principles and practices of financial management. - Legal & General

LEGAL & GENERAL REPORT TO POLICYHOLDERSPRINCIPLES AND PRACTICESOF FINANCIAL MANAGEMENT.LEGAL & GENERALASSURANCE SOCIETY LIMITED.REPORT ON COMPLIANCE FOR 2009.INSURANCE. SAVINGS.INVESTMENT MANAGEMENT.

PRINCIPLES AND PRACTICES OF FINANCIAL MANAGEMENT – REPORT ON COMPLIANCE FOR 20092INTRODUCTIONThe Board of Legal & General Assurance Society (the Society Board) published its Principles andPractices of Financial Management (PPFM) for its with profits business on 30 April 2004. RevisedPPFMs were published on 29 June 2005, 29 June 2007 and 31 December 2007.Each year, the Society Board must report to with profits policyholders on compliance with itsobligations relating to the PPFM. This report covers governance arrangements; exercise of discretion;compliance with the PPFM; competing or conflicting rights, interests and expectations; and includesstatements from the independent assessor and the With Profits Actuary.The report covers the period from 1 January 2009 to 31 December 2009 inclusive, plus the bonusdeclaration for the year ending 31 December 2009, which was announced on 18 February 2010.Defined terms in this report have the meaning set out in the PPFM published on 31 December 2007.GOVERNANCE ARRANGEMENTSThe following statements relate to the governance arrangements and systems and controls in placeover the period 1 January 2009 to 31 December 2009 and at the time of the 18 February 2010 bonusdeclaration.The Legal & General Group Board has overall responsibility for the Group’s internal control systemsand for monitoring their effectiveness. Implementation and maintenance of the internal controlsystems are the responsibility of the executive directors and senior management. The performanceof internal control systems was reviewed regularly by the Audit Committee, the Group Risk andCompliance Committee (GRCC) and the boards and risk committees of subsidiary companies,including the Society Board. The Group’s control policies and procedures were set out in an operatingmanual, which was regularly updated and distributed throughout the Group. Executive directors wererequired to confirm compliance with these policies.The GRCC met in February, June, September and December 2009 and was chaired by the Group ChiefExecutive. All executive directors of the Group were members. In addition, senior managers drawnfrom across the Group were regular attendees. Its primary role was to ensure there were appropriateprocesses in place across the Group to identify, assess, monitor and control critical risks facing theGroup, including regulatory risks.In order to provide more detailed management of risks, the following sub-committees of the GRCCwere in place:Group Capital Committee – to assess the capital requirements (including the risk-based capitalrequirements) of the Group; to monitor the sources of capital available to meet these requirementsand oversee the allocation of capital to firms.Group Counterparty Credit Committee – to set limits for the Group’s exposure to any singlecounterparty failure and to manage exposures within these established limits.Group Investment and Market Risk Committee – to ensure that investments supporting the UKinsurance business were appropriately managed.Group Insurance Risk Committee – to ensure that products for the UK businesses were appropriatelydesigned and priced, that product legal risks were assessed and that appropriate processes were in placeto identify, assess, monitor and, where deemed appropriate, reinsure risk.Group Operational Risk Assessment Committee – to ensure consistency in approaches to operationalrisk management across the Group.Bonus declaration decisions were made by the Society Board. These decisions were subject toratification by the Legal & General Group Board.

