50 Risk management and control

This section describes the [Group]’s approach to risk management. It covers the overall approach that applies to all risks, and includes a detailed review of risks within the Group’s key businesses.

Risk management objectives

The Group’s primary objective in undertaking risk management activity is to manage risk exposures in line with risk appetite, minimising its exposure to unexpected financial loss and limiting the potential for deviation from anticipated outcomes. In this respect, a framework of limits and qualitative statements, aligned with the Group’s risk appetite, is in place for material exposures.

Risk management approach

A significant part of the Group’s business involves the acceptance and management of risk. The Group is exposed to insurance, market, credit, liquidity and operational risks and operates a formal risk management framework to ensure that all significant risks are identified and managed. The risk factors mentioned below should not be regarded as a complete and comprehensive statement of all potential risks and uncertainties.

Insurance risk: the risk arising from higher claims being experienced than anticipated.

Market risk: the risk arising from fluctuations in interest rates, exchange rates, share prices and other relevant market prices.

Credit risk: the risk of loss if another party fails to perform its financial obligations to the Group.

Liquidity risk: the risk that the Group, though solvent, does not have sufficient financial resources available to enable it to meet its obligations as they fall due, or can only secure them at excessive cost.

Operational risk: the risk arising from inadequate or failed internal processes, people and systems, or from external events.

Contagion risk: the occurrence of a risk in one part of the Group may result in contagion elsewhere in the Group.

An explanation of the risk framework and the methods used to monitor and assess risk exposures can be found in chapter Corporate Governance.

Management of risks
The Group seeks to manage its exposures to risk through control techniques which ensure that the residual risk exposures are within acceptable tolerances agreed by the Board. The key control techniques for the major categories of risk exposure are summarised in the following sections.

Insurance risk

Insurance risk is implicit in the Group’s insurance business and arises as a consequence of the type and volume of business written and the concentration of risk in particular policies or groups of policies subject to the same risks. A detailed review of the Group’s inherent residual risks associated with insurance products is included below. Insurance risk is managed using the following techniques:

Policies and delegated authorities for underwriting, pricing and reinsurance
The Group’s insurance risk policy sets out the overall framework for the management of insurance risk. As part of the framework, a structure of delegated pricing and underwriting authorities is in place. Pricing is based on assumptions, such as mortality and persistency, which have regard to past experience and to trends. Insurance exposures are limited through reinsurance. Overall, the Group seeks to be conservative in its acceptance of insurance risks by establishing strict underwriting criteria and limits. The underwriting policy is clearly documented, setting out risks which are unacceptable and the terms applicable for non-standard risks.

Reinsurance is used to reduce potential loss to the Group from individual large risks and catastrophic events. It may also be used to manage capital or to provide access to specialist underwriting expertise. The Group makes extensive use of reinsurance for its UK individual protection business, placing a proportion of all risks meeting prescribed criteria.

The principal General Insurance reinsurances are excess of loss catastrophe treaties, under which the cost of claims from a weather event, in excess of an agreed retention level, is recovered from insurers.

Reserving policy
All subsidiaries writing insurance business have a documented reserving policy setting out the basis on which liabilities are to be determined using statistical analysis and actuarial experience. Policies for each subsidiary are in line with locally established actuarial techniques, relevant regulation and legislation. Further details of the assumption setting process are included in Note 37.

Market risk

The Group exposure to market risk is influenced by one or more external factors, including changes in specified interest rates, financial instrument prices, foreign exchange rates and indices of prices or rates.

Significant areas where the Group is exposed to these risks are:

• assets backing insurance and investment contracts other than unit linked contracts;
• assets and liabilities denominated in foreign currencies; and
• other financial assets and liabilities

The Group’s market risk policy sets out the overall framework for the management of market risk. The policy is reinforced by more granular investment policies for long term and other business, which have due regard to the nature of liabilities and guarantees and other embedded options given to policyholders.

The Group manages market risk using the following methods:

Asset liability matching
The Group manages its assets and liabilities in accordance with relevant regulatory requirements, reflecting the differing types of liabilities it has in each business.

For business such as immediate annuities, which is sensitive to interest rate risk, analysis of the liabilities is undertaken to create a portfolio of securities, the value of which changes in line with the value of liabilities when interest rates change. This type of analysis helps protect profits from changing interest rates. Interest rate risk cannot be completely eliminated, due to the nature of the liabilities and early redemption options contained in the assets.

For businesses where a range of asset types, including equity and property, are held to meet liabilities, the Group uses stochastic models to assess the impact of a range of future return scenarios on investment values and associated liabilities. This allows the Group to devise an investment and with-profits policyholder bonus strategy which optimises returns to its policyholders over time, whilst limiting the capital requirements associated with these businesses. The Group uses this method extensively in connection with its UK with-profits business.

