REG - Legal & General Grp - L&G Full Year Results 2016 Part 3 <Origin Href="QuoteRef">LGEN.L</Origin> - Part 2
08/03/2017 07:08
- Part 2: For the preceding part double click ID:nRSH8036Ya
Deduction and Aggregation basis and the sectoral capital requirements for non-insurance regulated firms.
Capital and Investments
Page 68
4.02 Group Economic Capital
Legal & General defines Economic Capital to be the amount of capital that the Board believes the group needs to hold, over
and above its liabilities, in order to meet its strategic objectives. This is not the same as regulatory capital which
reflects regulatory rules and constraints. The group's objectives include being able to meet its liabilities as they fall
due whilst maintaining the confidence of our investors, rating agencies, customers and intermediaries.
Further explanation of the underlying methodology and assumptions is set out in the sections below.
Legal & General maintains a risk-based capital model that is used to calculate the group's Economic Capital balance sheet
and support the management of risk within the group. This modelling framework, suitably adjusted for regulatory
constraints, also meets the needs of the Solvency II regime. Our Economic Capital model has not been reviewed by the
Prudential Regulatory Authority (PRA), nor will it be.
Solvency II has elements which are considered to be inconsistent with the group's definition of Economic Capital, so there
are differences between the two balance sheets. A reconciliation between the two bases is provided in section 4.02(g).
(a) Capital position
As at 31 December 2016, the group had an Economic Capital surplus of £8.3bn (2015: £7.6bn), corresponding to an Economic Capital coverage ratio of 230% (2015: 230%). The Economic Capital position is as follows:
2016 2015
£bn £bn
Core tier 1 Own Funds 11.9 10.8
Tier 1 subordinated liabilities 0.6 0.7
Tier 2 subordinated liabilities 2.1 2.3
Eligibility restrictions - (0.3)
Own Funds1 14.6 13.5
Economic Capital Requirement (ECR)2 (6.3) (5.9)
Surplus 8.3 7.6
ECR coverage ratio3 230% 230%
1. Economic Capital Own Funds do not include an accrual for the dividend of £616m (2015: £592m) declared after the balance sheet date.
2. The ECR is not subject to audit.
3. Coverage ratio is calculated on unrounded values.
The Economic Capital position does not exclude the ECR for with-profits fund and the final salary pension schemes for both Own Funds and ECR.
(b) Methodology
Own Funds are defined to be the excess of the value of assets over the liabilities. Subordinated debt issued by the group
is considered to be part of available capital, rather than a liability, as it is subordinate to policyholder claims.
Assets are valued at IFRS fair value with adjustments to remove intangibles and deferred acquisition costs, and to value
reassurers' share of technical provisions on a basis consistent with the liabilities on the Economic Capital balance
sheet.
Liabilities are valued on a best estimate market consistent basis, with the application of an Economic Matching Adjustment
for valuing annuity liabilities.
The Economic Capital Requirement is the amount of capital required to cover the 1-in-200 worst projected future outcome in
the year following the valuation, allowing for realistic management and policyholder actions and the impact of the stress
on the tax position of the group. This allows for diversification between the different firms within the group and between
the risks that they are exposed to.
The liabilities include a Recapitalisation Cost to allow for the cost of recapitalising the balance sheet following the
1-in-200 stress in order to maintain confidence that our future liabilities will be met. This is calculated using a cost of
capital that reflects the long term average rates at which it is expected that the group could raise debt and allowing for
diversification between all group entities.
All material insurance firms, including Legal & General Assurance Society Limited, Legal & General Insurance Limited, Legal
& General Assurance (Pensions Management) Limited (LGIM's insurance subsidiary) and Legal & General America (LGA) are
incorporated into the group's Economic Capital model assessment of required capital, assuming diversification of the risks
between the different firms within the group and between the risks to which they are exposed. These firms, as well as the
non-EEA insurance firm (Legal and General Reinsurance Company Limited based in Bermuda) contribute over 90% of the group's
ECR.
Firms for which the capital requirements are less material, are valued on the Solvency II Standard Formula basis.
Non-insurance firms are included using their current regulatory surplus, without allowing for any diversification with the
rest of the group.
