7th Dec 2006 13:33
Resolution PLC07 December 2006 7 December 2006 RESOLUTION PLC APPLIES ITS EUROPEAN EMBEDDED VALUE ("EEV") PRINCIPLES TO THE BUSINESSES ACQUIRED FROM ABBEY NATIONAL PLC Following the acquisition of the U.K. and offshore life insurance businesses ofAbbey National plc ("Abbey"), Resolution plc ("Resolution") has today announcedthe embedded value of the acquired businesses as at 30 June 2006, usingResolution's EEV methodology. • The EEV of the acquired businesses at 31 December 2005 was estimated at£3,770 million based on Resolution's methodology. • As at 30 June 2006, the embedded value of the acquired businesses hadincreased to £3,814 million reflecting the value of new business, the expectedreturn for the six months, movements in fixed interest yields and related timingof tax relief. • The effect of the acquisition and associated rights issue of £1,547million is to produce a pro forma embedded value for the group of £3,877 millionat 30 June 2006. This is equivalent to an embedded value per share of £5.66based on 685 million shares in issue following the completion of the rightsissue. The pro forma embedded value makes no allowance for: - the value of targeted acquisition expense synergies (estimated to be£10 million p.a. by end 2008, reducing thereafter) - the value of targeted asset management synergies from theacquisition (estimated at£7 million p.a. in 2007, reducing thereafter) - the present value of the targeted financial synergies arising fromthe acquisition (estimated at £114 million) - the value of the new business distribution capability, for which£100 million of the purchase consideration has been attributed - a significant proportion of the synergies from the earlier mergerbetween Britannic plc and Resolution Life Group Limited • On a pro forma basis the gearing ratio for the gross MCEV is 29.8 percent at 30 June 2006 following the repayment of £1.3 billion of the originalfunding for the acquisition. Paul Thompson, Group Chief Executive of Resolution plc commented: "We are pleased to announce that the EEV of the acquired businesses is broadlyin line with our expectations at the time of acquisition and consistent with theachievement of delivering an internal rate of return from the transaction of atleast 16%, post leverage, to shareholders." Analysts: There will be a presentation at 3.30 p.m. (UK time) today at 60 CannonStreet, London, EC4N 6JP. Slides will be available from 3.30 p.m. (UK time) atwww.resolutionplc.com. Enquiries: Ian Maidens Group Chief Actuary & Head of Corporate Development +44 (0)20 7489 4863 Jim Newman Group Financial Controller +44 (0)20 7489 4879 Steve Riley Investor Relations Director +44 (0)20 7489 4884 Media: Alex Child-Villiers Temple Bar Advisory +44 (0)7795 425 580 RESOLUTION PLC EUROPEAN EMBEDDED VALUE AS AT 30 JUNE 2006 OF LIFE BUSINESSES ACQUIRED FROMABBEY NATIONAL PLC 7 December 2006 This statement may contain certain "forward-looking statements" with respect tocertain of Resolution's plans and its current goals and expectations relating toits future financial condition, performance, results, strategy and objectives.Statements containing the words "believes", "intends", "expects", "plans", "seeks" and "anticipates", and words of similar meaning, are forward-looking. Bytheir nature, all forward-looking statements involve risk and uncertaintybecause they relate to future events and circumstances which are beyondResolution's control including, among other things, UK domestic and globaleconomic and business conditions, market related risks such as fluctuations ininterest rates and exchange rates, and the performance of financial marketsgenerally; the policies and actions of regulatory authorities, the impact ofcompetition, inflation, and deflation; experience in particular with regard tomortality and morbidity trends, lapse rates and policy renewal rates; thetiming, impact and other uncertainties of future acquisitions or combinationswithin relevant industries; and the impact of changes in capital, solvency oraccounting standards, and tax and other legislation and regulations in thejurisdictions in which Resolution affiliates operate. This may for exampleresult in changes to assumptions used for determining results of operations orre-estimations of reserves for future policy benefits. As a result Resolution'sactual future financial condition, performance and results may differ materiallyfrom the plans, goals, and expectations set forth in Resolution'sforward-looking statements. Resolution undertakes no obligation to update theforward-looking statements contained in this statement or any otherforward-looking statements it may make. Table of Contents 1. INTRODUCTION.......................................................... 5 2. RESOLUTION'S EEV METHODOLOGY.......................................... 6 3. EEV OF ACQUIRED BUSINESSES AT 30 JUNE 2006 ........................... 8 4. POST-COMPLETION EEV AT 30 JUNE 2006...................................13 5. PRO FORMA EEV OF RESOLUTION POST-ACQUISTION....................... 16 6. EEV ASSUMPTIONS ..................................................... 22 7. ERNST & YOUNG PROCEDURES ............................................ 