Derivatives
The Group uses derivatives to reduce market risk. The most widely used derivatives are exchange-traded equity futures and swaps. The Group may use futures to facilitate efficient asset allocation. In addition, derivatives are used to improve asset liability matching and to manage interest rate, foreign exchange and inflation risks. It is the Group’s policy that amounts at risk through derivative transactions are covered by cash or corresponding assets and that swaps are collateralised to reduce counterparty exposure.

Interest rate risk
Interest rate risk is the risk that the Group is exposed to lower returns or loss as a direct or indirect result of fluctuations in the value of, or income from, specific assets and liabilities arising from changes in underlying interest rates.

The Group is exposed to interest rate risk on the investment portfolio it maintains to meet the obligations and commitments under its non-linked insurance and investment contracts, in that the proceeds from the assets may not be sufficient to meet the Group’s obligations to policyholders.

To mitigate the risk that guarantees and commitments are not met, the Group purchases financial instruments, which broadly match the expected non-participating policy benefits payable, by their nature and term. The composition of the investment portfolio is governed by the nature of the insurance or savings liabilities, the expected rate of return applicable on each class of asset and the capital available to meet the price fluctuations for each asset class, relative to the liabilities they support.

Additionally, fluctuations in interest rates will vary the repayments on variable rate debt issued by the Group (Note 38).

Asset liability matching significantly reduces the Group’s exposure to interest rate risk. Sensitivity to interest rate changes is included in Table 6.

Inflation risk
Inflation risk is the potential for loss as a result of relative or absolute changes in inflation rates. The [Group] is exposed to inflation risk in two specific areas.

• Certain non-linked contracts, such as annuities, may provide for future benefits to be paid taking account of changes in the level of inflation. Contracts in payment may also include an annual adjustment for movements in prices indices, subject to an annual cap. The Group seeks to manage the risk of movements in price indices through an appropriate investment strategy including the use of inflation swaps.
• In writing long term business, the Group makes assumptions regarding the future costs of product servicing. The assumptions take account of changes in price indices and the costs of employment, with stress testing evaluating the effect of significant deviations on the Group’s capital position.

Currency risk
The Group is potentially exposed to loss as a result of fluctuations in the value of, or income from, assets denominated in foreign currencies. The Group manages its currency risk exposure in the following way:

• In respect of long term business assets and liabilities denominated in non-sterling currencies, the Group protects its exposure to exchange rate fluctuations by backing obligations with investments in the same currency.
• Balance sheet foreign exchange currency translation exposure in respect of the Group’s international subsidiaries is actively managed in accordance with a policy, agreed by the Group Board, which allows net foreign currency assets to be hedged through the use of derivatives.

As described in Note 49, the Group is not directly exposed to risks on unit linked contracts. Detailed risk disclosures have not been presented for unit linked assets and liabilities.

Table 1 – Currency risk
Table 1 summarises the Group’s exposure to foreign currency exchange risk, in sterling. The functional currency represents the currency of the primary economic environment in which each of the Group’s subsidiaries operates.

The Group’s management of currency risk reduces shareholders’ exposure to exchange rate fluctuations. The Group’s exposure to a 10% exchange movement in the Dollar and Euro on an [IFRS] basis, net of hedging activities, is detailed in Table 2.

Other price risk
Other price risk is the risk that the fair value of future cash flows of a financial instrument will fluctuate because of changes in market prices, other than those arising from interest rate risk or currency risk. These changes may be as a result of features of the individual instrument, its issuer, or factors affecting all similar financial instruments traded in the market.

The [Group] controls its exposure to geographic price risks by using internal country credit ratings. These ratings are based on macroeconomic data and key qualitative indicators. The latter take into account economic, social and political environments. Table 3 indicates the Group’s exposure to different equity markets around the world. Unit linked equity investments are excluded from the table as the risk is retained by the policyholder.

The Group holds non-unit linked property investments totalling £189m (2007: £435m), of which £182m (2007: £428m) are located in the UK.

Credit risk

The Group’s credit risk policy defines the overall framework for the management of credit risk. Significant areas where the Group is exposed to credit risk are:

• The Group holds corporate bonds to back part of its insurance liabilities. Significant exposures are managed by the application and regular review of concentration limits, with allowance being made in the actuarial valuation of the insurance liabilities for possible defaults.
• The Group limits its exposure to insurance risk by ceding part of the risks it assumes to the reinsurance market. To limit the risk of reinsurer default the Group operates a credit rating policy when arranging cover. When selecting new reinsurance partners the Group considers only companies which have a minimum credit rating equivalent to A– from Standard & Poor’s. Exposure limits for new and existing reinsurers are determined based on credit ratings and projected exposure.

