Scottish Widows Limited Annual Financial Report

7 April 2022

SCOTTISH WIDOWS LIMITED

PUBLICATION OF THE ANNUAL REPORT AND ACCOUNTS FOR THE YEAR ENDED 31 DECEMBER 2021

Scottish Widows Limited has published its Annual Report and Accounts for the year ended 31 December 2021 (the "Accounts") which will shortly be available on the Scottish Widows website at www.scottishwidows.co.uk Copies of the Accounts have also been submitted to the National Storage Mechanism and will shortly be available for inspection at https://data.fca.org.uk/#/nsm/nationalstoragemechanism

ADDITIONAL INFORMATION REQUIRED BY THE DISCLOSURE AND TRANSPARENCY RULES ("DTR")

The information below is extracted from the Accounts and constitutes the material required by DTR 6.3.5 to be communicated to the media in unedited full text through a Regulatory Information Service. This material is not a substitute for reading the full Accounts and is provided solely for the purposes of complying with DTR 6.3.5. Page numbers and cross-references in the extracted information below refer to page numbers and cross-references in the Accounts.

STATEMENT OF DIRECTORS' RESPONSIBILITIES

The Directors are responsible for preparing the Annual Report and Accounts in accordance with applicable law and regulation.

Company law requires the Directors to prepare financial statements for each financial year. Under that law, the Directors have prepared the Group and Company financial statements in accordance with international accounting standards in conformity with the requirements of the Companies Act 2006. Additionally, the Financial Conduct Authority's Disclosure Guidance and Transparency Rules require the Directors to prepare the Group financial statements in accordance with international financial reporting standards adopted pursuant to Regulation (EC) No 1606/2002 as it applies in the European Union. Under Company law the Directors must not approve the financial statements unless they are satisfied that they give a true and fair view of the state of affairs of the Group and Company and of the profit or loss of the Group and Company for that period. In preparing the financial statements, the Directors are required to:

· select suitable accounting policies and then apply them consistently

· state whether for the Group and Company, UK-adopted international accounting standards in conformity with the requirements of the Companies Act 2006 have been followed, subject to any material departures disclosed and explained in the financial statements

· make judgements and accounting estimates that are reasonable and prudent

· prepare the financial statements on the going concern basis unless it is inappropriate to presume that the Group and Company will continue in business

The Directors are also responsible for safeguarding the assets of the Group and Company and hence for taking reasonable steps for the prevention and detection of fraud and other irregularities.

The Directors are responsible for keeping adequate accounting records that are sufficient to show and explain the Group and Company's transactions and disclose with reasonable accuracy at any time the financial position of the Group and Company and enable them to ensure that the financial statements comply with the Companies Act 2006 and, as regards the Group financial statements, Article 4 of the IAS Regulation.

The Directors are responsible for the maintenance and integrity of the Company's website. Legislation in the United Kingdom governing the preparation and dissemination of financial statements may differ from legislation in other jurisdictions. A copy of the financial statements is placed on our website www.scottishwidows.co.uk.

Each of the Directors whose names are listed on page 3 confirms that, to the best of their knowledge:

· The Group and Company financial statements which have been prepared in accordance with UK-adopted international accounting standards in conformity with the requirements of the Companies Act 2006, give a true and fair view of the assets, liabilities, financial position and financial performance of the Group and Company

· the Group Strategic Report on pages 4 to 16, and the Directors' Report on pages 17 to 23 include a fair review of the development and performance of the business and the position of the Group and Company, together with a description of the principal risks and uncertainties that it faces

PRINCIPAL RISKS AND UNCERTAINTIES

Risks and uncertainties to our strategic plan, both positive and negative, are considered by product through the planning process. The following table describes the principal risks faced by the Group. Further details on financial risks and how the Group mitigates them can be found in note 36, as shown by the note reference.

Financial risks

Non-financial risks

In addition, as described in note 27, during the ordinary course of business the Group is subject to complaints and threatened or actual legal proceedings (including class or Group action claims) brought by or on behalf of current or former employees, customers, investors or other third parties, as well as legal and regulatory reviews, challenges, investigations and enforcement actions, both in the United Kingdom and overseas.

All such material matters are periodically reassessed, with the assistance of external professional advisors where appropriate, to determine the likelihood of the Group incurring a liability. In those instances where it is concluded that it is more likely than not that a payment will be made, a provision is established to management's best estimate of the amount required at the relevant balance sheet date. In some cases it will not be possible to form a view, for example because the facts are unclear or because further time is needed to properly assess the situation, and no provisions are held in relation to such matters. However the Group does not currently expect the final outcome of any such case to have a material adverse effect on its financial position, operations or cash flows.

36. Risk management

The Group is a part of Lloyds Banking Group. The principal activity is the undertaking of ordinary long-term insurance and savings business and associated activities in the United Kingdom. The Group offers a wide range of life insurance products such as annuities, pensions, whole life, term life and investment type products through independent financial advisors, the Lloyds Banking Group network and direct sales. The Company also reinsures business with insurance entities external to the Group.

This note summarises the financial risks and the way in which they are managed.

The Group writes a variety of insurance and investment contracts which are subject to a variety of financial risks, as set out below. Contracts can be either single or regular premium and conventional (non-profit), With Profits or unit-linked in nature.

The Group is exposed to a range of financial risks through its financial assets, financial liabilities, assets arising from reinsurance contracts and liabilities arising from insurance and investment contracts. In particular, the key financial risk is that long-term investment proceeds are not sufficient to fund the obligations arising from its insurance and investment contracts. The most important components of financial risk are market, insurance underwriting, credit, capital and liquidity risk.

The Group manages these risks in a number of ways, including risk appetite assessment and monitoring of capital resource requirements. In addition, the Principles and Practices of Financial Management (PPFMs) set out the way in which the With Profits business is managed. The Group also uses financial instruments (including derivatives) as part of its business activities and to reduce its own exposure to market risk and credit risk.

For With Profits business, subject to minimum guarantees, policyholders' benefits are influenced by the smoothed investment returns on assets held in the With Profits Funds. The smoothing cushions policyholders from daily fluctuations in investment markets. This process is managed in accordance with the published PPFMs.

The financial risks arising from providing minimum guaranteed benefits are borne in the With Profits Funds, but the Group bears financial risk in relation to the possibility that in extreme market conditions the With Profits Funds might be unable to bear the full costs of the guarantees. The amount of the guaranteed benefits increases as additional benefits are declared and allocated to policies.

For unit-linked business, policyholders' benefits are closely linked to the investment returns on the underlying funds. In the short-term, profit and equity are therefore largely unaffected by investment returns on assets in internal unit-linked funds as any gains or losses will be largely offset by changes in the corresponding insurance and investment contract liabilities, provided that there is appropriate matching of assets and liabilities within these funds. However, any change in the market value of these funds will have an indirect impact on the Group and Company through the collection of annual management and other fund related charges. As markets rise or fall, the value of these charges rises or falls correspondingly.

For non-participating business, the principal market risk is interest rate risk, which arises because assets and liabilities may exhibit differing changes in market value as a result of changes in interest rates. Asset and liability matching is used to mitigate the impact of changes in interest rates where the difference is material.

Financial assets and financial liabilities are measured on an on-going basis either at fair value or at amortised cost. The summary of significant accounting policies (note 1) describes how the classes of financial instruments are measured and how income and expenses, including fair value gains and losses, are recognised.

The timing of the unwind of the deferred tax assets and liabilities is dependent on the timing of the unwind of the temporary timing differences, arising between the tax bases of the assets and liabilities and their carrying amounts for financial reporting purposes, to which these balances relate.

The sensitivity analyses given throughout this note are based on a change in an assumption while holding all other assumptions constant. In practice, this is unlikely to occur as changes in some of the assumptions may be correlated, for example changes in interest rates and changes in market values. The sensitivity analysis presented also represents management's assessment of a reasonably possible alternative in respect of each sensitivity, rather than worst case scenario positions.

