Annual Financial Report
Chesnara plc (the 'Company')
ANNUAL FINANCIAL REPORT
Financial Statements for the year ended 31 December 2009
Notice of Annual General Meeting
Form of Proxy for the Annual General Meeting
Copies of the above documents which were issued to shareholders on 12 April
2010 have been submitted to the UK Listing Authority and will be available for
inspection at the UK Listing Authority's Document Viewing Facility, which is
situated at: The Financial Services Authority, 25 The North Colonade, Canary
Wharf, London E14 5HS. The Company's Financial Statements and Notice of Annual
General Meeting may also be found on its website at www.chesnara.co.uk.
The Company announced its preliminary results for the year ended 31 December
2009 on 31 March 2010 which included audited financial statements and a fair
review of business. The Company today provides the following additional
regulated information, included within its Financial Statements, in full
unedited text as required to be made public under the disclosure and
transparency rules.
STATEMENT OF DIRECTORS' RESPONSIBILITIES IN RESPECT OF THE FINANCIAL
STATEMENTS.
The directors are responsible for preparing the Annual Report and the financial
statements in accordance with applicable law and regulations.
Company law requires the directors to prepare financial statements for each
financial year. Under that law the directors are required to prepare the group
financial statements in accordance with International Financial Reporting
Standards (IFRSs) as adopted by the European Union and Article 4 of the IAS
Regulation and have also chosen to prepare the parent company financial
statements under IFRSs as adopted by the EU. Under company law the directors
must not approve the accounts unless they are satisfied that they give a true
and fair view of the state of affairs of the company and of the profit or loss
of the company for that period. In preparing these financial statements,
International Accounting Standard 1 requires that directors:
- properly select and apply accounting policies;
- present information, including accounting policies, in a manner that provides
relevant, reliable, comparable and understandable information;
- provide additional disclosures when compliance with the specific requirements
in IFRSs are insufficient to enable users to understand the impact of
particular transactions, other events and conditions on the entity's financial
position and financial performance; and
- make an assessment of the company's ability to continue as a going concern.
The directors are responsible for keeping adequate accounting records that are
sufficient to show and explain the company's transactions and disclose with
reasonable accuracy at any time the financial position of the company and
enable them to ensure that the financial statements comply with the Companies
Act 2006. They are also responsible for safeguarding the assets of the company
and hence for taking reasonable steps for the prevention and detection of fraud
and other irregularities.
The directors are responsible for the maintenance and integrity of the
corporate and financial information included on the company's website.
Legislation in the United Kingdom governing the preparation and dissemination
of financial statements may differ from legislation in other jurisdictions.
Responsibility statement
We confirm that to the best of our knowledge:
- the financial statements, prepared in accordance with International Financial
Reporting Standards, give a true and fair view of the assets, liabilities,
financial position and profit or loss of the company and the undertakings
included in the consolidation taken as a whole; and
- the management report, which is incorporated into the directors' report,
includes a fair review of the development and performance of the business and
the position of the company and the undertakings included in the consolidation
taken as a whole, together with a description of the principal risks and
uncertainties that they face.
THIS RESPONSIBILITY STATEMENT WAS APPROVED BY THE BOARD OF DIRECTORS ON 30
MARCH 2009 AND WAS SIGNED by Peter Mason, Chairman and Graham Kettleborough,
Chief Executive
PRINCIPAL RISKS AND UNCERTAINTIES
The Group's management of insurance risk is a critical aspect of the business.
The primary insurance activity carried out by the Group comprises the
assumption of the risk of loss from persons that are directly subject to the
risk. Such risks in general relate to life, accident, health and financial
perils that may arise from an insurable event, with the majority of the Group's
exposure relating to mortality risk on individual lives, predominantly in the
UK and Sweden. As such, the Group is exposed to the uncertainty surrounding the
timing and severity of claims under the related contracts.
The Group is also exposed to a range of financial risks through its life
assurance contracts, financial assets, financial liabilities, including
investment contracts and borrowings, and its reinsurance assets. In particular,
the key financial risk is that in the long-term its investment proceeds are not
sufficient to fund the obligations arising from its insurance and investment
contracts. The most important components of this financial risk are market risk
(interest rate risk and equity price risk), and credit risk, including the risk
of reinsurer default. The Group has procedures for setting and monitoring the
Group's assets and liability position with the objective of ensuring that the
Group can always meet its obligations without undue cost and in accordance with
the Group's internal and regulatory capital requirements.
Detailed information on the characteristics and management of insurance and
financial risks borne by the Group is provided in Notes 5 and 6 respectively of
the Company's published financial statements for the year ended 31 December
2009 and included below under Management of Insurance Risk and Management of
Financial Risk.
In addition, detailed information on accounting estimates and judgements is
included in Note 3 of the Company's published consolidated financial statements
for the year ended 31 December 2009 and included below under the heading
Accounting Estimates and Judgements.
The significant changes in the nature and incidence of risks and uncertainties
during the twelve months ended 31 December 2009 relate to the acquisition on 23
July 2009 of Moderna Försäkringar Liv AB, which, together with its subsidiary
and associated companies, comprises the Swedish Business. These changes arise
at both the Swedish entity and Group corporate levels, the latter principally
through the assumption of foreign currency exchange risk, as a significant
proportion of the Group's assets and liabilities are now denominated in Swedish
Kronor. The information set out under Accounting Estimates and Judgements,
Management of Insurance Risk and Management of Finance Risk below clearly
identifies these newly-arising risks and uncertainties. Further, in view of
recent investment market turbulence there is continuing uncertainty as to the
future direction of investment markets and attention is drawn particularly to
the sensitivity of the reported embedded value of the Group to the economic
sensitivities set out in Note 7 to the European Embedded Value Basis
Supplementary Information in the financial statements.
ACCOUNTING ESTIMATES AND JUDGEMENTS
The Group makes estimates and assumptions that affect the reported amounts of
assets and liabilities and also makes critical accounting judgements in
applying the Group's accounting policies. Such estimates and judgements are
continually evaluated and are based on historical experience and other factors,
including expectations of future events that are believed to be reasonable. The
more critical areas, where accounting estimates and judgements are made, and
which relate variously to the UK and Swedish businesses together, or to each
separately, are described below.
UK and Swedish Businesses
(a) Classification of long-term contracts
The Group has exercised judgement in its classification of long-term business
as between insurance and investment contracts, which fall to be accounted for
differently in accordance with the policies set out in Note 2 Significant
Accounting Policies, in the financial statements. Insurance contracts are those
where significant risk is transferred to the Group under the contract and
judgement is applied in assessing whether the risk so transferred is
significant, especially with regard to pensions contracts, which are
predominantly, but not exclusively, created for investment purposes.
(b) Deferred acquisition costs and deferred income - investment contracts
The Group applies judgement in deciding the amount of direct costs that are
incurred in acquiring the rights to provide investment management services in
connection with the issue of investment contracts. Judgement is also applied in
establishing the amortisation of the assets representing these contractual
rights and the recognition of initial fees received in respect of these
contracts. The assets are amortised over the expected lifetime of the
investment management service contracts and deferred income, where applicable,
is amortised over the expected period over which it is earned. Estimates are
applied in determining the lifetime of the investment management service
contracts and in determining the recoverability of the contractual rights
assets by reference to expected future income and expense levels. This test for
recoverability is performed using best estimates of future cash flows, using a
market consistent estimate of future investment returns.
As at 31 December 2009, the carrying values of deferred acquisition costs, net
of amortisation, and of deferred income, in respect of the UK Business, were
£7.7m and £13.1m respectively (as at 31 December 2008 £8.6m and £14.6m
respectively). An increase in the estimate of the lifetime of the investment
management service contract by one year in respect of deferred acquisition
costs would have increased profit before tax for the year ended 31 December
2009 by £0.1m and shareholders' equity as at 31 December 2009 by £0.1m and an
increase of one year in the length of the amortisation period in respect of
deferred income would have reduced profit before tax for the year ended 31
December 2009 by £0.1m and shareholders' equity as at 31 December 2009 by
£0.1m.
As at 31 December 2009, the carrying values of deferred acquisition costs, net
of amortisation, in respect of the Swedish Business, was £1.6m (as at 31
December 2008 £nil). An increase in the length of the amortisation period by
one year would have increased profit before tax for the year ended 31 December
2009 by £0.1m and shareholders' equity as at 31 December 2009 by £0.1m.
(c) Amortisation of acquired value of in-force business
The Group applies accounting estimates and judgement in determining the fair
value, amortisation and recoverability of acquired in-force business relating
to insurance and investment contracts. The acquired value of in-force business
has been amortised on a basis that reflects the expected profit stream arising
from the business acquired at the date of acquisition. This profit stream is
estimated from the experienced termination rates, expenses of management and
age of the individual contract holders as well as global estimates of
investment growth, based on recent experience at the date of acquisition.
Acquired value of in-force business is tested for recoverability by reference
to expected future income and expense levels.
As at 31 December 2009, the carrying value of acquired in-force business, net
of amortisation, was £24.8m in respect of the UK Business (as at 31 December
2008 £28.5m) and £61.7m in respect of the Swedish Business (as at 31 December
2008 £nil).
(d) Fair value of financial assets and unit-linked investments
Fair value measurement has been adopted to reduce volatility in reported
earnings in the income statement as the liabilities so determined are measured
in a way which is consistent with the fair value of the underlying invested
financial assets.
Fair value is the amount for which an asset could be exchanged, or a liability
settled, between willing, knowledgeable parties in an arm's length transaction.
Fair values are determined by reference to observable market prices where
available and reliable.
UKBusiness
(a) Estimates of future benefits payments arising from long-term insurance
contracts
The Group makes estimates of the expected number of deaths for each of the
years that it is exposed to risk. These estimates are based on either standard
mortality tables or reinsurers' rate tables as appropriate, adjusted to reflect
the Group's own experience. For contracts without fixed terms the Group has
assumed that it will be able to increase charges to policyholders in future
years, in line with emerging mortality experience.
The Group has offered guaranteed annuity options within certain contracts.
Estimates have been made of the number of contract holders who will exercise
these options, in order to measure their value. Changes in investment
conditions could result in significantly more contract holders exercising their
options than the Group has assumed in determining the liabilities arising from
these contracts.
The Group makes estimates of future deaths, voluntary contract terminations,
investment returns and administration expenses at the inception of long-term
insurance contracts with fixed and guaranteed terms. These estimates, which are
reconsidered annually, form the assumptions used to calculate the liabilities
arising from these contracts.
The assumptions used to establish insurance contract liabilities and
appropriate sensitivities relating to variations in critical assumptions are
disclosed in Note 33 of the financial statements and are included in Management
of Insurance Risk below.
As at 31 December 2009, the carrying value of insurance contract liabilities
was £1,044m (as at 31 December 2008 £923.5m).
(b) Fair value of investment contracts - guaranteed income and guaranteed
growth bonds
The fair value of investment contract liabilities, in respect of guaranteed
income and guaranteed growth bonds, (which are fully described in Note 34 to
the financial statements and are included in Management of Financial Risk
below) is established using a valuation technique, which approximates the
following methodology:
The fair value of the contract, measured at inception, is the purchase price
paid for it. This price implies a retail market rate of interest prevailing at
the inception of the contract, which is used to equate the contractual cash
flows payable under the bond to the purchase price, including an allowance for
expenses incurred in managing the contract; and
Subsequent measurement of the liability at fair value reflects the impact of
changes in retail market interest rates for these products: this is
accomplished in practice by tracking movements in the less-than-5-year gilt
index as the bonds are predominantly less than 5 years in term.
Fair value measurement has been adopted to reduce volatility in reported
earnings in the income statement as the liabilities so determined are measured
in a way which is consistent with the fair value of the underlying invested
financial assets.
