19 Financial investments.

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	Notes	Shareholder 2009 £m	Non profit non-unit linked 2009 £m	With-profits 2009 £m	Unit linked 2009 £m	Total 2009 £m
Financial investments at fair value designated as:
Fair value through profit or loss		2,938	21,628	16,546	227,845	268,957
Available-for-sale		1,862	–	–	5	1,867
Held for trading		257	1,269	63	2,160	3,749
Financial investments at fair value	(i)	5,057	22,897	16,609	230,010	274,573
Loans and receivables	(ii)	130	1	296	1,016	1,443
Total financial investments		5,187	22,898	16,905	231,026	276,016
Expected to be settled within 12 months						47,187
Expected to be settled after 12 months						228,829
	Notes	Shareholder 2008 £m	Non profit non-unit linked 2008 £m	With-profits 2008 £m	Unit linked 2008 £m	Total 2008 £m
Financial investments at fair value designated as:
Fair value through profit or loss		3,305	17,995	15,593	187,718	224,611
Available-for-sale		1,896	–	–	5	1,901
Held for trading		304	1,994	40	3,764	6,102
Financial investments at fair value	(i)	5,505	19,989	15,633	191,487	232,614
Loans and receivables	(ii)	98	–	282	1,520	1,900
Total financial investments		5,603	19,989	15,915	193,007	234,514
Expected to be settled within 12 months						40,742
Expected to be settled after 12 months						193,772

Investment risks on unit linked assets are borne by the policyholders. The remaining risks are outlined in the risk management note (see Note 48).

Financial investments include £714m (2008: £690m) of debt securities pledged as collateral against derivative liabilities. The assets used as collateral are Treasury Gilts, Foreign Government Bonds, AAA Supranational Bonds, and AAA, AA and BBB rated bonds (2008: Treasury Gilts, AAA Supranational Bonds, and AAA and AA rated bonds) having a residual maturity of over 18 years (2008: over 16 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.

(i) Financial investments at fair value

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	Notes	Shareholder 2009 £m	Non profit non-unit linked 2009 £m	With-profits 2009 £m	Unit linked 2009 £m	Total 2009 £m
Equity securities		856	–	4,461	140,308	145,625
Debt securities		3,897	21,264	11,838	86,512	123,511
Accrued interest		47	364	247	1,030	1,688
Derivative assets	20	257	1,269	63	2,160	3,749
Total investments at fair value		5,057	22,897	16,609	230,010	274,573
	Notes	Shareholder 2008 £m	Non profit non-unit linked 2008 £m	With-profits 2008 £m	Unit linked 2008 £m	Total 2008 £m
Equity securities		1,317	69	4,121	107,357	112,864
Debt securities		3,827	17,591	11,195	79,400	112,013
Accrued interest		56	335	251	965	1,607
Derivative assets	20	305	1,994	66	3,765	6,130
Total investments at fair value		5,505	19,989	15,633	191,487	232,614

Private equity investments are included within equity securities. A gain of £10m (2008: loss of £19m) has been recognised in the income statement in respect of the movement in fair value of these investments.

Property investments which are held via partnerships or unit trust vehicles are also included within equity securities. A loss of £3m (2008: loss of £9m) 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 (2008: £172m) of debt instruments which incorporate an embedded derivative linked to the value of the Group’s share price.

CDOs

The Group holds collateralised debt obligations (CDOs) with a market value of £1,212m at 2009 (2008: £1,004m).

These holdings include £108m (2008: £126m) in traded CDOs and £41m (2008: £34m) exposure to an equity tranche of a bespoke [CDO].

The balance of £1,063m (2008: £844m) relates to a further four CDOs that were constructed in 2007 and 2008 in accordance with terms specified by Legal & General as part of a strategic review of the assets backing the annuity portfolio. These CDOs mature in 2017 and 2018. The Group selected at outset and manages the reference portfolios underlying the CDOs to give exposure to globally diversified portfolios of investment grade corporate bonds. The Group is able to substitute the constituents of the original reference portfolios with new reference assets, allowing the management of the underlying credit risk although substitutions in 2009 were limited. A breakdown of the underlying CDO reference portfolio by sector is provided below:

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Sector	2009 %	2008 %
Technology & Telecoms	9	9
Oil & Gas	6	6
Utilities	10	10
Insurance	6	6
Industrials	20	20
Health Care	3	3
Financial Services	6	6
Banks	14	13
Consumer Services & Goods	26	27
	100	100

The CDOs are termed as super senior since default losses on the reference portfolio have to exceed 27%, on average across the four CDOs, before the CDOs incur any default losses. Assuming an average recovery rate of 30%, then over 39% of the reference names would have to default before the CDOs incur any default losses.

