Last checked at 31 Mar 2009 07:00
CHESNARA PLC
Continued Dividend Growth from Chesnara
31 March 2009
Chesnara today reported final results for the twelve months to 31 December 2008.
The Group is committed to offering shareholders an attractive long-term income stream arising from the profits of its life assurance business.
* Profits (on IFRS basis) before tax for the year ended 31 December 2008 down 18% to £22.7m (2007: £27.7m) * Earnings per share (on IFRS basis) of 19.24p (2007: 24.32p) * On EEV basis profit before tax increased by 150% to £16.0m (2007: £6.4m) * Adverse effect of global investment markets offset by good persistency and expense and assumption changes * Shareholder equity on EEV basis (pre-proposed dividend payment) now £182.7m - 180.0p per share (2007: £187.3m - 179.1p per share) * Share buyback of 2.96% of shares in issue successfully completed between September and November at average price of 108.05p per share * Life company solvency ratio, after dividend payment, remains strong at 177% (2007: 179%). Group solvency ratio (post dividend) strengthens further to 358% (2007: 312%) * Final dividend increased to 10.05p (2007: 9.85p). Total dividend for the year increased by 3% to 15.55p (2007: 15.10p) * Strong balance sheet enables Board to remain confident about future dividend flows * Search for value adding acquisition opportunities continues
Graham Kettleborough, Chief Executive said:
'It has certainly been a challenging year but our long standing prudent approach has helped deliver an increase in EEV profit. We expected a decline in IFRS profit, given we are a substantially closed book, and this was further impacted by adverse investments markets. That said, a profit of £22.7m is still a pleasing and resilient result in such troubled times and this enables us to maintain our progressive dividend policy. The well-timed share buyback has helped maintain shareholders' equity per share and, as one may expect in the current market conditions, we are beginning to see more potential acquisition opportunities arise as the market conditions take their toll.'
The Board approved this statement on 30 March 2009.
Enquiries
Graham KettleboroughChief Executive, Chesnara plc 07799 407519 Michael HenmanCubitt Consulting 0207 367 5100 Notes to Editors:
Chesnara plc, which listed on the London Stock Exchange in May 2004, is the owner of Countrywide Assured plc ("CA"). CA is a life assurance subsidiary that is substantially closed to new business. In June 2005 Chesnara acquired a further closed life insurance company - City of Westminster Assurance ("CWA"). With effect from 30 June 2006, CWA's policies and assets were transferred into CA plc. Chesnara's operating model is to maintain a relatively small governance team and outsource the majority of its back office functions.
FINANCIAL HIGHLIGHTS Year ended 31 December 2008 2007 IFRS basis Operating profit 23.5 28.8 Financing costs (0.8) (1.1) --------- --------- Profit before income taxes £22.7m £27.7m ========= ========= Basic earnings per share 19.24p 24.32p Dividend per share 15.55p 15.10p Shareholders' net equity £126.4m £125.8m ========= ========= European Embedded Value basis (EEV) Operating profit 25.9 13.5
Investment variances and economic assumption changes (9.9) (7.1)
--------- --------- Profit before tax 16.0 6.4 Tax (1.2) 5.7 --------- --------- Profit for the period £14.8m £12.1m ========= ========= Shareholders' equity on EEV basis Covered business Shareholder net worth 69.4 77.6 Value of in-force business 84.9 94.0 --------- --------- Embedded value of covered business 154.3 171.6 Acquired embedded value financed by debt (8.4) (12.4) Shareholders' equity in other Group companies 36.8 28.1 --------- --------- £182.7m £187.3m ========= ========= EEV per share 180.0p 179.1p Life annual premium income (AP) £92.6m £102.3m Life single premium income (SP) £23.9m £32.0m Life annualised premium income (AP + 1/10 SP) £95.0m £105.5m
In contrast with the IFRS basis of reporting, the EEV basis recognises the discounted value of the expected future cash flows, arising from the long-term business contracts in force at the year end, as a component of shareholder equity. Accordingly, the EEV result recognises, within profit, the movement in this component.
CHAIRMAN'S STATEMENT
I am pleased to present the fifth annual financial statements of Chesnara plc ('Chesnara') and my first since I took over the chairmanship of the Company from Christopher Sporborg who retired at the end of 2008. It is a time when the economy is facing its greatest challenges for decades and when the Company has been presented with its most difficult trading conditions since its launch in May 2004. With this in mind, it is particularly pleasing that the Group's results for 2008 show a high degree of resilience, enabling us to continue to maintain a reliable and progressive dividend policy, whilst being in a good position to pursue value-enhancing acquisitions as they arise.
Review of the Business
A key influence on Group performance in 2008 has clearly been the decline in global equity markets, with the leading UK indices, for example, showing a 32% decline over the year. However, positive influences have significantly mitigated the overall adverse impact of investment market falls.
On the IFRS basis, the pre-tax profit has progressed from £10.0m at the half-year to £22.7m for the full year ended 31 December 2008. This compares with £27.7m for 2007, the year on year decrease being primarily driven by the expected reduction in the level of surplus arising in a declining book of business and by a £5m adverse impact from investment markets. Furthermore the 2007 result benefited from a one-off release of £1.1m from the mortgage endowment complaints provision.
On the EEV basis we have recognised a pre-tax profit of £16.0m compared with £6.4m for 2007. The impact of investment markets and associated policyholder CGT effects has led to a reduction at the pre-tax level, of £20.3m. This was offset by the sharp fall in short-term interest rates in the last quarter which led to a significant capital appreciation in our non-linked fixed interest portfolio. This benefited the EEV (and IFRS) pre-tax result to the extent of £3.5m, so that the net adverse impact arising from investment market influences is some £16.8m. In addition to the expected return of £10.4m arising from the unwind of the risk discount rate, this was further offset by:
(i) favourable persistency experience of £5.5m;
(ii) some £6.5m arising from a re-setting of the longer-term expense assumptions,
which follows principally from a careful re-assessment of the expense
conditions that will prevail as the policy base in the Life business
diminishes; and
(iii) economic assumption change effects adding some £7m to embedded value: this
reflects an expected lower interest rate/lower inflation rate environment.
As stated in our Interim Management Statement issued in November 2008, following the entry of Kaupthing Singer and Friedlander into administration, we have fully written down a cash deposit with them and this has adversely impacted both the EEV and IFRS pre-tax result by £1.1m.
We have continued to maintain tight control over expenses, while the provisions we previously established for mortgage endowments misselling and unit pricing remedial redress exposures are considered to be adequate. The number of mortgage endowment misselling complaints received during the year at 1,200 shows a significant decline over the 2007 level of 2,234, while over 80% of all in-force mortgage endowment policies are now time-barred from complaint.
We have decided not to reflect the improvement in lapses experienced in 2008 in future EEV assumptions to allow for some future deterioration as a possible consequence of current economic conditions.
Shareholder Value and Returns to Shareholders
Total shareholder equity on the EEV basis, pre the final dividend appropriation, is £182.7m (180.0p per share) as at 31 December 2008, compared with £187.3m (179.1p per share) as at 31 December 2007. This movement includes the effect of dividends paid during the year of £16.1m and of £3.4m expended on a share buyback programme and is somewhat less than may be expected from the reducing underlying policy base. This results from the positive influences on EEV, which have more than outweighed the impact of adverse investment market conditions.
The capacity of the Company to continue to pursue its dividend policy relies on the continuing emergence of surplus in the Life business and on the ability to distribute this surplus, which in turn depends on the regulatory and solvency position of the Life business. While current economic and investment market conditions have challenged the strength of the Life business, I am pleased to report that the Life business's solvency ratio at 177% (179% at 31 December 2007) remains in excess of the target set by the Board of 150% and that the Group's post-dividend solvency ratio continues to strengthen significantly from 312% at 31 December 2007 to 358% at 31 December 2008.
It is particularly worthy of note that market turmoil in 2008 has led to a significant widening of spreads in corporate bonds, through a changed assessment of default and liquidity risk, and this has led to general concern within the Life industry. The existing prudent approach in our Life business has not necessitated any additional strengthening in this area.
Based on the strength of our results, and of our capital solvency ratios, the Board has decided to recommend a final dividend of 10.05p per share (2007 final dividend: 9.85p per share), giving rise to total dividends of 15.55p per share for 2008 which represents a 2.98% increase over total dividends of 15.1p per share for 2007. At the recent trading range of between 120p and 130p per share, this represents a yield to shareholders of between 12% and 13%.