Aggregate counterparty exposures are regularly monitored both at an individual subsidiary level and on a Groupwide basis.

The credit profile of the Group’s assets exposed to credit risk is shown in Table 4. The credit rating bands are provided by independent rating agencies. For unrated assets, the Group maintains internal ratings which are used to manage exposure to these counterparties. Unit linked assets have not been included as shareholders are not directly exposed to risk.

The carrying amount of non-unit linked assets included in the balance sheet represents the maximum credit exposure.

At the year end, the Group held £1,023m (2007: £245m) of collateral in respect of non-unit linked derivative assets.

Table 5 provides information regarding the carrying value of financial assets which have been impaired and the ageing analysis of financial assets which are past due but not impaired. Unit linked assets have not been included as shareholders are not exposed to the risks from unit linked policies.

Liquidity risk

A degree of liquidity risk is implicit in the [Group]’s businesses. Liquidity risk arises as a consequence of the uncertainty surrounding the value and timing of cash flows. The Group’s treasury function is responsible for managing the Group’s banking relationships, capital raising activities, overall cash and liquidity position and the payment of dividends. The Group seeks to manage funds and liquidity requirements on a pooled basis and to ensure the Group maintains sufficient liquid assets and standby facilities to meet a prudent estimate of its net cash outflows. In addition, it ensures that, even under adverse conditions, the Group has access to the funds necessary to cover surrenders, withdrawals and maturing liabilities. In practice, most of the Group’s invested assets are marketable securities. This, combined with the fact that a large proportion of the liabilities contain discretionary surrender values or surrender charges, reduces the liquidity risk. The Group has in place a £960m syndicated borrowing facility, expiring in 2012, which provides flexibility in the management of the Group’s liquidity.

Other risks

Operational risk
All business managers are required to confirm regularly the adequacy of controls over operational risks to business unit Risk and Compliance Committees (RCCs), the Group Risk and Compliance Committee (GRCC) and the Group Audit Committee. Significant control issues which business areas identify are escalated to business unit [RCCs], which oversee their resolution. There are a number of categories under which operational risk and its management across the Group can be considered, and these are outlined in the following paragraphs.

Internal process failure
The Group is potentially exposed to the risk of loss from failure of the internal processes with which it transacts its business. Each subsidiary is responsible for ensuring the adequacy of the controls over its processes and regular reviews are undertaken of their appropriateness and effectiveness.

People
The Group is potentially exposed to the risk of loss from inappropriate actions by its staff. The risk is actively managed by business management and human resource (HR) functions. Recruitment is managed centrally by [HR] functions, and all new recruits undergo a formal induction programme. All employees have job descriptions setting out their accountabilities and reporting lines, and are appraised annually in accordance with agreed performance management frameworks. Employees in regulated subsidiaries are provided with appropriate training to enable them to meet the relevant regulatory requirements. Risks relating to health and safety and other legislation are managed through the provision of relevant training to all staff.

Outsourcing
The Group is potentially exposed to the actions or failure of suppliers contracted to provide services on an outsourced basis. The required minimum standards of control for outsourced arrangements are set out in the Group’s outsourcing and key supplier policy.

Legal
Legal risk is the risk of loss from unclear or deficient product documentation; inadequate documentation in support of material contracts such as reassurance treaties; the incorrect interpretation of changes in legislation; employment related disputes and claims; and commercial disputes with suppliers. The risks are actively managed through the Group Legal Risk framework, which defines minimum standards of control to be applied to minimise the risk of loss.

Compliance
Compliance risk within the Group relates to the risk of non-adherence to legislative requirements, regulations and internal policies and procedures. Responsibility for ensuring adherence to relevant legal and regulatory requirements is vested in individual business managers. A Group compliance function has oversight of the Group’s compliance with regulatory requirements and standards, providing policy advice and guidance and oversight of compliance arrangements and responsibilities.

Event
Event risk relates to the potential for loss arising from significant external events such as terrorism, financial crisis, major changes in fiscal systems or disaster. Typically, such events have a low likelihood of occurrence, a material impact and can be difficult to prevent. The Group’s risk mitigation focuses on minimising the business disruption and potential financial loss which may ensue from such an event. This includes maintaining a framework for the management of major incidents, the maintenance and regular testing of detailed business, technical and location recovery plans and the provision of insurance cover for the loss of buildings, contents and information technology systems and for the increased cost of working in the event of business disruption.