PRINCIPLES AND PRACTICES OF FINANCIAL MANAGEMENT – REPORT ON COMPLIANCE FOR 20093EXERCISE OF DISCRETIONThe main areas in which discretion is exercised in the operation of with profits business areinvestment policy; setting of bonus rates; proportion of distributed surplus allocated to shareholders;setting of surrender values; new business terms and volumes; apportionment of expenses;investment management arrangements; changes to reviewable terms under policies; changesto the PPFM; policyholder communications on relevant issues.Investment policyInvestment policy was subject to review by the Group Investment and Market Risk Committee.Following the turbulence seen in investment markets worldwide during 2008, markets continued tofall in the early months of 2009 leading to further reductions in the value of the With Profits Fund’sequity, property and corporate bond holdings.In order to limit the impact of further equity market falls on the With Profits Fund’s capital position,the higher level of equity hedging maintained in the Inherited Estate established during 2008continued during the early part of 2009. Later in the year as equity markets rose the level of equityhedging was reduced accordingly but a short position in corporate bonds was established in theInherited Estate in order to reduce the impact of widening credit spreads on the With Profits Fund’scapital position. In addition, in the latter part of the year certain derivative contracts were enteredinto in order to reduce exposure to property market movements within asset shares and in orderto establish a partial hedge against the impact of these movements on the Inherited Estate.Significant holdings of equities and property were maintained within policyholder asset shares overthis period, albeit at reduced levels following market falls seen in 2008, consistent with the objectiveof maintaining a balance between risk and reward for groups of policies and the With Profits Fundas a whole. The value of the equity holdings rose materially over the latter part of the year as equitymarkets recovered worldwide.There were no other significant changes to investment strategy for the With Profits Fund overthis period.Setting of bonus ratesDue to the recovery in equity and credit markets seen during 2009 and the resulting reduction inpayout ratios the Society Board decided that it was not necessary to implement an interim bonusdeclaration during the year.When setting bonus rates at the 19 February 2009 bonus declaration, the Society Board took intoaccount the falls seen in most major investment markets during 2008 and the further reductions seenearly in 2009. The bonus declaration as at 18 February 2010 allowed for the impact of investmentreturns to 31 December 2009. The approach to smoothing used at this declaration allowed for thefact that the impact of market falls early in 2009 had already been taken account of at the earlierdeclaration. Decisions on annual and final bonus rates were again guided by the smoothingformulae used in recent declarations.All bonus decisions were made by the Society Board after receiving advice from the With ProfitsActuary. These decisions were then subject to ratification by the Legal & General Group Board.Shareholder transfer proportionThe Society Board decided to maintain a shareholder transfer proportion of 10% of distributedsurplus from the With Profits Fund and to charge additional tax due in respect of the shareholdertransfer to the Inherited Estate of the With Profits Fund.Setting of surrender valuesThe appropriateness of surrender values was regularly monitored over the period, in line withthe approach agreed at the Group Insurance Risk Committee. Surrender values and Market ValueReduction Factors were changed during the year, having regard principally to movements in thevalue of the underlying investments.

PRINCIPLES AND PRACTICES OF FINANCIAL MANAGEMENT – REPORT ON COMPLIANCE FOR 20094New business terms and volumesPricing terms for new business written in the With Profits Fund were subject to prior approval at theGroup Insurance Risk Committee. In the judgement of that committee, the terms struck an appropriatebalance between profitability (including required support from the Inherited Estate), value for money forcustomers, and capital requirements.Apportionment of expensesExpense apportionment between the With Profits Fund and the remainder of the Long Term Fund,and between different products, continued to follow the established approach.Judgements as to the level of support from the Inherited Estate for existing business, for example bylimiting the amount of transfer to shareholders or expenses deducted from policies when determininglevels of benefits, were taken by the Society Board in advance of the main bonus investigationexercise. In general, decisions relating to these matters were made at the product launch date (or dateof subsequent review) by the Group Insurance Risk Committee, but certain decisions, such as thetreatment of exceptional expenses, were made later.Investment management arrangementsOn 1 July 2007 changes to the Society’s investment management arrangements were introduced.With effect from this date the fees payable to Legal & General Investment Management Limited wereincreased, moving from a cost recovery basis to a scale of charges set by reference to typical marketfees for the investment services provided. Following these changes the Society gained the discretion,in certain circumstances, to seek investment management services from companies outside the Group.These arrangements remained in place during 2009.Changes to reviewable terms under policiesCertain with profits policies contain terms which can be reviewed at the discretion of the Society.These terms are periodically reviewed in light of prevailing conditions. No such changes were madeduring the period.Changes to the PPFMNo changes were made to the PPFM during 2009.Policyholder communicationsPolicyholders received a statement setting out details of the bonuses added to their investmentsfollowing the 19 February 2009 bonus declaration. They also received information on investmentperformance during 2009, the asset mix applicable to their investment and how investmentperformance affects bonus rates and surrender values.COMPLIANCE WITH THE PPFMIn the opinion of the Society Board it has complied with its PPFM over the period 1 January 2009to 31 December 2009, and as at the 18 February 2010 bonus declaration.Reasons for reaching this conclusion are presented in detail below.The amount payable under a with profits policyThe bonus reports presented to the Society Board provided evidence that the bonus methodology wasbased around the stated aims, and followed the approach set out in the PPFM. The proposed futureinvestment assumptions, together with material changes to other assumptions, were presented tothe Society Board for approval. The bonus rates declared demonstrated clear differentiation betweenproduct types and vintages.Investigations presented to the Society Board analysed the finances of the With Profits Fund usinga number of approaches.Regular reports on surrender values and Market Value Reduction Factors were provided to the GroupInsurance Risk Committee throughout the period.The Society’s PPFM contains target ranges for payout ratios on with profits policies. For the majorityof policies the target range for benefits at contractual points is 80% to 120% and for benefits notat contractual points is 75% to 120% of asset share. Analysis of maturity and surrender claims hasconfirmed that the Society complied with its policy on target ranges during 2009.

