Legal & General Group Plc

Full year results 2017 Part 3

 

Capital and Investments                                                                                                               Page 69

 

5.01 Group regulatory capital - Solvency II

 

The group complies with the requirements established by the Solvency II Framework Directive, as adopted by the Prudential Regulation Authority (PRA) in the UK and to measure and monitor its capital resources on this basis.

 

The Solvency II results are estimated and unaudited. Further explanation of the underlying methodology and assumptions are set out in the sections below.

 

In December 2015, the group received approval to calculate its Solvency II capital requirements using a Partial Internal Model (together with the approval by the PRA of applications for major model change in December 2016 and December 2017). The vast majority of the risk to which the group is exposed is assessed on the Internal Model basis approved by the PRA. Capital requirements for a few smaller entities are assessed using the Standard Formula basis on materiality grounds. The group's US insurance businesses are valued on a local statutory basis, following the PRA's approval to use the Deduction and Aggregation method of including these businesses in the group solvency calculation.

 

The table below shows the "shareholder view" of the group Own Funds, Solvency Capital Requirement (SCR) and Surplus Own Funds, based on the Partial Internal Model, Matching Adjustment and Transitional Measures on Technical Provisions (recalculated as at end December 2017 in line with the PRA guidance).

(a) Capital position
As at 31 December 2017 the group had a Solvency II surplus of £6.9bn (31 December 2016: £5.7bn) over its Solvency Capital Requirement, corresponding to a coverage ratio on a "shareholder view" basis of 189% (31 December 2016: 171%). The shareholder view of the Solvency II capital position is as follows:
								2017		2016
								£bn		£bn
Core tier 1 Own Funds								11.6		11.0
Tier 1 subordinated liabilities1								-		0.6
Tier 2 subordinated liabilities2								3.1		2.1
Eligibility restrictions								(0.1)		(0.1)
Solvency II Own Funds3,4								14.6		13.6
Solvency Capital Requirement5								(7.7)		(7.9)
Solvency II surplus								6.9		5.7
SCR coverage ratio6								189%		171%
1. Tier 1 subordinated liabilities of £0.6bn were redeemed on 2 May 2017.
2. Tier 2 subordinated liabilities include $1.35bn of USD subordinated notes issued in 2017.
3. Own Funds do not include an accrual for the dividend of £658m (2016: £616m) declared after the balance sheet date.
4. Solvency II Own Funds allow for a risk margin of £5.9bn (2016: £6.4bn) and TMTP of £6.2bn (2016: £7.0bn).
5. The SCR is not subject to audit.
6. Coverage ratio is based on unrounded inputs.

 

The "shareholder view" basis excludes the contribution that the with-profits fund and the final salary pension scheme would normally make to the group position. This is reflected by reducing the group's Own Funds and the group's SCR by the amount of the SCR for the with-profits fund and the final salary pension schemes.

 

On a proforma basis, which includes the contribution of with-profits fund and the final salary pension scheme in the group's Own Funds and corresponding SCR in group's SCR, the coverage ratio at 31 December 2017 is 181% (31 December 2016: 165%).

 

On 6 December 2017 the group announced its intention to sell the Mature Savings business to the ReAssure division of Swiss Re. Swiss Re assumed the economic exposure of the business from 1 January 2018 via a risk transfer agreement. It is expected that the formal transfer of the business will be completed in mid-2019, subject to satisfaction of normal conditions for a transaction including court sanction. The transfer will be effected by way of a Part VII transfer under the Financial Services Markets Act 2000. The impact of the risk transfer agreement has been reflected in the 2017 Own Funds. Due to the proximity of the transaction to the year end, the model change to make an allowance on the SCR will take place during 2018 and therefore the SCR in 2017 does not include any impact of the risk transfer agreement.

 

 

Capital and Investments                                                                                                               Page 70

 

5.01 Group regulatory capital - Solvency II (continued)

 

(b) Methodology

 

Own Funds comprise the excess of the value of assets over the liabilities, as valued on a Solvency II basis. 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. Own Funds include deductions in relation to fungibility and transferability restrictions, where the surplus Own Funds of a specific group entity cannot be freely transferred around the group due to local legal or regulatory constraints.

 

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 Solvency II balance sheet.