Despite having consistently fulfilled our undertaking to pursue a reliable and progressive dividend policy, between the end of June 2008 and the end of November 2008, the share price suffered from the wider investment market turbulence and traded at a significant discount to embedded value. The lowest closing price in this period was 100.25p, a 42% discount to the embedded value reported as at 30 June 2008.
In the light of this, the Board re-examined the opportunities for enhancing shareholder value. Through the year we examined a number of acquisition opportunities in the life assurance and related sectors. As none of the opportunities examined by us proved compelling, we decided to undertake a share buyback programme as an alternative and focussed way of delivering value to shareholders. The details of the programme which involved the utilisation of some £3.4m of funds are set out in Note 6.
Outlook
The global investment market volatility experienced in 2008 continues into 2009. While we remain optimistic that our financial position will continue to demonstrate resilience, these circumstances clearly present a heightened level of risk. Accordingly, we have taken additional steps to protect shareholder value. We regularly monitor our fixed interest and treasury fund portfolio to ensure that we are not unduly exposed to particular counterparties or to particular sectors. Further, as our underlying bond obligations to policyholders mature, so our exposure to possible default of matching corporate bonds progressively reduces through 2009. We also closely monitor the financial position of a significant financial reassurer, Guardian Assurance plc, and are satisfied that we do not currently carry an undue level of default risk in this regard. The impact of adverse circumstances to the Group continues to be appraised through a risk-based assessment of capital requirements in the Life business which tests the ability of the Life business to withstand various scenarios, including the stresses presented by sharply adverse investment market and economic conditions.
We believe that attractively priced target acquisitions are starting to become available as a result of the current turbulence in the market. We will continue to examine such opportunities as they arise and believe that we have a strong financial and operational platform from which to pursue them, although, given the current climate, we will continue to apply strict financial and risk criteria to any prospective acquisitions.
I believe we are well placed to fulfil our stated objective of continuing to deliver a reliable and progressive dividend flow and I wish to thank all our employees for their contribution to the Group in realising this aim.
In addition, I would particularly like to thank Christopher Sporborg who, as Chairman, has guided the Company skilfully, wisely and prudently in the years since its launch. I also welcome Peter Wright to the Board. Peter's skills and experience will, I'm sure, prove invaluable to the Company in the challenges ahead.
Peter MasonChairman30 March 2009
OPERATING AND FINANCIAL REVIEW
Basis of Accounting
The Group reports primarily in accordance with International Financial Reporting Standards ('IFRS'). As IFRS essentially permits the 'grandfathering' of the principles and bases used to measure profit arising on long-term insurance contracts under previously-adopted UK GAAP and, as the business of the Group predominantly relates to life contracts in run off, so the earnings profile of the Group will continue to be dominated by the underlying emergence of surplus in these businesses as measured for UK regulatory reporting purposes.
The Group continues to provide financial information supplementary to the IFRS basis. With effect from reporting periods commencing on 1 January 2006, the Group adopted European Embedded Value ('EEV') principles as the basis for providing this supplementary information. EEV methodology aims to measure the underlying embedded value of the Group's life assurance, pensions and annuity businesses and provides a framework which is intended to improve the comparability and transparency of embedded value reporting across Europe. We intend to comply with the European Insurance CFO Forum Market Consistent Embedded Value (MCEV) Principles (copyright © Stichting CFO Forum Foundation 2008) with effect from our interim financial statements for the six months ending 30 June 2009.
IFRS Result
The following summarises pre-tax earnings information reflected in the IFRS Consolidated Income Statement, showing, separately, the contribution from the Life business and from the parent company. .
Life Parent Amortisation business company of AVIF Total £000 £000 £000 £000 Year ended 31 December 2008 Operating profit 27,116 (135) (3,502) 23,479 Financing costs - (752) - (752) --------- --------- --------- --------- Profit before income 27,116 (887) (3,502) 22,727taxes ========= ========= ========= ========= Year ended 31 December 2007 Operating profit 31,240 1,071 (3,502) 28,809 Financing costs - (1,089) - (1,089) --------- --------- --------- --------- Profit before income 31,240 (18) (3,502) 27,720taxes ========= ========= ========= ========= Notes
(1) Financing costs are in respect of a bank loan raised to part finance the
acquisition of CWA Life Holdings plc ('CWA').
(2) Amortisation of Acquired Value In-Force (AVIF) represents a
post-acquisition charge to profits of the write down of the acquired value of CWA in-force business, as measured at the acquisition date. The pattern of amortisation is broadly intended to match the pattern of surplus arising from the run off of the underlying CWA insurance and investment contract portfolios.
The IFRS result before tax has progressed from £10.0m at the half-year to £22.7m as reflected above. Global investment market conditions continued to have a significant adverse impact (of some £5m over the year) on the core Life business, while, following the entry into administration of Kaupthing Singer and Friedlander, we considered it appropriate to fully write-down a cash deposit of £1.1m with them. However, these adverse effects were more than offset by the impact of the very sharp falls in short-term interest rates in the last quarter of 2008, which led to a significant capital appreciation in our fixed-interest portfolio. Overall, these investment market influences, in fact, gave rise to a £1.5m net favourable effect. This was reinforced by continuing tight control over expenses (£0.5m less than planned), but was offset by £3.2m following from the impact of statutory reserve releases in the Life company not being as high as anticipated - this, in turn, follows principally from favourable policy lapse experience, which, although overall beneficial to EEV, gives rise to an adverse short-term impact on the IFRS basis. Taken together, these factors contributed some £1.2m of the shortfall of £5.0m in the pre-tax result compared with the year-ended 31 December 2007. Other factors were:
(i) the 2007 result benefited from a release of £1.1m from the mortgage endowment
complaints provision, which has not been replicated in 2008; and
(ii) the level of surplus arising in the life business abates naturally as the
policy base diminishes over time.
EEV Result
Supplementary information prepared in accordance with EEV principles and set out later is presented to provide alternative information to that presented under IFRS. EEV principles assist in identifying the value being generated by the Life business. The result determined under this method represents principally the movement in the Life business embedded value, before transfers made to the Parent Company and ignoring any capital movements. As the Group's life assurance operations are now substantially closed to new business, the principal underlying components of the EEV result are the expected return from the business in force (being the yield at the risk discount rate on the related policy cash flows as they fall into surplus) together with (1) variances of actual experience from that assumed for each component of the policy in force cash flows and (2) the impact of resetting assumptions for each component of the prospective cash flows.
The following is a summarised statement of the EEV result:
Year ended 31 December 2008 2007 £000 £000 Operating profit before tax 25,906 13,506
Variation from longer term investment return (16,831) (3,020)
Economic assumption changes 6,951 (4,043) --------- --------- Profit before tax 16,026 6,443 Tax - current (3,759) (4,379) - deferred 2,559 10,053 --------- --------- Profit for the year after tax 14,826 12,117 ========= =========
A key determinant of the Group performance over the year, as measured on the EEV basis, has been the decline in global equity markets. The leading UK market indices show a 32% decline over 2008 and this, together with associated policyholder CGT effects, has given rise to a significant diminution of £20.3m in embedded value. However, as referred to in 'IFRS Result' above, the impact of this has been mitigated, to a degree, by the effect of the capital appreciation of the fixed-interest portfolio, following from the significant reduction in short-term interest rates so that, overall, the net adverse impact at the pre-tax operating level, arising from investment market influences is some £16.8m, as reflected in the variation in longer-term investment return above.
The following factors have also contributed to the strong operating profit before tax:
(i) unwind of the risk discount rate giving rise to a £10.4m contribution to
pre-tax operating profit;
(ii) favourable lapse experience of £5.5m;
(iii) new business of £0.7m;
(iv) an expenses underrun of £2.1m; and
(v) a re-setting of long-term expense assumptions giving rise to a favourable
effect of £6.5m.
This last item follows principally from a careful re-assessment of the expense conditions that will prevail as the policy base diminishes. It is clear that, as significant diseconomies of scale arise, steps will be taken to avoid them in practice. In particular, it is evident that the allocation of Parent Company expense to the Life business at the level previously assumed is untenable.