Fraud
The Group is potentially exposed to the risk of internal fraud, claims-related fraud, and external action by third parties. The risk of internal fraud is managed through a number of processes including the screening of staff at recruitment, segregation of duties and management oversight. The activities of Internal Audit also act to counter the risk. Claims-related fraud is managed by ensuring business processes are designed to fully validate claims and ensure that only bona fide claims are settled. Anti-fraud techniques are regularly updated to mitigate risks and emerging threats. The Group’s approach to mitigating fraud and other dishonest acts is supported by promoting an open and honest culture in all dealings between employees, managers and those parties with which the Group has contact. A formal code of ethics sets out the Group’s expectations in this respect. Effective and honest communication is essential if malpractice is to be effectively dealt with. The Group has defined whistle blowing procedures to enable all employees and those who work with Legal & General to raise matters of concern relating to Legal & General in confidence. Personnel independent of the business reporting line act as designated whistle blowing contacts and include the heads of Internal Audit and Group Compliance. The Group also operates a “speak up” hotline facility to report concerns, either in confidence or anonymously.

Technology
The Group places a high degree of reliance on [IT] in its business activities. The failure of IT systems could potentially expose the Group to significant business disruption and loss. To mitigate this risk, standards and methodologies for developing, testing and operating IT systems are maintained. There is a centralised management for development activity and production systems to ensure consistency and adherence to standards. Disaster recovery facilities enable [IT] operations to be conducted at remote locations in the event of the loss of computer facilities at a principal office site. All records are remotely backed up and computer suites are equipped with alternative power sources.

Contagion risk
The potential for contagion risk arises as a consequence of:

• the use of a common brand across the majority of the Group;
• the provision of intra-group loans and indemnities.

The Group has defined policies and procedures for managing matters that may have reputational implications, to ensure that Legal & General’s position is correctly understood. The Group also has defined policies for the provision of guarantees, indemnities and letters of comfort, with the position being subject to review by the [GRCC].

Concentration of risk
As part of the ongoing risk assessment processes the Group considers the concentration of risk. The Group seeks to manage concentrations by setting limits around the maximum exposure to loss that it can tolerate from a series of related events. Limits set include maximum exposures to single lives, geographic locations, financial instruments and reinsurance balances.

Long term insurance risks

UK long term insurance products are structured as either participating or non-participating. The level of shareholders’ interest in the value of policies and their share of the related profit or loss varies depending upon the contract structure.

Non-participating contracts
Non-participating business is written mainly in the non profit part of the [Society] [LTF]. Profits accrue solely to shareholders. In addition, there is some non-participating business in the with-profits part of the Society LTF where the profits are shared, between participating policyholders and shareholders.

Protection business (individual and group)
The Group offers protection products which provide mortality or morbidity benefits. They may include health, disability, critical illness and accident benefits; these additional benefits are commonly provided as supplements to main life policies but can also be sold separately. The benefit amounts would usually be specified in the policy terms. Some sickness benefits cover the policyholder’s mortgage repayments and are linked to the prevailing mortgage interest rates. In addition to these benefits, some contracts may guarantee premium rates, provide guaranteed insurability benefits and offer policyholders conversion options.

Life savings business
A range of contracts are offered in a variety of different forms to meet customers’ long term savings objectives. Policyholders may choose to include a number of protection benefits within their savings contracts. Typically, any guarantees under the contract would only apply on maturity or earlier death. On certain older contracts there may be provisions guaranteeing surrender benefits. Savings contracts may or may not guarantee policyholders an investment return. Where the return is guaranteed, the Group may be exposed to interest rate risk with respect to the backing assets.

Pensions (individual and corporate)
These are long term savings contracts through which policyholders accumulate pension benefits. Some older contracts contain a basic guaranteed benefit expressed as an amount of pension payable or a guaranteed annuity option, which exposes the Group to interest rate and longevity risk. These guarantees become more costly during periods when interest rates are low or when annuitant mortality improves faster than expected. The ultimate cost will also depend on the take-up rate of any option and the final form of annuity selected by the policyholder.

Other options provided by these contracts include an open market option on maturity, early retirement and late retirement. The Group would generally have discretion over the terms on which these options are offered.

Annuities
Deferred and immediate annuity contracts are offered. Immediate annuities provide a regular income stream to the policyholder, purchased with a lump sum investment, where the income stream starts immediately after the purchase. The income stream from a deferred annuity is delayed until a specified future date. Bulk annuities are also offered, where the Group accepts the assets and liabilities of a company pension scheme or a life fund.

Non-participating deferred annuities written by the Group do not contain guaranteed cash options.

Annuity products provide guaranteed income for a specified time, usually the life of the policyholder, in exchange for a lump sum capital payment. No surrender value is available under any of these products. The primary risks to the Group from annuity products are therefore mortality improvements and investment performance.

