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In 2008, Legal & General experienced a year of severe shock events with adverse impacts across all asset classes: equity, credit and property. As a result of these impacts, Legal & General’s key capital metrics were lower at the end of 2008. The following sections explain our capital position and summarise the de-risking activities we have taken since the year end.
Insurance company capital management in the UK is subject to extensive prudential regulation by the [FSA]. The [IGD] capital calculation and Legal & General Assurance Society Limited’s (Society) regulatory surplus capital (Pillar 1 capital) are the principal, publicly available financial strength measures used by our regulator, the FSA.
IGD Capital Strength
At the end of 2008, Legal & General’s IGD surplus capital was £1.8bn after paying the final dividend (2007: £4.1bn). The decrease over the year of £2.3bn reflects the adverse investment market conditions noted earlier, approximately £0.9bn of the reduction is attributable to investment market losses on our shareholder assets. The impact of the Group’s share buyback in 2008 reduced the surplus by £0.5bn, the acquisition of the Nationwide companies and Suffolk Life reduced the surplus by £0.3bn and a further £0.2bn represents coverage of Society’s solvency requirement from assets outside of the long term fund. Despite the fall in surplus capital, the stock of capital remains robust and sufficient to meet the Group’s requirements.
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Fig 2. Regulatory Surplus Capital | ||||||
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As at 31 December 2008 |
[IGD]1 |
Society1,2 | ||||
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Available capital resources |
4.4 |
4.0 | ||||
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Capital resources requirement |
2.6 |
2.4 | ||||
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Surplus capital |
1.8 |
1.6 | ||||
Society Surplus Capital
On a Pillar 1 basis, [Society’s] regulatory surplus capital was £1.6bn (2007: £4.4bn) representing capital resources of £4.0bn (2007: £8.4bn) less the capital resources requirement of £2.4bn (2007: £4.0bn). The reduction in capital resources was primarily caused by adverse investment markets throughout 2008. The largest impact was incurred in the With-profits part of the long term fund, where most asset classes were affected, although the capital resources outside of the long term fund, primarily invested in equities, were also significantly impacted. In addition to investment markets, the short term allowance for defaults on our corporate bond portfolio as described under significant events above, has reduced the surplus.
The capital resources requirement of £2.4bn (2007: £4.0bn) comprises the long term insurance capital requirement which is unchanged at £1.9bn, capital requirements of regulated undertakings which have increased to £0.3bn due to the acquisition of Nationwide Life and foreign exchange movements in the overseas subsidiaries of Society, and the With-profits Insurance Capital Component (WPICC) of £0.2bn (2007: £2.0bn).
Surplus Pillar 2 Capital
In addition to the Pillar 1 basis of reporting, the Group and its relevant subsidiaries are required by the FSA to calculate solvency requirements using stochastic techniques under the Individual Capital Assessment (ICA) rules. On review of these calculations, the [FSA] may apply additional amounts as Individual Capital Guidance (ICG). Together the ICA and ICG represent the Group’s Pillar 2 Capital. In addition to these FSA requirements, the Group also calculates its own economic capital requirements using similar modelling tools. Economic capital requirements are also reflected in the models which rating agencies use to measure the risk exposure and capital requirements in assessing the financial strength of life insurance companies. The Group’s capital is robust on both the Pillar 1 and Pillar 2 bases.
In preparation for the anticipated introduction in 2012 of the EU’s Solvency II Directive, which is constructed around effective capital management, Legal & General has made significant progress in refining its capital metrics, and further developing and advancing its Enterprise Risk Management systems.
Balance Sheet Quality and De-risking
As well as reviewing the amount of surplus capital, the Group also regularly reviews asset quality within its balance sheet. This was of particular importance during 2008.
Legal & General shareholders have exposure to funds invested in a well-diversified mix of assets including equities, fixed-income instruments and commercial property. Investment decisions are taken within a rigorous governance framework (Governance and Risk Management are discussed at Management of Risk and Note 50 to the Accounts, respectively). During 2008, investment strategy was adjusted to reflect the severe deterioration of market conditions. We manage our With-profits business with the objective of operating within its own capital resources in further stress scenarios. There is a wide range of management actions available to us which gives us confidence that this objective remains achievable.
Asset Quality
Shareholders have exposure to just 10% of the Group’s total assets under management, or £28bn. The portfolio of investments remains of high quality.
Equity Investments
Shareholders’ exposure to UK and overseas equities was £1.4bn at 31 December 2008, and is largely limited to assets held within the shareholders’ funds of Legal & General Assurance.
Bond Investments
The credit quality of our portfolio of bonds is good. Less than 1% of rated bonds are below investment grade. In 2008 we saw a modest increase in defaults on our UK non profit annuity portfolio, to an aggregate level of 0.3% – in line with our long term reserving assumption. This demonstrated significantly better experience than either UK or global corporate indices.
We have increased the diversification of our annuity portfolio in the last two years. Key to this was the separation of our decision making for liability cashflow matching and return generating strategies. This gives us flexibility to access a wider pool of globally diversified securities while ensuring cashflow matching through the use of derivatives. We have no material exposure to currency or overseas interest rate risks.
As a result of our decision to further diversify the portfolio, overall exposure to banks reduced to 22% at the end of 2008. We are now significantly underweight in banks in comparison to both global and local market index weightings.
Asset Backed Securities (ABS)
Within our bond portfolio, ABS investments at the end of 2008 stood at market value of £3.4bn. This figure excludes £1.0bn of [CDOs] that were previously categorised within ABS. Our portfolio of ABS securities remains defensive, investing in a range of high quality assets including £0.8bn of infrastructure bonds and whole-business securitisations. We have exposure to just £30m of sub-prime Residential Mortgage Backed Securities (RMBS).
Collaterised Debt Obligations (CDO)
We have separately identified our CDO investments, which have previously been classified within ABS. Of the total £1,004m of CDO investments, £844m relate to internally managed CDOs which are super-senior tranches of bespoke structures constructed and managed by Legal & General to provide enhanced yield with significant protection against default. The bespoke CDOs were previously classified under an internal rating basis. We believe it is appropriate to identify these internally managed assets separately, and they are now reported within the not rated category. The underlying credit exposures within our CDOs are investment grade. We estimate that, given normal levels of recoveries, it would take on average more than 40% of the underlying portfolio to default over a ten year period for any loss to accrue.
Credit Ratings
During 2008 and early 2009, Standard & Poor’s and Moody’s, the credit rating agencies, reviewed credit ratings across the sector due to the continuing deterioration in economic and market conditions.
Legal & General’s credit ratings as at 24 March 2009 are:
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Rating type |
Standard & Poor’s |
Moody’s | ||||||
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Financial Strength Rating* |
AA1 |
Aa12 | ||||||
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Long Term |
A+ |
A1 | ||||||
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Short Term |
A-1 |
P1 | ||||||
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Subordinated |
A- |
A2 | ||||||
Society remains one of the highest rated European life insurance funds with a Financial Strength Rating of AA from Standard & Poor’s.
Allocation of Capital
In common with other regulated insurance companies, Legal & General’s capital resources are held within key subsidiaries to meet the requirements of regulators in each business area and territory in which we operate.
Share Buyback
During the year, Legal & General substantially completed its £1bn share buyback announced in July 2007. As at the year end over 691 million shares had been repurchased and cancelled at a total cost including commission and stamp duty of £843m.