While investment market conditions have served to depress the EEV at the profit before tax level, it is also clear that, within the gloom of global recession, wider economic factors can serve to have a positive impact. The lower interest rate/lower inflation rate environment, together with some favourable policyholder tax effects has given rise to favourable economic assumption change effects of some £7m as reflected in the table above.
Overall, the embedded value has proved resilient in the face of a difficult trading environment. As this is likely to be subject to continuing volatility, attention is drawn to the sensitivity of the EEV to various factors as set out in Note 7 to the EEV Supplementary Information.
Shareholders' Equity and Embedded Value of Covered Business - EEV Basis
The consolidated balance sheet prepared in accordance with EEV principles maybe summarised as: 31 December 2008 2007 £000 £000 Value of in-force business 84,940 94,007 Other net assets 97,768 93,308 --------- --------- 182,708 187,315 ========= ========= Represented by: Embedded value ('EV') of covered business 154,329 171,639 Less: amount financed by borrowings (8,358) (12,469) --------- ---------
EV of covered business attributable to shareholders 145,971 159,170
Net equity of other Group companies 36,737 28,145 --------- --------- Shareholders' equity 182,708 187,315 ========= =========
The tables below set out the components of the value of in-force business by major product line at each period end:
31 December 2008 2007Number of policies 000 000 Endowment 62 68 Protection 64 73 Annuities 5 4 Pensions 53 56 Other 8 9 --------- --------- Total 192 210 ========= ========= 31 December 2008 2007Value in-force £m £m Endowment 53.8 58.3 Protection 51.2 63.0 Annuities 4.5 2.0 Pensions 33.5 38.1 Other - 1.4 --------- --------- Total at product level 143.0 162.8 Valuation adjustments Holding company expenses (8.7) (20.7) Other (26.3) (21.4) Cost of capital (5.1) (5.5) --------- --------- Value in-force pre-tax 102.9 115.2 Taxation (18.0) (21.2) --------- --------- Value in-force post-tax 84.9 94.0 ========= =========
The value-in-force represents the discounted value of the future surpluses arising from the insurance and investment contracts in force at each respective period end. The future surpluses are calculated by using realistic assumptions for each component of the cash flow.
'Other' valuation adjustments principally comprise expenses of managing policies which are not attributed at product level. Certain expenses, previously classified as holding company expenses, have, as at 31 December 2008, been included within these other valuation adjustments. The comparative figures as at 31 December 2007 have not been restated to reflect this reclassification and this explains part of the year-on-year increase in other valuation adjustments and part of the year-on-year decrease in holding company expenses reflected above. The balance of the year-on-year decrease in holding company expenses arises principally from the reassessment of the expense conditions that will prevail as the policy base diminishes, as referred to under 'EEV Result' above.
Policyholder Funds Investment Return
The CA Managed Fund, which is managed by Schroder Investment Management Limited and which represents a significant proportion of CA policyholder funds under management, returned -16.96% over the year ended 31 December 2008. The CWA Global Managed Fund, which is managed by Irish Life Investment Managers Limited and which represents a significant proportion of CWA policyholder funds under management, returned -16.0% over the same period. The performance of both funds compares favourably with the average of -20.78% achieved by the ABI Life Balanced Managed Fund sector.
Returns to Shareholders
Returns to shareholders are underpinned by the emergence of surplus in, and transfer of surplus from, the life business' long-term insurance fund to shareholder funds and by the return on shareholder net assets representing shareholder net equity. These realisations are utilised in the first instance for the repayment and servicing of the bank loan on the basis set out in Note 4. The surplus arises from the realisation of value in-force, which effectively unwinds at the risk discount rate used to discount the underlying cash flows: at 31 December 2008 this rate was reset to 6.3% (31 December 2007: 7.7%), following the methodology described in the EEV Supplementary Information. The return on shareholder net assets is determined by the Group's investment policy. Shareholder funds bear central corporate governance costs which cannot be fairly attributed to the long-term insurance funds and which arise largely in connection with the status of Chesnara as a listed company.
The Board's continuing primary aim is to provide a reliable and progressive dividend flow to shareholders within the context of the emergence of surplus in the life business, while the Group's embedded value supports this dividend flow and, in the absence of further acquisitions, holds out the prospect of a return of capital to shareholders. For the first half of 2008 the shares generally traded in a range from 145p to 165p. With total proposed dividends in respect of the year ended 31 December 2008 at 15.55p per share, this implied a yield of between 9.4% and 10.7%. The shares may also be characterised as having traded at a discount to Group embedded value, as reported on the EEV basis as at 31 December 2007, within a range of 8% to 19%.
Between the end of June 2008 and the end of November 2008, the share price suffered from the wider investment market turbulence and traded at a significantly deeper discount to embedded value. The lowest closing price recorded in this period was 100.25p, representing a 42% discount to the embedded value reported as at 30 June 2008. In the light of this, and in order to maximise shareholder value, the opportunity was taken to undertake a share buyback operation, the details of which are set out in Note 6.
Subsequent to the end of November 2008, the share price has recovered to trade, generally, in a range of 120p to 130p. This implies a yield, based on total 2008 proposed dividends, of between 12% and 13%, with the shares trading at a discount of between 28% and 33% to embedded value, as now reported as at 31 December 2008. Notwithstanding this, the share price performance in the early part of 2009 has significantly outperformed that for the Life sector as a whole.
Solvency and Regulatory Capital
Regulatory Capital Resources and Requirements
The regulatory capital of life insurance companies in the UK is calculated by reference to FSA prudential regulations. The rules are designed to ensure that companies have sufficient assets to meet their liabilities in specified adverse circumstances. As such, there is a restriction on the full transfer of surplus from the long-term business fund to shareholder funds of CA, and on the full distribution of reserves from CA to Chesnara.
The regulations include minimum standards for assessing the value of liabilities, including making an appropriate allowance for default risk on corporate bonds held to match liabilities when assessing the valuation discount rates used for valuing these liabilities. Market turmoil in 2008 has led to significant widening of spreads on corporate bonds above gilts, through changed assessment of default risk and liquidity issues, and therefore, with the widening spreads, this issue has been of concern to the industry. The Life company continues to maintain a prudent approach of limiting the assumed liquidity premium in corporate bonds to a maximum of 50bps as at 31 December 2008 (31 December 2007: 30bps).
Additionally, the CA Board continues to maintain their stance that permissive changes to regulations introduced in 2006, in FSA policy statement PS06/14, that would allow a reduction in liabilities are not appropriate for CA at this time.
The following summarises the capital resources and requirements of the life company for regulatory purposes, after making provision for dividend payments from CA to Chesnara, which were approved after the respective period ends.
31 December 2008 2007 £m £m Available capital resources ('CR') 43.0 47.6 --------- ---------
Long-term insurance capital requirement ('LTICR') 22.5 25.1
Resilience capital requirement ('RCR') 1.8 1.5 --------- --------- Total capital resources requirement ('CRR') 24.3 26.6 --------- --------- Target capital requirement cover 35.6 39.1 --------- --------- Ratio of available CR to CRR 177% 179% --------- --------- Excess of CR over target requirement £7.4m £8.5m --------- ---------
The CA Board, as a matter of policy, continues to target CR cover for total CRR at a minimum level of 150% of the LTICR and 100% of the RCR. To the extent that the target capital requirement cover of £35.6m as at 31 December 2008 falls short of the £40m share capital component of CR, so it follows that £4.4m of the reported excess of CR over target requirement is not available for distribution to shareholders except by way of a capital reduction.
It can be seen from this information that Chesnara, which relies on dividend distributions from its life company, is currently in a favourable position to service its loan commitments and to continue to pursue a progressive dividend policy.
Insurance Groups Directive
In accordance with the EU Insurance Groups Directive, the Group calculates the excess of the aggregate of regulatory capital employed over the aggregate minimum solvency requirement imposed by local regulators. The following sets out these calculations after the recognition of final dividends for the respective financial year, but approved by the Board and paid to Group shareholders after the respective dates:
31 December 2008 2007 £m £m Available group capital resources 86.9 82.9 Group regulatory capital requirement (24.3) (26.6) --------- --------- Excess 62.6 56.3 --------- --------- Cover 358% 312% --------- ---------
The regulatory requirement is that available group capital resources should be at least 100% of the capital requirement.