23 ANNEX 1 - CAPITAL MANAGEMENT POLICY ..........................................26 1. introduction On 7 June 2006, Resolution plc ("Resolution") announced its intention to acquirethe U.K. and offshore life insurance businesses of Abbey National plc ("Abbey")together with the associated new business infrastructure and service companies(the "Acquisition"). The Acquisition completed on 1 September 2006. The acquired businesses had an estimated value on Resolution's European EmbeddedValue ("EEV") basis at 31 December 2005 of £3,770 million, with Resolutionaccruing any change in embedded value between that date and completion of theAcquisition. The purpose of this document is to set out the value of the acquired businesseson Resolution's EEV basis, allowing for harmonisation of methodology andassumptions with Resolution's existing businesses as at 30 June 2006. It alsosets out the pro forma value of Resolution on an EEV basis assuming theAcquisition and related rights issue had completed on 30 June 2006. At 30 June 2006 the embedded value of Resolution's existing businesses was£2,215 million, equivalent to a value of £5.34 per share after restatement forthe effects of the rights issue on9 August 2006. The impact of the Acquisition is to increase the embedded valueper share to £5.66 at 30 June 2006. The EEV for the acquired businesses at 31 December 2005 and 30 June 2006 areshown in the table below. EEV for acquired businesses (£m) Pro forma 31 December 2005 Pro forma 30 Change June 2006 Adjusted net worth 2,287 2,489 +8.8%Value of in-force 1,483 1,325 -10.7%Embedded value 3,770 3,814 +1.2% Notes: (1) Pro forma EEV shown on a comparable basis with disclosures onannouncement of the Acquisition (2) All figures shown before adjustment for loans from acquired lifecompanies in September 2006 The remainder of this document gives detailed information on how Resolution hasapplied its EEV methodology to the acquired businesses and the pro forma groupembedded value. 2. RESOLUTION's EEV METHODOLOGY 2.1 Overview In implementing the EEV Principles, Resolution has adopted a "bottom-up"market-consistent approach. In principle, each cash flow is valued using adiscount rate that allows for the financial risks within that cash flow. Inpractice, we have calculated the market-consistent embedded value allowing forthe cost of options and guarantees, the cost of holding required capital and theimpact of non-market risks. We then derive risk discount rates that, when inputinto the traditional embedded value models, produce the same result as themarket-consistent embedded value. The derived risk discount rates vary by both product type and life company, andare shown in section 3.6. The key features of Resolution's methodology are highlighted below. 2.2 Intrinsic burn-through costs Within our existing businesses, there is an explicit allowance for the "intrinsic burn-through" cost in Phoenix & London Assurance Limited and Alba LifeLimited. This feature does not apply to any of the with-profits funds acquiredfrom Abbey. 2.3 Value of debt and minority interests The £200 million of subordinated debt within Scottish Mutual Assurance Limited("SMA") has been valued on a market-consistent basis. The impact of thisapproach is to increase the value of debt by £16.7 million, compared with theface value of the debt. 2.4 Valuation of in-force business Within the market-consistent embedded value, the value of in-force business ("VIF") is calculated using the "certainty equivalent" approach where the assumedfuture investment returns and the risk discount rate are both set equal to therisk-free rate. 2.5 Allowance for the cost of financial options and guarantees Under the market-consistent EEV ("MCEV") basis, there are two elements to thecost of financial options and guarantees: a) the intrinsic cost of financial options and guarantees based on theassumed risk-free future investment returns; and b) the time value of the cost of financial options and guarantees usingmarket-consistent stochastic models calibrated to market prices at 30 June 2006. Within the time value of financial options and guarantees, allowance has alsobeen made for the impact of non-market risk where, as a result of asymmetries inthe shareholder interest in the with-profits funds, best estimate assumptions donot fully reflect the impact of extreme events. 2.6 Allowance for non-market risk on non-profit business The EEV assumptions are based on best estimates of future experience. However,in practice there are asymmetries in the value of in-force business where thebest estimate assumptions do not fully reflect the impact of extreme events. The methodology used to determine the appropriate allowance for non-market riskis based on the analysis undertaken as part of the application of Resolution'sindividual capital assessment ("ICA") methodology to the acquired businesses. The non-market risks considered include: longevity, mortality and operationalrisk. 2.7 Cost of required capital The required capital for each of the acquired life companies has been defined asthe greater of: a) the minimum amount of capital required to meet the Financial ServicesAuthority's ("FSA") capital adequacy requirements; b) the capital required under Resolution's published capital managementpolicy (as set out in Annex 1); and c) the commitments made to credit rating agencies. The cost of capital under a market-consistent embedded value is the differencebetween the market value of the required capital and the market-consistent valueof the future release of capital, allowing for the impact of tax and investmentexpenses. 2.8 Cost of group required capital Resolution holds capital at group level in order to meet the commitments made tocredit rating agencies. Under EEV we have included this capital in ourdefinition of required capital and have allowed for the frictional costs ofholding this capital. 2.9 Harmonisation Certain experience and embedded value methodology assumptions have been adjustedto ensure consistency with Resolution's existing approach. 