36. Risk management (continued)

(a) Market risk

Market risk is defined as the risk that our capital or earnings profile is affected by adverse market rates, in particular equity, credit default spreads, interest rates and inflation in Insurance business.

Investment holdings within the Group are diversified across markets and, within markets, across sectors. Holdings of individual assets are diversified to minimise specific risk and large individual exposures are monitored closely. For assets held with unit-linked funds, investments are only permitted in countries and markets which are sufficiently regulated and liquid.

Market risk policy is dependent on the nature of the funds in question, and can be broadly summarised as follows:

• Assets held in shareholder funds are invested in money-market funds, gilts, loans and investment grade bonds to match regulatory capital requirements. The balance of the shareholder fund assets is managed in line with the policies of Lloyds Banking Group to optimise shareholder risk and return. This includes suitable use of derivatives to minimise shareholder risk

- Unit-linked assets are invested in accordance with the nature of the fund mandates. "Unit matching" is adopted on a significant proportion of unit-linked business, under which sufficient units are created to cover Solvency II technical provisions. An equity hedging programme has also been established in respect of the unit-linked business that is not subject to unit matching. This is an economic hedge designed to mitigate the effects of the equity market on profit

- Conventional non-profit liabilities are 'close matched' as far as possible in relation to currency, nature and duration

- With Profits Funds are managed in line with the published PPFMs. Benchmarks and minimum and maximum holdings in asset classes are specified to allow limited investment management discretion whilst ensuring adequate diversification. Swaps and swaptions provide significant protection to the With Profits Funds from the effects of interest rate falls in respect of the cost of guaranteed annuity rates (as annuity rates are determined by interest rates)

Below is an analysis of the carrying values of assets and liabilities at fair value through profit or loss and assets and liabilities for which a fair value is required to be disclosed, according to their fair value hierarchy (as defined in note 1 (d)).

Group As at 31 December 2021

For all financial assets held at amortised cost by the Group and Company, carrying value is a reasonable approximation of fair value. The fair value of subordinated debt is presented in note 29.

36. Risk management (continued)

(a) Market risk (continued)

Company As at 31 December 2021

For all financial instruments held at amortised cost by the Group and Company, carrying value is a reasonable approximation of fair value.

Group As at 31 December 2020

36. Risk management (continued)

(a) Market risk (continued)

Company As at 31 December 2020

Contracts with reinsurers held at fair value through profit and loss are valued using the published price for the funds invested in. Fair values have not been disclosed for participating investment contracts. There is currently no agreed definition of fair valuation for these types of contracts applied under IFRS and therefore the range of possible fair values of these contracts cannot be measured reliably.

The derivative securities classified as Level 2 above have been valued using a tri-party pricing model as determined by the Pricing Source Agreement between Investment Manager(s) and the Third-Party Administrator (State Street). Further detail on valuation is given in note 1(n).

Assets classified as Level 3 include portfolios of illiquid loans and advances to customers, investments in private debt funds and private equity assets, investment properties, investments in asset-backed securities, derivatives and corporate debt instruments. Private equity investments are valued using the financial statements of the underlying companies prepared by the general partners, adjusted for known cash flows since valuation and subject to a fair value review to take account of other relevant information. Investment property is independently valued as described in the Property section of this note below.

COVID-19

Markets in 2021 have been less volatile than in 2020 although pandemic related sector uncertainties remain as well as new inflationary pressures. Equity markets have risen over the last six months increasing the value of collective investments and driving the rise in value in the linked portfolio assets. The shape of the risk-free interest rate curve has changed significantly during the second half of 2021, with rising interest rates at the short end of the curve but rate falls at the long end creating a more negatively sloped GBP curve. Inflationary pressures have seen the short end of the Retail Price Index (RPI) curves also rise sharply and become more negatively sloped. The majority of the debt security and illiquid credit asset positions have seen value declines as a result of rising rates. Credit spread moves have been more subdued, but with some steepening amongst investment grade ratings.

The following valuation methods and sensitivity of valuation assumptions are applied to both the Group and the Company.

36. Risk management (continued)

(a) Market risk (continued)

Loan assets

Loans classified as Level 3 within debt securities are valued using a discounted cash flow model. The discount rate comprises market observable interest rates, a risk margin that reflect loan credit ratings and calibrated to weighted average life on borrower level using sector bond spread curves for each rating, and an incremental illiquidity premium that is estimated by reference to historical spreads at origination on similar loans where available and established measures of market liquidity. Libor tenor and base rate options are valued by comparing the current tenor with the lowest tenor option (basis swap approach). Prepayment options are valued using a monthly time step binomial lattice approach.

The base valuation of loans is £8.8 billion (2020: £9.1 billion). The unobservable inputs in the valuation model include the credit spread and specifically the illiquidity premium of loans compared to bonds and the spread adjustments due to the specific credit characteristics of the borrower. The impact of current economic conditions on the valuation of the loan portfolio has been taken into account in the year end valuation. The impact of applying reasonably possible alternative assumptions to the value of these loans would be to decrease the fair value by £402 million (2020: £575 million) or increase it by £442 million (2020: £454 million). The impact of alternative assumptions, mainly related to credit spread and illiquidity premium sensitivities would be -4.6 per cent (2020: -6.3 per cent) to base in adverse scenario and +5.1 per cent (2020: +5.0 per cent) to base in the favourable scenario. The skew observed in 2021 is less pronounced than 2020 due to refinements in the interplay between rating and sector spread uncertainty and changes in the dispersion of base market data.

Agricultural Loans - Agriculture SPV

A portfolio of agricultural loans is securitised through a Special Purpose Vehicle into a Senior Note (A Note) and a Junior Note (E Note). These notes are classified as Level 3 within debt securities. The underlying agricultural loans are valued using a discounted cash flow approach. The discount rate comprises market observable interest rates, a risk margin that reflect underlying loan credit ratings, a spread to represent the risks associated with the Agricultural sector and an incremental illiquidity premium including additional spread for prepayment uncertainty.

The unobservable input in the valuation model is principally the credit spread including the illiquidity premium of loans compared to mortgages, the spread adjustments relevant to the Agricultural sector and the credit profile of the borrowers and the notes issued from the securitisation.

The base valuation of Agricultural loans is £327 million (2020: £379 million). The impact of applying reasonably possible alternative assumptions to the valuation of the loans and senior note would be to decrease the fair value of the SPV by £20 million (2020: £21 million) or increase it by £17 million (2020: £13 million). Impact of alternative assumptions on credit spread, illiquidity premium and prepayment assumptions is -6.1 per cent (2020: -5.5 per cent) to base in the adverse scenario and +5.2 per cent (2020: +3.5 per cent) to base in the favourable scenario.

Securitised Lifetime Mortgages

A portfolio of historical Lifetime Mortgages is securitised through a Special Purpose Vehicle into a Senior Note (A Note) and a Junior Note (B Note). The value of the B Note is determined using a discounted cashflow approach. The spread is derived using expert judgement, supported by spreads in comparable LTM Mortgages against changes in the expected performance of the underlying mortgage portfolio. The value of the A Note is derived as a balancing item from the value of the underlying portfolio less the value of the B Note and expenses. These notes are classified as Level 3 within debt securities due to the unobservable parameters required in the valuation of the Senior Note, Junior Note and in the valuation of the portfolio of mortgages.

These lifetime mortgages are valued using a discounted cash flow approach. Decrements (mortality, voluntary early repayment, entry into long-term care) are used to determine the incidence of cash flows. The discount rate is based on a risk-free rate plus a spread assessed by reference to the current comparable lifetime mortgages market, after adjusting for the relative risks associated with this portfolio of mortgages and those of a notional portfolio of new mortgages. In the assessment of the value of the risks, the No Negative Equity Guarantee (NNEG) for Lifetime Mortgages is valued using a time-dependent Black-Scholes model. The value of NNEG is £9 million (2020: £14 million).