As at 31 December 2009, the carrying value of investment contract liabilities
in respect of guaranteed income and guaranteed growth bonds was £22.9m (as at
31 December 2008 £55.1m).
(c) Liability for future redress in respect of mortgage endowment misselling
complaints
Included within insurance contract liabilities is a liability in respect of
amounts anticipated to be payable as redress for upheld mortgage endowment
misselling complaints. In establishing this liability the Group makes estimates
about the number of future upheld complaints (taking into account the number of
complaints received, the number of complaints time-barred and the number of
complaints which are admitted) and about the average cost of redress per upheld
complaint. These estimates are determined, taking into account historical
experience and investment return projections. Variations in these estimates
could result in higher or lower than expected numbers of upheld complaints and
higher or lower than expected amounts of redress per upheld complaint. The
impact of variations in these assumptions is disclosed in Note 33 to the
financial statements.
As at 31 December 2009, the liability for future redress in respect of mortgage
endowment misselling complaints was £2.9m (as at 31 December 2008 £4.2m).
Swedish Business
(a) Insurance claim reserves
Provisions are determined by management based on experience of claims settled
and on statistical models which require certain assumptions to be made
regarding the timing, incidence and amount of claims. In order to calculate
the total provision required, the historical development of claims is analysed
using statistical methodology to extrapolate, within acceptable parameters, the
value of outstanding claims.
For more recent underwriting years the provisions will make more use of
techniques that incorporate expected loss ratios. As underwriting years
mature, the reserves are increasingly driven by methods based on actual claims
experience. The data used for statistical modelling is internally generated.
Actual claims experience may differ from the historical pattern on which the
estimate is based and the cost of individual claims may exceed that assumed.
Liabilities carried in respect of waiver of premium and income protection
policies are sensitive to the Group's assessment of the length of period in
which benefits will be paid to policyholders (which can be significant).
Estimates are made based on the sex, age and occupation of the claimant as well
as the length of time the claimant has been claiming on the policy.
As at 31 December 2009, the carrying value of the insurance claim reserves,
gross of reinsurance, was £32.4m (as at 31 December 2008 £nil). The key
sensitivities in respect of insurance claim reserves are considered in Note 5
of the financial statements and under Management of Insurance Risk below.
(b) Insurance claim reserves - reinsurance recoverable
A significant proportion of the insurance claims arising within the Swedish
Business are ceded to reinsurers. In preparing the financial statements the
Directors have made an assessment as to whether claims ceded to reinsurers are
recoverable. As at 31 December 2009, such claims ceded to reinsurers and
reflected on the balance sheet were £27.3m (31 December 2008 £nil). The
application of a 10 per cent bad debt provision on the reinsurance balance
would reduce 2009 profit before tax by £2.7m and shareholders' equity by £2.0m.
(c) Accounting for pension plans
The Group participates in a defined benefit pension scheme on behalf of its
Swedish employees. The scheme is a multi-employer plan to which a number of
third party employers also contribute. The underlying assets and liabilities
of the scheme are pooled and are not allocated between the contributing
employers. As a result, information is not available to account for the scheme
as a defined benefit scheme and the Group has accounted for the scheme as a
defined contribution scheme.
(d) Income tax expense
Commissions payable and receivable from fund managers in respect of the
unit-linked business have been included as part of the unit-linked funds and
subject to fund yield tax. Management is aware that the Swedish tax authority
has questioned, in respect of another unit-linked business, whether such
commissions receivable from fund managers should be part of the Group's income
and be subject to corporation tax of 26.3 per cent (being the Swedish
corporation tax for the year 2009). Management consider that the current
accounting treatment remains appropriate.
MANAGEMENT OF INSURANCE RISK
Introduction
The Group's management of insurance risk is a critical aspect of the business.
Notwithstanding that the Group pursues common overarching objectives and
employs similar techniques in managing this risk, the disparate characteristics
of the products and of the market and regulatory environments of the UK and
Swedish businesses are such that this risk is managed separately for the
respective businesses, as follows:
UKBusiness
The primary insurance activity carried out by the Group's UK Business comprises
the assumption of the risk of loss from persons that are directly subject to
the risk. Such risks in general relate to life, accident, health and financial
perils that may arise from an insurable event, with the majority of the UK
Business's exposure relating to mortality risk on individual lives,
predominantly in the UK. As such, the UK Business is exposed to the uncertainty
surrounding the timing and severity of claims under the related contracts.
The UK Business manages its insurance risk through underwriting limits,
approval procedures for new products or for policies that exceed set limits,
pricing guidelines, reinsurance and monitoring of emerging issues. The UK
Business is substantially closed to new insurance business in the UK and, in
practice, only sells a limited amount of new insurance business to existing
policyholders: the assumption of new insurance risks is, accordingly, limited.
The principal risk is that the frequency and severity of claims is adverse to
that expected. The theory of probability is applied to the pricing and
provisioning for a portfolio of insurance contracts. Insured events are, by
their nature, random, and the actual number and size of events during any one
year may vary from those estimated using established statistical techniques.
The risk under assurance policies is partly naturally hedged by risks under
annuity policies where the exposure is to the risk of longevity.
Underwriting strategy
The aim of the underwriting strategy is to avoid the assumption of undue
concentration of risk on any one life and there are defined underwriting
procedures embracing the limits on cover for individual policies.
Reinsurance strategy
The aim of the reinsurance strategy is to reinforce the underwriting strategy
by avoiding the retention of undue concentration of risk on any one life.
Accordingly, there is a policy on reinsurance, which limits the total exposure
on any one policy. However, there are a small number of policies which breach
these limits due to historical reasons.
The UK Business holds a wide range of reinsurance treaties, including wholly
reinsured business and risk premium reinsurance which includes original terms
reinsurance and facultative reinsurance.
Ceded reinsurance contains credit risk, and such reinsurance recoverables are
reported after deductions for known insolvencies and uncollectable items. The
UK Business monitors the financial condition of reinsurers on an ongoing basis
and reviews its reinsurance arrangements periodically.
The UK Business has a policy in place of only entering into new reinsurance
contracts with reinsurers rated A and above.
Terms and conditions of insurance contracts
The terms and conditions of insurance contracts that have a material effect on
the amount, timing and uncertainty of future cash flows arising from insurance
contracts are set out in the product analyses below, which give an assessment
of the main products of the UK Business and of the ways in which the associated
risks are managed.
Sums assured - gross and net of reinsurance
31 December 2009 31 December 2008
Gross Net Gross Net
£000 £000 £000 £000
Annuities-immediate (per annum) 4,899 4,812 4,568 4,514
Long-term with DPF 68,633 204 72,728 204
Long-term without DPF 4,488,927 3,280,348 5,024,349 3,632,144
--------- --------- --------- ---------
Total 4,562,459 3,285,364 5,101,645 3,636,862
========= ========= ========= =========
Long-term insurance contracts - immediate annuities
Product features
This type of annuity is purchased with a single premium at outset, and is paid
to the policyholder for the remainder of his/her lifetime. Annuities may be
level or escalate at a fixed rate.
There are two types of immediate annuities: retirement and voluntary. Voluntary
annuities are made at the discretion of the policyholder. Policyholders of
personal pensions may have to purchase an immediate annuity on retirement.
Other variations (joint life annuities) are to continue the annuity (at the
same level or lower) to the surviving spouse or partner.
Payments are often guaranteed to be paid for a minimum term regardless of
survival (e.g. 5 or 10 years).
Profit on existing contracts arises when mortality and investment experience
are better than expected. All risks and rewards associated with this type of
product accrue to shareholders.
Management of risks
The main risks associated with this product are longevity and investment risks.
Longevity risks arise as the annuities are paid for the lifetime of the
policyholder, and this risk is managed through the initial pricing of the
annuity. Investment risk depends on the extent to which the annuity payments
under the contracts have been matched by suitable assets. The UK Business
regularly monitors the asset matching for these contracts as explained in the
Market Risk Management section of Note 6 of the financial statements and
included below under Management of Financial Risks.
The key risks are managed through appropriate pricing and product design.
Reinsurance is not generally used for this product, although there is a small
number of reinsured policies. Underwriting is not used for this product.
In respect of mortality risk (longevity), the pricing assumption is based on
both historic in-house and industry available information on mortality
experience for the population of policyholders, including allowances for future
mortality improvements.
In respect of investment risk, with this type of product the lump sum premium
is available for the UK Business to invest at the start of the contract. The
asset mix will consist of fixed interest securities, including gilts, with
varying redemption dates. The income earned on the investment will not usually
be sufficient to cover the annuity and the expense outgo, so each year part of
the lump sum will be disinvested, which is taken account of in the asset mix,
in order to balance the fund. If annuitants die as expected the assets referred
to above would be appropriate. However, in most cases annuitants will not die
as expected and, therefore, the UK Business will need to buy and sell assets as
necessary throughout the term of the policies to minimise the risk of mismatch.
This position is monitored on a regular basis. Details of default risk on the
fixed interest securities are set out in the Credit Risk Management section of
Note 6 of the financial statements and included below under Management of
Financial Risks.
Concentration of insurance risks
The tables for immediate annuity contracts set out below illustrate the
concentration of risk based on two bands of contracts grouped by the annuity
payable each year for each annuity policy insured.
Annuity payable each year for Total annuities payable each year
each life insured
Before reassurance After reassurance
As at 31 December 2009 £000 % £000 %
£0 - £25,000 4,854 99.1 4,803 99.8
More than £25,000 45 0.9 9 0.2
--------- --------- --------- ---------
4,899 100.0 4,812 100.0
========= ========= ========= =========
As at 31 December 2008
£0 - £25,000 4,523 99.0 4,505 99.8
More than £25,000 45 1.0 9 0.2
--------- --------- --------- ---------
4,568 100.0 4,514 100.0
========= ========= ========= =========
Long-term insurance contracts - with discretionary participation features
Product features
The UK Business historically wrote with-profits business in the UK, where the
policyholder benefits comprise a guaranteed sum assured payable on death or at
maturity, to which may be added a discretionary annual bonus and a
discretionary terminal bonus.
Management of risks
This business is wholly reassured to Guardian Assurance plc ("Guardian") and
hence the only risk retained by the Group for this business is the risk of
default by the reinsurer. This risk is detailed in the Credit Risk Management
section of Note 6 of the financial statements and Management of Financial risk
below.
Long-term insurance contracts - without discretionary participation features
Product features
The UK Business has written both non-linked and unit-linked contracts, which
include death and morbidity benefits on a whole life, endowment and term
assurance basis.
For contracts where death is the insured risk, the most significant factors
that could increase risk are epidemics (such as AIDS, SARS or a flu pandemic)
or widespread changes in lifestyle, such as eating, smoking and exercise
habits, resulting in earlier or more claims than expected.
Management of risks
Unit-linked insurance contracts are contracts where monthly reviewable charges
are made for insurance risk and administration charges and consist mainly of
regular unit-linked endowments where the primary purpose is to provide an
investment return. In addition, the policyholder is insured against death and
serious injury. Unit-linked contracts operate by investing the policyholders'
premiums into pooled investment funds of the UK Business, the policyholders'
share of the fund being represented by units. The benefit is payable on death,
or maturity if earlier, the amount payable on death being subject to a
guaranteed minimum amount. Therefore, the UK Business is exposed only to
insurance risk insofar as the value of the unit-linked fund is lower than the
guaranteed minimum death benefit. The maturity or surrender value depends on
the investment performance of the underlying fund and on the level of charges
levied by the UK Business for policy administration fees, mortality and other
charges.
For contracts with fixed and guaranteed benefits and fixed future premiums,
there are no mitigating terms and conditions that reduce the insurance risk
accepted. This is the case for a small proportion (approximately 5% of total
sums assured) of the life assurance business sold by the UK Business.
For the remainder of the business, operated on a quasi-linked basis, the UK
Business charges for mortality risk on a monthly basis and has the right to
alter these charges based on its mortality experience and hence minimise its
exposure to mortality risk. The UK Business also reserves the right at regular
intervals to change the premium payable in the light of charges made for
insurance risk and administration services and the investment performance of
the assets notionally backing these contracts. Delays in implementing increases
in charges and market or regulatory restraints over the extent of the increases
may reduce this mitigating effect.
A number of these contracts also include Permanent Health Insurance (PHI)
benefits which have reviewable charges and the UK Business reserves the right
to alter these charges based on its morbidity experience and hence to minimise
its exposure to morbidity risk. Delays in implementing increases in charges and
market or regulatory restraints over the extent of the increases may reduce
this mitigating effect.
