Understanding our risk landscape

The products that we write, the investments that we hold to meet our obligations and the environment in which we operate give rise to a broad range of risks. Our risk management framework, which is described on the adjacent page, seeks to ensure that we are only exposed to those residual risks for which we have an appetite.

1. THE PRODUCTS WE WRITE

Insurance risk

Longevity, mortality and morbidity

The pricing of long term life insurance business requires assumptions to be made for future trends in the life expectancy and general health of those that we insure; with the risk that actual experience may diverge to our assumptions, requiring an increase in reserves and reducing profits.

Life catastrophe

We also make assumptions about the likelihood of catastrophic events that could cause a widespread loss of life or disability within the pool of the lives that we insure; with the risk that future events could be more extreme to those that we have assessed in determining our reserves.

Weather events

In pricing household insurance products, we make assumptions about the potential level of claims that we may receive from adverse weather events; with the risk that the actual number and severity of weather events experienced may diverge from our assumptions, resulting in a higher than expected level of claims.

Persistency (lapse)

We’re exposed to the risks that acquisition costs may not be recovered from product margins if policies lapse earlier than we anticipated within our pricing assumptions.

Product expenses

Our product pricing must also take account of the future costs of product servicing, with deviations in actual costs presenting the risk of reduced product profitability.

2. THE INVESTMENTS WE HOLD

Market Risks

Investment performance

We invest in a range of investment assets including equities, bonds and property to meet the obligations from our insurance products; however, there is a risk that the income and value of these investment assets may under perform relative to required targets.

Interest rates and inflation

Interest rate movements and inflation can impact the value of the investment assets we hold to meet our obligations, as well as the value of the obligations themselves.

Currency

Fluctuations in exchange rates can vary both the value and income from investment assets denominated in foreign currencies, as well as the sterling profits and value of our overseas businesses.

Credit Risks

Bond default

We hold a significant portfolio of corporate bonds to back our annuity business. The portfolio is diversified across a range of sectors and geographies, but inherently is exposed to the risk of default resulting in financial loss.

Property direct lending counterparties

We also hold property lending and sale and leaseback investments and are inherently exposed to the risk of default by a borrower or tenant, although we seek to protect our interests by taking security over underlying property.

Banks and the issuers of financial instruments

Banking and money market counterparties, the issuers of financial instruments and the providers of settlement and custody services may default on their obligations to us, resulting in financial loss.

3. ENVIRONMENT WE OPERATE IN

Credit Risks

Reinsurance counterparties

In using reinsurance in our annuity and protection businesses, we are exposed to the risk that a reinsurer may default, impacting the payment of claims to us and requiring us to either seek alternative reinsurance arrangements, potentially on less advantageous terms or bear the reinsured risks directly.

Operational risk

People, process, systems and external events

Our business processes can be complex, with significant reliance placed upon a combination of IT systems and manual processes. We also rely upon the knowledge and expert judgement of our people. Weakness or failure in our systems and processes, the loss of key personnel, or errors and ommissions, could result in financial loss or adversely affect our customers and reputation.

Regulation and legislation

The markets in which we operate are highly regulated. Changes in regulation or legislation can require changes to our products or business processes. A breach of legislative or regulatory requirements may expose us to financial penalties, remediation costs and damage our reputation.

Liquidity risk

Contingent events

Low probability and typically extreme events that if not adequately planned for can result in unanticipated requirements for liquidity.

Collateral

Failure to hold sufficient cash or suitable liquid assets to meet collateral requirements for financial instruments, resulting in unplanned disposals of assets at excessive cost.

There are potentially material correlations between all the above risks, with a single event leading to losses on multiple risk types. These correlations are difficult to estimate though they would tend to be more acute as the underlying risk scenarios become more extreme.

An assessment of the principal risks and uncertainties that may impact our business strategy, earnings or profitability are set out in the Principal risks and uncertainties section. Note 8 (‘asset risk’), Note 19 (‘insurance risk’) and Note 29 (‘operational risk’) to the financial statements further describe how the above risks relate to our businesses and the control techniques that we apply to manage them.