Final Results

5 March 2015

Friends Life Group Limited

Results for the year ended 31 December 2014

Strong cash performance

· Sustainable free surplus £373 million, up 15% (2013: £325 million) and marginally ahead of guidance

· Continued strong performance in Corporate Benefits, positive net fund flows of £0.6 billion, taking assets under administration to £22.0 billion; significant improvement in underlying free surplus, up to £29 million (2013: £11 million)

· IFRS based operating profit before tax of £556 million, up 38% (2013: £402 million)

· MCEV operating profit before tax of £498 million, down 7% (2013: £535 million); mainly due to reduction in VNB

· Value of new business down £47 million to £132 million (including £32 million reduction in Retirement Income VNB) as predicted trends continue

Capital position robust

· Available shareholder assets £1,066 million

· IGCA(i) surplus £2.3 billion, coverage ratio 240%

· Economic capital surplus(i) £3.7 billion, coverage ratio 196%

· Full year dividend of 31.15 pence per share subject to completion of the Proposed Acquisition by Aviva plc (2013: 21.14 pence per share)(ii)

Business highlights

· Successful reallocation of £760 million of annuities from with-profits funds, resulting in a sustainable free surplus ("SFS") benefit of circa £7 million per annum from 2015

· Recapture of £1.6 billion of assets backing annuities in November, resulting in a SFS benefit of circa £13 million per annum from 2015

· Further reallocation of £665 million of annuities completed in the first quarter of 2015 resulting in a SFS benefit of circa £5 million per annum from 2015

· Friends Life has responded strongly to the legislative and regulatory changes to pensions and workplace savings:

· New individual customer platform My Savings on track to be launched in April 2015

· Developed a range of products and services to meet new regulatory requirements, including an income tool, investment risk appetite assessments, retirement planning and tax information and tools

· Invested in the creation of a Retirement Information Centre

· Annuity sales down only 15%, outperforming the market which is down 38%(iii)

· Efficient cost management, with operating expenses down a further 2% to £549 million

· Auto-enrolment activity, which peaked in the first half of 2014, has enrolled 957 schemes this year, contributing to a net increase in members of 169,000 in 2014

· Following the re-platforming of the new business, the International division is on track for re-platforming in-force business during 2015

· Successful sale of Lombard for £316 million, completed in October 2014

Proposed Acquisition of Friends Life Group Limited by Aviva plc

· All share acquisition:

· 0.74 new Aviva shares for each Friends Life Group share

· The proposed second interim dividend includes a 10 pence per share enhancement to the 2013 final dividend

· Value share(iv) will be settled

· Accelerates Friends Life's existing strategy, creating the UK's leading insurance, savings and asset management business:

· Creates the UK's largest back book(v) with the potential to release substantial capital synergies

· Leading market positions in corporate pensions and protection; and one in four retiring defined contribution pension customers(vi)

· Proven track record in the successful integration and delivery of cost savings

· Court and shareholder general meeting to be held on 26 March, completion expected in the second quarter of 2015

Andy Briggs, Group Chief Executive said:

"I am pleased with the progression shown in this year's results, in spite of the unprecedented regulatory and legislative challenges Friends Life, and the UK life insurance industry as a whole, have faced in 2014. We have delivered a substantial improvement in cash today, marginally ahead of guidance, and put ourselves in a strong position to deliver cash tomorrow. I have the utmost confidence in our standalone position, but I'm excited by the opportunity the Aviva deal offers to accelerate our proven, successful strategy."

Enquiries:

Notes

(i) Estimated and unaudited.

(ii) In the event that the Proposed Acquisition does not complete, Friends Life expects that its 2014 final dividend and therefore its 2014 full year dividend would be in line with Friends Life's 2013 final dividend and 2013 full year dividend, respectively.

(iii) Based on ABI data for the first three quarters of 2014.

(iv) Details of the value share arrangement can be found on page 74 of the 2013 Report and Accounts.

(v) Based on analysis of 2013 PRA returns of UK gross reserves. Back book defined as per Friends Life's methodology and includes with-profit products, unit-linked bonds and other legacy products.

(vi) 1 in 4 retiring defined contribution pension customers is based on company data and HMT report published September 2014.

