Insurance & Investment

Memorandum of Understanding concerning FRS 27 (Life Assurance)
Introduction
FRS 27 Life Assurance was published in December 2004 and the Accounting Standards Board (ASB) has accepted that it would be unrealistic to mandate full compliance for financial periods ending on 31 December 2004. Accordingly, certain modifications to the disclosure requirements of the Standard have been agreed for this year. The modified disclosure requirements are set out in a Memorandum of Understanding to which the ASB and representatives of the life insurance industry, including HBOS, are signatories. As part of the agreement, HBOS and the other signatories to the Memorandum have committed to complying in full with the requirements of FRS 27 for financial periods ending in 2005 onwards.

The life assurance business of the Group, which is transacted within the long term funds of approved insurance companies, comprises unit-linked, other non-profit business and with-profit business. Several companies within the Group transact either unit-linked and / or other non-profit business, but all with-profit business is underwritten by Clerical Medical Investment Group Ltd (Clerical Medical), part of HBOS Financial Services.

The key assumptions used in the measurement of insurance liabilities are determined by the respective Board of Directors of each insurance company on advice from the Head of Actuarial Function of the relevant company. All such values have been determined in accordance with the requirements of the FSA’s Integrated Prudential Sourcebook for Insurers.

With-profits Business
Clerical Medical underwrites two main types of with-profits business: conventional with-profits business and unitised with-profits business.

With-profits business is now subject to the “twin peaks” test under the FSA’s prudential reporting regime. The capital requirement is based on the higher of the regulatory position and the realistic position. At 31 December 2004 the regulatory peak of the Clerical Medical with-profits fund exceeded the realistic peak in the “twin-peaks” test. This was due to the nature of the liabilities and the level of prudence assumed in determining the regulatory value of those liabilities.

The regulatory reserve for conventional with-profits policies is calculated using a prospective valuation of future cashflows, taking account of any excess of guaranteed benefits over premiums, and using prudent assumptions for investment return, expenses and mortality. The regulatory reserve for unitised with-profits policies is determined by comparing a projection of the cashflows on the contracts, allowing for guaranteed benefits, with the lower of the value of the with-profits units held and the surrender value payable at the valuation date. The higher of the two values is taken as the reserve.

The realistic reserve for with-profits business is based on the asset share. In addition many with-profits contracts feature options and guarantees whose potential value is affected by the behaviour of certain financial variables. These options and guarantees are reserved for at fair value or a value using models that reflect market conditions at the valuation date.

Specifically, several classes of With-profit Bonds allow withdrawals to be taken without penalty and the bonds to be encashed at specific dates on guaranteed minimum terms. Also, certain pension contracts contain the option to vest the contracts at any time between the 60th and 75th birthday on annuity rates that were guaranteed at the outset of the contract.

A comparison of the provisional realistic assets and provisional realistic liabilities of the with-profit fund is set out in the table below. For this purpose, the amount of the realistic liabilities (including options and guarantees) has been adjusted to eliminate the shareholders’ share of future bonuses, as required by FRS 27.

With-profits Business	£m
Provisional amount of realistic assets	17,883
Provisional amount of realistic liabilities	17,278
Provisional excess of realistic assets over realistic liabilities	605

Unit-linked and Non-profit Business
For unit-linked policies, the liability is equal to the sum of the value of the assets to which the contracts are linked, plus an additional reserve taking account of the risks and uncertainties for each separate class of business, subject to an overall minimum of the surrender value.

For other non-profit policies, the liability is equal to the discounted value of any excess of contractual benefits over premiums, taking account of expenses and the risks and uncertainties for each separate class of business.

Key Assumptions used in determining Regulatory Liabilities
The following mortality assumptions and interest rates were used for the key product lines to value the regulatory liabilities.

Business	Mortality	Interest
Unit-linked Policies
Life assurance	70-150% AM/F92(1)	2.6% - 3.75%
Pensions	70-150% AM/F92(1)	3.25% - 4.75%
Non-profit Policies
Pension Annuities
Males	95% PMA92mc	Matching assets
Females	80% PFA92	Matching assets
Term Assurances
Males	43-145% TM92(2)	2.6% - 4%
Females	55-160% TF92(2)	3% - 4%
With-profit
Life assurance	70-100% AM/F92	3% - 3.75%
Pensions	70-100% AM/F92	3.75%

Note 1 With age adjustments for some classes of business.
Note 2 An AIDS uplift to mortality is assumed in line with FSA guidance.

Mortality and morbidity assumptions are determined following comparison of market data with the actual experience over a period of up to 5 years and contain a margin for prudence. For annuities, future improvements in mortality are based on standard projections from the Continuous Mortality Investigation Bureau; in particular, for males, the medium cohort projection is used. The valuation rates of interest for annuities are closely linked to market returns on the matching assets; allowance is made for credit risk on corporate bonds by considering historic default rates. Expense assumptions are based on company experience together with a prudent margin, and contracts are assumed to remain in force until their natural expiry.

Capital Position Statement as at 31 December 2004

Note 1
The with-profit fund surplus capital represents the excess of its assets over the value of its liabilities to policyholders

Note 2
The loan capital includes a contingent loan from the parent in the HBOS FS UK non-profit fund and subordinated debt in the Shareholders’ funds

Note 3
Other adjustments to net assets include the following:
£167m in respect of closure reserve
£75m for dividend payable
£14m for inadmissible assets
£7m for deferred tax adjustments
£8m for other

Capital Resources available within the Group’s Life Assurance Businesses
The Capital Position Statement shown above demonstrates how Shareholders’ funds in the life assurance businesses relate to the total capital available to meet regulatory requirements. Within the long term business fund, capital available to meet the regulatory requirements has been determined by deducting the regulatory value of insurance and other liabilities from the market value of assets.

On the regulatory basis, the with-profit fund sensitivity to changes in market conditions arises from the movement in the Fund for Future Appropriations, which is one element of the capital resources. If asset values increase significantly the “twin peaks” test could result in the realistic peak biting. For unit-linked and non-profit policies, changes in market conditions have minimal impact on Shareholders’ funds as assets and liabilities are closely matched.

Each insurance company regularly reviews its capital adequacy position to ensure that sufficient capital exists to cover its regulatory requirements.

Restrictions apply to the transfer of assets from any long term fund. At all times each long term fund must maintain an excess of assets over liabilities. Transfers of assets from a long term fund must be made on terms that are no less than fair to the policyholders. Transfers of assets from Clerical Medical’s with-profits fund are subject to a number of additional restrictions, including the terms of the scheme of demutualisation effected in 1996 and the conditions contained in the Principles and Practices of Financial Management of the with-profits fund that were published in 2004.