Reinsurance is used extensively on the business described above to mitigate
concentrations of insurance risk. The insurance risk is further managed through
pricing, product design and, for non-linked and quasi-linked contracts,
appropriate investment strategy.
For units held under unit-linked contracts all of the investment risk is borne
by the policyholder with the exception of a small number of contracts which
provide for a minimum guaranteed rate of return, as investment performance
directly affects the value of the unit fund and hence the benefits payable.
Concentration of insurance risk
The tables for long term insurance contracts set out below illustrate the
concentration of risk based on five bands of contracts grouped by benefits
assured for each policy assured.
Benefits assured for
each life assured Total benefits assured
Before reinsurance After reinsurance
In £000's bands £m % £m %
As at 31 December 2009
0 - 250 4,407 96.7 3,259 99.3
250 - 500 102 2.3 20 0.6
500 - 750 27 0.6 2 0.1
750 - 1,000 13 0.2 - -
More than 1,000 8 0.2 - -
--------- --------- --------- ----------
4,557 100.0 3,281 100.0
========= ========= ========= ==========
As at 31 December 2008
0 - 250 4,930 96.8 3,611 99.4
250 - 500 116 2.3 20 0.6
500 - 750 27 0.5 1 -
750 - 1,000 12 0.2 - -
More than 1,000 12 0.2 - -
--------- --------- --------- ---------
5,097 100.0 3,632 100.0
========= ========= ========= =========
In addition to the above the UK Business has, at 31 December 2009, a total of
approximately £13.8m per annum of retained PHI sums assured (31 December 2008:
approximately £15.5m). The UK Business does not retain PHI sums assured on any
one life greater than £25,000 per annum.
Long-term insurance contracts - guaranteed annuity options
Product features
There are a small number of unit-linked deferred annuity policies with
guarantees regarding the rate at which the policyholder is able to convert the
unit fund into an annuity at retirement, which creates an insurance liability.
At retirement the fund available can either be transferred to another provider,
used to purchase an annuity with a Group company at the annuity rates then
applying, or used to purchase an annuity from a Group company at guaranteed
annuity rates written into the policy document. The guaranteed annuity rates
are only available in certain circumstances. Policyholders gain the benefit of
whichever of the then-current annuity rates and guaranteed annuity rates give
them the higher benefits.
Management of risks
The main risks associated with this product are longevity and market risks.
These were controlled through product design and pricing. However, the
guaranteed annuity rates were set during the 1960s and 1970s, when these
products were sold. As these rates are no longer suitable in current
conditions, appropriate technical provisions are held to reflect the risk
arising from the guarantees.
The longevity assumptions underlying the technical provisions are based on both
historic in-house and industry available information on mortality experience
for the population of policyholders, including allowances for future mortality
improvements.
Concentration of insurance risks
There are 251 such policies in force as at 31 December 2009 (as at 31 December
2008: 292). The underlying contracts have total unit funds of £2.4m (as at 31
December 2008: £2.6m), with the largest fund being less than £0.2m.
Other risks on insurance contracts
Apart from financial risks relating to the financial assets, which support life
assurance contracts, as set out in Note 6 of the financial statements and
included below under Management of Financial Risks, there are other significant
types of risk pertaining to life insurance contracts, as follows:
Expense risk
The strategy of the UK Business is to outsource all operational activities to
third party administrators in order to reduce the significant expense
inefficiencies that would arise with fixed and semi-fixed costs on a
diminishing policy base. There are, however, risks associated with the use of
outsourcing. In particular, there will be a need in future to renegotiate the
terms of the outsourcing arrangements as the existing agreements expire. There
is also a risk that, at some point in the future, third party administrators
could default on their obligations. The UK Business monitors the financial
soundness of third party administrators and it has retained step-in rights on
the more significant of these agreements. There are also contractual
arrangements in place which provide for financial penalties in the event of
default by the administration service providers.
Mortgage endowment misselling complaints
The life businesses have experienced a significant level of complaints from
mortgage endowment policyholders since their first regulatory mailing programme
in 2000. In response to this, the life businesses hold mortgage endowment
complaints redress provisions. The UK Business continues to monitor closely,
among other factors, the volume of complaints and the value of compensation
paid to policyholders in order to assess the continuing adequacy of the
provisions.
There remains however a residual risk that at some point in future the levels
of complaints received may prove to be higher than those anticipated within the
provision.
Persistency risk
Persistency risk is the risk that the investor cancels the contract or
discontinues paying new premiums into the contract, thereby exposing the UK
Business to a loss resulting from an adverse movement in the actual experience
compared to that expected in the product pricing. Although changes in the
levels of persistency would not adversely affect the result in the short term
they would reduce future profits available from the contract.
Assumptions
The principal assumptions underlying the calculation of the insurance contract
provisions are:
Mortality
A base mortality table is selected which is most appropriate for each type of
contract taking into account rates charged to the UK Business by reinsurers.
The mortality rates reflected in these tables are periodically adjusted,
allowing for emerging experience and changes in reinsurer rates.
Morbidity
Morbidity tables are derived based on reinsurer tables. These are periodically
adjusted to take into account emerging experience where appropriate.
Persistency
In general, no allowance is made for lapses or surrenders within the valuation
of insurance contract liabilities.
Discount rates
The UK Business has used the following rates of interest in discounting the
projected liabilities:
31 December 2009 31 December 2008
CA CWA CA CWA
Rate of interest business business business business
Assurances
without profit: non linked 3.40% 3.70% 3.40% 3.20%
business
without profit: annual 3.40% 3.70% 3.40% 3.20%
premium
Annuities
without profit: deferred 3.40% 3.70% 3.40% 2.80%
without profit: vested 4.10% 3.70% 3.80% 3.10%
The rates of interest shown above have been set after consideration of the risk
of default on non-government bonds by applying the following adjustments to the
earned yield:
(i) a standard risk deduction, varying by credit rating, of 0.1% for 'AAA'-rated
bonds, 0.3% for 'AA'-rated bonds and 0.5% for 'A'-rated bonds, based on ratings
according to Standard and Poors credit rating system. No assets are held with a
credit rating less than 'A'; and
(ii)an overall maximum margin over the equivalent term government fixed interest
security of 0.5%.
For many of the life insurance products the interest rate risk is managed
through asset/liability management strategies that seek to match the interest
rate sensitivity of the assets to that of the underlying liabilities. The
overall objective of these strategies is to limit the net change in value of
assets and liabilities arising from interest rate movements. While it is more
difficult to measure the interest rate sensitivity of the UK Business's
insurance liabilities than those of the related assets, to the extent that the
UK Business can measure such sensitivities, it believes that interest rate
movements will generate asset changes that substantially offset changes in
value of the liabilities relating to the underlying products.
Under the gross premium method and to a lesser extent the net premium method,
the insurance contract provision is sensitive to the interest rate used when
discounting. For annuities in payment and assurances, the provision is
sensitive to the assumed future mortality experience of policyholders.
Renewal expenses and inflation
The renewal expenses assumed are based on the charges made to the UK Business
by its two third party insurance administration services providers, with
appropriate margins. These are assumed to inflate at a mix of current inflation
rates in the UK, being the Retail Price Index and the National Average Earnings
Index. Explicit allowance is also made for Governance expenses incurred by the
UK Business.
Taxation
The UK Business has assumed that current tax legislation and tax rates will not
change.
Changes in assumptions and sensitivity to changes in assumptions
Assumptions are adjusted for changes in mortality, investment return, policy
maintenance expenses and expense inflation to reflect anticipated changes in
market conditions and market experience and price inflation.
The major changes to the bases used for the calculation of the provisions were
as follows.
As a consequence of the fact that the valuation basis makes no allowance for
lapses, when lapses occur it is necessary to allocate fixed expenses across a
smaller number of in-force policies. Consequently the per policy expense
reserve has increased. This increased the reserves by £0.8m as at 31 December
2009 (31 December 2008: £0.3m).
The reserve held in respect of the CWA business for guaranteed annuity rates
was reduced by £0.1m, making allowance principally for the vesting of policies
with the guarantee, changes in unit values and interest rates.
The basis for the calculation of the reserve held for complaints, principally
mortgage endowment complaints, is given below.
The UK Business re-runs its valuation models on various bases. An analysis of
sensitivity around various scenarios provides an indication of the sensitivity
of the estimates to changes in assumptions in respect of its life assurance
contracts. The table presented below demonstrates the sensitivity of assets and
insured liability estimates to particular movements in assumptions used in the
estimation process. Certain variables can be expected to impact on life
assurance liabilities more than others, and consequently a greater degree of
sensitivity to these variables may be expected.
Impact on reported net of tax profits and equity to changes in key variables:
Change in Change in net of tax profits and
variable equity
2009
% £m
Investment return +1 (1.8)
Investment return -1 0.9
Mortality/morbidity +10 0.8
Mortality alone +10 1.5
Morbidity alone +10 (0.7)
Policy maintenance +10 (1.3)
expenses
The above sensitivities are calculated as an expected impact on IFRS-based
profits, net of reinsurance and tax and the analysis has been prepared for a
change in the stated variable, with all other assumptions remaining constant.
The sensitivities to the changes in investment returns are calculated taking
into account the consequential changes to valuation assumptions.
The sensitivities to mortality and morbidity (critical illness) rates shown
above are calculated on the assumption that there would be no consequential
change in rates to policyholders. In practice, Group policy is to pass costs on
to policyholders where it considers that the impact of the change is
significant.
An increase in mortality rates would have a negative impact on the CA business
due to the preponderance of assurance business. In contrast, there would be a
positive impact occurring in the CWA business due to its preponderance of
annuity business. On a consolidated basis the impacts are closely balanced. A
decrease in mortality rates would have the contrary effect in each business but
the results would remain closely balanced.
Changes in mortality and morbidity rates are not correlated: one may increase
whilst the other remains unchanged or reduces. The figure shown above assumes
both rates increase by 10%. The effects of separate 10% increases would be an
increase in consolidated net of tax profits and equity by £1.3m for increased
mortality rates and a reduction in consolidated net of tax profits and equity
by £0.7m for increased morbidity rates. The sensitivities to changes in these
assumptions in the opposite direction will result in changes of similar
magnitude but in the opposite direction.
Increases in expenses due to inflation would predominantly be passed on to
policyholders through higher policy fees.
The main expense risk is that of unforeseen changes to third party
administration expenses. The impact shown above quantifies a 10% increase in
those expenses.
Swedish Business
The terms and conditions of insurance contracts which have a material effect on
the amount, timing and uncertainty of future cash flows arising from insurance
contracts are set out in the product analyses below, which give an assessment
of the main products of the Swedish Business and of the ways in which the
associated risks are managed. The breakdown of the insurance products of the
Swedish Business, by gross and net premiums written and by claims outstanding,
which reflects the scale of business written, is as follows. Certain of the
information includes amounts and balances relating to the pre-acquisition
period and is provided for illustrative purposes.
Premiums Before reinsurance After reinsurance
Year ended 31 December Year ended 31 December
2009 2008 2009 2008
Group £000 £000 £000 £000
Sweden 11,312 8,625 2,652 2,181
Norway 5,291 7,524 978 1,256
Individual
Death 471 450 53 56
Waiver of premium 4,344 4,155 850 892
Income protection 3,213 3,073 623 654
--------- --------- --------- ---------
24,631 23,827 5,156 5,039
========= ========= ========= =========
Claims outstanding Before reinsurance After reinsurance
Year ended 31 December Year ended 31 December
2009 2008 2009 2008
Group £000 £000 £000 £000
Sweden 12,131 9,920 1,377 1,135
Norway 8,869 7,996 1,450 1,234
Individual
Death 422 333 75 66
Waiver of premium 5,931 5,276 1,110 1,047
Income protection 5,000 4,414 1,079 872
--------- --------- --------- ---------
32,353 29,739 5,091 4,354
========= ========= ========= ==========
Terms and conditions
Product features - Group Contracts
Group Contracts insure policyholders in respect of death with the option to
include additional accident and disability benefits. Policyholders may also
include their spouse and children (up to the age of 25) on the policy.
