Review of the Year

Financial Review

Financial strength

Economic capital

We continue to use economic capital to inform business decisions. We have developed a sophisticated capital model, which has helped with setting our financial risk appetite and our continued drive for capital efficiency. The model forms the basis for discussions with the FSA to agree the individual capital requirements for each company based on an assessment of its own risk profile. During the year the model helped to inform decisions to reinsure longevity risk and lower exposure to equities in shareholder funds and the pension scheme. It also informed the determination of the cash buffer needed to sustain the business strategy.

EEV required capital is set at the higher of regulatory capital and requirements arising from internal capital management policies, which include economic risk capital objectives. In aggregate, EEV required capital is higher than regulatory requirements by approximately £200m (2006: £200m).

Life & Pensions capital

The total available capital resources, calculated on a realistic basis for the FPLP With-Profits Fund and on a regulatory basis for all other funds, amount to £2.3bn (2006: £2.5bn). The regulatory capital requirement is £0.7bn (2006: £0.7bn). Therefore the excess capital resources over the capital requirement amount to £1.6bn (2006: £1.8bn). The bulk of the Group's capital is held outside the With-Profits Funds and, consequently, can be deployed around the Group with a relatively high degree of flexibility.

Group solvency

The Insurance Groups Directive requires a very prudent measure of excess capital resources as it excludes any surplus capital held within a long-term fund. On this measure, the provisional surplus Group capital resources were approximately £1.3bn at 31 December 2007 (2006: £1.0bn). The increase mainly arises from the share capital issued as a result of the conversion of £290m convertible bond.

FPLP realistic solvency

The assets and liabilities of the FPLP With-Profits Fund are calculated on a realistic basis. Policyholder liabilities (including options and guarantees) are valued using a market consistent stochastic model. At 31 December 2007, surplus assets amounted to £246m and the Risk Capital Margin (RCM) was £246m. At 31 December 2006, surplus assets amounted to £220m and the RCM amounted to £220m. Our objective continues to be to manage the fund so that, over time, the RCM remains covered from assets within the Fund. The FPLP With-Profits Fund Realistic Balance Sheet is reasonably resilient in the event of falls or rises in investment markets. This is due in large measure to the actions taken to hedge the provisions made to cover the cost of guarantees and options.

FPLP regulatory solvency

In addition to a realistic basis, the solvency for FPLP's With-Profits Fund is assessed on a regulatory basis. The two calculations are then compared and the more onerous requirement is applied. For 2007 and 2006 the more onerous requirement for FPLP has been the realistic basis.

The Free Asset Ratio is a common measure of financial strength. It is the ratio of assets less liabilities (including actuarial reserves but before the capital requirements), expressed as a percentage of actuarial reserves. For FPLP it has been relatively stable, estimated as 22.3% at the end of 2007 (2006: 22.2%) and available assets to meet capital requirements are £3.7bn (2006: £3.9bn).

Ratings

FPLP's financial strength rating and Friends Provident plc's credit rating from Standard & Poor's and Moody's were put on negative watch in November 2007 after we announced our intention to carry out a strategic review of the business. The FPLP financial strength ratings were downgraded one notch in January 2008 following the announcement of our new strategy. Standard & Poor's rating is now A (strong) with negative outlook. Fitch's rating is A (strong) with negative outlook. Moody's rating is A2 (strong) with negative outlook. Our objective is to maintain FPLP's financial strength rating within the broad 'A' range.

The Friends Provident plc's credit ratings were also downgraded one notch in January 2008. Standard & Poor's rating is now BBB+ (good) with negative outlook. Fitch's rating is now BBB+ (good) with negative outlook. Moody's rating is now Baa2 (good) with negative outlook.

All ratings are on negative outlook, reflecting their view of the risks involved in the implementation of the changes to our strategy.

Revolving credit facility

We have an unused revolving credit facility of £500m which expires in April 2011.

Financial risk

We actively manage financial risk and have taken a number of initiatives to reduce our exposures:

In April 2007, FPP entered into a reinsurance treaty with Swiss Re transferring all the mortality and investment risk of FPP's in-force pension annuity book, with effect from 1 January 2007. The value of the statutory liabilities reinsured was £1.7bn. This transaction is consistent with our attitude to longevity risk and has modestly aided the financial results. FPP has retained the management of the policyholder relationship and policyholders will therefore not see any change as a result of this arrangement. The treaty does not apply to annuities coming into force from 1 January 2007.

The overall aim for the FPLP With-Profits Fund remains to balance risk to shareholders with maximising returns to policyholders whilst ensuring guarantees are met as they fall due. Particular activities include:

• Managing the proportion of equities and property backing the asset shares. At 2007 year-end this proportion was 52% (2006: 54%): 44% in equity and 8% in property.
• Active management of bonuses and any market value reduction factors.
• Hedging strategies to mitigate equity market and interest rate risks.

Risk mitigation activities for other Life & Pensions funds include cash flow matching and other inflation and interest rate hedging.

The equity exposure of the FPLP shareholder fund was reduced from 55% to almost 0% in 2007 as equities were sold or completely hedged with sold futures. This has decreased the loss the Group would incur in the event of an equity shock and releases capital to be deployed elsewhere.

The Friends Provident Pension Scheme (FPPS) reduced its equity exposure from 65% to 40% over 2007, also decreasing its sensitivity to a subsequent equity shock.

The following asset backed and monoline wrapped securities (ABS) are managed by F&C on behalf of the Group (in particular this excludes investments in ABS held by third party managed funds in the UK and International businesses).