Forward-looking statements

This announcement may contain certain "forward-looking statements" with respect to certain of Friends Life's (and its subsidiaries) plans and current goals and expectations relating to future financial condition, performance, results, strategy and objectives. Statements containing the words "believes", "intends", "expects", "plans", "seeks", "aims", "may", "could", "outlook", "estimates" and "anticipates", and words of similar meanings, are forward-looking statements. By their nature, all forward-looking statements involve risk and uncertainty. Accordingly, Friends Life's (and its subsidiaries) actual future financial condition, performance or other indicated results may differ materially from those indicated in any forward-looking statement.

Any forward-looking statements contained in this announcement are made only as of the date hereof. Friends Life undertakes no obligation to update the forward-looking statements contained in this announcement or any other forward-looking statements it may make.

No statement contained in this announcement should be construed as a profit forecast.

Analysts/Investors

A full year results presentation will take place at 08:30am (GMT) at the Aviva offices in the Talbot and Hartley Rooms, Level 23, Aviva plc, St Helen's, 1 Undershaft, London EC3P 3DQ. Dial in telephone number: 020 3059 8125 (UK) + 44 20 3059 8125 (all other locations), Participant password: Friends Life.

A webcast of the presentation and the presentation slides will be available on Friends Life's website, www.friendslifegroup.com.

In accordance with the obligations for issuers of listed debt contained in the Disclosure and Transparency Rules, Friends Life Holdings plc will issue a separate full year results announcement later today.

Financial calendar

2014 Second interim dividend

(i) The second interim dividend is contingent on shareholder approval of the Proposed Acquisition by Aviva plc, in the event that the Proposed Acquisition does not complete, Friends Life expects that its 2014 final dividend would be in line with Friends Life's 2013 final dividend.

(ii) The dates given are indicative only and are based on Friends Life's current expectations and may be subject to change (including as a result of changes to the regulatory timetable).

Website: www.friendslifegroup.com

Contents

Chairman's statement

Accelerating value creation

On 2 December 2014, we announced that we had agreed the terms of a proposed offer by Aviva plc ("Aviva") to acquire Friends Life Group Limited (the "Proposed Acquisition"). The combination of Friends Life's existing customer base with Aviva's will create the UK's largest life insurer, and is an attractive opportunity to accelerate the delivery of the Friends Life strategy. The increased scale, brand recognition and resourcing, combined with the expected financial synergies and cost savings strongly supports our focus on generating value for our shareholders and policyholders.

Proposed terms and dividend

Under the terms of the Proposed Acquisition our shareholders will receive 0.74 Aviva shares for each Friends Life share owned. In addition, a proposed second interim dividend of 24.1 pence per share will be paid to Friends Life shareholders after the Scheme is approved, resulting in a 2014 full year dividend of 31.15 pence per share, payable in April 2015 (the 2013 full year dividend was 21.14 pence per share). Full details are set out in the Scheme Document that was published by Friends Life on 19 January 2015, and the Aviva Prospectus which was issued by Aviva on the same day (both documents are available on the Aviva and Friends Life websites). As noted in the Scheme Document, in the event that the Proposed Acquisition does not complete, the proposed second interim dividend will not be paid, and we expect that the 2014 full year dividend would be in line with the 2013 full year dividend.

Next steps

Shareholder and regulatory approval is required for the Proposed Acquisition which, if approved, will be implemented by way of a scheme of arrangement (the "Scheme"). Shareholders will have the opportunity to attend and vote at the required shareholders meetings which will be held on 26 March 2015 to approve the proposals. The relevant documents and voting forms have been sent to shareholders in preparation for the meetings. The Friends Life Directors unanimously recommend that Friends Life shareholders vote in favour of the Scheme and the associated resolutions to be proposed at the shareholders meetings, and it is not too late to submit your vote. Deadlines for submitting your vote are set out in the Scheme document. If the Proposed Acquisition is approved by shareholders and the Court, the Scheme will become effective on 10 April 2015, new Aviva shares will be issued to Friends Life shareholders on 13 April 2015, and the proposed second interim dividend will be paid by 24 April 2015.