The Swedish product provides a maximum coverage of insured benefits up to 40
times a base amount (as at 31 December 2009 SEK 42,700, being approximately
£3,700) although most policies are between 7.5 to 20 times the base amount.
The Norwegian product provides a maximum coverage of insured benefits up to 80
times a base amount (as at 31 December 2009 NOK 70,256, being approximately
£7,580) although most policies are around 40 times the base amount.
Policies are sold in both Sweden and Norway and all sales are intermediated.
Group Contracts sold in Sweden allow the policyholder to choose the sum assured
level. Contracts sold in Norway have sum assured levels that are normally
determined by the policyholders' employer and apply to all members of that
company scheme.
All contracts are for an annual period and premium payments are made usually on
either an annual or quarterly basis.
Product features - Individual Contracts
In relation to Individual Contracts, the Swedish Business writes contracts,
which include death and morbidity benefits on term assurance with disability,
waiver of premium and income protection options. Policies are sold in Sweden
and all sales are intermediated.
In relation to the income protection and the waiver of premium benefits within
the Individual Contracts, the monthly benefits upon a claim may be payable to
the policyholders over a long period up to their retirement.
The contracts have been unbundled as between insurance and investment
contracts. Risk in respect of investment contracts is described in Note 6 of
the financial statements and under the Management of Financial Risks below. All
insurance contracts are for an annual period and payments are made on a monthly
basis.
Management of risk
The main risk associated with the Group and Individual Contracts is the
frequency of claims (for either death or accident or sickness). Claims
experience can be variable, with the main factors being the age, sex and
occupation of the policyholder.
In addition, for the Group Contracts, the Swedish Business is exposed to a
single loss event that covers a number of employees of an organisation.
The key risks are managed through appropriate product design and pricing of the
policies to ensure that the potential cost to the Swedish Business of these
events (and associated expenses of underwriting and administration) are
reflected in the price charged to the policyholder. Key controls implemented
include a defined pricing structure based on the characteristics of the
policyholder and the regular review of management information on the type and
frequency of accidents.
Group Contracts are issued on an annual basis which means that the Swedish
Business's exposure runs for a period of 12 months, after which the Swedish
Business has the option to decline to renew or can increase the price on
renewal.
Individual Contracts are long-term contracts but the Swedish Business has the
option to review the premiums on an annual basis.
For both the Group and Individual Contracts, between 80 per cent to 90 per cent
of the premiums and claims relating to this product are ceded to a reinsurer
which reduces the overall insurance risk exposure to the Swedish Business.
In addition, for Group Contracts, the loss arising from a single event to
multiple employees is reinsured. The reinsurance provides indemnity for a
single loss between SEK 5m (approximately £0.4m) and SEK 100m (approximately
£8.7m).
Concentration of insurance risk
Concentration of insurance risk is determined by reference to benefits assured
for Individual Contracts and by estimated maximum loss for Group Contracts.
The following tables highlight the maximum exposure to the Swedish Business
arising from Individual Contracts, grouped by sums assured, at each balance
sheet date.
Total benefits assured
31 December 2009
Benefit in £000 bands Before reinsurance After reinsurance
£000 £000
0-250 439,948 68,259
250-500 1,254 251
500-750 117 23
750-1000 70 14
Over 1,000 - -
--------- ---------
441,389 68,547
========= =========
In respect of Group Contracts, the business is exposed to multiple employees of
the same organisation being involved in a single loss event. The Swedish
Business estimates that its largest such exposures arise in Norway, where the
Group Contracts sold tend to cover all employees within that organisation
(whereas in Sweden employees may opt in to the Group Contract). The Swedish
Business forecasts that its maximum loss would be approximately SEK 27 million
(approximately £2.3m) gross of reinsurance and SEK 5 million (approximately
£0.4m) after reinsurance.
Assumptions and sensitivities for Group Contract and Individual Contract
insurance provisions
Group Contracts are sold on an annual basis and the Individual contracts
include an option for the Group to increase the premium on an ongoing basis.
Therefore, for both Group and Individual Contracts, the Group adopts a
reserving approach that is similar to that of a non-life insurance business,
with claim reserves projected using an estimated loss ratio with reference to
previous loss development for earlier years.
The insurance contract provisions comprise unearned premium provisions,
outstanding claims and associated reinsurance recoveries. Except for the
income protection and the waiver of premium benefits within the Individual
Contracts, provisions for the insurance contracts are not discounted because of
the short term nature of the liabilities, which are generally paid by the
fourth year of development for a single accident year. Income protection and
waiver of premium contracts are discounted at a rate equivalent to a high
quality (i.e. AA rated) corporate bond.
Unearned premiums
Unearned premiums represent a proportion of the premium relating to policies
that expire after the balance sheet date. Unearned premiums are calculated
automatically by the underwriting system on a straight-line basis over the
period of the policy.
Outstanding claims
Outstanding claims include notified claims, claims incurred as at the balance
sheet date but not reported and an estimate of the external cost of handling
the claims.
The key risk in respect of notified claims is that they are paid or handled
inappropriately (for example invalid or fraudulent claims are paid). All
claims handling is outsourced, although physical payment of the claims is
performed by the Swedish Business. The Swedish Business also inspects companies
performing outsourced claims handling services on at least an annual basis.
Management information is also reviewed on a regular basis to identify unusual
trends in the payment of claims.
The estimation of claims incurred but not reported ('IBNR') is generally
subject to a greater degree of uncertainty than the estimation of costs of
settling claims already notified to the Swedish Business, where more
information about the claim event is generally available. In calculating the
estimated cost of claims which have not been notified, the Swedish Business
uses a variety of estimation techniques, generally based upon statistical
analyses of historical experience, which assumes that the development pattern
of the current claims will be consistent with past experience.
The most common methods that are used are the chain ladder method and the
Bornhuetter-Ferguson method. Chain ladder methods involve the analysis of
historical claims development factors and the selection of estimated
development factors based on this historical pattern. The selected factors are
applied to cumulative claims data for each accident year that is not fully
developed to provide an estimated ultimate claims cost. The
Bornhuetter-Ferguson method uses a combination of an initial estimate of the
expected loss ratio and an estimate based on observed claims experience. The
two estimates are combined using a formula that gives more weight to the
experience-based estimate as time passes.
The use of different approaches assists in giving greater understanding of the
trends inherent in the data being projected and also assists in setting the
range of possible outcomes. The most appropriate estimation technique is
selected taking into account the characteristics of the policies sold. Where
deemed appropriate, an allowance is made for changes or uncertainties which may
create distortions in the underlying statistics or which might cause the cost
of unsettled claims to increase or reduce when compared with the cost of
previously settled claims. Although claim reserves are considered reasonable,
on the basis of information available to the Swedish Business, the ultimate
liabilities will vary as a result of subsequent information and events.
Income protection and waiver of premium benefits within Individual Contracts
For reported claims, the liabilities are reviewed on a case by case basis. A
discounted cash flow model is used to determine the liabilities and the key
factors used are:
- the probability of 'recovery' (i.e. return to work). The recovery rates depend
on age, sex and length of time the claimant has been claiming the benefits;
- the mortality rate; and
- the discount rate.
For unreported claims, the claims development table (as described below) is
used.
Sensitivity analysis
The key sensitivities in the measurement of the Group and Individual Contracts
insurance claim reserves are a movement in the loss ratio applied to earned
premium and the foreign exchange risk arising on business written in Norway. In
addition, for the income protection and the waiver of premium benefits within
the Individual Contracts, the claims reserves are impacted by the discount rate
used. The impact of these sensitivities is shown below: the information
includes pre-acquisition amounts and is presented for illustrative purposes.
Pre-tax profit Shareholders' equity
2009 2008 2009 2008
£000 £000 £000 £000
5% increase in loss ratio
Gross before reinsurance (1,193) (1,096) (910) (839)
Net after reinsurance (174) (330) (132) (252)
5% decrease in loss ratio
Gross before reinsurance 1,193 1,096 910 839
Net after reinsurance 174 330 132 252
10% increase in the Norwegian Krone
Gross before reinsurance (857) (752) (654) (576)
Net after reinsurance (140) (41) (107) (31)
10% decrease in the Norwegian Krone
Gross before reinsurance 857 752 654 576
Net after reinsurance 140 41 107 31
1% increase in discount rate
Gross before reinsurance 788 751 601 575
Net after reinsurance 156 141 119 108
1% decrease in discount rate
Gross before reinsurance (896) (860) (683) (658)
Net after reinsurance (178) (180) (136) (138)
In addition to the scenario testing above, the development of insurance
liabilities provides a measure of the Swedish Business's ability to estimate
the ultimate value of claims. The top half of the table below illustrates how
the Swedish Business's estimate of total claims outstanding for each accident
year has changed at successive year-ends. The bottom half of the table
reconciles the cumulative claims to the amount appearing in the balance sheet.
An accident-year basis is considered to be the most appropriate for the
business written by the Swedish Business. The information is presented on both
a gross and net of reinsurance basis.
Analysis of claims development - gross
2004 2005 2006 2007 2008 2009
£000 £000 £000 £000 £000 £000
Estimate of ultimates
End of accident year 4,556 7,102 10,031 15,902 17,908 18,501
One year later 4,749 7,140 8,822 12,052 14,089 -
Two years later 4,888 6,319 7,125 10,335 - -
Three years later 4,938 5,440 6,954 - - -
Four years later 4,887 4,744 - - - -
Five years later 4,828 - - - - -
Current estimate of
ultimate claims 4,828 4,744 6,954 10,335 14,089 18,501
Cumulative payments (3,725) (3,864) (4,845) (5,744) (6,641) (3,214)
--------- -------- -------- -------- -------- --------
In balance sheet 1,103 880 2,109 4,591 7,448 15,287
========= ======== ======== ======== ======== ========
Provision for prior
years 935
Liability in balance
sheet 32,353
=========
Analysis of claims development - net
2004 2005 2006 2007 2008 2009
£000 £000 £000 £000 £000 £000
Estimate of ultimates
End of accident year 493 787 1,220 2,474 2,469 3,162
One year later 547 769 988 1,567 2,144 -
Two years later 550 675 700 1,499 - -
Three years later 550 495 695 - - -
Four years later 501 474 - - - -
Five years later 483 - - - - -
Current estimate of
ultimate claims 483 474 695 1,499 2,144 3,162
Cumulative payments (373) (386) (485) (784) (991) (442)
--------- ------- -------- -------- -------- --------
In balance sheet 110 88 210 715 1,153 2,720
========= ======= ======== ======== ======== ========
Provision for
prior years 95
Liability in
balance sheet 5,091
========
MANAGEMENT OF FINANCIAL RISK
Introduction
The Group is exposed to a range of financial risks through its insurance
contracts, financial assets, including assets representing shareholder assets,
financial liabilities, including investment contracts and borrowings, and its
reinsurance assets: accordingly, the key financial risk is that, in the
long-term, its investment proceeds are not sufficient to fund the obligations
arising from its insurance and investment contracts. The most important
components of this financial risk are market risk (interest rate risk, equity
price risk and foreign currency exchange risk), and credit risk, including the
risk of reinsurer default. These risks arise from open positions in interest
rate, equity and currency products, all of which are exposed to general and
specific market movements.
For unit-linked contracts the Group's objective is to match the liabilities,
both insurance and investment contract liabilities, with units in the assets of
the funds to which the value of the liabilities is linked, such that the
policyholder bears the market risk. This minimises the impact of market risks
and of credit risk on these contracts, such that the primary exposure to market
risk is the risk of volatility in asset management fees due to the impact of
interest rate, equity price and foreign currency movements on the fair value of
the unit-linked assets, on which management fees are based. For the UK
Business, however, there is residual market risk, which arises generally from
the specific terms and conditions of the related insurance and investment
contracts, as described below.
For non unit-linked business, the Group's objective is to match the timing of
cash flows from insurance and investment contract liabilities with the timing
of cash flows from assets subject to identical or similar risks. By matching
the cash flows of liabilities with those of suitable assets, market risk is
managed effectively, whilst liquidity risk is minimised. These processes to
manage the risks, which the Group has not changed from previous periods, ensure
that the Group is able to meet its obligations under its contractual
liabilities as they fall due.