The group completed the sale of Cofunds in January 2017 and has announced the sale of Legal & General Netherlands (subject
to regulatory approval). The Economic Capital result as at 31 December 2016 does not reflect the expected impacts of these
sales.
Allowance is made within the Economic Capital balance sheet for the group's defined benefit pension schemes based upon the
scheme's funding basis, and allowance is made within the capital requirement by stressing the funding position, using the
same Economic Capital basis as for the insurance firms.
Capital and Investments
Page 69
4.02 Group Economic Capital (continued)
(c) Assumptions
The calculation of the Economic Capital balance sheet and associated capital requirement requires a number of assumptions,
including:
(i) assumptions required to derive the present value of best estimate liability cash flows. Non-market assumptions are
consistent with those used to derive the group's IFRS disclosures, but with the removal of any prudence margins. Future
investment returns and discount rates are based on market data where a deep and liquid market exists or using appropriate
estimation techniques where this is not the case. The risk-free rates used to discount liabilities are market swap rates,
with a 17 basis point deduction to allow for a credit risk adjustment;
(ii) assumptions regarding management actions and policyholder behaviour across the full range of scenarios. The only
management actions allowed for are those that have been approved by the Board and are in place at the balance sheet date;
(iii) assumptions regarding the volatility of the risks to which the group is exposed. Assumptions have been set using a
combination of historic market, demographic and operating experience data. In areas where data is not considered robust,
expert judgement has been used; and
(iv) assumptions on the dependencies between risks, which are calibrated using a combination of historic data and expert
judgement.
For annuities the liability discount rate includes an Economic Matching Adjustment, which is derived using the same
approach as the Solvency II matching adjustment, but any constraints we consider economically artificial, such as capping
the yield on assets with a credit rating below BBB and any ineligibility of certain assets and liabilities, have not been
applied. The Economic Matching Adjustment was 146bps after allowing for future defaults and downgrades totalling 61bps.
The other key assumption relating to the annuity business is the assumption of longevity. As for IFRS, Legal & General
models base mortality and future improvement of mortality separately. For our Economic Capital assessment we believe it is
appropriate to ensure that the balance sheet makes sufficient allowance to meet the 1-in-200 stress to longevity over the
run-off of the liabilities rather than just over a 1 year timeframe as required by Solvency II.
(d) Analysis of change
The table below shows the movement (net of tax) during the financial year in the group's Economic Capital surplus.
31.12.16
surplus
£bn
Operational Surplus Generation1 0.8
New Business Surplus 0.5
Net Surplus Generation 1.3
Dividends paid2 (0.8)
Operating variances3 -
Market Movements4 0.2
Total Surplus (after dividends) 0.7
1. Release of surplus generated by in-force business. It may include management actions which at the start of the year could have been reasonably expected to take place. For 2016, no management actions were included which impacted the Economic Capital balance sheet.
2. Dividends paid are the amounts from the declarations at year-end 2015 and HY2016.
3. Operating variances comprise of model and assumption changes and changes in asset mix across the group (with corresponding increase in Economic Capital Requirement).
4. Market Movements is the impact of market movements over the year and changes to future economic assumptions. It includes the capital impact of investment portfolio changes implemented by LGC.
Capital and Investments
Page 70
4.02 Group Economic Capital (continued)
(e) Reconciliation of IFRS shareholders' equity to Economic Capital Eligible Own Funds
The table below gives a reconciliation of the group's IFRS shareholders' equity to the Own Funds on an Economic Capital basis.
2016 2015
£bn £bn
IFRS shareholders' equity 6.9 6.4
Remove DAC, goodwill and other intangible assets and liabilities (2.1) (2.0)
Add subordinated debt treated as available capital1 2.5 2.5
Insurance contract valuation differences2 7.9 7.0
Add value of shareholder transfers 0.2 0.2
Difference in value of net deferred tax liabilities (resulting from valuation differences) (0.5) (0.5)
Other (0.3) 0.2
Eligibility restrictions3 - (0.3)
Own Funds4 14.6 13.5
1. Treated as available capital on the Economic Capital balance sheet as the liabilities are subordinate to policyholder claims.
2. Differences in the measurement of liabilities between IFRS and Economic Capital, offset by the inclusion of the recapitalisation cost.
