4 Our principal risks and uncertainties.

Set out below is an analysis of current principal risks and uncertainties. A detailed review of the Group’s inherent risk exposures and high level control processes are set out at Notes 7, 15 and 25 to the financial statements.

Risks and uncertainties

Trend and outlook


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 period of retention of products 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 some changes in regulation having a retrospective effect on our businesses.

2012 has seen the successful delivery of our Retail Distribution Review (RDR) proposition together with the transition of our business partners to the new regime. We have also delivered the core components of our Solvency II (SII) programme. However, there remains much uncertainty both to the implementation timescales of SII and the final calibrations that will be used for long term business. The regulatory change agenda also continues with the transition of the FSA into the Prudential Regulatory Authority and Financial Conduct Authority. Whilst the high level approaches of the respective bodies have been published, potential remains that their new rule books present unintended consequences to the insurance sector and that a more aggressive supervision and enforcement regime leads to increased capital requirements and increased compliance costs. Other areas of significant regulatory change include further regulation of the UK mortgage market and the EU Packaged Retail Investment Products directive.

We seek to actively participate with Government and regulatory bodies in the UK and Europe to assist in the evaluation of change so as to develop outcomes that meet the needs of all stakeholders. Internally, we evaluate the impact of all legislative and regulatory change as part of our formal risk identification and assessment processes, with material matters being considered at the Group Risk Committee and the Group Board.

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 the 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. In addition, 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 the period of retention of retail financial services products.

Although investment markets have shown a strong recovery in 2012 and early 2013, the outlook for the global economy continues to remain uncertain. Rates of economic growth look set to be subdued and macro-economic policy responses are likely to drive a prolonged period of low interest rates. While EU governments have acted to stabilise the Euro zone, there remains potential for shocks to global financial markets, which, in the extreme, could impact our ability to execute hedging strategies that ensure the profile of our assets and liability/cash flows are appropriately matched.

As illustrated in the Market environment section we model our business plans across a broad range of economic scenarios and take account of alternative economic outlooks 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 What makes us different? section. Sensitivities to interest rate mismatches, exposure to worldwide equity markets and currencies are set out at Notes 17 and 13 respectively.

In dealing with issuers of debt and other types of counterparty the Group is exposed to the risk of default. A default event within the banking sector, or a major Sovereign debt event, could result in dislocation of bond markets, significantly widening credit spreads, and in extreme conditions may result in default of strongly rated issuers of debt, requiring us to increase our default provisions. We also have exposures to banking, money market and reinsurance counterparties, and the providers of settlement, custody and other bespoke business services to the Group, a failure of which could expose us either to financial loss or short-term operational disruption of our business processes.

Over 2012 credit spreads have begun to normalise, reflecting increased market confidence in the issuers of investment grade bonds and at L&G we continue to experience a very low level of actual defaults. However, while we assess the occurrence of a major bank default or Sovereign event as being a more extreme outcome than in previous years, the risk and associated uncertainties remain. The current economic environment also presents an increased risk that suppliers of business services may be unable to meet their obligations.

We actively manage our exposure to default risks, setting robust counterparty selection criteria and exposure limits. We continue to diversify the asset classes backing our annuities business, to include the use of property lending, sale and leaseback and infrastructure assets. Details of our default provisions are set out Managing our capital section. Exposures to credit risk are set out at Note 14 and sensitivities to changes in credit spreads at Note 17. Our service providers are also subject to rigorous selection criteria.

As a UK-based Group, our earnings are influenced by the performance and perception of the UK financial services sector as a whole. The financial crisis, subsequent investment performance and low interest rate environment together with consumers’ perceptions of the robustness of financial institutions may impact consumer attitudes to long-term savings. Recent regulatory actions, for example in the banking sector with regard to Payment Protection Insurance (PPI), may also adversely impact consumers’ perception of the value of insurance products and result in changes to the regulatory and legislative environment in which we operate.

As a significant participant in the long-term savings markets, we are inherently exposed to the risk of a downturn in new business volumes and changes in policy persistency as a consequence of consumer sentiment. We are also exposed to the risk of increased costs of regulatory compliance through regulatory and legislative responses to events in the banking sector being read across to insurers without reference to the different business models.

We actively manage our brand 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 businesses. We also actively engage with our regulators to support understanding of the risk drivers in the markets in which we operate.

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. The frequency of extreme events may result in the need to recalibrate these assumptions. Forced changes in reserves can also be required because of regulatory or legislative intervention in the way that products are priced.

Whilst we regularly appraise the assumptions underpinning the business that we write using both external and our own mortality data, extreme events, such as a rapid advance in medical science leading to significantly enhanced annuitant longevity or an event causing widespread mortality/morbidity remain inherent risks to our business. Following the implementation of EU gender-neutral pricing legislation in the UK, there also remains potential for further legislation to price insurance products irrespective of other risk factors, such as age or health.

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. We remain focused on developing a comprehensive understanding of annuitant mortality and we continue to evolve and develop our underwriting capabilities. The sensitivities of our UK long term business to annuitant mortality are set out at Note 17. We also continue to ensure that legislators recognise the benefits to consumers of pricing insurance products based on the risk factors that each policy presents.

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. 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.

The UK Government continues to focus on a broad range of changes to the provision of State benefits and the encouragement of self-provision, for example, the introduction of auto enrolment. Such changes will impact the way in which consumers approach protecting their income and planning for their retirement. The distribution landscape is also expected to continue to evolve post the implementation of RDR presenting a range of opportunities.

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. As set out in the What we are doing section we have re-aligned our internal organisation to fully support our ambition, including the development of our digital capabilities.

A material failure in our business processes may result in unanticipated loss or reputation damage. We have constructed our framework of internal controls to minimise the risk of unanticipated loss or damage to our reputation. However, no system of internal control can completely eliminate the risk of error, financial loss, fraudulent actions or reputational damage.

As our business grows we continue to invest in our system capabilities and business processes to ensure that we meet the expectations of our customers; comply with regulatory, legal and financial reporting requirements; and mitigate the risks of loss or reputational damage from operational risk events.

Our ‘three lines of defence’ risk governance model set out in the Risk Management section seeks to ensure that business management take an active part in developing an appropriate control environment for the risks implicit in the business processes they manage, with expert advice and guidance from the Group Chief Risk Officer team. Our Internal Audit function provides independent assurance on the adequacy and effectiveness of our controls. The report of the Group Audit Committee in the Governance section outlines its work during the year in reviewing our internal control system.