Individual Capital Assessments
The FSA Prudential Sourcebooks require an insurance company to make its own assessment of its capital needs to a required standard (a 99.5% probability of being able to meet its liabilities to policyholders after one year). In the light of scrutiny of this assessment, the FSA may impose its own additional individual capital guidance. The Individual Capital Assessment is based on a realistic liability assessment, rather than on the statutory mathematical reserves, and involves stress testing the resultant realistic balance sheet for the impact of adverse events, including such market effects as significant falls in equity values, interest rate increases and decreases, bond defaults and further widening of bond spreads.
CA completed a further full annual assessment during 2008 as a result of which it was concluded that the effective current- and medium-term capital requirement constraints on distributions to Chesnara will continue to be on the basis set out under 'Regulatory capital resources and requirements' above. This assessment is subject to quarterly high-level update until the next full annual assessment.
Capital Structure, Treasury Policy and Liquidity
The Group's operations are ordinarily financed through retained earnings and through the current emergence of surplus in the Life business. It normally does not make use of financial reinsurance or similar arrangements. There is no significant trading in any currencies other than sterling. Cash available for more than twelve months is normally transferred to fund managers for longer-term investment.
The Board continues to have a conservative approach to the investment of shareholder funds in the Life business, which underpins our strong solvency position. This approach targets the investment of 100% of available funds in cash and fixed interest securities. In the light of current volatility in financial markets, particular attention is given to the mix and spread of these investments to ensure that we are not unduly exposed to particular sectors and that our counterparty limits are strictly adhered to. Notwithstanding these safeguards, we had one specific exposure in respect of a cash deposit of £1.1m with Kaupthing Singer and Friedlander, which we have fully written down following its entry into administration. Current economic conditions also heighten the risk of corporate bond default and observations on this are made in the 'Going Concern' section below.
The profile and mix of investment asset holdings between fixed interest stocks and cash on deposit is such that realisations to support dividend distributions can be made in an orderly and efficient way.
Other factors which may place a demand on capital resources in the future include the costs of unavoidable large scale systems development such as those which may be involved with changing regulatory requirements and the requirement to finance further possible acquisitions. To the extent that ongoing administration of the Life business is performed within the terms of its third party outsourcing agreements, the Group is sheltered, to a degree, from these development costs as they are likely to be on a shared basis.
To the extent that the Group proposes to acquire life businesses in the future, it is intended that this could be done through a suitable combination of equity and debt financing and, to a lesser degree, from internal resources. This would be done, however, within the constraints of the operation of regulatory rules regarding the level of debt finance which may be borne by Insurance Groups.
Cash Flows
The Group's longer-term cash flow cycle is currently characterised by the inflow to shareholders funds of transfers from the long-term insurance funds, which are supported by the emergence of surplus within those funds. These flows are used to support dividend distributions to shareholders and to repay our debt obligations as set out in Note 4.
Going Concern
The Group's cash flow position described above, together with the return on financial assets in the Parent Company, supports the ability to trade in the short-term. Accordingly, the underlying solvency position of the Life business and its ongoing ability to generate surpluses which support cash transfers to shareholder funds is critical to the ongoing ability of the Group to continue trading and to meet its obligations as they fall due.
The information set out in 'Solvency and Regulatory Capital' above indicates a strong solvency position as at 31 December 2008 as measured at both the individual Life Company and at the Group level. In addition, a Financial Condition Report and a detailed annual Individual Capital Assessment, as also set out above, have continued to be produced for the Life business. These include assessments of the ability of the business to withstand key events, including those which may now become more significantly adverse in the current financial and economic environment, being an increased rate of policy lapse, expense overruns and unfavourable investment market conditions. The assessments indicate that the Group is able to withstand the impact of these adverse scenarios, including the effect of continuing significant investment market falls, while the Group's outsourcing arrangements protect it from significant expense overruns.
Notwithstanding that the Group is well capitalised, the current financial and economic environment does present some specific threats to its short-term cash flow position and it is appropriate to assess these. In the first instance, the Group does not rely on the renewal or extension of bank facilities to continue trading - indeed, as indicated, its normal operations are cash generative. The Group does, however, rely on cash flow from the maturity or sale of fixed interest securities which match its obligations to its Guaranteed bond policyholders: in the current economic environment there is clearly a higher risk of bond default, particularly in respect of financial institutions. In order to manage this risk we ensure that our bond portfolio is actively monitored and well diversified. Further, this risk abates through 2009 as our underlying bond obligations to policyholders mature. Other significant counterparty default risk relates to our principal reassurer Guardian Assurance ('Guardian'). We monitor Guardian's financial position and are satisfied that any associated credit default risk is low.
Our expectation is that, notwithstanding the risks set out above, the Group will continue to generate surplus in its long-term business sufficient to meet its debt obligations as they fall due and to continue to pursue a reliable and progressive dividend policy.
CONSOLIDATED INCOME STATEMENT FOR THE YEAR ENDED 31 DECEMBER 2008
Year ended 31 December 2008 2007 Note £000 £000 Insurance premium revenue 94,274 103,554 Insurance premium ceded to reinsurers (17,193) (18,716) --------- --------- Net insurance premium revenue 77,081 84,838 Fee and commission income Insurance contracts 35,289 38,032 Investment contracts 9,305 9,149 Net investment return (222,742) 90,210 --------- --------- Total revenue (net of reinsurance payable) (101,067) 222,229 Other operating income 1,314 1,298 --------- --------- (99,753) 223,527 --------- --------- Insurance contract claims and benefits incurred Claims and benefits paid to insurance contract holders (131,829) (154,657) Net decrease/(increase) in insurance contract provisions 180,265 (2,457) Reinsurers' share of claims and benefits (8,736) 26,518 --------- --------- Net insurance contract claims and benefits 39,700 (130,596) --------- --------- Change in investment contract liabilities 108,516 (50,697) Reinsurers' share of investment contract liabilities (4,743) 11,534 --------- --------- Net change in investment contract liabilities 103,773 (39,163) --------- --------- Fees, commission and other acquisition costs (1,377) (1,546) Administrative expenses (13,633) (15,955) Other operating expenses Charge for amortisation of acquired value of in-force business (3,578) (3,734) Other (1,653) (3,724) --------- --------- 123,232 (194,718) --------- --------- Operating profit 23,479 28,809 Financing costs (752) (1,089) --------- --------- Profit before income taxes 22,727 27,720 Income tax expense 3 (2,710) (2,281) --------- --------- Profit for the year 20,017 25,439 Basic earnings per share 8 19.24p 24.32p --------- --------- Diluted earnings per share 8 19.24p 24.32p ========= =========
CONSOLIDATED BALANCE SHEET AT 31 DECEMBER 2008
31 December 2008 2007 Note £000 £000 Assets Intangible assets Deferred acquisition costs 8,590 9,542 Acquired value of in-force business Insurance contracts 16,866 19,427 Investment contracts 11,610 12,627 Reinsurers' share of insurance contract provisions 182,693 212,353 Amounts deposited with reinsurers 22,181 27,558 Investment properties 3,432 4,983 Financial assets
Equity securities at fair value through income 363,879 743,670
Holdings in collective investment schemes at fair value through income 576,502 508,857 Debt securities at fair value through income 279,104 247,152 Insurance and other receivables 11,056 15,131 Prepayments 1,600 284 Derivative financial instruments 5,570 9,525 --------- --------- Total financial assets 1,237,711 1,524,619 --------- ---------
Reinsurers' share of accrued policyholder claims 4,100 4,661