Beyond 27% 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. For illustration a £200m loss could be incurred if default losses to the reference portfolios exceeded 30% or if 43% of the names in the diversified global investment grade portfolio defaulted, with an average 30% recovery rate. (All figures are averages across the four CDOs.)

Despite the difficult financial conditions in early 2009, the underlying reference portfolio has had no reference entity defaults in 2009.

Losses are limited under the terms of the CDOs to assets and collateral invested.

These CDOs also incorporate features under which, in certain circumstances, the Group can choose either to post additional cash collateral 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. No additional collateral was posted to any of the CDOs in 2009 (2008: £155m).

These CDOs are valued using an internal valuation which is based on observable market inputs. This is then validated against the counterparty valuation 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 is 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. For [EEV] purposes, the yield on the CDOs, reduced by the realistic default assumption, is similarly included in assumed future investment returns.

(ii) Loans and receivables

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	Shareholder 2009 £m	Non profit non-unit linked 2009 £m	With-profits 2009 £m	Unit linked 2009 £m	Total 2009 £m
Deposits with credit institutions	50	1	295	1,016	1,362
Policy loans	75	–	–	–	75
Other loans	5	–	1	–	6
Total loans and receivables	130	1	296	1,016	1,443
	Shareholder 2008 £m	Non profit non-unit linked 2008 £m	With-profits 2008 £m	Unit linked 2008 £m	Total 2008 £m
Deposits with credit institutions	11	–	107	1,520	1,638
Policy loans	62	–	23	–	85
Other loans	25	–	152	–	177
Total loans and receivables	98	–	282	1,520	1,900

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

(iii) Fair value hierarchy

Fair value is the amount for which an asset could be exchanged or a liability settled between knowledgeable willing parties in an arm’s length transaction.

Fair value measurements are based on observable and unobservable inputs. Observable inputs reflect market data obtained from independent sources, while unobservable inputs reflects the Group’s view of market assumptions in the absence of observable market information. The Group utilises techniques that maximise the use of observable inputs and minimise the use of unobservable inputs.

The levels of fair value measurement bases are defined as follows:

Level 1: fair values measured using quoted prices (unadjusted) in active markets for identical assets or liabilities.

Level 2: fair values measured using valuation techniques for all inputs significant to the measurement other than quoted prices included within Level 1 that are observable for the asset or liability, either directly (i.e. as prices) or indirectly (i.e. derived from prices).

Level 3: fair values measured using valuation techniques for any input for the asset or liability significant to the measurement that is not based on observable market data (unobservable inputs).

The following table presents the Group’s assets by IFRS 7 hierarchy levels:

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	Total £m	Level 1 £m	Level 2 £m	Level 3 £m	Amortised cost £m
Shareholder
Equity securities	856	654	99	103	–
Debt securities	3,897	950	2,932	15	–
Accrued interest	47	18	29	–	–
Derivative assets	257	2	255	–	–
Loans and receivables	130	–	–	–	130
Non profit non-unit linked
Debt securities	21,264	945	20,319	–	–
Accrued interest	364	10	354	–	–
Derivative assets	1,269	46	1,223	–	–
Loans and receivables	1	–	–	–	1
With-profits
Equity securities	4,461	3,966	2	493	–
Debt securities	11,838	3,930	7,908	–	–
Accrued interest	247	61	186	–	–
Derivative assets	63	5	58	–	–
Loans and receivables	296	–	–	–	296
Unit linked
Equity securities	140,308	140,027	84	197	–
Debt securities	86,512	51,885	34,625	2	–
Accrued interest	1,030	355	675	–	–
Derivative assets	2,160	364	1,796	–	–
Loans and receivables	1,016	–	–	–	1,016
Total financial investments	276,016	203,218	70,545	810	1,443

In current market conditions, the liquidity of financial instruments is less than it has been in the past. All of the Group’s level 2 assets have been valued using standard market pricing sources, such as iBoxx, IDC and Bloomberg except for bespoke [CDO] and swaps holdings (see below). In normal market conditions, we would consider these market prices to be observable market prices. However, following consultation with our pricing providers and a number of their contributing brokers, we have considered that these prices are not from a suitably active market and have prudently classified them as level 2.