3. EEV results for the acquired businessES at 30 June 2006 3.1 EEV at 30 June 2006 The pro forma embedded values for the acquired businesses on the EEV basis at 31December 2005 and 30 June 2006 are shown in the table below. EEV for acquired businesses (£m) Pro forma 31 December Pro forma 30 Change 2005 June 2006 Adjusted net worth 2,287 2,489 +8.8%Value of in-force 1,483 1,325 -10.7%Embedded value 3,770 3,814 +1.2% Notes: (1) Pro forma EEV shown on a comparable basis with disclosures on announcementof the Acquisition (2) All figures shown before adjustment for loans from acquired life companiesin September 2006 3.2 Change in EEV during first 6 months of 2006 The table below sets out the movement from the estimated EEV at 31 December 2005to the EEV at 30 June 2006. £m Net of tax impactEstimated EEV for acquired businesses at 31 December 2005 3,770Movements for the six months ended 30 June 2006 Contribution from new business 21 Expected return on in-force business 87 Expected profit 108 Persistency assumption changes (15) Longevity assumption changes (24) Harmonisation and other changes 45 Tax variance (47) Economic effects (23) 44EEV for acquired businesses at 30 June 2006 3,814 New business added value The new business added value of £21 million reflects the actual business sold inthe first 6 months of 2006, on the pricing and commission terms in force at thattime, valued on a market-consistent basis. We estimate that the equivalentvalue on post acquisition commission terms would have been £18 million. Expected return on existing business The expected return on existing business reflects the expected change in thevalue of in-force business and the expected return on shareholders' net worthwithin the long term business funds, based on the real world investmentassumptions at 31 December 2005. Changes to persistency and longevity assumptions The reductions of £15 million for persistency assumptions and of £24 million forlongevity assumptions reflect the strengthening of the embedded valueassumptions in line with the changes identified as being required during the duediligence exercise which preceded the Acquisition. Harmonisation and other changes There were a number of harmonisation and other revisions during the first 6months of 2006 which resulted in a net increase of £45 million. These includedharmonising the individual capital assessments (and the subsequent impact on thenon-market risk allowance); improvements made to modelling systems and closerharmonisation of reserving methodologies as recognised at the time of the duediligence exercise which preceded the Acquisition. Tax variance The adverse tax variance of £47 million primarily reflects a change in thetiming of the utilisation of tax losses. This is the result of changes in giltrates and the movement in the yield curve during the period 6 months ended 30June 2006. Economic effects The adverse economic experience of £23 million arose primarily from the changein the shape and level of the risk-free yield curve during the first 6 months of2006. 3.3 Adjusted net worth A reconciliation of the adjusted net worth under the IFRS and EEV bases is shownin the table below. Reconciliation to IFRS net worth for the acquired businesses at 30 June 2006 (£m)IFRS net worth 3,052Pension fund deficit 110Goodwill and other intangible assets (69)Acquired in-force business (507)Deferred acquisition costs and deferred income (381)Reserve changes 48Mark to market of SMA subordinated debt (17)Taxation (including tax on adjustments) 253EEV adjusted net worth 2,489 The net worth of the acquired businesses at 30 June 2006 on an IFRS basis was£3,052 million. The IFRS basis of preparation at 30 June 2006 does notincorporate the changes that will arise following the acquisition by Resolutionand that will be reflected in the acquisition balance sheet. However, for EEVpurposes certain adjustments have been made to net worth to reflect the impactof the Acquisition, as discussed below. The pension fund deficit has been eliminated as Resolution does not haveresponsibility for funding the deficit from the date of Acquisition and thiswill be reflected in the acquisition balance sheet. Goodwill and otherintangible assets have been eliminated as they relate to the acquisition ofScottish Provident Limited ("SPL") and therefore only represent intangibleassets for part of the business. Furthermore, any goodwill or value attributedto other intangible assets for the whole of the acquired businesses would onlyappear in Resolution's 2006 group financial statements. The acquired in-forcebusiness value has been eliminated as this arises mainly from the acquisition ofSPL and is replaced by the value of in-force for the acquired life businesses onan EEV basis. Deferred acquisition costs and deferred revenue are eliminated as the financialimpact of these items is already included in the cash flows used to calculatethe EEV value of in-force business. In addition, changes to certain reserves fornon-participating business have been made in moving from IFRS to EEV net worth. As part of the Acquisition, Resolution acquired the listed subordinated debt ofSMA. The SMA debt has been marked to market in compliance with EEV requirementsand Resolution's overall approach to the valuation of debt. The above adjustments have, where appropriate, been adjusted for taxation andcertain other changes to taxation have been made in moving from IFRS to EEV networth. 3.4 Required capital The market-consistent cost of holding the required capital is £83.8 million. The required capital within the acquired businesses, after application ofResolution's capital management policy, along with the regulatory requiredcapital is shown in the table below. EEV Regulatory EEV as percentage Cost of required required of regulatory capital capital capital required capital (£m) (£m) (£m)Shareholder capital supporting capital 819.8 510.5 161% 79.7requirementsWith-profit fund capital supporting 1,510.4 1,487.5 102% -capital requirementsTotal 2,330.2 1,998.0 117% 79.7Shareholder capital supporting group 29.0 - n/a 4.1credit ratingTotal 2,359.2 1,998.0 118% 83.8 Resolution's capital management policy for the acquired businesses is set out inAnnex 1. The shareholder capital supporting the group's credit rating is inrespect of the SMA bonds. Whilst these bonds are a liability of SMA, capitalequivalent to two years' interest payments is held at group level in accordancewith the group's rating agency commitments. 