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Name | Symbol | Market | Type |
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Scottish Wid 43 | LSE:40VY | London | Bond |
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TIDM40VY
RNS Number : 4895T
Scottish Widows Limited
25 March 2021
25 March 2021
SCOTTISH WIDOWS LIMITED
PUBLICATION OF THE ANNUAL REPORT AND ACCOUNTS FOR THE YEARED 31 DECEMBER 2020
Scottish Widows Limited has published its Annual Report and Accounts for the year ended 31 December 2020 (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, international accounting standards in conformity with the requirements of the Companies Act 2006 and, for the Group, international financial reporting standards adopted pursuant to Regulation (EC) No 1606/2002 as it applies in the European Union have been followed, subject to any material departures disclosed and explained in the financial statements
-- make judgments 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 financial statements, which have been prepared in accordance with international accounting standards in conformity with the requirements of the Companies Act 2006 and in accordance with international financial reporting standards adopted pursuant to Regulation (EC) No 1606/2002 as it applies in the European Union and the Company financial statements which have been prepared in accordance with international accounting standards in conformity with the requirements of the Companies Act 2006
-- the Group strategic report on pages 4 to 15, and the Directors' Report on pages 16 to 20 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
Details of key risks are set out in note 37. Key risks include economic and political uncertainty alongside operational risk which is heightened by the current level of change being undertaken to execute our strategy. Risks and uncertainties to our strategic plan, both positive and negative, are considered by product through the planning process. The following table describes the key risks faced by the Group. Further details on these risks and how the Group mitigates them can be found in note 37, as shown by the note reference.
Key Risk Note reference Description ----------------- -------------- --------------------------------------------------------- Market risk 37(c)(1) Market risk is the risk that the Group's capital or earnings profile is affected by adverse market rates. Of particular importance to the Group are equity, credit default spreads, interest rates and inflation for assets backing insurance business. Insurance 37(c)(2) Risks are transferred from policyholders to underwriting the Group through writing insurance business. risk These include mortality risk, morbidity risk and persistency risk. Credit risk 37(c)(3) Credit risk is the risk that parties with whom we have contracted, fail to meet their financial obligations. The Group is subject to credit risk through 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. Capital risk 37(c)(4) Capital risk is the risk that the Group has a sub-optimal quantity or quality of capital or that capital is inefficiently deployed across the Group. Capital, which includes regulatory capital for the Company and regulated subsidiaries, comprises all components of equity and subordinated debt. In addition to ensuring that the Company maintains sufficient regulatory capital to meet Solvency II capital requirements (based on a one in 200 year event), the Group's capital management strategy, as part of the integrated insurance business (see note 37(c)(4)) requires it to hold capital in line with the stated risk appetite for the business, which is to be able to withstand a one in ten year stress event without breaching the capital requirements. Liquidity 37(c)(5) Liquidity risk is the risk that the Group does risk not have sufficient financial resources to meet its commitments as they fall due, or can only secure them at excessive cost. The Group is exposed to liquidity risk from payments to policyholders and non- policyholder related activity, such as investment purchases and the payment of shareholder expenses). Operational 37(d) Operational risk is the risk of loss from inadequate risk or failed internal processes, people and systems or from external events. Economic risk 37(e), 37(f) The Group faces economic and political uncertainty and UK political arising from the impact of Covid-19, as well uncertainties as the need to continue monitoring developments following the adoption of the UK / EU TCA.
In addition, as described in note 28, 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.
37. 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 risks associated with the activities of the Company and the way in which they are managed.
(a) Governance framework
Lloyds Banking Group has established a Risk function with responsibility for implementing the Lloyds Banking Group risk management framework (with appropriate Insurance focus) within the Group.
The risk management approach aims to ensure effective independent checking or 'oversight' of key decisions by operating a 'three lines of defence' model. The first line of defence is line management, who have direct accountability for risk decisions. The Risk function provides oversight and challenge and is the second line of defence. Internal Audit, the third line of defence, provide independent assurance to the Insurance Audit Committee and the Board that risks are recognised, monitored and managed within acceptable parameters.
This enterprise-wide risk management framework for the identification, assessment, measurement and management of risk covers the full spectrum of risks that the Group and Company are exposed to, with risks categorised according to an approved Lloyds Banking Group risk language. This covers the principal risks faced by the Group, including the exposures to market, insurance underwriting, model risk, credit, capital, liquidity, regulatory and legal, conduct, people, governance and operational risks. The Group assesses the relative costs and concentrations of each type of risk and material issues are escalated to the appropriate Insurance executive committees and onto the Board if required. The performance of the Group, its continuing ability to write business and the strategic management of the business depend on its ability to manage these risks.
Responsibility for setting and managing risk appetite and risk policy resides with the Board. Risks are managed in line with Lloyds Banking Group and Insurance risk policies. The Board has delegated certain risk matters to the Insurance Risk Oversight Committee with operational implementation assigned to the Insurance and Wealth Risk Committee (IWRC).
Policy owners, identified from appropriate areas of Lloyds Banking Group and the Insurance and Wealth Division, are responsible for drafting risk policies, ensuring they remain up-to-date and for facilitating any changes. Policies are subject to at least an annual review. Limits are prescribed within which those responsible for the day-to-day management of each Company within the Group can take decisions. Line management are required to follow prescribed reporting procedures to the bodies responsible for monitoring compliance with policy and controlling the risks.
In response to the contingency planning requirements for Covid-19, daily Risk Surgeries were put in place establishing a control amendment process to support colleagues to continue to serve customers and to maintain the operation of business processes. A key aim of the Risk Surgery and control amendment process is to take reasonable steps to ensure that all changes to current ways of working (including operational home working), operational processes or customer treatment is robustly risk assessed and reviewed by the appropriate risk SMEs across the three lines of defence. The changes implemented helped to manage operational and conduct risks e.g. enhancements to the contribution holiday process to support Longstanding Pension customers during the Covid-19 crisis and Individual Annuities quote guarantee period extension. Following the success of the Risk Surgeries, these will continue beyond Covid-19 and are part of our ongoing governance activity. In addition, through the Group's incident management process, we managed key business continuity factors such as absence levels, productivity, IT stability, strategic change activity, regulatory focus, supplier performance and health and safety measures.
(b) Risk appetite
The Board has approved a risk appetite framework that covers Customer Risk, Strategy and Brand Risk and Financial Risks.
Risk appetite is the amount and type of risk that the Board prefers, accepts or wishes to avoid and is aligned to Group strategy. The risk appetite statements set limits for exposures to the key risks faced by the business.
Risk appetite is reviewed at least annually by the Board. Executive owned Tier 2 and Tier 3 limits sit beneath Board owned risk appetite (Tier 1) and are managed and governed within the Insurance and Wealth Division.
Experience against Risk Appetite is reported monthly (by exception) to each meeting of IWRC and ROC. Copies are also supplied regularly to the Group's regulators as part of the close and continuous relationship. Reporting focuses on ensuring, and demonstrating to the Board, and their delegate the ROC that the Group is run in line with approved risk appetite. Any breaches of risk appetite require clear plans and timescales for resolution.
