Legislation and regulation

Changes in regulation or legislation may have a detrimental effect on our strategy or profitability

Legislation and government fiscal policy can influence our product design, the retention of existing business and our required reserves for future liabilities. Regulation defines the overall framework for the design, marketing and distribution of our products; and the prudential capital that we hold. The nature of long term business can result in certain regulatory changes having a retrospective effect.

[Solvency II], which is scheduled for full implementation in 2013, will lead to a fundamental change in the way that insurance companies are required to calculate their prudential capital. While the high level regulation is defined, detailed capital requirements and implementation rules have not been finalised.

There remain a number of areas of considerable uncertainty in proposed Solvency II regulation. Solvency II will also coincide with a change in the determination of taxable profits for UK insurance companies, creating a potential for volatility in the amount of tax payable. For certain business segments, such as annuities, Solvency II proposals may require firms to hold a disproportionate amount of capital relative to the risk exposure. While transitional arrangements are expected to apply, the scope and duration of these remain undecided.

The Group is actively participating with Government and regulatory bodies in the UK and Europe to ensure capital requirements accurately reflect the risks implicit in insurance products. Further details are set out in the Industry and markets section. We are also engaged with HM Treasury working groups in the development of the tax regime. We are actively looking at innovative capital management solutions to mitigate unintended effects of Solvency II.

The International Accounting Standards Board’s (IASB’s) project on accounting for insurance contracts, which seeks to improve and ensure consistency in accounting, is targeted for completion in mid 2011, with possible implementation between 2013 and 2015.

Whilst we support the need for clear and consistent financial reporting, the proposals of the latest exposure draft would result in a significant change in the timing of profit recognition, inconsistencies with capital measurement under Solvency II and increased complexity for users of accounts.

We are working with the IASB, the European CFO forum and the ABI to ensure that the IASB proposals are appropriate to the insurance sector and meet the needs of investors.

The Retail Distribution Review (RDR), the rules for which come into force in 2012, will change the regulations for the provision of sales advice for retail investment products and the relationship between advisers and manufacturers of these products.

RDR will require significant changes to our products and distribution processes, particularly for our savings business. Poor execution of change would impact our earnings and profitability. Other factors that could hinder successful transition include consumers failing to understand the change and the exiting of financial advisers from the market.

As set out in the Savings: Focus on risk management section we have undertaken significant activity during the year to implement the requirements of the RDR, covering both the commercial and regulatory changes to our business. We are also committed to helping our customers and business partners transition to the new framework.

The FSA has recently published proposals to amend existing rules on the operation of with-profits funds, with further proposals to be published later in 2011.

Effective governance of With Profits business and the fair treatment of policyholders is sound business practice. However, the differing interpretation and application of regulation over time, may have a detrimental effect on our strategy and profitability.

As a continuing provider of With Profit based products, we will actively engage with the FSA to assist in the evaluation of proposed rule changes on the operators of with profit funds that remain open to new business, and their stakeholders.

Financial market and economic conditions

Investment market performance or conditions in the broader economy may adversely impact our earnings and profitability

The performance and liquidity of investment markets, interest rate movements and inflation can impact the value of investment assets we hold to meet the obligations arising from insurance business as well as the value of the obligations themselves, resulting in mismatches in the profile of cash flows of our assets and liabilities. Significant falls in investment values can also impact the fee income of our investment management business. Broader economic conditions can impact the timing of the purchase and retention of retail financial services products.

2010 saw further recovery of major investment markets, which has continued into 2011. However, the outlook for the broader economy remains uncertain with potential for a rise in inflation and increases in interest rates.

A prolonged period of economic uncertainty or a return to recession may result in increased levels of consumer saving benefiting our retail savings business. However, other product segments such as protection may experience reduced demand, impacting our new business volumes and our earnings.

We model our business plans across a broad range of economic scenarios and take account of alternative projected economic conditions within our overall business strategy. As part of our medium term plan we have sought to ensure focus upon those market segments that will be resilient in projected conditions. Details of our business strategy are set out in the Strategic overview section.

As well as presenting macro-economic risks, the ongoing potential for a eurozone-based sovereign debt crisis presents the risk of falls in investment asset values and significant disruption and illiquidity in global financial markets.

Disruption from a major Sovereign debt event may impact our ability to execute hedging strategies that ensure the profile of cash flows of our assets and liabilities are appropriately matched. Falls in investment values may impact the value of and income from our Shareholder cash flows.

Over the last 18 months we have reviewed our risk management and hedging strategies to ensure that they remain effective across a broad range of financial conditions. We have also refined our Shareholders’ fund investment strategy. Sensitivities to interest rate mismatches, exposures to worldwide equity markets and currencies, changes in credit spreads are set out in Note 48.

Counterparty & third party risks

In dealing with issuers of debt and other types of counterparty the Group is exposed to the risk of default

As part of our strategies to match long term assets and liabilities, exposures arise to the issuers of corporate debt and other financial instruments. We also have exposures to banking, money market and reinsurance counterparties, and the providers of settlement, custody and IT services.

