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Chesnara plc (the 'Company')ANNUAL FINANCIAL REPORT * Financial Statements for the year ended 31 December 2008* Notice of Annual General Meeting* Form of Proxy for the Annual General Meeting
Copies of the above documents which were issued to shareholders on 14 April2009 have been submitted to the UK Listing Authority and will be available forinspection at the UK Listing Authority's Document Viewing Facility, which issituated at: The Financial Services Authority, 25 The North Colonade, CanaryWarf, London E14 5HS. The Company's Financial Statements and Notice of AnnualGeneral Meeting may also be found on its websire at www.chesnara.co.uk. The Company announced its preliminary results for the year ended 31 December2008 on 31 March 2009 which included audited financial statements and a fairreview of business. The Company today provides the following additionalregulated information, included within its Financial Statements, in fullunedited text as required to be made public under the disclosure andtransparency rules.
STATEMENT OF DIRECTORS' RESPONSIBILITIES IN RESPECT OF THE FINANCIAL STATEMENTS.
The Directors are responsible for preparing the Group and Parent Company financial statements in accordance with applicable law and regulations.
Company law requires the Directors to prepare Group and Parent Companyfinancial statements for each financial year. Under that law they are requiredto prepare the Group financial statements in accordance with IFRSs as adoptedby the EU and applicable law and have elected to prepare the Parent Companyfinancial statements on the same basis.The Group and Parent Company financial statements are required by law and IFRSsas adopted by the EU to present fairly the financial position of the Group andthe Parent Company and the performance for the period; the Companies Act 1985provides in relation to such financial statements that references in therelevant part of that Act to financial statements giving a true and fair vieware references to their achieving a fair presentation.
In preparing each of the Group and Parent Company financial statements, the Directors are required to:
* select suitable accounting policies and then apply them consistently;* make judgements and estimates that are reasonable and prudent;
* state they have been prepared in accordance with IFRSs as adopted by the EU;
and
* prepare the financial statements on the going concern basis unless it is
inappropriate to presume that the Group and Parent Company will continue in
business.
The Directors are responsible for keeping proper accounting records thatdisclose with reasonable accuracy at any time the financial position of theParent Company and enable them to ensure that the financial statements complywith the Companies Act 1985. They have general responsibility for taking suchsteps as are reasonably open to them to safeguard the assets of the Group anddetect fraud and other irregularities.Under applicable law and regulations, the Directors are also responsible forpreparing a Directors' Report, Directors' Remuneration Report and the CorporateGovernance Statement that comply with that law and those regulations.
The Directors are responsible for the maintenance and integrity of the corporate and financial information included on the Company's website. Legislation in the UK governing the preparation and dissemination of financial statements may differ from legislation in other jurisdictions.
We confirm that, to the best of our knowledge:
* the financial statements, prepared in accordance with the applicable set of
accounting standards, give a true and fair view of the assets, liabilities,
financial position and profit or loss of the Company and the undertakings
included in the consolidation taken as a whole; and
* the Directors' Report includes a fair review of the development and performance
of the business and the position of the issuer and the undertakings included in
the consolidation taken as a whole, together with a description of the
principal risks and uncertainties that they face.
This responsibility statement was approved by the Board of Directors on 30 March 2009 and was signed by Peter Mason, Chairman and Graham Kettleborough, Chief Executive
PRINCIPAL RISKS AND UNCERTAINTIES
The Group's management of insurance risk is a critical aspect of the business.The primary insurance activity carried out by the Group comprises theassumption of the risk of loss from persons that are directly subject to therisk. Such risks in general relate to life, accident, health and financialperils that may arise from an insurable event, with the majority of the Group'sexposure relating to mortality risk on individual lives, predominantly in theUK. As such, the Group is exposed to the uncertainty surrounding the timing andseverity of claims under the related contracts.The Group is also exposed to a range of financial risks through its lifeassurance contracts, financial assets, financial liabilities, includinginvestment contracts and borrowings, and its reinsurance assets. In particular,the key financial risk is that in the long-term its investment proceeds are notsufficient to fund the obligations arising from its insurance and investmentcontracts. The most important components of this financial risk are market risk(interest rate risk and equity price risk), and credit risk, including the riskof reinsurer default. The Group has procedures for setting and monitoring theGroup's assets and liability position with the objective of ensuring that theGroup can always meet its obligations without undue cost and in accordance withthe Group's internal and regulatory capital requirements.Detailed information on the characteristics and management of insurance andfinancial risks borne by the Group is provided in Notes 4 and 5 respectively ofthe Company's published financial statements for the year ended 31 December2008 and included below under Management of Insurance Risk and Management ofFinancial Risk.
In addition, detailed information on accounting estimates and judgements is included in Note 3 of the Company's published consolidated financial statements for the year ended 31 December 2008 and included below under the heading Accounting Estimates and Judgements.
There have been no changes in the nature and incidence of the principal risksand uncertainties, referred to above, during the twelve months ended 31December 2008, except in relation to volatility in global investment markets.The impact of this on reported results for the twelve months ended 31 December2008 is set out in the commentary under 'IFRS Result' and 'EEV Result' in theOperating and Financial Review in the financial statements. Clearly there iscontinuing significant uncertainty with regard to the direction of investmentmarkets and attention is drawn particularly to the sensitivity of the reportedembedded value of the Company to investment market and interest rate movementsset out in Note 7 to the European Embedded Value Basis SupplementaryInformation in the financial statements.
ACCOUNTING ESTIMATES AND JUDGEMENTS
The Group makes estimates and assumptions that affect the reported amounts ofassets and liabilities and also makes critical accounting judgements inapplying the Group's accounting policies. Such estimates and judgements arecontinually evaluated and are based on historical experience and other factors,including expectations of future events that are believed to be reasonable. Themore critical areas where accounting estimates and judgements are made aredescribed below.
(a) Classification of long-term contracts
The Group has exercised judgement in its classification of long-term businessas between insurance and investment contracts, which fall to be accounted fordifferently in accordance with the policies set out in Note 2 of the financialstatements, Accounting Policies. Insurance contracts are those wheresignificant risk is transferred to the Group under the contract and judgementis applied in assessing whether the risk so transferred is significant,especially with regard to pensions contracts, which are predominantly, but notexclusively, created for investment purposes.
(b) Estimates of future benefits payments arising from long-term insurance contracts
The Group makes estimates of the expected number of deaths for each of theyears that it is exposed to risk. These estimates are based on either standardmortality tables or reinsurers' rate tables as appropriate, adjusted to reflectthe Group's own experience. For contracts without fixed terms the Group hasassumed that it will be able to increase charges to policyholders in futureyears, in line with emerging mortality experience.The Group has offered guaranteed annuity options within certain contracts.Estimates have been made of the number of contract holders who will exercisethese options, in order to measure their value. Changes in investmentconditions could result in significantly more contract holders exercising theiroptions than the Group has assumed in determining the liabilities arising fromthese contracts.The Group makes estimates of future deaths, voluntary contract terminations,investment returns and administration expenses at the inception of long-terminsurance contracts with fixed and guaranteed terms. These estimates, which arereconsidered annually, form the assumptions used to calculate the liabilitiesarising from these contracts.