3. Relating to the Own Funds of US captive reassurers and the UK with-profits fund.
4. Own Funds do not include an accrual for the dividend of £616m (2015: £592m) declared after the balance sheet date.
(f) Sensitivity analysis The following sensitivities are
provided to give an indication of how the group's
Economic Capital surplus as at 31 December 2016 would
have changed in a variety of adverse events. These are
all independent stresses to a single risk. In practice
the balance sheet is impacted by combinations of
stresses and the combined impact can be larger than
adding together the impacts of the same stresses in
isolation. It is expected that, particularly for market
risks, adverse stresses will happen together.
Impact on
Impact on economic
net of tax capital
capital coverage
surplus ratio
2016 2016
£bn %
Credit spreads widen by 100bps assuming a level addition 0.2 9
to all ratings1
Credit spreads widen by 100bps assuming an escalating 0.1 6
addition to ratings1,2
Credit migration (0.6) (10)
20% fall in equity markets (0.4) (5)
40% fall in equity markets (0.8) (10)
20% rise in equity markets 0.5 5
15% fall in property markets (0.2) (3)
100bps increase in risk free rates 0.6 21
50bps fall in risk free rates3 (0.3) (11)
1% reduction in annuitant base mortality (0.2) (3)
1% increase in annuitant base mortality 0.2 3
1. All spread sensitivities apply to Legal & General's
corporate bond (and similar) holdings, with no change in
the firm's long term default expectations.
2. The stress for AA bonds is twice that for AAA bonds,
for A bonds it is three times, for BBB four times and so
on, such that the weighted average spread stress for the
portfolio is 100bps.
3. In the interest rate down stress negative rates are
allowed, i.e. there is no floor at zero.
The above sensitivity analysis does not reflect
management actions which could be taken to reduce the
impacts. In practice, the group actively manages its
asset and liability positions to respond to market
movements. The impacts of these stresses are not linear
therefore these results should not be used to
extrapolate the impact of a smaller or larger stress.
The results of these tests are indicative of the market
conditions prevailing at the balance sheet date. The
results would be different if performed at an
alternative reporting date.
Capital and Investments
Page 71
4.02 Group Economic Capital (continued)
(g) Analysis of Group Economic Capital Requirement
The table below shows a breakdown of the group's Economic Capital Requirement by risk type. The split is shown after the effects of diversification.
2016
%
Interest Rate 2
Equity 10
Property 6
Credit1 45
Currency 1
Inflation 2
Total Market Risk2 66
Counterparty Risk 2
Life Longevity3 14
Life Lapse 3
Life Catastrophe 5
Non-life underwriting 1
Expense 1
Total Insurance Risk 24
Operational Risk 9
Miscellaneous4 (1)
Total ECR 100
1. Credit risk is Legal & General's most significant exposure, arising predominantly from the portfolio of bonds backing the group's annuity business.
2. In addition to credit risk the group also has significant exposure to other market risks, primarily due to the investment holdings within the shareholder funds but also the risk to fee income from assets backing unit linked and with-profits Savings business.
3. Longevity risk is Legal & General's most significant insurance risk exposure, arising from the annuity book on which the majority of the longevity risk is retained.
4. Miscellaneous includes the sectoral capital requirements for non-insurance regulated firms.
(h) Reconciliation from Economic Capital surplus to Solvency II surplus
The Economic Capital position does not reflect regulatory constraints.
The regulatory constraints imposed by the Solvency II regime result in a
lower surplus. The table below provides an analysis of the key
differences between the two bases. The Solvency II results are reported
net of Estimated TMTP.
2016 2015
£bn £bn
Economic Capital surplus 8.3 7.6
LGA on a D&A basis1 0.1 0.1
Different annuity capital requirements2 (2.6) (1.7)
Risk margin vs. Recapitalisation cost3 - -
Eligibility of group Own Funds4 (0.1) (0.5)
Solvency II surplus5 5.7 5.5
1. To ensure consistency of risk management across the group, L&G America
remains within the Internal Model for Economic Capital purposes.
2. This includes the difference between the Economic Matching Adjustment
and the Solvency II Matching Adjustment as well as the fact that Economic
Capital and Solvency II balance sheets use different calibrations for
longevity risk.