There is a block of immediate and deferred annuities within the UK non profit business with benefits linked to changes in the [RPI], but with contractual maximum or minimum increases. In particular, most of these annuities have a provision that the annuity will not reduce if RPI falls. The total of such annuities in payment at 31 December 2008 was £226m (2007: £162m). Thus, 1% negative inflation, which was reversed in the following year would result in a guarantee cost of approximately £2m (2007: £2m). Negative inflation sustained over a longer period would give rise to significantly greater guarantee costs. Some of these guarantee costs have been partially matched through the purchase of negative inflation hedges and limited price indexation bonds.

Key risk factors
(a) Insurance risk
(i) Mortality risk
For contracts providing death benefits, higher mortality rates would lead to an increase in claims costs. For annuity contracts, the Group is exposed to the risk that mortality experience is lower than assumed; lower than expected mortality would require payments to be made for longer and increase the cost of benefits provided. The Group regularly reviews its mortality experience and industry projections of longevity and adjusts the valuation and pricing assumptions accordingly.

The Group is exposed to mortality risk on protection and annuity business. For protection products, the Group has entered into reinsurance arrangements to mitigate this risk and provide financing. Annuity contracts are not reinsured externally.

(ii) Persistency
In the early years of a policy, lapses and surrenders are likely to result in a loss to the Group, as the acquisition costs associated with the contract would not have been recovered from product margins. Some contracts include surrender deductions to mitigate this risk.

In later periods, once the acquisition costs have been recouped, the effect of lapses and surrenders depends upon the relationship between the exit benefit, if any, and the liability for that contract. Exit benefits are not generally guaranteed and the Group has some discretion in determining the amount of the payment. As a result, the effect on profit at later duration is expected to be broadly neutral.

Following the adoption of PS06/14 in 2006 the persistency assumption for non-participating protection business allows for the expected pattern of persistency, adjusted to incorporate a margin for adverse deviation.

There is no persistency risk exposure for annuities in payment.

These contracts do not provide a lapse or surrender option.

(iii) Morbidity rates
The cost of health related claims depends on both the incidence of policyholders becoming ill and the duration over which they remain ill. Higher than expected incidence or duration would increase costs over the level currently assumed in the calculation of liabilities.

(iv) Expense variances
Higher expenses and/or expense inflation will tend to increase the amount of the reserves required. The Group is exposed to the risk that its liabilities are not sufficient to cover future expenses.

(v) Geographic concentrations of risk
Insurance risk may be concentrated in geographic regions, altering the risk profile of the Group. The most significant exposure of this type arises for the group protection business, where a single event could result in a large number of related claims. To reduce the overall exposure, current contracts include an ‘event limit’ which caps the total liability. Additionally, excess of loss reinsurance arrangements further mitigate the exposure.

(vi) Epidemics
The spread of an epidemic could cause large aggregate claims across the Group’s portfolio. Quota share reinsurance contracts are used to manage this risk. The management of associated counterparty risks from the use of reinsurance is set out above.

(vii) Accumulation of risks
There is limited potential for single incidents to give rise to a large number of claims across the different contract types written by the Group. In particular, there is little significant overlap between the long term and short term insurance business written by the Group. However, there are potentially material correlations of insurance risk with other types of risk exposure. These correlations are difficult to estimate though they would tend to be more acute as the underlying risk scenarios became more extreme. An example of the accumulation of risk is the correlation between reinsurer credit risk with mortality and morbidity exposures.

(b) Market risk
Investment of the assets backing the Group liabilities reflects the nature of the liabilities being supported. For non-participating business, the strategy is to invest in fixed income securities of appropriate maturity dates. The risk of default on fixed interest securities is managed through diversified portfolios with exposure limited to individual economies, sectors and counterparties.

Interest rate risk is reduced by managing the duration and maturity structure of each investment portfolio in relation to the estimated cash flows of the liabilities it supports. A number of derivatives are held to enable the closer matching of assets and liabilities and to mitigate further exposure to interest rate movements, in particular, to limit the exposure to any options and guarantees in contracts.

In addition, the exposure to these risks is allowed for in the actuarial valuation of liabilities under these contracts.

Participating contracts
Participating contracts are supported by the with-profits part of the Society LTF. They offer policyholders the possibility of the payment of benefits in addition to those guaranteed by the contract. The amount and timing of the additional benefits (usually called bonuses) are contractually at the discretion of the Group.