The assumptions used to establish insurance contract liabilities and appropriate sensitivities relating to variations in critical assumptions are disclosed in Note 25 of the financial statements.
(c) Fair value of investment contracts
Guaranteed income and guaranteed growth bonds
The fair value of investment contract liabilities, in respect of guaranteedincome and guaranteed growth bonds, (which are fully described in Note 5 of thefinancial statements and below in Management of Financial Risk) is establishedusing a valuation technique, which approximates the following methodology: The fair value of the contract, measured at inception, is the purchase pricepaid for it. This price implies a retail market rate of interest prevailing atthe inception of the contract, which is used to equate the contractual cashflows payable under the bond to the purchase price, including an allowance forexpenses incurred in managing the contract; and
Subsequent measurement of the liability at fair value reflects the impact of changes in retail market interest rates for these products: this is accomplished in practice by tracking movements in the less-than-5-year gilt index as the bonds are predominantly less than 5 years in term.
Fair value measurement has been adopted to reduce volatility in reported earnings in the income statement as the liabilities so determined are measured in a way which is consistent with the fair value of the underlying invested financial assets.
(d) Liability for future redress in respect of mortgage endowment misselling complaints
Included within insurance contract liabilities is a liability in respect ofamounts anticipated to be payable as redress for upheld mortgage endowmentmisselling complaints. In establishing this liability the Group makes estimatesabout the number of future upheld complaints (taking into account the number ofcomplaints received, the number of complaints time-barred and the number ofcomplaints which are admitted) and about the average cost of redress per upheldcomplaint. These estimates are determined, taking into account historicalexperience and investment return projections. Variations in these estimatescould result in higher or lower than expected numbers of upheld complaints andhigher or lower than expected amounts of redress per upheld complaint. Theimpact of variations in these assumptions is disclosed in Note 25 of thefinancial statements.
(e) Deferred acquisition costs and deferred income
The Group applies judgement in deciding the amount of direct costs that areincurred in acquiring the rights to provide investment management services inconnection with the issue of investment contracts. Judgement is also applied inestablishing the amortisation of the assets representing these contractualrights and the recognition of initial fees received in respect of thesecontracts. The assets are amortised on a straight-line basis over the expectedlifetime of the investment management service contracts and deferred income isamortised on a straight-line basis over the expected period over which it isearned. Estimates are applied in determining the lifetime of the investmentmanagement service contracts and in determining the recoverability of thecontractual rights assets by reference to expected future income and expenselevels. This test for recoverability is performed using best estimates offuture cash flows, using a market consistent estimate of future investmentreturns.
(f) Amortisation of acquired value of in-force business
The Group applies accounting estimates and judgement in determining the fairvalue, amortisation and recoverability of acquired in-force business relatingto insurance and investment contracts. The acquired value of in-force businesshas been amortised on a basis that reflects the expected profit stream arisingfrom the business acquired at the date of acquisition. This profit stream isestimated from the experienced termination rates, expenses of management andage of the individual contract holders as well as global estimates ofinvestment growth, based on recent experience at the date of acquisition.Acquired value of in-force business is tested for recoverability by referenceto expected future income levels. MANAGEMENT OF INSURANCE RISK IntroductionThe Group's management of insurance risk is a critical aspect of the business.The primary insurance activity carried out by the Group comprises theassumption of the risk of loss from persons that are directly subject to therisk. Such risks in general relate to life, accident, health and financialperils that may arise from an insurable event, with the majority of the Group'sexposure relating to mortality risk on individual lives, predominantly in theUK. As such, the Group is exposed to the uncertainty surrounding the timing andseverity of claims under the related contracts.
The Group manages its insurance risk through underwriting limits, approval procedures for new products or for policies that exceed set limits, pricing guidelines, reinsurance and monitoring of emerging issues. The Group is substantially closed to new insurance business and, in practice, only sells a limited amount of new insurance business to existing policyholders: the assumption of new insurance risks is, accordingly, limited.
The principal risk is that the frequency and severity of claims is adverse tothat expected. The theory of probability is applied to the pricing andprovisioning for a portfolio of insurance contracts. Insured events are, bytheir nature, random, and the actual number and size of events during any oneyear may vary from those estimated using established statistical techniques.The risk under assurance policies is partly naturally hedged by risks underannuity policies where the exposure is to the risk of longevity.
Underwriting strategy
The aim of the underwriting strategy is to avoid the assumption of undue concentration of risk on any one life and there are defined underwriting procedures embracing the limits on cover for individual policies.
Reinsurance strategy
The aim of the reinsurance strategy is to reinforce the underwriting strategyby avoiding the retention of undue concentration of risk on any one life.Accordingly, there is a policy on reinsurance, which limits the total exposureon any one policy. However, there are a small number of policies which breachthese limits due to historical reasons.
The Group holds a wide range of reinsurance treaties, including wholly reinsured business and risk premium reinsurance which includes original terms reinsurance and facultative reinsurance.
Ceded reinsurance contains credit risk, and such reinsurance recoverables arereported after deductions for known insolvencies and uncollectable items. TheGroup monitors the financial condition of reinsurers on an ongoing basis andreviews its reinsurance arrangements periodically.
The Group has a policy in place of only entering into new reinsurance contracts with reinsurers rated A and above.
Terms and conditions of insurance contracts
The terms and conditions of insurance contracts that have a material effect onthe amount, timing and uncertainty of future cash flows arising from insurancecontracts are set out in the product analyses below, which give an assessmentof the Group's main products and the ways in which it manages the associatedrisks. Sums assured - gross and net of reinsurance 31 December 2008 31 December 2007 Gross Net Gross Net £000 £000 £000 £000 Annuities-immediate (per 4,568 4,514 4,200 4,108 annum) Long-term with DPF 72,728 204 75,697 204 Long-term without DPF 5,024,349 3,632,144 5,233,417 3,712,227 ---------- ---------- ---------- ---------- Total 5,101,645 3,636,862 5,313,314 3,716,539 ========== ========== ========== ==========
Long-term insurance contracts - immediate annuities
Product features
This type of annuity is purchased with a single premium at outset, and is paid to the policyholder for the remainder of his/her lifetime. Annuities may be level or escalate at a fixed rate.
There are two types of immediate annuities: retirement and voluntary. Voluntary annuities are made at the discretion of the policyholder. Policyholders of personal pensions may have to purchase an immediate annuity on retirement. Other variations (joint life annuities) are to continue the annuity (at the same level or lower) to the surviving spouse or partner.
Payments are often guaranteed to be paid for a minimum term regardless of survival (e.g. 5 or 10 years).
Profit on existing contracts arises when mortality and investment experienceare better than expected. All risks and rewards associated with this type ofproduct accrue to shareholders.
Management of risks
The main risks associated with this product are longevity and investment risks.Longevity risks arise as the annuities are paid for the lifetime of thepolicyholder, and this risk is managed through the initial pricing of theannuity. Investment risk depends on the extent to which the annuity paymentsunder the contracts have been matched by suitable assets. The Group regularlymonitors the asset matching for these contracts as explained in the Market RiskManagement section of Note 5 of the financial statements and included belowunder Management of Financial Risks.
