9 Assumptions

UK assumptions

The assumed future pre-tax returns on fixed interest and RPI linked securities are set by reference to the portfolio yield on the relevant backing assets held at market value at the end of the reporting period. The calculated return takes account of derivatives and other credit instruments in the investment portfolio. Indicative yields on the portfolio, excluding annuities within LGR, but after allowance for long term default risk, are shown below.

For LGR, separate returns are calculated for new and existing business. An indicative combined yield, after allowance for long term default risk and the following additional assumptions, is also shown below. These additional assumptions are:

  1. Where cash balances and debt securities are held at the reporting date in excess of, or below strategic investment guidelines, then it is assumed that these cash balances or debt securities are immediately invested or disinvested at current yields.
  2. Where interest rate swaps are used to reduce risk, it is assumed that these swaps will be sold before expiry and the proceeds reinvested in corporate bonds with a redemption yield of 0.70% p.a. (0.70% p.a. at 31 December 2013) greater than the swap rate at that time (i.e. the long term credit rate).
  3. Where reinvestment or disinvestment is necessary to rebalance the asset portfolio in line with projected outgo, this is also assumed to take place at the long term credit rate above the swap rate at that time.

The returns on fixed and index-linked securities are calculated net of an allowance for default risk which takes account of the credit rating, outstanding term of the securities. The allowance for corporate securities expressed as a level rate deduction from the expected returns for annuities was 21bps at 31 December 2014 (27bps at 31 December 2013).

UK covered business

  1. Assets are valued at market value.
  2. Future bonus rates have been set at levels which would fully utilise the assets supporting the policyholders’ portion of the with-profits business in accordance with established practice. The proportion of profits derived from with-profits business allocated to shareholders amounts to almost 10% throughout the projection.
  3. The value of in-force business reflects the cost, including administration expenses, of providing for benefit enhancement or compensation in relation to certain products.
  4. Other actuarial assumptions have been set at levels commensurate with recent operating experience, including those for mortality, morbidity, persistency and maintenance expenses (excluding the development costs referred to below). These are normally reviewed annually.

An allowance is made for future mortality improvement. For new business, mortality assumptions may be modified to take certain scheme specific features into account.

  1. Development costs relate to investment in strategic systems and development capability that are charged to the covered business. Projects charged to the non-covered business are included within group investment projects in LGC and group expenses.

Overseas covered business

  1. Other actuarial assumptions have been set at levels commensurate with recent operating experience, including those for mortality, morbidity, persistency and maintenance expenses.

Economic assumptions

 

As at
2014
% p.a.

As at
2013
% p.a.

As at
2012
% p.a.

1.

The risk free rate is the gross redemption yield on the 15-year gilt index. The Europe risk free rate is the 10-year ECB AAA-rated Euro area central government bond par yield. The LGA risk free rate is the 10-year US Treasury effective yield.

2.

The LGR inflation rate has been set with reference to a curve.

Risk margin

3.3

3.4

3.7

Risk free rate1

 

 

 

– UK

2.2

3.4

2.3

– Europe

0.6

2.2

1.7

– US

2.2

3.1

1.8

Risk discount rate (net of tax)

 

 

 

– UK

5.5

6.8

6.0

– Europe

3.9

5.6

5.4

– US

5.5

6.5

5.5

Reinvestment rate (US)

5.0

5.8

4.3

 

 

 

 

Other UK business assumptions

 

 

 

Equity risk premium

3.3

3.3

3.3

Property risk premium

2.0

2.0

2.0

 

 

 

 

Investment return (excluding annuities in LGR)

 

 

 

– Fixed interest:

 

 

 

– Gilts and non gilts

1.7 – 2.4

2.2 – 3.6

1.9 – 2.9

– Equities

5.5

6.7

5.6

– Property

4.2

5.4

4.3

 

 

 

 

Long-term rate of return on non-profit annuities in LGR

3.6

4.6

4.3

 

 

 

 

Inflation2

 

 

 

