Notes to the consolidated financial statements

• « 31 Debt securities in issue
• 32 Liabilities arising from insurance contracts
  and participating investment contracts
• 33 Life insurance sensitivity analysis »

32 Liabilities arising from insurance contracts and participating investment contracts

	2008 £m		2007 £m
Insurance contract liabilities	22,173		23,189
Participating investment contract liabilities	11,619		14,874
	33,792		38,063

At 31 December 2008 £29,967 million (2007: £35,603 million) of liabilities arising from insurance contracts and participating investment contracts had a contractual residual maturity of greater than one year.

Insurance contract liabilities

Insurance contract liabilities, substantially all of which relate to business written in the United Kingdom, are comprised as follows:

	2008						2007
	Gross £m		Reinsurance* £m		Net £m		Gross £m		Reinsurance* £m		Net £m
Life insurance (see (1))	21,518		(380)		21,138		22,526		(340)		22,186
Non-life insurance (see (2) below):
Unearned premiums	472		–		472		456		–		456
Claims outstanding	183		(5)		178		207		(10)		197
	655		(5)		650		663		(10)		653
	22,173		(385)		21,788		23,189		(350)		22,839

*Reinsurance balances receivable are reported within other assets (note 27).

(1) Life insurance

The movement in life insurance contract liabilities over the year can be analysed as follows:

	Gross £m		Reinsurance £m		Net £m
At 1 January 2007	25,763		(425)		25,338
New business	2,428		(18)		2,410
Changes in existing business	(1,316)		15		(1,301)
Disposal of businesses	(4,349)		88		(4,261)
At 31 December 2007	22,526		(340)		22,186
New business	2,915		(32)		2,883
Changes in existing business	(3,923)		(8)		(3,931)
At 31 December 2008	21,518		(380)		21,138

The movement in liabilities arising from participating investment contracts may be analysed as follows:

	£m
At 1 January 2007	15,095
New business	491
Changes in existing business	(712)
At 31 December 2007	14,874
New business	208
Changes in existing business	(3,463)
At 31 December 2008	11,619

Process for determining key assumptions

The process for determining the key assumptions for insurance contracts and participating investment contracts is set out below.

These policy liabilities can be split into With Profit Fund liabilities, accounted for using the FSA's realistic capital regime (realistic liabilities) and Non-Profit Fund liabilities, accounted for using a traditional prospective actuarial discounted cash flow methodology as described in the accounting policies.

With Profit Fund realistic liabilities

The Group's With Profit Fund contains life insurance contracts and participating investment contracts. The calculation of With Profit Fund realistic liabilities uses best estimate assumptions for mortality, persistency rates and expenses. These are calculated in a similar manner to those used for the value of in-force business as discussed in note 24. The persistency rates used for the realistic valuation of the With Profit Fund liabilities make an allowance for potential changes in future experience as the guarantees and options within with-profits contracts become more valuable under adverse market conditions.

Other key assumptions are:

Investment returns and discount rates

The realistic capital regime dictates that With Profit Fund liabilities are valued on a market-consistent basis. This is achieved by the use of a valuation model which values liabilities on a basis calibrated to tradable market option contracts and other observable market data. The With Profit Fund financial options and guarantees are valued using a stochastic simulation model where all assets are assumed to earn, on average, the risk-free yield and all cash flows are discounted using the risk-free yield. The risk-free yield is defined as the spot yield derived from the UK gilt yield curve.

Guaranteed annuity option take-up rates

The guaranteed annuity option take-up rates are set with regard to the Group's actual experience and make allowance for potential increases in take-up rates when the Guaranteed Annuity Options become more valuable to the policyholder.

Investment volatility

The calibration of the stochastic simulation model uses implied volatilities of derivatives where possible, or historical volatility where it is not possible to observe meaningful prices. For example, as at 31 December 2008, the 10 year equity-implied at-the-money assumption was set at 34.6 per cent (31 December 2007: 25.5 per cent). The assumption for property volatility was 15 per cent (31 December 2007: 15 per cent), with swaption volatility of broadly 16 per cent (31 December 2007: broadly 11 per cent).

Mortality

The mortality assumptions, including allowances for improvements in longevity for annuitants, are set with regard to the Group's actual experience where this is significant, and relevant industry data otherwise.

Lapse rates

Lapse rates refer to the rate of policy termination and the rate at which policyholders stop paying regular premiums. These rates are based on a combination of historical experience and management's views on future experience taking into consideration potential changes in future experience that may result from guarantees and options becoming more valuable under adverse market conditions.