PRINCIPLES AND PRACTICES OF FINANCIAL MANAGEMENT – REPORT ON COMPLIANCE FOR 20095Investment policyChanges made to investment policy during the year were designed to ensure that the With Profits Fundcontinued to be managed in a manner consistent with the overriding principle that its assets should besufficient to meet its liabilities, whilst maintaining a balance between risk and return for policyholdersand the With Profits Fund as a whole.Asset allocation, counterparty exposure, liquidity (including forecasts) and performance, together withdeviations from benchmarks, were monitored monthly.Business riskThe methodology followed in bonus investigation and surrender value work took account of non-investmentexperience within the With Profits Fund, such as surrender, expense and mortality profits or losses. The workcarried out to investigate non-investment experience grouped together similar policies.Charges and expensesThe calculation of investment management expenses is set out in the Investment Management Agreementbetween Legal & General Investment Management Limited and the Society. A revised approach to theassessment of these charges was introduced with effect from 1 July 2007 and the new approach wasincluded in the 29 June 2007 PPFM.Apportionment of other expenses was subject to external audit.A framework for assessing the level of deductions from asset shares in respect of guarantees and optionswas introduced in the 29 June 2005 PPFM.Financial conditions as at 31 December 2008 meant that a charge for guarantees and options of 0.75% of assetshares was justified under the approach previously communicated to policyholders. However, the assessmentof the guarantee charge and the Society Board decision to take the charge was made after the 2008 bonusdeclaration and so no adjustment was made to bonus rates at this declaration. Surrender values followingthe Board decision were, however, adjusted to allow for the impact of this charge and expected futureguarantee charges.Financial conditions as at 31 December 2009 meant that a refund of 0.4% of asset shares was appropriateunder the approach previously communicated to policyholders. However, the assessment of the guaranteecharge and the Society Board decision to make the refund was made after the 2009 bonus declaration andso no adjustment was made to bonus rates at this declaration. Surrender values following the Society Boarddecision were, however, adjusted to allow for the impact of this refund.Management of the Inherited EstateThe Board had regard to the current and projected financial position of the With Profits Fund in its financialmanagement.The financial effect of writing new business on the With Profits Fund, including any potential support fromthe Inherited Estate for expenses or costs of shareholder transfer or tax, was reported to the Society Board.Volumes of new business and arrangements on stopping taking new businessThe Society’s planning process in relation to new business had regard to insurance market conditions.No specific volume limitations were placed on with profits new business, though with profits new businessvolumes were regularly monitored.The Society remained open to new with profits business throughout the period.Equity between the With Profits Fund and shareholdersAudited accounts provided evidence of the separate treatment of the With Profits Fund. The auditedcalculation of distributed surplus and shareholder transfer from the With Profits Fund was consistentwith the PPFM.Contractual Minimum Addition (CMA)CMA was calculated and applied in line with the formulae set out in the PPFM.COMPETING OR CONFLICTING RIGHTS, INTERESTS AND EXPECTATIONSShareholders and with profits policyholdersTax and expensesIt is financially advantageous to shareholders, but disadvantageous for with profits policyholders, for taxand expenses to be apportioned to the With Profits Fund, rather than other parts of the Long Term Fund.The Society has an established practice of charging to the With Profits Fund an amount of tax calculated