Notwithstanding that the Group pursues common overarching objectives and
employs similar techniques in managing financial risk, the disparate
characteristics of the products and of the market and regulatory environment of
the UK and Swedish Businesses are such that the operation of the Group's
overall management of financial risk is devolved as between the UK and Swedish
Businesses. In addition, there is specific foreign currency exchange risk,
which arises at the Group Corporate level. Accordingly, the description of the
specific management of financial risk is set out separately below at the UK
Business, Swedish Business and Corporate levels.
UKBusiness
The UK Business manages its market risks within an asset liability management
(ALM) framework that has been developed to achieve long-term investment returns
at least equal to its obligations under insurance and investment contracts,
with minimal risk. Within the ALM framework the business periodically produces
reports at legal entity and asset and liability class level, which are
circulated to the UK Business's key management. The principal technique of the
ALM framework is to match assets to the liabilities arising from insurance and
investment contracts by reference to the type of benefits payable to
policyholders, with separate portfolios of assets being maintained for each
distinct class of liability.
Terms and conditions of investment contracts
The terms and conditions of insurance contracts that have a material effect on
the amount, timing and uncertainty of future cash flows arising from insurance
contracts are set out in Note 5 of the financial statements and included above
under Management of Insurance Risk. The terms and conditions of investment
contracts that have a material effect on the amount, timing and uncertainty of
future cash flows arising from investment contracts are set out in the product
analyses below.
The UK Business provides three types of investment contract which are
predominantly written in the UK.
(i) Unit-linked savings
These are typically single premium contracts, with the premiums invested in a
pooled investment fund (usually an internal fund of the life assurance
company), where the policyholder's investment in the fund is represented by
units. There is a small additional benefit payable on death which does not
transfer significant insurance risk to the business for these contracts. The
benefits payable at maturity or surrender of the contract are the bid value of
these units less surrender penalties, where applicable. The key variables
affecting the timing and uncertainty of future cash flows are investment
performance, persistency and expense inflation.
(ii) Unit-linked pensions
The contractual features are similar to unit-linked savings, except they may be
single or regular premium contracts. The benefits payable on retirement
purchase an open market pension annuity.
The key variables affecting the timing and uncertainty of future cash flows are
investment performance, interest risks, persistency and expense inflation.
(iii) Guaranteed Income and Growth Bonds
Guaranteed Income bonds are mainly single premium contracts for a fixed term
offering, either monthly or annually, fixed payments together with a return of
premium at the maturity date. A guaranteed growth bond variant has also been
issued which offers no income but a higher guaranteed payment at the maturity
date.
The key variables affecting the timing and uncertainty of cash flows are
expense inflation, interest rates, persistency and mortality.
Risks associated with investment contracts
The risks associated with investment contracts are expense risk, persistency
risk and market risk. Market risk is the risk that the fair value of future
cash flows will fluctuate because of a change in interest or foreign currency
exchange rates or in equity prices and the consequent effect that this has on
the value of charges earned by the business and on any guarantees in the
contracts. Expense risk is of the same nature as described under other risks on
insurance contracts in Note 5 of the financial statements and included above
under Management of Insurance Risk. Persistency risk is the risk that the
investor cancels the contract or discontinues paying new premiums into the
contract, thereby exposing the business to a loss resulting from an adverse
movement in the actual experience compared to that expected in the product
pricing. Although changes in the levels of persistency would not adversely
affect the result in the short term they would reduce future profits available
from the contract.
Market risk management
The notes below explain how market risks are managed using the categories
utilised in the UK Business's ALM framework. In particular, the ALM framework
requires the management of interest risk, equity price risk, and liquidity risk
at the portfolio level, so that the appropriate risks for each portfolio may be
managed in an effective way. The business is not significantly exposed to
foreign exchange risk as the only assets denominated in foreign currencies are
matched by corresponding insurance contract provisions and financial
liabilities. To reflect the business's risk management approach the required
disclosures for interest rate, equity price and liquidity risks, as
appropriate, are given separately for each portfolio of the ALM framework. The
following tables reconcile the balance sheet to the classes and portfolios used
in the business's ALM framework.
31 December 2009 Other
Insurance Unit- non-linked
contracts linked Annuities contracts
Guaranteed with DPF contracts in
Total bonds payment Other
Assets £000 £000 £000 £000 £000 £000 £000
Intangible
assets
Deferred
acquisition
costs 7,683 - - - - - 7,683
Acquired
value of
in-force
business
Insurance
contracts 14,195 - - - - - 14,195
Investment
contracts 10,593 - - - - - 10,593
Reinsurers'
share of
insurance
contract
provisions 209,604 - 88,880 117,918 - 2,806 -
Amounts
deposited
with
reinsurers 27,056 - - 26,192 - - 864
Investment
properties 3,355 - - 2,880 - - 475
Financial
assets
Equity
securities
at fair
value
through
income 454,970 - 2 454,961 - 7 -
Holdings
in
collective
investment
schemes at
fair value
through
income 697,259 - 3,116 663,148 - 10,247 20,748
Debt
securities
at fair
value
through
income 245,928 18,026 - 118,239 80,478 23,960 5,225
Insurance
and other
receivables 9,593 532 - - - 3,237 5,824
Prepayments 1,628 - - - - - 1,628
Derivative
financial
instruments 4,420 - - 4,420 - - -
--------- --------- --------- --------- --------- --------- ------
Total
financial
assets 1,413,798 18,558 3,118 1,240,768 80,478 37,451 33,425
--------- --------- --------- --------- --------- --------- ------
Reinsurers'
share of
accrued
policyholder
claims 4,728 - - - - 900 3,828
Cash and
cash
equiva-
lents 120,830 5,757 395 32,889 449 8,912 72,428
--------- --------- --------- --------- --------- --------- ------
Total
assets 1,811,842 24,315 92,393 1,420,647 80,927 50,069 143,491
========= ========= ========= ========= ========= ========= =======
Other
Insurance Unit- non-linked
contracts linked Annuities contracts
Guarteed with DPF contracts in
Total bonds payment Other
Liabilities £000 £000 £000 £000 £000 £000 £000
Bank
overdraft 2,312 - - 235 - 1,593 484
Insurance
contract
provisions 1,044,680 - 92,393 835,884 80,927 35,476 -
Financial
liabilities
Investment
contracts 610,930 22,923 - 578,523 - 9,484 -
Borrowings - - - - - - -
Derivative
financial
instruments 54 - - 54 - - -
--------- ------- --------- --------- --------- -------- -------
Total
financial
liabilities 610,984 22,923 - 578,577 - 9,484 -
--------- ------- ---------- --------- --------- -------- -------
Provisions 1,452 - - - - 203 1,249
Deferred tax
liabilities 9,613 30 - - - 19 9,564
Reinsurance
payables 2,064 - - - - 225 1,839
Payables
related to
direct
insurance
and
investment
contracts 24,751 1,362 - - - 964 22,425
Deferred
income 13,132 - - - - - 13,132
Income taxes 854 - - - - - 854
Other
payables 3,825 - - - - 2,105 1,720
--------- ------- --------- --------- --------- -------- -------
Total
liabilities 1,713,667 24,315 92,393 1,414,696 80,927 50,069 51,267
========= ======= ========= ========= ========= ======== =======
31 December 2008 Other
Insurance non-linked
contracts Unit-linked Annuities contracts
Guarteed with DPF contracts in
Total Bonds payment Other
£000 £000 £000 £000 £000 £000 £000
Intangible
assets
Deferred
acquisition
costs 8,590 - - - - - 8,590
Acquired
value of
in-force
business
Insurance
contracts 16,866 - - - - - 16,866
Investment
contracts 11,610 - - - - - 11,610
Reinsurers'
share of
insurance
contract
provisions 182,693 - 79,484 100,093 - 3,116 -
Amounts
deposited
with
reinsurers 22,181 - - 22,181 - - -
Investment
properties 3,432 - - 2,932 - - 500
Financial
assets
Equity
securities
at fair
value
through
income 363,879 - 2 363,872 - 5 -
Holdings
in
collective
investment
schemes at
fair value
through
income 576,502 - 2,578 554,817 - 8,041 11,066
Debt
securities
at fair
value
through
income 279,104 51,360 - 129,517 70,957 21,392 5,878
Insurance
and other
receivables 9,879 2,127 - - - 1,423 6,329
Prepayments 1,600 - - - - - 1,600
Derivative
financial
instruments 5,570 - - 5,570 - - -
--------- ------- -------- --------- --------- --------- -------
Total
financial
assets 1,236,534 53,487 2,580 1,053,776 70,957 30,861 24,873
--------- ------- ------- --------- --------- --------- -------
Reinsurers'
share of
accrued
policyholder
claims 4,100 - - - - 1,192 2,908
Cash and
cash
equiv-
alents 155,009 3,031 368 50,257 7,260 13,135 80,958
--------- ------- ------- --------- --------- --------- -------
Total
assets 1,641,015 56,518 82,432 1,229,239 78,217 48,304 146,305
========= ======= ======== ========== ========= ========== =======
Other
Insurance non-linked
contracts Unit-linked Annuities contracts
Guarteed with DPF contracts in
Total bonds payment Other
Liabilities £000 £000 £000 £000 £000 £000 £000
Bank
overdraft 1,086 - - 38 - 822 226
Insurance
contract
provisions 923,506 - 82,432 728,179 78,217 34,678 -
Financial
liabilities
Investment
contracts 558,542 55,119 - 494,449 - 8,974 -
Borrowings - - - - - - -
Derivative
financial
instruments 70 - - 70 - - -
--------- ------- --------- --------- --------- --------- -------
Total
financial
liabil-
ities 558,612 55,119 - 494,519 - 8,974 -
--------- ------- --------- --------- --------- --------- -------
Provisions 3,397 - - - - 179 3,218
Deferred
tax
liabilities 10,798 90 - - - 147 10,561
Reinsurance
payables 1,397 - - - - 253 1,144
Payables
related to
direct
insurance
and
investment
contracts 23,891 1,309 - - - 942 21,640
Deferred
income 14,575 - - - - - 14,575
Income
taxes 1,213 - - - - - 1,213
Other
payables 4,207 - - - - 2,309 1,898
--------- ------- --------- --------- --------- --------- -------
Total
liabil-
ities 1,542,682 56,518 82,432 1,222,736 78,217 48,304 54,475
========= ======= ========= ========= ========= ========= =======
Guaranteed bonds
These contracts are for a fixed term with financial benefits that are fixed and
guaranteed at the inception of the contract. The business manages its market
risk, its only material risk on these products, by matching closely contracts
written with fixed interest debt securities of a suitable duration and quality,
as indicated by their credit rating. The result is that, for these contracts,
the business's primary financial risk is the risk that interest income and
capital redemptions from the financial assets backing the liabilities are
insufficient to fund the guaranteed benefits payable. By using fixed interest
debt securities, there is no exposure to equity price risk for this portfolio.
Regular monitoring of the interest rate risk is carried out by analysis of
expected cash flows from the financial assets held with those for the
liabilities. Cash flows for the liabilities are determined assuming all
contracts continue until their expected maturity date. This analysis also
enables the business to control its liquidity risk for this portfolio.
The following tables indicate the amount and timing of the cash flows arising
from the liabilities in this category of the business's ALM framework.
31 December 2009
Contractual cash flows (undiscounted)
Carrying values and cash flows Carrying 0-1 year 1-2 years 2-3 years
arising from: amounts
£000 £000 £000 £000
Assets backing liabilities:
Debt securities at fair
value through income 18,026 14,258 7,914 1,248
Insurance and other receivable 532 532 - -
Cash and cash equivalents 5,757 5,757 - -
--------- --------- --------- ---------
Total 24,315 20,547 7,914 1,248
Liabilities 24,315 15,617 7,938 1,075
--------- --------- --------- ---------
Difference in expected cash - 4,930 (24) 173
flows
========= ========= ========= =========
31 December 2008
Contractual cash flows (undiscounted)
Carrying values and cash flows Carrying 0-1 year 1-2 years 2-3 years
arising from: amounts
£000 £000 £000 £000
Assets backing liabilities:
Debt securities at fair
value through income 51,360 35,498 12,455 6,907
Insurance and other 2,127 2,127 - -
receivables
Cash and cash equivalents 3,031 3,031 - -
Total 56,518 40,656 12,455 6,907
Liabilities 56,518 36,628 13,982 7,135
--------- --------- --------- ---------
Difference in expected cash - 4,028 (1,527) (228)
flows
======== ========= ========= =========
These contracts can be surrendered before maturity for a cash surrender value.
