Financial Review
continued

Cost:income Ratio

With underlying net operating income up 9% and underlying operating expenses up 6%, the Group cost:income ratio improved to 40.9% (2005 42.2%).

	Year ended 31.12.2006 £m	Year ended 31.12.2005 £m
Underlying operating expenses	4,908	4,642
Net interest income	7,400	6,829
Underlying non-interest income	4,591	4,169
Underlying net operating income	11,991	10,998
Group cost:income ratio	40.9%	42.2%

 

Divisional cost:income ratios are summarised below:

	Year ended 31.12.2006 %	Year ended 31.12.2005 %
Retail	38.4	39.8
Corporate	28.9	28.7
International	38.3	40.0
Treasury & Asset Management	47.2	48.5

Group Items

Group Items principally comprise the expenses of managing the Group, including technology so far as it is not devolved to divisions, accommodation and other shared services such as cheque clearing, mailing, etc. The costs of technology, accommodation and other shared services (other than those borne directly by Group functions) are subsequently recharged to divisions according to their usage and are shown under the operating expense analysis for each division.

	Year ended 31.12.2006 £m	Year ended 31.12.2005 £m
Staff	291	255
Accommodation, repairs and maintenance	345	330
Technology	91	85
Marketing and communication	67	57
Depreciation:
Property and equipment and intangible assets	192	208
Other	200	221
Sub total	1,186	1,156
Less Recharges:
Technology	(365)	(360)
Accommodation	(365)	(353)
Other shared services	(215)	(220)
Total	241	223

Group Embedded Value Information (IFRS Basis)

The sources of profit from all long term assurance business accounted for as insurance contracts on an embedded value (‘EV’) basis under IFRS 4 are set out below. This table includes that part of our Repayment Insurance business accounted for on an EV basis but excludes investment contracts accounted for under IAS 39.

	Year ended 31.12.2006				Year ended 31.12.2005
	UK Investment £m	Europe £m	UK General Insurance £m	Total £m	UK Investment £m	Europe £m	UK General Insurance £m	Total £m
Expected contribution from existing business	140	44	5	189	133	30	24	187
Actual vs expected experience on existing business*	16	19	33	68	77	7		84
	156	63	38	257	210	37	24	271
Contribution from new business	216	36	25	277	176	25	15	216
Investment earnings on net assets using long term assumptions	113	3	6	122	105	3	7	115
Contribution from insurance contracts**	485	102	69	656	491	65	46	602

* Actual vs expected experience on existing business for 2005 has been restated as follows: (i) the interest cost of subordinated debt liabilities is now shown separately in the Investment profit disclosure, (ii) certain interest income is now shown within Investment earnings on net assets and (iii) overhead expenses not relating to existing business have been re-allocated to ‘overheads associated with development activity’ in the Investment profit disclosure to reflect changes to the overhead allocation methodology.
** On an underlying basis.

The embedded value of long term assurance business accounted for under IFRS 4, which excludes investment contract business accounted for under IAS 39, is set out below.

	As at 31.12.2006				As at 31.12.2005
	UK Investment £m	Europe £m	UK General Insurance £m	Total £m	UK Investment £m	Europe £m	UK General Insurance £m	Total £m
Shareholder funds*	2,315	69	52	2,436	2,445	138	78	2,661
Value of in-force business (net of tax)	1,544	419	162	2,125	1,373	361	139	1,873
Total embedded value (net of tax)	3,859	488	214	4,561	3,818	499	217	4,534
Shareholder funds as a % of total EV	60%	14%	24%	53%	64%	28%	36%	59%

* Shareholder funds for 2005 have been restated to exclude subordinated debt liabilities as the interest cost of that subordinated debt is now shown separately in the Investment profit disclosure and does not impact the contribution from insurance contracts.

	Year ended 31.12.2006
	UK Investment £m	Europe £m	UK General Insurance £m	Total £m
Opening embedded value	3,818	499	217	4,534
Contribution from Insurance contracts	485	102	69	656
Development costs, associated overheads and financing costs	(258)			(258)
Underlying embedded value profit before tax	227	102	69	398
Short term investment fluctuations	(97)	16		(81)
Tax charge	2	(23)	(9)	(30)
Dividends (paid)/received	(42)	42	(63)	(63)
Other capital movements	(49)	(148)		(197)
Movement in embedded value in the year	41	(11)	(3)	27
Closing embedded value	3,859	488	214	4,561

The economic assumptions (gross of tax) used in the calculation of the embedded values are unchanged from those used at the end of 2005. These are as follows:

	As at 31.12.2006 %	As at 31.12.2005 %
Risk discount rate*	8.0	8.0
Return on fixed income securities	5.0 – 5.5	5.0 – 5.5
Return on equities	7.5	7.5
Expense inflation rate	3.0	3.0

* Included in the risk discount rate is an investment risk component which is chosen so as to avoid capitalising any investment risk premiums over the long term view of the risk free rate of return.

Sensitivities of Embedded Value Related to Long Term Assurance

The table below indicates the stand alone impact of changes to certain key variables
on insurance contracts:

	Change in variable	Impact on profit after tax £m
Interest rates increase into perpetuity	+100bps	(97)
Equity/property market values fall and thereafter increase based on the long term view of the risk free rate	-10%	(77)
Maintenance expenses fall and thereafter increase by the estimated expense inflation rate	-10%	44
Mortality/morbidity decreases (policyholders live longer) across all policy types and age groups	-5%	(4)
Lapse and surrender rates decrease across all policy types and cohorts over the duration of their lives (excluding paid-up policies)	-10%	64

It should be noted that, in practice, some of the variables are correlated and their impact may also be non-linear.

