Setting new standards - Friends Life

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FINANCIAL STATEMENTS IFRS FINANCIAL STATEMENTS EEV SUPPLEMENTARY INFORMATION Notes to the consolidated accounts continued 30. Risk management objectives and policies for mitigating risks continued (a) Market risk Market risk includes equity and property risk, foreign exchange risk and interest rate risk. The Group manages market risk attaching to assets backing specific policyholder liabilities and to assets held to deliver income and gains for the shareholder. Within the unit-linked funds and with-profits funds, the Group manages market risk so as to provide a return in line with the expectations of policyholders. The principal objective for shareholder assets is to manage them so that they meet the capital requirements of the Group, and support its future strategic and operational objectives. Appetite for market risk varies for different asset classes and by the nature of the liabilities or funds that they represent. For example, in the Life & Pensions business, in relation to equity risk, appetite varies from taking on the risk when it is beneficial to do so for shareholder earnings at risk from annual management charges on unit-linked policies to avoiding risk wherever possible for assets backing non-linked, non-profit policies. For assets backing policyholder liabilities, market risk is managed by matching, where possible, the duration and profile of assets to the policyholder liabilities they are backing. This helps manage market risk to the extent that changes in the values of assets are matched by a corresponding movement in the values of liabilities. Market risk arises on guarantees and options offered on certain of the Group’s products. As described within the section on policyholder liabilities (see note 27), the Group is exposed to guarantees on bonus additions that become more valuable as investment values fall. In addition, the Group is exposed to guaranteed cash and annuity options on certain pension policies that become more valuable as interest rates fall. Shareholders’ earnings are further exposed to market risk to the extent that the income from policyholder funds is based on the value of financial assets held within those unit-linked or with-profits funds. Within F&C, there is no net market risk in relation to customer assets because the risk is fully borne by the clients concerned. Other assets and liabilities do not expose the Asset Management business to significant market risk. F&C actively pursues market risk in relation to the impact on management fees of movements in market variables such as equity prices and interest rates. The following summarises the key actions undertaken by the Group to manage all aspects of market risk: The Group Board Investment Committee oversees investment policy and strategy, which the Group actions primarily through the use of investment fund mandates. Day-to-day implementation of investment policy and strategy is managed predominantly by F&C in line with these approved mandates, subject to robust monitoring by the Group. Mandates are set for each relevant fund within each of the insurance legal entities within the Group taking account of the relevant factors outlined above. Unit-linked funds are managed in line with their underlying objectives. The mandates set limits on the level of market risk permitted using some or all of the following mechanisms: • defined performance benchmarks • a maximum proportion of the fund that can be held in equities and, for with-profits funds, a minimum level • restrictions on the size of companies within which equity investment can be held (eg potentially restricting UK equity to FTSE 100 stocks) • defined asset allocations between UK and overseas equity exposure in specific regions • restrictions on the variation of the duration of the portfolio of bonds from the benchmark duration. Equity derivatives are permitted to be held to facilitate efficient portfolio management or to reduce investment risk (without disproportionately increasing other types of risk), and appropriate approval must be obtained for their use. Currency forwards and other derivatives may be held to manage currency risk, but only if permitted by individual fund mandates. In addition to the mandates, the Group undertakes a programme of asset/liability management. For example, in order to manage the impact of interest changes on profit, corporate bonds and gilts are held to match the duration of annuity and permanent health insurance policies. This provides matching of cash flows and valuation movements and is supplemented by the use of interest rate swaps to improve asset/liability matching as necessary. 144 Friends Provident Annual Report & Accounts 2006
PARENT COMPANY ACCOUNTS ABBREVIATIONS AND DEFINITIONS Notes to the consolidated accounts continued 30. Risk management objectives and policies for mitigating risks continued In order to manage the exposure arising from guarantees and options, the Group purchases a number of derivatives, including interest rate swaps, equity put options, interest rate swaptions, and equity futures to manage exposures to movements in equity prices or interest rates. Hedge accounting has not been applied to these derivatives, as movements in the fair value of these instruments will be offset by the movement in the valuation of the liability. As noted, the majority of these guarantees arise within FPLP’s With-Profits Fund and so any net fair value movement will be reflected in the FFA rather than within shareholders’ funds. The following provides additional information on the exposure to equity and property risk, foreign exchange risk and interest rate risk: (i) Equity and property risk For with-profits and unit-linked policies, the policyholders bear the majority of the investment risk and any change in asset values is matched by a broadly equivalent change in the liability. Shareholder funds invest in equities and are subject to risk from fluctuation in their value. Charges which are expressed as a percentage of fund are also impacted. The approximate impact of a 10% change in equity and property values on post-tax shareholder profits and equity is £53m (2005: £72m). (ii) Foreign exchange risk The Group invests in financial instruments denominated in currencies other than its measurement currency (pounds sterling). Consequently, the Group is exposed to the risk that the exchange rate of its presentation currency relative to other currencies may change in a manner that has an adverse effect on the value of the Group’s financial assets and liabilities. For unit-linked contracts, currency risk is borne by the policyholder. As noted above, the shareholders are subject to currency risk only to the extent that income from policyholder funds is based on the value of the financial assets held in those funds. The liability for non-linked insurance contracts in currencies other than sterling is immaterial. The impact of exchange rate movements on F&C is minimised by repatriation of excess foreign currency funds to sterling, and by holding regulatory capital in the local currency. (iii) Interest rate risk The Group is exposed to fair value interest rate risk where changes to interest rates result in changes to fair values rather than cash flows, for example fixed interest rate loans and assets and derivatives that convert floating rate interest payments to fixed rates. Conversely, floating rate loans and derivatives that convert fixed interest rates to floating rates expose the Group to cash flow interest rate risk. The following table shows effective interest rates for those financial instruments held at amortised cost and hence where such a rate is deemed applicable. Assets 2006 2005 % % Cash and cash equivalents 4.56 4.64 Liabilities £215m Undated subordinated guaranteed bonds - 9.13 £260m Floating rate subordinated loan notes 6.75 - £380m Floating rate secured notes 4.95 4.98 £230m Secured bonds 5.23 5.23 £290m Convertible bonds 5.25 5.25 Bank overdrafts 5.64 5.63 If interest rates increased by 1% across the whole yield curve there would be a fall in the value of fixed interest assets but the discount rate for valuing liabilities would be increased to partially offset the impact. The net effect of a 1% increase in interest rates at all terms would reduce post-tax profit and equity by about £92m (2005: £86m). The impact of a 1% reduction in interest rates would be to increase post-tax profit and equity by about £110m (2005: £79m). The following table indicates the contractual re-pricing dates for the Group’s significant financial assets and liabilities and insurance and investment contracts that are exposed to interest rate risk (there were no instances where the re-pricing dates were before maturity dates). Assets and liabilities held within unit-linked funds where all financial risks are borne by the policyholder are excluded from the table below, as are any assets not directly exposed to interest rate risk. Friends Provident Annual Report & Accounts 2006 145
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Friends Provident plc Pixham End Do
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