Cash and cash equivalents 192,381 225,127 --------- --------- Total assets 1,679,564 2,040,897 --------- --------- Liabilities Bank overdrafts 1,094 1,229 Insurance contract provisions 923,506 1,110,848 Financial liabilities Investment contracts 558,542 726,503 Borrowings 4 8,358 12,469 Derivative financial instruments 70 265 --------- --------- Total financial liabilities 566,970 739,237 --------- --------- Provisions 3,397 3,575 Deferred tax liabilities 10,798 11,847 Reinsurance payables 1,397 1,622 Payables related to direct insurance and investment contracts 23,891 22,859 Deferred income 14,575 16,362 Income taxes 1,074 743 Other payables 6,494 6,791 --------- --------- Total liabilities 1,553,196 1,915,113 --------- --------- Net assets 126,368 125,784 ========= ========= Shareholders' equity Share capital 5 41,501 41,501 Share premium 5 20,458 20,458 Treasury shares 6 (3,379) - Other reserves 50 50 Retained earnings 7 67,738 63,775 --------- --------- Total shareholders' equity 126,368 125,784 ========= =========
CONSOLIDATED STATEMENT OF CASH FLOWS FOR THE YEAR ENDED 31 DECEMBER 2008
Year ended 31 December 2008 2007 £000 £000 Profit for the year 20,017 25,439 Adjustments for: Amortisation of deferred acquisition costs. 952 1,145 Amortisation of acquired in-force value 3,577 3,734 Tax expense 2,710 2,281 Interest receivable (24,398) (26,650) Dividends receivable (35,781) (35,997) Interest expense 752 1,089 Change in fair value of investment properties 324 (1,873) Fair value losses on financial assets 247,210 31,768 Interest received 22,150 28,707 Dividends received 39,278 37,810 Changes in operating assets and liabilities Decrease/(increase) in financial assets 38,166 (54,327) Decrease/(increase) in reinsurers share of insurance contract provisions 30,221 (5,544) Decrease in amounts deposited with reinsurers 5,377 36,163 Decrease/(increase) in insurance and other receivables 194 (2,259) Increase in prepayments 1,316 284 Decrease in insurance contract provisions (187,342) (4,349) Decrease in investment contract liabilities (167,961) (86,476) (Decrease)/increase in provisions (178) 2,978 Decrease in reinsurance payables (225) (1,437) Increase/(decrease) in payables related to direct insurance and investment contracts 1,032 (2,068) Decrease in other payables (2,728) (3,060) --------- --------- Cash utilised by operations (5,337) (52,642) Income tax paid (2,921) (5,399) --------- --------- Net cash utilised by operating activities (8,258) (58,041) ========= ========= Cash flows from financing activities Repayment of borrowings (4,200) (4,200) Dividends paid (16,054) (13,910) Interest paid (720) (1,169) Purchase of treasury shares (3,379) - --------- --------- Net cash utilised by financing activities (24,353) (19,279) ========= ========= Net decrease in cash and cash equivalents (32,611) (77,320)
Cash and cash equivalents at beginning of period 223,898 301,218
--------- --------- Cash and cash equivalents at end of period 191,287 223,898 ========= =========
Consolidated Statement of Changes in Equity for the year ended 31 December 2008
Year ended 31 December 2008 Capital Share Share redemption Treasury Retained capital premium reserve Shares earnings Total £000 £000 £000 £000 £000 £000 Equity shareholders' funds at 41,501 20,458 50 - 63,775 125,784 1 January 2008 Purchase of treasury shares - - - (3,379) - (3,379) Profit for the period representing total recognised income and expenses - - - - 20,017 20,017 Dividends paid - - - - (16,054) (16,054) --------- --------- --------- --------- --------- --------- Equity shareholders' funds at 31 December 2008 41,501 20,458 50 (3,379) 67,738 126,368 ========= ========= ========= ========= ========= ========= Year ended 31 December 2007 Capital Share Share redemption Treasury Retained capital premium reserve Shares earnings Total £000 £000 £000 £000 £000 £000 Equity shareholders' funds at 41,501 20,458 50 - 52,246 114,255 1 January 2007 Purchase of treasury shares - - - - - - Profit for the period representing total recognised income and expenses - - - - 25,439 25,439 Dividends paid - - - - (13,910) (13,910) --------- --------- --------- --------- --------- --------- Equity shareholders' funds at 31 December 2007 41,501 20,458 50 - 63,775 125,784 ========= ========= ========= ========= ========= ========= NOTES 1 General information
These financial statements have been prepared in accordance with International Financial Reporting Standards including International Accounting Standards and Interpretations (collectively 'IFRS') issued by the International Accounting Standards Board ('IASB') and endorsed for use by companies in the EU, and with those parts of the UK Companies Act 1985 applicable to companies reporting under IFRS.
Full details of IFRS policies applied, which are, except as noted below, unchanged from those applied for the year ended 31 December 2007, are set out in the full financial statements for the year then ended, a copy of which is available from our website www.chesnara.co.uk.
The following new policy has been applied in respect of the financial statements for the year ended 31 December 2008:
Shares held in treasury
Where the company purchases its own equity share capital, the consideration paid, including directly attributable costs, is deducted from total shareholders' equity and shown separately as 'treasury shares' until they are cancelled. Where such shares are subsequently sold, any consideration received is included within shareholders' equity.
2 Status of financial information
The financial information contained in this preliminary announcement does not constitute the Company's consolidated statutory financial statements for the years ended 31 December 2007 or 2008 but is derived from those financial statements. The financial statements for the year ended 31 December 2008 will be delivered following the Company's Annual General Meeting. The auditors have reported on those financial statements; their reports were unqualified and did not contain statements under section 237(2) or (3) of the Companies Act 1985.
3 Income tax expense Year ended 31 December 2008 2007 £000 £000 Current tax expense Current year 3,037 4,411 Overseas tax 730 472 Adjustment to prior years (8) (503) --------- --------- 3,759 4,380 Deferred tax expense Origination and reversal of temporary differences (1,049) (2,099) --------- --------- Total income tax expense 2,710 2,281 ========= ========= Reconciliation of effective tax rate on profit Year ended 31 before tax December 2008 2007 £000 £000 Profit before tax 22,727 27,720 --------- --------- Income tax using the domestic corporation tax rate of 28.5% (2007: 30%) 6,477 8,316 Impact of small companies rate for subsidiaries - (2) Permanent differences 116 66 Effect of UK taxing bases on insurance profits Offset of franked investment income (3,885) (5,115) Variation in rate of tax on amortisation of acquired in-force value 90 (467) Other (80) (14) Over provided in prior years (8) (503) --------- --------- Total income tax expense 2,710 2,281 ========= ========= 4 Borrowings 31 December 2008 2007 £000 £000 Bank loan 8,358 12,469 ========= ========= Current 4,168 4,127 Non-current 4,190 8,342 --------- --------- Total 8,358 12,469 ========= =========
The bank loan, which was drawn down on 2 June 2005 under a facility made available on 4 May 2005, is unsecured and is repayable in five equal annual instalments on the anniversary of the draw down date. Accordingly the current portion as at 31 December 2008, being that payable within one year, is £4,168,000 and the non-current portion is £4,190,000. The outstanding principal on the loan bears interest at a rate based on the London Inter-bank Offer Rate, payable in arrears over a period which varies between one and six months at the option of the borrower.
The fair value of the bank loan at 31 December 2008 was £8,400,000 (31 December 2007: £12,600,000).
5 Share capital and share premium
Group 31 December 2008 31 December 2007 Share Share Number of capital Number of capital shares £000 shares £000 Share capital 104,588,785 41,501 104,588,785 41,501 ========= ========= ========= =========
There have been no changes in Group share capital and share premium during the year ended 31 December 2008.
The number of shares in issue at the balance sheet date included 3,096,194 shares held in treasury (31 December 2007: nil).
Under the reverse acquisition basis of accounting, at the date of acquisition of Chesnara plc (the legal parent) the amount of issued share capital in the consolidated balance sheet represents the amount of issued share capital of Countrywide Assured Life Holdings Limited (the legal subsidiary) immediately before the acquisition and the deemed cost of acquisition, which is taken as £nil. The number of shares, representing the equity structure, reflects the equity structure of Chesnara plc as set out below.
Company
The share capital of Chesnara plc comprises:
31 December 2008 31 December 2007Authorised £ £
201,000,000 Ordinary shares of 5p each 10,050,000 10,050,000
========= ========= Number of shares Share Capital Share CapitalIssued £ £Ordinary shares of 5p each 104,588,785 5,229,439 5,229,439 ========= ========= =========
The number of shares in issue at the balance sheet date included 3,096,194 shares held in treasury (31 December 2007: nil).
There have been no changes in Company share capital and share premium during the year ended 31 December 2008.