Performance

Aside from the Proposed Acquisition, I am pleased to confirm that the Group has performed well throughout 2014. Notwithstanding the historic changes to the pensions market brought about by the UK Chancellor's 2014 Budget, I am pleased to report that the Company continues to deliver strongly as clearly evidenced in our 2014 results. Highlights of the Group's delivery throughout the year include sustainable free surplus rising to £373 million in 2014 from £325 million in 2013, and the successful disposal of the Lombard business. The Group is also well placed to support its customers when the pension reforms come into force in April 2015, having developed a new customer platform and enhanced our customer service offering, as detailed in the Group Chief Executive's Review. 

Colleagues and the Board

Finally, I would like to thank the Board and all our employees for their continued commitment, without which the Company would not have had the success it has achieved, nor delivered these returns to our shareholders. 

Group Chief Executive's review

Our Strategy

2014 has been a year of unprecedented change for both the UK life and pensions industry and Friends Life itself. Throughout this time, the company has been consistent in the execution of its strategy that can be summarised in three main principles:

· To maximise the value of the Heritage book through efficient management of legacy products, innovative capital and revenue optimisation initiatives and a focus on deepening the relationship with our significant customer base;

· To participate in key growth areas in the UK life and pensions market, where we have scale and a demonstrable competitive advantage, focusing on our existing customers; and

· To look for opportunities to enhance or accelerate value through inorganic activities.

The sweeping reforms to the pensions market resulting from the UK Chancellor's 2014 Budget have meant that every pensions provider, including Friends Life, has needed to adapt to a new approach to retirement provision. I have been extremely pleased with how we have responded to these challenges, making great improvements by enhancing our customer engagement, taking the time to understand our customers' needs and focusing on developing the products and services our customers will require as the pension reforms come into force in April 2015.

Our new individual customer platform My Savings is on track to launch in April 2015. It will enable our existing customers to make the most of the new pension freedoms whilst providing an online system to manage their pensions and other savings in one place. Our goal is to help our customers make informed choices and decisions based on their personal circumstances. We will offer a range of products including flexi-access drawdown, NISAs and a general investment account alongside our standard and enhanced annuity offerings. This will be complemented by a range of other tools and services including an income tool to help customers understand the potential income from the different options available, investment risk appetite assessments, retirement planning, accumulation modelling, and tax information and tools to assist our customers in understanding the tax implications of taking cash from their pension.

Given the volume of legislative and regulatory change to pensions and workplace savings, customers will need more support than ever before to clarify their options. We have enhanced and strengthened our customer service teams, who are well equipped to anticipate, prompt and resolve all kinds of customer enquiries, from the simple to the complex. We know that around half a million of our current customers will be in a position to take advantage of the pension rule changes in April 2015 so we have dedicated significant resources to create a Retirement Information Centre to support customers and intermediaries.

Friends Life has successfully managed a number of major change programmes and their impact on customers in recent years. Following the changes brought about by the Budget, our UK business has already been restructured into a more customer centred model, fostering better collaboration across the business and enabling us to engage better with our customers.

In October 2014, we announced completion of the disposal of the Lombard business to the Blackstone Group. Lombard, although a good business, has always had a different profile to the rest of the Group. The disposal was in the best interests of both Friends Life and Lombard and allowed us to deliver on our commitment to secure maximum value for shareholders.

Our other international business, Friends Provident International, has faced a number of challenges this year, particularly in Asia where difficult market conditions impacted the business performance in the first half of the year. However, I have been encouraged by how the team responded to these challenges and we have started to see improved momentum in the business in the second half, particularly in the Middle East.

Our journey so far

The amount of change we have undergone this year is substantial, but it is not dissimilar to the transformation the business has been undergoing over the last four years.

When we started our restructuring and transformation journey four years ago, the Group was generating less than £100 million of sustainable free surplus. In 2014, this has risen to £373 million. This turnaround in cash generation has been delivered by applying rigorous financial discipline including delivering run-rate cost savings of £140 million and contractually securing total run-rate cost savings of £160 million by the end of 2015.

Beyond the cost synergies, we have delivered substantial capital synergies. Through the capital optimisation programme, in which the seven UK life companies were re-organised into two UK life companies for closed and open business, we drove efficiencies which have delivered a benefit of nearly £300 million to total free surplus over three years.