37. Risk management (continued) (c) Financial risks
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 numbers 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.
(1) 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.
37. Risk management (continued) (c) Financial risks (continued) (1) Market risk (continued)
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
-- 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
Below is an analysis 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 2020
Fair value hierarchy Level Level Level Total 1 2 3 GBPm GBPm GBPm GBPm ------------------------------------------- ------- ------ ------ --------- Investment properties - - 3,324 3,324 Assets arising from reinsurance contracts held at fair value through profit or loss - 19,549 - 19,549 Shares and other variable yield securities 94,188 164 605 94,957 Debt and other fixed/variable income securities 12,802 24,267 187 37,256 Loans and advances to customers - - 9,646 9,646 Loans and advances to banks - 4,693 - 4,693 Derivative financial assets 56 5,040 128 5,224 ------------------------------------------- ------- ------ ------ ------- Total assets 107,046 53,713 13,890 174,649 ------------------------------------------- ------- ------ ------ ------- Derivative financial liabilities 47 4,562 - 4,609 Liabilities arising from non-participating investment contracts - 38,448 - 38,448 Subordinated debt - 1,892 - 1,892 ------------------------------------------- ------- ------ ------ ------- Total liabilities 47 44,902 - 44,949 ------------------------------------------- ------- ------ ------ -------
For all financial instruments held at amortised cost by the Group and Company, carrying value is a reasonable approximation of fair value.
37. Risk management (continued) (c) Financial risks (continued) (1) Market risk (continued)
Company As at 31 December 2020
Fair value hierarchy Level Level Level Total 1 2 3 GBPm GBPm GBPm GBPm ------------------------------------------- ------- ------ ------ --------- Investment properties - - 120 120 Assets arising from reinsurance contracts held at fair value through profit or loss - 19,549 - 19,549 Shares and other variable yield securities 107,067 152 665 107,884 Debt and other fixed/variable income securities 8,106 7,729 842 16,677 Loans and advances to customers - - 9,095 9,095 Loans and advances to banks - 1,468 - 1,468 Deposits with cedants - 1,509 - 1,509 Derivative financial assets 39 4,965 128 5,132 Total assets 115,212 35,372 10,850 161,434 ------------------------------------------- ------- ------ ------ ------- Derivative financial liabilities 40 4,550 - 4,590 Liabilities arising from non-participating investment contracts - 38,433 - 38,433 Subordinated debt - 1,923 - 1,923 ------------------------------------------- ------- ------ ------ ------- Total liabilities 40 44,906 - 44,946 ------------------------------------------- ------- ------ ------ -------
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 2019
Fair value hierarchy Level Level Level Total 1 2 3 GBPm GBPm GBPm GBPm ------------------------------------------- ------- ------ ------ --------- Investment properties - - 3,523 3,523 Assets arising from reinsurance contracts held at fair value through profit or loss - 22,837 - 22,837 Shares and other variable yield securities 92,947 - 785 93,732 Debt and other fixed/variable income securities 11,878 20,205 283 32,366 Loans and advances to customers - - 8,804 8,804 Loans and advances to banks - 2,255 - 2,255 Derivative financial assets 45 3,777 146 3,968 ------------------------------------------- ------- ------ ------ ------- Total assets 104,870 49,074 13,541 167,485 ------------------------------------------- ------- ------ ------ ------- Derivative financial liabilities 36 3,409 - 3,445 Liabilities arising from non-participating investment contracts - 37,456 - 37,456 Subordinated debt - 1,795 - 1,795 ------------------------------------------- ------- ------ ------ ------- Total liabilities 36 42,660 - 42,696 ------------------------------------------- ------- ------ ------ ------- 37. Risk management (continued) (c) Financial risks (continued) (1) Market risk (continued)
Company As at 31 December 2019
Fair value hierarchy Level Level Level Total 1 2 3 GBPm GBPm GBPm GBPm ------------------------------------------- ------- ------ ------ --------- Investment properties - - 132 132 Assets arising from reinsurance contracts held at fair value through profit or loss - 22,837 - 22,837 Shares and other variable yield securities 100,727 28 848 101,603 Debt and other fixed/variable income securities 7,394 6,978 927 15,299 Loans and advances to customers - - 8,250 8,250 Loans and advances to banks - 1,203 - 1,203 Deposits with cedants - 1,507 - 1,507 Derivative financial assets 22 3,726 146 3,894 Total assets 108,143 36,279 10,303 154,725 ------------------------------------------- ------- ------ ------ ------- Derivative financial liabilities 31 3,403 - 3,434 Liabilities arising from non-participating investment contracts - 37,455 - 37,455 Subordinated debt - 1,820 - 1,820 ------------------------------------------- ------- ------ ------ ------- Total liabilities 31 42,678 - 42,709 ------------------------------------------- ------- ------ ------ -------
Assets arising from reinsurance contracts 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 DPFs 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. Property investment vehicles are valued based on the net asset value of the relevant Company which incorporates surveyors' valuations of property. Investment property is independently valued as described in note 17. Valuations are based on observable market prices for similar properties. Adjustments are applied, if necessary, for specific characteristics of the property, such as the nature, location, or condition of the specific asset. If such information is not available alternative valuation methods such as discounted cash flow analysis or recent prices in less active markets are used. Where any significant adjustments to observable market prices are required, the property would be classified as Level 3. Whilst such valuations are sensitive to estimates, it is believed that changing one or more of the assumptions to reasonably possible alternative assumptions would not change the fair value significantly.
Covid-19
The current year has experienced a period of major market turbulence, increased volatility and greater illiquidity whilst risk free interest rates have fallen to near historical lows. The effects of the Covid-19 pandemic, and the related actions of central banks and governments, have had uneven impacts across different assets and notably between industry segments. There has been a sustained recovery in equity prices and corporate credit spreads since the initial market shock, however the worsening credit environment has started to have some effect on corporate bond and loan ratings. The Company's assessment for the range of valuation uncertainty has increased 24% between year ends principally due to greater market illiquidity although all valuation methods and models have remained effective.
The following valuation methods and sensitivity of valuation assumptions are applied to both the Group and the Company.
37. Risk management (continued) (c) Financial risks (continued) (1) 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 GBP9.1 billion (2019: GBP8.2 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 in to 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 GBP575 million (2019: GBP332 million) or increase it by GBP454 million (2019: GBP345 million). The impact of alternative assumptions, mainly related to credit spread and illiquidity premium sensitivities is -6.3% (2019: -4.1%) to base in adverse scenario and +5.0% (2019: +4.2%) to base in the favourable scenario.
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 GBP379 million (2019: GBP376 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 GBP21 million (2019: GBP12 million) or increase it by GBP13 million (2019: GBP9 million). Impact of alternative assumptions on credit spread, illiquidity premium and prepayment assumptions is -5.5% (2019: -3.1%) to base in the adverse scenario and +3.5% (2019: +2.3%) to base in the favourable scenario. The capital repayment holiday option is a new option in response to the onset of the Covid-19 pandemic, it did not though have a significant impact on the valuation of Agricultural loans.
