Operating Review
continued
Corporate
Underlying profit before tax increased 17% to £1,663m. Underlying net operating income increased by 9% with net interest income up 10%. Corporate margin increased to 222bps (2005 215bps).
Underlying non-interest income increased by 6%, benefiting from a 16% increase in net fees and commissions to £341m (2005 £293m) and despite a lower contribution in aggregate from dividend receipts, realised gains, impairment on investment securities and other operating income of £293m (2005 £366m).
In addition, overall performance was boosted by the emergence of higher profits from our portfolio of associates and joint ventures, which contributed £157m to profits in 2006 (2005 £65m). We expect this portfolio to be a sustainable source of additional profit going forward.
Underlying operating expenses rose by 9% which included the consolidation of Lex Vehicle Finance (‘Lex’) from 31 May 2006. Excluding Lex, the increase in underlying expenses was 5%.
We continue to be cautious of the weaker returns available from lending to certain segments of the UK market and we have therefore continued our strategy of selective growth, continuing to focus on our origination and distribution model which has benefited the net interest margin. Growth in lending before sell downs was 16% but our risk and return criteria have seen us sell this down to a hold growth rate of 8%.
Customer deposits reduced by 7% as we completed the move away from expensive short term deposits towards a base more suitable for funding purposes.
The credit environment continues to remain at historically benign levels and once again our credit performance in Corporate has improved. Impaired loans as a percentage of closing advances fell to 1.32% (2005 1.41%). Impairment losses as a percentage of average advances also fell to 0.52% (2005 0.56%). The coverage of impaired loans by impairment provisions remained constant at 63% (2005 63%).
Insurance & Investment
Underlying profit before tax increased by 19% to £581m (2005 £489m).
Underlying profit before tax for the General Insurance business increased by 20% to £304m (2005 £254m) reflecting the benign underwriting cycle in Household Insurance which helped alleviate further claims inflation in our Motor Insurance business.
Overall, General Insurance sales fell 4% to £1,894m, as measured by Gross Written Premiums (2005 £1,977m). Household Insurance sales increased by 11%, offset by lower sales of Repayment Insurance and Motor Insurance. Repayment Insurance sales fell 10% reflecting the market-wide slowdown in consumer credit. Motor Insurance sales fell 9% in a highly competitive market which has yet to see a sustained increase in prices sufficient to warrant the pursuit of a faster pace of sales growth.
Underlying profit before tax for our Investment Business increased by 18% to £277m (2005 £235m), growth again being held back by the increased new business strain arising on the sale of investment contracts.
UK Investment sales were strong across all channels, increasing 23% to £1,817m APE (2005 £1,473m). Sales through the Bancassurance channel were up 12%, Intermediary channel up 28% and Wealth Management up 58%, making us the UK’s number one provider of new investment products in 2006. New business profitability improved to 27% of APE (2005 24%).
On pages 20 to 24 of the Financial Review, we have provided supplementary embedded value (‘EV’) information for our Investment Business. This shows that the contribution from new investment business in 2006 on the ‘Full EV’ basis (i.e. assuming all investment business is EV accounted) was £474m (2005 £365m) higher than the reported IFRS result. On the same basis, the contribution from existing investment business was lower. This results in underlying profit before tax in 2006 being £262m higher than the reported IFRS result (2005 £179m).
On the Full EV basis, the total net of tax embedded value for our Investment Business in 2006 was £2,525m higher (2005 £2,006m) than the reported IFRS figure.
International
Underlying profit before tax in International increased by 34% to £820m (2005 £610m), reaffirming our confidence that the ongoing investment in our international markets is the right choice for shareholders.
In a strong Australian market, underlying profit before tax increased 24% to £278m (2005 £224m). Net interest income increased by 21% reflecting strong growth in lending and resilient margins, which fell 6bps to 233bps (2005 239bps). Underlying operating expenses increased by 10%, primarily because of our investment in nine additional commercial business sites on the East Coast. Lending and deposits grew 24% and 28% respectively.
Impaired loans as a percentage of closing advances increased to 1.00% (2005 0.66%), the increase due in large part to a small number of impaired corporate transactions, where we expect the ultimate recovery rate to be high. Impairment losses as a percentage of average advances increased to 0.27% (2005 0.19%).
In Ireland, underlying profit before tax increased by 43% to £149m (2005 £104m). Performance in 2006 was driven by a buoyant Irish economy but also, encouragingly, by the performance of our Business Banking and mortgage operations, both of which have benefited from increased customer awareness generated by our ongoing investment commitment to the market.
Net interest income increased by 32% reflecting the growth in lending and broadly stable margins which fell by 4bps to 173bps (2005 177bps). Underlying operating expenses increased by 39% as a result of our investment in the new Retail branch network which commenced in early 2006. We have now opened 24 branches and expect to complete the branch opening programme of 46 branches by the end of 2007. Lending and deposits grew by 31% and 32% respectively.
Credit conditions remain relatively benign and this is reflected in impairment losses which, as a percentage of average advances, were unchanged at 0.20% (2005 0.20%). As a percentage of closing advances, impaired loans decreased slightly to 1.87% (2005 1.98%).
In Europe & North America, underlying profit before tax increased by 39% to £393m (2005 £282m). Net interest income increased by 17% reflecting the overall growth in lending, in particular in Corporate Europe and Corporate North America. Margins fell by 39bps to 370bps (2005 409bps) as a result of the continued diversification of the Corporate portfolio.
Underlying non-interest income increased 64% mainly as a result of the full year impact of consolidating Heidelberger Leben into our results. Underlying operating expenses grew by 33%, again reflecting the consolidation of Heidelberger Leben and ongoing investments such as the expansion of our branch network in Spain and the opening of our Corporate Europe office in Stockholm.
Credit quality in 2006 again reflected the generally benign conditions in most of the markets in which we operate. Impairment losses as a percentage of average advances improved to 1.13% (2005 1.26%) and impaired loans as a percentage of closing advances improved to 0.62% (2005 1.61%). Excluding Drive, impairment losses were only £14m (2005 £32m) and as a percentage of average advances improved to 0.13% (2005 0.35%).
The disposal of our shareholding in Drive was completed in early December and gave rise to a profit on sale of £180m which has not been included in the reporting of underlying results.
