22 FINANCIAL INVESTMENTS.


The Group holds financial investments to back insurance contracts on behalf of policyholders and as Group capital.

The Group classifies its financial investments on initial recognition as held for trading (HFT), designated at fair value through profit or loss (FVTPL), available-for-sale (AFS) or loans and receivables. Initial recognition of financial investments is on the trade date.

The Group’s policy is to measure investments at FVTPL except for certain overseas assets where the related liability is valued on a passive basis (not using current information), in which case investments are classified as AFS. All derivatives other than those designated as hedges are classified as HFT.

Certain financial investments held by the Group are designated as FVTPL as their performance is evaluated on a total return basis, consistent with asset performance reporting to the Group Investment and Market Risk Committee and the Group’s investment strategy. Assets designated as FVTPL include debt securities and equity instruments which would otherwise have been classified as AFS under IAS 39, ‘Financial instruments: recognition and measurement’. Assets backing participating and non-participating policyholder liabilities outside the US are designated as FVTPL. For participating contracts the assets are managed on a fair value basis to maximise the total return to policyholders over the contract life. The Group’s non-participating investment contract liabilities outside of the US are measured on the basis of current information and are designated as FVTPL to avoid an accounting mismatch in the income statement.

The fair values of quoted financial investments are based on bid prices. If the market for a financial investment is not active, the Group establishes fair value by using valuation techniques such as recent arm’s length transactions, consensus market pricing, reference to similar listed investments, discounted cash flow models or option pricing models.

Private equity investments are valued in accordance with the International Private Equity and Venture Capital Valuation Guidelines, which represent current best practice, developed by the Association Français des Investisseurs en Capital, the British Venture Capital Association and the European Private Equity and Venture Capital Association. The techniques used for determining fair value include earnings multiples, the price of a recent investment or a net asset basis.

Financial investments classified as HFT and FVTPL are measured at fair value with gains and losses reflected in the income statement. Transaction costs are expensed as incurred.

Financial investments classified as AFS are measured at fair value with unrealised gains and losses recognised in a separate reserve within equity. Realised gains and losses, impairment losses, dividends, interest and foreign exchange movements on non-equity instruments are reflected in the income statement. Directly attributable transaction costs are included in the initial measurement of the investment.

Loans and receivables are initially measured at fair value plus acquisition costs, and subsequently measured at amortised cost using the effective interest method.

Future developments

[IFRS] 9, ‘Financial Instruments’ issued in November 2009 (effective for annual periods commencing on or after 1 January 2015) is the first part of a new standard on classification and measurement of financial assets that will replace IAS 39. IFRS 9 has two measurement categories: amortised cost and fair value. All equity instruments are measured at fair value. A debt instrument is at amortised cost only if the entity is holding it to collect contractual cash flows and the cash flows represent principal and interest, otherwise it must be measured at fair value through profit or loss. Further amendments to IFRS 9, dealing with financial liabilities, were published in October 2010. These include amortised cost accounting for most financial liabilities, with bifurcation of embedded derivatives. The main change in the amendment is that in cases where the fair value option is taken for financial liabilities, the part of a fair value change due to an entity’s own credit risk is recorded in other comprehensive income rather than the income statement, unless this creates an accounting mismatch. The Group does not intend to early adopt this standard.

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Notes

Shareholder
2011
£m

Non profit non-unit linked
2011
£m

With-profits
2011
£m

Unit linked
2011
£m

Total
2011
£m

Financial investments at fair value designated as:

 

 

 

 

 

 

Fair value through profit or loss

 

4,692

26,406

16,406

243,920

291,424

Available-for-sale

 

2,068

5

2,073

Held for trading

 

308

3,107

167

3,174

6,756

Financial investments at fair value

(i)

7,068

29,513

16,573

247,099

300,253

Loans and receivables

(ii)

85

1

265

351

Total financial investments

 

7,153

29,513

16,574

247,364

300,604

Expected to be received within 12 months

 

 

 

 

 

33,770

Expected to be received after 12 months

 

 

 

 

 

266,834

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Notes

Shareholder
2010
£m

Non profit non-unit linked
2010
£m

With-profits
2010
£m

Unit linked
2010
£m

Total
2010
£m

Financial investments at fair value designated as:

 

 

 

 

 

 

Fair value through profit or loss

 

4,191

23,679

17,106

248,144

293,120

Available-for-sale

 

2,021

5

2,026

Held for trading

 

288

1,425

84

2,217

4,014

Financial investments at fair value

(i)