The key risks are managed through appropriate pricing and product design. Reinsurance is not generally used for this product, although there is a small number of reinsured policies. Underwriting is not used for this product.
In respect of mortality risk (longevity), the pricing assumption is based onboth historic in-house and industry available information on mortalityexperience for the population of policyholders, including allowances for futuremortality improvements. In respect of investment risk, with this type of product the lump sum premiumis available for the Group to invest at the start of the contract. The assetmix will consist of fixed interest securities, including gilts, with varyingredemption dates. The income earned on the investment will not usually besufficient to cover the annuity and the expense outgo, so each year part of thelump sum will be disinvested, which is taken account of in the asset mix, inorder to balance the fund. If annuitants die as expected the assets referred toabove would be appropriate. However, in most cases annuitants will not die asexpected and, therefore, the Group will need to buy and sell assets asnecessary throughout the term of the policies to minimise the risk of mismatch.This position is monitored on a regular basis. Details of default risk on thefixed interest securities are set out in the Credit Risk Management section ofNote 5 of the financial statements and included below under Management ofFinancial Risks.
Concentration of insurance risks
The tables for immediate annuity contracts set out below illustrate the concentration of risk based on two bands of contracts grouped by the annuity payable each year for each annuity policy insured.
Annuity payable each year for each life Total annuities payable each year insured Before After reassurance reassuranceAs at 31 December 2008 £000 % £000 % £0 - £25,000 4,523 99.0 4,505 99.8 More than £25,000 45 1.0 9 0.2 4,568 100.0 4,514 100.0 As at 31 December 2007 £0 - £25,000 4,155 98.9 4,099 99.8 More than £25,000 45 1.1 9 0.2 4,200 100.0 4,108 100.0
Long-term insurance contracts - with discretionary participation features
Product features
The Group historically wrote with-profits business in the UK, where the policyholder benefits comprise a guaranteed sum assured payable on death or at maturity, to which may be added a discretionary annual bonus and a discretionary terminal bonus.
Management of risks
This business is wholly reassured to Guardian and hence the only risk retainedby the Group for this business is the risk of default by the reinsurer. Thisrisk is detailed in the Credit Risk Management section of Note 5 of thefinancial statements and included below under Management of Financial Risks.
Long-term insurance contracts - without discretionary participation features
Product features
The Group has written both non-linked and unit-linked contracts, which include death and morbidity benefits on a whole life, endowment and term assurance basis.
For contracts where death is the insured risk, the most significant factors that could increase risk are epidemics (such as AIDS, SARS or a flu pandemic) or widespread changes in lifestyle, such as eating, smoking and exercise habits, resulting in earlier or more claims than expected.
Management of risks
Unit-linked insurance contracts are contracts where monthly reviewable chargesare made for insurance risk and administration charges and consist mainly ofregular unit-linked endowments where the primary purpose is to provide aninvestment return. In addition, the policyholder is insured against death andserious injury. Unit-linked contracts operate by investing the policyholders'premiums into pooled investment funds of the Group, the policyholders' share ofthe fund being represented by units. The benefit is payable on death, ormaturity if earlier, the amount payable on death being subject to a guaranteedminimum amount. Therefore, the Group is exposed only to insurance risk insofaras the value of the unit-linked fund is lower than the guaranteed minimum deathbenefit. The maturity or surrender value depends on the investment performanceof the underlying fund and on the level of charges levied by the Group forpolicy administration fees, mortality and other charges.
For contracts with fixed and guaranteed benefits and fixed future premiums, there are no mitigating terms and conditions that reduce the insurance risk accepted. This is the case for a small proportion (approximately 5% of total sums assured) of the life assurance business sold by the Group.
For the remainder of the business, operated on a quasi-linked basis, the Groupcharges for mortality risk on a monthly basis and has the right to alter thesecharges based on its mortality experience and hence minimise its exposure tomortality risk. The Group also reserves the right at regular intervals tochange the premium payable in the light of charges made for insurance risk andadministration services and the investment performance of the assets notionallybacking these contracts. Delays in implementing increases in charges and marketor regulatory restraints over the extent of the increases may reduce thismitigating effect.
A number of these contracts also include Permanent Health Insurance (PHI) benefits which have reviewable charges and the Group reserves the right to alter these charges based on its morbidity experience and hence to minimise its exposure to morbidity risk. Delays in implementing increases in charges and market or regulatory restraints over the extent of the increases may reduce this mitigating effect.
Reinsurance is used extensively on the business described above to mitigate concentrations of insurance risk. The insurance risk is further managed through pricing, product design and, for non-linked and quasi-linked contracts, appropriate investment strategy.
For units held under unit-linked contracts all of the investment risk is borne by the policyholder with the exception of a small number of contracts which provide for a minimum guaranteed rate of return, as investment performance directly affects the value of the unit fund and hence the benefits payable.
Concentration of insurance risk
The tables for long term insurance contracts set out below illustrate the concentration of risk based on five bands of contracts grouped by benefits assured for each policy assured.
Benefits assured for each Total benefits assured life assured Before reinsurance After reinsurance In £000's bands £m % £m % As at 31 December 2008 0 - 250 4,930 96.8 3,611 99.4 250 - 500 116 2.3 20 0.6 500 - 750 27 0.5 1 - 750 - 1,000 12 0.2 - - More than 1,000 12 0.2 - - ---------- ---------- ---------- ---------- 5,097 100.0 3,632 100.0 ========== ========== ========== ========== As at 31 December 2007 0 - 250 5,136 96.8 3,694 99.5 250 - 500 117 2.2 17 0.4 500 - 750 33 0.6 2 0.1 750 - 1,000 12 0.2 - - More than 1,000 12 0.2 - - ---------- ---------- ---------- ---------- 5,310 100.0 3,713 100.0 ========== ========== ========== ========== In addition to the above the Group has, at 31 December 2008, a total ofapproximately £10.3m per annum of retained PHI sums assured (31 December 2007:approximately £17m). The Group does not retain PHI sums assured on any one lifegreater than £25,000 per annum.
Long-term insurance contracts - guaranteed annuity options
Product features
There are a small number of unit-linked deferred annuity policies withguarantees regarding the rate at which the policyholder is able to convert theunit fund into an annuity at retirement, which creates an insurance liability.At retirement the fund available can either be transferred to another provider,used to purchase an annuity with a Group company at the annuity rates thenapplying, or used to purchase an annuity from a Group company at guaranteedannuity rates written into the policy document. The guaranteed annuity ratesare only available in certain circumstances. Policyholders gain the benefit ofwhichever of the then-current annuity rates and guaranteed annuity rates givethem the higher benefits.Management of risks
The main risks associated with this product are longevity and market risks. These were controlled through product design and pricing. However, the guaranteed annuity rates were set during the 1960s and 1970s, when these products were sold. As these rates are no longer suitable in current conditions, appropriate technical provisions are held to reflect the risk arising from the guarantees.