To enhance value further, our Heritage management team has carried out revenue optimisation initiatives since 2012 that have generated increases of over £40 million per annum in future cash generation through:

· The reallocation of three tranches of annuity policies from with-profits funds to the shareholder fund;

· The strategic partnership with Schroders;

· The establishment of Friends Life Investments Limited ("FLI") for the management of fixed income assets; and

· The recapture of £1.6 billion of assets backing annuities in November 2014.

For the last of these revenue optimisation initiatives, our Heritage division has undertaken the recapture in November 2014 of £1.6 billion of assets backing annuities where the investment risk was previously reinsured, which is expected to deliver a benefit of circa £13 million of sustainable free surplus per annum from 2015 onwards at a cost of £4 million in 2014. This clearly demonstrates the skills and capabilities that the Friends Life team has in enhancing value for shareholders.

We have rationalised our open business in the UK, reducing the number of open lines of business to three. The UK division is focused on Retirement Income, Corporate Benefits and Protection, where we have the scale and expertise to grow new business and where we have delivered a turnaround in value generation. In 2010, when we started our transformation project, the UK business was loss making, with a negative value of new business ("VNB") of £10 million. In 2014, we have delivered UK VNB of £141 million, a strong achievement considering the business has seen much lower VNB from Retirement Income this year. Retirement Income VNB has been affected by both the improved competitiveness of our offering as we entered the open market in December 2013 and the impact of pension reforms on volumes. I am particularly pleased with the progress we have made in our Corporate Benefits business. Positive net fund flows of £0.6 billion in 2014 have driven assets under administration up to £22.0 billion. The business continues to enjoy the benefits of scale and cost efficiency. Having turned cash positive a year ago, Corporate Benefits underlying free surplus generation has more than doubled in 2014 to £29 million. As the cost base is relatively fixed, further growth in assets under administration will only further enhance the operating leverage effect. 

Outlook

Looking back over what we have achieved in 2014, I have absolute confidence in Friends Life's strategy and future prospects. However it would be remiss of me not to mention the Proposed Acquisition of the Group by Aviva. My belief is that the standalone future of Friends Life is attractive, but the opportunity to accelerate the Friends Life strategy through the combination with Aviva is even more attractive. The combination is expected to create the leading player in the UK life and pensions market, with even greater scale in the key markets that Friends Life already participates in.

In terms of enhancing cash generation capacity, the combined entity is expected to have the UK's largest back book(i) and the combined group could potentially release substantial capital synergies through:

· Diversification of economic capital with general insurance and international businesses;

· Optimisation of the Friends Life businesses on an economic capital basis;

· Further capital initiatives on the combined back book; and

· Leveraging Friends Life's capital strength as part of a larger group.

Furthermore, the combined group expects to have a significant scale advantage and hence, post-delivery of synergies, significant cost advantage. So, if completed, the transaction is expected to not only benefit cash today, but also support growth in the future.

The combination of Aviva and Friends Life also offers attractive growth opportunities for the UK open businesses, as the increased scale will drive better profitability and improved service to customers with easier access to a broader range of products. The deal creates the UK's leading insurance, savings and asset management business with leadership positions in Corporate Benefits and Protection and one in four retiring defined contribution pension customers. All of this is underpinned by an in-house asset manager, with a broad product set, and an established track record.

The complementary benefits of the Proposed Acquisition from both a financial and strategic perspective are compelling and with our proven track record in the successful integration of UK Life businesses, we would be well placed to ensure the successful integration of the two businesses.

All in all it has been a good year for Friends Life and I would like to give my thanks to all of our staff, whose dedication and hard work have made Friends Life the success it is.

(i) Based on analysis of 2013 PRA returns of UK gross reserves. Back book defined as per Friends Life's methodology and includes with-profits products, unit-linked bonds and other legacy products.

Chief Financial Officer's review

Introduction

I am delighted that the product of our consistent strategy to maximise cash generation is clearly evident in our 2014 results. Sustainable free surplus has grown 15% on last year, an excellent result, enabled by carefully targeted growth within the UK division alongside the ability demonstrated by our expert team in the Heritage division to optimise cash generation from the in-force book. Our focus on maximising the cash generation of the Group is unwavering; further initiatives have also been completed in 2014 which are expected to contribute to increased cash generation in future years and we have more opportunities in 2015 to explore. Notwithstanding this, and despite the higher sustainable free surplus in 2014, the adverse impact from falls in long-term interest rates during the year have resulted in lower free surplus generation.