Discretionary increases to benefits on participating contracts are allowed in one or both of regular and final bonus form. These bonuses are determined in accordance with the principles outlined in the Group’s [PPFM] for the management of the with-profits part of the [Society] [LTF]. The principles include:

• The with-profits part of the Society LTF will be managed with the objective of ensuring that its assets are sufficient to meet its liabilities without the need for additional capital.
• With-profits policies have no expectation of any distribution from the with-profits part of the Society LTF’s inherited estate. The inherited estate is the excess of assets held within the Society LTF over and above the amount required to meet liabilities, including those which arise from the regulatory duty to treat customers fairly in settling discretionary benefits.
• Bonus rates will be smoothed so that some of the short term fluctuations in the value of the investments of the with-profits part of the Society LTF and the business results achieved in the with-profits part of the UK LTF are not immediately reflected in payments under with-profits policies.

At 30 June 2005 an assessment was made of the expected cost of guarantees and options to be paid in the future, and funds with the same value to meet these costs were associated from the capital in the with-profits sub-fund. The value of the funds is regularly assessed and is reduced by the cost of guarantees and options paid since 1 July 2005. At each assessment point, if the value of the funds is lower than the expected cost of guarantees and options, it is intended to make deductions from asset shares to cover the difference. It is intended to limit deductions to no more than 0.75% each year, up to a maximum of 5% per policy.

Following the movement in the expected cost and the value of the associated funds up to 31 December 2008, and in accordance with the Group’s PPFM, a deduction of 0.75% has been made from the asset shares. In the technical provisions, allowance has also been made for future deductions in respect of the expected costs of meeting future guarantees and options not covered by the current year deduction. For policyholders who decide to surrender a charge will generally be made in respect of the expected cost of guarantees and options not covered by the charge already taken.

Some older participating contracts include a guaranteed minimum rate of roll up of the policyholders’ fund up to the date of retirement or maturity.

The nature of the participating contracts written in the with-profits part of the Society LTF is that more emphasis can be placed on investing to maximise future investment returns. This results in a broader range of investments being held within the fund.

With-profits bonds
These contracts provide an investment return to the policyholder which is determined by the attribution of regular and final bonuses over the duration of the contract. In addition, the contracts provide a death benefit, typically of 101% of the value of the units allocated to the policyholder.

Pension contracts
The Group has sold pension contracts containing guaranteed annuity options which expose the Group to both interest rate and longevity risk. The market consistent value of these guarantees carried in the balance sheet is £48m (2007: £59m).

Deferred annuity contracts
The Group has written some deferred annuity contracts which guaranteed minimum pensions. These options expose the Group to interest rate risk as the cost would be expected to increase with interest rates. The market consistent value of these guarantees carried in the balance sheet is £133m (2007: £111m).

Key risk factors
The insurance and market risk exposures for participating business are largely the same as those discussed for non-participating contracts. The main differences in the operation of these contracts are discussed below.

(a) Insurance risk – Persistency
At early durations, the nature of the persistency risks on with-profits business is largely the same as for non-participating business and is influenced mainly by the ability to recover acquisition costs from product margins. At later durations, there is less scope for withdrawal to result in a loss for the Group as these contracts typically provide explicit allowances for market conditions. Allowance for future withdrawals is made in the assessment of participating contract liabilities. The Group is generally exposed to the risk that future withdrawals are lower than assumed, resulting in higher future guarantee costs.

(b) Market risk
The financial risk exposure for participating contracts is different from that for non-participating business. Greater emphasis is placed on investing to maximise future investment returns rather than matching assets to liabilities. This results in holding significant equity and property investments. Lower investment returns increase the costs associated with maturity and investment guarantees provided on these contracts.

These risks are managed by maintaining capital sufficient to cover the consequences of mismatch under a number of adverse scenarios. In addition, different investment strategies are followed for assets backing policyholder asset shares and assets backing other participating liabilities and surplus. The former include significant equity and property holdings, whilst the latter are invested largely in fixed interest securities. The assets held are managed so as to provide a partial hedge to movements in fixed interest yields and equity markets.

The methodology used to calculate the liabilities for participating contracts makes allowance for the possibility of adverse changes in investment markets on a basis consistent with the market cost of hedging the guarantees provided. The methodology also makes allowance for the cost of future discretionary benefits, guarantees and options.

The value of future discretionary benefits depends on the return achieved on assets backing these contracts. The asset mix varies with investment conditions reflecting the Group’s investment policy, which aims to optimise returns to policyholders over time whilst limiting capital requirements for this business.

The distribution of surplus to shareholders depends upon the bonuses declared for the period. Typically, bonus rates are set having regard to investment returns, although the Group has some discretion setting rates and would normally smooth bonuses over time. The volatility of investment returns could have both a favourable and unfavourable impact on the fund’s capital position and its ability to pay bonuses. If future investment conditions were less favourable than anticipated, the lower bonus levels resulting would also reduce future distributions to shareholders.