For these contracts the business is not required to separately measure this
embedded derivative at fair value. The terms are such that the surrender value
will broadly change in line with changes in the market value of the matching
assets, and so there is no significant risk of mismatch.
Sensitivity analysis - interest rate risk
The sensitivity analysis for interest rate risk illustrates how changes in the
fair value or future cash flows of a financial instrument will fluctuate
because of changes in market rates at the reporting date.
The carrying amount of both the liabilities and the assets, which are fixed
interest debt securities valued at fair value, will be sensitive to changes in
the level of interest rates. By reviewing the matching of the cash flows by
term, on a quarterly basis, management aims to minimise the impact of a change
in values due to a parallel movement in all yield curves.
A 100 basis point increase or decrease in interest yields would not have a
material effect on either profit for the year ended 31 December 2009 and for
the year ended 31 December 2008 or shareholder equity as at those dates.
Insurance contracts with discretionary participation features
The business historically wrote with-profits business in the UK, where the
policyholder benefits comprise a discretionary annual bonus and a discretionary
terminal bonus. The with-profits business is wholly reinsured to Guardian and
hence the only risk retained by the business for this business is the risk of
default by the reinsurer. This risk is detailed under 'Credit Risk Management'
below.
With-profits business can be surrendered before maturity for cash surrender
specified in the contractual terms and conditions. The impact on the business's
current year results would be minimal as any payments to policyholders are
matched by payments from Guardian under the reinsurance contract. For all these
contracts the Group is not required to separately measure this embedded
derivative at fair value.
A maturity analysis based on the earliest contractual repayment date would
present all the liabilities as due in the earliest period of the table because
these options can be exercised immediately by all policyholders.
For a small element of the with-profits business, policyholders have the option
to invest a portion of their investment in unit-linked funds as an alternative
to the with-profits fund. In this case a portion of the business is retained,
with the management of financial risks of this portion being the same as
described under 'Unit-linked Contracts' below.
Unit-linked contracts
For unit-linked contracts, which may be insurance or investment contracts, the
business matches all the financial liabilities, which are linked to units in
the insurance company funds, with assets on which the unit prices are based.
This approach results in the business having no significant market risk (being
interest rate, equity price and currency risks) or credit risk on these
contracts. Its primary exposure to market risk is the risk of volatility in
asset management fees due to the impact of interest rate and equity price
movements on the fair value of the assets held in the linked funds, on which
investment management fees are based.
In practice, there remain a number of areas where there is a residual risk as
follows:
(i) Surplus units
Market risk arises from the existence of surplus units (over and above
requirements to match policyholder unit liabilities) in the insurance company
funds. Such surplus units (which effectively back surplus carried forward in
the long-term insurance funds) arise because the number of units in the funds
are in decline.
(ii) Mortgage endowment misselling redress provision
Market risk arises in two ways in respect of the redress provisions for
mortgage endowment misselling. The first is that a fall in equity prices
directly increases the cost of future redress payments. In addition it is also
likely that a large fall in equity prices would increase the propensity for
policyholders to make a complaint about their mortgage endowment policies. The
sensitivity of the redress provision to equity price changes is disclosed in
Note 33 of the financial statements.
(iii) Guaranteed annuity options
For a small number of unit-linked contracts guarantees exist regarding the rate
at which the policyholder is able to convert the unit fund into an annuity at
retirement, as described above. As the policyholders gain the benefit of
whichever of the then-current annuity rates and guaranteed annuity rates give
them the higher benefits, this creates an interest rate risk, in that yields
available at the time the option is taken may be lower than those assumed in
the guaranteed rates. A provision of £0.6 m is held for the cost of this
guarantee (31 December 2008: £0.7m).
(iv) Guarantees in Timed Investment Funds
Investment guarantees have been made in respect of policies invested in the
business's Timed Investment Funds whereby the price paid to policyholders for
their units on death or maturity will always be the highest price that the
units have reached during their period of investment in the funds. Although
there is a charge paid by policyholders for this guarantee there is a risk to
shareholders that this will be insufficient to meet the full cost of this
guarantee: this risk is managed within the investment strategy of the fund (see
Note 32 of the financial statements for more details). A provision of £0.1m is
held to meet the full cost of this guarantee (31 December 2008: £1.2m).
The key assumption underlying the provision is the level of potential future
falls in equities and the sensitivity of the provision to the assumption
changes depending on whether, at the valuation date, the guarantee is 'in the
money'. An increase in this assumption, from 24% to 34%, would result in a £
1.6m decrease in profit for the year ended 31 December 2009 and in shareholder
equity as at 31 December 2009 (an increase in the assumption from 25% to 35%
would have resulted in a decrease of £0.4m in profit for the year ended 31
December 2008 and in shareholder equity as at 31 December 2008).
(v) Change in insurance contract provisions
When calculating insurance contract provisions for the non-unit component of
liabilities under linked contracts, allowance is made for both future
investment management charges and investment expenses as a proportion of unit
funds. As investment charges are generally in excess of investment expenses
this surplus is used to offset future administration expenses on the contracts.
In a falling market the absolute amount of the surplus of investment charges
over investment expenses would reduce and hence this might lead to an increase
in insurance contract provisions.
(vi) Bonus units
Certain contracts (primarily investment contracts) contain a condition that
bonus units are allocated at fixed dates in the future, essentially as a rebate
of a portion of the management fees charged during the period since the last
such bonus allocation. Financial assets are held to back the units that will be
allocated, so as to remove the risk of adverse market price movements. This
results in an apparent excess of financial assets over liabilities with an
exposure to market risk.
Unit-linked contracts can be surrendered before maturity for cash surrender
specified in the contractual terms and conditions. The terms are such that the
surrender value will either be equal to the carrying amount of the contract
liability, or in some cases lower due to surrender penalties specified in the
contract terms and conditions. The impact on the business's current year
results would therefore be minimal. For all these contracts the business is not
required to separately measure this embedded derivative at fair value.
A maturity analysis based on the earliest contractual repayment date would
present all the liabilities as due in the earliest period of the table because
these options can be exercised immediately by all policyholders.
Sensitivity analysis - equity risk
A decrease of 10% in the value of the assets would reduce asset management
fees, which would result in a £0.8 m decrease in profit for the year ended 31
December 2009 and to shareholder equity as at 31 December 2009 (year ended 31
December 2008 and as at 31 December 2008: £0.8m decrease).
Annuities in payment
These are contracts which pay guaranteed financial benefits, generally monthly,
for the lifetime of the policyholder, and in some cases of their spouse. For
certain contracts payments are guaranteed to be paid for a minimum term
regardless of survival (e.g. for 5 or 10 years). The terms are guaranteed at
the inception of the contract. The financial component of these contracts is a
guaranteed fixed interest rate and hence the UK Business's primary financial
risk on these contracts is the risk that interest income and capital
redemptions from the financial assets backing the liabilities are insufficient
to fund the benefits payable.
The UK Business manages the interest rate risk by matching closely new
contracts written with fixed interest debt securities of a suitable duration
and quality, as indicated by their credit rating. By using fixed interest debt
securities, there is no exposure to equity price risk for this portfolio.
Regular monitoring of the interest rate risk is carried out by analysis of
expected cash flows from the financial assets held with those for the
liabilities. Cash flows for the liabilities are determined by means of
projecting expected cash flows from the contracts using prudent estimates of
mortality.
The following tables indicate the estimated amount and timing of the cash flows
arising from the liabilities in this category of the ALM framework:
31 December 2009 Contractual cash flows (undiscounted)
Carrying Carrying 0-5 years 5-10 10-15 15-20 >20 years
values and amounts years years years
cash flows
arising
from:
£000 £000 £000 £000 £000 £000
Assets
backing
liabilities:
Debt 80,478 26,342 23,738 17,508 28,962 52,216
securities
at fair
value
through
income
Cash and 449 449 - - - -
cash
equivalents
--------- --------- --------- --------- --------- --------
Total 80,927 26,791 23,738 17,508 28,962 52,216
Liabilities 80,927 24,339 22,417 20,177 17,610 52,027
--------- --------- --------- --------- --------- ---------
Difference - 2,452 1,321 (2,669) 11,352 189
in expected
cash flows
======== ========= ========= ========= ========= =========
31 December 2008 Contractual cash flows (undiscounted)
Carrying Carrying 0-5 years 5-10 10-15 15-20 >20 years
values and amounts years years years
cash flows
arising
from:
£000 £000 £000 £000 £000 £000
Assets
backing
liabilities:
Debt 70,957 21,085 19,958 16,581 22,341 41,035
securities
at fair
value
through
income
Cash and 7,260 7,260 - - - -
cash
equivalents
--------- --------- --------- --------- --------- ---------
Total 78,217 28,345 19,958 16,581 22,341 41,035
Liabilities 78,217 22,488 20,513 18,228 15,705 45,216
--------- --------- -------- -------- --------- ---------
Difference - 5,857 (555) (1,647) 6,636 (4,181)
in expected
cash flows
========= ========= ========= ========= ========= =========
Sensitivity analysis - interest rate risk
The sensitivity analysis for interest rate risk illustrates how changes in the
fair value or future cash flows of a financial instrument will fluctuate
because of changes in market rates at the reporting date.
The carrying amount of both the liabilities and the assets, which are debt
securities valued at fair value, will be sensitive to changes in the level of
interest rates. By reviewing the matching of the cash flows by term, on a
quarterly basis, management aim to minimise the impact of a change in values
due to a parallel movement in all yield curves.
An increase of 100 basis points in interest yields of the matching assets would
result in a decrease of £0.1m in profit for the year ended 31 December 2009 and
in shareholder equity as at 31 December 2009 (year ended 31 December 2008 and
as at 31 December 2008: £0.3m decrease).
A decrease of 100 basis points in interest yields would result in an increase
of £0.1m in profit for the year ended 31 December 2009 and in shareholder
equity as at 31 December 2009 (year ended 31 December 2008 and as at 31
December 2008: £1.7m decrease).
Other non-linked contracts
This category consists of two groups of contracts. The first group,
representing £12.1m of liabilities out of the total of £50.1m as at 31 December
2009 (£10.1m out of the total of £48.3m as at 31 December 2008) is operated on
a quasi-linked basis; these are contracts for which, while not classed as
unit-linked due to the fact that there is no surrender value which depends on
unit values, all other aspects of the risk management of these contracts are
the same as for unit-linked contracts. As a result the business operates the
same risk management processes as described under 'Unit-linked Contracts'
above.
The following is a maturity analysis of the contractual liabilities for this
group of contracts, prepared on an estimated basis using estimates of
mortality. The analysis represents the gross liabilities, before taking into
account offsetting linked assets that are scheduled to mature in a similar
profile.
Contractual cash flows (undiscounted)
0-5 5-10 10-15 15-20 >20
years years years years years
£000 £000 £000 £000 £000
As at 31 December 20,796 22,314 18,148 6,655 2,904
2009
======== ========= ========= ======== ========
As at 31 December 22,686 24,813 21,543 10,105 4,080
2008
======== ======== ======= ========= ========
Sensitivity analysis - equity risk
An increase or decrease of 10% in the value of the assets which back this group
of contracts would not have a material effect on either profit for the year
ended 31 December 2009 and the year ended 31 December 2008 or shareholder
equity as at those dates.
The second group of contracts comprises contracts which pay guaranteed benefits
on death or other insurance events, the terms being guaranteed at the inception
of the contract. The financial component of these contracts is a guaranteed
fixed interest rate, and hence, the Group's primary financial risk on these
contracts is the risk that interest income and capital redemptions from the
financial assets backing the liabilities are insufficient to fund the benefits
payable.
