7 Asset risk.

The Group is exposed to the following categories of risk as a consequence of offering the principal products outlined in Note 6.

Market risk

Exposure to loss as a direct or indirect result of fluctuations in the value of, or income from, specific assets.

Credit risk

Exposure to loss if another party fails to perform its financial obligations to the Group.

Liquidity risk

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

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. A description of the risks associated with the Group’s principal products and the associated control techniques is detailed below.

Protection and Annuities

(XLS:) Protection and Annuities – market risks

Market Risk

 

 

Risk

Product

Control

Investment Performance Risk

 

 

The Group is exposed to the risk that the income from, and value of, assets held to back insurance liabilities do not perform in line with investment and product pricing assumptions leading to a mismatch with contractual cash flows.

All

Stochastic models are used to assess the impact of a range of future return scenarios on investment values and associated liabilities in order to determine optimum portfolios of invested assets. For immediate annuities, which are 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.

Currency Risk

 

 

To diversify credit risk within the annuities business corporate bond portfolio, investments are held in corporate bonds denominated in Euros and US Dollars. Fluctuations in the value of, or income from, these assets relative to liabilities denominated in Sterling could result in unforeseen loss.

Annuities

To mitigate the risk of loss from currency fluctuations, currency swaps are used to hedge exposures to corporate bonds denominated in currencies other than Sterling. Hedging arrangements are placed only with strongly rated counterparties with collateral requirements being subject to regular review and reconciliation with the counterparties.

Inflation Risk

 

 

Inflation risk is the potential for loss as a result of relative or absolute changes in inflation rates. Annuity contracts may provide for future benefits to be paid taking account of changes in the level of inflation. Annuity contracts in payment may include an annual adjustment for movements in prices indices.

Annuities

The investment strategy for annuities business takes explicit account of the effect of movements in price indices on contracted liabilities. Significant exposures that may adversely impact profitability are hedged using inflation swaps. Annuity contracts also typically provide for a cap on the annual increase in inflation linked benefits in payment.

(XLS:) Protection and Annuities – credit risks

Credit Risk

 

 

Risk

Product

Control

Bond Default Risk

 

 

A significant portfolio of corporate bonds is held to back the liabilities arising from writing general insurance and annuities business. Whilst the portfolio is diversified, the asset class is inherently exposed to the risk of issuer default.

Annuities and General insurance

Issuer limits are set by financial strength rating, sector and geographic region so as to limit exposure from a default event. Issuer limits are regularly reviewed to take account of changes in market conditions, sector performance and the re-assessment of financial strength by rating agencies and the Group’s own internal analysts. Exposures are monitored relative to limits. Financial instruments are also used to mitigate the impact of rating downgrades and defaults.

Reinsurance Counterparty Risk

 

 

Exposure to insurance risk is mitigated by ceding part of the risks assumed to the reinsurance market. Default of a reinsurer would require the business to be re-brokered potentially on less advantageous terms, or for the risks to be borne directly.

All

When selecting new reinsurance partners, the Group considers only companies which have a minimum credit rating equivalent to A- from Standard & Poor’s. For each reinsurer, exposure limits are determined based on credit ratings and projected exposure over the term of the treaty. Actual exposures are regularly monitored relative to these limits.

(XLS:) Protection and Annuities – liquidity risks

Liquidity Risk

 

 

Risk

Product

Control

Contingent Event Risk

 

 

Events that result in liquidity risk may include a flu pandemic or natural disaster leading to significantly higher levels of claims than would normally be expected, or extreme market conditions impacting the timing of cash flows or the ability to realise investments at a given value within a specified timeframe.

Protection and General insurance

A limited level of contingent liquidity risk is an accepted element of writing contracts of insurance. However, the Group’s insurance businesses seek to maintain sufficient liquid assets and standby facilities to meet a prudent estimate of the cash outflows that may arise from contingent events. The level of required liquidity is identified using techniques including stress tests for shock events, with the profile of actual liquid assets being regularly compared to the required profile. The Group’s treasury function provides formal facilities to the Group to cover contingent liquidity requirements arising from more extreme events and where investment assets may not be readily realisable. The level of insurance funds held in cash and other readily realisable assets at 31 December 2012 was £2.9bn (2011: £2.3bn).

