48 Management of capital resources

Capital structure

The [Group]’s total capital resources of £6.1bn (2007: £8.6bn) on an [IFRS] basis comprise equity holders’ capital, £3.6bn (2007: £5.5bn), subordinated debt, £1.6bn (2007: £1.4bn), and unallocated divisible surplus, £0.9bn (2007: £1.7bn).

From a regulatory perspective the Group is required to measure and monitor its capital resources on an ongoing basis and to comply with the minimum capital requirements of regulators in each territory in which we operate. At 31 December 2008, Legal & General’s Insurance Group Directive (IGD) capital resources were £1.8bn in excess of capital requirements of £2.6bn, representing a solvency coverage ratio of 169%. This surplus capital is after the payment of the 2008 final dividend of £120m.

The Group writes a range of long term insurance and investment business in the long term fund (LTF) of its main operating insurance subsidiary, Legal & General Assurance Society Limited (Society). This fund is segregated from the Group’s other assets. The fund includes participating (with-profits) business where policyholders and shareholders share in the risks and rewards, and non-participating (non profit) business, where the shareholders receive profits or incur losses. Capital in excess of the amount required to cover the liabilities is currently held within Society. This capital provides support for new and existing non profit business within our UK life and pensions business.

The non-linked non profit pensions and annuity business of Society is ceded, on arm’s length terms, to a wholly owned Insurance Special Purpose Vehicle (ISPV), Legal & General Pensions Limited (LGPL). Whilst an [ISPV] is not required to segregate policyholder assets within an [LTF], [LGPL] continues to manage policyholder and shareholder assets separately for internal purposes.

Managed pension fund business is written through Legal & General Assurance (Pensions Management) Limited (PMC), which is a life company writing predominantly non-participating group pension business effected by trustees of occupational schemes in the UK (or their equivalent overseas). The assets are held in a LTF and are separate from other assets within the Group.

In addition, the Group operates two UK long term insurance businesses acquired during the year (Nationwide Life Limited and Suffolk Life Annuities Limited). General insurance business is written in the UK by Legal & General Insurance Limited, and long term insurance business is written by subsidiaries in America, the Netherlands and France.

Capital management policies and objectives

The Group aims to manage its capital resources to maintain financial strength, policyholder security and relative external ratings advantage. The Group also seeks to maximise its financial flexibility by maintaining strong liquidity and by utilising a range of alternative sources of capital including equity, senior debt, subordinated debt and reinsurance.

Capital measures

The Group measures its capital on a number of different bases, including those which comply with the regulatory frameworks within which the Group operates and those which the directors consider most appropriate for managing the business. The measures used by the Group include:

• Accounting bases
  Management use the primary financial statements prepared on an IFRS basis to manage capital and cash flow usage and to determine dividend paying capacity. In addition, the supplementary accounts prepared using [EEV] principles provide a meaningful reflection of the Group’s long term operations and the value of the business to shareholders. Accordingly the Group’s net asset value and total capital employed are also analysed and measured on this basis.
• Regulatory bases
  The financial strength of the Group’s insurance subsidiaries is measured under various local regulatory requirements (see below). One of these regulatory measures, Individual Capital Assessment (ICA), measures capital using risk based stochastic techniques, and provides a measure of the level of economic capital required to run the Group’s business.

Basis of regulatory capital and corresponding regulatory capital requirements

In each country in which the Group operates, the local insurance regulator specifies rules and guidance for the minimum amount and type of capital which must be held by long term insurance subsidiaries in excess of their insurance liabilities. The minimum required capital must be maintained at all times throughout the year. This helps to ensure that payments to policyholders can be made as they fall due.

The required capital is calculated by either assessing the additional assets which would be required to meet the insurance company’s liabilities in specified, stressed financial conditions, or by applying fixed percentages to the insurance company’s liabilities and risk exposures. The requirements in the different jurisdictions in which the Group operates are detailed below:

UK regulatory basis
Required capital for the life business is based on the rules of the [FSA]. [Society] must hold assets in excess of the higher of two amounts, the first being calculated using the FSA rules (pillar 1), the second being an economic capital assessment by the Company which is reviewed by the FSA (pillar 2), otherwise known as Individual Capital Assessment (ICA).

The public pillar 1 capital calculation is calculated by applying fixed percentages to liabilities and sums assured at risk (Peak 1). There are further stress tests for participating business, as measured in the Realistic Balance Sheet (Peak 2), which may increase the required capital under Peak 1 calculations.