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 cash flow approach with a spread based judging movements in the spread for comparable instruments against the changes in expected performance of the underlying portfolio of mortgages.
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, B 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 with the spread assessed 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. In the assessment of the value of the risks, the No Negative Equity Guarantee for Lifetime Mortgages is valued using a time-dependent Black-Scholes model. The value of NNEG is GBP14 million (2019: GBP15 million).
Inputs in the valuation model include the gross interest rate applicable to a notional portfolio of new 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 GBP176 million. December 2020 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 notional portfolio rate assumptions was 3.50% to 4.27% (2019: 3.26% to 4.94%).
37. Risk management (continued) (c) Financial risks (continued) (1) Market risk (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 GBP5 million (2019: GBP6 million) or increase it by GBP9 million (2019: GBP12 million). The impact of alternative assumptions on credit spread and illiquidity premium is -2.9% (2019: -3.3%) to base in the adverse scenario and +5% (2019: +6.6%) 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 SWL. The loans are being warehoused with the intention to securitise.
The valuation methodology uses the same principles as that for the securitised 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.
Inputs to the valuation model include the Notional Portfolio updated monthly, risk free rates, swaption volatilities for the Economic Scenario generator, residential property volatilities, property valuation haircuts, settlement delay as well as decrement assumptions on mortality, voluntary early redemption and entry into long-term care.
The base valuation of Originated Life Time Mortgage is GBP16 million (2019: nil). December 2020 Valuation Uncertainty calculations principally reflect uncertainty in the market rates for comparable notional portfolios, prepayment scenarios and for the recognition of types of acquisition costs and their corresponding impact on the loan portfolio. The range of Notional Interest Rates as of December 2020 for the Favourable scenario was 2.48% to 3.66% and for the Adverse Scenario was 2.68% to 4.18% compared to Base case range of 2.54% to 3.66%. 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 GBP0.7 million or increase it by GBP0.3 million.
Private Credit Funds
SWL hold investments in two private credit funds that hold portfolios of loans to European medium-sized enterprises where loans are often backed by commercial real estate. 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 flow 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.
Private equity base value at GBP544 million (2019: GBP614 million). The effect of applying reasonably possible alternative assumptions to the value of these assets would be to decrease the fair value by GBP19 million (2019: GBP7 million) or increase it by GBP3 million (2019: GBP1 million). For Pemberton European Mid-Market Debt Fund II (E) (Pemberton), the impact of alternative assumptions on credit spread and illiquidity premium is -2.0% (2019: -1.2%) to base in the adverse scenario and 0% (2019: 0%) to base in the favourable. For AgFe UK Real Estate Senior Debt Fund LP (AgFe), an alternative approach is used incorporating alternative assumptions on debt margin for the underlying loans, resulting in a -5.9% (2019: -0.9%) to base in the adverse scenario and +1.9% (2019: +0.5%) to base in favourable scenario.
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 GBP128 million (2019: GBP146 million). The effect of applying reasonably possible alternative assumptions to the value of these assets would be to decrease the fair value by GBP17 million (2019: GBP26 million) or increase it by GBP1 million (2019: GBP1 million). The impact of alternative assumptions is -13.8% (2019: -17.5% to base in the adverse scenario and +1.1% (2019: +0.8%) to base in the favourable scenario.
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).
37. Risk management (continued) (c) Financial risks (continued) (1) Market risk (continued)
Group
2020 2019 GBPm GBPm GBPm GBPm -------------------------------------------- ------ ----------- ------ ------------- Assets Liabilities Assets Liabilities Balance at 1 January 13,541 - 12,532 - Transfers in 179 - 421 - Transfers out (356) - (147) - Purchases 756 - 1,422 - Disposals (534) - (984) - Net gains recognised within net gains on assets and liabilities at fair value through profit or loss in the statement of comprehensive income 311 - 297 - Balance at 31 December 13,897 - 13,541 - -------------------------------------------- ------ ----------- ------ ----------- Total unrealised gains for the period included in the statement of comprehensive income for assets and liabilities held at 31 December 692 - 245 - -------------------------------------------- ------ ----------- ------ -----------
Company
2020 2019 GBPm GBPm GBPm GBPm -------------------------------------- ------ ----------- ------ ------------- Assets Liabilities Assets Liabilities Balance at 1 January 10,303 - 8,932 - Transfers in 154 - 267 - Transfers out (340) - - - Purchases 676 - 1,355 - Disposals (407) - (649) - Assets held for sale - - - - Net gains recognised within net gains on assets and liabilities at fair value through profit or loss in the statement of comprehensive income 464 - 398 - Balance at 31 December 10,850 - 10,303 - -------------------------------------- ------ ----------- ------ ----------- Total unrealised gains for the period included in the statement of comprehensive income for assets and liabilities held at 31 December 498 - 340 - -------------------------------------- ------ ----------- ------ -----------
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.
37. Risk management (continued) (c) Financial risks (continued) (1) 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, mainly due to the hedge payoff under falling markets.
Impact on profit after tax and equity for the year 2020 2019 GBPm GBPm -------------------------------------------- ------------ ----------- 10% (2019: 10%) decrease in equity prices 180 131 10% (2019: 10%) decrease in property prices (5) (5) -------------------------------------------- ------------ --------- (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 36. 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.
37. Risk management (continued) (c) Financial risks (continued) (1) Market risk (continued) (ii) Interest rate risk (continued) Impact on profit after tax and equity for the year 2020 2019 GBPm GBPm ------------------------------------------------- ------------ ----------- 25 basis points (2019: 25 basis points) increase in yield curves 43 28 25 basis points (2019: 25 basis points) decrease in yield curves (51) (34) 50 basis points (2019: 50 basis points) increase in yield curves 79 51 50 basis points (2019: 50 basis points) decrease in yield curves (111) (75)
Interest Rate Benchmark Reform
For the purposes of determining whether:
-- a forecast transaction is highly probable -- hedged future cash flows are expected to occur
-- a hedge is expected to be highly effective in achieving offsetting changes in fair value or cash flows attributable to the hedged risk
-- 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 Group is exposed to 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 (2019: nil) at 31 December 2020. The value of liabilities designated in fair value hedges had a notional of GBP1.5 billion (2019: GBP1.5 billion) at 31 December 2020.
At 31 December 2020, the notional amount of the hedging instruments in hedging relationships to which these amendments apply was GBP1.5 billion (2019: GBP1.5 billion).
The Group is managing the process to transition to alternative benchmark rates as part of Lloyds Banking Group's Group-wide IBOR Transition Programme. This programme has developed an implementation plan for new products and a transition plan for legacy products. The programme also encompasses the associated impacts on systems, processes, accounting and reporting and includes dealing with the impact on hedge accounting relationships of the transition to alternative reference rates.