A default event within the banking sector, or a sovereign debt event, could result in dislocation of bond markets, significantly widening credit spreads, and in extreme conditions contagion may result in default by strongly rated issuers of debt.

Market reaction to a significant default event could result in the short term diminution in the market value of corporate bond assets held in respect of our annuities business and in extreme circumstances may require an increase in default provisions for potential or actual defaults. A failure by a key service provider may result in short term operational disruption of our business processes.

We actively manage our exposure to default risk, setting robust counterparty selection criteria and exposure limits. During 2010, limits were regularly reviewed from the perspective of sovereign and other events. Asset classes backing our annuities business have also been broadened. Details of our default provisions are set out in the Credit default reserve section. Exposures to credit risk are set out in Note 48. Our service providers are subject to rigorous selection criteria, with contingency plans developed should services not be available.

UK financial services sector contagion risks

As a UK based Group, our earnings are influenced by the perception of the UK financial services sector as a whole

Investment market performance, actions by regulators against organisations operating in the financial services sector and shock events can impact the confidence of retail investors in the sector as a whole. Such events may also result in changes to the regulatory and legislative environment in which we operate.

Reaction to events in the banking sector has resulted in the development of new regulatory supervision frameworks in Europe and the UK, for both the banking and insurance industries.

We support a robust regulatory regime for the financial services sector. However, there is a risk that differences between insurance and banking business models are not reflected in the new regimes, and conflicting approaches between national and European bodies, resulting in additional capital requirements or increased costs of regulation.

We seek to engage with regulators and legislators at a UK and European level to assist in the evaluation of change and influence the development of outcomes that meet the needs of all stakeholders. In July 2010, our Chief Executive was appointed Chairman of the ABI, which provides a focal point for representation of the UK insurance industry.

The financial crisis, subsequent investment performance and low interest rate environment, together with ongoing regulatory debates, may impact consumer perception and attitudes to long term savings.

As a significant participant in the long term savings markets, we are inherently exposed to downturns in new business volumes and persistency levels as a consequence of changes in consumer sentiment.

We manage our brand and reputation and seek to differentiate our business model from that of our competitors, focusing on our customers’ needs through a diversified portfolio of risk, savings and investment management businesses. In addition, as set out
in the International section we continue to focus on developing our international businesses.

Mortality catastrophe and other assumption uncertainties

Reserves for long term business may require revision as a result of changes in experience, regulation or legislation

The writing of long term insurance business necessarily requires the setting of assumptions for long term trends in factors such as mortality, persistency, valuation interest rates, expenses and credit defaults. Extreme events may require recalibration of these assumptions. Forced changes in reserves can also be required as a result of changes in regulation or legislation.

In writing annuity business, pricing requires assumptions to be made for factors such as improvements in the general health of the population and advances in medical science. For protection business assumptions are made for the expected level of mortality, taking account of factors such as pandemics, for example as a result of avian or swine flu.

We undertake significant analysis of longevity and mortality risks to ensure an appropriate premium is charged for the risks we take on and that our reserves remain appropriate. However, extreme events, such as a rapid advance in medical science leading to significantly enhanced annuitant longevity or an event causing widespread mortality/morbidity, coupled with a reinsurer default may require assumptions to be recalibrated impacting profitability and capital.

We are focused on developing a comprehensive understanding of annuitant mortality, including the development of ‘cause of death’ models using UK population data and engaging directly with the medical profession and scientific community. For our protection and general insurance businesses we continue to evolve and develop our underwriting capabilities. The sensitivities of our UK Long Term Business to annuitant mortality and reinsurer default are set out in Note 48.

There is an increasing trend for legislative intervention to price products irrespective of differing risk factors arising from age or gender. Most recently, the European Court of Justice (ECJ) have ruled that insurance product pricing must be gender neutral from 21 December 2012 .

Our product pricing assumptions for annuities, protection and other insurance business reflect the risks we assess as being exposed to. A requirement to price products irrespective of differing risk factors will have the potential to increase the costs of insurance products to certain consumers; any retrospection of legislation will impact required reserves of our insurance businesses.

We are evaluating the full implications of the ruling by the ECJ for our customers and the required changes to our business. However, we continue to highlight to legislators the benefits to consumers of being able to price insurance products on the risks implicit in that business, and participate in discussions with the UK legislator on the implementation approach of the ECJ ruling in the UK.

Industry change

The Group may not maximise opportunities from structural and other changes within the financial services sector

The financial services sector continues to go through a period of change. This presents a range of challenges as well as opportunities to providers of sufficient scale such as Legal & General.

Following the general election in 2010, the UK Government, has initiated changes to the default retirement age and annuity compulsion at 75. Consultation on early access to pension savings and simplified financial products has also been published. Such changes may effect the way consumers approach long term saving and retirement planning.

Significant changes in the markets in which we operate may require the review and realignment of elements of our business strategy. A failure to be sufficiently responsive to potential change and understand the implication to our businesses, or the incorrect execution of change may impact the achievement of our strategic objectives.

We seek to ensure we have market leading expertise in the core fields in which we operate, and actively focus on retaining the best personnel with the knowledge to design and support our products, and manage their evolution as market and consumer requirements change. We believe we have a strong record on responding to change.