Whilst 2014 provided many new challenges for the Group, I am proud of how we have been able to react quickly and decisively. Once again, the strict financial discipline that underpins everything that we do has also ensured that our balance sheet has stayed both strong and resilient.

Financial performance

(i) With the exception of the capital strength measures, the 2013 results have been restated to exclude the results of Lombard, which has been classified as discontinued in the year.

(ii) Key performance indicator.

(iii) Capital strength coverage ratios are estimated and unaudited.

Cash today

We are reporting strong growth in sustainable free surplus, with a 15% increase to £373 million (2013: £325 million). This is an excellent result, marginally ahead of our own expectations of "low double digit percentage growth" communicated in August 2014, and demonstrates our continuing delivery on growing the cash generation of the Group.

The targeted increase of £39 million in free surplus expected returns from the UK and Heritage divisions, as set out in our 2013 results, has also been delivered in line with previous guidance with expected returns totalling £600 million in 2014. This strong growth in expected cash generation has been driven by the profitable new business written by the UK division and the benefits of the revenue optimisation initiatives undertaken in 2013, with these more than offsetting the run-off of the in-force book.

The growth in sustainable free surplus has been achieved whilst simultaneously increasing the investment in writing profitable new business in the UK division, helping to generate the cash for tomorrow and offsetting the run-off of the Heritage book. Overall however, the investment in new business is still lower than in the previous year due to the closure to new business of the non-core OLAB business during 2013.

Cash tomorrow

In addition to the growth in sustainable free surplus in 2014, further revenue optimisation initiatives have been undertaken during the year to help offset the Heritage run-off and drive further cash generation growth in future years. In 2014 we have:

· Completed a £760 million reallocation of annuities from with-profits funds, which is expected to generate circa £7 million per annum of sustainable free surplus from 2015 onwards. In addition to this, in the first quarter of 2015 we have completed a transfer of a further £665 million of annuities from with-profits funds, generating circa £5 million per annum of sustainable free surplus from 2015 onwards;

· Completed the previously announced £14 billion transfer of investment management of assets (£12 billion to Schroders and £2 billion to Friends Life Investments) previously managed by F&C. This is expected to generate circa £3 million per annum of sustainable free surplus from 2015 onwards;

· Undertaken a recapture of £1.6 billion of assets backing annuities, which is expected to result in a benefit of circa £13 million per annum of sustainable free surplus from 2015 onwards; and

· Made investments into a number of different asset classes to drive increased yield within the annuity portfolio and shareholder funds across the Group.

The benefits to cash generation from these initiatives are not one-off; they provide continued free surplus generation year-on-year. This is sustainable free surplus generation in its truest sense.

In line with expectations, and as previously communicated, VNB has been impacted by both the increased competitiveness of our annuity offering and the impact of pension reforms on annuity volumes, in addition to the continuing challenges for the International division. However, even though the headline VNB figure is lower than in 2013, there are many aspects of our new business performance to be pleased with.

The Corporate Benefits business has developed strongly during 2014. As an asset-based business, Corporate Benefits focuses primarily on the net fund flows metric for measuring performance. Positive net fund flows of £0.6 billion in 2014 is a pleasing result, considering this incorporates the previously guided loss of one very large scheme (£0.4 billion) in the fourth quarter to pursue an unbundled proposition. The continuing growth in this business is driving increased operating leverage, illustrated by the 164% increase in underlying free surplus to £29 million (2013: £11 million).

The Protection business has also performed well during 2014. APE volumes are up 6%, due to strengthened relationships with financial advisers. In line with our guidance at the start of the year, VNB of £69 million (2013: £75 million) is lower than in 2013 due to a change in mix to lower margin life business and less favourable economics. However, the free surplus investment in new business has been reduced despite the higher volumes, driven by pricing discipline and rigorous cost control.