3.5 Components of Market-Consistent Embedded Value at 30 June 2006 The acquired businesses MCEV is set out below. Components of market-consistent embedded value at 30 June 2006 (£m) Net Intrinsic Good-will Adjusted Certainty Time value Allowance Cost of Total worth burn-through net worth equivalent of for non- required MCEV cost VIF options & market capital guarantees risksLife Division NorthScottish Mutual 1,446.1 - - 1,446.1 770.0 (41.1) (47.3) (52.9) 2,074.8Scottish Provident 886.0 - - 886.0 453.4 (15.5) (17.0) (15.1) 1,291.8Phoenix Life 372.8 - - 372.8 227.1 - (9.7) (9.5) 580.7Assurance*Scottish Mutual 170.5 - - 170.5 35.3 - (3.3) (2.2) 200.3InternationalLDN holding (293.3) - - (293.3) - - - - (293.3)companiesTotal Life Division 2,582.1 - - 2,582.1 1,485.8 (56.6) (77.3) (79.7) 3,854.3NorthScottish Provident 41.6 - - 41.6 57.9 - (2.0) - 97.5InternationalManagement services 41.9 - - 41.9 - - - - 41.9Asset management 40.7 - - 40.7 - - - - 40.7Group - - - - - - - (4.1) (4.1)Gross embedded 2,706.3 - - 2,706.3 1,543.7 (56.6) (79.3) (83.8) 4,030.3value Scottish Mutual (216.7) - - (216.7) - - - - (216.7)bonds Net embedded value 2,489.6 - - 2,489.6 1,543.7 (56.6) (79.3) (83.8) 3,813.6 Notes: (1) Group cost of capital relates to the cost of holding required capital forthe SMA bonds * Formerly Abbey National Life plc 3.6 Derived risk discount rates by product group Having calculated the market-consistent embedded value at 30 June 2006 for theacquired businesses, the implied risk discount rates by product group werederived, as shown in the table below. Derived risk discount rates by product group at 30 June 2006 With-profits Annuities Unit-linked Other non-profit Weighted totalRisk free rate 4.8% 4.8% 4.8% 4.8% 4.8%Impact of:Bottom-up market risk 1.1% 0.0% 0.3% (0.2)% 0.1%Cost of options &guarantees- market risks 0.7% 0.1%- non-market risks 0.8% 0.2%Other non-market risk 0.2% 1.1% 0.8% 0.8%Risk discount rate 7.4% 5.0% 6.2% 5.4% 6.0%EEV VIF £100m £32m £660m £576m £1,325m Notes: (1) With-profits business relates to the SPL fund only as VIF plusburn-through and cost of capital of conventional with-profits business withinSMA is negative (£40 million) (2) Weighted total includes the estimated impact of the group cost ofcapital on SMA bonds and the with-profit business in SMA (3) UWP business VIF and non-market risk within Scottish Mutual and ScottishProvident is included within the unit-linked analysis The EEV VIF shown in the table above comprises the certainty equivalent presentvalue of future profits less the cost of options and guarantees, the allowancefor non-market risks and the cost of required capital. The key observations from the table above are: • The derived risk discount rates on annuity and other non-profit businessreflect the relatively high proportion of gilts and cash equivalents backing theliabilities and the resulting low levels of market risk compared with theassumed risk-free returns. • Within the unit-linked business we have included the unitisedwith-profits business written in SMA and SPL which accounts for around 35% ofthe linked business (by reserves). The majority of charges applied to theseunitised with-profits contracts are based on smoothed unit values which reducesthe level of market risk. 4. post-completion EEv at 30 june 2006 4.1 Pro forma MCEV post-completion Following completion, the following corporate actions were taken: • Resolution's capital management policy was adopted • Individual capital assessments were updated in line with Resolution'sexisting methodology • Loans of £1,650 million were made from the acquired life companies toResolution Life Limited ("RLL"): - Scottish Mutual Assurance Limited loaned £790 million - Scottish Provident Limited loaned £660 million - Phoenix Life Assurance Limited loaned £200 million • A capital injection of £215 million was made to RLL Holdings Limited ("RLLHL") by RLL • RLLHL sold Scottish Provident International Life Assurance Limited andits parent company to RLL for £85 million • RLLHL repaid an outstanding loan of £292 million to SPL • The management services business paid a £30 million dividend to RLL The pro forma MCEV for the acquired businesses, allowing for these actions isshown below: Pro forma MCEV of acquired businesses at 30 June 2006 (£m) Net Intrinsic Good-will Adjusted Certainty Time value Allowance Cost of Total worth burn-through net equivalent of for non- required MCEV cost worth VIF options & market capital guarantees risksLife Division NorthScottish Mutual 656.1 - - 656.1 770.0 (41.1) (47.3) (52.9) 1,284.8Scottish Provident 226.0 - - 226.0 453.4 (15.5) (17.0) (15.1) 631.8Phoenix Life Assurance* 172.8 - - 172.8 227.1 - (9.7) (9.5) 380.7Scottish Mutual 170.5 - - 170.5 35.3 - (3.3) (2.2) 200.3InternationalLDN holding companies 6.7 - - 6.7 - - - - 6.7Total Life Division 1,232.1 - - 1,232.1 1,485.8 (56.6) (77.3) (79.7) 2,504.3NorthScottish Provident 41.6 - - 41.6 57.9 - (2.0) - 97.5InternationalManagement services 11.9 - - 11.9 - - - - 11.9Asset management 40.7 - - 40.7 - - - - 40.7Group - - - - - - - (4.1) (4.1)Gross embedded value 1,326.3 - - 1,326.3 1,543.7 (56.6) (79.3) (83.8) 2,650.3 Scottish Mutual bonds (216.7) - - (216.7) - - - - (216.7) Net embedded value 1,109.6 - - 1,109.6 1,543.7 (56.6) (79.3) (83.8) 2,433.6 