Inputs in the valuation model include the gross interest rate applicable to a notional portfolio of comparable Lifetime Mortgages, risk free rates, residential property volatilities, property valuation haircuts and settlement lags as well as decrement assumptions on mortality, voluntary early repayment and entry into long-term care.

The base valuation of Securitised Lifetime Mortgages is £162 million (2020: 176 million). December 2021 Valuation Uncertainty calculations reflects uncertainty in the market rates for comparable notional portfolios as well as decrement assumptions and their impacts on the value of the A Note and B Note. The range of the notional portfolio rate assumption was 3.95 per cent to 4.30 per cent (2020: 3.50 per cent to 4.27 per cent).

36. Risk management (continued)

(a) Market risk (continued)

Securitised Lifetime Mortgages (continued)

The effect of applying the aforementioned reasonably possible alternative assumptions in line with the ranges disclosed above on the A & B Notes would be to decrease the fair value by £5 million (2020: £5 million) or increase it by £5 million (2020: £9 million). The impact of alternative assumptions on credit spread and illiquidity premium is -2.5 per cent (2020: -2.9 per cent) to base in the adverse scenario and +3 per cent (2020: +5 per cent) to base in the favourable scenario.

Originated Lifetime Mortgages

New Lifetime Mortgage Loans have been originated by Lloyds Banking Group Retail since April 2020 on behalf of the Company. The loans are being warehoused with the intention to securitise in 2022.

The valuation methodology uses the same principles as that for the securitised historical mortgages. The mortgages are valued using a discounted cash flow approach. Decrements (mortality, voluntary early repayment, entry into long-term care) are used to determine the incidence of cash flows. The discount rate includes an illiquidity spread by reference to the market for new Lifetime Mortgages, after adjusting for the relative risks associated with this portfolio of mortgages and those of a notional portfolio of new mortgages. The model for originated mortgages utilises a Jarrow-Yildirim model, which is a variant of the Black-Scholes mechanism, and an Economic Scenario generator in determining the No Negative Equity Guarantee. The model also includes additional features and factors that are pertinent to recently originated mortgages as compared those that are more mature.

The base valuation of Originated Lifetime Mortgage is £123 million (2020: £16 million). December 2021 Valuation Uncertainty calculations principally reflect uncertainty in the market rates and acquisition costs of comparable notional portfolios and their corresponding impact on the loan portfolio values. The effect of applying the aforementioned reasonably possible alternative assumptions in line with the ranges disclosed above on the loans would be to decrease the fair value by £3 million (2020: £0.7 million) or increase it by £5 million (2020: £0.3 million). The increase in this range year-on-year is due to the significant increase of new loan origination throughout 2021. The range of Notional Interest Rates as of December 2021 for the Favourable scenario was 2.76 per cent to 3.41 per cent (2020: 2.48 per cent to 3.66 per cent) and for the Adverse Scenario was 2.99 per cent to 3.79 per cent (2020: 2.68 per cent to 4.18 per cent) compared to Base case range of 2.93 per cent to 3.41 per cent (2020: 2.54 per cent to 3.66 per cent).

ERM Public Securitisation 

On 2 November 2021 the Company purchased a new public securitisation of UK Lifetime Mortgages sponsored by RGA Americas Reinsurance Company Ltd (RGA). The origination of the underlying Lifetime Mortgages is by More2Life (M2L). The assets purchased are £25 million of the Class A1 notes and £8 million of the Class A2 notes.

The assets are classified as Level 3 and are included within Asset Backed Securities. The valuation for the Class A1 notes as of Dec 2021 was £26 million and the Class A2 notes valuation is £8 million. The valuation of these assets is provided by the lead manager on a monthly basis.

Private Credit Funds

The Company holds investments in two private credit funds that hold portfolios to European medium sized enterprises. The assets are classified as level 3 and are included within equity securities. The underlying loan values, on which the investment values are based, are assessed by the fund manager on a discounted cash flows approach using spreads determined from the credit quality and illiquidity of the loans as compared to other credit assets. Our valuation uncertainty on these investments is assessed based on the valuation uncertainty characteristics of the underlying illiquid loans.

The fair value of Private Credit Funds is £456 million (2020: £544 million) as valued by the fund manager. The effect of applying reasonably possible alternative assumptions to the value of these assets would be to decrease the fair value by £11 million (2020: £19 million) or increase it by £10 million (2020: £3 million). For Pemberton European Mid-Market Debt Fund II (E) (Pemberton), the impact of alternative assumptions on credit spread and illiquidity premium is -2.5 per cent (2020: -2.0 per cent) to base in the adverse scenario and 2.1 per cent (2020: 0 per cent) to base in the favourable. The stable credit spread environment has meant there is now a favourable scenario related to these positions as compared to the fund managers pricing model.

For AgFe UK Real Estate Senior Debt Fund LP (AgFe), the fair valuations are provided by the fund manager. For the assessment of valuation uncertainty alternative assumptions on debt margin for the underlying loans are applied, resulting in a -1.9 per cent (2020: -5.9 per cent) to base in the adverse scenario and +1.9 per cent (2020: +1.9 per cent) to base in favourable scenario.

36. Risk management (continued)

(a) Market risk (continued)

Derivatives with Unobservable inputs

Derivatives are used to hedge interest rate and inflation risks. Where complex risks arise in other assets or liabilities, these hedging derivatives can be complex and have unobservable inputs such as volatilities, correlations and basis differences to vanilla derivatives. In these cases, the complex derivatives are assessed as level 3.

Favourable and adverse scenarios are determined by stressing unobservable inputs into the valuation models, with reference to the valuations of the instruments they hedge where appropriate, in order to generate a plausible range of fair values that different market participants might apply.

The base valuation of Derivatives is £359 million (2020: £567 million). The effect of applying reasonably possible alternative assumptions to the value of these assets would be to decrease the fair value by £84 million (2020: £62 million) or increase it by £23 million (2020: £20 million). The impact of alternative assumptions is -23.3 per cent (2020: -10.9 per cent) to base in the adverse scenario and +6.4 per cent (2020: +3.5 per cent) to base in the favourable scenario.

Property

Investment properties are valued by external Chartered Surveyors using industry standard techniques based on guidance from the Royal Institute of Chartered Surveyors. The valuation methodology includes an assessment of general market conditions and sector level transactions and takes account of expectations of occupancy rates, rental income and growth. Properties undergo individual scrutiny using cash flow analysis to factor in the timing of rental reviews, capital expenditure, lease incentives, dilapidation and operating expenses; these reviews utilise both observable and unobservable inputs.

The effect of applying reasonably possible alternative assumptions to the value of these assets would be to decrease the fair value by £14 million (2020: £21 million) or increase it by £22 million (2020: £17 million).

36. Risk management (continued)

(a) Market risk (continued)

The table below shows movements in the assets and liabilities measured at fair value based on valuation techniques for which any significant input is not based on observable market data (Level 3 only).

Group

Company

Total gains or losses for the period included in the statement of comprehensive income, as well as total gains or losses relating to assets and liabilities held at the reporting date, are presented in the statement of comprehensive income, through net gains/losses on assets and liabilities at fair value through profit or loss.

36. Risk management (continued)

(a) Market risk (continued)

(i) Equity and property risk

The exposure of the Group's insurance and investment contract business to equity risk relates to financial assets and financial liabilities whose values will fluctuate as a result of changes in market prices other than from interest and foreign exchange fluctuations. This is due to factors specific to individual instruments, their issuers or factors affecting all instruments traded in the market. Accordingly, the Group monitors exposure limits both to any one counterparty and any one market.

