Setting new standards - Friends Life

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