13 Financial investments and Investment property

The group holds financial investments and investment property to back insurance and investment 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, which management believe to be representative of fair value. 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.

Investment property comprises land and buildings which are held for long term rental yields and capital growth. It is carried at fair value with changes in fair value recognised in the income statement within investment return.

Investment property in the UK is valued bi-annually by external chartered surveyors at open market values in accordance with the ‘Appraisal and Valuation Manual’ of The Royal Institution of Chartered Surveyors or using internal valuations and estimates during the intervening period. Outside the UK, valuations are produced in conjunction with external qualified professional valuers in the countries concerned. In the event of a material change in market conditions between the valuation date and balance sheet date, an internal valuation is performed and adjustments made to reflect any material changes in fair value.

Future developments

IFRS 9, ‘Financial Instruments’ issued in July 2014 is effective for annual periods beginning on or after 1 January 2018, subject to EU endorsement. It contains three strands. The first is a principle-based model for classification and measurement of financial instruments driven by cash flow characteristics and the business model in which an asset is held, replacing existing requirements. The second is a single expected loss impairment model that will require more timely recognition of expected credit losses. Specifically, the new Standard requires entities to account for expected credit losses from when financial instruments are first recognised, and it lowers the threshold for recognition of full lifetime expected losses. Finally, IFRS 9 also introduces a substantially reformed model for hedge accounting with enhanced disclosures about risk management activities, enabling entities to better reflect these activities in their financial statements. The publication of IFRS 9 now completes the IASB’s project to replace IAS 39, Financial Instruments: Recognition and Measurement. The group does not intend to early adopt this Standard.

(i) Financial investments and investment property at fair value

 

Note

Share­holder
2014
£m

Non profit non-unit linked
2014
£m

With-profits
2014
£m

Unit linked
2014
£m

Total
2014
£m

Financial investments at fair value designated as:

 

 

 

 

 

 

Fair value through profit or loss

 

5,267

40,993

13,036

289,075

348,371

Available-for-sale

 

1,698

7

1,705

Held for trading

 

113

3,850

61

6,011

10,035

Financial investments at fair value

 

7,078

44,843

13,097

295,093

360,111

Loans and receivables

13(iii)

286

29

188

503

Total financial investments

 

7,364

44,843

13,126

295,281

360,614

Investment property

 

151

1,879

1,034

5,088

8,152

Total financial investments and investment property

 

7,515

46,722

14,160

300,369

368,766

Expected to be received within 12 months

 

 

 

 

 

45,996

Expected to be received after 12 months

 

 

 

 

 

322,770

 

Note

Share­holder
2013
£m

Non profit non-unit linked
2013
£m

With-profits
2013
£m

Unit linked
2013
£m

Total
2013
£m

1.

Total financial investments and investment property has been restated to reflect the adoption by the group of IFRS 10, ‘Consolidated Financial Statements’. Further details are contained in Note 1.

Financial investments at fair value designated as:

 

 

 

 

 

 

Fair value through profit or loss

 

5,534

29,734

15,015

277,420

327,703

Available-for-sale

 

1,754

7

1,761

Held for trading

 

207

2,100

48

2,391

4,746

Financial investments at fair value

 

7,495

31,834

15,063

279,818

334,210

Loans and receivables

13(iii)

79

30

221

330

Total financial investments

 

7,574

31,834

15,093

280,039

334,540

Investment property

 

153

1,294

979

3,951

6,377

Total financial investments and investment property1

 

7,727

33,128

16,072

283,990

340,917

Expected to be received within 12 months

 

 

 

 

 

45,023

Expected to be received after 12 months

 

 

 

 

 

295,894

Investment risks on unit linked assets are borne by the policyholders. The remaining risks associated with financial investments are outlined in Note 8.

Financial investments include £554m (2013: £313m) of debt securities pledged as collateral against derivative liabilities. The assets used as collateral are Treasury Gilts, Foreign Government Bonds, AAA and AA Corporate Bonds and Cash (2013: Treasury Gilts, Foreign Government Bonds, AAA Supranational Bonds and AA Corporate Bonds) having a residual maturity of over 41 years (2013: over 42 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.

Various bulk purchase annuity deals were undertaken throughout the year and £3,008m of Corporate Bonds and Treasury Gilts are pledged as collateral in relation to these.