The Retirement Income business has achieved resilient results despite the changes announced in the UK Chancellor's 2014 Budget, with sales volumes down only 15%, outperforming our peer group and exceeding expectations. This was a result of more competitive pricing, strong customer engagement and the significant proportion of policies with Guaranteed Annuity Options ("GAO"s), where new volumes are not expected to fall as significantly from their pre-Budget levels. 51% of new annuity volumes in 2014 arose from pension policies with GAOs. The move to an increasingly competitive annuity pricing position has lowered the IRR for our open insurance businesses to 15.1% (2013: 18.1%), in line with our performance ambition of 15% set a year ago. Including the benefit of discretionary investment of shareholder assets in the with-profits annuity reallocation and the recapture of assets backing annuities, the 2014 Group IRR is 16.7%.

Challenging trading conditions within the International division have led to a disappointing new business performance in the year, with VNB of £12 million (2013: £21 million). There are however causes for optimism with sales in the second half of 2014 up 34% on the first half, reflecting the benefits of sales initiatives and regulatory changes in the UAE and Hong Kong. The International IT platform development has been progressing to plan and the business is now focused on re-platforming the in-force book in 2015. In light of recent trading performance, adverse foreign exchange movements and the current low long-term interest rates the International division will, not pay a dividend for 2014. The International division continues to work with the Japanese regulator on its licence application and expects to be authorised to distribute investments business in Japan in the second quarter of 2015. Our access to the market for expatriates and affluent Japanese to purchase multi-currency savings products is an exciting opportunity for the next phase of International's growth.

Returns

IFRS based operating profit has grown by 38% to £556 million (2013: £402 million). The growth was positively impacted by a number of one-off benefits including a change to annuitant longevity assumptions (£103 million), the recapture of £1.6 billion of assets backing annuities (£90 million) and a reallocation of annuities from with-profits funds (£19 million). Notwithstanding the benefits from these one-off items, IFRS in-force surplus has increased by £31 million, which principally reflects the benefit from management actions undertaken during 2013 and improved economic conditions.

MCEV operating profit is lower at £498 million (2013: £535 million) and principally reflects the £47 million lower VNB as described above. However, the MCEV operating profit metric does illustrate the value created by the cash optimisation activities undertaken in the year. The recapture of £1.6 billion of assets backing annuities has generated £97 million of MCEV operating profit and the previously announced £760 million reallocation of annuities from with-profits funds generated £68 million.

The cash return ratio is up to 25.1% in 2014 (2013: 23.8%), in line with our performance ambition of 25%. The growth in sustainable free surplus has been partially offset by an increased shareholder net worth, primarily due to positive economic variances in 2013 which increased the 2014 opening position.

Operating expenses

Following the 4% reduction in operating expenses in 2013 (restated to exclude Lombard), I am pleased to confirm that our operating expenses have reduced by a further 2% in 2014 to £549 million (2013: £563 million). The reduction in 2014 represents the continued realisation of benefits from the integration programme including contractual savings arising from the outsourcing agreement with Diligenta. This more than offsets the modest cost increases to support new business growth in the UK and International divisions in addition to further improvements made to customer service and engagement in the year. This demonstrates that efficient management of the cost base is a core competence of the Group.

Consistent with previous communications, all costs associated with new retirement income product and platform development have been reported within non-recurring items.

Capital strength

Our consistent financial discipline across all areas of the business has maintained the strong balance sheet and robust capital position of the Group. Our estimated and unaudited coverage ratios on both an IGCA and economic capital basis are both higher at 240% and 196% respectively (31 December 2013: 238% and 193% respectively).

Group available shareholder assets are higher at £1,066 million (31 December 2013: £917 million). The movement over the year principally reflects the proceeds from the Lombard disposal net of the £30 million utilised for the share buyback programme prior to its suspension upon the announcement of the Proposed Acquisition by Aviva. Should the Proposed Acquisition not proceed, Friends Life would look to reinstate the buyback programme at the earliest opportunity. The receipt of the Lombard disposal proceeds are partially offset by working capital which we have decided to set aside now to meet the additional capital requirements of £138 million expected to arise in relation to the Department of Work and Pensions "charge cap", which will be introduced in April 2015. Note this capital will not be required upon transition to the Solvency II regime in 2016.