6,500

25,104

17,190

250,366

299,160

Loans and receivables

(ii)

93

88

229

410

Total financial investments

 

6,593

25,104

17,278

250,595

299,570

Expected to be received within 12 months

 

 

 

 

 

44,307

Expected to be received after 12 months

 

 

 

 

 

255,263

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 £616m (2010: £435m) 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 Corporate Bonds (2010: Treasury Gilts, Foreign Government Bonds, AAA Supranational Bonds and AAA Corporate Bonds) having a residual maturity of over 44 years (2010: over 45 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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Note

Shareholder
2011
£m

Non profit non-unit linked
2011
£m

With-profits
2011
£m

Unit linked
2011
£m

Total
2011
£m

Equity securities

 

913

4,264

136,904

142,081

Debt securities

 

5,771

26,018

11,924

105,998

149,711

Accrued interest

 

76

388

218

1,023

1,705

Derivative assets

23

308

3,107

167

3,174

6,756

Total investments at fair value

 

7,068

29,513

16,573

247,099

300,253

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Note

Shareholder
2010
£m

Non profit non-unit linked
2010
£m

With-profits
2010
£m

Unit linked
2010
£m

Total
2010
£m

Equity securities

 

976

4,995

150,635

156,606

Debt securities

 

5,167

23,323

11,887

96,481

136,858

Accrued interest

 

69

356

224

1,033

1,682

Derivative assets

23

288

1,425

84

2,217

4,014

Total investments at fair value

 

6,500

25,104

17,190

250,366

299,160

Non-consolidated private equity investments are included within equity securities. A loss of £2m (2010: gain of £14m) 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 £nil (2010: loss of £nil) 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 £182m (2010: £183m) 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 (CDO) with a market value of £998m at 31 December 2011 (2010: £1,022m).

These holdings include £846m (2010: £875m) relating to 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 no substitutions were made in 2010 and substitutions in 2011 were limited. A breakdown of the underlying CDO reference portfolio by sector is provided below:

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Sector

At 31.12.11
%

At 31.12.10
%

Banks

14

14

Utilities

10

10

Consumer Services & Goods

25

26

Financial Services

6

6

Technology & Telecoms

9

9

Insurance

6

6

Industrials

20

20

Oil & Gas

6

6

Health Care

4

3

 

100

100

The CDOs are termed as super senior since default losses on the reference portfolio have to exceed 27.5%, 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 28% 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 31% or if 44% 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.)

The underlying reference portfolio has had no reference entity defaults in 2010 or 2011.

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 dependant on the portfolios’ weighted average spreads, default experience to date and time to maturity. No additional collateral was posted to any of the CDOs for the year ended 31 December 2011 (2010: £nil). During the year the Group received £nil (2010: £155m) of previously posted collateral.

These CDOs are valued using an external valuation which is based on observable market inputs. This is then validated against the internal valuation.

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.

The balance of £152m (2010: £147m) of CDO holdings includes a £26m (2010: £37m) exposure to an equity tranche of a bespoke CDO.

(ii) Loans and receivables

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Shareholder
2011
£m

Non profit non-unit linked
2011
£m

With-profits
2011
£m

Unit linked
2011
£m

Total
2011
£m

Deposits with credit institutions

9

265

274

Policy loans

71

71

Other loans

5

1

6

Total loans and receivables

85

1

265

351

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Shareholder
2010
£m

Non profit non-unit linked
2010
£m

With-profits
2010
£m

Unit linked
2010
£m

Total
2010
£m

Deposits with credit institutions

16

87

229

332

Policy loans

73

73

Other loans

4

1

5

Total loans and receivables

93

88

229

410

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 reflect 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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For the year ended 31 December 2011

Total
£m

Level 1
£m

Level 2
£m

Level 3
£m

Amortised
cost
£m

Shareholder

 

 

 

 

 

Equity securities

913

564

221

128

Debt securities

5,771

2,020

3,745

6

Accrued interest

76

38

38

Derivative assets

308

14

294

Loans and receivables

85

85

Non profit non-unit linked

 

 

 

 

 

Debt securities

26,018

3,415

22,603

Accrued interest

388

25

363

Derivative assets

3,107

255

2,820

32

Loans and receivables

With-profits

 

 

 

 

 

Equity securities

4,264

3,584

22

658

Debt securities

11,924

4,001

7,919

4

Accrued interest

218

58

160

Derivative assets

167

21

143

3

Loans and receivables

1

1

Unit linked

 

 

 

 

 