(iii) 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 SWL SII capital position.
Sensitivity analysis for the impact of a 10 per cent depreciation of sterling against foreign currency shows a GBP(117 million) impact for 2020 on profit after tax and equity (2019: GBP(131 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; and
-- 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
37. Risk management (continued) (c) Financial risks (continued) (2) 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; and
-- 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 mortality rates over 2020 due to the Covid-19 pandemic, it is expected that current mortality rates will revert to broadly the previous level. The longer-term impacts of Covid-19 on future mortality improvements remain unclear, with limited data available to date to support any change to the assumptions. The mortality assumptions disclosed therefore do not include any allowance for Covid-19. Mortality assumptions are updated annually, reflecting both historic experience and future expectations. Therefore as further information becomes available it will be incorporated in future assumptions.
A provision is held in respect of life assurance and to reflect that fact that a short-term spike in mortality claims is expected. A provision is also held in respect of morbidity products as the reduced availability of medical screening has reduced critical illness claims made in 2020. It is expected that this reduction will be offset in 2021 as delayed claims arise. Increased mortality on annuity contracts reduces the payments made and so no provision is necessary for these.
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.
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.
37. Risk management (continued) (c) Financial risks (continued) (2) Insurance underwriting risk (continued)
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 and the ability to renew short-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 has resulted in a significant negative shock to the global economy. This is expected to result in increased levels of redundancies. Consequently, it is expected that there will be reduced premium income for contracts in the Workplace and Savings business as premiums are directly linked to the policyholders' employment. A provision is held in respect of this risk.
Further information on assumptions, changes in assumptions and sensitivities in respect of insurance and participating investment contracts is given in note 36.
(3) 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 Investment Strategy Committee (IISC) assists the IISC Chair 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 IISC, 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.
37. Risk management (continued) (c) Financial risks (continued) (3) Credit risk (continued)
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 Standard & Poor's 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.
Group As at 31 December 2020
BBB or Total AAA AA A lower Not rated GBPm GBPm GBPm GBPm GBPm GBPm ------------------------------ ------ ----- ------ ------ ------ ----------- Stage 1 assets Cash and cash equivalents 218 1 - 191 26 - Loans and receivables at amortised cost 775 - - 341 - 434 Loss allowance - - - - - - ------------------------------ ------ ----- ------ ------ ------ --------- Exposure to credit risk 993 1 - 532 26 434 Simplified approach assets Loans and receivables at amortised cost 250 - - 54 - 196 Loss allowance (7) - - (3) - (4) ------------------------------ ------ ----- ------ ------ ------ --------- Exposure to credit risk 243 - - 51 - 192 Assets at FVTPL Assets arising from reinsurance contracts held classified at fair value through profit and loss 19,549 - 19,230 - 314 5 Debt and other fixed/variable income securities 37,256 2,036 16,831 8,602 9,756 31 Derivative financial instruments 5,224 - 636 4,426 90 72 Loans and advances to customers 9,646 76 266 6,131 2,570 603 Loans and advances to
banks 4,693 - 213 4,440 3 37 Other Reinsurance contracts 810 - 810 - - - ------------------------------ ------ ----- ------ ------ ------ --------- Total 78,414 2,113 37,986 24,182 12,759 1,374 ------------------------------ ------ ----- ------ ------ ------ ---------
Cash at bank, included with Stage 1 assets, is considered to have low credit risk.
37. Risk management (continued) (c) Financial risks (continued) (3) Credit risk (continued)
Group As at 31 December 2019
BBB or Total AAA AA A lower Not rated GBPm GBPm GBPm GBPm GBPm GBPm ------------------------------ ------ ----- ------ ------ ------ ----------- Stage 1 assets Cash and cash equivalents 276 1 17 204 48 6 Loans and receivables at amortised cost 483 - - 403 - 80 Loss allowance - - - - - - ------------------------------ ------ ----- ------ ------ ------ --------- Exposure to credit risk 759 1 17 607 48 86 Simplified approach assets Loans and receivables at amortised cost 514 - - 22 - 492 Loss allowance (5) - - - - (5) ------------------------------ ------ ----- ------ ------ ------ --------- Exposure to credit risk 509 - - 22 - 487 Assets at FVTPL Assets arising from reinsurance contracts held classified at fair value through profit and loss 22,837 - - 22,551 286 - Debt and other fixed/variable income securities 32,366 2,152 15,026 6,689 8,337 162 Derivative financial instruments 3,968 - 454 3,395 74 45 Loans and advances to customers 8,804 73 1,324 4,439 2,376 592 Loans and advances to banks 2,255 - 18 2,172 58 7 Other Reinsurance contracts 720 - 589 131 - - ------------------------------ ------ ----- ------ ------ ------ --------- Total 72,218 2,226 17,428 40,006 11,179 1,379 ------------------------------ ------ ----- ------ ------ ------ --------- 37. Risk management (continued) (c) Financial risks (continued) (3) Credit risk (continued)
Company As at 31 December 2020
BBB or Total AAA AA A lower Not rated GBPm GBPm GBPm GBPm GBPm GBPm ------------------------------ ------ ---- ------ ------ ------ ----------- Stage 1 assets Cash and cash equivalents 95 - - 69 26 - Loans and receivables at amortised cost 383 - - 382 - 1 Loss allowance - - - - - - ------------------------------ ------ ---- ------ ------ ------ --------- Exposure to credit risk 478 - - 451 26 1 Simplified approach assets Loans and receivables at amortised cost 236 - - 54 - 182 Loss allowance (4) - - (3) - (1) ------------------------------ ------ ---- ------ ------ ------ --------- Exposure to credit risk 232 - - 51 - 181 Assets at FVTPL Assets arising from reinsurance contracts held classified at fair value through profit and loss 19,549 - 19,230 - 314 5 Debt and other fixed/variable income securities 16,677 514 9,741 2,714 3,561 147 Derivative financial instruments 5,132 - 606 4,385 90 51 Loans and advances to customers 9,095 76 266 6,131 2,570 52 Loans and advances to banks 1,468 - - 1,437 - 31 Deposits with cedants 1,509 - - - - 1,509 Other Reinsurance contracts 819 - 819 - - - ------------------------------ ------ ---- ------ ------ ------ --------- Total 54,959 590 30,662 15,169 6,561 1,977 ------------------------------ ------ ---- ------ ------ ------ ---------
Cash at bank, included with Stage 1 assets, is considered to have low credit risk.