Notes: (1) Group cost of capital relates to the cost of holding required capitalfor the SMA bonds * Formerly Abbey National Life plc 4.2 Sensitivities The table below summarises the key sensitivities to the EEV based on thepost-completion pro forma position at 30 June 2006. EEV sensitivities at 30 June 2006 Change in EEV % Change (£m)Base EEV at 30 June 2006 2,433.6100 basis point increase in risk discount rates (116.2) -4.8%100 basis point increase in equity and property returns n/a100 basis point decrease in risk-free rates 20.3 0.8%10% reduction in market values of equity and property assets (35.7) -1.5%10% proportionate decrease in lapse rates and PUP rates 34.3 1.4%10% proportionate increase in lapse rates and PUP rates (33.8) -1.4%5% proportionate decrease in mortality and morbidity (annuity) (13.2) -0.5%5% proportionate decrease in mortality and morbidity (assurance) 22.3 0.9%Decrease in required capital to statutory minimum 28.7 1.2% 100 basis point increase in risk discount rates The reduction in EEV of £116.2 million arises from increasing the risk discountrates derived in section 3.6 by 1%. 100 basis point increase in equity and property returns There is no impact on the EEV of an increase in equity or property returnsbecause under a market-consistent valuation, all assets are assumed to earn therisk-free rate of return. 100 basis point decrease in risk-free rates EEV increases by £20.3 million, arising from a number of different effects. Thereduction in cost of capital and increase in VIF outweigh the revaluation ofassets and increase in financial options and guarantees. 10% reduction in market values of equity and property assets A 10% immediate reduction in the market value of equity and property assetsleads to a reduction in the EEV of £35.7 million. 10% proportionate decrease in lapse rates and PUP rates A decrease in lapse and paid-up ("PUP") rates across all product lines andcompanies results in a £34.3 million increase in the EEV. 10% proportionate increase in lapse rates and PUP rates The impact of an increase in lapse and PUP rates across all product lines andcompanies is symmetrical with the previous sensitivity and leads to a reductionof £33.8 million in the EEV. 5% proportionate decrease in mortality and morbidity (annuity) A 5% decrease in the base mortality rates for annuity and morbidity businesswould cause a £13.2 million reduction in the EEV. 5% proportionate decrease in mortality and morbidity (assurance) A 5% decrease in the base mortality rates for assurance and morbidity businesswould cause a £22.3 million increase in the EEV. Decrease in required capital to statutory minimum Altering the definition of required capital to the capital required to meet thestatutory minimum capital requirements would reduce the cost of capital by £28.7million. 5. PRO FORMA EEV OF RESOLUTION POST-ACQUISTION 5.1 Overview Resolution acquired Abbey's life insurance businesses for £3,600 million on 1September 2006. The Acquisition was financed by a rights issue on 9 August 2006which raised £1,547 million and by additional borrowings of £2,230 million madeup of bridging finance of £1,680 million and loan facilities of £550 million.The funding also enabled the group to repay £85 million of existing debt. Following the Acquisition, the acquired life businesses made loans of £1,650million to Resolution Life Limited, the holding company for the life businesses,of which £1,300 million was used to repay a substantial amount of the bridgingfinance on 6 September 2006. The pro forma embedded value results for Resolution have been prepared toreflect the value of the group as if the above transactions had completed by 30June 2006. 5.2 Resolution - pro forma group embedded value as at 30 June 2006 The following table sets out the components of the group pro forma embeddedvalue as at 30 June 2006. Pro forma MCEV development for Resolution as at 30 June 2006 (£m) Published Rights Net debt Abbey Transaction Corporate Loans Debt Mark to Resolution MCEV issue raised companies costs restructure from repaid market pro forma 30/6/06 acquired acquired and MCEV life cost of companies capitalLife Division - - - 3,854.3 - 300.0 (1,650.0) - - 2,504.3NorthLife Division 2,405.5 - - - - (10.6) - - - 2,394.9SouthScottish - - - 97.5 - - - - - 97.5ProvidentInternationalManagement 52.6 - - 41.9 - (30.0) - - - 64.5servicesAsset management 178.0 - - 40.7 - - - - - 218.7Group 154.8 1,547.2 2,145.0 (3,604.1) (85.0) (259.4) 1,650.0 (1,300.0) (3.4) 245.1Gross embedded 2,790.9 1,547.2 2,145.0 430.3 (85.0) - - (1,300.0) (3.4) 5,525.0value Perpetual reset (491.3) - - - - - - - - (491.3)capitalsecuritiesResolution (85.0) - 85.0 - - - - - - -senior debtBridging finance - - (1,680.0) - - - - 1,680.0 - -Resolution term - - (550.0) - - - - - (1.5) (551.5)loanBridging finance - - - - - - - (380.0) (9.0) (389.0)SMA bonds - - - (216.7) - - - - - (216.7)Total debt (576.3) - (2,145.0) (216.7) - - - 1,300.0 (10.5) (1,648.5)Net embedded 2,214.6 1,547.2 - 213.6 (85.0) - - - (13.9) 3,876.5valueEEV gearing 20.6% - - - - - - - - 29.8%ratio Notes: (1) EEV gearing ratio is total debt divided by gross embedded value Abbey companies acquired The total value of the acquired businesses at 30 June 2006 was £3,813.6 million,including a charge for cost of capital in respect of the SMA bonds of £4.1million. The purchase price of £3,600 million therefore gives a net increase invalue of £213.6 million. The purchase price included £100 million attributed tothe new business capability. However, no value has been attributed to the newbusiness capability for EEV reporting purposes as it is our intent to onlyrecognise income arising from distribution capability when new business iswritten. Corporate restructuring The corporate