6 Purchase of own shares and treasury shares
Purchase of own shares
The Company was granted authority at the Annual General Meeting on 19 May 2008to purchase its own shares up to a total aggregate number of 10,458,878,representing 10% of the Company's issued share capital at that date subject tocertain conditions. In accordance with that authority and with the specifiedconditions and in order to enhance shareholder value, the Company purchased atotal of 3,096,194 shares between 24 September 2008 and 20 November 2009 with anominal value of £154,971, representing 2.96% of the Company's issued sharecapital on 24 September 2008, at a total cost of £3,379,000. These shares areheld in Treasury. The existing authority to purchase own shares expires on thedate of the 2009 Annual General Meeting, at which a resolution will be proposedfor its renewal.Treasury shares Year ended 31 December 2008 2007 £000 £000 Balance at 1 January - - Purchases during the year 3,379 - --------- --------- Balance at 31 December 3,379 - ========= ========= 7 Retained earnings Year ended 31 December 2008 2007 £000 £000 Retained earnings attributable to equity holders of the parent company comprise Balance at 1 January 63,775 52,246 Profit for the year 20,017 25,439 Dividends Final approved and paid for 2006 - (8,419) Interim approved and paid for 2007 - (5,491) Final approved and paid for 2007 (10,302) - Interim approved and paid for 2008 (5,752) - --------- --------- Balance at 31 December 67,738 63,775 ========= =========
The interim dividend in respect of 2007, approved and paid in 2007, was paid at the rate of 5.25p per share. The final dividend in respect of 2007, approved and paid in 2008, was paid at the rate of 9.85p per share so that the total dividend paid to the equity shareholders of the Parent Company in respect of the year ended 31 December 2007 was made at the rate of 15.10p per share.
The interim dividend in respect of 2008, approved and paid in 2008, was paid at the rate of 5.50p per share to equity shareholders of the Parent Company registered at the close of business on 12 September 2008, the dividend record date.
A final dividend of 10.05p per share in respect of the year ended 31 December 2008 payable on 20 May 2009 to equity shareholders of the Parent Company registered at the close of business on 14 April 2008, the dividend record date, was approved by the Directors after the balance sheet date. The resulting total final dividend of £10.2m has not been provided for in these financial statements and there are no income tax consequences.
The following summarises dividends per share in respect of the year ended 31 December 2007 and 31 December 2008:
2008 2007 p p Interim - approved and paid 5.50 5.25 Final - proposed 10.05 9.85 --------- --------- Total 15.55 15.10 ========= ========= 8 Earnings per share
Earnings per share is based on the following:
Year ended 31 December 2008 2007 Profit for the year (£000) 20,017 25,439 --------- ---------
Weighted average number of ordinary shares 104,021,765 104,588,785
--------- --------- Basic earnings per share 19.24p 24.32p --------- --------- Diluted earnings per share 19.24p 24.32p ========= =========
The weighted average number of ordinary shares in respect of the year ended 31 December 2008 is based on 104,588,785 shares in issue at the beginning of the period and on 104,588,785 shares in issue at the end of the period less 3,096,194 own shares held in treasury as disclosed in Note 6, taking account of the timing of the purchases of own shares.
The weighted average number of ordinary shares in respect of the years ended 31 December 2008 and 31 December 2007 is based on 104,588,785 shares in issue at the beginning and end of those periods.
There were no share options outstanding during the year ended 31 December 2007 or during the year ended 31 December 2008. Accordingly, there is no dilution of the average number of ordinary shares in issue in respect of these periods.
9 Additional Information
Additional information relating to the Company can be found on its website www.chesnara.co.uk.
10 Forward looking statements
This document may contain forward-looking statements with respect to certain of the plans and current expectations relating to future financial condition, business performance and results of Chesnara plc. By their nature, all forward-looking statements involve risk and uncertainty because they relate to future events and circumstances that are beyond the control of Chesnara plc including, amongst other things, UK domestic and global economic and business conditions, market-related risks such as fluctuations in interest rates, inflation, deflation, the impact of competition, changes in customer preferences, delays in implementing proposals, the timing, impact and other uncertainties of future acquisitions or other combinations within relevant industries, the policies and actions of regulatory authorities, the impact of tax or other legislation and other regulations in the jurisdiction in which Chesnara plc and its subsidiaries operate. As a result, Chesnara plc's actual future condition, business performance and results may differ materially from the plans, goals and expectations expressed or implied in these forward-looking statements.
SUPPLEMENTARY INFORMATION - EUROPEAN EMBEDDED VALUE BASIS
SUMMARISED CONSOLIDATED INCOME STATEMENT
Year ended 31 December 2008 2007 Note £000 £000
Operating profit of covered business 6 25,521 13,522
Other operational result 385 (16) --------- --------- Operating profit 25,906 13,506
Variation from longer-term investment return (16,831) (3,020)
Effect of economic assumption changes 6,951 (4,043) --------- --------- Profit before tax 16,026 6,443 Tax (1,200) 5,674 --------- --------- Profit for the period 14,826 12,117 ========= ========= Earnings per share Based on profit for the period 14.25p 11.59p --------- --------- Diluted earnings per share Based on profit for the period 14.25p 11.59p --------- ---------
SUPPLEMENTARY INFORMATION - EUROPEAN EMBEDDED VALUE BASIS
SUMMARISED CONSOLIDATED BALANCE SHEET
31 December 2008 2007 Note £000 £000 Assets Value of in force business 5,8 84,940 94,007
Reinsurers' share of insurance contract provisions 165,648 187,486
Amounts deposited with reinsurers 21,404 26,702 Investment properties 3,432 4,983 Deferred tax assets - 88 Financial assets
Equity securities at fair value through income 363,879 743,670
Holdings in collective investment schemes at fair value through income 576,502 508,857 Debt securities at fair value through income 279,104 247,152 Insurance and other receivables 11,056 15,131 Prepayments 1,600 284 Derivative financial instruments 5,570 9,525 --------- --------- Total financial assets 1,237,711 1,524,619 --------- --------- Reinsurers' share of accrued policy claims 4,100 4,660 Cash and cash equivalents 192,381 225,127 --------- --------- Total assets 1,709,616 2,067,672 --------- --------- Liabilities Bank Overdraft 1,094 1,229 Insurance contract provisions 907,071 1,086,581 Financial liabilities Investment contracts at fair value through income 573,955 744,222 Borrowings 8,358 12,469 Derivative financial instruments 70 265 --------- --------- Total financial liabilities 582,383 756,956 --------- --------- Provisions 3,397 3,575 Reinsurance payables 1,397 1,622 Payables related to direct insurance and investment contracts 23,891 22,859 Income taxes 1,181 743 Other payables 6,494 6,792 --------- --------- Total liabilities 1,525,908 1,880,357 --------- --------- Net assets 182,708 187,315 ========= ========= Shareholders' equity Share capital 41,501 41,501 Share premium 20,458 20,458 Treasury shares (3,379) - Other reserves 50 50 Retained earnings 124,078 125,306 --------- --------- Total shareholders' equity 5,8 182,708 187,315 ========= =========
SUPPLEMENTARY INFORMATION - EUROPEAN EMBEDDED VALUE BASIS
SUMMARISED CONSOLIDATED STATEMENT OF CHANGES IN EQUITY
Year ended 31 December 2008 2007 £000 £000 Shareholders' equity at 1 January 187,315 189,108 Purchase of treasury shares (3,379) - Profit for the period representing total recognised income and expense 14,826 12,117 Dividends paid (16,054) (13,910) --------- --------- Shareholders' equity at 31 December 182,708 187,315 ========= =========
Notes to the Supplementary Information
1. Basis of preparation
This section sets out the detailed methodology followed for producing these Group financial statements which are supplementary to the Group's primary financial statements which have been prepared in accordance with International Financial Reporting Standards ('IFRS'). These financial statements have been prepared in accordance with the European Embedded Value ('EEV') principles issued in May 2004 by the European CFO Forum and supplemented by Additional Guidance on EEV Disclosures issued by the same body in October 2005. The principles provide a framework intended to improve comparability and transparency in embedded value reporting across Europe.
2. Covered business
The Group uses EEV methodology to value its individual life assurance, pension and annuity business, which has been written, with only insignificant exceptions, in the UK ('covered business'). This business comprises the Group's long-term business operations, being those contracts falling under the definition of long-term insurance business for UK regulatory purposes.
