Our principal risks and uncertainties.

Our principal risks and uncertainties.

Set out below is an assessment 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 8, 18 and 28 of the financial statements.




Changes in regulation or legislation may have a detrimental effect on our strategy. Legislation and government fiscal policy 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. Significant changes in regulation may reduce our earnings and profitability or require us to hold more capital.

The implementation of the Retail Distribution (RDR) at the start of 2013 has resulted in dramatic shifts in the distribution landscape. The retrenchment by the banks and challenges to IFA distribution models in response to RDR and other regulatory initiatives, together with a slow transition of consumers to the RDR model has presented broader market uncertainty for products that rely on customers access to advice. Solvency II is targeted for implementation in early 2016. Revised capital calibrations for long term business provide sufficient flexibility to address many of the adverse capital impacts for UK insurance firms. Challenges remain, however, in ensuring that final implementation is proportionate and cost effective for the insurance sector.

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. We maintain a flexible distribution model to respond to changing market trends.

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 impact the value of investment assets we hold in shareholders’ funds and those to meet the obligations arising from insurance business. Interest rate movement and inflation can also change the value of the obligations. We use a range of techniques to manage mismatches between assets and liabilities. However, financial loss can still arise from adverse investment markets. In addition, significant falls in investment values can reduce the fee income of our investment management business. Broader economic conditions impact the timing of the purchase and the period of retention of retail financial services products.

Global investment markets have returned to pre-financial crisis levels, responding both to the more positive economic outlook and the conditions created by the monetary policies being exercised by central banks. There is limited resilience, however, in the current environment for ‘shocks’ such as those from an abrupt change in monetary policy, with potential for significant falls in the value of certain asset classes should markets reassess returns.

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 business plans we have sought to ensure focus upon those market segments that we expect to be resilient in projected conditions. Details of our business strategy are set out in the Our progress section. Sensitivities to interest rates, exposure to worldwide equity markets and currencies are set out in Note 20, Note 16 and Note 16(ii) respectively.

In dealing with issuers of debt and other types of counterparty the Group is exposed to the risk of financial loss. A systematic default event within the corporate sector, or a major sovereign debt event, could result in dislocation of bond markets, significantly widening credit spreads, and may result in default of even strongly rated issuers of debt, exposing us to financial loss. We are also exposed to banking, money market and reinsurance counterparties, and settlement, custody and other bespoke business services, a failure of which could expose us to both financial loss and operational disruption of our business processes.

2013 saw a further narrowing of credit spreads reflecting market confidence in the issuers of investment grade bonds. We have continued to experience low levels of default on our corporate bond portfolio. There remains, however, a range of factors that could trigger write downs in our investment assets. These factors include a deterioration in the confidence in banks within the eurozone or the currency area itself; a failure to definitively resolve the US government debt ceiling; and a financial crisis in emerging markets.

We actively manage our exposure to default risks, setting counterparty selection criteria and exposure limits and hold reserves against our assessment of counterparty debt defaults. We continue to diversify the asset classes backing our annuities business, to include the use of property lending, sale and leaseback and other forms of direct investment. Our bond default provisions are set out in the Disciplined investment of capital section. Exposures to credit risk are set out in Note 17 and sensitivities to changes in credit spreads in Note 20.

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. Regulatory actions 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 exposed to changes in consumer sentiment. We are also exposed to increased costs of regulatory compliance through regulatory and legislative responses to events in the financial services sector. Recent examples include the EU transaction tax and the central clearing of certain derivative instruments, which would increase the costs associated with pension savings products and annuities, respectively.

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, and highlight matters where we believe the industry need to change.

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 requires the setting of assumptions for long-term trends in factors such as mortality, lapse rates and persistency, valuation interest rates, expenses and credit defaults. Actual experience may result in the need to recalibrate these assumptions reducing profitability. Forced changes in reserves can also be required because of regulatory or legislative intervention in the way that products are priced, reducing profitability and future earnings.

We regularly appraise the assumptions underpinning the business that we write. In our annuities business we are, however, exposed to factors such as improvements in medical science beyond those anticipated leading to unexpected changes in life expectancy. In protection business we remain inherently exposed to loss from events causing widespread mortality/morbidity or significant policy lapse rates. As illustrated by the implementation of the EU gender neutral pricing legislation, there is also potential for legislative intervention in the pricing of insurance products irrespective of 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 business to a range of scenarios are set out in Note 20. 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, adversely impacting future earnings. 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.

Macro trends in the markets in which we operate include an ageing population, the increasing use of digital technologies and significant reform in the provision of state welfare. Within the investment management business asset classes are increasingly homogeneous providing opportunities for businesses with scale such as us. The retrenchment of the banks also provides opportunity for insurance firms to participate in investment and lending activities. Responding to these macro trends potentially creates organisational challenges and management stretch across the range of initiatives.

As set out in Our strategy and our progress section, we’ve clear strategies to respond to the macro trends. Risks arising from macro trends have been considered as part of the Group Risk Committee focused business and risk reviews. The Committee and the Group Board has also debated the risks of management stretch, with strategic projects being re-focused as appropriate. As set out in the Who we are section during 2013 we undertook a significant re-structure of our businesses to deliver our strategic responses to the changes in the markets in which we operate.

A material failure in our business processes may result in unanticipated financial loss or reputation damage. We have constructed our framework of internal controls to minimise the risk of unanticipated financial 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. Our plans for growth inherently will increase the profile of operational risks across our businesses.

As we grow 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. The restructure of our business divisions seeks to support the positioning of appropriate resources to manage these risks.

Our risk governance model set out in the Our risk management framework section seeks to ensure that business management are actively engaged in ensuring an appropriate control environment is in place. The group risk team provides expert advice and guidance on the required control environment, together with objective challenge in the way risks are being managed. Our internal audit function provides independent assurance on the adequacy and effectiveness of our controls. The work of the Group Audit Committee in reviewing our internal control system is set out in the Internal and external audit section.

The financial services sector is increasingly becoming a target of ‘cyber crime’. As we and our business partners increasingly digitalise our businesses, we are inherently exposed to the risk that third parties may seek to disrupt our on-line business operations, steal customer data or perpetrate acts of fraud using digital media. A significant cyber event could result in reputation damage and financial loss.

The financial services sector has seen a significant rise in attempts by third parties to seek and exploit perceived vulnerabilities in IT systems. Potential threats include denial of service attacks, network intrusions to steal data for the furtherance of financial crime, and the electronic diversion of funds.

We’re focused on maintaining a robust and secure IT environment that protects our customer and corporate data. Working with our business partners we deploy control techniques to evaluate the security of our systems and proactively address emerging threats. During 2013 the Group Risk Committee reviewed cyber risks and our control framework, with further review scheduled for 2014. We remain vigilant to the range of risks, however, the evolving nature of cyber threats means that residual risks will remain.

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