restructuring adjustments in the above table reflect thefollowing: • The establishment of Life Division North ("LDN") as a separate reportingunit; comprising the acquired life businesses and related immediate holdingcompany (RLLHL). • The payment of a £30 million dividend from the acquired businesses'management services company to RLL. • The recapitalisation of RLLHL by RLL (£215 million). • The purchase by RLL of Scottish Provident International Life AssuranceLimited and its parent company from LDN (£85 million). • A revision to our previous presentation, to reflect RLL as a groupentity. RLL is now the holding company for both life divisions (North andSouth). Previously RLL was categorised as part of Life Division South. At 30June 2006, RLL had negative net assets of £214.1 million. • A change in EEV accounting policy to show the value of the loans fromboth life divisions, where the payment of a dividend is currently restricted, toRLL as net assets of the group, reflecting more appropriately the economicimpact of these arrangements on the capital base. Life Division South hadoutstanding loans to RLL subject to dividend restrictions totalling £224.7million at 30 June 2006. • Loans totalling £1,650 million were made from LDN to RLL. The group hasretained £50 million as working capital, repaid £1,300 million of itsoutstanding bridging loan and used £300 million to effect this corporaterestructuring. Mark to market and capital required In accordance with commitments given to the group's rating agencies, the groupmaintains cash balances equivalent to at least two years' interest payments onexternal debt. Consequently, there is an additional cost of capital of £3.4million to cover the additional debt taken on as part of the acquisition of theAbbey life businesses. This debt has been priced on a market consistent basis,resulting in a charge of £10.5 million. The resulting embedded value of £3,876.5 million is further analysed in thetable which follows. Pro forma MCEV as at 30 June 2006 (£m) Net worth Intrinsic Goodwill Adjusted Certainty Time value Allowance Cost of Total burn-through net worth equivalent of for non- required MCEV cost VIF options & market capital guarantees risksLife Division North 1,232.1 - - 1,232.1 1,485.8 (56.6) (77.3) (79.7) 2,504.3Life Division South 1,535.7 (124.7) - 1,411.0 1,210.6 (45.1) (71.3) (110.3) 2,394.9Scottish Provident 41.6 - - 41.6 57.9 - (2.0) -International 97.5Total life division 2,809.4 (124.7) - 2,684.7 2,754.3 (101.7) (150.6) (190.0) 4,996.7 Management services 54.5 - 10.0 64.5 - - - - 64.5Asset management 84.2 - 134.5 218.7 - - - - 218.7Group 260.0 - - 260.0 - - - (14.9) 245.1Gross embedded 3,208.1 (124.7) 144.5 3,227.9 2,754.3 (101.7) (150.6) (204.9) 5,525.0value Perpetual reset (491.3) - - (491.3) - - - - (491.3)capital securitiesBridging finance (389.0) - - (389.0) - - - - (389.0)Resolution term (551.5) - - (551.5) - - - - (551.5)loanSMA bonds (216.7) - - (216.7) - - - - (216.7) Net embedded value 1,559.6 (124.7) 144.5 1,579.4 2,754.3 (101.7) (150.6) (204.9) 3,876.5 5.3 Pro forma embedded value per share as at 30 June 2006 The embedded value per share has increased from the rights adjusted value of£5.34 per share at 30 June 2006 for Resolution to a pro forma value of £5.66 pershare after accounting for the acquired businesses. The change in embeddedvalue and embedded value per share is summarised in the table below.Resolution embedded value£million Resolution pre acquisition 30 Resolution post Abbey acquisition June 2006 pro forma 30 June 2006 Adjusted net worth 1,238.1 1,579.4VIF 976.5 2,297.1Embedded value 2,214.6 3,876.5Shares in issue (millions) 362.6 685.0EEV per share* £5.34 £5.66 Notes: * Pre acquisition EEV per share for Resolution at 30 June 2006 is as adjustedfor the rights issue The pro forma embedded value makes no allowance for the targeted expense, assetmanagement and financial synergies or the new business distribution capability.It also does not reflect all of the synergies to be delivered from the earliermerger between Britannic plc and Resolution Life Group Limited. 5.4 Pro forma group EEV derived risk discount rates by product group at 30 June2006 The table below sets out the pro forma discount rates derived for each productgroup, on a group wide basis, by calculating the risk discount rate under atraditional embedded value approach that, together with the economic assumptionsset out in section 6, produces the same result as that derived using themarket-consistent embedded value approach. With-profit Annuities Unit-linked Other Weighted non-profit total SPL BA PLP PALAL Risk free rate 4.8% 4.8% 4.8% 4.8% 4.8% 4.8% 4.8% 4.8% Impact of: Bottom-up market 1.1% 2.0% 1.6% 0.7% 1.1% 0.6% (0.1%) 0.6%risk Cost of optionsand guarantees Market risks 0.7% 0.1% 0.7% 0.1% Non-market risks 0.8% 0.4% 0.3% 0.2% Other non-market 0.3% 1.1% 1.1% 0.8%risk Risk discount rate 7.4% 7.3% 7.4% 5.5% 6.2% 6.5% 5.8% 6.5%at 30 June 2006 VIF (£m) 100 242 142 8 72 905 889 2,297 Notes: (1) Weighted total includes the estimated impact of the with-profitsbusiness in PLL, Century, Cornhill, Alba and SMA as well as the group cost ofcapital 5.5 Pro forma group required capital The pro forma required capital for the group reflects the application ofResolution's capital management policy and is calculated in accordance with thedefinition set out in section 2.7 of this document. The shareholder capital supporting the group credit rating is equivalent to twoyears' interest on the perpetual reset capital securities, the term loans andthe SMA bonds. Group cost of capital and required capital as at 30 June 2006 EEV required Regulatory EEV as percentage Cost of capital capital required capital of regulatory required capital £m £m % £mShareholder