The Group has no significant business activities other than those relating to the covered business. In particular, the operating activities of the holding company, Chesnara plc, are treated as an integral part of the covered business. Under EEV principles no distinction is made between insurance and investment contracts, as there is under IFRS, which accords these classes of contracts different accounting treatments.
3. Methodology(a) Embedded ValueOverview
Shareholders' equity comprises the embedded value of the covered business, together with the net equity of other Group companies, including that of the holding company which is stated after writing down fully the carrying value of the covered business.
The embedded value of the covered business is the aggregate of the shareholder net worth (SNW) and the present value of future shareholder cash flows from in-force covered business (value of in-force business) less any deduction for the cost of required capital. It is stated after allowance has been made for aggregate risks in the business. SNW comprises those amounts in the long-term business, which are either regarded as required capital or which represent surplus assets within that business.
New business
Much of the covered business is in run-off and is, accordingly, substantially closed to new business. The Group does still sell guaranteed bonds but, overall, the contribution from new business to the results established using EEV methodology is not material. Accordingly, not all of those items related to new business values, which are recommended by the EEV guidelines, are reported in this supplementary financial information.
Value of in-force business
The cash flows attributable to shareholders arising from in-force business are projected using best estimate assumptions for each component of cash flow.
The present value of the projected cash flows is established by using a discount rate which reflects the time value of money and the risks associated with the cash flows which are not otherwise allowed for. There is a deduction for the cost of holding the required capital, as set out below.
Taxation
The present value of the projected cash flows arising from in-force business takes into account all tax which is expected to be paid under current legislation, including tax which would arise if surplus assets within the covered business were eventually to be distributed.
The value of the in-force business has been calculated on an after-tax basis and is grossed up to the pre-tax level for presentation in the income statement. The amount used for the grossing up is the amount of shareholder tax payable in the policyholder fund plus any direct tax charge within the shareholder fund.
Cost of capital
The cost of holding the required capital to support the covered business (see 3b below) is reflected as a deduction from the value of in-force business and is determined as the difference between the amount of the required capital and the projected release of capital and investment income.
Financial options and guarantees
The principal financial options and guarantees are (i) guaranteed annuity rates offered on some unit-linked pension contracts and (ii) a guarantee offered under Timed Investment Funds that the unit price available at the selected maturity date (or at death, if earlier) will be the highest price attained over the policy's life. The cost of these options and guarantees has been assessed, in principle, on a market-consistent basis, but, in practice, this has been carried out on approximate bases, which are appropriate to the level of materiality of the results.
Allowance for risk
Allowance for risk within the covered business is made by:
1) setting required capital levels by reference to the Directors' assessment of capital needs;
2) setting the risk discount rate, which is applied to the projected cash flows arising on the in-force business, at a level which includes an appropriate risk margin; and
3) explicit allowance for the cost of financial options and guarantees and, where appropriate, for reinsurer default.
(b) Level of Required Capital
The level of required capital of the covered business reflects the amount of capital that the Directors consider necessary and appropriate to manage the business. In forming their policy the Directors have regard to the minimum statutory requirements and an internal assessment of the market, insurance and operational risks inherent in the underlying products and business operations. The capital requirement resulting from this assessment represents 150% of the long-term insurance capital requirement ('LTICR') together with 100% of the resilience capital requirement ('RCR'), as set out in FSA regulations.
The required capital is provided by the retained surplus in the long-term business fund and the retained earnings and issued share capital in the shareholder fund.
(c) Risk Discount Rate
The risk discount rate ('RDR') is a combination of the risk-free rate and a risk margin. The risk-free rate reflects the time value of money and the risk margin reflects any residual risks inherent in the covered business and makes allowance for the risk that future experience will differ from that assumed. In order to reduce the subjectivity when setting the RDR, the Board has decided to adopt a 'bottom up' market-consistent approach to allow explicitly for market risk.
Using the market-consistent approach each cash flow is valued at a discount rate consistent with that used in the capital markets: in accordance with this, equity-based cash flows are discounted at an equity RDR and bond-based cash flows at a bond RDR. In practice a short-cut method known as the 'certainty equivalent' approach has been adopted. This method assumes that all cash flows earn the risk-free rate of return and are discounted at the risk-free rate. In general, and consistent with the market's approach to valuing financial instruments for hedging purposes, the risk-free rate is based on swap yields. Where, however, non-linked business is substantially backed by government bonds, the yields on these assets have been taken.
Within the risk margin allowance also needs to be made for non-market risks. For some of these risks e.g. mortality and expense risk it is assumed that the shareholder can diversify away any uncertainty where the impact of variations in experience on future cash flows is symmetrical. For those risks that are assumed to be diversifiable no adjustment to the risk margin has been made. For any remaining risks that are considered to be non-diversifiable risks there is no risk premium observable in the market and therefore a constant margin of 50 basis points has been added to the risk margin. The RDR is determined by equating the results from the traditional embedded value approach, including the assumed actual investment returns and traditional cost of capital, to that derived using the market-consistent method, this process being known as calibration of the RDR. The risk margin is then the difference between the derived RDR and the risk-free rate. The selection of the assumed actual investment returns and the reported cost of capital will have no impact on the reported result, as changes in these produce corresponding changes in the RDR.
A market-consistent valuation approach also generally requires consideration of 'frictional' costs of holding shareholder capital: in particular, the cost of tax on investment returns and the impact of investment management fees can reduce the face value of shareholder funds. In the Group's case, the expenses relating to corporate governance functions eliminate any taxable investment return in shareholder funds, while investment management fees are not material.
(d) Analysis of Profit
The contribution to operating profit, which is identified at a level which reflects an assumed longer-term level of investment return, arises from three sources:
(i) new business;
(ii) return from in-force business; and
(iii) return from shareholder net worth.
Additional contributions to profit arise from:
(i) variances between the actual investment return in the period and the assumed long-term investment return; and(ii) the effect of economic assumption changes.
The contribution from new business represents the value recognised at the end of each period in respect of new business written in that period, after allowing for the cost of acquiring the business, the cost of establishing the required technical provisions and after making allowance for the cost of capital.
The return from in-force business is calculated using closing assumptions and comprises:
(i) the expected return, being the unwind of the discount rate over the period
applied to establish the value of in-force business at the beginning of the
period;
(ii) variances between the actual experience over the period and the assumptions
made to establish the value of business in force at the beginning of the
period; and
(iii)the net effect of changes in future assumptions, made prospectively at the end
of the period, from those used in establishing the value of business in force
at the beginning of the period, other than changes in economic assumptions.
The contribution from shareholder net worth comprises the actual investment return on residual assets in excess of the required capital.
(e) Assumption Setting
There is a requirement under EEV methodology to use best estimate demographic assumptions and to review these at least annually with the economic assumptions being reported at each reporting date. The current practice is detailed below.
Each year the demographic assumptions are reviewed as part of year-end processes and hence were reviewed in December 2008.
The detailed projection assumptions, including mortality, morbidity, persistency and expenses reflect recent operating experience. Allowance is made for future improvement in annuitant mortality based on experience and externally published data. Favourable changes in operating experience, particularly in relation to expenses and persistency, are not anticipated until the improvement in experience has been observed. Holding company expenses (for the Chesnara Group such expenses relate largely to listed company functions) are principally allocated to the covered business to reflect effort expended within the holding company relating to the transaction of life assurance business through the subsidiary companies. Hence the expense assumptions used for the cash flow projections include the full cost of servicing this business.
The economic assumptions are reviewed and updated at each reporting date based on underlying investment conditions at the reporting date. The assumed discount rate and inflation rates are consistent with the investment return assumptions.
The assumptions required in the calculation of the value of the guarantee on pension business with annuity guarantees have been set equal to best-estimate assumptions.
4. Assumptions
(a) Investment Returns (pre- tax)
The assumed future pre-tax returns on fixed interest and RPI linked securities are set by reference to redemption yields available in the market at the end of the reporting period. The corresponding return on equities and property is equal to the fixed interest gilt assumptions plus an appropriate risk margin; for equities, the return is split between franked income and capital gains based on a best estimate of long-term average dividend yields. For linked business the aggregate return has been determined by reference to the benchmark asset mix within the Managed Funds.
