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 (b) Policy cash flow risk (including insurance risk) Policy cash flow risk consists of the following four main areas: Insurance risks: • mortality risk – risk of loss arising due to policyholder deaths experience being different from expectations; or for annuities, risk of annuitants living longer than expected (called annuity longevity risk); • morbidity risk – risk of loss arising due to policyholder health experience being different from expectations; Other risks: • policyholder decision risk – risk of loss arising from experience of actual policyholder behaviour (eg lapses, option take-up) being different from expectations; • expense risk – risk of loss due to expense experience being different from expectations. The Life & Pensions business actively pursues mortality risk and morbidity risk in those areas where it believes it has a competitive advantage in managing these risks to generate shareholder value (without compromising the interests of policyholders, and the need to treat customers fairly). Policyholder decision risk and expense risk are taken on when it is deemed financially beneficial for the organisation to do so, or where the taking of these risks is in support of the Group’s strategic objectives. Underpinning the Group’s management of policy cash flow risk is: • adherence to an approved underwriting policy that takes into account the level of risk that the Group is prepared to accept; • controls around the development of products and their pricing; and • regular analysis of actual mortality, morbidity and lapse experience which feeds into the development of products and policies. Risks in excess of agreed underwriting limits may be reinsured. The Group’s objective is to purchase reinsurance in the most cost-effective manner from reinsurers whose creditworthiness is deemed appropriate. Substantially all insurance contracts, and 60% of the combined insurance and investment contract portfolio, are written in the UK and so results are sensitive to changes in the UK insurance market and tax regime. Otherwise the Group sells a diverse range of products to a diverse group of people. Note 27 describes the main insurance contracts written by the Group and the basis of setting assumptions in measuring insurance liabilities which will take into account the risks above. The following sections describe how policy cash flow risks are managed and provide an indication of the sensitivity of reported profit to the risk. Each sensitivity has been calculated independently of the remaining risks (ie correlations between risks have been ignored). F&C insurance contracts are all annuity contracts with guaranteed payment during the life time of the annuitant at a specified level or with a specified escalation factor. They are 100 per cent reinsured to Friends Provident Pensions Limited. (i) Mortality and morbidity risk Life assurance Most insurance policies other than annuities and deferred annuity policies include life assurance. When pricing policies, an assumption is made as to the likelihood of death and this assumption is reviewed as part of the annual valuation of policies. To the extent that actual mortality experience is worse than that anticipated in pricing (and subsequently in the insurance liability valuation) a loss will be made. The risk is greater for those policies such as term assurance where the maturity or surrender benefit is small in relation to the death benefit. Other policies which have a savings element, such as endowment assurance have significant liabilities relating to the maturity benefit, particularly as the policy approaches maturity. Contractual terms for unit-linked and unitised with-profits products include provision for increases in mortality charges. Critical illness The Group writes a number of critical illness policies that pay out in the event of a policyholder’s ill health. As for life assurance, the amount payable on ill health can be significantly higher than the amount payable if the policy is surrendered. An increase in experienced mortality and morbidity will reduce IFRS profit. A 5% increase in assurance mortality and critical illness experience will reduce post-tax profit and equity by £19m (2005: £26m) before allowing for reinsurance and £8m (2005: £6m) net of reinsurance. This takes into account the impact from increasing the provision for future mortality as well as the impact from actual experience. A 5% reduction in assurance mortality and critical illness experience would increase post-tax profit and equity by £18m (2005: £22m) before reinsurance and £7m (2005: £4m) net of reinsurance. Income protection Income protection policies pay a regular level of benefit if the policyholder is unable to work due to incapacity for more than a specified period. The two main risks involved are an increase in the frequency of claims (the inception rate) and an increase in the average length of the claim (a reduction in recovery rate). Most income protection policies are regular premium with the premium and cover fixed at inception. Some group policies allow premiums to be reviewed but the premium rates are usually guaranteed for three years. The impact of inception rates increasing by 5% and recovery rates reducing by 5% would be a £21m (2005: £45m) reduction in post-tax IFRS profit and equity. A 5% reduction in inception rates and a 5% increase in recovery rates would increase post-tax profit and equity by about £11m (2005: £33m). The impact assumes that the reserving basis is adjusted to reflect the change in experience. Annuities Life annuities are contracts that, in return for a lump sum, pay a regular amount (usually monthly or annually and sometimes increasing at a fixed or index-linked rate), until the death of the policyholder. As a result, if annuitants live longer than expected on average, profits will reduce. In many cases the annuity is guaranteed payable for a fixed term (usually five years) even in the event of death. Many policies are written on joint lives so that when the first life dies the benefit continues, sometimes at a reduced level. These features tend to reduce the volatility of results to random fluctuations in experience but not the impact of a general increase in longevity. 