capital supporting capital 1,677.0 1,128.6 149% 190.0requirementsWith -profit fund capital supporting 4,036.9 3,876.5 104% -capital requirementsTotal 5,713.9 5,005.1 114% 190.0Shareholder capital supporting group 173.1 - n/a 14.9credit ratingTotal 5,887.0 5,005.1 118% 204.9 5.6 Pro forma group sensitivities The table below summaries the key sensitivities to the EEV for Resolution basedon the post-completion pro forma position at 30 June 2006.EEV sensitivities at 30 June 2006 Change in EEV % Change (£m)Base EEV at 30 June 2006 3,876.5100 basis point increase in risk discount rates (267.7) -6.9%100 basis point increase in equity and property returns n/a100 basis point decrease in risk-free rates (17.2) -0.4%10% reduction in market values of equity and property assets (126.2) -3.3%10% proportionate decrease in lapse rates and PUP rates 32.0 0.8%10% proportionate increase in lapse rates and PUP rates (28.4) -0.7%5% proportionate decrease in mortality and morbidity (annuity) (63.2) -1.6%5% proportionate decrease in mortality and morbidity (assurance) 51.6 1.3%Decrease in required capital to statutory minimum 54.5 1.4% 100 basis point increase in risk discount rates The reduction in the EEV of £267.7 million arises from increasing the derivedrisk discount rates by 1%. 100 basis point increase in equity and property returns There is no impact on the EEV of an increase in equity or property returnsbecause under a market-consistent valuation, all assets are assumed to earn therisk-free rate of return. 100 basis point decrease in risk-free rates The EEV decreases by £17.2 million, arising from a number of different effects.The increase in the cost of financial options and guarantees outweighs thereduction in cost of capital and the increase in VIF. 10% reduction in market values of equity and property assets A 10% immediate reduction in the market values of equity and property assetsleads to a reduction in the EEV of £126.2 million. 10% proportionate decrease in lapse rates and PUP rates A decrease in lapse and PUP rates across all product lines and companies resultsin a £31.9 million increase in the EEV. 10% proportionate increase in lapse rates and PUP rates An increase in lapse and PUP rates across all product lines and companiesresults in a £28.4 million decrease in the EEV. 5% proportionate decrease in mortality and morbidity (annuity) A 5% decrease in the base mortality rates for annuity and morbidity businesswould cause a £63.2 million reduction in the EEV. 5% proportionate decrease in mortality and morbidity (assurance) A 5% decrease in the base mortality rates for assurance and morbidity businesswould cause a £51.6 million increase in the EEV. Decrease in required capital to statutory minimum Altering the definition of required capital to the capital required to meet thestatutory minimum capital requirements would reduce the cost of capital by £54.4million. 6. EEV assumptions 6.1 Economic assumptions The gilt yield at 30 June 2006 was 4.7% (defined as the annualised return on theFTSE UK 15 year gilt index). The risk free yield curve at the valuation date wasdefined as the annually compounded UK nominal spot curve plus 10 basis points.Thus the risk-free rate at 30 June 2006 was assumed to be 4.8%. Having adopted a market-consistent bottom-up approach, the economic assumptionsbelow affect only the derived risk discount rates and do not impact themarket-consistent embedded value. The economic assumptions gross of tax (realworld assumptions) and assumed margin over gilts are shown in the table below. Investment returns by asset class at 30 June 2006 Income Gains Total returnGilts 4.7% - 4.7%Other fixed interest 5.2% - 5.2%Index linked gilts 2.2% 2.5% 4.7%Equities - UK 3.1% 4.1% 7.2%Equities - overseas 2.0% 5.2% 7.2%Property 7.2% - 7.2% 6.2 Expenses The projected per policy expenses are based on the proposed new agreements withResolution's management services company, adjusted to allow for costs incurreddirectly by the acquired life companies (eg regulatory fees). The projected investment expenses are based on the fees agreed with the group'sinternal asset manager (or external fund managers, where appropriate), allowingfor the current and projected future asset mix. Corporate expenses have not been capitalised, and will be included within theincurred expenses for the management services company in each year as theyarise. 6.3 Other assumptions All other assumptions reflect the best estimate of future experience, and arereviewed regularly in the light of emerging data on both industry andcompany-specific experience. 7. ERNST & YOUNG PROCEDURES The Directors Resolution plc Juxon House 100 St Paul's Churchyard London EC4M 8BU Dear Sirs European Embedded Value at 30 June 2006 of life businesses acquired from AbbeyNational plc You have engaged us to perform an audit of the European Embedded Value balancesheet of Resolution plc at 31 December 2006 and our opinion in respect of thatbalance sheet will be included in the Supplementary Information to be publishedwith the 2006 Report and Accounts. You have engaged us to perform certain procedures in respect of the EuropeanEmbedded Value information in respect of the life businesses acquired from AbbeyNational plc ("the former Abbey life businesses") as at 30 June 2006 and thoseprocedures are the subject of this report. Due to the fact that we have notperformed an audit of the balance sheet at 30 June 2006 of Resolution plc or anaudit or review of the balance sheet at 30 June 2006 of the former Abbey lifebusinesses prepared under IFRS or on an embedded value basis, these proceduresdo not constitute an audit or review made in accordance with InternationalStandards on Auditing or International Standards on Review Engagements. In