From 2018, exposure to market risk has been managed by the implementation of unit matching and equity hedging to reduce the sensitivity of future dividend payments to market movements. Unit matching involves more effectively matching unit linked liabilities on a best-estimate view (as defined by Solvency regulations). This best-estimate view incorporates an allowance for expected future income and expenses, which are not fully allowed for under IFRS. As a result, this leads to a mismatch between IFRS statutory assets and liabilities in respect of market movements. For example, in the event of rising markets, a loss would now be recognised in the accounts as a result of this mismatch, which would be offset in the future due to higher income as fees are received.

The effect on the Group of changes in the value of investment property held in respect of investment contract liabilities due to fluctuations in property prices is negligible as any changes will be offset by movements in the corresponding liability.

The sensitivity analysis below illustrates how the fair value of future cash flows in respect of equities and properties, net of offsetting movements in insurance and investment contract liabilities, will fluctuate because of changes in market prices at the reporting date. The equity sensitivity includes the impact of unit matching and equity hedging which leads to a statutory profit or loss, mainly due to the hedging result under falling and rising markets respectively.

(ii) Interest rate risk

Interest rate risk is the risk that the value of future cash flows of a financial instrument will fluctuate because of changes in interest rates and the shape of the yield curve. Interest rate risk in respect of the Group's insurance and investment contracts arises when there is a mismatch in duration or yield between liabilities and the assets backing those liabilities.

The Group's interest rate risk policy requires that the maturity profile of interest-bearing financial assets is appropriately matched to the guaranteed elements of the financial liabilities.

A fall in market interest rates will result in a lower yield on the assets supporting guaranteed investment returns payable to policyholders. This investment return guarantee risk is managed by matching assets to liabilities as closely as possible. An increase in market interest rates will result in a reduction in the value of assets subject to fixed rates of interest which may result in losses, as a result of an increase in the level of surrenders, the corresponding fixed income securities have to be sold.

The effect of changes in interest rates in respect of financial assets which back insurance contract liabilities is given in note 35. The effect on the Group of changes in the value of investments held in respect of investment contract liabilities due to fluctuations in market interest rates is negligible as any changes will be offset by movements in the corresponding liability.

The sensitivity analysis below illustrates how the fair value of future cash flows in respect of interest-bearing financial assets, net of offsetting movements in insurance and investment contract liabilities, will fluctuate because of changes in market interest rates at the reporting date.

36. Risk management (continued)

(a) Market risk (continued)

(ii) Interest rate risk (continued)

* Amount restated. See note 41 for details of the restatement.

Interest Rate Benchmark Reform

During 2021, the Group has continued to manage its process to transition to alternative benchmark rates under its Lloyds Banking Group-wide IBOR Transition Programme and has delivered the core changes required to its technology and business processes. Through this programme, the Group has ensured that the most appropriate benchmark rate is used for financial instruments impacted by the IBOR reform and has managed the impacts and risks relating to systems, processes, accounting and reporting. Most affected financial instruments were transitioned to new benchmark rates prior to 31 December 2021, with activity continuing to transition or otherwise remove the exposure to LIBOR for the remainder. The Group does not expect material changes to its risk management approach and strategy as a result of interest rate benchmark reform.

The material risks identified include the following:

Conduct and litigation risk

The Group may be exposed to conduct and litigation charges as a direct result of inappropriate or negligent actions taken during IBOR transition resulting in detriment to the customer. The Group is working closely with its counterparties to avoid this outcome.

Market risk

IBOR transition is expected to lead to changes in the Group's market risk profile which will continue to be monitored and managed within the appropriate risk appetites. The key change is expected to be on the management of basis risk profile during the period when alternative benchmark rates are referenced in contracts up to the cessation of the in-scope IBOR index.

Credit risk

Clients may wish to renegotiate the terms of existing transactions as a consequence of IBOR reform. This could lead to a change in the credit risk exposure of the client depending on the outcome of the negotiations. The Group will continue to monitor and manage changes within the appropriate risk appetites.

Accounting risk

If IBOR transition is finalised in a manner that does not permit the application of the reliefs introduced in the IFRS Phase 2 amendments, the financial instrument may be required to be derecognised and a new instrument recognised.

Operational risk

Additional operational risks may arise due to the IBOR transition programme impacting all businesses and functions within the Group and leading to the implementation of changes to technology, operations, client communication and the valuation of in-scope financial instruments.

At 31 December 2021, the Group had the following significant exposures impacted by interest rate benchmark reform which have yet to transition to the replacement benchmark: Sterling LIBOR non-derivative financial instruments at fair value through profit or loss of £1,432 million, and sterling LIBOR interest rate derivatives with contract/notional amount of £3,226 million. As at December 2021, these Sterling LIBOR balances relate to contracts that have not converted to a risk-free rate, for example where a contract matures in 2022 and it is not in both parties' interests to transition, or where both parties have not agreed to include fallback provisions that would have effect when LIBOR ceases. In both cases, these contracts will have both cash flows and valuations determined on a 'synthetic' LIBOR basis for reporting periods during 2022, unless they are transitioned to alternative benchmark rates.

36. Risk management (continued)

(a) Market risk (continued)

(ii) Interest rate risk (continued)

Interest Rate Benchmark Reform (continued)

In respect of the Group's hedge accounting relationships, for the purposes of determining whether:

a. a forecast transaction is highly probable

b. a hedge is expected to be highly effective in achieving offsetting changes in fair value or cash flows attributable to the hedged risk

c. an accounting hedging relationship should be discontinued because of a failure of the retrospective effectiveness test

The Group assumes that the interest rate benchmark on which the hedged risk or the cash flows of the hedged item or hedging instrument are based is not altered by uncertainties resulting from interest rate benchmark reform. In addition, for a fair value hedge of a non-contractually specified benchmark portion of interest rate risk, the Group assesses only at inception of the hedge relationship and not on an ongoing basis that the risk is separately identifiable and hedge effectiveness can be measured.

The interest benchmark reform affects the Sterling LIBOR interest rate benchmarks in respect of a fair value hedge. The value of assets designated in fair value hedges had a notional of nil (2020: nil) at 31 December 2021. The value of liabilities designated in fair value hedges had a notional of £1.5 billion (2020: £1.5 billion) at 31 December 2021.

At 31 December 2021, the notional amount of the hedging instruments in hedging relationships to which these amendments apply was £1.5 billion (2020: £1.5 billion).

(iii) Inflation risk

The Company's exposure to inflation risk on its liabilities arises primarily from annuity contracts, where the benefit payments are linked to an inflation index, and from the element of all policyholder liabilities relating to the future expenses of administering the in-force policies which are expected to increase with higher inflation. This exposure is hedged through holding appropriate assets, generally RPI linked swaps, such that the change in value of the assets is broadly offsetting to the change in value of the liabilities.

Within the Group, Scottish Widows Europe also hedges its exposure to inflation from the liability to future expenses.

Residual risk remains after the hedges. For example due to caps and floors to payments on some of the annuity liabilities and differences in inflation measures between assets and liabilities (e.g. RPI, CPI and salary growth).

The sensitivity below shows the expected impact of a 0.5 per cent increase to inflation in all future years. This is a multiple of the impact of one year's inflation increasing.

36. Risk management (continued)

(a) Market risk (continued)

(iiii) Foreign exchange risk

Foreign exchange risk relates to the effects of movements in exchange markets including changes in exchange rates.

The Group's foreign currency exposure is driven by holding financial instruments to hedge changes in future investment management fees resulting from exchange rate movements. These investment management fees are based on charges to policyholder funds invested in overseas equities. The hedges are placed by the Company to reduce foreign exchange exposure in the SII capital position.

Sensitivity analysis for the impact of a 10 per cent depreciation of sterling against foreign currency shows a £(175) million impact for 2021 on profit after tax and equity (2020: £(117) million).