Non-Profit Fund liabilities

Generally, assumptions used to value Non-Profit Fund liabilities are prudent in nature and therefore contain a margin for adverse deviation. This margin for adverse deviation is based on management's judgement and reflects management's views on the inherent level of uncertainty. The key assumptions used in the measurement of Non-Profit Fund liabilities are:

Interest rates

The rates used are derived in accordance with the FSA Rules. These limit the rates of interest that can be used by reference to a number of factors including the redemption yields on fixed interest assets at the valuation date.

Margins for risk are allowed for in the assumed interest rates. These are derived from the limits in the FSA Rules, including reductions made to the available yields to allow for default risk based upon the credit rating of each stock.

Mortality and morbidity

The mortality and morbidity assumptions, including allowances for improvements in longevity for annuitants, are set with regard to the Group's actual experience where this provides a reliable basis, and relevant industry data otherwise, and include a margin for adverse deviation.

Lapse rates

Lapse rates, set with regard to the Group's actual experience and with a margin for adverse deviation, are allowed for on some Non-Profit Fund contracts.

Maintenance expenses

Allowance is made for future policy costs explicitly. Expenses are determined by reference to an internal analysis of current and expected future costs plus a margin for adverse deviation. Explicit allowance is made for future expense inflation.

Key changes in assumptions

During 2008, following a detailed review of the Group's current and expected experience, there has been a change in the key assumption in respect of lapse and paid-up rates. The impact of this change has been to decrease profit before tax by £143 million; this amount includes movements in liabilities and value of the in-force business in respect of insurance contracts and participating investment contracts.

(2) Non-life insurance

Gross non-life insurance contract liabilities are analysed by line of business as follows:

	2008 £m		2007 £m
Credit protection	293		274
Home	359		385
Health	3		4
	655		663

For non-life insurance contracts, the methodology and assumptions used in relation to determining the bases of the earned premium and claims provisioning levels are derived for each individual underwritten product. Assumptions are intended to be neutral estimates of the most likely or expected outcome. There has been no significant change in the assumptions and methodologies used for setting reserves.

The reserving methodology and associated assumptions are set out below:

The unearned premium reserve is determined on a basis that reflects the length of time for which contracts have been in force and the projected incidence of risk over the term of each contract.

Claims outstanding comprise those claims that have been notified and those that have been incurred but not reported. Claims incurred but not reported are determined based on the historical emergence of claims and their average cost. The notified claims element represents the best estimate of the cost of claims reported using projections and estimates based on historical experience.

The movements in non-life insurance contract liabilities and reinsurance assets over the year have been as follows:

	Gross £m		Reinsurance £m		Net £m
Provisions for unearned premiums
At 1 January 2007	438		–		438
Increase in the year	632		(23)		609
Release in the year	(614)		23		(591)
At 31 December 2007	456		–		456
Increase in the year	651		(23)		628
Release in the year	(635)		23		(612)
At 31 December 2008	472		–		472

These provisions represent the liability for short-term insurance contracts for which the Group's obligations are not expired at the year end.

	Gross £m		Reinsurance £m		Net £m
Claims and loss adjustment expenses
Notified claims	127		(4)		123
Incurred but not reported	22		–		22
At 1 January 2007	149		(4)		145
Cash paid for claims settled in the year	(275)		–		(275)
Increase (decrease) in liabilities:
Arising from current year claims	341		(9)		332
Arising from prior year claims	(8)		3		(5)
At 31 December 2007	207		(10)		197
Cash paid for claims settled in the year	(245)		7		(238)
Increase (decrease) in liabilities:
Arising from current year claims	221		–		221
Arising from prior year claims	–		(2)		(2)
At 31 December 2008	183		(5)		178
Notified claims	160		(5)		155
Incurred but not reported	23		–		23
At 31 December 2008	183		(5)		178
Notified claims	188		(10)		178
Incurred but not reported	19		–		19
At 31 December 2007	207		(10)		197

Non-life insurance claims development table

The development of insurance liabilities provides a measure of the Group's ability to estimate the ultimate value of claims. The top half of the table below illustrates how the Group's estimate of total claims outstanding for each accident year has changed at successive year ends. The bottom half of the table reconciles the cumulative claims to the amount appearing in the balance sheet. The accident year basis is considered the most appropriate for the business written by the Group.

Non-life insurance all risks – gross

	2004 £m	2005 £m	2006 £m	2007 £m	2008 £m	Total £m
Accident year
Estimate of ultimate claims costs:
At end of accident year	227	211	208	317	205	1,168
One year later	209	207	206	311
Two years later	207	204	204
Three years later	206	202
Four years later	206
Current estimate of cumulative claims	206	202	204	311	205	1,128
Cumulative payments to date	(204)	(197)	(195)	(265)	(99)	(960)
Liability recognised in the balance sheet	2	5	9	46	106	168
Liability in respect of earlier years						8
Total liability included in the balance sheet						176

The liability of £176 million shown in the above table excludes £7 million of unallocated claims handling expenses.