REG - Legal & General Grp - L&G Full Year Results 2015 Part 3 <Origin Href="QuoteRef">LGEN.L</Origin> - Part 8

Legal & GeneralAnnouncement

15/03/2016 07:07

- Part 8: For the preceding part double click  ID:nRSO0691Sg 

time value cost is recognised accordingly. 
 
The time value of FOGs has been calculated stochastically using a large number of real world economic scenarios derived
from assumptions consistent with the deterministic EEV assumptions and allowing for appropriate management actions where
applicable. The management action primarily relates to the setting of bonus rates. Future regular and terminal bonuses on
participating business within the projections are set in a manner consistent with expected future returns available on
assets deemed to back the policies within the stochastic scenarios. 
 
In recognising the residual value of any projected surplus assets within the with-profits part of the fund in the
deterministic projection, it is assumed that terminal bonuses are increased to exhaust all of the assets in the part of the
fund over the future lifetime of the in-force with-profits policies. However, under stochastic modelling, there may be some
extreme economic scenarios when the total projected assets within the with-profits part of the fund are insufficient to pay
all projected policyholder claims and associated costs. The average additional shareholder cost arising from this shortfall
has been included in the time value cost of FOGs and is referred to as the with-profits burn-through cost. 
 
Economic scenarios have been used to assess the time value of the financial guarantees for non profit business by using the
inflation rate generated in each scenario. The inflation rate used to project index-linked annuities will be constrained in
certain real world scenarios, for example, where negative inflation occurs but the annuity payments do not reduce below
pre-existing levels. The time value cost of FOGs allows for the projected average cost of these constrained payments for
the index-linked annuities. It also allows for the small additional cost of the guaranteed early retirement and cash
commutation terms for the minority of deferred annuity business where such guarantees have been written. 
 
LGA FOGs relate to guaranteed minimum crediting rates and surrender values on a range of contracts, as well as impacts on
no-lapse guarantees (NLG). The guaranteed surrender value of the contract is based on the accumulated value of the contract
including accrued interest. The crediting rates are discretionary but related to the accounting income for the amortising
bond portfolio. The majority of the guaranteed minimum crediting rates are between 3% and 4%. The assets backing these
contracts are invested in US Dollar denominated fixed interest securities. 
 
LGN separately provides for two types of guarantees: interest rate guarantees and maturity guarantees. Certain contracts
provide an interest rate guarantee where there is a minimum crediting rate based on the higher of 1-year Euribor and the
policy guarantee rate. This guarantee applies on a monthly basis. Certain other linked contracts provide a guaranteed
minimum value at maturity where the maturity amount is the higher of the fund value and a guarantee amount. The fund values
for both these contracts are invested in Euro denominated fixed interest securities. 
 
Risk free rate 
 
The risk free rate is set to reflect both the pattern of the emerging profits under EEV and the relevant duration of the
liabilities where backing assets reflect this assumption (e.g. equity returns). For the UK, it is set by reference to the
gross redemption yield on the 15 year gilt index. For LGA, the risk free rate is the 10 year US Treasury effective yield,
while the 10 year ECB AAA-rated Euro area central government bond par yield is used for LGN. 
 
European Embedded Value                                                                                                    
       101 
 
5.07 Methodology (continued) 
 
Risk discount rate 
 
The risk discount rate (RDR) is a combination of the risk free rate and a risk margin, which reflects the residual risks
inherent in the group's covered businesses, after taking account of prudential margins in the statutory provisions, the
required capital and the specific allowance for FOGs. 
 
The risk margin has been determined based on an assessment of the group's weighted average cost of capital (WACC). This
assessment incorporates a beta for the group, which measures the correlation of movements in the group's share price to
movements in a relevant index. Beta values therefore allow for the market's assessment of the risks inherent in the
business relative to other companies in the chosen index. 
 
The WACC is derived from the group's cost of equity and debt, and the proportion of equity to debt in the group's capital
structure measured using market values. Each of these three parameters is forward looking, although informed by historic
information and appropriate judgements where necessary. The cost of equity is calculated as the risk free rate plus the
equity risk premium for the chosen index multiplied by the company's beta. Forward-looking or adjusted betas make allowance
for the observed tendency for betas to revert to 1 and therefore a weighted average of the historic beta and 1 tends to be
a better estimate of the company's beta for the future period. We have computed the WACC using an arithmetical average of
forward-looking betas against the FTSE 100 index. 
 
The cost of debt used in the WACC calculations takes account of the actual locked-in rates for our senior and subordinated
long term debt. All debt interest attracts tax relief at a rate of 18.5% (2014: 20.1%). 
 
Whilst the WACC approach is a relatively simple and transparent calculation to apply, subjectivity remains within a number
of the assumptions. Management believes that the chosen margin, together with the levels of required capital, the inherent
strength of the group's regulatory reserves and the explicit deduction for the cost of options and guarantees, is
appropriate to reflect the risks within the covered business. 
 
Analysis of profit 
 
Operating profit is identified at a level which reflects an assumed longer term level of investment return. 
 
The contribution to operating profit in a period is attributed to four sources: 
 
i.  new business; 
 
ii.  the management of in-force business; 
 
iii. development costs; and 
 
iv.    return on shareholder net worth. 
 
Further profit contributions arise from actual investment return differing from the assumed long term investment return,
and from the effect of economic assumption changes. These are shown below operating profit. 
 
The contribution from new business represents the value recognised at the end of each period from new business written in
that period, after allowing for the actual cost of acquiring the business and of establishing the required technical
provisions and reserves and after making allowance for the cost of capital. New business contributions are calculated using
closing assumptions. 
 
The contribution from in-force business is calculated using opening assumptions and comprises: 
 
i.  expected return - the discount earned from the value of business in-force at the start of the year; 
 
ii.  experience variances - the variance in the actual experience over the reporting period from that assumed in the value
of business in-force as at the start of the year; and 
 
iii. operating assumption changes - the effects of changes in future assumptions, other than changes in economic
assumptions from those used in valuing the business at the start of the year. These changes are made prospectively from the
end of the period. 
 
Development costs relate to investment in strategic systems and development capability. 
 
The contribution from shareholder net worth comprises the increase in embedded value based on assumptions at the start of
the year in respect of the expected investment return on the Society shareholder capital. 
 
Further profit contributions arise from investment return variances and the effect of economic assumption changes. 
 
Economic variances represent: 
 
i.      the effect of actual investment performance and changes to investment policy on SNW and VIF business from that
assumed at the beginning of the period; and 
 
ii.      the effect of changes in economic variables on SNW and VIF business from that assumed at the beginning of the
period, which are beyond the control of management, including associated changes to valuation bases to the extent that they
are reflected in revised assumptions. 
 
This information is provided by RNS
The company news service from the London Stock Exchange