With the exception of these holdings, the overall risk to the Group is minimal due to the following:

• The Group's principal transactions are carried out in pounds sterling

• The Group's financial assets are primarily denominated in the same currencies as its insurance and investment contract liabilities

• Other than shareholder funds, all non-linked investments of the non-profit funds are in sterling or are currency matched. The effect on the Group of changes in the value of investments held in respect of investment contract liabilities due to fluctuations in foreign exchange rates is negligible as any changes will be offset by movements in the corresponding liability

(b) Insurance underwriting risk

Insurance underwriting risk is defined as the risk of adverse developments in the timing, frequency and severity of claims for insured/underwritten events and in customer behaviour, leading to reductions in earnings and/or value.

The principal risk the Group faces under insurance contracts is that the actual claims and benefit payments exceed the amounts expected at the time of determining the insurance liabilities.

The nature of the Group's business involves the accepting of insurance underwriting risks which primarily relate to mortality, longevity, morbidity, persistency and expenses. When transacting new business, the Group underwrites policies to ensure an appropriate premium is charged for the risk or that the risk is declined.

The Group principally writes the following types of life insurance contracts:

• Life assurance - where the life of the policyholder is insured against death or permanent disability, usually for pre-determined amounts

• Annuity products - where typically the policyholder is entitled to payments which cease upon death

• Morbidity products - where the policyholder is insured against the risk of contracting a defined illness

For contracts where death is the insured risk, the most significant factors that could increase the overall level of claims are epidemics or widespread changes in lifestyle, such as eating, smoking and exercise habits, resulting in earlier or more claims than expected. The occurrence of a pandemic, such as the one arising from COVID-19 in 2020, is regarded as a potentially significant mortality risk. For contracts where survival is the insured risk, the most significant factor is continued improvement in medical science and social conditions that would increase longevity.

Despite an unprecedented spike in annuitant mortality rates during 2020 and 2021, it is expected that current annuitant mortality rates will revert to broadly the previous level in the short term. The longer-term impacts of COVID-19 on future annuitant mortality improvements remain unclear, however it is becoming clear that the pandemic is likely to have a net negative impact so smaller increases in life expectancy in the near future are now reflected in assumptions. Mortality assumptions continue to be updated annually, reflecting both historic experience and future expectations so as further information becomes available it will be incorporated in future assumptions. No additional provisions are held in respect of annuitant mortality.

A provision is held in respect of morbidity products as the reduced availability of medical screening has reduced critical illness claims made in 2021. It is expected that this reduction will be offset in 2022 as delayed claims arise.

For contracts with fixed and guaranteed benefits and fixed future premiums, there are no mitigating terms and conditions that significantly reduce the insurance underwriting risk accepted. For participating investment contracts, the participating nature of these contracts results in a significant portion of the insurance underwriting risk being shared with the policyholder.

36. Risk management (continued)

(b) Insurance underwriting risk (continued)

Insurance underwriting risk is also affected by the policyholders' right to pay reduced or no future premiums, to terminate the contract completely, to exercise a guaranteed annuity option or, for bulk annuity business, for pensioners to exercise options following retirement. As a result, the amount of insurance underwriting risk is also subject to policyholder behaviour. On the assumption that policyholders will make decisions that are in their best interests, overall insurance underwriting risk will generally be aggravated by policyholder behaviour. For example, it is likely that policyholders whose health has deteriorated significantly will be less inclined to terminate contracts insuring death benefits than those policyholders who remain in good health.

The Group has taken account of the expected impact of policyholder behaviour in setting the assumptions used to measure insurance and investment contract liabilities.

The principal methods available to the Group to control or mitigate longevity, mortality and morbidity risk are through the following processes:

• Underwriting (the process to ensure that new insurance proposals are properly assessed)

• Pricing-to-risk (new insurance proposals would usually be priced in accordance with the underwriting assessment)

• Demographics to accurately assess mortality risk

• Claims management

• Product design

• Policy wording

• The use of reinsurance and other risk mitigation techniques

Rates of mortality and morbidity are investigated annually based on the Group's recent experience. Future mortality improvement assumptions are set using the latest population data available. In addition, bulk annuity business pricing and valuation assumptions also consider underlying experience of the scheme where available. Where they exist, the reinsurance arrangements of each company in the Group are reviewed at least annually.

Persistency risk is the risk associated with the ability to retain long-term business. The Group aims to reduce its exposure to persistency risk by undertaking various initiatives to promote customer loyalty. These initiatives are aimed both at the point of sale and through direct contact with existing policyholders, for example through annual statement information packs.

COVID-19 and changes to the labour market have created uncertainty over employment levels and, as a result, Workplace pension contributions. This could negatively impact the value of Workplace pensions. There is a provision held in relation to this risk.

Further information on assumptions, changes in assumptions and sensitivities in respect of insurance and participating investment contracts is given in note 35.

36. Risk management (continued)

(c) Credit risk

The risk that parties with whom we have contracted, fail to meet their financial obligations (both on and off balance sheet).

The Group accepts credit risk with a variety of counterparties through invested assets which are primarily used to back annuity business, cash in liquidity funds and bank accounts, derivatives and reinsurance. These are managed through a credit control framework which uses a tiered approach to set credit limits:

• Tier 1: Credit limits are set by the Insurance Board as part of the overall Insurance Risk Appetite

• Tier 2: Insurance Asset and Liability Committee (IWALCO) assists the Chief Investment Officer to set additional controls, sub limits and guidelines. These operate within the boundaries of the Board's Tier 1 Risk Appetite statements and are designed to assist the business with more efficient utilisation of higher level Board Risk Appetite statements in delivery of Insurance's investment strategy

• Tier 3: Insurance Credit approvers have individual personal delegated authorities from the Insurance Board to approve exposures to individual counterparties. Amounts above these delegated authorities require approval by the Insurance Board

Group exposure limits are set for the maximum single name concentration, industry sector, country of risk and portfolio quality. In addition, each individual counterparty exposure requires a counterparty limit or is within the criteria of an approved sanction matrix.

Group exposures are reported on a monthly basis to the Insurance Shareholder Investment Management Committee (ISIM) and semi-annually to IWALCO, and other senior committees. Any exceptions to limits must be approved in advance by the relevant authority that owns that limit, and any unapproved excesses notified to that authority as a breach.

A core part of the invested asset portfolio which backs the annuity business is invested in loan assets. These have predominately been purchased from Lloyds Banking Group although the Group has also started originating new business. All loan assets are assessed and monitored using established robust processes and controls.

Reinsurance is primarily used to reduce insurance risk. However, it is also sought for other reasons such as improving profitability, reducing capital requirements and obtaining technical support. In addition, reinsurance is also used to offer policyholders access to third-party funds via Investment Fund Links which we are unable to provide through other means. The Group's reinsurance strategy is to reduce the volatility of profits through the use of reinsurance whilst managing the insurance and credit risk within the constraints of the risk appetite limits.

The Group has reinsurance on all significant lines of business where mortality, morbidity or property risks exceed set retention limits. This does not, however, discharge the Group's liability as primary insurer. If a reinsurer fails to pay a claim for any reason, the Group remains liable for the payment to the policyholder. All new material reinsurance treaties are subject to Board approval and reinsurance arrangements are reviewed annually to ensure that the reinsurance strategy is being achieved. Reinsurance for Investment Fund Links is not assessed as a counterparty exposure for the Group since with invested assets matching liabilities, any loss to the Group would only be the result of operational failures of internal controls and as such it is outside of the credit control framework described above.

Shareholder funds are managed in line with the Insurance Credit Risk Policy and the wider Lloyds Banking Group Credit Risk Policy which set out the principles of the credit control framework outlined above.

Credit risk in respect of unit-linked funds and With Profits Funds is largely borne by the policyholders. Consequently, the Group has no significant exposure to credit risk for those funds.