– Expenses/earnings

3.7

4.1

3.4

– Indexation

3.2

3.6

2.9

Tax

  1. The profits on the covered business, except for the profits on the Society shareholder capital held outside the long term fund, are calculated on an after tax basis and are grossed up by the notional attributed tax rate for presentation in the income statement. For the UK, the after tax basis assumes the annualised current tax rate of 21.5% and the subsequent enacted future reduction in corporation tax to 20% from 1 April 2015. The tax rate used for grossing up is the long-term corporate tax rate in the territory concerned, which for the UK is 20% (31 December 2013: 20%) after taking into account the expected further rate reduction to 20% by 1 April 2015. The profits on the Society shareholder capital held outside the long term fund are calculated before tax and therefore tax is calculated on an actual basis.

    US, Netherlands and France covered business profits are also grossed up using the long term corporate tax rates of the respective territories i.e. US is 35% (31 December 2013: 35%), France is 34.43% (31 December 2013: 34.43%) and Netherlands is 25% (31 December 2013: 25%).

Stochastic calculations

  1. The time value of options and guarantees is calculated using economic and non-economic assumptions consistent with those used for the deterministic embedded value calculations.

    A single model has been used for UK and international business, with different economic assumptions for each territory reflecting the significant asset classes in each territory.

    Government nominal interest rates are generated using a LIBOR Market Model projecting full yield curves at annual intervals. The model provides a good fit to the initial yield curve.

    The total annual returns on equities and property are calculated as the return on one year bonds plus an excess return. The excess return is assumed to have a lognormal distribution. Corporate bonds are modelled separately by credit rating using stochastic credit spreads over the risk free rates, transition matrices and default recovery rates. The real yield curve model assumes that the real short rate follows a mean-reverting process subject to two normally distributed random shocks.

    The significant asset classes are:
    – UK with-profits business – equities, property and fixed rate bonds of various durations;
    – UK annuity business – fixed rate and index-linked bonds of various durations; and
    – International business – fixed rate bonds of various durations.

    The risk discount rate is scenario dependent within the stochastic projection. It is calculated by applying the deterministic risk margin to the risk free rate in each stochastic projection.

Sensitivity calculations

  1. A number of sensitivities have been produced on alternative assumption sets to reflect the sensitivity of the embedded value and the new business contribution to changes in key assumptions. Relevant details relating to each sensitivity are:
    • 1% variation in discount rate – a one percentage point increase/decrease in the risk margin has been assumed in each case (for example a 1% increase in the risk margin would result in a 4.3% risk margin).
    • 1% variation in interest rate environment – a one percentage point increased/decreased parallel shift in the risk free curve with consequential impacts on fixed asset market values, investment return assumptions, risk discount rate, including consequential changes to valuation bases.
    • 1% higher equity/property yields – a one percentage point increase in the assumed equity/property investment returns, excluding any consequential changes, for example, to risk discount rates or valuation bases, has been assumed in each case (for example a 1% increase in equity returns would increase assumed total equity returns from 5.5% to 6.5%).
    • 10% lower equity/property market values – an immediate 10% reduction in equity and property asset values.
    • 10% lower maintenance expenses, excluding any consequential changes, for example, to valuation expense bases or potentially reviewable policy fees (for example a 10% decrease on a base assumption of £10 per annum would result in a £9 per annum expense assumption).
    • 10% lower assumed persistency experience rates, excluding any consequential changes to valuation bases, incorporating a 10% decrease in lapse, surrender and premium cessation assumptions (for example a 10% decrease on a base assumption of 7% would result in a 6.3% lapse assumption).
    • 5% lower mortality and morbidity rates, excluding any consequential changes to valuation bases but including assumed product repricing action where appropriate (for example if base experienced mortality is 90% of a standard mortality table then, for this sensitivity, the assumption is set to 85.5% of the standard table).

The sensitivities for covered business allow for any material changes to the cost of financial options and guarantees but do not allow for any changes to reserving bases or capital requirements within the sensitivity calculation, unless indicated otherwise above.