3. The Risk Margin represents the amount a third party insurance company
would require to take on the obligations of a given insurance company. It
is equal to the cost of capital on the SCR necessary to support insurance
risks that cannot be hedged over the lifetime of the business. This is
presented net of Estimated TMTP. The recapitalisation cost is an
equivalent measure under Economic Capital, but represents the cost of
recapitalising the balance sheet following a stress event. It also
removes elements of Solvency II specifications that are, in Legal &
General's view, uneconomic.
4. Deductions for regulatory restrictions in respect of fungibility and
transferability restrictions. These do not apply to the Economic Capital
balance sheet.
5. There are also differences in the valuation of with-profits business
and the group pension schemes that have lower order impacts on the
difference between the surpluses.
Capital and Investments
Page 72
4.03 Estimated Solvency II new business contributions
(a) New business by product
Contri-
bution
from new
PVNBP business2 Margin
For the year ended 31 December 2016 £m £m %
LGR - UK annuity business 6,661 693 10.4
UK Insurance Total 1,466 153 10.4
- Retail protection 1,255 139 11.1
- Group protection 211 14 6.6
LGA3 631 78 12.4
1. Selected lines of business only.
2. The contribution from new business is defined as the present value at the point of sale of expected future Solvency II surplus emerging from new business written in the period using the risk discount rate applicable at the end of the reporting period.
3. In local currency, LGA reflects PVNBP of $855m and a contribution from new business of $106m.
(b) Assumptions
The key economic assumptions as at 31 December 2016 are as follows:
%
Risk Margin 3.1
Risk free rate
- UK 1.7
- US 2.1
Risk discount rate (net of tax)
- UK 4.8
- US 5.2
Long-term rate of return on non-profit annuities in LGR 3.1
The cashflows are discounted using duration-based discount rates, which is the sum of a duration-based risk free rate and a
flat Risk Margin. The risk free rates have been based on a swap curve net of the EIOPA-specified Credit Risk Adjustment.
The risk free rate shown above is a weighted average based on the projected cash flows.
All other economic and non-economic assumptions and methodologies that would have a material impact on the margin for these
contracts are unchanged from those used for the European Embedded Value reporting at end 2015 other than the cost of
currency hedging which has been updated to reflect current market conditions and hedging activity in light of Solvency II.
In particular:
· The assumed future pre-tax returns on fixed interest and RPI linked securities are set by reference to the portfolio
yield on the relevant backing assets held at market value at the end of the reporting period. The calculated return takes
account of derivatives and other credit instruments in the investment portfolio. The returns on fixed and index-linked
assets are calculated net of an allowance for default risk which takes account of the credit rating and the outstanding
term of the assets. The allowance for corporate and other unapproved credit asset defaults within the new business
contribution is based on a level rate deduction from the expected returns for the overall annuities portfolio of 19bps.
· Non-economic assumptions have been set at levels commensurate with recent operating experience, including those for
mortality, morbidity, persistency and maintenance expenses (excluding development costs). An allowance is made for future
mortality improvement. For new business, mortality assumptions may be modified to take certain scheme specific features
into account. These are normally reviewed annually.
Tax
The profits on the new business are calculated on an after tax basis and are grossed up by the notional attributed tax
rate. For the UK, the after tax basis assumes the annualised current rate of 20% and subsequent enacted future reductions
in corporation tax to 19% from 1 April 2017 and 17% from 1 April 2020 onwards. The tax rate used for grossing up is the
long term corporate tax rate in the territory concerned, which for the UK is 17%.
US covered business profits are also grossed up using the long term corporate tax rate of 35%.
Capital and Investments
Page 73
4.03 Estimated Solvency II new business contribution (continued)
(c) Methodology
Basis of preparation
The group is required to comply with the requirements established by the EU Solvency II Directive. Consequently, a Solvency
II value reporting framework, which incorporates a best estimate of cash flows in relation to insurance assets and
liabilities, has replaced EEV reporting in the management information used internally to measure and monitor capital
resources. Solvency II new business contribution reflects the portion of Solvency II value added by new business written
in 2016, recognising that the statutory solvency in the UK is now on a Solvency II basis. It has been calculated in a
manner consistent with European Embedded Value (EEV) principles.