The tables below analyse financial assets and reinsurance assets subject to credit risk exposure using S&P Global Ratings' rating or equivalent. For certain classes of assets, internally generated ratings have been used where external ratings are not available. This includes credit assets held in both shareholder and policyholder funds. No account is taken of any collateral held to mitigate the risk.

36. Risk management (continued)

(c) Credit risk (continued)

Group As at 31 December 2021

Cash at bank, included with Stage 1 assets, is considered to have low credit risk.

36. Risk management (continued)

(c) Credit risk (continued)

Group As at 31 December 2020

36. Risk management (continued)

(c) Credit risk (continued)

Company As at 31 December 2021

Cash at bank, included with Stage 1 assets, is considered to have low credit risk.

36. Risk management (continued)

(c) Credit risk (continued)

Company As at 31 December 2020

Amounts classified as 'not rated' within contracts with reinsurers at fair value through profit or loss principally relate to an amount due from SWE which is not rated by Standard & Poor's or an equivalent rating agency.

Expected credit losses are calculated using three key input parameters: the probability of default (PD) (except for lifetime expected credit losses), the expected loss given default (LGD) and the exposure at default (EAD). The probability of default and expected loss given default are determined using internally generated credit ratings. For lease receivables, the past due information is used to determine the expected loss given default.

Expected credit losses are measured on a collective basis for certain Groups of financial assets, such as control accounts, trade receivables and intercompany receivables, which are considered to be homogenous in terms of their risk of default.

Maximum credit exposure

The maximum credit risk exposure of the Group in the event of other parties failing to perform their obligations is detailed below. No account is taken of any collateral held and the maximum exposure to loss, which includes amounts held to cover unit-linked and With Profits Funds liabilities, is considered to be the balance sheet carrying amount.

Net credit exposure represents the exposure net of offsetting, as defined in section 36(c)(iii).

36. Risk management (continued)

(c) Credit risk (continued)

Shareholder asset credit experience

The Group invests in a non-cyclical and high quality portfolio of assets, and regarding shareholder assets, the majority of these are used to match against long term annuity liabilities. The bonds, loans and gilts in which the Group invests have an average rating of A and are well diversified. In 2021 the net downgrades to sub-investment grade totalled £7 million, this was a result of £63 million of downgrades offset by total upgrades to investment grade of £56 million. A total of 0.5 per cent of shareholder assets are currently rated sub-investment grade.

The Group continues to have no direct exposure to Russia or Ukraine in its shareholder asset portfolios. There is limited indirect exposure in the corporate bond portfolio, but no material impact is expected. There has been no immediate impact on credit quality in the shareholder portfolio, however should a conflict and/or sanctions persist, there will be increased risk of credit deterioration due to macroeconomic pressures such as inflation or increasing energy prices.

36. Risk management (continued)

(c) Credit risk (continued)

(i) Concentration risk

Credit concentration risk

Credit concentration risk relates to the inadequate diversification of credit risk.

Credit risk is managed through the setting and regular review of counterparty credit and concentration limits on asset types which are considered more likely to lead to a concentration of credit risk. For other asset types, such as UK government securities or investments in funds falling under the Undertakings for Collective Investment in Transferable Securities (UCITS) Directive, no limits are prescribed as the risk of credit concentration is deemed to be immaterial. This policy supports the approach mandated by the PRA for regulatory reporting.

At 31 December 2021 and 31 December 2020, the Group did not have any significant concentration of credit risk with a single counterparty or Group of counterparties where limits applied. Regarding shareholder assets, the largest aggregated counterparty exposure is 0.2 per cent (2020: 0.2 per cent) of the Group's total assets.

The following table shows where the Group and Company has concentrations of credit risk with counterparties sharing similar features, specifically type of counterparty:

For other receivables, the largest single counterparty balance is with policyholders, which totals £132 million for Group (2020: £83 million) and £76 million for Company (2020: £83 million).

Liquidity concentration risk

Liquidity concentration risk arises where the Group is unable to meet its obligations as they fall due or do so only at an excessive cost, due to over-concentration of investments in particular financial assets or classes of financial asset.

As most of the Group's invested assets are diversified across a range of marketable equity and debt securities in line with the investment options offered to policyholders it is unlikely that a material concentration of liquidity concentration could arise.

This is supplemented by active liquidity management in the Group, to ensure that even under stress conditions the Group has sufficient liquidity as required to meet its obligations. This is delegated by the Board to and monitored through the Insurance and Wealth Asset and Liability Committee (IWALCO), IWRC, ISIM and Banking and Liquidity Operating Committee (BLOC).

(ii) Collateral management

Collateral in respect of derivatives

The requirement for collateralisation of OTC derivatives, including the levels at which collateral is required and the types of asset that are deemed to be acceptable collateral, are set out in a Credit Support Annex (CSA), which forms part of the International Swaps and Derivatives Association (ISDA) agreement between the Company and the counterparty.

The CSA will require collateralisation where any net exposure to a counterparty exceeds the OTC counterparty limit, which must be established in accordance with the Derivatives Risk Policy (DRP). The aggregate uncollateralised exposure to any one counterparty must not exceed limits specified in the DRP. Where derivative counterparties are related, the aggregate net exposure is considered for the purposes of applying these limits.

Acceptable collateral is defined in each instance and must take into account the quality and appropriateness of the proposed collateral as well as being acceptable to the entity receiving the collateral. Collateral may include cash, corporate bonds, supranational debt and government debt.

36. Risk management (continued)

(c) Credit risk (continued)

(ii) Collateral management (continued)

Collateral in respect of derivatives (continued)

Assets with the following carrying amounts have been pledged in accordance with the terms of the relevant CSAs entered into in respect of various OTC and other derivative contracts:

Collateral pledged in form of financial assets, is continued to be recognised in the balance sheet as the Group and Company retains all risks and rewards of the transferred assets. The Group and the Company has the right to recall any collateral pledged provided that this is replaced with alternative acceptable assets. The counterparty has right to repledge or sell the collateral in the absence of default by the Group and Company.

Cash collateral pledged where the counterparty retains the risks and rewards is derecognised from the balance sheet and a corresponding receivable is recognised for its return.

Where the Group and Company receives collateral in form of financial instruments for which the counterparty retains all risks and rewards, it is not recognised in the balance sheet. The fair value of financial assets accepted as collateral for OTC derivatives but not recognised in the balance sheet amounts to £1,162 million (2020: £1,440 million) by the Group and £1,162 million (2020: £1,440 million) by the Company, all of which is permitted to be sold or repledged in the absence of default. However the policy of the Group and Company is not to repledge assets, and hence no collateral was sold or repledged by the Group or Company during the year or in the prior year. Non-cash collateral received during the year was made up of high quality government Bonds such as UK Gilts and Treasury Bills, with the exception of one asset which was a Corporate bond.

Where the Group and Company receives collateral in form of cash, it is recognised in the balance sheet along with a corresponding liability to repay the amount of collateral received within other financial liabilities. The amount of cash collateral received by the Group and Company amounts to £463 million (2020: £868 million) and £390 million (2020: £821 million) respectively.

Collateral in respect of Stock Lending

Stock lending activity has been suspended. Until the prior year, the Group and Company lent financial assets held in its portfolio to other institutions. The IISC and its sub-committee Investment Management Operational Review Committee (IMOR) were responsible for setting the parameters of stock lending. Stock lending is permitted in accordance with the Insurance Stock Lending Policy. All stock lending took place on an open/call basis, enabling the loan to be recalled at any time within the standard settlement terms of the market concerned.

The financial assets lent do not qualify for derecognition as the Group and Company retains all risks and rewards of the transferred assets except for the voting rights. The aggregate carrying value of securities on loan by the Group is £1 million (2020: £1 million) and by the Company is nil (2020: nil).