 

Liabilities are valued on a best estimate market consistent basis, with the application of a Solvency II Matching Adjustment for valuing annuity liabilities. This incorporates changes to the Internal Model and Matching Adjustment during 2017 and the impacts of a recalculation of the TMTP as at end December 2017. In line with the requirements to recalculate the TMTP every two years we applied to recalculate and the PRA granted approval in December 2017, but the PRA will not review our detailed methodology until later in 2018. The recalculated TMTP of £6.2bn (2016: £7.0bn) is net of amortisation to 31 December 2017.

 

The liabilities include a Risk Margin of £5.9bn (2016: £6.4bn) which represents an allowance for the cost of capital for a purchasing insurer to take on the portfolio of liabilities and residual risks that are deemed to be not hedgeable under Solvency II. This is calculated using a cost of capital of 6% as prescribed by the European Insurance and Occupational Pensions Authority (EIOPA).

 

The Solvency 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 to which they are exposed.

 

All material EEA insurance firms, including Legal & General Assurance Society Limited (the LGAS), Legal & General Insurance Limited, and Legal & General Assurance (Pensions Management) Limited are incorporated into the group's Solvency II Internal Model assessment of required capital, assuming diversification of the risks between and within those firms. These firms, as well as the non-EEA insurance firm (Legal & General Reinsurance Company Limited (LGRe) based in Bermuda) contribute over 97% of the group's SCR.

 

Firms for which the capital requirements are less material are valued on a Solvency II Standard Formula basis. Firms which are not regulated but which carry material risks to the group's solvency are modelled in the Internal Model on the basis of applying an appropriate stress to their net asset value.

 

Legal & General America's Banner Life and its subsidiaries (LGA) are incorporated into the calculation of group solvency using a Deduction and Aggregation basis. All risk exposure in these firms is valued on a local statutory basis, with capital requirements set to a multiple of local statutory Risk Based Capital (RBC) and further restrictions on the surplus contribution to the group. The US regulatory regime is considered to be equivalent to Solvency II by the European Commission. The contribution to group SCR is 150% of the local Company Action Level RBC (CAL RBC). The contribution to group's Own Funds is the SCR together with any surplus capital in excess of 250% of CAL RBC.

 

All non-insurance regulated firms are included using their current regulatory surplus.

 

Allowance is made within the Solvency II balance sheet for the group's defined benefit pension schemes using results on an IFRS basis. Within the SCR an allowance is made by stressing the IFRS result position using the same Internal Model basis as for the insurance firms.

 

The impact of the risk transfer agreement with the ReAssure division of Swiss Re has been reflected in the calculation of Own Funds. Due to the proximity of the transaction to the year end the model change required to reflect the impact of the agreement on the SCR has not been made.  The change is expected in H1 2018. The impact of recognising the risk transfer in Own Funds is to reduce the reported coverage ratio by 2%. Once the model change is implemented the coverage ratio is expected to improve by an estimated 2%. It is expected that there will be a further improvement in the group's coverage ratio in 2019 when the Part VII transfer is finalised.

 

 

Capital and Investments                                                                                                               Page 71

 

5.01 Group regulatory capital - Solvency II (continued)

 

(c) Assumptions

 

The calculation of the Solvency II balance sheet and associated capital requirements 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 underlying the group's IFRS disclosures, but with the removal of any prudence margins. Future investment returns and discount rates are those defined by EIOPA, which means that the risk free rates used to discount liabilities are market swap rates, with a 10 basis points (2016: 17 basis points) deduction to allow for a credit risk adjustment for sterling denominated liabilities. For annuities that are eligible, the liability discount rate includes a Matching Adjustment. This Matching Adjustment varies between LGAS and LGRe and by the currency of the relevant liabilities.

 

At 31 December 2017 the Matching Adjustment for UK GBP was 106 basis points (31 December 2016: 124 basis points) after deducting an allowance for the EIOPA fundamental spread equivalent to 51 basis points (31 December 2016: 58 basis points). The reduction in Fundamental Spread is driven by change in the factors supplied by EIOPA and changes in the asset portfolio which have improved the overall credit quality.

 

(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.

 

 

(d) Analysis of change

 

Operational Surplus Generation is the expected surplus generated from the assets and liabilities in-force at the start of the year. It is based on real world assumed returns and best estimate non-market assumptions. It includes the impact of management actions to the extent that, at the start of the year, these were reasonably expected to be implemented over the year.

 

New Business Strain is the cost of acquiring, and setting up Technical Provisions and SCR capital (net of any premium income), on actual new business written over the year. It is based on economic conditions at the point of sale.