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.

 

Note

Share­holder
2014
£m

Non profit non-unit linked
2014
£m

With-profits
2014
£m

Unit linked
2014
£m

Total
2014
£m

1.

Non profit non-unit linked debt securities includes £919m (2013: £568m) of commercial loans designated as fair value through profit and loss.

Equity securities

 

1,891

279

4,065

163,471

169,706

Debt securities1

 

5,033

40,238

8,860

124,635

178,766

Accrued interest

 

41

476

111

976

1,604

Derivative assets

14

113

3,850

61

6,011

10,035

Total investments at fair value

 

7,078

44,843

13,097

295,093

360,111

 

Note

Share­holder
2013
£m

Non profit non-unit linked
2013
£m

With-profits
2013
£m

Unit linked
2013
£m

Total
2013
£m

1.

Non profit non-unit linked debt securities includes £919m (2013: £568m) of commercial loans designated as fair value through profit and loss.

2.

This has been restated to reflect the adoption by the group of IRFS 10, ‘Consolidated Financial Statements’. Further details are contained in Note 1.

Equity securities

 

1,609

83

4,506

167,891

174,089

Debt securities1

 

5,624

29,251

10,357

108,510

153,742

Accrued interest

 

55

400

152

1,026

1,633

Derivative assets

14

207

2,100

48

2,391

4,746

Total investments at fair value2

 

7,495

31,834

15,063

279,818

334,210

Non consolidated private equity investments are included within equity securities. A loss of £14m (2013: loss of £2m) has been recognised in the Consolidated 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 gain of £47m (2013: gain of £5m) has been recognised in the Consolidated Income Statement in respect of the movement in fair value of these investments.

Included within unit linked equity securities are £315m (2013: £306m) of debt instruments which incorporate an embedded derivative linked to the value of the group’s share price.

(ii) Collateralised debt obligations (CDOs)

The group holds CDOs with a market value of £1,215m at 31 December 2014 (2013: £1,098m).

These holdings include £994m (2013: £983m) 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 there have been no substitutions in 2013 or 2014. A breakdown of the underlying CDO reference portfolio by sector is provided below:

Sector

2014
%

2013
%

Banks

14

14

Utilities

10

10

Consumer Services and Goods

25

25

Financial Services

6

6

Technology and Telecoms

9

9

Insurance

6

6

Industrials

20

20

Oil and Gas

6

6

Health Care

4

4

 

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 27.5% 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 30.4% or if 43.5% of the names in the reference 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 2013 or 2014.

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 dependent on the portfolios’ weighted average spreads, default experience to date and time to maturity. No additional collateral was posted to any of the CDOs during 2014 (2013: £nil). During 2014, the group received £nil (2013: £nil) previously posted collateral. The amount of the cash equivalent collateral attached to CDOs during the year is £nil.

These CDOs are valued using an external valuation based on observable market inputs, which include CDX and iTraxx index tranches and CDS spreads on underlying reference entities. This is then validated against the internal valuation.

The remaining balance of CDO holdings is £221m (2013: £115m). Unit linked CDOs are excluded from the analysis as the risk is retained by the policyholders.

(iii) Loans and receivables

 

Share­holder
2014
£m

Non profit non-unit linked
2014
£m

With-profits
2014
£m

Unit linked
2014
£m

Total
2014
£m

1.

Other loans includes £188m (2013: £6m) of commercial mortgage loans in 2014.

Deposits with credit institutions

1

1

188

190

Policy loans

39

28

67

Other loans1

246

246

Total loans and receivables

286

29

188

503

 

Share­holder
2013
£m

Non profit non-unit linked
2013
£m

With-profits
2013
£m

Unit linked
2013
£m

Total
2013
£m

1.

Other loans includes £188m (2013: £6m) of commercial mortgage loans in 2014.

Deposits with credit institutions

9

221

230

Policy loans

40

29

69

Other loans1

30

1

31

Total loans and receivables

79

30

221

330

There are no material differences between the carrying values reflected above and the fair values of these loans. Were these loans to be held at fair value they would fall within level 2 of the fair value hierarchy.

(iv) Fair value hierarchy

Fair value is the price that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants at the measurement date.