The longevity assumptions underlying the technical provisions are based on bothhistoric in-house and industry available information on mortality experiencefor the population of policyholders, including allowances for future mortalityimprovements.
Concentration of insurance risks
There are 292 such policies in force as at 31 December 2008 (as at 31 December2007: 330). The underlying contracts have total unit funds of £2.6m (as at 31December 2007: £4.1m), with the largest fund being less than £0.4m.
Other risks on insurance contracts
Apart from financial risks relating to the financial assets, which support lifeassurance contracts, as set out in Note 5 of the financial statements andincluded below under Management of Financial risks, there are other significanttypes of risk pertaining to life insurance contracts, as follows:
Expense risk
The Group strategy is to outsource all operational activities to third partyadministrators in order to reduce the significant expense inefficiencies thatwould arise with fixed and semi-fixed costs on a diminishing policy base. Thereare, however, risks associated with the use of outsourcing. In particular,there will be a need in future to renegotiate the terms of the outsourcingarrangements as the existing agreements expire. There is also a risk that, atsome point in the future, third party administrators could default on theirobligations. The Group monitors the financial soundness of third partyadministrators and it has retained step-in rights on the more significant ofthese agreements. There are also contractual arrangements in place whichprovide for financial penalties in the event of default by the administrationservice providers.
Mortgage endowment misselling complaints
The life businesses have experienced a significant level of complaints frommortgage endowment policyholders since their first regulatory mailing programmein 2000. In response to this, the Life business hold mortgage endowmentcomplaints redress provisions. The Group continues to monitor closely, amongother factors, the volume of complaints and the value of compensation paid topolicyholders in order to assess the continuing adequacy of the provisions.There remains however a residual risk that at some point in future the levelsof complaints received may prove to be higher than those anticipated within
theprovision. Persistency riskPersistency risk is the risk that the investor cancels the contract ordiscontinues paying new premiums into the contract, thereby exposing the Groupto a loss resulting from an adverse movement in the actual experience comparedto that expected in the product pricing. Although changes in the levels ofpersistency would not adversely affect the result in the short term they wouldreduce future profits available from the contract. MANAGEMENT OF FINANCIAL RISK IntroductionThe Group's management of financial risk is a critical aspect of the business.For a significant proportion of the Group's life insurance contracts, the cashflows are linked, directly or indirectly, to the performance of the financialassets which support those contracts. This gives rise to financial risk, whichalso arises on the Group's investment contracts in relation to financial assetswhich support these contracts. The Group has procedures for setting andmonitoring the Group's assets and liability position with the objective ofensuring that the Group can always meet its obligations without undue cost andin accordance with the Group's internal and regulatory capital requirements.The Group is exposed to a range of financial risks through its life assurancecontracts, financial assets, financial liabilities, including investmentcontracts and borrowings, and its reinsurance assets. In particular, the keyfinancial risk is that in the long-term its investment proceeds are notsufficient to fund the obligations arising from its insurance and investmentcontracts. The most important components of this financial risk are market risk(interest rate risk and equity price risk), and credit risk, including the riskof reinsurer default.The Group manages these risks within an asset liability management (ALM)framework that has been developed to achieve long-term investment returns atleast equal to its obligations under insurance and investment contracts, withminimal risk. Within the ALM framework the Group periodically produces reportsat legal entity and asset and liability class level, which are circulated tothe Group's key management. The principal technique of the Group's ALMframework is to match assets to the liabilities arising from insurance andinvestment contracts by reference to the type of benefits payable topolicyholders, with separate portfolios of assets being maintained for eachdistinct class of liability.For unit-linked contracts the Group's objective is to match the liabilities,both insurance and investment contract liabilities, with units in the fund towhich the value of the liability is linked. For other business, the Group'sobjective is to match the timing of cash flows from insurance and investmentcontract liabilities with the timing of cash flows from assets subject toidentical or similar risks. By matching the cash flows of liabilities withthose of suitable assets, market risk is managed effectively, whilst liquidityrisk is minimised. These processes to manage the risks, which the Group has notchanged from previous periods, ensure that the Group is able to meet itsobligations under its contractual liabilities as they fall due.
Terms and conditions of investment contracts
The terms and conditions of insurance contracts that have a material effect onthe amount, timing and uncertainty of future cash flows arising from insurancecontracts are set out in Note 4 of the financial statements and included aboveunder Management of Insurance Risk. The terms and conditions of investmentcontracts that have a material effect on the amount, timing and uncertainty offuture cash flows arising from investment contracts are set out in the productanalyses below.
The Group provides three types of investment contract which are predominantly written in the UK.
Unit-linked savingsThese are typically single premium contracts, with the premiums invested in apooled investment fund (usually an internal fund of the life assurancecompany), where the policyholder's investment in the fund is represented byunits. There is a small additional benefit payable on death which does nottransfer significant insurance risk to the Group for these contracts. Thebenefits payable at maturity or surrender of the contract are the bid value ofthese units less surrender penalties, where applicable. The key variablesaffecting the timing and uncertainty of future cash flows are investmentperformance, persistency and expense inflation.
Unit-linked pensions
The contractual features are similar to unit-linked savings, except they may be single or regular premium contracts. The benefits payable on retirement purchase an open market pension annuity.
The key variables affecting the timing and uncertainty of future cash flows are investment performance, interest risks, persistency and expense inflation.
Guaranteed Income and Growth Bonds
Guaranteed Income bonds are mainly single premium contracts for a fixed termoffering, either monthly or annually, fixed payments together with a return ofpremium at the maturity date. A guaranteed growth bond variant has also beenissued which offers no income but a higher guaranteed payment at the maturitydate.
The key variables affecting the timing and uncertainty of cash flows are expense inflation, interest rates, persistency and mortality.