148 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 Deferred annuities are contracts whereby there is a promise to pay a life annuity starting from a specified date in the future. These policies are subject to a similar risk from the impact of longevity, the only difference being that the risk of adverse impact is greater given that the annuity is payable further into the future. However, most of these policies are with-profits and the impact would be offset by a reduction in the FFA, with relatively little resulting impact on shareholder profits. A 5% reduction in annuitant mortality would reduce post-tax IFRS profit and equity by £31m (2005: £32m). This takes into account the impact from increasing the provision for future mortality as well as the impact from paying more annuity than expected. A 5% increase in expected annuitant mortality would increase post-tax profit and equity by £28m (2005: £29m). These impacts assume that the reserving basis changes to reflect experience. The impact of a mortality shock on term assurance business would normally be at least partially offset by a favourable impact on the annuity book. (ii) Policyholder decision risk Persistency experience varies over time as well as from one type of contract to another. Factors that will cause lapse rates to vary over time include changes in investment performance of the assets underlying the contract where appropriate, regulatory changes that make alternative products more attractive, customer perceptions of the insurance industry in general and the Group in particular, and the general economic environment. The immediate impact on IFRS profit of a change in lapse rates is relatively small. An increase in lapse rates will normally result in a small reduction in profit due mainly to eliminating the deferred acquisition cost asset in respect of the insurance contracts that lapse. However the impact is much smaller than the effect of other factors considered here. Lapses have a more significant effect on the Group’s other basis of measurement – being EEV profit. The valuation of the Group’s guarantees and options is described in note 27. As stated in that note, the cost of guaranteed annuity options is dependent on decisions made by policyholders such as policy discontinuance and tax-free cash take-up. These assumptions are set by reference to recent experience. (iii) Expense risk Though under IFRS 4 expense risk is not a component of insurance risk, it is an important financial risk in the context of insurance and investment contracts. The whole of the impact of changes in expense levels is borne by shareholders with the following exceptions. In 2009 the charges made to the FPLP With-Profits Fund for managing policies will be reviewed to reflect market rates at the time. Pre-demutualisation with-profits policyholders will bear the impact of any resulting changes to charges. Also FPLA closed fund with-profits policyholders bear the full expense risk for the fund. Contractual terms for unit-linked and unitised with-profits products include provision for increases in charges. Certain expenses (such as fees/commissions) are fixed at the time a contract is written. If the remaining renewal expenses were to increase by 10%, the impact on post-tax profits and equity would be approximately £15m (2005: £14m). (c) Credit risk Credit risk can be described as the risk of loss due to the default of a company, individual or country, or a change in investors’ risk appetite. It includes investment credit risk, derivative and reinsurance counterparty risks, deposit and loan risks. The Life & Pensions business will take on investment credit risk and loan risk when it is deemed financially beneficial to do so in support of the Group’s strategic objectives (eg on making an investment decision between two corporate bonds of differing credit quality, the default risk of the lower rated bond would be weighed up against the additional yield gained with a view to ensuring that the expected reward exceeded the potential cost of the default risk). F&C actively pursues credit risk in relation to the impact on management fees of credit events. The Group is averse to most other types of credit risk, in particular that related to the default of derivative counterparties, reinsurers and deposit takers. To mitigate credit risk: • Investment mandates for many funds will have a prescribed minimum credit rating of bonds that may be held. Investing in a diverse portfolio reduces the impact from individual companies defaulting. • Counterparty limits are set for investments, cash deposits, foreign exchange trade exposure and stock lending. • All derivative transactions are covered by collateral and derivatives are only taken out with counterparties with a suitable credit rating. • The Group regularly reviews the financial security of its reinsurers. In F&C, credit risk (including derivative counterparty risk) is managed by the application of a strict investment policy designed to limit exposure to companies with poor credit ratings and to avoid undue investment with any single counterparty. Regular meetings are held to consider credit developments and all credit exposures are reviewed at least annually. Collateral is not usually obtained for credit risk exposures on derivative instruments, except where margin deposits are required from counterparties. The Group is subject to the risk of increases in credit spreads reducing the value of corporate bonds. Bases for valuing liabilities will reflect bond yields, reduced for default risk. To the extent that the increase in credit spreads reflects an increase in actual default rates, this will result in a reduction in profits. A 0.25% pa increase in average credit spread which is reflected by an increase in actual defaults will reduce post-tax profit and equity by £60m (2005: £70m). Friends Provident Annual Report & Accounts 2006 149
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Setting new standards Friends Provi
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ANNUAL REVIEW CORPORATE GOVERNANCE
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Group financial highlights Group
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INTERNATIONAL LIFE & PENSIONS ASSET
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