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).

All of the group’s level 2 assets have been valued using standard market pricing sources, such as iBoxx, IDC and Bloomberg, which use mathematical modelling and multiple source validation in order to determine “consensus” prices, except for bespoke CDO and swaps holdings (see below). In normal market conditions, we would consider these market prices to be observable market prices. 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. The CDOs are valued using an external valuation based on observable market inputs, which include CDX and iTRaxx index tranches and CDS spreads on underlying reference entities. This is then validated against the internal valuation. Accordingly, these assets have also been classified in level 2.

There have been no significant transfers between level 1 and level 2 in 2014 (2013: £nil).

The following table presents the group’s assets by IFRS 13 hierarchy levels:

For the year ended 31 December 2014

Total
£m

Level 1
£m

Level 2
£m

Level 3
£m

Amortised cost
£m

Shareholder

 

 

 

 

 

Equity securities

1,891

1,664

1

226

Debt securities

5,033

1,975

2,818

240

Accrued interest

41

20

19

2

Derivative assets

113

28

85

Loans and receivables

286

286

Investment property

151

151

Non profit non-unit linked

 

 

 

 

 

Equity securities

279

268

11

Debt securities

40,238

6,315

32,951

972

Accrued interest

476

42

427

7

Derivative assets

3,850

41

3,809

Loans and receivables

Investment property

1,879

1,879

With-profits

 

 

 

 

 

Equity securities

4,065

3,531

14

520

Debt securities

8,860

4,174

4,668

18

Accrued interest

111

45

66

Derivative assets

61

31

30

Loans and receivables

29

29

Investment property

1,034

1,034

Unit linked

 

 

 

 

 

Equity securities

163,471

157,191

5,895

385

Debt securities

124,635

84,287

40,344

4

Accrued interest

976

339

637

Derivative assets

6,011

444

5,567

Loans and receivables

188

188

Investment property

5,088

5,088

Total financial investments and investment property

368,766

260,395

97,331

10,537

503

For the year ended 31 December 20131

Total
£m

Level 1
£m

Level 2
£m

Level 3
£m

Amortised cost
£m

1.

This has been restated to reflect the adoption by the group of IFRS 10 ‘Consolidated Financial Statements’. Further details are contained in Note 1.

Shareholder

 

 

 

 

 

Equity securities

1,609

1,435

28

146

Debt securities

5,624

2,071

3,493

60

Accrued interest

55

26

29

Derivative assets

207

62

145

Loans and receivables

79

79

Investment property

153

153

Non profit non-unit linked

 

 

 

 

 

Equity securities

83

72

11

Debt securities

29,251

4,371

24,331

549

Accrued interest

400

38

358

4

Derivative assets

2,100

171

1,929

Loans and receivables

Investment property

1,294

1,294

With-profits

 

 

 

 

 

Equity securities

4,506

3,956

19

531

Debt securities

10,357

4,155

6,184

18

Accrued interest

152

53

99

Derivative assets

48

43

5

Loans and receivables

30

30

Investment property

979

979

Unit linked

 

 

 

 

 

Equity securities

167,891

164,917

2,688

286

Debt securities

108,510

62,400

46,108

2

Accrued interest

1,026

313

713

Derivative assets

2,391

625

1,766

Loans and receivables

221

221

Investment property

3,951

3,951

Total financial investments and investment property

340,917

244,708

87,895

7,984

330

(a) Assets measured at fair value based on level 3

Level 3 assets where internal models are used to represent a small proportion of assets to which shareholders are exposed, comprise both property and unquoted equities, the latter 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 within 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.

 

Equity securities
2014
£m

Other financial invest­ments1
2014
£m

Invest­ment property
2014
£m

Total
2014
£m

Equity securities
20132
£m

Other financial invest­ments1
20132
£m

Invest­ment property
20132
£m

Total
20132
£m

1.

Other financial investments comprise debt securities and derivative assets.

2.

This has been restated to reflect the adoption by the group of IFRS 10, ‘Consolidated Financial Statements’. Further details are contained in Note 1.

3.

The group holds regular discussion with its pricing providers to determine whether transfers between levels of the fair value hierarchy have occurred. The above transfers occurred as result of this process.

