18 Financial investments

Investment risks on unit linked assets are borne by the policyholders. The remaining risks are outlined in the risk management note (see Note 50).

Financial investments include £690m (2007: £164m) of debt securities pledged as collateral against derivative liabilities. The assets used as collateral are Treasury Gilts, AAA Supranational Bonds and AAA & AA rated bonds (2007: AAA rated bonds) having a residual maturity of over 16 years (2007: over 21 years). The [Group] is entitled to receive all of the cash flows from the asset during the period when it is pledged as collateral. Further, there is no obligation to pay or transfer these cash flows to another entity. The Group can decide to substitute an asset which is designated as collateral at any time, provided the relevant terms and conditions of the International Swap Dealers Association agreement are met.

Financial investments have been allocated between those expected to be settled within 12 months and after 12 months in line with the expected settlement of the backed liabilities. Assets in excess of the insurance and investment contract liabilities have been classified as expected to be settled after 12 months.

Private equity investments are included within equity securities. £(19)m (2007: gain of £47m) has been recognised in the income statement in respect of the fair value losses on these investments.

Property investments which are held via partnerships or unit trust vehicles are also included within equity securities. £(9)m (2007: £(7)m) has been recognised in the income statement in respect of the movement in fair value of these investments.

Included within unit linked equity securities are £172m (2007: £335m) of debt instruments which incorporate an embedded derivative linked to the value of the Group’s share price.

The Group obtains pricing information from a range of pricing services and brokers. Where there are indications that there is no active market, the Group seeks further evidence of the fair value from alternative pricing sources and market information.

The Group holds collateralised debt obligations (CDO) with a market value of £1,004m classified within debt securities.

These holdings include £126m in traded CDOs and £34m exposure to an equity tranche of a bespoke [CDO]. The current market value of the equity tranche is approximately equal to the present value of future interest payable on the notes.

The balance of £844m relates to a further four CDOs that were constructed in 2007 and 2008 in accordance with terms specified by Legal & General. These CDOs mature in 2017 and 2018. The Group selects the reference portfolios underlying the CDOs to give exposure to globally diversified portfolios of investment grade corporate bonds.

The CDOs are termed as super senior since default losses on the reference portfolio have to exceed 28%, on average across the four CDOs, before the CDOs incur any default losses. Assuming an average recovery rate of 33%, then over 42% of the reference names would have to default before the CDOs incur any default losses.

Beyond 28% of default losses on the reference portfolio, losses to the CDO would occur at a rate that is a multiple of the loss rate on the reference portfolio. Losses are limited under the terms of the CDOs to assets and collateral invested. For illustration a £200m loss could be reached if default losses to the reference portfolios exceeded 32% or if 48% of the names in the diversified global investment grade portfolio defaulted, with an average 33% recovery rate. (All figures are averages across the four CDOs).

The CDOs also incorporate features under which, in certain circumstances, the Group can choose either to post additional cash or to allow wind up of the structures. These features are dependent on the portfolios’ weighted average spreads, default experience to date and time to maturity. To manage this, the Group has the right to substitute individual securities into and out of the reference portfolio. An additional £155m was posted into one of the CDOs during 2008.

These CDOs are valued using an internal valuation which is based on market inputs. This is then validated against a third party valuation model and, at the year end, validated by independent external consultants.

For the purposes of valuing the non profit annuity regulatory and [IFRS] liabilities the yield on the CDOs are included within the calculation of the yield used to calculate the valuation discount rate for the annuity liabilities. An allowance for the risks, including default, is also made.

There are no material differences between the carrying values reflected above and the fair value of these loans.