Risks associated with investment contracts
The risks associated with investment contracts are expense risk, persistencyrisk and market risk. Market risk is the risk that the fair value of futurecash flows will fluctuate because of a change in interest or foreign currencyexchange rates or in equity prices and the consequent effect that this has onthe value of charges earned by the Group and on any guarantees in thecontracts. Expense risk is of the same nature as described under other risks oninsurance contracts in Note 4 (see page 59). Persistency risk is the risk thatthe investor cancels the contract or discontinues paying new premiums into thecontract, thereby exposing the Group to a loss resulting from an adversemovement in the actual experience compared to that expected in the productpricing. Although changes in the levels of persistency would not adverselyaffect the result in the short term they would reduce future profits availablefrom the contract.Market risk managementThe notes below explain how market risks are managed using the categoriesutilised in the Group's ALM framework. In particular, the ALM frameworkrequires the management of interest risk, equity price risk, and liquidity riskat the portfolio level, so that the appropriate risks for each portfolio may bemanaged in an effective way. The Group is not significantly exposed to foreignexchange risk as the only assets denominated in foreign currencies are matchedby corresponding insurance contract provisions and financial liabilities. Toreflect the Group risk management approach the required disclosures forinterest rate, equity price and liquidity risks, as appropriate, are givenseparately for each portfolio of the ALM framework. The following tablesreconcile the balance sheet to the classes and portfolios used in the Group'sALM framework. 31 December 2008 Insurance Other Guaranteed contracts Unit-linked Annuities Non-linked Total bonds with DPF contracts in payment contracts Other Assets £000 £000 £000 £000 £000 £000 £000 Intangible assets Deferred acquisition costs 8,590 - - - - - 8,590 Acquired value of in-force business Insurance contracts 16,866 - - - - - 16,866 Investment contracts 11,610 - - - - - 11,610 Reinsurers' share of insurance contract provisions 182,693 - 79,484 100,093 - 3,116 - Amounts deposited with reinsurers 22,181 - - 22,181 - - - Investment properties 3,432 - - 2,932 - - 500 Financial assets Equity securities at fair value through income 363,879 - 2 363,872 - 5 - Holdings in collective investment schemes at fair value through income 576,502 - 2,578 554,817 - 8,041 11,066 Debt securities at fair value through income 279,104 51,360 - 129,517 70,957 21,392 5,878 Insurance and other receivables 11,056 2,127 - - - 1,423 7,506 Prepayments 1,600 - - - - - 1,600 Derivative financial instruments 5,570 - - 5,570 - - - ---------- ---------- ---------- ---------- ---------- --------- --------- Total financial assets 1,237,711 53,487 2,580 1,053,776 70,957 30,861 26,050 ---------- ---------- ---------- ---------- ---------- --------- --------- Reinsurers' share of accrued policyholder claims 4,100 - - - - 1,192 2,908 Cash and cash equivalent 192,381 3,031 368 50,257 7,260 13,135 118,330 ---------- ---------- ---------- ---------- --------- --------- --------- Total 1,679,564 56,518 82,432 1,229,239 78,217 48,304 184,854Assets ========== ========== ========== ========== ========== ========== ========= Insurance Other Guaranteed contracts Unit-linked Annuities non-linked Total bonds with DPF contracts in payment contracts Other Liabilities £000 £000 £000 £000 £000 £000 £000 Bank overdraft 1,094 - - 38 - 822 234 Insurance contract provisions 923,506 - 82,432 728,179 78,217 34,678 - Financial liabilities Investment contracts 558,542 55,119 - 494,449 - 8,974 - Borrowings 8,358 - - - - - 8,358 Derivative financial instruments 70 - - 70 - - - ---------- ---------- ---------- ---------- ---------- ---------- ------- Total financial liabilities 566,970 55,119 - 494,519 - 8,974 8,358 ---------- ---------- ---------- ---------- -------- ---------- ------- Provisions 3,397 - - - - 179 3,218 Deferred tax liabilities 10,798 90 - - - 147 10,561 Reinsurance payables 1,397 - - - - 253 1,144 Payables related to direct insurance and investment contracts 23,891 1,309 - - - 942 21,640 Deferred income 14,575 - - - - - 14,575 Income taxes 1,074 - - - - - 1,074 Other payables 6,494 - - - - 2,309 4,185 ---------- ---------- ---------- ---------- ---------- ---------- ------- Total liabil-ities 1,553,196 56,518 82,432 1,222,736 78,217 48,304 64,989 ========== ========== ========== ========== ========== ========== ======= 31 December 2007 Insurance Other Guaranteed contracts Unit-linked Annuities Non-linked Total bonds with DPF contracts in payment contracts Other Assets £000 £000 £000 £000 £000 £000 £000 Intangible assets Deferred acquisition costs 9,542 - - - - - 9,542 Acquired value of in-force business Insurance contracts 19,427 - - - - - 19,427 Investment contracts 12,627 - - - - - 12,627 Reinsurers' share of insurance contract provisions 212,353 - 87,279 122,327 - 2,747 - Amounts deposited with reinsurers 27,558 - - 27,558 - - - Investment properties 4,983 - - 4,483 - - 500 Financial assets Equity securities at fair value through income 743,670 - 1,020 740,105 - 2,545 - Holdings in collective investment schemes at fair value through income 508,857 - 2,093 467,916 - 5,224 33,624 Debt securities at fair value through income 247,152 80,844 - 84,424 59,589 18,727 3,568 Insurance and other receivables 15,131 2,750 - - - 874 11,507 Prepayments 284 - - - - - 284 Derivative financial instruments 9,525 - - 9,525 - - - ---------- ---------- ---------- ---------- ---------- ---------- -------- Total financial assets 1,524,619 83,594 3,113 1,301,970 59,589 27,370 48,983 ---------- --------- ---------- ---------- ---------- ---------- -------- Reinsurers' share of accrued policyholder claims 4,661 - - - - 1,109 3,552 Cash and cash equivalent 225,127 2,834 399 104,291 2,965 17,107 97,531 ---------- ---------- ---------- ---------- ---------- ---------- -------- Total 2,040,897 86,428 90,791 1,560,629 62,554 48,333 192,162 assets ========== ========== ========== ========== ========== ========== ======== Insurance Other Guaranteed contracts Unit-linked Annuities non-linked Total bonds with DPF contracts in payment contracts Other Liabilities £000 £000 £000 £000 £000 £000 £000 Bank overdraft 1,229 - - - - - 1,229 Insurance contract provisions 1,110,848 - 90,791 922,419 62,554 35,084 - Financial liabilities Investment contracts 726,503 85,367 - 630,844 - 10,292 - Borrowings 12,469 - - - - - 12,469 Derivative financial instruments 265 - - 265 - - - ---------- ---------- ---------- ---------- ---------- ---------- ------- Total financial liabilities 739,237 85,367 - 631,109 - 10,292 12,469 ---------- ---------- ---------- ---------- ---------- ---------- ------- Provisions 3,575 - - - - 159 3,416 Deferred tax liabilities 11,847 (250) - - - 25 12,072 Reinsurance payables 1,622 - - - - 372 1,250 Payables related to direct insurance and investment contracts 22,859 1,311 - - - 504 21,044 Deferred income 16,362 - - - - - 16,362 Income taxes 743 - - - - - 743 Other payables 6,791 - - - - 1,897 4,894 ---------- ---------- ---------- ---------- ---------- ---------- ------- Total liab-ilities 1,915,113 86,428 90,791 1,553,528 62,554 48,333 73,479 ========== ========== ========== ========== ========== ========== ======= Guaranteed bonds
These contracts are for a fixed term with financial benefits that are fixed andguaranteed at the inception of the contract. The Group manages its market risk,its only material risk on these products, by matching closely contracts writtenwith fixed interest debt securities of a suitable duration and quality, asindicated by their credit rating. The result is that, for these contracts, theGroup's primary financial risk is the risk that interest income and capitalredemptions from the financial assets backing the liabilities are insufficientto fund the guaranteed benefits payable. By using fixed interest debtsecurities, there is no exposure to equity price risk for this portfolio.
Regular monitoring of the interest rate risk is carried out by analysis of expected cash flows from the financial assets held with those for the liabilities. Cash flows for the liabilities are determined assuming all contracts continue until their expected maturity date. This analysis also enables the Group to control its liquidity risk for this portfolio.
The following tables indicate the amount and timing of the cash flows arising from the liabilities in this category of the Group's ALM framework.