The private pillar 2 capital calculation is an assessment of the economic capital required to ensure that the Company can meet its liabilities, with a high likelihood, as they fall due. This is achieved by stochastic modelling and scenario testing. The result is reviewed and may be modified by the [FSA].

Regulatory capital for the general insurance business is also calculated using FSA pillar 1 and pillar 2 requirements. The pillar 1 calculation applies fixed percentages to premiums and claims. Pillar 2 creates a higher capital requirement and is therefore applied in this business.

US regulatory basis
Required capital is determined to be the Regulatory Action Level Risk Based Capital (RBC) based on the National Association of Insurance Commissioners’ [RBC] model. RBC is a method of measuring the minimum amount of capital appropriate for an insurance company to support its overall business operations, taking into account its size and risk profile. The calculation is based on applying factors to various asset, premium, claim, expense and reserve items, with higher factors used for those items with greater underlying risk and lower factors for less risky items.

French and Dutch regulatory bases
The minimum required capital is defined by the French Ministry of Finance’s ‘Code des Assurances’ and the ‘De Nederlandsche Bank N.V.’ (Dutch Supervisory Body) respectively. The basis of the calculation is a percentage of the liabilities plus a percentage of the sum assured at risk and, for some contracts, the premium. The percentages depend on the guarantees given and the amount of reinsurance cover.

Group regulatory basis
In addition to the regulatory capital calculations for the individual firms, the [Group] is required to comply with the requirements of the Insurance Group’s Directive (IGD).

Available regulatory capital resources

Capital resources available to meet regulatory UK capital requirements are determined using FSA valuation rules. The asset valuation rules are based on UK [GAAP], adjusted for admissibility and counterparty exposure limits and specific valuation differences.

The Group’s regulatory capital position statement in Table 1 sets out the different sources of capital held within the Group. The Group’s total available capital resources, based on unaudited¹ FSA returns, are £4.0bn (2007: £6.5bn) of which £2.6bn (2007: £3.9bn) is held by the life businesses. The use of capital held by the UK and overseas life businesses is generally constrained by local regulatory requirements, and may not be available to provide funding for other businesses.

The total available capital resources of the Group’s with-profits business (with-profits estate) is determined in accordance with the realistic balance sheet rules prescribed by the FSA.

At 31 December 2008, the realistic value of the UK participating liabilities was £14.7bn (2007: £18.5bn) under the FSA realistic capital regime. The excess of realistic assets over realistic liabilities was £0.6bn (2007: £1.0bn). The capital resources reflect the surplus in that part of the fund which is in excess of any constructive obligation to policyholders. The liabilities within the consolidated balance sheet do not include the amount representing the shareholders’ share of future bonuses. However, for capital reporting, the shareholders’ share is deducted from capital resources in the capital position statement.

1. The FSA returns are audited and filed subsequent to the publication of the Group’s capital position.

Available regulatory capital resource risks

The [Group]’s available capital resources are sensitive to changes in market conditions, both to changes in the value of the assets and to the impact which changes in investment conditions may have on the value of the liabilities. Capital resources are also sensitive to assumptions and experience relating to mortality and morbidity and, to a lesser extent, expenses and persistency. The most significant sensitivities arise from the following four risks:

• market risk in relation to UK participating business which crystallise if adverse changes in the value of the assets supporting this business could not be fully reflected in payments to policyholders because of the effect of guarantees and options. The capital position of this business would also deteriorate if increases to the market cost of derivatives resulted in an increase in the liability for guarantees and options in the realistic balance sheet.
• market risk in relation to the UK annuity business, which crystallise if the return from the fixed interest investments supporting this business were lower than that assumed for reserving.
• mortality risk in relation to the UK annuity business, which crystallise if the mortality of annuitants improved more rapidly than the assumptions used for reserving.
• mortality risk in relation to the UK and US term assurance businesses, which crystallise if mortality of the lives insured was higher than that assumed, possibly because of an epidemic.

A range of management actions is available to mitigate any adverse impact from changing market conditions and experience, including changes to with-profits bonus rates, changes to discretionary surrender terms and charging for guarantees. To the extent that management actions are expected only to offset partially adverse experience, then liabilities would be increased to anticipate the future impact of the adverse experience and total capital resources would be reduced.

Movements in life business regulatory capital resources

The movement in the life business regulatory capital resources is shown in Table 2.