Financial Reporting Overview
Legal & General, in common with other European listed life assurers, reports financial information to shareholders under two complementary reporting bases.
The primary financial statements, which are found in the Financial Statement section of this report, are prepared on the International Financial Reporting Standards (IFRS) basis. This basis is the one that all EU listed companies are required to follow. We believe this gives an insight into the Company’s ability to generate cash flows to support dividends.
For companies which write long term insurance contracts, the emphasis of the IFRS basis on movements in a single year gives an incomplete assessment of performance as it does not provide information on the value created over the life of the contracts. Legal & General therefore provides supplementary financial statements which are prepared on the European Embedded Value (EEV) basis. Those statements provide an assessment of the value that has been generated by the business during a financial year.
In our Operating and Financial Review we focus on operating profit on the EEV basis which we believe provides shareholders with a better understanding of the Group’s performance. Operating profit reports the change in embedded value in a financial year, but excludes fluctuations from assumed longer term investment returns.
The key differences between the EEV and IFRS bases are set out in Figure 14.
Fig 14. Key differences between the EEV and IFRS bases
The total profit arising from a long term insurance contract over
its entire life will be the same under both the EEV and IFRS bases
of reporting. The main difference between the two bases is in respect
of the timing of profit recognition. A description of when the profits
are recognised for each basis is given in the table below.
EEV
EEV seeks to recognise, at the point new business is written, the inherent value to shareholders of that business over its entire lifetime. This is achieved by projecting future shareholder cash flows arising from new business using best estimate assumptions and then discounting those cash flows using an appropriate risk discount rate.
EEV profit arising on in-force business represents the unwind of the risk discount rate, reflecting the fact that future cash flows projected are one year nearer to realisation, together with the impact of actual experience varying from previous best estimate assumptions used to determine projections.
IFRS
IFRS does not recognise, in the year of sale, profits expected to arise on the contract in future years. Instead it recognises only the profit or loss arising on new business in the year it is written. Despite IFRS allowing some acquisition costs to be deferred, most product lines will incur a loss in the year business is first written, reflecting the initial cost and reserving “strain” of writing long term business.
Under IFRS, the loss recognised in the first year of writing new business due to the typical expense strains in acquiring it will be offset by the profits emerging in future years over the lifetime of the business.
Financial Reporting Developments
Legal & General adopted the IFRS basis of reporting for its primary financial statements in 2005. In 2006, the International Accounting Standards Board (IASB) announced a period of stability in financial reporting. As a result of this, no major new standards, or changes to existing standards will become effective until 1 January 2009. Therefore, it is currently anticipated that few significant changes will be required to the Group’s consolidated financial statements over the next two years.
The IASB continues to develop the accounting for insurance contracts. It is expected that an exposure draft will be released in 2008 followed by a final standard in 2009. We continue to monitor these developments closely and to contribute fully to the debate.
In 2005, Legal & General also adopted the European Chief Financial Officer (CFO) Forum’s EEV methodology to prepare its supplementary financial statements. We anticipate that EEV methodology will continue to evolve during 2007, improving further the consistency of company disclosures. In particular, we anticipate that the CFO Forum will work to harmonise the disclosure framework for Market Consistent Embedded Value (MCEV) reporting. The MCEV methodology builds upon existing market-consistent valuation techniques and has been used by some European insurers in their adoption of EEV. When a stable framework of guidance exists, we will consider moving to a market-consistent methodology for our supplementary financial statements. As an active member of the CFO Forum, we expect to contribute fully to these developments.
| 2006 | Target operating range | |
|---|---|---|
| IGD surplus capital * | £2.1bn | £1-2bn |
| Society surplus capital * | £4.9bn | £2.5-3.5bn |
| Economic capital | Very strong AA | Strong AA |
| Return on EV | 12.50% | Increase over medium term |
- *
- Figures extracted from the draft regulatory returns
Group Capital
Capital management
Legal & General has developed a balanced scorecard for capital management which can be seen in Figure 15, including 2006 values and target operating ranges. Our aim in developing the scorecard has been to help demonstrate how we manage capital and to provide a transparent framework for shareholders.
We use four inter-related measures for capital. The first two measures, the Insurance Groups Directive (IGD) surplus capital and the regulatory surplus capital for Legal & General Assurance Society Limited (Society) are key measures of financial strength for our regulator, the FSA. The Economic Capital measure reflects our aim to run the business to a strong AA financial strength rating. The fourth measure is Return on Embedded Value (RoEV) as we believe it is appropriate to include a performance metric in our capital balanced scorecard. This measure ensures that there is a healthy tension between quantum of capital and the return earned on that capital.
We anticipate that the scorecard will evolve over time as industry performance measures evolve and we develop our Economic Capital model.
Fig 16. Group Capital Review
- Pensions and annuity company
- Investment policy for with-profits business
- Investment policy for shareholders’ funds
- Investment management contract
- Ongoing funding of pension funds
- Society capital structure
- Society transfer formula
- HMRC consultation
- Regulatory approvals
Capital structure
During 2006, we initiated a wide ranging review of the Group’s capital. An early conclusion was that although our current structure has proved very efficient over the last decade, we believe that we are able to enhance it to take account of the way our business model has developed and recent changes in the external environment.
It is essential to have a robust and stable capital structure, and any new structure needs to be capable of supporting our successful growing business for a number of years. In addition, we are seeking a clearer, more transparent structure, which will ultimately benefit shareholders.
The most significant areas being considered by the review and the high level timeline for implementation are set out in Figure 16. Some of these will deliver quickly, while others, such as the review of corporate capital structure, will take longer as there are more external dependencies and uncertainties. The most significant uncertainty is the outcome of the ongoing Her Majesty’s Revenue & Customs (HMRC) consultation on the taxation of life companies and certainty is not expected in this area before the start of 2008.