Equity securities

136,904

134,993

1,559

352

Debt securities

105,998

70,221

35,776

1

Accrued interest

1,023

315

708

Derivative assets

3,174

231

2,943

Loans and receivables

265

265

Total financial investments

300,604

219,755

79,314

1,184

351

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For the year ended 31 December 2010

Total
£m

Level 1
£m

Level 2
£m

Level 3
£m

Amortised
cost
£m

Shareholder

 

 

 

 

 

Equity securities

976

731

115

130

Debt securities

5,167

2,059

3,099

9

Accrued interest

69

35

34

Derivative assets

288

5

283

Loans and receivables

93

93

Non profit non-unit linked

 

 

 

 

 

Debt securities

23,323

2,542

20,781

Accrued interest

356

20

336

Derivative assets

1,425

78

1,347

Loans and receivables

With-profits

 

 

 

 

 

Equity securities

4,995

4,361

17

617

Debt securities

11,887

4,008

7,874

5

Accrued interest

224

61

163

Derivative assets

84

6

78

Loans and receivables

88

88

Unit linked

 

 

 

 

 

Equity securities

150,635

149,692

693

250

Debt securities

96,481

63,531

32,949

1

Accrued interest

1,033

372

661

Derivative assets

2,217

259

1,958

Loans and receivables

229

229

Total financial investments

299,570

227,760

70,388

1,007

415

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). 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 classified them as level 2.

These CDOs are valued using an external valuation which is based on observable market inputs. This is then validated against the internal valuation. Accordingly, these assets have also been classified in level 2.

Level 3 assets, where internal models are used to 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 with 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
2011
£m

Other
financial
investments1
2011
£m

Total
2011
£m

Equity
securities
2010
£m

Other
financial
investments1
2010
£m

Total
2010
£m

1.

Other financial investments comprise debt securities and derivative assets.

As at 1 January

997

10

1,007

793

17

810

Total gains or (losses) for the period recognised:

 

 

 

 

 

 

– in profit

147

147

119

2

121

– in other comprehensive (expense)/income

(1)

(1)

2

2

Purchases

236

236

176

1

177

Sales

(256)

(2)

(258)

(91)

(5)

(96)

Settlements

(7)

(7)

Transfers into level 3

17

40

57

Transfers out of level 3

(3)

(1)

(4)

As at 31 December

1,138

46

1,184

997

10

1,007

There have been no significant transfers to or from level 3 during both 2010 and 2011.

As discussed above, the fair values 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 observable 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.

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

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Reasonably possible alternative assumptions

For the year ended 31 December 2011
Financial instruments

Main assumptions

Current fair value
2011
£m

Increase in fair value
2011
£m

Decrease in fair value
2011
£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 assumptions.

Assets

 

 

 

 

Shareholder

 

 

 

 

– Private equity investment vehicles1

Price earnings multiple

13

1

(1)

– Unquoted investments in property vehicles2

Property yield; occupancy

115

8

(8)

– Asset backed securities

Cash flows; expected defaults

6

Non profit non-linked

 

 

 

 

– Derivative assets (interest rate contracts)

Cash flows

32

2

(2)

With-profits

 

 

 

 

– Private equity investment vehicles1

Price earnings multiple

146

7

(7)

– Unquoted investments in property vehicles2

Property yield; occupancy

516

40

(40)

– Derivative assets (equity/index derivatives)

Cash flows

3

Unit linked

 

 

 

 

– Unquoted investments in property vehicles2

Property yield; occupancy

317

14

(14)

– Suspended securities

Estimated recoverable amount

8

6

(6)

– Asset backed securities

Cash flows; expected defaults

28

1

(1)

Total

 

1,184

79

(79)

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Reasonably possible alternative assumptions

For the year ended 31 December 2010
Financial instruments

Main assumptions

Current fair value
2010
£m

Increase in fair value
2010
£m

Decrease in fair value
2010
£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 assumptions.

Assets

 

 

 

 

Shareholder

 

 

 

 

– Private equity investment vehicles1

Price earnings multiple

13

1

(1)

– Unquoted investments in property vehicles2

Property yield; occupancy

118

5

(5)

– Asset backed securities

Cash flows; expected defaults

8

With-profits

 

 

 

 

– Private equity investment vehicles1

Price earnings multiple

126

9

(9)

– Unquoted investments in property vehicles2

Property yield; occupancy

491

36

(36)

Unit linked

 

 

 

 

– Unquoted investments in property vehicles2

Property yield; occupancy

248

31

(31)

– Suspended securities

Estimated recoverable amount

3

3

(3)

Total

 

1,007

85

(85)

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