However, business which is written in the with-profits part of the Society LTF is managed to be self-supporting. The unallocated divisible surplus in the fund would normally be expected to absorb the impact of these investment risks. Only in extreme scenarios, where shareholders were required to provide capital support to the with-profits part of the Society LTF, would these risks affect equity.

As part of the 2007 Society LTF restructure, the 1996 Sub-fund (£321m) was merged into the Shareholder Retained Capital (SRC). As a result, Society’s Board of Directors undertook to initially maintain £500m of assets within Society to support the with-profits business. The amount of the commitment will reduce to £450m in 2009 and then gradually reduce to zero over a period not exceeding nine years.

The Group’s approach to setting bonus rates is designed to treat customers fairly. The approach is set out in the Society’s PPFM for the with-profits part of the Society LTF. In addition, bonus declarations are also affected by [FSA] regulations relating to Treating Customers Fairly (TCF), which limit the discretion available when setting bonus rates. The Group’s approach to setting bonuses and meeting the FSA’s [TCF] regulations may increase the Group’s exposure to market risk should the ability to cut bonuses, during periods when investment returns are poor, be reduced.

Unit linked contracts
The Group’s primary exposure to financial risk from these contracts is the risk of volatility in asset management fees due to the impact of interest rate and market price movements on the fair value of the assets held in the linked funds, on which investment management fees are based. The [Group] is also exposed to the risk of an expense overrun should the market depress the level of charges which could be imposed, although for some contracts the Group has discretion over the level of management charges levied.

International life and pensions

Legal & General America (LGA)
The principal products written by [LGA] are individual term assurance, universal life insurance and smaller blocks of deferred and immediate annuities.

The individual term assurances provide death benefits over the medium to long term. The contracts have level premiums for an initial period with premiums increasing annually thereafter. During the initial period, there is generally an option to convert the contract to a universal life contract. After the initial period, the premium rates are not guaranteed, but cannot exceed the age related guaranteed premium.

Reinsurance is used to reduce the insurance risk on this portfolio and manage liquidity risks, through the reinsurance commission received under quota share arrangements. Reinsurance and securitisation are used to provide regulatory solvency relief (including relief from regulation Triple X). These practices lead to the establishment of reinsurance assets on the Group’s balance sheet.

The universal life insurance and deferred annuities provide a savings component. In addition, the universal life contract provides substantial death benefits over the medium to long term. The savings element has a guaranteed minimum growth rate. LGA has exposure to loss in the event that interest rates decrease and it is unable to earn enough on the underlying assets to cover the guaranteed rate. LGA is also exposed to loss should interest rates increase, as the underlying market value of assets will generally fall without a change in the surrender value. The reserves for universal life and deferred annuities totalled $753m and $230m respectively at 31 December 2008 (2007: $758m and $248m respectively). The guaranteed interest rates associated with those reserves ranged from 0.0% to 6.0%, with the majority of the policies having a 4.0% guaranteed rate (the same rates applied in 2007).

The deferred annuity contracts also contain a provision that, at maturity, a policyholder may move the account value into an immediate annuity, at rates which are either those currently in effect, or rates guaranteed in the contract. The other annuity contracts have similar risks to those in the UK.

Legal & General Netherlands (LGN)
[LGN] principally writes non-participating individual unit-linked savings, protection and annuity business. The unit-linked savings business generally includes an element of exposure to mortality risk. The individual term assurances provide death benefits over the medium to long term. Reinsurance is used to reduce the share of insurance risk.

The annuity contracts have similar risks to those in the UK; however, the majority of annuity business has a term of three years or less.

Legal & General France (LGF)
[LGF] writes a range of long term insurance and investment business through its subsidiaries. The principal products written are life assurance and pensions savings, group protection, annuities and open ended investment vehicles.

The group protection business consists of group term assurance, renewable on an annual basis, sickness and disability, and medical expenses assurance. The group sickness and disability and medical expenses policies integrate with social security benefits providing a level of top-up to those benefits. Reinsurance is used to manage exposure to large individual and group claims.

The annuity contracts have similar risks to those in the UK.

Table 6 below shows the effect of alternative assumptions on the long term embedded value, prepared in accordance with the guidance issued by the [CFO] Forum in October 2005. These sensitivities correspond to those contained within the Supplementary Financial Statements of the Annual Report & Accounts.

Opposite sensitivities are broadly symmetrical.

The Group also uses embedded value (EV) financial information in addition to IFRS to manage and monitor performance, and to manage interdependences between different aspects of financial risks, for example for market risk. This provides information about the value which is being created on the Group’s long term insurance contracts.

[EV] information is calculated for the Group’s life and pensions business (covered business). All other businesses are accounted for on the IFRS basis adopted in the primary financial statements.