31 December 2008 Contractual cash flows (undiscounted)Carrying Carrying 0-1 year 1-2 years 2-3 years 3-4 years values and amounts cash flows arising from: £000 £000 £000 £000 £000 Assets backing liabilities: Debt 51,360 35,498 12,455 6,907 - securities at fair value through income Insurance 2,127 2,127 - - - and other receivables Cash and 3,031 3,031 - - - cash equivalents ---------- ---------- ---------- ---------- ---------- Total 56,518 40,656 12,455 6,907 - Liabilities 56,518 36,628 13,982 7,135 - ---------- ---------- ---------- ---------- ---------- Difference - 4,028 (1,527) (228) - in expected cash flows ========== ========== ========== ========== ========== 31 December 2007 Contractual cash flows (undiscounted)Carrying Carrying 0-1 year 1-2 years 2-3 years 3-4 years values and amounts cash flows arising from: £000 £000 £000 £000 £000 Assets backing liabilities: Debt 80,844 36,480 35,126 11,899 5,691 securities at fair value through income Insurance 2,750 2,750 -- -- -- and other receivables Cash and 2,834 2,834 -- -- -- cash equivalents ---------- ---------- ---------- ---------- ---------- Total 86,428 42,064 35,126 11,899 5,691 Liabilities 86,428 38,137 35,480 12,579 5,068 ---------- ---------- ---------- ---------- ---------- Difference -- 3,927 (354) (680) 623 in expected cash flows ========== ========== ========== ========== ========== These contracts can be surrendered before maturity for a cash surrender value.For these contracts the Group is not required to separately measure thisembedded derivative at fair value. The terms are such that the surrender valuewill broadly change in line with changes in the market value of the matchingassets, and so there is no significant risk of mismatch.
Sensitivity analysis - interest rate risk
The sensitivity analysis for interest rate risk illustrates how changes in the fair value or future cash flows of a financial instrument will fluctuate because of changes in market rates at the reporting date.
The carrying amount of both the liabilities and the assets, which are fixedinterest debt securities valued at fair value, will be sensitive to changes inthe level of interest rates. By reviewing the matching of the cash flows byterm, on a quarterly basis, management aim to minimize the impact of a changein values due to a parallel movement in all yield curves.
A 100 basis point increase or decrease in interest yields would not have a material effect on either profit for the year ended 31 December 2008 and for the year ended 31 December 2007 or shareholder equity as at those dates.
Insurance contracts with discretionary participation features
The Group historically wrote with-profits business in the UK, where thepolicyholder benefits comprise a discretionary annual bonus and a discretionaryterminal bonus. The with-profits business is wholly reinsured to Guardian andhence the only risk retained by the Group for this business is the risk ofdefault by the reinsurer. This risk is detailed under 'Credit Risk Management'below.With-profits business can be surrendered before maturity for cash surrenderspecified in the contractual terms and conditions. The impact on the Group'scurrent year results would be minimal as any payments to policyholders arematched by payments from Guardian under the reinsurance contract For all thesecontracts the Group is not required to separately measure this embeddedderivative at fair value.
A maturity analysis based on the earliest contractual repayment date would present all the liabilities as due in the earliest period of the table because these options can be exercised immediately by all policyholders.
For a small element of the with-profits business, policyholders have the optionto invest a portion of their investment in unit-linked funds as an alternativeto the with-profits fund. In this case a portion of the business is retained,with the management of financial risks of this portion being the same asdescribed under 'Unit-linked Contracts' below.
Unit-linked contracts
For unit-linked contracts, which may be insurance or investment contracts, theGroup matches all the financial liabilities, which are linked to units in theinsurance company funds, with assets on which the unit prices are based. Thisapproach results in the Group having no significant market risk (being interestrate, equity price and currency risks) or credit risk on these contracts. Itsprimary exposure to market risk is the risk of volatility in asset managementfees due to the impact of interest rate and equity price movements on the fairvalue of the assets held in the linked funds, on which investment managementfees are based.
In practice, there remain a number of areas where there is a residual risk as follows:
Surplus unitsMarket risk arises from the existence of surplus units (over and aboverequirements to match policyholder unit liabilities) in the insurance companyfunds. Such surplus units (which effectively back surplus carried forward inthe long-term insurance funds) arise because the number of units in the fundsare in decline.
Mortgage endowment misselling redress provision
Market risk arises in two ways in respect of the redress provisions formortgage endowment misselling. The first is that a fall in equity pricesdirectly increases the cost of future redress payments. In addition it is alsolikely that a large fall in equity prices would increase the propensity forpolicyholders to make a complaint about their mortgage endowment policies. Thesensitivity of the redress provision to equity price changes is disclosed inNote 26 of the financial statements.
Guaranteed annuity options
For a small number of unit-linked contracts guarantees exist regarding the rateat which the policyholder is able to convert the unit fund into an annuity atretirement, as described above. As the policyholders gain the benefit ofwhichever of the then-current annuity rates and guaranteed annuity rates givethem the higher benefits, this creates an interest rate risk, in that yieldsavailable at the time the option is taken may be lower than those assumed inthe guaranteed rates. A provision is held for the cost of this guarantee.
Guarantees in Timed Investment Funds
Investment guarantees have been made in respect of policies invested in theGroup's Timed Investment Funds whereby the price paid to policyholders fortheir units on death or maturity will always be the highest price that theunits have reached during their period of investment in the funds. Althoughthere is a charge paid by policyholders for this guarantee there is a risk toshareholders that this will be insufficient to meet the full cost of thisguarantee: this risk is managed within the investment strategy of the fund (seeNote 25(f) of the financial statements for more details). A provision is heldfor the cost of this guarantee.The key assumption in determining this provision is the level of potentialfuture fall in equities. An increase in this assumption, from 25% to 30%, wouldresult in a £0.2m decrease in profit for the year ended 31 December 2008 and toshareholder equity as at 31 December 2008 (the increase would not have had amaterial effect for the year ended 31 December 2007 and as at 31 December 2007)
Change in insurance contract provisions
When calculating insurance contract provisions for the non-unit component ofliabilities under linked contracts, allowance is made for both futureinvestment management charges and investment expenses as a proportion of unitfunds. As investment charges are generally in excess of investment expensesthis surplus is used to offset future administration expenses on the contracts.In a falling market the absolute amount of the surplus of investment chargesover investment expenses would reduce and hence this might lead to an increasein insurance contract provisions.
Bonus units
Certain contracts (primarily investment contracts) contain a condition thatbonus units are allocated at fixed dates in the future, essentially as a rebateof a portion of the management fees charged during the period since the lastsuch bonus allocation. Financial assets are held to back the units that will beallocated, so as to remove the risk of adverse market price movements. Thisresults in an apparent excess of financial assets over liabilities with anexposure to market risk.Unit-linked contracts can be surrendered before maturity for cash surrenderspecified in the contractual terms and conditions. The terms are such that thesurrender value will either be equal to the carrying amount of the contractliability, or in some cases lower due to surrender penalties specified in thecontract terms and conditions. The impact on the Group's current year resultswould therefore be minimal. For all these contracts the Group is not requiredto separately measure this embedded derivative at fair value.