37. Risk management (continued) (c) Financial risks (continued) (3) Credit risk (continued)
Company As at 31 December 2019
BBB or Total AAA AA A lower Not rated GBPm GBPm GBPm GBPm GBPm GBPm ------------------------------ ------ ---- ------ ------ ------ ----------- Stage 1 assets Cash and cash equivalents 98 - - 53 45 - Loans and receivables at amortised cost 411 - - 402 - 9 Loss allowance - - - - - - ------------------------------ ------ ---- ------ ------ ------ --------- Exposure to credit risk 509 - - 455 45 9 Simplified approach assets Loans and receivables at amortised cost 208 - - 22 - 186 Loss allowance (2) - - - - (2) ------------------------------ ------ ---- ------ ------ ------ --------- Exposure to credit risk 206 - - 22 - 184 Assets at FVTPL Assets arising from reinsurance contracts held classified at fair value through profit and loss 22,837 - - 22,551 286 - Debt and other fixed/variable income securities 15,299 591 9,065 2,792 2,605 246 Derivative financial instruments 3,894 - 452 3,347 74 21 Loans and advances to customers 8,250 73 1,324 4,439 2,376 38 Loans and advances to banks 1,203 - - 1,188 15 - Deposits with cedants 1,507 - - - - 1,507 Transferred to Assets held for sale - - - - - - Other Reinsurance contracts 726 - 595 131 - - ------------------------------ ------ ---- ------ ------ ------ --------- Total 54,431 664 11,436 34,925 5,401 2,005 ------------------------------ ------ ---- ------ ------ ------ ---------
Amounts classified as 'not rated' within assets arising from reinsurance contracts held principally relate to amounts due from other Group companies which are 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.
37. Risk management (continued) (c) Financial risks (continued) (3) Credit risk (continued) Group 2020 2019 Maximum Maximum exposure Net exposure exposure Net exposure GBPm GBPm GBPm GBPm ----------------------------------- --------- ------------ --------- -------------- Loans and receivables at amortised cost 1,018 1,107 997 997 Investments at fair value through profit or loss: Assets arising from reinsurance contracts held classified at fair value through profit and loss 19,549 19,549 22,837 22,837 Debt securities 37,256 37,256 32,366 32,366 Derivative Financial Instruments 5,224 5,224 3,968 3,968 Loans and advances to customers 9,646 9,646 8,804 8,804 Loans and advances to banks 4,693 4,693 2,255 2,255
Reinsurance contracts 810 810 720 720 Cash and cash equivalents 218 218 276 276 ----------------------------------- --------- ------------ --------- ------------ At 31 December 78,414 78,503 72,223 72,223 ----------------------------------- --------- ------------ --------- ------------ Company 2020 2019 Maximum Maximum exposure Net exposure exposure Net exposure GBPm GBPm GBPm GBPm ----------------------------------- --------- ------------ --------- -------------- Loans and receivables at amortised cost 615 615 619 619 Investments at fair value through profit or loss: Assets arising from reinsurance contracts held classified at fair value through profit and loss 19,549 19,549 22,837 22,837 Debt securities 16,677 16,677 15,299 15,299 Derivative Financial Instruments 5,132 5,132 3,894 3,894 Loans and advances to customers 9,095 9,095 8,250 8,250 Loans and advances to banks 1,468 1,468 1,203 1,203 Deposits with cedants 1,509 1,509 1,507 1,507 Reinsurance contracts 819 819 726 726 Cash and cash equivalents 95 95 98 98 ----------------------------------- --------- ------------ --------- ------------ At 31 December 54,959 54,959 54,433 54,433 ----------------------------------- --------- ------------ --------- ------------
Covid-19
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. All shareholder assets are subject to continued assessment for the impact of Covid-19. Since 1 January 2020 downgrades to sub-investment grade across loans and bonds were GBP99 million, with a total of 0.5 per cent of shareholder assets rated sub-investment grade.
37. Risk management (continued) (c) Financial risks (continued) (3) 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 2020 and 31 December 2019, the Group did not have any significant concentration of credit risk with a single counterparty or Group of counterparties where limits applied. With the exception of government bonds and UCITS funds, the largest aggregated counterparty exposure is 0.20 per cent (2019: 0.20 per cent) of the Group's total assets).
Total GBPm ------------------------------------------------------ ------- Trade and other receivables: Amounts due from brokers 57 Amounts due from Group undertakings 375 Other receivables 586 Cash and cash equivalents with financial institutions 218 ------------------------------------------------------ ----- Total 1,236 ------------------------------------------------------ -----
For other receivables, the largest single counterparty balance is with policyholders, which totals GBP83 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.
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:
37. Risk management (continued) (c) Financial risks (continued) (3) Credit risk (continued) (ii) Collateral management (continued)
Collateral in respect of derivatives (continued)
2020 2019 GBPm GBPm GBPm GBPm -------------------------- ----- ------- ----- --------- Group Company Group Company Financial assets: Investments at fair value through profit or loss 1,483 1,483 773 773 Cash and cash equivalents 445 425 369 369 -------------------------- ----- ------- ----- ------- Total 1,928 1,908 1,142 1,142 -------------------------- ----- ------- ----- -------
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 GBP1,440 million (2019: GBP1,191 million) by the Group and GBP1,440 million (2019: GBP1,191 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 GBP868 million (2019: GBP281 million) and GBP821 million (2019: GBP250 million) respectively.
Collateral in respect of Stock Lending
Stock lending activity has discontinued during the year. Until this year and in prior years, 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 GBP1 million (2019: GBP4,137 million) and by the Company is nil (2019: GBP573 million).
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 GBP1 million (2019: GBP4,059 million) by the Group and nil (2019: GBP528 million) 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 (2019: GBP334 million) and nil (2019: GBP66 million) respectively.
There were no defaults in respect of stock lending during the year ended 31 December 2020 (2019: none) which required a call to be made on collateral.
37. Risk management (continued) (c) Financial risks (continued) (3) Credit risk (continued) (ii) Collateral management (continued)
Collateral in respect of Reverse Repurchase Agreement
Reverse Repurchase Agreements were closed during the year. In previous years, the Group and Company entered into Reverse Repurchase Agreements whereby it purchased financial instruments with an agreement to resell them back to the counterparty at an agreed price. These transactions are in effect collateralised loans and are reported accordingly. The cash on loan is recognised as Loans and Receivables. The amount of cash on loan in this regard is nil (2019: GBP334 million) for the Group and nil (2019: GBP66 million) for Company.
The financial assets received as collateral were not recognised on the balance sheet as the counterparty retains all risks and rewards. The fair value of financial assets accepted as collateral amounted to is nil (2019: GBP349 million) for the Group and nil (2019: GBP69 million) for Company.
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 2020, 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 in respect of Bulk Annuity business was GBP1,436 million (2019: GBP1,471 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 (2019: nil). Total derivatives presented in the balance sheet are shown in note 20.
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.