The business manages the interest rate risk for this group by closely matching
new contracts written with financial assets of a suitable duration and quality,
as indicated by their credit rating. By using fixed interest debt securities
there is no exposure to equity price risk. Regular monitoring of the interest
rate risk is carried out by analysis of expected cash flows from the financial
assets held with those for the liabilities. Cash flows for the liabilities are
determined by means of projecting expected cash flows from the contracts using
prudent estimates of mortality.
The following tables indicate the estimated amount and timing of the cash flows
arising from the liabilities in the second group of this category of the ALM
framework:
31 December 2009 Contractual cash flows (undiscounted)
Carrying Carrying 0-5 years 5-10 10-15 15-20 >20 years
values and amounts years years years
cash flows
arising
from:
£000 £000 £000 £000 £000 £000
Assets
backing
liabilities:
Reinsurers' 5,701 375 694 1,027 1,305 5,926
share of
insurance
contract
provisions
Debt 20,102 5,563 5,583 2,857 5,081 12,392
securities
at fair
value
through
income
Insurance 3,237 3,237 - - - -
and other
receivables
Cash and 8,919 8,919 - - - -
cash
equivalents
--------- --------- --------- --------- -------- ---------
Total 37,959 18,094 6,277 3,884 6,386 18,318
Liabilities 37,959 16,502 7,140 6,283 6,198 19,514
--------- --------- --------- --------- --------- ---------
Difference - 1,592 (863) (2,399) 188 (1,196)
in expected
cash flows
========= ========= ========= ========= ========= =========
31 December 2008 Contractual cash flows (undiscounted)
Carrying Carrying 0-5 years 5-10 10-15 15-20 >20 years
values and amounts years years years
cash flows
arising
from:
£000 £000 £000 £000 £000 £000
Assets
backing
liabilities:
Reinsurer's 6,072 411 760 1,124 1,429 6,487
share of
insurance
contract
provisions
Debt 17,724 4,929 4,300 2,702 3,126 9,953
securities
at fair
value
through
income
Insurance 1,423 1,423 - - - -
and other
receivables
Cash and 12,967 12,967 - - - -
cash
equivalents
--------- --------- --------- --------- --------- ---------
Total 38,186 19,730 5,060 3,826 4,555 16,440
Liabilities 38,186 15,022 7,048 6,211 6,182 20,601
--------- --------- --------- --------- --------- ---------
Difference
in expected
cash flows - 4,708 (1,988) (2,385) (1,627) (4,161)
========= ========= ========= ========= ========= =========
Sensitivity analysis - interest rate risk
The sensitivity analysis for interest rate risk illustrates how changes in the
fair value or future cash flows of a financial instrument will fluctuate
because of changes in market rates at the reporting date.
The carrying amount of both the liabilities and the assets, which include debt
securities valued at fair value, will be sensitive to changes in the level of
interest rates. By reviewing the matching of the cash flows by term, on a
quarterly basis, management aim to minimise the impact of a change in values
due to a parallel movement in all yield curves.
An increase of 100 basis points in interest yields would result in a decrease
of £0.2m in profit for the year ended 31 December 2009 and in shareholder
equity as at 31 December 2009 (year ended 31 December 2008 and as at 31
December 2008: £0.6m decrease).
A decrease of 100 basis points in interest yields would result in an increase
of £0.1m in profit for the year ended 31 December 2009 and in shareholder
equity as at 31 December 2009 (year ended 31 December 2008 and as at 31
December 2008: increase of £0.5m).
Certain of the contracts in this second group of contracts are invested in the
Guaranteed Growth Fund which provides a return to policyholders which is linked
to the average mortgage rate. This creates a risk due to a mismatch of assets
and liabilities as there are no suitable assets available to back this
guarantee and hence the assets are held in cash. This means that the return on
assets held is lower than the return given to policyholders. Provisions are
held to meet this shortfall, on appropriate assumptions as to future levels of
return on assets and return given to policyholders. There is a risk that the
return given to policyholders will increase by more than the return on assets
due to inability to match the guarantee - that is, that the spread between
mortgage rates and cash deposit rates will increase.
Other
This category comprises two groups of assets and liabilities which have
different risk characteristics.
(i) Intangible assets and deferred income
These comprise acquired value of in-force business, deferred acquisition cost
and deferred income which are non-monetary items. There is, therefore, no
financial risk associated with these assets and liabilities which are amortised
in line with the related accounting policies.
(ii) Other assets and liabilities
These primarily comprise tradeable collective investment scheme assets, cash
and debt securities and, as such, are exposed to limited counterparty credit
risk as explained below in 'Credit Risk Management'.
Net of associated liabilities, the items broadly match the shareholder equity
of the UK Business and, therefore, contribute to the return on the Group's
investment in the UK Business.
UKBusiness and Other Group Activities
Credit risk management
The UK Business has exposure to credit risk, which is the risk that a
counterparty will be unable to pay amounts in full when due. Key areas where
the business is exposed to credit risk are:
- Reinsurers' share of insurance liabilities;
- Amounts deposited with reinsurer in relation to investment contracts;
- Amounts due from reinsurers in respect of claims already paid; and
- Counterparty risk with respect to corporate bond, deposits and debt securities.
In addition there will be some exposures to individual policyholders, on
amounts due on insurance contracts. These are tightly controlled, with plans
being terminated or benefits amended if amounts owed are for more than 3
months, so there is no significant risk to the results of the business.
The business structures the levels of credit risk it accepts by placing limits
on its exposure to a single counterparty, or group of counterparties. Such
risks are subject to at least an annual review.
By far the largest credit risk to the UK Business is in relation to its
reinsurance assets. Although the business holds a significant proportion of its
financial assets in securities, the risk of default on these is mitigated to
the extent that any losses arising in respect of unit-linked funds backing the
insurance and investment contracts which the business issues, would effectively
be passed on to policyholders and investors through the unit-linked funds
backing the insurance and investment contracts.
The UK Business retains some residual risks on assets which support annuities,
guaranteed investment bonds and shareholder's equity. These risks are
monitored: a key aspect of this is the business's current policy of investing
new monies only in high-quality bonds of supra-national corporations and in
government-backed debt. The business has never purchased assets rated below AA
by Standard & Poors.
The UK Business's objective is to earn competitive relative returns by
investing in a diversified portfolio of securities. Watch lists are maintained
for exposures requiring additional review and all credit exposures are reviewed
monthly.
The UK Business's exposure to credit risk in relation to its debt securities
and cash balances is summarised below:
Cash
Credit rating-debt securities balances Total
AAA AA A Unrated
As at 31 £000 £000 £000 £000 £000 £000
December
2009
Debt
securities,
deposits and
cash
balances
with credit
institutions
Linked 41,284 51 410 - 41,630 83,375
Non-linked 25,959 4,748 4,026 - 98,835 133,568
Government
or pseudo
Government
deposits
Linked 63,475 - - - - 63,475
Non-linked 105,975 - - - - 105,975
-------- --------- ------- --------- --------- ---------
Total debt,
deposits and
cash
balances 236,693 4,799 4,436 - 140,465 386,393
========= ========= ======= ========= ========= =========
Cash
Credit rating-debt securities balances Total
AAA AA A Unrated
As at 31 £000 £000 £000 £000 £000 £000
December
2008
Debt
securities,
deposits and
cash
balances
with credit
institutions
Linked 40,507 137 - - 45,046 85,690
Non-linked 44,937 15,385 3,520 - 147,335 211,177
Government
or pseudo
Government
deposits
Linked 72,999 - - - - 72,999
Non-linked 101,619 - - - - 101,619
--------- --------- ------- --------- --------- ---------
Total debt,
deposits and
cash
balances 260,062 15,522 3,520 - 192,381 471,485
========= ========= ====== ========= ========== =========
Reinsurance credit risk
Reinsurance is used to manage insurance risk in the UK Business. This does not
however discharge the business's liability as primary insurer. If a reinsurer
fails to pay a claim for any reason, the business remains liable for the
payment to the policyholder. The creditworthiness of major reinsurers is
considered on an annual basis by reviewing their financial strength.
It should be noted that for historical reasons the UK Business has a
significant exposure of £232.9m as at 31 December 2009 (31 December 2008: £
200.6m) to Guardian, which does not have a published credit rating. Of this
amount £204.1m (31 December 2008: £182.5m) is in respect of currently
guaranteed benefits. The exposure which relates to reinsured insurance contract
liabilities, and which relates to amounts deposited with Guardian in respect of
investment contract liabilities, was mitigated during 2006 when Guardian
granted to Countrywide Assured plc a floating charge over related investment
assets, which ranks that company equally with Guardian policyholders. In order
to monitor the ongoing creditworthiness of Guardian, the UK Business reviews
the financial statements and regulatory returns submitted by Guardian to the
FSA on an annual basis.
In addition the business also has an exposure on a number of its risk premium
reinsurance contracts, although in general the premiums payable under these
contracts in any period will be higher than the claims payments received.
Financial assets that are past due or impaired
In 2008, a cash deposit with Kaupthing Singer and Friedlander ('KSF') was
written down by its full amount of £1,091,000 as a result of KSF entering
administration.
During 2009, interim distributions totalling £326,000 were made from the
administrators in respect of the deposit.
There are no other Group financial assets that are impaired, would otherwise be
past due, or impaired, whose terms have been negotiated, or past due but not
impaired.
Swedish Business
Terms and conditions of unit-linked investment contracts
The insurance and investment elements of unit-linked contracts provided by the
Swedish Business have been unbundled. The principal risks associated with the
insurance contracts are disclosed in Note 5 of the financial statements and the
Management of Insurance Risks above . The terms and conditions of investment
contracts that could have a material effect on the amount, timing and
uncertainty of future cash flows arising from investment contracts are set out
in the product analyses below.
The Swedish Business provides two types of investment contract:
Unit-linked savings
These are single premium or regular premium contracts, with the premiums
invested in unit-linked funds or trust accounts where the policyholder decides
where to invest. On certain contracts there is a small additional benefit
payable on death which is deemed not to transfer significant insurance risk to
the business for these contracts. The benefits payable at maturity or surrender
of the contracts are the underlying value of the investment in the unit-linked
funds or trust accounts.
Unit-linked pensions
The contractual features are similar to unit-linked savings. The savings can be
transferred to another pension provider or can be cashed on retirement over a
period of least five years. There is no annuity linked to the unit-linked
pensions.
As the business matches all the financial liabilities with assets on which the
unit liabilities are based, this approach results in the business having no
significant market risk (being interest rate, equity price and currency risks)
or credit risk on these contracts.
Contractual maturity analysis
The liquidity risk within the Swedish Business is limited, since the premiums
are collected in advance and any large claims payments are usually known within
a short period of their occurrence. To reduce the remaining liquidity risk, the
business's cash flow is analysed continuously. The main part of the business's
assets is placed in securities which can be sold with short notice, without the
price being greatly affected. Investments are also made into listed securities
where the liquidity risk is deemed to be limited.
The following table sets out the contractual maturity analysis of the financial
assets and financial liabilities of the Swedish Business: the information as at31 December 2008 is in respect of the pre-acquisition period and is provided
for illustrative purposes.
31 December 2009
Carrying year years years years years Unit
amounts 0-1 1-2 2-3 3-4 >4 linked*
Carrying values £000 £000 £000 £000 £000 £000 £000
and cash flows
arising from:
Assets
Equity
securities at
fair value
through income - - - - - - -
Collective
investment
schemes 915,602 5,963 - - - - 909,639
Policyholders'
funds held by
the group 41,107 - - - - - 41,107
Debt
securities at
fair value
through income 1,908 1,908 - - - - -
Reinsurers'
share of
insurance
contract
provisions 27,262 15,359 3,733 2,328 922 4,920 -
Insurance and
other
receivables 10,208 9,548 660 - - - -
Accrued income
and prepayments 2,093 2,093 - - - - -
Derivative
financial
instruments 3,544 1,051 1,437 863 183 10 -
Cash and cash
equivalents 14,776 14,776 - - - - -
---------- ------- ------ ------ ------ ------- ---------
Total 1,016,500 50,698 5,830 3,191 1,105 4,930 950,746
--------- ------- ------ ------ ------ ------ ---------
Liabilities
Insurance
contract
provisions 32,353 17,893 4,397 2,774 1,151 6,138 -
Investment
contracts 918,291 - - - - - 918,291
Liabilities
relating to
policyholders'
funds held by
the group 41,107 - - - - - 41,107
Other
liabilities 46,705 23,876 7,205 6,223 3,436 5,965 -
--------- ------- ------ ------ ------ ------ ---------
Total 1,038,456 41,769 11,602 8,997 4,587 12,103 959,398
--------- ------- ------ ------ ------ ------ ---------
Difference in
expected cash
flows (21,956) 8,929 (5,772)(5,806)(3,462) (7,173) (8,652)
========= ======= ====== ====== ====== ====== =========
* Amounts included under unit linked funds are deemed to have a maturity up to
one year as they are repayable or transferable on demand.