accordance with our engagement letter dated 24 November 2006 we haveundertaken the procedures described below in connection with the marketannouncement (RNS) to be issued by Resolution plc entitled 'European EmbeddedValue as at 30 June 2006 of life businesses acquired from Abbey National plc' ("the EEV information"). Responsibility The Directors are responsible for the preparation of the EEV information, forthe contents of the market announcement and for the development and operation ofthe models used to compute EEVs. It is our responsibility to perform the procedures set out below in respect ofthe EEV information and to report the results of those procedures to you. Scope of work We have performed the procedures detailed below. Our work was undertaken inaccordance with the International Standard on Related Services applicable toagreed-upon procedures engagements. • A comparison of the European Embedded Value methodology applied inrespect of the former Abbey life businesses with the Resolution plc EEVmethodology; • A review of the economic and operating assumptions applied indetermining the EEV of the former Abbey life businesses for consistency withResolution plc EEV policies; • Checking on a sample basis that the models used to compute the EEVfor the former Abbey life businesses reflect the stated methodology; • Checking on a sample basis that the disclosed economic and operatingassumptions have been applied in the models used to compute the EEV for theformer Abbey life businesses; • Agreeing the EEV Information in respect of for the former Abbey lifebusinesses to the output from the models; • Agreeing the pro forma information in sections 5.1 to 5.3 to theunaudited Resolution plc Interim Statement at 30 June 2006 or underlyingaccounting records, as appropriate; • Checking the computation of the pro forma information in sections5.4 to 5.6; and • Agreeing the reconciliation of adjusted EEV net worth to IFRS networth in section 3.3 to underlying accounting records. We did not perform procedures in respect of the change in EEV during the firstsix months of 2006 included at section 3.2. Results of procedures In respect of the procedures listed above: • The European Embedded Value methodology applied to the former Abbeylife businesses is consistent with the Resolution plc EEV methodology; • The economic and operating assumptions are consistent withResolution plc EEV policies; • The models used to compute the EEV reflect the stated methodologyand assumptions; • The EEV Information in respect of the former Abbey life businessesis consistent with the output from the models; • The pro forma information in sections 5.1 to 5.3 is in agreementwith the unaudited Resolution plc Interim Statement at 30 June 2006 orunderlying accounting records, as appropriate; • The pro forma information in sections 5.4 to 5.6 has been properlycomputed; and • The reconciliation of adjusted EEV net worth to IFRS net worth insection 3.3 is in agreement with underlying accounting records. Because the above procedures do not constitute either an audit or a review madein accordance with International Standards on Auditing or InternationalStandards on Review Engagements, we do not express any assurance on the EEVinformation. Had we performed additional procedures or had we performed an audit or review ofthe EEV information in accordance with International Standards on Auditing orInternational Standards on Review Engagements, other matters might have come toour attention that would have been reported to you. This report relates only to the items specified above and does not extend to anyfinancial statements of Resolution plc, taken as a whole. Our report isprepared solely for the purpose set out in the first paragraph of this reportand for your information and is not to be used for any other purpose. Ernst &Young LLP only accepts responsibility to the addressees of this report on thebasis of the engagement letter and assumes no responsibility whatsoever inrespect of or arising out of or in connection with the contents of this reportto parties other than yourselves. If other parties choose to rely, in any way,on the contents of this report, they do so entirely at their own risk. Yours faithfully Ernst & Young LLP London 6 December 2006Annex 1 - capital management policy for acquired businesses The capital management policies for the acquired businesses are set out below: For closed with-profits funds we will hold sufficient capital tocover the greater of: (i) 100% of Pillar 1 CRR plus 50% of (LTICR + RCR); (ii) 140% of ICA; and (iii) 110% of (ICA + ICG) For closed non-profit funds we will hold sufficient capital to coverthe greater of: (i) 125% Pillar 1 CRR; (ii) 140% of ICA; and (iii) 110% of (ICA + ICG) For open non-profit funds we will hold sufficient capital to coverthe greater of: (i) 135% of Pillar 1 CRR; (ii) 150% of ICA; and (iii) 110% of (ICA + ICG) Where: CRR means Capital Resource Requirements LTICR means Long term Insurance Capital Requirement RCR means Resilience Capital Requirement ICA means Individual Capital Assessment ICG means Individual Capital Guidance provided by the FSA To the extent that a particular with-profits fund does not have sufficientcapital to pass this test, additional capital will be retained in a non-profitfund or the shareholders fund of the relevant company to ensure that the companyconcerned satisfies its capital policy in aggregate. Surplus capital inwith-profits funds will not be allowed to cover the capital requirements inrespect of non-profit funds that arise from the above capital policies. This information is provided by RNS The company news service from the London Stock ExchangeRelated Shares:
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