37. Risk management (continued) (c) Financial risks (continued) (3) Credit risk (continued) (iii) Offsetting (continued) b) Repurchase and Reverse Repurchase Arrangements (continued)
Group as at 31 December 2020
Related amounts where set off not permitted in the balance sheet (sub note 2) Net amounts presented Potential Amounts in the net amounts Gross set off balance if offset amounts in the sheet of related of assets balance (sub Financial amounts / liabilities sheet note 1) instruments Collateral permitted GBPm GBPm GBPm GBPm GBPm GBPm ---------------------- -------------- -------- ----------- ------------ ---------- -------------- Financial assets OTC Derivatives 5,169 - 5,169 (3,233) (2,225) (289) ET Derivatives 55 - 55 (29) (26) - Reverse Repo - - - - - - Financial liabilities OTC Derivatives (4,562) - (4,562) 3,233 1,695 366 ET Derivatives (46) - (46) 29 17 - ---------------------- -------------- -------- ----------- ------------ ---------- ------------
Group as at 31 December 2019
Related amounts where set off not permitted in the balance sheet (sub note 2) Net amounts presented Potential Amounts in the net amounts Gross set off balance if offset amounts in the sheet of related of assets balance (sub Financial amounts / liabilities sheet note 1) instruments Collateral permitted
GBPm GBPm GBPm GBPm GBPm GBPm ---------------------- -------------- -------- ----------- ------------ ---------- -------------- Financial assets OTC Derivatives 3,923 - 3,923 (2,352) (1,499) 72 ET Derivatives 45 - 45 (7) (38) - Repo - - - - - - Reverse Repo 334 - 334 - (349) (15) Financial liabilities OTC Derivatives (3,409) - (3,409) 2,352 1,018 (39) ET Derivatives (36) - (36) 7 29 - ---------------------- -------------- -------- ----------- ------------ ---------- ------------ 37. Risk management (continued) (c) Financial risks (continued) (3) Credit risk (continued) (iii) Offsetting (continued) b) Repurchase and Reverse Repurchase Arrangements (continued)
Company as at 31 December 2020
Related amounts where set off not permitted in the balance sheet (sub note 2) Gross Net amounts Potential amounts presented net amounts of assets Amounts in the if offset / liabilities set off balance of related in the sheet amounts balance (sub Financial permitted sheet note 1) instruments Collateral GBPm GBPm GBPm GBPm GBPm GBPm ---------------------- -------------- -------- ----------- ------------ ---------- -------------- Financial assets OTC Derivatives 5,093 - 5,093 (3,233) (2,185) (325) ET Derivatives 39 - 39 (26) (13) - Reverse Repo - - - - - - Financial liabilities OTC Derivatives (4,550) - (4,550) 3,233 1,689 372 ET Derivatives (40) - (40) 26 14 - ---------------------- -------------- -------- ----------- ------------ ---------- ------------
Company as at 31 December 2019
Related amounts where set off not permitted in the balance sheet (sub note 2) Gross Net amounts amounts presented Potential of assets Amounts in the net amounts / liabilities set off balance if offset in the sheet of related balance (sub Financial amounts sheet note 1) instruments Collateral permitted GBPm GBPm GBPm GBPm GBPm GBPm ---------------------- -------------- -------- ----------- ------------ ---------- -------------- Financial assets OTC Derivatives 3,872 - 3,872 (2,352) (1,467) 53 ET Derivatives 22 - 22 (1) (20) 1 Repo - - - - - - Reverse Repo 66 - 66 - (69) (3) Financial liabilities OTC Derivatives (3,403) - (3,403) 2,352 1,018 (33) ET Derivatives (31) - (31) 1 30 - ---------------------- -------------- -------- ----------- ------------ ---------- ------------
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 20.
37. Risk management (continued) (c) Financial risks (continued) (3) Credit risk (continued) (iii) Offsetting (continued) b) Repurchase and Reverse Repurchase Arrangements (continued)
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.
(4) 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. This is reviewed on a quarterly basis by the PRA.
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; and
- to meet the requirements of the Schemes of Transfer
The capital management strategy is such that the integrated insurance business (comprising Scottish Widows Group Limited (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 a one in ten year stress event 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 reinsurance 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 30).
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 current year information is an estimate of the final result:
37. Risk management (continued) (c) Financial risks (continued) (4) Capital Risk (continued) Company 2020 2019 GBPm GBPm ------------------------ ----- ------- Regulatory Capital held 7,434 7,724 ------------------------ ----- -----
The solvency position reduced over 2020 due to the impacts of the Covid-19 pandemic, but remains above risk appetite at 31 December 2020. The pandemic may impact credit assets further in 2021 and the Company continues to actively monitor and manage its credit asset portfolio. This 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.
(5) 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.
Non-participating contracts
For unit-linked products, portfolios are invested in accordance with unit fund mandates. Deferral clauses are included in policyholder contracts to give time, when necessary, to realise linked assets without being a forced seller. As at 31 December 2020, there are no funds under management subject to deferral (2019: none).
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.
37. Risk management (continued) (c) Financial risks (continued) (5) Liquidity risk (continued)
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.
Group As at 31 December Contractual cash flows 2020 Liabilities Carrying No stated Less 1-3 months 3-12 1-5 years More amount maturity than months than 1 month 5 years GBPm GBPm GBPm GBPm GBPm GBPm GBPm -------------------------- -------- --------- -------- ---------- ------- --------- ---------- Liabilities arising from non-participating investment contracts 38,448 - 38,448 - - - - External interests in collective investment vehicles 12,620 12,620 - - - - - Derivatives held for trading 4,609 - 49 81 139 837 3,673 Subordinated debt 1,892 - - - 113 1,074 1,420 Borrowings 2 - 2 - - - - Lease liabilities 80 - - - 1 2 77 Other financial liabilities 2,214 229 1,961 15 9 - - -------------------------- -------- --------- -------- ---------- ------- --------- -------- Total 59,865 12,849 40,460 96 262 1,913 5,170 -------------------------- -------- --------- -------- ---------- ------- --------- -------- Group As at 31 December Contractual cash flows 2019 Carrying No stated Less 1-3 months 3-12 1-5 years More amount maturity than months than Liabilities 1 month 5 years GBPm GBPm GBPm GBPm GBPm GBPm GBPm -------------------------- -------- --------- -------- ---------- ------- --------- ---------- Liabilities arising from non-participating investment contracts 37,456 - 37,456 - - - - External interests in collective investment vehicles 11,966 11,855 - - - - - Derivatives held for trading 3,445 - 16 67 110 677 2,872 Subordinated debt 1,795 - - - 112 1,128 1,465 Borrowings 3 - 3 - - - - Lease liabilities 197 - - - 2 7 188 Other financial liabilities 1,889 297 1,557 28 7 - - -------------------------- -------- --------- -------- ---------- ------- --------- -------- Total 56,751 12,152 39,032 95 231 1,812 4,525 -------------------------- -------- --------- -------- ---------- ------- --------- --------
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.
37. Risk management (continued) (c) Financial risks (continued) (5) Liquidity risk (continued)
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:
Group As at 31 December More 2020 Less than than 1-3 3-12 1-5 5 Total 1 month months months years years Maturity Analysis for liabilities arising from insurance and investment contracts GBPm GBPm GBPm GBPm GBPm GBPm ----------------------------- ------- -------- ------- ------- ------ -------- Insurance and participating investment contracts 115,965 866 1,257 3,964 25,702 84,176 Non-participating investment contracts 38,448 469 537 2,363 11,510 23,569 ----------------------------- ------- -------- ------- ------- ------ ------ Group As at 31 December More 2019 Less than than 1-3 3-12 1-5 5 Total 1 month Months months years years Maturity Analysis for liabilities arising from insurance and investment contracts GBPm GBPm GBPm GBPm GBPm GBPm ----------------------------- ------- -------- ------- ------- ------ -------- Insurance and participating investment contracts 110,919 893 1,335 4,020 26,343 78,328 Non-participating investment contracts 37,456 334 360 1,596 8,077 27,089 ----------------------------- ------- -------- ------- ------- ------ ------ Company As at 31 Contractual cash flows December 2020 Less More Carrying No stated than 3-12 than amount maturity 1 month 1-3 months months 1-5 years 5 years Liabilities GBPm GBPm GBPm GBPm GBPm GBPm GBPm Liabilities arising from non-participating investment contracts 38,433 - 38,433 - - - - Derivative financial instruments 4,590 - 40 71 138 837 3,673 Subordinated debt 1,923 - - - 92 1,100 1,444 Other financial liabilities 1,972 229 1,743 - - - - ------------------------ -------- --------- -------- ---------- ------- --------- -------- Total 46,920 229 40,218 71 230 1,937 5,117 ------------------------ -------- --------- -------- ---------- ------- --------- -------- 37. Risk management (continued) (c) Financial risks (continued) (5) Liquidity risk (continued) Company As at 31 December Contractual cash flows 2019 Less More Carrying No stated than 3-12 than amount maturity 1 month 1-3 months months 1-5 years 5 years Liabilities GBPm GBPm GBPm GBPm GBPm GBPm GBPm Liabilities arising from non-participating investment contracts 37,455 - 37,455 - - - - Derivative financial instruments 3,434 - 10 62 110 677 2,872 Subordinated debt 1,820 - - - 92 1,147 1,490 Other financial liabilities 1,422 313 1,109 - - - - ---------------------------- -------- --------- -------- ---------- ------- --------- -------- Total 44,131 313 38,574 62 202 1,824 4,362 ---------------------------- -------- --------- -------- ---------- ------- --------- --------
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:
Company As at 31 December More 2020 Less than than 1-3 3-12 1-5 5 Total 1 month months months years years Maturity Analysis for liabilities arising from insurance contracts and investment contracts GBPm GBPm GBPm GBPm GBPm GBPm ----------------------------- ------- -------- ------- ------- ------ -------- Insurance and participating investment contracts 115,487 851 1,227 5,329 25,107 82,972 Non-participating investment contracts 38,433 469 536 2,361 11,504 23,563 ----------------------------- ------- -------- ------- ------- ------ ------ (d) Non-financial risks
The Group faces a variety of non-financial risks through its operations and service provision. The Group manages these risks by following the embedded Risk Management Framework, which uses methodologies and systems consistent with those implemented across the Group. The various stages of the framework are:
Identification
-- Risks identified in products, processes, channels, customers and people -- Emerging risks
-- Changes to the risk profile through on-going tracking, pricing reviews and monitoring of external factors
-- Change Management at project, programme or portfolio level
-- Implement Risk and Control Framework and standards, including loss estimation and provisioning
Measurement
-- Evaluate risk exposure vs appetite -- Modelling and stress testing, including Internal Model outputs -- Actual vs expected losses -- Scenario analysis -- Reverse stress testing 37. Risk management (continued) (d) Non-financial risks (continued)
Management
-- Identify and operate controls -- Perform day-to-day control activities -- Ensure appropriate segregation of duties -- Control assessment and estimation of residual risk
-- Controls testing activities including Sarbanes-Oxley and Own Risk and Solvency Assessment (ORSA) review
-- Effectiveness reviews
Monitoring
-- Performance vs risk appetite -- Internal Model performance monitoring -- Risk metrics on for example products, processes, customer experience, service, retention -- Change portfolio -- Regulatory and external environment -- Quality checking -- Action management
Reporting
-- Monthly Executive Risk Reporting presented through the corporate governance structure leads to top down review and challenge evidenced via the Insurance Consolidated Risk Report
-- Material Events escalation, including related actions -- ORSA reporting
The primary non-financial risk categories are:
Conduct risk
Conduct risk is defined as the risk of customer detriment across the customer lifecycle including: failures in product management, distribution and servicing activities; from other risks materialising, or other activities which could undermine the integrity of the market or distort competition, leading to unfair customer outcomes, regulatory censure, reputational damage or financial loss.
Governance risk
Governance risk is defined as the risk that the Group's organisational infrastructure fails to provide robust oversight of decision-making and the control mechanisms to ensure strategies and management instructions are implemented effectively.
Model risk
The risk of financial loss, regulatory censure, reputational damage or customer detriment, as a result of deficiencies in the development, application and on-going operation of Models and Ratings systems.
Operational risk
Operational risk is defined as the risk of loss from inadequate or failed internal processes, people and systems or from external events. As operational risk covers such a range of elements, there are secondary risk-types within this area, including:
- Change risk
Change risk is defined as the risk that, in delivering its change agenda, the Group fails to ensure compliance with laws and regulation, maintain effective customer service and availability, and/or operate within the Group's risk appetite.
37. Risk management (continued) (d) Non-financial risks (continued)
Operational risk (continued)
- Cyber and information security
The risk of financial loss, disruption or damage to the reputation of Lloyds Banking Group from a malicious attack that impacts the confidentiality and/or integrity of electronic data or the availability of systems. The risk also to the security of information and data.
- Data management
The risk that the Group fails to effectively govern, manage and protect its data (or the data shared with Third-Party Suppliers) impacting the Group's agility, accuracy, access and availability of data, ultimately leading to poor customer outcomes, loss of value to the Group and mistrust from regulators.
- Financial crime
Financial crime is the risk of acts intended to bribe, corrupt, launder money, fund terrorist activity or circumvent sanctions intended for personal gain or to cause loss to another party, by customers/clients, suppliers, third parties or colleagues.
- Financial reporting risk
Financial reporting risk is defined as the risk that the Group suffers reputational damage, loss of investor confidence and/or financial loss arising from the adoption of inappropriate accounting policies, ineffective controls over business or finance processes impacting financial, prudential regulatory, and tax reporting, failure to manage the associated risks of changes in taxation rates, law, corporate ownership or structure and the failure to disclose timely and appropriate information in accordance with regulatory requirements.
- Fraud
The risk of acts of deception or omission intended for personal gain or to cause loss to another party, by customers/clients, third parties or colleagues,
- Internal service provision
The risk associated with the management of internal service arrangements.
- IT systems
The risk of failure in technology governance and the development, delivery and maintenance of effective IT solutions.
- Operational resilience risk
Operational resilience risk covers the risk that the Group fails to design resilience into business operations, underlying infrastructure and controls (people, process, technical) so that it is able to withstand external or internal events which could impact the continuation of operations, and fails to respond in a way which meets stakeholder expectations and needs when the continuity of operations is compromised.
- Physical security risk
The risk to the security of people and property (including damage (malicious or non-malicious) to
Lloyds Banking Group branches and buildings managed through Group Property).
- Sourcing
Sourcing risk covers the risk associated with the activity related to the agreement and management of services provided by third parties including outsourcing (excludes internal service arrangements).
People risk
People risk is defined as the risk that the Group fails to provide an appropriate colleague and customer-centric culture, supported by robust regard and wellbeing policies and processes; effective leadership to manage colleague resources; effective talent and succession management; and robust control to ensure all colleague-related requirements are met.
37. Risk management (continued) (d) Non-financial risks (continued)
Regulatory and legal risk
The risk of financial penalties, regulatory censure, criminal or civil enforcement action or customer detriment as a result of failure to identify, assess, correctly interpret, comply with, or manage regulatory and/or legal requirements.
(e) UK political uncertainties including EU exit
The UK / EU Trade and Cooperation Agreement means a disorderly Brexit has been avoided. While the TCA contains limited, high-level provisions on financial services, further detail is expected to emerge during this year, and the Group will continue to monitor developments closely. In advance of the UK leaving the EU, a European subsidiary (SWE) was created to ensure continuity of certain insurance business for EEA customers. As a result of Brexit, some customers' bank accounts have had to be closed, meaning these customers will need to set up alternative payment arrangements to continue other Group products and services, including savings, investments and insurance cover. Measures have been put in place to support affected customers, although to date customer responses remain low. The Group continues to monitor the wider post-Brexit environment, including for market volatility. Scenario planning exercises are performed as part of business as usual, while contingency plans have been recalibrated and are regularly reviewed for potential strategic, operational and reputational impacts.
(f) Economic Risk
UK economic growth is muted due to impacts from the Covid-19 pandemic and political uncertainty. High levels of credit market liquidity have reduced spreads and weakened terms in some sectors, creating a potential under-pricing of risk and heightened risk of a market correction. The Group's response is:
-- The Group has a robust through the cycle credit risk appetite, including individual limit guidelines, specific sector appetite statements and policies, and affordability and indebtedness controls at origination. In addition to on-going focused monitoring, we conduct portfolio deep dives and larger exposure reviews. We have enhanced our use of early warning indicators including sector specific indicators
-- Capital and liquidity are reviewed regularly through committees, ensuring compliance with risk appetite and regulatory requirements
-- Internal contingency plans recalibrated and regularly reviewed for potential strategic, operational and reputational impacts
-- Wide array of risks considered in setting strategic plans
Additionally, the Covid-19 outbreak and related global health issues are impacting economies and markets. More detail is given in respect of market risk (note 37 (c) (1)), insurance underwriting risk (note 37 (c) (2)), credit risk (note 37 (c) (3)) and capital risk (note 37 (c) (4)).
RELATED PARTY TRANSACTIONS
38. Related party transactions (a) Ultimate parent and shareholding
The Group's immediate parent undertaking is Scottish Widows Group Limited, a Company registered in the United Kingdom. Scottish Widows Group Limited 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. Once approved, 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.
2020 Income Expenses Payable Receivable during during at period at period period period end end GBPm GBPm GBPm GBPm ---------------------- ------- -------- ---------- ------------ Relationship Parent 14 (560) - 348 Other related parties 403 (848) (1,671) 2,762 ---------------------- ------- -------- ---------- ---------- 2019 Income Expenses Payable Receivable during during at period at period period period end end GBPm GBPm GBPm GBPm ---------------------- ------- -------- ---------- ------------ Relationship Parent 15 (300) - 351 Other related parties 335 (822) (1,831) 2,275 ---------------------- ------- -------- ---------- ----------
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 GBP219 million (2019: GBP574 million) of shares in the ultimate parent undertaking on the balance sheet, with associated transactions of GBP(90) million (2019: GBP(30) million) during the year.
38. Related party transactions (continued) (b) Transactions with other Lloyds Banking Group companies (continued) 2020 Income Expenses Payable Receivable during during at period at period period period end end GBPm GBPm GBPm GBPm ---------------------- ------- -------- ---------- ------------ Relationship Parent 14 (560) - 348 Subsidiary 352 (233) (1,679) 675 Other related parties 386 (713) (1,651) 2,650 ---------------------- ------- -------- ---------- ---------- 2019 Income Expenses Payable Receivable during during at period at period period period end end GBPm GBPm GBPm GBPm ---------------------- ------- -------- ---------- ------------ Relationship Parent 15 (300) - 351 Subsidiary 1,588 (88) (1,612) 662 Other related parties 335 (743) (1,826) 2,175 ---------------------- ------- -------- ---------- ----------
Further, amounts relating to other related parties of GBP2,234 million due from OEICs investments were outstanding at 31 December 2020 (2019: GBP3,418 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 GBP(9) million (2019: GBP330 million) from OEIC investments.
Parent undertaking transactions relate to all reported transactions and balances with Scottish Widows Group Limited, 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.
(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:
2020 2020 2019 2019 GBPm GBPm GBPm GBPm ----------------------------- ----- ------- ----- --------- Group Company Group Company Short-term employee benefits 5 5 7 7 Share-based payments 1 1 2 2 ----------------------------- ----- ------- ----- ------- Total 6 6 9 9 ----------------------------- ----- ------- ----- -------
Included in short-term employee benefits is the aggregate amount of emoluments paid to or receivable by Directors in respect of qualifying services of GBP2 million (2019: GBP3 million).
There were no retirement benefits accruing to Directors (2019: nil) under defined benefit pension schemes. Two Directors (2019: three Directors) are paying into a defined contribution scheme. There were no contributions paid to a pension scheme for qualifying services (2019: 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.
38. 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 share-based incentive schemes in respect of Directors qualifying services was one (2019: GBP1 million). During the year, two Director exercised share options (2019: two Directors) and two Directors received qualifying service shares under long-term incentive schemes (2019: three Directors). Movements in share options are as follows:
2020 2019 GBPm GBPm Options Options --------------- ------- --------- Outstanding at 1 January 15 15 Granted 11 8 Exercised (4) (4) Forfeited (6) (4) Outstanding at 31 December 16 15 ----------------- ------- -------
Detail regarding the highest paid Director is as follows:
2020 2020 2019 2019 GBPm GBPm GBPm GBPm --------------------------------- ----- ------- ----- --------- Group Company Group Company Apportioned aggregate emoluments 1 1 2 2 Apportioned share-based payments - - 1 1
The highest paid Director did not exercise share options during the year. (2019: The highest paid Director did exercise share options during the year).
Further details of the above can also be obtained by contacting Secretariat, Insurance, Lloyds Banking Group plc, Level 7 Block E, Port Hamilton, 69 Morrison Street, Edinburgh EH3 8YF.
LEI NUMBER: 549300ZT0RVWCG8T4L55
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(END) Dow Jones Newswires
March 25, 2021 05:53 ET (09:53 GMT)
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