The EV methodology requires assets of an insurance company, as reported in the primary financial statements, to be attributed between those supporting the covered business and the remainder. The method accounts for assets in the covered business on an EV basis and the remainder of the Group’s assets on the [IFRS] basis adopted in the primary financial statements. Sensitivities have been presented for covered business only. In this context the non-covered business is considered not to be material. Whilst [EV] sensitivities do not directly reflect the short term movements under IFRS, they more closely reflect the long term economic out turn.

Cash flow projections are determined using realistic assumptions for each component of cash flow and for each policy group. Future economic and investment return assumptions are based on conditions at the end of the financial year. Future investment returns are projected by one of two methods. The first method is based on an assumed investment return attributed to assets at their market value. The second, which is used in the US, where the investments of that subsidiary are substantially all fixed interest, projects the cash flows from the current portfolio of assets and assumes an investment return on reinvestment of surplus cash flows. The assumed discount and inflation rates are consistent with the investment return assumptions. The main assumptions are provided in the Supplementary Financial Statements.

UK general insurance

• Household contracts. These provide cover in respect of policyholders’ homes, investment properties, contents, personal belongings and incidental liabilities which they may incur as a property owner, occupier and individual. Exposure is normally limited to the rebuilding cost of the home, the replacement cost of belongings and a policy limit in respect of liability claims. [LGI] uses reinsurance to manage the exposure to an accumulation of claims arising from any one incident, usually severe weather. The catastrophe cover reinsures LGI for losses between £30m and £270m (2007: £30m and £230m) for a single weather event.
• Accident, sickness and unemployment (ASU). These contracts provide cover in respect of continuing payment liabilities incurred by customers when they are unable to work as a result of accident, sickness or unemployment. They protect predominantly mortgage payments. Exposure is limited to the monthly payment level selected by the customer sufficient to cover the payment and associated costs, up to the duration limit specified in the policy, usually 12 months.
• Motor insurance. These contracts provide cover in respect of customers’ private cars and their liability to third parties in respect of damage to property and injury. Exposure is normally limited to the replacement value of the vehicle, and a policy limit in respect of third party property damage. Exposure to third party bodily injury is unlimited in accordance with statutory requirements. The motor book continues in run-off, the final policy having expired in August 2007, but this is expected to take several years.
• Healthcare. These contracts are primarily private medical insurance, which compensate customers for the costs of eligible medical consultations, diagnostic tests, in-patient, day care and outpatient treatment up to the limits specified in the policy. They are mainly exposed to the underlying incidence of morbidity, medical claims inflation and advances in medical treatments. The healthcare business is in run-off with the final policies having expired in July 2008. By the year end, the level of residual claims was minimal and claims payments are expected to cease during 2009.
• Domestic mortgage indemnity (DMI). These contracts (primarily in run-off) protect a mortgage lender should an insured property be repossessed and subsequently sold at a loss. Since 1993, the contract has included a maximum period of cover of 10 years, and a cap on the maximum claim. For business accepted prior to 1993, cover is unlimited and lasts until the insured property is remortgaged or redeemed.

Key risk factors

Weather events
Significant weather events such as windstorms, and coastal and river floods can lead to significant claims.

The insurance of properties which are concentrated in high risk areas, or an above average market share in a particular region, can give rise to a concentration of insurance risk. This risk is managed by ensuring that the risk acceptance policy, terms and premiums both reflect the expected claim cost associated with the location and avoid adverse selection. Additionally, exposure and competitor activity is monitored by location to ensure that there is a geographic spread of business. Catastrophe reinsurance cover reduces the Group’s exposure to concentrations of risk. The catastrophe reinsurance is designed to protect against a modelled windstorm and coastal flood event with a return probability of 1 in 200 years.

Subsidence
The incidence of subsidence can have a significant impact on the level of claims on household policies. The Group’s underwriting and reinsurance strategy mitigates the exposure to concentrations of risk arising from geographic location or adverse selection.

ASU
Periods of rapid and prolonged national economic downturn can create significant variation in the frequency and severity of claims experience.

This risk is managed through the monitoring of economic trends and the underwriting of policies only when attached to the customer completing a mortgage loan transaction, having achieved credit scoring approval.

Unlimited motor claims
A single motor policy can result in major multiple liability claims in extreme scenarios. To mitigate this risk, accident excess of loss reinsurance is in place for claims in excess of £1m (2007: £1m).

Sensitivity analysis
Table 7 shows material sensitivities for the General insurance business on pre-tax profit and equity, net of reinsurance.

For any single event with claims in excess of £30m but less than £270m, the ultimate cost to the Group would be £30m. The impact of a 1 in 500 year modelled windstorm and coastal flood event would exceed the catastrophe cover by approximately £120m.