As at 1 January

974

633

6,377

7,984

891

99

5,438

6,428

Total gains or (losses) for the year recognised in profit:

 

 

 

 

 

 

 

 

– in other comprehensive income

9

9

(1)

(1)

– realised and unrealised gains or (losses)

71

99

668

838

7

248

255

Purchases/Additions

210

1,026

1,559

2,795

365

397

1,306

2,068

Improvements

20

20

23

23

Sales/Disposals

(118)

(531)

(472)

(1,121)

(323)

(4)

(638)

(965)

Transfers into level 33

5

10

15

34

143

177

Transfers out of level 33

(3)

(3)

(1)

(1)

As at 31 December

1,142

1,243

8,152

10,537

974

633

6,377

7,984

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

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.

For the year ended 31 December 2014
Financial instruments and Investment property

Main assumptions

Reasonably possible alternative assumptions

Current fair value
£m

Increase in fair value
£m

Decrease in fair value
£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 and direct holdings in investment property 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

16

1

(1)

– Unquoted investments in property vehicles2

Property yield; occupancy

117

7

(7)

– Untraded debt securities

Cash flows; expected defaults

241

12

(12)

– Unquoted securities

Cash flows; expected defaults

94

2

(2)

– Investment property2

Property yield; occupancy

151

8

(8)

Non profit non-linked

 

 

 

 

– Asset backed securities

Cash flows; expected defaults

497

25

(25)

– Untraded debt securities

Cash flows; expected defaults

281

14

(14)

– Unquoted securities

Cash flows; expected defaults

173

6

(6)

– Other

 

39

– Investment property2

Property yield; occupancy

1,879

94

(94)

With-profits

 

 

 

 

– Private equity investment vehicles1

Price earnings multiple

160

9

(9)

– Unquoted securities

Cash flows; expected defaults

375

18

(18)

– Other

 

3

– Investment property2

Property yield; occupancy

1,034

52

(52)

Unit linked

 

 

 

 

– Suspended securities

Estimated recoverable amount

7

– Asset backed securities

Cash flows; expected defaults

7

4

(4)

– Untraded debt securities

Cash flows; expected defaults

2

– Unquoted securities

Cash flows; expected defaults

373

15

(15)

– Investment property2

Property yield; occupancy

5,088

255

(255)

Total

 

10,537

522

(522)

For the year ended 31 December 20131
Financial instruments and Investment property

Main assumptions

Reasonably possible alternative assumptions

Current fair value
£m

Increase in fair value
£m

Decrease in fair value
£m

1.

This has been restated to reflect the adoption by the group of IFRS 10, ‘Consolidated Financial Statements’. Further details are contained in Note 1.

2.

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.

3.

Unquoted investments in property vehicles and direct holdings in investment property 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 vehicles2

Price earnings multiple

24

1

(1)

– Unquoted investments in property vehicles3

Property yield; occupancy

131

9

(9)

– Untraded debt securities

Cash flows; expected defaults

51

3

(3)

– Investment property3

Property yield; occupancy

153

7

(7)

Non profit non-linked

 

 

 

 

– Untraded debt securities

Cash flows; expected defaults

162

1

(1)

– Asset backed securities

Cash flows; expected defaults

402

20

(20)

– Investment property3

Property yield; occupancy

1,294

65

(65)

With-profits

 

 

 

 

– Private equity investment vehicles2

Price earnings multiple

213

14

(14)

– Unquoted investments in property vehicles3

Property yield; occupancy

336

17

(17)

– Investment property3

Property yield; occupancy

979

49

(49)

Unit linked

 

 

 

 

– Unquoted investments in property vehicles3

Property yield; occupancy

265

13

(13)

– Suspended securities

Estimated recoverable amount

17

1

(1)

– Untraded debt securities

Cash flows; expected defaults

6

2

(2)

– Investment property3

Property yield; occupancy

3,951

198

(198)

Total

 

7,984

400

(400)

(v) Net asset value attributable to unit holders

Amounts attributable to unit holders are repayable on demand and the group is responsible for ensuring there is sufficient liquidity within the corresponding asset portfolio to enable the liability to be met as it falls due.

At 31 December 2014, the level 1 net asset value attributable to unit holders is £17,139m (2013: £10,818m).