Property Counterparty Risk

 

 

As part of our asset diversification strategy, we hold property lending and sale & leaseback investments. We are inherently exposed to the risk of default by a borrower or tenant.

Annuities

Each property lending and sale & leaseback investment transaction is subject to a due diligence process to assess the credit risks implicit in the transaction and confirm that any risk of default has been appropriately mitigated. We also protect our interests through taking security over the underlying property associated with the investment transaction.

Collateral Liquidity Risk

 

 

Within the Annuities business, the use of financial instruments to hedge default, interest rate, currency and inflation risks can require the posting of collateral with counterparties, and as such an appropriate pool of the asset types specified by counterparties must either be held or readily available.

Annuities

Liquidity requirements to meet potential collateral calls are actively managed. Typically within the overall fund of investment assets held to meet the long term liabilities arising from annuity business, £500m is held in cash and other highly liquid investment types for general liquidity purposes. As at 31 December 2012 eligible assets worth 6.8 times the outstanding collateral were held (using the most onerous definition of collateral contained within the company’s different collateral agreements).

Savings

(XLS:) Savings – market risks

Market Risk

 

 

Risk

Product

Control

Investment Performance 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.

With-profits

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.

For unit linked contracts, there is a risk of volatility in asset management fee income 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. There is also the risk of expense over-runs should the market depress the level of charges which could be imposed.

Unit linked

The risk is managed through maintaining a diversified range of funds in which customers may invest. The performance of linked investment funds relative to their investment objectives are subject to regular monitoring. Periodic assessment is also made of the long term profitability to Group of these funds. For some contracts the Group has discretion over the level of management charges levied.

(XLS:) Savings – liquidity risks

Liquidity Risk

 

 

Risk

Product

Control

Investment Liquidity Risk

 

 

Within the with-profit fund, exposure to liquidity risk may arise if the profile of investment assets held to meet obligations to policyholders is not aligned with the maturity profile of policies, or the profile does not adequately take account of the rights of policyholders to exercise options or guarantees to specified early surrender terms or minimum rates of return.

With-profits

Liquidity risk is managed ensuring that an appropriate proportion of the fund is held in cash or other readily realisable assets to meet each tranche of maturities and anticipated early withdrawals as they fall due. Where policyholders have discretion to require early payment of policy proceeds, contractual safeguards are in place to ensure that the fund and remaining policyholders are not disadvantaged should a material number of policyholders exercise this discretion.

Non-participating savings contracts are exposed to liquidity risk in that certain asset classes in which underlying funds invest, such as property, may not be readily realisable in certain market conditions, or only realisable at a diminution of value.

Non-par savings

Liquidity risks associated with non-participating savings contracts are documented and communicated to customers within product terms and conditions. The terms also highlight that for certain asset classes such as property, the Group retains the right to defer the processing of fund withdrawal requests for up to six months, should underlying assets need to be realised to meet payment requests.

The financial risks associated with LGIM’s businesses are directly borne by the investors in its funds. Therefore detailed risk disclosures have not been presented. The approach to the management of operational risks, including loss arising from trading errors, breach of fund management guidelines or valuation errors, where a breakdown in controls could lead to successful litigation against the company by one or more clients, is set out in Note 25.

The principal risks and associated controls relevant to our US Protection business are consistent with those identified for our Protection and Annuities and Savings businesses and therefore have not been repeated here.

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. The Group is exposed to asset risk on shareholder’s equity supporting the non profit Protection and Annuities and Savings businesses and capital within the Group’s treasury function. Risks attributable to Group capital and financing assets are outlined below.

Shareholder Funds

Shareholder assets include portfolios of equity, property, bond and other investments, not directly required to meet contractual obligations to policyholders. The value of, and income from, these assets is sensitive to conditions within investment markets and the broader economy. Potential volatility in returns are managed using a range of techniques, including performance benchmarks and limits on concentrations of exposures by asset type and geographic region.

Group Treasury and Liquidity Management

The Group’s treasury function manages the Group’s banking relationships, capital raising activities, overall cash and liquidity position and the payment of dividends. The Group seeks to manage its corporate 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. As at 31 December 2012, the Group had in place a £1bn syndicated committed revolving credit facility provided by a number of its key relationship banks, maturing in October 2017. The facility provides flexibility in the management of the Group’s liquidity. No drawings were made under these facilities during 2012.