PRINCIPLES AND PRACTICES OF FINANCIAL MANAGEMENT – REPORT ON COMPLIANCE FOR 20097Surrender values were reviewed so that payments to those leaving with profits, other than at contractualpoints, did not materially affect the interests of remaining with profits investors.Terms for new with profits policyholders can influence the benefits of existing policyholders, as theamount of new business, and the terms on which it is written, can affect the overall financial positionof the With Profits Fund. This area was reviewed by the Group Insurance Risk Committee.Judgements as to the level of support from the Inherited Estate for existing business, for example by limitingthe amount of transfer to shareholders, or expenses, deducted from policies when determining levels ofbenefits, were taken by the Society Board in advance of the main bonus investigation exercise, having regardto representations made to with profits policyholders.Exercise of discretion in the setting of investment policy used in the determination of investment returnsapplicable when setting policy benefits, and the split of asset mix between different groups of policies,is carried out by Group Investment and Market Risk Committee, referring to the Society Board whereappropriate. Assets in excess of those either taken into account in the assessment of policy benefits orbacking non-participating business were invested mainly in fixed interest securities in order to make theWith Profits Fund more resilient to falls in the value of investments. Partial hedges against falls in the valueof the With Profits Fund’s equities, corporate bonds and property holdings have also been established in theInherited Estate in order to further enhance the resilience of the capital position of the With Profits Fund.Independent assessmentThe Board asked Nick Dumbreck of Milliman to carry out an independent assessment of compliance with thePPFM and to report on how competing or conflicting rights and interests of policyholders and shareholdershave been addressed. The independent assessor has provided the following statement to be made availableto policyholders.“I have reviewed the management of the Society’s with profits business for the period 1 January 2009 to31 December 2009, including the bonus declaration as at 31 December 2009. On the basis of this review,I am satisfied that the Society complied with its PPFM during that period. I also consider that any competingor conflicting rights and interests of policyholders and shareholders were reasonably addressed.In giving this opinion I have relied upon both written and oral information provided by the Society. I havegenerally accepted the information reviewed without independent verification. In particular I have notchecked the application of various assumptions made, nor the accuracy of the calculations undertaken.I have assumed information provided to me is complete and that there are no significant decisions oractions on the management of with profits business which have not been disclosed to me.”REPORT FROM THE WITH PROFITS ACTUARY“I have been commissioned by the Board, consistent with requirements of FSA regulations, to report topolicyholders on whether the exercise of discretion has been reasonable and proportionate. This reporthas been prepared in accordance with the Board for Actuarial Standard’s Technical Actuarial Standard R:Reporting Actuarial Information.I have reviewed the management of the Legal & General Assurance Society’s With Profits business for theperiod from 1 January 2009 to 31 December 2009 inclusive, plus the bonus declaration as at 31 December2009, which was announced on 18 February 2010.The approach I have taken when reviewing discretion over this period has been to test whether in my viewthe exercise of discretion has been consistent with the approach set out in the Society’s PPFM and whethercompeting rights, interests and expectations have been appropriately addressed.I can confirm that, in my view, the exercise of discretion over this period has been consistent with the PPFMfor the reasons set out in the Board’s report to policyholders.In addition I believe competing rights, interests and expectations have been appropriately addressed forthe reasons set out in the Board’s report to policyholders.As a result of this analysis I am able to confirm that:In my judgement, the exercise of with profits discretion at the 18 February 2010 bonus declaration and overthe period 1 January 2009 to 31 December 2009 has taken into account the interests of the relevant groupsof policyholders in a reasonable and proportionate manner.”

Legal & General Assurance Society Limited.Registered in England No.166055Registered office: One Coleman Street, London EC2R 5AAWe are authorised and regulated by the Financial Services Authority.We are members of the Association of British Insurers.W10592 06/10