Notes to the consolidated financial statements
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- 24 Value of in-force business
- 25 Other intangible assets »
24 Value of in-force business
The asset in the consolidated balance sheet and movement recognised in the income statement are as follows:
Gross value of in-force insurance and participating investment business
|
2008 |
2007 |
||
|---|---|---|---|
|
At 1 January |
2,218 |
2,723 |
|
|
Movements in the year: |
|||
|
New business |
368 |
264 |
|
|
Existing business: |
|||
|
Expected return |
(112) |
(166) |
|
|
Experience variances |
(46) |
(38) |
|
|
Assumption changes |
(92) |
69 |
|
|
Economic variance |
(443) |
(222) |
|
|
Movement in value of in-force business taken to income statement (note 9) |
(325) |
(93) |
|
|
Disposal of business |
– |
(412) |
|
|
At 31 December |
1,893 |
2,218 |
This breakdown shows the movement in the value of in-force business only, and does not represent the full contribution that each item in the breakdown contributes to profit before tax, which would also contain changes in the other assets and liabilities of the relevant businesses. Economic variance is the element of earnings which is generated from changes to economic experience in the period and to assumptions over time. The presentation of economic variance includes the impact of financial market conditions being different at the end of the reporting period from those included in assumptions used to calculate new and existing business returns.
The principal features of the methodology and process used for determining key assumptions used in the calculation of the value of in-force business are set out below:
Economic assumptions
Each cash flow is valued using the discount rate consistent with that applied to such a cash flow in the capital markets. In practice, to achieve the same result, where the cash flows are either independent of or move linearly with market movements, a method has been applied known as the 'certainty equivalent' approach whereby it is assumed that all assets earn the risk-free rate and all cash flows are discounted at the risk-free rate.
A market consistent approach has been adopted for the valuation of financial options and guarantees, using a stochastic option pricing technique calibrated to be consistent with the market price of relevant options at each valuation date. The risk free rate used for the value of financial options and guarantees is defined as the spot yield derived from the UK gilt yield curve in line with Scottish Widows' FSA realistic balance sheet assumptions.
The valuation of the Group's annuity business has been affected by the recent upheaval in the capital markets which has caused a significant widening in corporate bond spreads in 2008. Based on available market analysis, an element of this widening in corporate bond spreads has been assessed as arising from an increase in the illiquidity premium. Annuity contracts cannot be surrendered and have reasonably certain cash flows best matched by assets of equivalent maturity with similar liquidity characteristics. As a result, in 2008 the value of in-force business asset for annuity business has been calculated after taking into account an estimate of 154 basis points for the market premium for illiquidity, which has been derived from market and other published sources using a portfolio of investment grade bonds with similar cash flow characteristics as the annuity liabilities. The effect of this has been to increase the value of in-force business by £842 million as at 31 December 2008 with a similar increase in profit before tax. This is reflected as an economic variance in the table above, together with other market movements.
The risk free rate assumed in valuing the in-force asset for annuity business is presented as a single risk free rate to allow easier comparison to the rate used for other business. That single risk free rate has been derived to give the equivalent value to the annuity book, had the book been valued using the UK gilt yield curve increased to reflect the illiquidity premium as described above. For 2008, the risk-free rate assumed in valuing the in-force asset for non-annuity business is the 15-year gilt yield.
The table below shows the range of resulting yields and other key assumptions at 31 December:
|
2008 |
2007 |
||
|---|---|---|---|
|
Risk-free rate (value of in-force non-annuity business) |
3.74 |
4.65 |
|
|
Risk-free rate (value of in-force annuity business) |
5.22 |
4.65 |
|
|
Risk-free rate (financial options and guarantees) |
1.11 to 4.24 |
4.28 to 4.81 |
|
|
Retail price inflation |
2.75 |
3.28 |
|
|
Expense inflation |
3.50 |
4.18 |
Non-market risk
An allowance for non-market risk is made through the choice of best estimate assumptions based upon experience, which generally will give the mean expected financial outcome for shareholders and hence no further allowance for non-market risk is required. However, in the case of operational risk and the With Profit Fund there are asymmetries in the range of potential outcomes for which an explicit allowance is made.
Non-economic assumptions
Future mortality, morbidity, lapse and paid-up rate assumptions are reviewed each year and are based on an analysis of past experience and represent management's best estimate of likely future experience.
Further information about the effect of changes in key assumptions is given in note 32.