A maturity analysis based on the earliest contractual repayment date would present all the liabilities as due in the earliest period of the table because these options can be exercised immediately by all policyholders.
Sensitivity analysis - equity risk
A decrease of 10% in the value of the assets would reduce asset managementfees, which would result in a £0.8m decrease in profit for the year ended 31December 2008 and to shareholder equity as at 31 December 2008 (year ended 31December 2007 and as at 31 December 2007: £0.9m decrease).
Annuities in payment
These are contracts which pay guaranteed financial benefits, generally monthly,for the lifetime of the policyholder, and in some cases of their spouse. Forcertain contracts payments are guaranteed to be paid for a minimum termregardless of survival (e.g. for 5 or 10 years). The terms are guaranteed atthe inception of the contract. The financial component of these contracts is aguaranteed fixed interest rate and hence the Group's primary financial risk onthese contracts is the risk that interest income and capital redemptions fromthe financial assets backing the liabilities are insufficient to fund thebenefits payable.The Group manages the interest rate risk by matching closely new contractswritten with fixed interest debt securities of a suitable duration and quality,as indicated by their credit rating. By using fixed interest debt securities,there is no exposure to equity price risk for this portfolio.
Regular monitoring of the interest rate risk is carried out by analysis of expected cash flows from the financial assets held with those for the liabilities. Cash flows for the liabilities are determined by means of projecting expected cash flows from the contracts using prudent estimates of mortality.
The following tables indicate the estimated amount and timing of the cash flows arising from the liabilities in this category of the Group's ALM framework.
31 December 2008 Contractual cash flows(undiscounted)Carrying Carrying 0-5 years 5-10 years 10-15 15-20 >20 yearsvalues and amounts years years cash flows arising from: £000 £000 £000 £000 £000 £000 Assets backing liabilities: Debt 70,957 21,085 19,958 16,581 22,341 41,035securities at fair value through income Cash and 7,260 7,260 - - - -cash equivalents Total 78,217 28,345 19,958 16,581 22,341 41,035 Liabilities 78,217 22,488 20,513 18,228 15,705 45,216 ---------- ---------- ---------- ---------- ---------- ---------- Difference - 5,857 (555) (1,647) 6,636 (4,181)in expected cash flows ========== ========== ========== ========== ========== ========== 31 December 2007 Contractual cash flows(undiscounted)Carrying Carrying 0-5 years 5-10 years 10-15 15-20 >20 yearsvalues and amounts years years cash flows arising from: £000 £000 £000 £000 £000 £000 Assets backing liabilities: Debt 59,589 21,176 17,538 16,929 21,677 34,469securities at fair value through income Cash and 2,965 2,965 -- -- -- --cash equivalents ---------- ---------- ---------- ---------- ---------- ---------- Total 62,554 24,141 17,538 16,929 21,677 34,469 Liabilities 62,554 20,434 18,611 16,541 14,258 39,078 ---------- ---------- ---------- ---------- ---------- ---------- Difference -- 3,707 (1,073) 388 7,419 (4,609)in expected cash flows ========== ========== ========== ========== ========== ==========
Sensitivity analysis - interest rate risk
The sensitivity analysis for interest rate risk illustrates how changes in the fair value or future cash flows of a financial instrument will fluctuate because of changes in market rates at the reporting date.
The carrying amount of both the liabilities and the assets, which are debtsecurities valued at fair value, will be sensitive to changes in the level ofinterest rates. By reviewing the matching of the cash flows by term, on aquarterly basis, management aim to minimize the impact of a change in valuesdue to a parallel movement in all yield curves.An increase of 100 basis points in interest yields of the matching assets wouldresult in a decrease of £0.3m in profit for the year ended 31 December 2008 andin shareholder equity as at 31 December 2008 (year ended 31 December 2007 andas at 31 December 2007: £0.4m decrease).An increase or decrease of 100 basis points in interest yields would result ina decrease of £1.7m in profit for the year ended 31 December 2008 and inshareholder equity as at 31 December 2008 (year ended 31 December 2007 and asat 31 December 2007: £0.5m decrease).
Other non-linked contracts
This category consists of two groups of contracts. The first group,representing £10.1m of liabilities out of the total of £48.3m as at 31 December2008 (£10.9m out of the total of £48.3m as at 31 December 2007) is operated ona quasi-linked basis; these are contracts for which, while not classed asunit-linked due to the fact that there is no surrender value which depends onunit values, all other aspects of the risk management of these contracts arethe same as for unit-linked contracts. As a result the Group operates the samerisk management processes as described under 'Unit-linked Contracts' above.The following is a maturity analysis of the contractual liabilities for thisgroup of contracts, prepared on an estimated basis using estimates ofmortality. The analysis represents the gross liabilities, before taking intoaccount offsetting linked assets that are scheduled to mature in a similar
profile. Contractual cash flows (undiscounted) 0-5 5-10 10-15 15-20 >20 years years years years years £000 £000 £000 £000 £000 As at 31 December 22,686 24,813 21,543 10,105 4,080 2008 ========= ========= ========= ========= ========= As at 31 December 24,427 28,028 27,378 15,352 6,580 2007 ========= ========= ========= ========= =========
Sensitivity analysis - equity risk
An increase or decrease of 10% in the value of the assets which back this group of contracts would not have a material effect on either profit for the year ended 31 December 2008 and the year ended 31 December 2007 or shareholder equity as at those dates.
The second group of contracts comprises contracts which pay guaranteed benefitson death or other insurance event, the terms being guaranteed at the inceptionof the contract. The financial component of these contracts is a guaranteedfixed interest rate, and hence, the Group's primary financial risk on thesecontracts is the risk that interest income and capital redemptions from thefinancial assets backing the liabilities are insufficient to fund the benefitspayable.The Group manages the interest rate risk for this group by closely matching newcontracts written with financial assets of a suitable duration and quality, asindicated by their credit rating. By using fixed interest debt securities thereis no exposure to equity price risk. Regular monitoring of the interest raterisk is carried out by analysis of expected cash flows from the financialassets held with those for the liabilities. Cash flows for the liabilities aredetermined by means of projecting expected cash flows from the contracts usingprudent estimates of mortality.The following tables indicate the estimated amount and timing of the cash flowsarising from the liabilities in the second group of this category of theGroup's ALM framework.31 December 2008 Contractual cash flows(undiscounted)Carrying Carrying 0-5 5-10 10-15 15-20 >20 values and amounts years years years years years cash flows arising from: £000 £000 £000 £000 £000 £000 Assets backing liabilities: Reinsurers' 6,072 411 760 1,124 1,429 6,487share of insurance contract provisions Debt 17,724 4,929 4,300 2,702 3,126 9,953securities at fair value through income Insurance 1,423 1,423 - - - -and other receivables Cash and 12,967 12,967 - - - -cash equivalents ========== ======== ======= ======= ========= ====== Total 38,186 19,730 5,060 3,826 4,555 16,440 Liabilities 38,186 15,022 7,048 6,211 6,182 20,601 ---------- -------- ------- -------- --------- ------ Difference - 4,708 (1,988) (2,385) (1,627)(4,161)in expected cash flows ========== ======== ======= ======== ========= ====== 31 December 2007 Contractual cash flows(undiscounted)Carrying Carrying 0-5 5-10 10-15 15-20 >20 values and amounts years years years years years cash flows arising from: £000 £000 £000 £000 £000 £000 Assets backing liabilities: Reinsurer's 6,784 459 849 1,256 1,596 7,248share of insurance contract provisions Debt 15,970 4,811 4,819 3,322 3,908 11,508securities at fair value through income Insurance 874 874 -- -- -- --and other receivables Cash and 13,805 13,805 -- -- -- --cash equivalents ---------- ------- ------ ------ --------- ------ Total 37,433 19,949 5,668 4,578 5,504 18,756 Liabilities 37,433 19,688 5,572 5,151 5,253 19,617 ---------- ------- ------ -------- -------- ------ Difference -- 261 96 (573) 251 (861)in expected cash flows ========== ======== ======= ======== ======== ======
Sensitivity analysis - interest rate risk
The sensitivity analysis for interest rate risk illustrates how changes in the fair value or future cash flows of a financial instrument will fluctuate because of changes in market rates at the reporting date.