It is the Group's and Company's practice to obtain collateral in stock lending transactions. The accepted collateral can include cash, equities, certain bonds and money-market instruments. On a daily basis, the fair value of collateral is compared to the fair value of stock on loan. The value of collateral must always exceed the value of stock on loan.

Where the Group and Company receives collateral in form of financial instruments for which counterparty retains all risks and rewards, it is not recognised in the balance sheet. The fair value of financial assets accepted as collateral but not recognised in the balance sheet amounts to £1 million (2020: £1 million) by the Group and nil (2020: nil) by the Company. The Group and the Company is not permitted to sell or repledge the collateral in the absence of default.

Where the Group and Company receives collateral in form of cash, it is recognised in the balance sheet along with a corresponding liability to repay the amount of collateral received within other financial liabilities. The amount of cash collateral received by the Group and Company amounts to nil (2020: nil) and nil (2020: nil) respectively.

There were no defaults in respect of stock lending during the year ended 31 December 2021 (2020: none) which required a call to be made on collateral.

36. Risk management (continued)

(c) Credit risk (continued)

(ii) Collateral management (continued)

Collateral in respect of Bulk Annuity Business

Acceptable collateral is defined in each instance and must take into account the quality and appropriateness of the proposed collateral as well as being acceptable to the entity receiving the collateral. Collateral may include cash, corporate bonds, supranational debt and government debt.

During 2021, the Company purchased Bulk Annuity contracts which provide buy in and buy-out solutions to defined benefit pension schemes. To enter into the transaction some trustees may seek collateral to cover the counterparty default scenario. Collateral pledged cumulatively in respect of Bulk Annuity business was £1,314 million (2020: £1,436 million) for Group and Company.

(iii) Offsetting

The Group and Company are not offsetting under master netting arrangements. Financial assets and liabilities are offset in the statement of financial position when the Group and/or Company has a legally enforceable right to offset and has the intention to settle the asset and liability on a net basis, or to realise the asset and settle the liability simultaneously.

a) Derivatives

The derivative assets and liabilities in the tables below consist of OTC and exchange traded (ET) derivatives. The value of gross/net amounts for derivatives in the table below comprises those that are subject to master netting arrangements. The right to set off balances under these master netting agreements or to set off cash and securities collateral only arises in the event of non payment or default and, as a result, these arrangements do not qualify for offsetting under IAS 32. As a result no amount has been set off in the balance sheet (2020: nil). Total derivatives presented in the balance sheet are shown in note 19.

The 'financial instruments' amounts in the tables below show the values that can be set off against the relevant derivatives asset and liabilities in the event of default under master netting agreements. In addition, the Group and the Company holds and provides cash and securities collateral in respect of derivative transactions to mitigate credit risks.

In the tables below, the amounts of derivative assets or liabilities presented are offset first by financial instruments that have the right of offset under master netting with any remaining amount reduced by the amount collateral.

b) Repurchase and Reverse Repurchase Arrangements

The Group and the Company participates in repurchase (repo) and reverse repurchase arrangements (reverse repo). The gross/net amount in the table shows the relevant assets that the Group and the Company has transferred to counterparties under these arrangements. Cash and non cash collateral is received by the Group and the Company for securities transferred. Cash collateral may be reinvested by the Group and Company through reverse repo against non cash collateral.

In the tables below, the amounts that are subject to repo and reverse repo are set off against the amount of collateral received according to the relevant legal agreements, showing the potential net amounts.

The actual fair value of collateral may be greater than amounts presented in the tables below in the case of over collateralisation.

36. Risk management (continued)

(c) Credit risk (continued)

(iii) Offsetting (continued)

b) Repurchase and Reverse Repurchase Arrangements (continued)

Group as at 31 December 2021

Group as at 31 December 2020

36. Risk management (continued)

(c) Credit risk (continued)

(iii) Offsetting (continued)

b) Repurchase and Reverse Repurchase Arrangements (continued)

Company as at 31 December 2021

Company as at 31 December 2020

The following sub notes are relevant to the tables on this and the preceding page:

1. The value of net amounts presented in the balance sheet for derivatives comprises those derivatives held by the Group and the Company that are subject to master netting arrangements. Total derivatives presented in the balance sheet are shown in note 19.

2. The Group and the Company enters into derivative transactions with various counterparties which are governed by industry standard master netting agreements. The Group and the Company holds and provides cash and securities collateral in respective of derivative transactions covered by these agreements. The right to set off balances under these master netting agreements or to set off cash and securities collateral only arises in the event of non-payment or default and, as a result, these arrangements do not qualify for offsetting under IAS 32.

36. Risk management (continued)

(d) Capital Risk

Capital risk is defined as the risk that the Group has a sub-optimal quantity or quality of capital or that capital is inefficiently deployed across the Group. The risk that:

• the Group, or one of its separately regulated subsidiaries, has insufficient capital to meet its regulatory capital requirements

• the Group has insufficient capital to provide a stable resource to absorb all losses up to a confidence level defined in the risk appetite

• the Group loses reputational status by having capital that is regarded as inappropriate, either in quantity, type or distribution

The business of several of the companies within the Group is regulated by the PRA and the FCA. The PRA rules, which incorporate all Solvency II requirements, specify the minimum amount of capital that must be held by the regulated companies within the Group in addition to their insurance liabilities. Under the Solvency II rules, each insurance Company within the Group must hold assets in excess of this minimum amount, which is derived from an economic capital assessment undertaken by each regulated Company and the quality of capital held must also satisfy Solvency II tiering rules.

The Solvency II minimum required capital must be maintained at all times throughout the year. These capital requirements and the capital available to meet them are regularly estimated in order to ensure that capital maintenance requirements are being met.

The Group's objectives when managing capital are:

- to have sufficient capital to safeguard the Group's ability to continue as a going concern so that it can continue to provide returns for the shareholder and benefits for other stakeholders

- to comply with the insurance capital requirements set out by the PRA in the UK

- when capital is needed, to require an adequate return to the shareholder by pricing insurance and investment contracts according to the level of risk associated with the business written

- to meet the requirements of the Schemes of Transfer

The capital management strategy is such that the integrated insurance business (comprising SWG and its subsidiaries, including the Group) will hold capital in line with the stated risk appetite for the business, which is to be able to withstand high-severity stress events without breaching the capital requirements. At SWG level it is intended that all surplus capital above that required to absorb a one in ten year stress event will be distributed to Lloyds Banking Group.

Capital support arrangements are in place for SWUTM and SWAS, which are provided by the Company. These irrevocable guarantees will come into effect on the occurrence of a material operational risk event impacting their respective capital positions. In addition for SWAS only, these arrangements will also come into effect on the occurrence of a material reinsured fund default event impacting its capital position. The Company has made these arrangements to provide sufficient capital to meet the regulatory capital adequacy and internal capital surplus requirements of these subsidiaries if such events occur.

The Company's capital comprises all components of equity, movements in which are set out in the statement of changes in equity and includes subordinated debt (note 29).

36. Risk management (continued)

(d) Capital Risk (continued)

The table below sets out the regulatory capital held (specifically, eligible own funds, allowing for any year-end foreseeable dividend, available to cover the solvency capital requirement) at 31 December in each year for the Company on a Solvency II basis.

The solvency position increased over 2021 due to recovery in the markets and is expected to remain above risk appetite at 31 December 2021. Exposure of the solvency position to market volatility continues to be actively monitored, in particular relating to interest rates and credit assets. The credit portfolio is average 'A' rated, well diversified and non-cyclical, with less than 1 per cent invested in sub investment grade or unrated assets.

All minimum regulatory requirements were met during the year.

(e) Liquidity risk

Liquidity risk is defined as the risk that the Group does not have sufficient financial resources to meet its commitments as they fall due, or can only secure them at excessive cost.