Solvency II new business contribution has been calculated for the group's most material insurance-related businesses,
namely, LGR, UK Insurance and LGA.
Description of methodology
The objective of the Solvency II new business contribution is to provide shareholders with information on the long term
contribution of new business written in 2016.
With the exception of the discount rate, cost of currency hedging and the statutory solvency basis, new business
contribution arising from the new business premiums written during the reporting period has been calculated on the same
economic and operating assumptions as would have been used under the EEV methodology.
The PVNBP is equivalent to total single premiums plus the discounted value of annual premiums expected to be received over
the term of the contracts using the same economic and operating assumptions used for the calculation of the new business
contribution for the financial period.
The new business margin is defined as new business contribution divided by the PVNBP. The premium volumes used to calculate
the PVNBP are the same as those used to calculate new business contribution.
LGA is consolidated into the group solvency balance sheet on a US Statutory solvency basis. Therefore, the LGA margin is
largely unchanged from the EEV basis, where new business profitability was also based on the US Statutory solvency basis.
Intra-group reinsurance arrangements are in place between the US and UK businesses, and it is expected that these
arrangements will be periodically extended to cover recent new business. LGA new business premiums and contribution reflect
the groupwide expected impact of LGA directly-written business (i.e. looks through any intra-group reinsurance
arrangements).
Comparison to EEV new business contribution
The key difference between Solvency II and EEV new business contribution is the Statutory solvency basis used for UK
business. Due to the different reserving and capital bases under Solvency II compared to Solvency I, the timing of profit
emergence changes. The impact on new business contribution therefore largely reflects the cost of capital effect of this
change in profit timing. The impact on new business contribution of moving to a Solvency II basis will differ by type of
business. Products which are more capital consumptive under Solvency II will have a lower new business value and vice
versa for less capital consumptive products.
Projection assumptions
Cash flow projections are determined using best estimate assumptions for each component of cash flow for each line of
business. Future economic and investment return assumptions are based on conditions at the end of the financial period.
Detailed projection assumptions including mortality, morbidity, persistency and expenses reflect recent operating
experience and are normally reviewed annually. Allowance is made for future improvements in annuitant mortality based on
experience and externally published data. Favourable changes in operating experience are not anticipated until the
improvement in experience has been observed.
All costs relating to new business, even if incurred elsewhere in the group, are allocated to the new business. The expense
assumptions used for the cash flow projections therefore include the full cost of servicing this business.
Tax
The projections take into account all tax which is expected to be paid, based on best estimate assumptions, applying
current legislation and practice together with substantively enacted future changes.
Risk discount rate
The risk discount rate (RDR) is duration-based and is a combination of the risk free curve and a flat Risk Margin, which
reflects the residual risks inherent in the group's businesses, after taking account of margins in the statutory technical
provisions, the required capital and the specific allowance for financial options and guarantees.
The risk free rates have been based on a swap curve net of the EIOPA-specified Credit Risk Adjustment (31 December 2016:
17bps for UK and 15bps for US).
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.
Capital and Investments
Page 74
4.03 Estimated Solvency II new business contribution (continued)
(c) Methodology (continued)
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 time adjusted rate of 17.7%.
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.
(d) PVNBP to gross written premium reconciliation
2016 2015
Notes £bn £bn
PVNBP 4.03(a) 8.8
Effect of capitalisation factor (1.8)
New business premiums from selected lines 7.0
Other1 1.9
Total LGR, Insurance and LGA new business 3.07/3.08 8.9 3.3
Annualisation impact of regular premium long-term business (0.1) (0.2)
IFRS gross written premiums from existing long-term insurance business
- More to follow, for following part double click ID:nRSH8036YcRecent news on Legal & General
See all newsREG - Legal & General Grp - Transaction in Own Shares
AnnouncementREG - Legal & General Grp Morgan Stanley - Holding(s) in Company
AnnouncementREG - Legal & General Grp Morgan Stanley - Holding(s) in Company
AnnouncementREG - Legal & General Grp - Transaction in Own Shares
AnnouncementREG - Legal & General Grp Morgan Stanley - Holding(s) in Company
Announcement