The first change has already been made with the establishment of a new pensions and annuity reinsurance company called Legal & General Pensions Limited (LGP). On 31 December 2006, the pensions and annuity business of Society was ceded to LGP. The creation of a separate company provides greater capital transparency and flexibility, and will enhance Legal & General’s ability to compete in the annuity and pensions markets. The structure will ensure that both non profit life and pensions business are taxed appropriately.
Further detail of the financial impact of this change is provided in the Operating and Financial Review.
Capital resources
The Group is required to measure and monitor its capital resources on a regulatory basis and to comply with the minimum capital requirements of regulators in each territory in which we operate. The regulators require more prudent assumptions than IFRS. Legal & General’s total capital resources are substantially in excess of both total regulatory capital and the minimum level of regulatory capital we are required to hold.
Figure 17 compares the Group’s available capital resources with the capital resources requirement for Legal & General Group Plc and Society.
| As at 31 December 2006 | Group1 £bn |
Society1,2 £bn |
|---|---|---|
| Available capital resources | 6.7 | 9.3 |
| Capital resources requirement | 4.6 | 4 |
| Excess | 2.1 | 5 |
- 1.
- Figures extracted from draft regulatory returns
- 2.
- Long term business only
Figure 18 shows the Group’s structure. Total capital resources of £8.4bn on an IFRS basis comprise ordinary equity holders’ capital (£5.4bn), subordinated debt (£0.8bn) and unallocated divisible surplus (£2.2bn, including £0.3bn of Sub-fund).
Fig 18. Group Structure
As at December 2006
The largest allocation of capital has been made to Society, reflecting the significance of this operation and the importance of ensuring its financial strength to support long erm growth of our business. Financial flexibility is achieved from Society’s £5.5bn of shareholder capital. Of this total, £2.2bn is held outside any long term fund as Society Shareholder Capital (SSC), of which approximately £1bn is within LGP; the remainder of £3.3bn is held within Society’s Long Term Fund as Shareholder Retained Capital. These assets maintain the financial strength of Society and fund new business growth.
Society continues to be one of the two highest rated European life insurers. As at March 2007, our financial strength ratings from Standard & Poor’s, Moody’s and A.M. Best were maintained at AA+, Aa1 and A+ respectively. All ratings have a stable outlook.
The Group’s Capital Position Statement prepared on the FRS 27 ‘Life Assurance’ basis is included within Note 50. This demonstrates the different sources of capital held within the Group.
Individual Capital Assessment (ICA)
The Financial Services Authority (FSA) requires insurers to hold capital on the greater of two bases. The first basis (Pillar 1) encompasses the rules-based regulatory capital requirements in the FSA’s Prudential Source Book, including the with-profits realistic balance sheet. The second basis (Pillar 2) is the firm’s own internal assessment of its capital requirements, together with any additional amount which may be required by the FSA.
During 2006, the FSA completed its first review of the Group’s assessment of its Pillar 2 capital requirements.
Solvency II
During 2006, the European Commission and its advisors have continued work on revised capital and solvency standards for EU insurers under the Solvency II project. It is expected that a draft EU directive will be laid before the European parliament in 2007.
Legal & General participates actively in the consultation process through the Association of British Insurers (ABI) and its links with the FSA and Government. The Group endorses the approach taken by FSA to ensure that Solvency II benefits from the experience of the FSA’s implementation of ICA for UK insurers.
Group Cash Flows
In recent years, Society and LGIM have been the Group’s main sources of subsidiary dividends. These amounts have been supplemented by regular, small dividends from the Netherlands and a series of one-off dividends from our General Insurance business. Society remains the largest source of dividends, with contributions from the non profit business and the with-profits business each year.
The Group dividend recommended to shareholders is determined by the directors after taking account of future capital requirements, our projections of future dividends from subsidiaries and current projected investment market conditions. The final dividend per share proposed for 2006 has been increased by 5% to 3.81p (2005: 3.63p) bringing the total dividend for the year up to 5.55p an increase of 5.1%.
Debt and Debt Facilities
Access to the capital markets is maintained through a £2bn Medium Term Note programme, which allows debt capital to be raised in both senior and subordinated form. The latter satisfies the FSA’s criteria for upper tier II and lower tier II forms of capital for insurance companies. The Group also makes use of a US$2bn Commercial Paper programme, which facilitates access to both international and domestic money markets. Additionally, the Group has a £1bn five year revolving credit facility which matures in 2011. Together these facilities satisfy the Group’s liquidity and working capital needs. At the end of 2006, we redeemed our £525m convertible bond at par, having thereby provided the Group with a very attractive low cost source of senior debt over the previous five years.
During 2006, Legal & General America completed a second securitisation for its term assurance business. This raised US$450m non recourse subordinated debt to finance Triple X reserve requirements on new business written in 2005 and 2006.
Total debt at the end of 2006 was £2.4bn (2005: £2.4bn) of which £0.6bn (2005: £0.4bn) was non recourse funding. £1.5bn (2005: £2.0bn) carries a fixed rate of interest. The weighted average cost of the Group’s core borrowings during 2006 was 5.1% p.a. (2005: 5.3% p.a.).
The Group’s current long term and short term debt ratings are, from Standard & Poor’s, AA- and A1+ and, from Moody’s, Al and P1.
Tax
Excluding the tax impact of corporate restructure and, in 2005, the effect of UK tax changes, the reported rate of tax on the EEV basis was 27% (2005: 27%). The principal reasons for the rate being slightly lower than the UK corporate tax rate of 30% were the lower rate of tax on the return on UK equities held in shareholder funds, and the fact that property income attributable to minority interests did not give rise to a tax charge.
Andrew Palmer
Group Director (Finance)