Liquidity risk may result from either the inability to sell financial assets quickly at their fair values; or from an insurance liability falling due for payment earlier than expected; or from the inability to generate cash inflows as anticipated.

Liquidity risk has been analysed as arising from payments to policyholders (including those where payment is at the discretion of the policyholder) and non policyholder related activity (such as investment purchases and the payment of shareholder expenses).

In order to measure liquidity risk exposure the Group's liquidity is assessed in a stress scenario. Liquidity risk is actively managed and monitored to ensure that, even under stress conditions, the Company and Group has sufficient liquidity to meet its obligations and remains within approved risk appetite. Liquidity risk appetite considers two time periods; three month stressed outflows are required to be covered by primary liquid assets; and one-year stressed outflows are required to be covered by primary and secondary liquid assets. Primary liquid assets are gilts or cash, and secondary liquid assets are corporate bonds. The stressed outflows also make allowance for the increased collateral that needs to be posted under derivative contracts in stressed conditions. Liquidity risk is actively managed and monitored to ensure that, even under stress conditions, the Group has sufficient liquidity to meet its obligations and remains within approved risk appetite.

Liquidity risk is managed in line with the Insurance Liquidity Risk Policy and the wider Lloyds Banking Group Funding and Liquidity Policy. Liquidity risk in respect of each of the major product areas is primarily mitigated as follows:

Annuity contracts

Assets are held which are specifically chosen to correspond to the expectation of timing of annuity payments. Gilts, corporate bonds, loans and, where required, derivatives are selected to reflect the expected annuity payments as closely as possible and are regularly rebalanced to ensure that this remains the case in future.

With Profits contracts

For With Profits business, a portfolio of assets is held in line with investment mandates which will reflect policyholders' reasonable expectations.

Liquidity is maintained within the portfolio via the holding of cash balances and a substantial number of highly liquid assets, principally gilts, bonds and listed equities.

36. Risk management (continued)

(e) Liquidity risk (continued)

Non-participating contracts

For unit-linked products, portfolios are managed through mandates which ensure that they are run within defined tolerances, maintaining sufficient liquidity to carry out operations of the portfolio without material disruption. Deferral clauses are included in policyholder contracts to give time, when necessary, to realise linked assets without being a forced seller. Redemptions (other than on death, maturity or retirement) of units in certain property-linked funds were deferred during 2020 due to material uncertainty in the valuation of the underlying assets and were unrestricted in 2021. As at 31 December 2021, there are no funds subject to deferral (2020: one).

For non-linked products other than annuity contracts, backing investments are mostly held in gilts with minimal liquidity risk. Investments are arranged to minimise the possibility of being a distressed seller whilst at the same time investing to meet policyholder obligations. This is achieved by anticipating policyholder behaviour and sales of underlying assets within funds.

Shareholder funds

For shareholder funds, liquidity is maintained within the portfolio via the holding of cash balances and a substantial number of highly liquid assets, principally gilts and bonds.

The following tables indicate the timing of the contractual cash flows arising from the Group and Company's financial liabilities, as required by IFRS 7. The table is based on the undiscounted cash flows of financial liabilities based on the earliest date on which the Group and Company are obliged to pay. The table includes both interest and principal cash flows.

Liquidity risk in respect of liabilities arising from insurance contracts and participating investment contracts has been analysed based on the expected pattern of maturities as permitted by IFRS 4 rather than by contractual maturity. A maturity analysis of liabilities arising from non-participating investment contracts based on expected contract maturities is also given as it is considered that this analysis provides additional useful information in respect of the liquidity risk relating to contracts written by the Group and Company.

36. Risk management (continued)

(e) Liquidity risk (continued)

The contractual cash flow analysis set out above has been based on the earliest possible contractual date, regardless of the surrender penalties that might apply and has not been adjusted to take account of such penalties.

An analysis of the contractual cash flows in respect of insurance and investment contract liabilities by expected contract maturity, on a discounted basis, is shown below:

* restated. See note 41 for details of restatement.

The 2020 Group figures for Insurance and participating investment contracts have been adjusted to enhance the consistency between the Group and Company maturity analysis.

36. Risk management (continued)

(e) Liquidity risk (continued)

The contractual cash flow analysis set out above has been based on the earliest possible contractual date, regardless of the surrender penalties that might apply and has not been adjusted to take account of such penalties.

An analysis of liabilities arising from insurance and investment contracts by expected contract maturity, on a discounted basis, is shown below:

* restated. See note 41 for details of restatement.

RELATED PARTY TRANSACTIONS

37. Related party transactions

(a) Ultimate parent and shareholding

The Group's immediate parent undertaking is SWG, a Company registered in the United Kingdom. SWG has taken advantage of the provisions of the Companies Act 2006 and has not produced consolidated financial statements.

The ultimate parent undertaking and controlling party is Lloyds Banking Group which is the parent undertaking of the only group to consolidate these financial statements. Copies of the consolidated Annual Report and Accounts of Lloyds Banking Group may be obtained from Lloyds Banking Group's head office at 25 Gresham Street, London EC2V 7HN or downloaded via www.lloydsbankinggroup.com.

(b) Transactions with other Lloyds Banking Group companies

In accordance with IAS 24 'Related Party Disclosures', transactions and balances between Group companies have been eliminated on consolidation and have not been reported as part of the consolidated financial statements.

The Group has entered into transactions with related parties in the normal course of business during the year.

The Company has entered into transactions with related parties in the normal course of business during the year. Holdings by the Group, including consolidated OEIC investments, give rise to £197 million (2020: £219 million) of shares in the ultimate parent undertaking on the balance sheet, with associated transactions of £(82) million (2020: £(90) million) during the year.

37. Related party transactions (continued)

(b) Transactions with other Lloyds Banking Group companies (continued)

Further, amounts relating to other related parties of £2,513 million due from OEICs investments were outstanding at 31 December 2021 (2020: £2,234 million). The above balances are unsecured in nature and are expected to be settled in cash.

Included within the consolidated statement of comprehensive income were net (expense)/income amounts related to other parties of £216 million (2020: £(9) million) from OEIC investments.

Parent undertaking transactions relate to all reported transactions and balances with SWG, the Group's immediate parent. Such transactions with the parent Company are primarily financing (through capital and subordinated debt), provision of loans and payment of dividends.

Transactions with other related parties (which includes Subsidiary and Other categories above) are primarily in relation to operating and employee expenses.

There are no loss allowances on intercompany balances as the risk of default is minimal.

(c) Transactions between the Group and entity employing key management

Key management personnel are those persons having authority and responsibility for planning, directing and controlling the activities of the Company which, for the Company, are all Directors and Insurance and Wealth Executive Committee (IWEC) members. Key management personnel, as defined by IAS 24, are employed by a management entity, transactions with this entity are as follows:

Key management compensation:

Included in short-term employee benefits is the aggregate amount of emoluments paid to or receivable by Directors in respect of qualifying services of £2 million (2020: £2 million).

There were no retirement benefits accruing to Directors (2020: nil) under defined benefit pension schemes. Two Directors (2020: two Directors) are paying into a defined contribution scheme. There were no contributions paid to a pension scheme for qualifying services (2020: nil) for Group and Company.

Certain members of key management in the Group, including the highest paid Director, provide services to other companies within Lloyds Banking Group. In such cases, for the purposes of this note, figures have been included based on an apportionment to the Group of the total compensation earned.

37. Related party transactions (continued)

(c) Transactions between the Group and entity employing key management (continued)

The aggregate amount of money receivable and the net value of assets received/receivable under Lloyds Banking Group share-based incentive schemes in respect of Directors qualifying services was £1 million (2020: £1 million). During the year, one Director exercised share options (2020: two Directors) and one Director received qualifying service shares under long-term incentive schemes (2020: two Directors). Movements in share options are as follows:

Detail regarding the highest paid Director is as follows: