Financial Statements

Notes to the consolidated accounts

29. FPLP's With-Profits Balance Sheet

FPLP's with-profits business can be summarised as follows:

	2007 £m	2006 £m
Total net assets	14,739	16,087
Less non-profit liabilities including long-term insurance capital requirements	(2,561)	(2,670)
Total regulatory assets	12,178	13,417
Additional assets arising on realistic basis	219	265
Total assets	12,397	13,682
Policyholder liabilities:
Asset shares	10,323	11,365
Financial guarantees (net of charges)	210	101
Options (guaranteed annuities)	628	747
Other liabilities	990	1,249
Total liabilities	12,151	13,462
Excess of assets over liabilities	246	220

At 31 December 2007, the surplus of assets over liabilities initially amounted to £274m (2006: £254m) with a Risk Capital Margin (RCM) of £246m (2006: £220m), the surplus assets have subsequently been reduced by £28m (2006: £34m) via a reduction in future guarantee charges leaving the working capital at £246m (2006: £220m) fully covering the RCM. Adding back the shareholders' share of future bonuses totalling £94m (2006: £95m) and deducting adjustments to eliminate double counting of other assets of £2m (2006: £19m), the excess in accordance with FRS 27 amounted to £338m (2006: £296m).

The main element of the liabilities is the asset shares of with-profits business. This represents the premiums received to date together with the investment return earned less expenses and charges. This is mainly calculated on an individual policy basis using historic information and in line with the company's PPFM. Asset shares are closely matched since they move with the value of the underlying assets.

Policyholder liabilities (including options and guarantees) are then valued using a market consistent stochastic model. Included in other liabilities are provisions for specific items such as mortgage endowment reviews and other liabilities of the fund. Realistic valuations also allow for future profits of non-profit business written in the With-Profits Fund to be included. In accordance with FRS 27, the value of future profits of non-profit business has been deducted from policyholder liabilities in the IFRS balance sheet.

Options and guarantees are features of life assurance and pensions contracts that confer potentially valuable benefits to policyholders. They are not unique to with-profits funds and can arise in non-participating funds. They can expose an insurance company to two types of risk: insurance (such as mortality/morbidity) and financial (such as market prices/interest rates). The value of an option or guarantee comprises two elements: the intrinsic value and the time value. The intrinsic value is the amount that would be payable if the option or guarantee was exercised immediately. The time value is the additional value that reflects the possibility of the intrinsic value increasing in future, before the expiry of the option or guarantee. Under FSA rules all options and guarantees must be valued and included in policyholder liabilities. For funds within the FSA's realistic capital methodology, options and guarantees are valued on a market-consistent stochastic basis that takes into account both the time value and the intrinsic value of the options and guarantees.

The majority of the Group's life and pensions options and guarantees are within FPLP's With-Profits Fund. These are valued stochastically and included in the liabilities. There are two main types of guarantees and options in the FPLP With-Profits Fund: maturity guarantees and guaranteed annuity options. Maturity guarantees are in respect of conventional with-profits business and unitised with-profits business and represent the sum assured and reversionary bonuses declared to date. The cost of these guarantees, net of charges, has been calculated at £210m (2006: £101m). For certain with-profits pension policies issued, there are options guaranteeing the rates at which annuities can be purchased. The cost of these guarantees has been calculated at £628m (2006: £747m).

The cost of the with-profits guarantees is assessed using a market-consistent stochastic model (using The Smith Model (TSM) Plus as the scenario generator) and is calculated using 6,300 simulations. The model has been calibrated using the gilt risk-free curve assuming interest rates of between 4.1% and 4.6% pa (2006: between 3.9% and 5.3% pa) and implied volatilities in the market. The capital return has been calibrated and compared to the actual asset portfolio. For equities, the capital return volatility varies by year with 26% pa (2006: 20% pa) assumed in year 7, increasing to 26% pa (2006: 23% pa) by year 14 and 27% pa (2006: 25% pa) by year 21. Volatility for property total returns varies by year with 15% pa assumed in year 7 (2006: 15% pa), increasing to 17% pa (2006: 15% pa) by year 14 and 17% pa (2006: 15% pa) by year 21.

The cost of guarantees also depends on management actions that would be taken under various scenarios. The regular bonus rate is set each year such that, by maturity, guaranteed benefits are targeted as a prescribed fraction of the total asset share, leaving the remaining portion of the asset share to be paid as final bonus. This management action is in line with the company's PPFM and is programmed into the model.

The guarantee cost in respect of guaranteed annuity options is assessed using a market-consistent stochastic model and values both the current level of the guaranteed annuity rate benefit (allowing for future improvements in annuitant mortality) and the time value due to uncertainty in future interest rates. The guarantee cost in each scenario is the value of the excess annuity benefit provided by the options, relative to an annuity purchased in the open market. In estimating the future open market annuity rate, the model allows for stochastic variation in interest rates and for future mortality improvements. The stochastic interest rate assumption reflects that implied by current market interest rate derivative prices. Future annuitant mortality has been derived from the premium basis at which annuities can be purchased from Friends Provident Pensions Limited, which allows for future mortality improvements.

The guaranteed annuity options cost also depends upon other factors such as policy discontinuance and tax-free cash take-up. The factors are based on recent experience adjusted to reflect industry benchmarks and to anticipate trends in policyholder behaviour. A summary of the key assumptions is as follows:

Policy discontinuances: lapse, early retirement and paid-up rates vary by policy type and period and have been based on recent experience.

Policy lapses for pensions are generally in the range of 1% to 4% pa (2006: 1% to 3% pa) with policy lapses for life business in the range of 3% to 10% pa (13% pa for mortgage endowment and 20% pa for with-profit bond policies) (2006: 3% to 9% pa (13% pa for mortgage endowment policies)). Paid-up rates for pensions are generally in the range of 5% to 12% pa (2006: 7% to 11% pa) with life policies generally in the region of 0.5% to 2% pa (2006: 0.5% to 2% pa). Early retirement rates vary by age band and policy type and have been reviewed and amended in 2007 based on recent experience.

Tax-free cash option: where a guaranteed annuity option is more valuable than the cash equivalent it is assumed that 18% to 27% of the benefit is taken as tax-free, depending on type of business (2006: 18% to 27%). This is based on recent experience.

There are also guarantees and options in respect of some of the other life assurance business within the Group, but these are not considered to be material to the Group's future cash flows. In addition, they have largely been matched with suitable assets and there is no material exposure to market or interest rate changes. Provisions have been established using deterministic scenarios based on prudent assumptions.