to the Scottish Widows Group's circumstances,
consistently applied and adequately disclosed.
We planned and performed our audit so as to obtain all the information and
explanations which we considered necessary in order to provide us with
sufficient evidence to give reasonable assurance that the supplementary
financial information is free from material misstatement, whether caused by
fraud or other irregularity or error. In forming our opinion, we also evaluated
the overall adequacy of the presentation of information in the supplementary
financial information.
Opinion
In our opinion, the accompanying EEV supplementary financial information for the
year ended 31 December 2005 has been prepared, in all material respects, in
accordance with the basis set out on pages 3 to 5, which describes that the
supplementary financial information has been prepared in accordance with the
twelve European Embedded Value principles as set out in 'European Embedded Value
Principles'. This section includes the assumptions made by the directors of
Scottish Widows Group about the policies expected to be adopted when they
prepare the first set of supplementary financial statements of the Scottish
Widows Group on an EEV basis for the year to 31 December 2006.
PricewaterhouseCoopers LLP
Chartered Accountants
Edinburgh
22 November 2006
Page 17 of 21
TRANSITION TO EUROPEAN EMBEDDED VALUE AT SCOTTISH WIDOWS
12. GLOSSARY OF TERMS
Best estimate assumption
Best estimate is defined as the mean financial outcome to shareholders.
CFO Forum
The CFO Forum is a high-level discussion group formed and attended by the Chief
Financial Officers of major European insurance companies. The CFO Forum was
created in 2002.
Covered business
The contracts to which the EEV methodology has been applied.
EEV Guidance
Guidance providing preferred interpretation of the EEV Principles, as set out
under each Principle. Compliance with guidance is preferred but not compulsory
in order to comply with the EEV Principles.
EEV Principles
Compliance with the EEV Principles requires compliance with each of the 12
Principles. The Principles provide a framework for the derivation of valuation
assumptions, calculation and reporting of embedded value results.
EEV shareholders' net assets
The EEV shareholders' net assets are the total assets less the regulatory
reserves. This is also equal to the required capital plus free surplus.
Embedded value
This is the sum of: free surplus allocated to the covered business; required
capital less any costs of holding required capital; and the present value of
future shareholder cash flows from in-force covered business.
European Embedded Value
An embedded value calculation which complies with the European Embedded Value
Principles.
Experience variance
The impact on embedded value of a variation during the reporting period in the
experience in performance of the covered business when compared to projection
assumptions used for that area of experience.
Fair value
The International Accounting Standards definition of fair value is 'the amount
for which an asset could be exchanged or a liability settled between
knowledgeable, willing parties in an arm's length transaction'.
Financial options and guarantees
Features of the covered business conferring potentially valuable guarantees
underlying, or options to change, the level or nature of policyholder benefits
and exercisable at the discretion of the policyholder, whose potential value is
impacted by the behaviour of financial variables.
Page 18 of 21
TRANSITION TO EUROPEAN EMBEDDED VALUE AT SCOTTISH WIDOWS
12. GLOSSARY OF TERMS (continued)
Free surplus
The amount of any capital and surplus allocated to, but not required to support,
the in-force business covered by the EEV methodology as defined in Principle 4.
IAS
International Accounting Standard.
IFRS
International Financial Reporting Standards, developed by the International
Accounting Standards Board.
Look-through basis
A basis via which the impact of an action on the whole group, rather than on a
particular part of the group, is measured.
LTICR
Long Term Insurance Capital Requirement.
Market Consistent Embedded Value ('MCEV')
This is an embedded value calculation where each projected cash flow is
discounted using a discount rate appropriate to the risk associated with that
cash flow, as measured by the market.
OEIC
Open Ended Investment Company.
Participating business
Covered business in which policyholders have the right to participate (receive
additional benefits) in the performance of a specified pool of assets or
contracts, fund or company within the group.
Present value
The value of a future cash flow at the valuation date, discounted at a discount
rate appropriate to that cash flow.
Required capital
The amount of assets, over and above the value placed on liabilities in respect
of covered business, whose distribution to shareholders is restricted, defined
in Principle 5.
Risk-free rates
Prospective yields on securities of suitable term considered to be materially
free of default or credit risk.
Scheme of Transfer
The Court approved Scheme of Transfer which created Scottish Widows following
the demutualisation of Scottish Widows Fund and Life Assurance Society in 2000.
Stochastic techniques
Techniques that incorporate the potential future variability in assumptions
affecting their outcome.
Page 19 of 21
TRANSITION TO EUROPEAN EMBEDDED VALUE AT SCOTTISH WIDOWS
12. GLOSSARY OF TERMS (continued)
Supplementary reporting
Reporting within financial statements that is a) produced using a methodology
other than that on which the primary financial statements are based, and b) not
covered by the primary financial statement's audit opinion.
Traditional Embedded Value
This is an embedded value calculation where the projected cash flows are
discounted using a single risk discount rate across the entire business.
Value of in-force business
The present value of future payments to shareholders arising from contracts that
are in-force at the valuation date and part of the covered business.
Page 20 of 21
TRANSITION TO EUROPEAN EMBEDDED VALUE AT SCOTTISH WIDOWS
CONTACTS
For further information please contact:-
Michael Oliver
Director of Investor Relations
Lloyds TSB Group plc
020 7356 2167
E-mail: michael.oliver@ltsb-finance.co.uk
Sarah Pollard
Senior Manager, Investor Relations
Lloyds TSB Group plc
020 7356 1571
E-mail: sarah.pollard@ltsb-finance.co.uk
Mary Walsh
Director of Corporate Relations
Lloyds TSB Group plc
020 7356 2121
E-mail: mary.walsh@lloydstsb.co.uk
Page 21 of 21
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