31 December 2008
Carrying year years years years years Unit
amounts 0-1 1-2 2-3 3-4 >4 linked*
Carrying values £000 £000 £000 £000 £000 £000 £000
and cash flows
arising from:
Assets
Equity
securities at
fair value
through income - - - - - - -
Collective
investment
schemes 588,744 5,482 - - - - 583,262
Debt
securities at
fair value
through income 613 613 - - - - -
Reinsurers'
share of
insurance
contract
provisions 24,678 7,070 3,944 1,489 609 11,566 -
Insurance and
other
receivables 8,876 8,876 - - - - -
Accrued income
and prepayments 1,119 1,119 - - - - -
Cash and cash
equivalents 21,769 8,557 - - - - 13,212
---------- ------ ------ ------ ------- ------ ---------
Total 645,799 31,717 3,944 1,489 609 11,566 596,474
--------- ------ ------ ------ ------- ------ ---------
Liabilities
Insurance
contract
provisions 27,938 7,131 4,730 1,777 715 13,585 -
Investment
contracts 596,474 - - - - - 596,474
Other
liabilities 49,082 27,704 6,880 6,184 3,649 4,665 -
--------- ------ ------ ------ ------- ------ ---------
Total 673,494 34,835 11,610 7,961 4,364 18,250 596,474
--------- ------ ------ ------ ------ ------ ---------
Difference in
expected cash
flows (27,695)(3,118)(7,666)(6,472) (3,755)(6,684) -
====== ====== ====== ====== ====== ====== ======
* Amounts included under unit linked funds are deemed to have a maturity up to
one year as they are repayable or transferable on demand.
Foreign exchange exposure
The Swedish Business underwrites insurance contracts in Norway and its
exposures to foreign exchange risk arises primarily with respect to the
Norwegian Krone. The business reinsures 90 per cent of the risk and has some
assets denominated in the same currencies as the foreign insurance liabilities,
which should eliminate most of the foreign currency exchange rate risk on these
operations.
The following table sets out the foreign exchange exposure of the financial
assets and financial liabilities of the Swedish Business: the information as at
31 December 2008 relates to the pre-acquisition period and is provided for
illustrative purposes.
31 December 31 December
2009 2008 2009 2008
Foreign assets and NOK 000 NOK 000 EUR 000 EUR 000
liabilities
Assets:
Reinsurers' share of
insurance contract
provisions 85,543 76,952 - -
Deferred acquisition costs 327 209 - -
Equity securities at fair
value through income - - - -
Debt securities at fair
value through income - - - -
Insurance and other
receivables (402) 2,030 - -
Loans and other receivables - - 7,609 -
Cash and cash equivalents 12,135 12,263 16 119
--------- --------- --------- ---------
Total 97,603 91,454 7,625 119
--------- ---------- --------- ---------
Liabilities
Insurance contract
provisions (102,262) (90,997) - -
Other liabilities (762) (4,740) - -
--------- --------- --------- ---------
Total (103,024) (95,737) - -
--------- --------- --------- ---------
Foreign exchange mismatch (5,421) (4,283) 7,625 119
========= ========== ========= =========
Credit risk exposure
The Swedish Business has exposure to credit risk, which is the risk that a
counterparty will be unable to pay amounts in full when due. Key areas where
the business is exposed to credit risk are:
- Reinsurers' share of insurance liabilities;
- Amounts due from reinsurers in respect of claims already paid;
- Counterparty risk with respect to corporate bond, deposits and debt securities;
and
- Amounts paid to independent financial advisers representing advances of
commission not yet earned by them.
Amounts due from policyholders are insignificant and claims against
policyholders carry a limited credit risk as non-payment leads to cancellation
of the insurance policy. Unit-linked assets are only acquired upon receipt of
the premium from the policyholder.
The business structures the levels of credit risk it accepts by placing limits
on its exposure to a single counterparty, or group of counterparties. Such
risks are subject to at least an annual review. By far the largest credit risk
to the business is in relation to its reinsurance assets.
The business retains some residual risks on assets which support shareholders'
equity. The business's objective is to earn competitive relative returns by
investing in a diversified portfolio of securities. Watch lists are maintained
for exposures requiring additional review and all credit exposures are reviewed
monthly.
The exposure to credit risk of the Swedish Business in relation to its debt
securities, receivables and cash balances is summarised below: the information
as at 31 December 2008 relates to the pre-acquisition period and is provided
for illustrative purposes.
Credit rating- debt securities
AAA AA A Unrated Total
As at 31 £000 £000 £000 £000 £000
December
2009
Debt
securities
at fair
value
through
income 1,908 - - - 1,908
Insurance
and other
receivables - - - 10,108 10,108
Cash
balances - - - 14,776 14,776
--------- --------- --------- --------- ---------
Total debt,
receivables
and cash
balances 1,908 - - 24,884 26,792
========= ========= ========= ========= =========
Credit rating- debt securities
AAA AA A Unrated Total
As at 31 £000 £000 £000 £000 £000
December
2008
Debt
securities
at fair
value
through
income 613 - - - 613
Insurance
and other
receivables - 3,155 - 5,721 8,876
Cash
balances - 20,607 1,076 86 21,769
--------- --------- --------- ---------- ---------
Total debt,
receivables
and cash
balances 613 23,762 1,076 5,807 31,258
========= ========= ========= ========= =========
Reinsurance credit risk
Reinsurance is used to manage insurance risk in the Swedish Business. This does
not however discharge the business's liability as primary insurer. If a
reinsurer fails to pay a claim for any reason, the business remains liable for
the payment to the policyholder. The creditworthiness of major reinsurers is
considered on an annual basis by reviewing their financial strength. The
current rules state that re-insurance should only be made using reinsurance
companies with a credit rating from Standard & Poor's of A or higher (except
for the reinsurer which is an associate of the Group).
The business has entered into reinsurance arrangements with four reinsurers.
With the main reinsurer, there is an associated financial reinsurance agreement
in place whereby the amount due to the reinsurer is more than the reinsurer's
share of the claims.
In relation to the other significant reinsurer (which is an associate of the
Group), there is a credit risk exposure which is managed by the Group being
represented on the Board of the reinsurer. The Group is therefore closely
involved and can influence its strategy.
Reinsurance Credit Risk Exposure
Credit rating- reinsurers
AAA AA A Unrated Total
£000 £000 £000 £000 £000
As at 31
December - 16,483 38 10,741 27,262
2009
--------- --------- --------- --------- ---------
As at 31
December - 9,917 3 17,913 27,833
2008*
--------- --------- --------- --------- ---------
* This information relates to the pre-acquisition period and is provided for
illustrative purposes.
Financial assets that are past due or impaired
There are no financial assets that are impaired, would otherwise be past due or
impaired whose terms have been renegotiated or past due but not impaired.
Sensitivity analysis
Certain of the information below relates to the pre acquisition period and is
provided for illustrative purposes.
Sensitivity analysis - interest rate risk
The sensitivity analysis for interest rate risk within the Swedish Business
illustrates how changes in the fair value or future cash flows of a financial
instrument will fluctuate because of changes in market rates at the reporting
date.
The carrying amount of both the liabilities and the assets, which are fixed
interest debt securities valued at fair value, will be sensitive to changes in
the level of interest rates. By reviewing the matching of the cash flows by
term, on a quarterly basis, management aim to minimise the impact of a change
in values due to a parallel movement in all yield curves.
The interest rate risk for the fixed interest debt securities of the Swedish
Business is deemed to be low as these assets are mainly short term (less than a
year). A 100 basis point increase or decrease in interest yields would not have
a material effect on either profit for the year ended 31 December 2009 or
shareholder equity as at that date.
Sensitivity analysis - equity risk
The direct and indirect investment in equities of the Swedish Business and the
management fees on the unit linked assets (which are based on the asset value
of the unit-linked assets) are impacted by movement in the equities market.
A decrease of 10 per cent in equities markets would result in a £0.1m decrease
in profit for the year ended 31 December 2009 and to shareholder equity as at
31 December 2009, (year ended 31 December 2008 and as at 31 December 2008
£0.1m).
An increase of 10 per cent in equities markets would result in a £0.1m increase
in profit for the year ended 31 December 2009 and to shareholder equity as at
31 December 2009 (year ended 31 December 2008 and as at 31 December 2008:
£0.1m).
Sensitivity analysis - foreign exchange risks
An increase or decrease of 10% in exchange rates in relation to the Swedish
Business has no material effect on profit and shareholder equity either for the
year ended 31 December 2009 or for the year ended 31 December 2008 or as at
those dates.
Corporate
The financial risks in relation to Other Group Activities relate to the risks
associated with Chesnara plc company assets and liabilities. These comprise:
Cash and cash equivalents
The related risks are included in the analysis of credit risk management set
out above.
Borrowings
Borrowings issued at variable rates of interest expose the Group to cash flow
interest risk. Information on borrowings is set out in Note 36 of the financial
statements. A 1% increase in interest rates would result in a decrease of less
than £0.1m in profit after tax attributable to shareholders for the year ended
31 December 2009 (year ended 31 December 2008: £0.1m decrease) and in
shareholder equity as at 31 December 2009 (31 December 2008: £0.1m decrease)
Foreign exchange rate risk
The Group has exposure to foreign exchange risk in relation to movements
between the Swedish Krona and Sterling as a result of its ownership of the
Swedish Business.
An increase of 10% in the 31 December 2009 SEK to £ rate from SEK 11.5305 to £1
to SEK 12.6836 to £1 would result in a reduction in shareholder equity of £4.3m
as at 31 December 2009.
An increase of 10% in the average SEK to £ rate from SEK 11.5594 to £1 to SEK
12.7153 to £1 for the year ended 31 December 2009 would result in an increase
in the profit after tax attributable to shareholders of £0.2m for the year
ended 31 December 2009.
POST BALANCE SHEET EVENT
On 19 February 2010, Chesnara plc's Swedish subsidiary, Moderna Försäkringar
Liv AB ('Moderna'), entered into an agreement with the Swedish Regulatory
Authority, Finansinspektionen ('FI'), to take over the operational management
of Aspis Försäkrings Liv AB ('Aspis'). This means that Moderna will acquire
the in force business, the personnel, expertise and systems of Aspis and will
also manage, but not be responsible for, the payment of in-force claims that
had occurred up to 12 November 2009. Moderna, under the terms of an asset
transfer agreement entered into on 10 December 2009, acquired the right to
offer renewal policies to Aspis policyholders from 12 November 2009.
The FI had recently determined to revoke the Aspis licence due to issues
regarding its solvency capital which remained unresolved. By taking this
opportunity Moderna removes significant uncertainty for the Aspis customers,
staff and supporting intermediaries and acquires a book of protection business
which represents an excellent strategic fit with its current pension and savings
business. The transaction is expected to be earnings enhancing in the medium
term but, given the recent timings of the transaction, we are unable to make
a reliable estimate of the effect on the Group's financial results at this time.
This is because the negative press coverage that Aspis received within Sweden
prior to the agreement will have had a negative impact on lapse rates of policies
at the date of renewal which will impact the quantification of the value of the
in-force intangible assets acquired. As a result, the fair value of the net
assets acquired and the goodwill arising on acquisition cannot be assessed with
reliability at this time.
For further information please contact
Graham Kettleborough 01772 840001
Chief Executive, 07799 407519
Chesnara plc
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