31 December 2008 2007 Equity risk premium 2.7% 2.7% Property risk premium 2.7% 2.7% Investment return Fixed Interest 3.6% 4.6% Equities 6.3% 7.3% Property 6.3% 7.3% UK equities dividend yield 3.1% 3.0% Inflation RPI 1.5% 3.1% (b) Actuarial Assumptions
The demographic assumptions used to determine the value of the in-force business have been set at levels commensurate with the underlying operating experience identified in the periodic actuarial investigations.
(c) Taxation
Projected tax has been determined assuming current tax legislation and rates continue unaltered, except where future tax rates or practices have been announced.
(d) Expenses
The expense levels are based on internal expense analysis investigations and are appropriately allocated to the new business and policy maintenance functions. These have been determined by reference to:
(i) the outsourcing agreements in place with our third-party business process administrators;(ii) anticipated revisions to the terms of such agreements as they fall due for renewal; and(iii) corporate governance costs relating to the covered business.
The expense assumptions also include the expected future holding company expenses which will be recharged to the covered business.
No allowance has been made for future productivity improvements in the expense assumptions.
(e) Risk Discount Rate
The risk-free rate is set by reference to the sterling mid swap rates available in the market at the end of the reporting period. Where, however, non-linked business is substantially backed by government bonds, the yields on these assets have been used.
An explicit constant margin of 50 basis points is added to the risk-free rate to cover any remaining risks that are considered to be non-market, non-diversifiable risks, as there is no risk premium observable in the market. This margin gives due recognition to the fact that:
(i) the covered business is substantially closed to new business;(ii) there is no significant exposure in the with profits business, which is wholly reinsured;(iii) expense risk is limited as a result of the outsourcing of substantially all policy administration and related functions to third-party business process administrators; and(iv) for much of the life business the Group has the ability to vary risk charges made to policyholders. 31 December 2008 2007 Risk-free rate 3.6% 5.0% Non-diversifiable risk 0.5% 0.5% Risk margin 2.2% 2.2% Risk discount rate 6.3% 7.7%
5. Analysis of shareholders' equity
31 December 2008 2007 Covered business Required capital 35,615 39,149 Free surplus 33,774 38,483 --------- --------- Shareholder net worth 69,389 77,632 Value of in-force business 84,940 94,007 --------- --------- Embedded value of covered business 154,329 171,639 Less: amount financed by borrowings (8,358) (12,469) --------- --------- Embedded value of covered business attributable to shareholders 145,971 159,170 Net equity of other Group companies 36,737 28,145 --------- --------- Total shareholders' equity 182,708 187,315 ========= ========= The movement in the value of in-force business comprises: Value at beginning of period 94,007 109,941 Amount charged to operating profit (9,067) (15,934) --------- --------- Value at end of period 84,940 94,007 ========= =========
On 2 June 2005, the Group drew down £21m on a bank loan facility, in order to part fund the acquisition of CWA Life Holdings plc. This effectively represented a purchase of part of the underlying value in force of CWA by way of debt finance and it follows that the embedded value of the covered business is not attributable to equity shareholders of the Group to the extent of the outstanding balance on the loan account at each balance sheet date. The loan is repayable in five equal annual instalments on the anniversary of the draw down date, the funds for the repayment effectively being provided by way of the realisation of the underlying value of in-force business of the covered business. In accordance with this, £4.2m of the loan was repaid on 2 June 2007 and a further £4.2m was repaid on 2 June 2008, leaving principal outstanding at that date of £8.4m.
6. Analysis of profit of covered business
Year Ended 31 December 2008 2007 £000 £000 New business contribution 715 1,261 Return from in-force business Expected return 10,445 10,206 Experience variances 9,166 4,238 Operating assumption changes 4,590 (4,236) Return on shareholder net worth 605 2,053 --------- --------- Operating profit 25,521 13,522
Variation from longer-term investment return (16,831) (3,020)
Effect of economic assumption changes 6,951 (4,043) --------- --------- Profit on covered business before tax 15,641 6,459 Tax (1,376) 5,677 --------- --------- Profit on covered business after tax 14,265 12,136 ========= =========
The profit of covered business varies from amounts presented in the summarised consolidated income statement in respect of the pre-tax result of the holding company presented as 'other operational result', and in respect of any tax pertaining thereto, which is included in 'other tax'.
In respect of the year ended 31 December 2007, £3,844,000 of adverse variances, previously reported as adverse experience variances within the return from in-force business, have been re-classified as variation from longer-term investment return, as this more properly reflects the nature of the variances. This has the effect of increasing the net return from in-force experience variances from £394,000, as previously reported, to £4,238,000 and of re-stating the variation from longer-term investment return from a net credit of £824,000, as previously reported, to a net charge of £3,020,000. In accordance with this, operating profit has increased from £9,678,000, as previously reported, to £13,522,000. The profit on covered business before tax remains unchanged at £6,459,000.
7. Sensitivities to alternative assumptions
The following table shows the sensitivity of the embedded value of the covered business as reported at 31 December 2008 to variations in the assumptions adopted in the calculation of the embedded value. Sensitivity analysis is not provided in respect of the new business contribution for the year ended 31 December 2008 as the reported level of new business contribution is not considered to be material (see Note 3a) above). It largely relates to guaranteed bond business, where a close asset/liability matching approach leaves values largely insensitive to changes in experience.
Embedded Value ('EV') of covered business as at 31 December 2008 £154.2m Change in EV (£m) Economic sensitivities 100 basis point increase in risk discount rate (5.0) 100 basis point reduction in yield curve 2.9 10% decrease in equity and property values (4.8) Operating sensitivities 10% decrease in maintenance expenses 2.0 10% decrease in lapse rates 3.2 5% decrease in mortality/morbidity rates Assurances 1.7 Annuities (0.9) Reduction in the required capital to statutory minimum 1.7
The key assumption changes represented by each of these sensitivities are as follows:
Economic sensitivities
(i) 100 basis point increase in the risk discount rate. The 6.3% RDR increases to 7.3%;(ii) 100 basis point reduction in the yield curve. The fixed interest return is reduced by 1% and the equity/property returns are also reduced by 1%, thus maintaining constant equity/property risk premiums. The rate of future inflation has also been reduced by 1% so that real yields remain constant. In addition the risk discount rate has also reduced by 1%; and (iii) 10% decrease in the equity and property values. This gives rise to a situation where, for example, a Managed Fund unit liability with a 60% equity holding would reduce by 6% in value.
Operating sensitivities
(i) 10% decrease in maintenance expenses, giving rise to, for example, a base assumption of £20 per policy pa reducing to £18 per policy pa;(ii) 10% decrease in persistency rates giving rise to, for example, a base assumption of 10% of policy base lapsing pa reducing to 9% pa;(iii) 5% decrease in mortality/morbidity rates giving rise to, for example, a base assumption of 95% of the parameters in a selected mortality/morbidity table reducing to 90% of the parameters in the same table; and(iv) the sensitivity to the reduction in the required capital to the statutory minimum shows the effect of reducing the required capital from 150% of the LTICR plus 100% RCR to the amounts of 100% LTICR plus 100% RCR, being the minimum requirement prescribed by FSA regulation.
In each sensitivity calculation all other assumptions remain unchanged except where they are directly affected by the revised economic conditions: for example, as stated, changes in interest rates will directly affect the risk discount rate.
The sensitivities to changes in the assumptions in the opposite direction will result in changes of similar magnitude to those shown in the above table but in the opposite direction.
8. Reconciliation of shareholders' equity on the IFRS basis to shareholderequity on the EEV basis 31 December 2008 2007 £000 £000 Shareholders' equity on the IFRS basis 126,368 125,784 Adjustments Deferred acquisition costs Investment contracts (8,047) (8,961) Deferred income 13,705 15,426 Adjustment to provisions on investment contracts, net of amounts deposited with reinsurers (15,863) (18,220) Adjustments to provisions on insurance contracts, net of reinsurers' share (610) (600) Acquired in-force value (21,020) (23,785) Deferred tax 3,235 3,664 --------- --------- Group shareholder net worth 97,768 93,308 Value of inforce business 84,940 94,007 --------- --------- Shareholders' equity on the EEV basis 182,708 187,315 ========= ========= Group shareholder net worth comprises: Shareholder net worth in covered business 69,389 77,632
Shareholder's equity in other Group companies 36,737 28,145
Debt finance (8,358) (12,469) --------- --------- Total 97,768 93,308 ========= =========
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