The table below shows the movement (net of tax) during the financial year in the group's Solvency II surplus.
		2017	2016
		£bn	£bn
Surplus arising from back-book (including release of SCR)		1.3	1.2
Release of Risk Margin1		0.4	0.3
Amortisation of TMTP2		(0.4)	(0.3)
Operational Surplus Generation3		1.3	1.2
New Business Strain		(0.1)	(0.1)
Net Surplus Generation		1.2	1.1
Dividends paid4		(0.9)	(0.8)
Operating variances5		0.4	0.2
Market movements6		-	(0.3)
Subordinated debt7		0.5	-
Total Surplus movement (after dividends paid in the year)		1.2	0.2
1. Based on the risk margin in force at the end of 2017 and does not include the release of any risk margin added by new business written in 2017.
2. TMTP amortisation based on a linear run down of the end-2016 TMTP of £5.9bn (net of tax, £7.0bn before tax) which was management's estimate of the TMTP on end-2017 market conditions.
3. Release of surplus generated by in-force business and includes management actions which at the start of the year could have been reasonably expected to take place. For 2017 these are to deliver further eligible assets and liabilities into the Matching Adjustment portfolio in respect of a small amount of pension risk transfer business and an increase in direct investments allocation to the annuity back-book.
4. Dividends paid are the amounts from the 2016 final and 2017 interim dividend declarations paid in 2017 (2016: 2015 final and 2016 interim dividend declarations).
5. Operating variances include the impact of experience variances, changes to valuation and capital calibration assumptions, changes to planned volumes of new business, tax rate changes, PRA approval of changes to the Internal Model and Matching Adjustment and other management actions including changes in asset mix, Matching Adjustment optimisation, hedging strategies, M&A activities (sale of Mature Savings, Legal & General Netherlands and Cofunds) and update to the longevity assumptions.
6. Market movements represents the impact of changes in investment market conditions over the period and changes to future economic assumptions. It also includes the capital impact of investment portfolio changes implemented by LGC. Market movements in 2017 include a reduction in the Risk Margin of £0.2bn (net of tax). 31 December 2016 included an increase in the Risk Margin of £1.1bn (net of tax) offset by an increase in the estimated TMTP of £1.0bn (net of tax).
7. Movement in subordinated debt includes $1.35bn US Dollar subordinated notes issued and £0.6bn of sub-debt redeemed.

 

 

Capital and Investments                                                                                                               Page 72

 

5.01 Group regulatory capital - Solvency II (continued)
(e) Reconciliation of IFRS Net Release from Operations to Solvency II Net Surplus Generation
(i) The table below provides a reconciliation of the group's IFRS Release from Operations to Solvency II Operational Surplus Generation.
			2017	2016
			£bn	£bn
IFRS Release from Operations			1.3	1.3
Expected release of IFRS prudential margins			(0.5)	(0.5)
Releases of IFRS specific reserves1			(0.1)	(0.1)
Solvency II investment margin2,3			0.2	0.2
Release of Solvency II Capital Requirement and Risk Margin less TMTP amortisation4			0.4	0.4
Other Solvency II items and presentational differences			-	(0.1)
Solvency II Operational Surplus Generation			1.3	1.2
1. Release of prudence from IFRS specific reserves which are not included in Solvency II (e.g. long term expenses and longevity margins).
2. Release of prudence related to differences between the EIOPA-defined fundamental spread and L&G's best estimate default assumption.
3. Expected market returns earned on LGR's free assets in excess of risk free rates over 2017.
4. Solvency II Operational Surplus Generation includes management actions which at the start of 2017 were expected to take place within the group plan.
(ii) The table below provides a reconciliation of the group's IFRS New Business Surplus to Solvency II New Business Strain.
			2017	2016
			£bn	£bn
IFRS New Business Surplus			0.2	0.2
Removal of requirement to set up prudential margins above best estimate on New Business1			0.2	0.5
Set up of Solvency II Capital Requirement on New Business2			(0.3)	(0.7)
Set up of Risk Margin on New Business3			(0.2)	(0.1)
Solvency II New Business Strain			(0.1)	(0.1)
1. Release of margin was higher in 2016 primarily due to the acquisition of bulk-annuity liabilities from Aegon.
2. The lower SCR for 2017 new business strain reflects both premiums written and the success of our strategy to source direct investments (including lifetime mortgages) to back new annuity sales.
3. Risk Margin in 2016 is net of Estimated TMTP attached to the acquisition of bulk-annuity liabilities from Aegon.