Our holdings in bespoke CDOs and swaps are priced using industry standard internal models which utilise market assumptions. The CDO valuations have also been verified using externally provided prices. Accordingly, these assets have also been classified as level 2.

Level 3 assets, where internal models are used, represent a small proportion of assets to which shareholders are exposed and reflect unquoted equities including investments in private equity, property vehicles and suspended securities.

In many situations, inputs used to measure the fair value of an asset or liability may fall into different levels of the fair value hierarchy. In these situations, the Group determines the level in which the fair value falls based upon the lowest level input that is significant to the determination of the fair value. As a result, both observable and unobservable inputs may be used in the determination of fair values that the Group has classified as level 3.

The Group determines the fair values of certain financial assets and liabilities based on quoted market prices, where available. The Group also determines fair value based on estimated future cash flows discounted at the appropriate current market rate. As appropriate, fair values reflect adjustments for counterparty credit quality, the Group’s credit standing, liquidity and risk margins on unobservable inputs.

Where quoted market prices are not available, fair value estimates are made at a point in time, based on relevant market data, as well as the best information about the individual financial instrument. Illiquid market conditions have resulted in inactive markets for certain of the Group’s financial instruments. As a result, there is generally no or limited observable market data for these assets and liabilities. Fair value estimates for financial instruments deemed to be in an illiquid market are based on judgements regarding current economic conditions, liquidity discounts, currency, credit and interest rate risks, loss experience and other factors. These fair values are estimates and involve considerable uncertainty and variability as a result of the inputs selected and may differ significantly from the values that would have been used had a ready market existed, and the differences could be material. As a result, such calculated fair value estimates may not be realisable in an immediate sale or settlement of the instrument. In addition, changes in the underlying assumptions used in the fair value measurement technique could significantly affect these fair value estimates.

Fair values are subject to a control framework designed to ensure that input variables and outputs are assessed independent of the risk taker. These inputs and outputs are reviewed and approved by a valuation committee.

(a) Significant transfers between level 1 and level 2:

There have been no significant transfers between level 1 and level 2.

(b) Assets measured at fair value based on level 3

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	Equity securities £m	Debt securities £m	Total £m
As at 1 January 2009	743	20	763
Total gains or losses for the period recognised:
– in profit and loss	(106)	1	(105)
– in other comprehensive income	–	1	1
Purchases	269	1	270
Sales	(113)	(6)	(119)
As at 31 December 2009	793	17	810

There have been no significant transfers to or from level 3 during 2009.

(c) Effect on changes in significant unobservable inputs (level 3) to reasonably possible alternative assumptions

As discussed above, the fair value of financial instruments are, in certain circumstances measured using valuation techniques that incorporate assumptions that are not evidenced by prices from observable current market transactions in the same instrument and are not based on unobservable market data. The following table shows the level 3 financial instruments carried at fair value as at the balance sheet date, the valuation basis, main assumptions used in the valuation of these instruments and reasonably possible increases or decreases in fair value based on reasonably possible alternative assumptions.

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			Reasonably possible alternative assumptions
Financial instruments	Main assumptions	Current fair value 2009 £m	Increase in fair value 2009 £m	Decrease in fair value 2009 £m
1. Private equity investments are valued in accordance with the International Private Equity and Venture Capital Valuation Guidelines. Reasonably possible alternative valuations have been determined using alternative price earnings multiples. 2. Unquoted investments in property vehicles are valued by independent valuers on the basis of open market value as defined in the appraisal and valuation manual of the Royal Institute of Chartered Surveyors. Reasonably possible alternative valuations have been determined using alternative yield and occupancy assumption.
Assets
Shareholder
Private equity investment vehicles1	Price earnings multiple	9	1	(1)
Unquoted investments in property vehicles2	Property yield; occupancy	94	10	(10)
Asset backed securities	Cash flows; expected defaults	15	9	(9)
With-profits
Private equity investment vehicles1	Price earnings multiple	98	7	(7)
Unquoted investments in property vehicles2	Property yield; occupancy	395	40	(40)
Unit linked
Unquoted investments in property vehicles2	Property yield; occupancy	193	15	(15)
Suspended securities	Estimated recoverable amount	6	–	–
Total		810	82	(82)