The carrying amount of both the liabilities and the assets, which include debtsecurities valued at fair value, will be sensitive to changes in the level ofinterest rates. By reviewing the matching of the cash flows by term, on aquarterly basis, management aim to minimize the impact of a change in valuesdue to a parallel movement in all yield curves.
An increase of 100 basis points in interest yields would result in a decrease of £0.6m in profit for the year ended 31 December 2008 and in shareholder equity as at 31 December 2008 (year ended 31 December 2007 and as at 31 December 2007: £0.2m increase).
A decrease of 100 basis points in interest yields would result in an increase of £0.5m in profit for the year ended 31 December 2008 and in shareholder equity as at 31 December 2008 (year ended 31 December 2007 and as at 31 December 2007: decrease of £0.2m).
Certain of the contracts in this second group of contracts are invested in theGuaranteed Growth Fund which provides a return to policyholders which is linkedto the average mortgage rate. This creates a risk due to a mismatch of assetsand liabilities as there are no suitable assets available to back thisguarantee and hence the assets are held in cash. This means that the return onassets held is lower than the return given to policyholders. Provisions areheld to meet this shortfall, on appropriate assumptions as to future levels ofreturn on assets and return given to policyholders. There is a risk that thereturn given to policyholders will increase by more than the return on assetsdue to inability to match the guarantee - that is, that the spread betweenmortgage rates and cash deposit rates will increase.
Other
This category represents assets and liabilities other than for insurance andinvestment contracts, relating, principally, to surplus net assets representingshareholder equity.Borrowings issued at variable rates of interest expose the Group to cash flowinterest risk. Information on borrowings is provided in Note 28 on page 87. A1% increase in interest rates would result in a decrease of £0.1m in profit forthe year ended 31 December 2008 and in shareholder equity as at 31 December2008 (year ended 31 December 2007 and as at 31 December 2007: £0.1m decrease).
Credit risk management
The Group has exposure to credit risk, which is the risk that a counterpartywill be unable to pay amounts in full when due. Key areas where the Group isexposed to credit risk are:* Reinsurers' share of insurance liabilities;* Amounts deposited with reinsurer in relation to investment contracts;* Amounts due from reinsurers in respect of claims already paid; and
* Counterparty risk with respect to corporate bond, deposits and debt securities.
In addition there will be some exposures to individual policyholders, on amounts due on insurance contracts. These are tightly controlled, with plans being terminated or benefits amended if amounts owed are for more than 3 months, so there is no significant risk to the results of the Group.
The Group structures the levels of credit risk it accepts by placing limits onits exposure to a single counterparty, or group of counterparties. Such risksare subject to at least an annual review.By far the largest credit risk to the Group is in relation to its reinsuranceassets. Although the Group holds a significant proportion of its financialassets in securities, the risk of default on these is mitigated to the extentthat any losses arising in respect of unit-linked funds backing the insuranceand investment contracts the Group issues, would effectively be passed on topolicyholders and investors through the unit-linked funds backing the insuranceand investment contracts.The Group retains some residual risks on assets which support annuities,guaranteed investment bonds and shareholder's equity. These risks aremonitored: a key aspect of this is the Group's current policy of investing newmonies only in high-quality bonds of supra-national corporations and ingovernment-backed debt. The Group has never purchased assets rated below AA byStandard and Poors.The Group's objective is to earn competitive relative returns by investing in adiversified portfolio of securities. Watch lists are maintained for exposuresrequiring additional review and all credit exposures are reviewed monthly.
The Group's exposure to credit risk in relation to its debt securities and cash balances is summarised below:
Cash Credit rating-debt securities balances Total AAA AA A Unrated As at 31 £000 £000 £000 £000 £000 £000 December 2008 Debt securities, deposits and cash balances with credit institutions Linked 40,507 137 - - 45,046 85,690 Non-linked 44,937 15,385 3,520 - 147,335 211,177 Government or pseudo Government deposits Linked 72,999 - - - - 72,999 Non-linked 101,619 - - - - 101,619
---------- ---------- ---------- ---------- ---------- ---------- Total debt, deposits and cash balances 260,062 15,522 3,520 - 192,381 471,485 ========== ========== ========== ========== ========== ========== Cash Credit rating-debt securities balances Total AAA AA A Unrated As at 31 £000 £000 £000 £000 £000 £000 December 2007 Debt securities, deposits and cash balances with credit institutions Linked 3,098 647 86 - 110,146 113,977 Non-linked 50,531 36,843 3,755 151 114,981 206,261 Government or pseudo Government deposits Linked 62,137 - - - - 62,137 Non-linked 89,904 - - - - 89,904 ---------- ---------- ---------- ---------- ---------- ---------- Total debt, deposits and cash balances 205,670 37,490 3,841 151 225,127 472.279 ========== ========== ========== ========== ========== ========== Reinsurance credit riskReinsurance is used to manage insurance risk. This does not however dischargethe Group's liability as primary insurer. If a reinsurer fails to pay a claimfor any reason, the Group remains liable for the payment to the policyholder.The creditworthiness of major reinsurers is considered on an annual basis byreviewing their financial strength.It should be noted that for historical reasons the Group has a significantexposure of £200.6m as at 31 December 2008 (31 December 2007: £236.9m) toGuardian, which does not have a published credit rating. Of this amount £182.5m(31 December 2007: £212.0m) is in respect of currently guaranteed benefits. Theexposure which relates to reinsured insurance contract liabilities, and whichrelates to amounts deposited with Guardian in respect of investment contractliabilities, was mitigated during 2006 when Guardian granted to CountrywideAssured plc a floating charge over related investment assets, which ranks thatcompany equally with Guardian policyholders.
In addition the Group also has an exposure on a number of its risk premium reinsurance contracts, although in general the premiums payable under these contracts in any period will be higher than the claims payments received.
For further information please contact
Graham KettleboroughChief Executive, Chesnara plc 01772 84000107799 407519
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