Life Insurance Regulatory Capital

In each of our life insurance entities, surplus capital in excess of the various regulatory requirements, including the individual capital assessment, is maintained in order to absorb changes in both the underlying businesses and the capital requirements over the short term.

At 31 December 2006, the available capital excluding the with-profit fund was 462% (2005 473%) of the provisional capital requirements of £555m (2005 £562m). At 31 December 2006 the total available capital including the with-profit fund on a realistic basis was 354% (2005 270%) of the provisional capital requirements of £1,131m (2005 £1,312m).

Taxation

The tax charge for the year of £1,772m (2005 £1,546m) includes £220m (2005 £200m) in respect of the tax charge levied on life companies for policyholder tax. Excluding this results in an effective rate of 28.3% (2005 29.2%). The main reason for the lower effective tax rate is the tax exempt one-off gain of £180m on the disposal of Drive. Adjusting for this gain and goodwill impairment results in an underlying tax rate of 29.0% (2005 29.2%). The tax charge of £1,772m includes overseas tax of £206m (2005 £161m).

Definition of Underlying

References to underlying incorporate the following adjustments:

• Excluding the profit on sale of Drive, mortgage endowment compensation, goodwill impairment, Retail rationalisation costs, policyholder tax payable, the impact of short term fluctuations (‘STFs’) and changes to economic assumptions for long term assurance business accounted for on an embedded value basis; and
• Netting against income of operating lease depreciation, impairment on investment securities, changes in insurance and investment contract liabilities, change in unallocated surplus and net claims incurred on insurance contracts.

Balance Sheet Analysis

Loans and advances to customers increased by 10% to £376.8bn (2005 £343.8bn). The increase was 9% in Retail, 8% in Corporate and 24% in International.

Customer deposits increased by 5% to £211.9bn (2005 £200.9bn) and wholesale funding increased by 13% to £214.2bn (2005 £190.0bn).

Classification of advances

The mix of the Group’s gross lending portfolio at the year end is summarised in the following table:

	As at 31.12.2006 %	As at 31.12.2005 %
Energy	1
Manufacturing industry	2	2
Construction and property	11	11
Hotels, restaurants and wholesale and retail trade	3	4
Transport, storage and communication	2	1
Financial	2	3
Other services	5	6
Individuals:
Residential mortgages	61	60
Other personal lending	6	7
Overseas residents	7	6
Total	100	100

Credit Quality & Provisions

The total charge for loan impairment losses against Group profits in 2006 was £1,742m (2005 £1,599m) representing 0.48% of average advances (2005 0.49%).

	Total £m
At 1 January 2006	2,938
Amounts written off during the year	(1,485)
New impairment provisions less releases	1,819
Exchange movements	(19)
Disposals	(65)
Discount unwind on impaired advances	(99)
Closing balance at 31 December 2006	3,089
New impairment provisions less releases	1,819
Recoveries of amounts previously written off	(77)
Net charge to income statement	1,742

 

	Retail £bn	Corporate £bn	International £bn	Treasury & Asset Mgmt £bn	Total 31.12.2006 £bn	Total 31.12.2005 £bn
Loans and advances to customers	237.7	85.3	53.0	0.8	376.8	343.8
Impairment provisions	2.1	0.7	0.3		3.1	2.9
Loans and advances to customers (before provisions)	239.8	86.0	53.3	0.8	379.9	346.7
Risk weighted assets	112.4	100.7	47.1	15.0	276.0*	255.1*
Customer deposits	144.6	38.7	18.3	10.3	211.9	200.9

* Includes risk weighted assets of £0.8bn (2005 £1.0bn) attributable to Insurance & Investment.

Impairment provisions as a percentage of closing advances are analysed in the following table:

	£m	As at 31.12.2006 As % of closing advances	£m	As at 31.12.2005 As % of closing advances
Retail	2,108	0.89	1,924	0.88
Corporate	709	0.83	704	0.89
International	272	0.51	310	0.72
Total impairment provisions	3,089	0.82	2,938	0.85

 

Impaired loans as a percentage of closing advances and impairment provisions as a percentage of impaired loans are analysed by division in the following table:

		Advances	Impaired loans	Impaired loans as % of closing advances	Impairment provisions	Impairment provisions as % of impaired loans
		£bn	£m	%	£m	%
As at 31 December 2006
Retail:	Secured	219.4	4,047	1.84	408	10
	Unsecured	18.3	2,411	13.17	1,700	71
	Total	237.7	6,458	2.72	2,108	33
Corporate		85.3	1,124	1.32	709	63
International		53.0	620	1.17	272	44
Treasury & Asset Management		0.8
Total		376.8	8,202	2.18	3,089	38
As at 31 December 2005
Retail:	Secured	201.2	4,452	2.21	424	10
	Unsecured	17.8	2,049	11.51	1,500	73
	Total	219.0	6,501	2.97	1,924	30
Corporate		79.2	1,114	1.41	704	63
International		42.9	549	1.28	310	56
Treasury & Asset Management		2.7
Total		343.8	8,164	2.37	2,938	36

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