 

(f) Reconciliation of IFRS shareholders' equity to Solvency II Own Funds

A reconciliation of the group's IFRS shareholders' equity to Own Funds is given below:
			2017	2016
			£bn	£bn
IFRS shareholders' equity			7.8	6.9
Remove DAC, goodwill and other intangible assets and liabilities			(1.9)	(2.1)
Add IFRS carrying value of subordinated debt treated as available capital under Solvency II1			2.9	2.5
Insurance contract valuation differences2			7.4	7.9
Difference in value of net deferred tax liabilities			(0.6)	(0.5)
SCR for with-profits fund and final salary pension schemes			(0.7)	(0.7)
Other3			(0.2)	(0.3)
Eligibility restrictions4			(0.1)	(0.1)
Own Funds5			14.6	13.6
1. Treated as available capital on the Solvency II balance sheet as the liabilities are subordinate to policyholder claims.
2. Differences in the measurement of technical provisions between IFRS and Solvency II.
3. Reflects valuation differences on other assets and liabilities, predominately in respect of borrowings measured at fair value under Solvency II.
4. Relating to the Own Funds of non-insurance regulated entities that are subject to local regulatory rules.
5. Own Funds do not include an accrual for the dividend of £658m (2016: £616m) declared after the balance sheet date.

 

 

Capital and Investments                                                                                                               Page 73

 

5.01 Group regulatory capital - Solvency II (continued)
(g) Sensitivity analysis   The following sensitivities are provided to give an indication of how the group's Solvency II surplus as at 31 December 2017 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	Impact on	Impact on
			net of tax	net of tax	net of tax	net of tax
			Solvency II	Solvency II	Solvency II	Solvency II
			capital	coverage	capital	coverage
			surplus7	ratio7	surplus	ratio
			2017	2017	2016	2016
			£bn	%	£bn	%
Credit spreads widen by 100bps assuming an escalating addition to ratings1,2			0.2	8	0.2	7
Credit spreads narrow by 100bps assuming an escalating addition to ratings1,2			(0.3)	(9)	(0.2)	(7)
Credit migration3			(0.5)	(6)	(0.6)	(8)
25% rise in equity markets4			0.5	5	0.5	6
25% fall in equity markets4			(0.5)	(5)	(0.5)	(6)
15% fall in property markets			(0.4)	(4)	(0.2)	(3)
15% rise in property markets			0.3	4	0.2	3
100bps increase in risk free rates			0.8	20	1.0	22
50bps decrease in risk free rates5			(0.5)	(10)	(0.5)	(10)
Substantially reduced Risk Margin6			0.1	1	0.1	1
1. The spread sensitivity applies to all assets within the group's holdings where the capital treatment depends on a credit rating (for example corporate bonds and income strips), 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 100 basis points.
3. Credit migration stress covers the cost of an immediate big letter downgrade on 20% of all assets where the capital treatment depends on a credit rating (including corporate bonds and income strips).
4. The +/-25% equity impacts from 2016 were approximated using existing sensitivities.
5. In the interest rate down stress negative rates are allowed, i.e. there is no floor at zero rates.
6. This represents a reduction of two-thirds in Risk Margin and subsequent recalculation of TMTP.
7. The 2017 sensitivities ignore the impact of the Mature Savings business (including the With-Profits fund) as the risks have been transferred to ReAssure division of Swiss Re from 1 January 2018.
The above sensitivity analysis does not reflect all 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. These results all allow (on an approximate basis) for the recalculation of TMTP as at 31 December 2017 where the impact of the stress would cause this to change materially.    The impacts of these stresses are not linear therefore these results should not be used to interpolate or 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 74

 

5.01 Group regulatory capital - Solvency II (continued)
(h) Analysis of Group Solvency Capital Requirement
The table below shows a breakdown of the group's SCR by risk type. The split is shown before the effects of diversification and tax.
			2017	2016
			%	%
Interest Rate			2	4
Equity			6	5
Property			5	5
Credit1			26	25
Currency			3	3
Inflation			4	2
Total Market Risk 2			46	44
Counterparty Risk			1	1
Life Mortality			2	3
Life Longevity3			31	32
Life Mass Lapse			2	2
Life Non-Mass Lapse			3	3
Life Catastrophe			3	4
Expense			3	3
Total Insurance Risk			44	47
Non-life underwriting			2	2
Operational Risk			4	4
Miscellaneous4			3	2
Total SCR			100	100
1. Credit risk is one of the group's most significant exposures, arising predominantly from the portfolio of bonds and bond-like assets 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 Savings business.
3. Longevity risk is the group's most significant insurance risk exposure, arising from the annuity book on which the majority of the longevity risk is retained.
4. Miscellaneous includes LGA on a Deduction and Aggregation basis and the sectoral capital requirements for non-insurance regulated firms.

 

 

Capital and Investments                                                                                                               Page 75

 

5.02 Estimated Solvency II new business contribution
(a) New business by product 1
Management estimates of the present value of new business premium (PVNBP) and the margin for selected lines of business are provided below:
			Contri-			Contri-
			bution			bution
			from new			from new
		PVNBP	business2	Margin3	PVNBP	business2	Margin
		2017	2017	2017	2016	2016	2016
		£m	£m	%	£m	£m	%
LGR - UK annuity business		4,083	346	8.5	6,661	693	10.4
UK Protection Total		1,496	129	8.6	1,466	153	10.4
- Retail Protection		1,293	111	8.6	1,255	139	11.1
- Group Protection		203	18	8.7	211	14	6.6
US Protection4		764	89	11.7	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. Margin is based on unrounded inputs.
4. In local currency, US Protection reflects PVNBP of $985m (2016: $855m) and a contribution from new business of $115m (2016: $106m).
The change in LGR margin reflects differences in the mix of new business. In particular, 2017 margin includes a £250m scheme where the group passes on all of the risk and retains a small facilitation fee. We have maintained a strong pricing discipline in a competitive market.   In the UK Protection business, the increase in the Solvency II new business margin on Group Protection is more than offset by a reduction in the margin on new Retail Protection products, which is caused by competitive pressure and a change in mix towards lower margin products.   The new business contribution from US Protection has increased by 14% following a significant increase in new business sales. The Solvency II new business margin has reduced in the year as a result of competitive pricing movements during the year resulting in the higher new business volumes.

 

 

Capital and Investments                                                                                                               Page 76

 

5.02 Estimated Solvency II new business contribution (continued)

 

(b) Assumptions

 

 

The key economic assumptions as at 31 December 2017 are as follows:

		%
Margin for risk		3.0
Risk free rate
- UK		1.6
- US		2.4
Risk discount rate (net of tax)
- UK		4.6
- US		5.4
Long-term rate of return on non-profit annuities in LGR		3.0

 

The future earnings are discounted using duration-based discount rates, which is the sum of a duration-based risk free rate and a flat Margin for Risk.  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.

 

Other than updating for recent experience, 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 previously used by the group for its European Embedded Value reporting, 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 18 basis points.

 

·      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 19.25% 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 grossed up using the long term corporate tax rate of 21%.

 

 

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5.02 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 European Embedded Value (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 the period, recognising that the statutory solvency in the UK is now on a Solvency II basis.  It has been calculated in a manner consistent with EEV principles.

 

Solvency II new business contribution has been calculated for the group's most material insurance-related businesses, namely, LGR, LGI 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 2017.

 

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.  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 expected impact of LGA directly-written business at group level (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 Margin for Risk, 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 10 basis points for GBP and for USD (2016: 17 basis points for GBP and 15 basis points for USD).

 

The Margin for Risk 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.

 

 

Capital and Investments                                                                                                               Page 78

 

5.02 Estimated Solvency II new business contribution (continued)

 

(c) Methodology (continued)

 

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.

 

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 17.5% (2016: 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) Reconciliation of PVNBP to gross written premium
A reconciliation of PVNBP and gross written premium is given below:
			2017	2016
			£bn	£bn
PVNBP			6.3	8.8
Effect of capitalisation factor			(2.0)	(1.8)
New business premiums from selected lines			4.3	7.0
Other			2.4	1.9
Total LGR and LGI new business			6.7	8.9
Annualisation impact of regular premium long-term business			(0.2)	(0.1)
IFRS gross written premiums from existing long-term insurance business			2.8	2.5
IFRS gross written premiums from Savings business2			-	0.1
Deposit accounting for lifetime mortgage advances			(1.0)	(0.6)
General Insurance gross written premiums			0.4	0.3
Future premiums on longevity swap new business			(0.8)	(0.9)
Total gross written premiums			7.9	10.2
1. Other principally includes annuity sales in the US, lifetime mortgage advances and discounted future cash flows on longevity swap new business.
2. This excludes gross written premiums from discontinued operations.