Regulatory developments

2014 has been a year which has seen some major regulatory developments in the industry. I am pleased with how we have been able to respond to these developments and I believe we are well positioned to benefit from them.

We remain fully engaged with the Financial Conduct Authority ("FCA") on their legacy review. Our Heritage division was established specifically to cater to the needs of legacy business customers so we have been in a good position to respond to the FCA's questions and we look forward to learning the outcomes of their review.

The UK Chancellor's 2014 Budget dramatically changed the UK pensions market landscape and I am pleased with the way we have been able to adapt in the 12 months since the announcement. As referred to in the Group Chief Executive's review, we have developed new products and a new platform, all designed specifically for the new world of retirement provision. Our strong customer service and engagement model is an area of focus for the Group and we expect this to be an even greater differentiator in the new world. On 27 February, we received final rules from the FCA (PS15/4: "Retirement reforms and the guidance guarantee") requiring providers to give appropriate risk warnings to customers accessing their pension savings. This Policy Statement also sets out how this interacts with the new free guidance regime and with customers who have received independent regulated advice. We are adapting our processes and procedures to meet these significant additional requirements which take effect from 6 April, with the aim of providing our customers with the support they require to navigate through the choices and flexibility available to them.

We have made good progress in the year in preparation for the move to the Solvency II regime in 2016. As previously announced, we intend to use the standard formula from the beginning of 2016 and apply for internal model approval subsequent to this. In light of the Proposed Acquisition by Aviva, we are reviewing our Solvency II programme and internal model application plans.

Sesame

In February 2013, we commenced a strategic review of the businesses of the Sesame Bankhall Group, including Sesame Limited. This strategic review is still ongoing with a number of potential options and outcomes being considered. There remains the risk of further adverse financial and reputational impacts to the Group, due to the ongoing trading performance of Sesame Limited, the potential future liabilities of the Sesame business and the outcomes of the strategic review.

Outlook

The continued growth in sustainable free surplus demonstrates our consistent focus on maximising the generation of cash for shareholders, and the continued delivery against that strategy. Our rigorous financial discipline and strong balance sheet have underpinned this delivery, and by carefully selecting the markets that we play in, we have the right strategy to build further on our success in the future.

Business review

2014 highlights

Heritage division 

· Sustainable free surplus generation up to £462 million (2013: £445 million), reflecting £19 million higher expected return from in-force business and reduced levels of free surplus invested in new business from the closed non-core OLAB business.

· Phase 2 reallocation of with-profits fund annuities completed in the third quarter of 2014, with £760 million of annuities transferred from with-profits funds to non-profit funds. This transfer is expected to provide future sustainable free surplus benefits of circa £7 million per annum for an upfront cost of £(11) million.

· Phase 3 reallocation of with-profits fund annuities to non-profit funds has been completed in the first quarter of 2015, which transferred a further £665 million of annuities. This transfer is expected to provide future sustainable free surplus benefits of circa £5 million per annum for an upfront cost of circa £(25) million.

· The transfer of investment management of assets to Schroders was completed in the fourth quarter of 2014 with £12 billion of equity and multi-asset funds transferred from F&C. As part of this transaction a further £2 billion of fixed interest assets was transferred from F&C to Friends Life Investments. These transfers are expected to provide future sustainable free surplus benefits of circa £3 million per annum.

· Recapture of £1.6 billion of assets backing annuities in November 2014 where the investment risk was previously reinsured. This is expected to deliver a benefit of circa £13 million of sustainable free surplus from 2015 onwards, when gilt assets received are invested in higher yielding assets, at a cost of £(4) million in 2014.

UK division

· Sustainable free surplus generation up £13 million to £(27) million, principally reflecting a £20 million increase in expected return, driven by strong growth in the Corporate Benefits business.

· New business APE up 5% from increased sales in the Corporate Benefits and Protection businesses and a lower than expected fall of 15% in annuity sales despite the UK Chancellor's 2014 Budget announcement.

· VNB down £43 million to £141 million due to the increased competitiveness of our annuity offering and the impact of pension reforms on annuity volumes. However, Retirement Income PVNBP margin has been maintained in excess of 9%.

· Strong Protection business IRR of 19.2% (2013: 13.8%) delivered through pricing discipline and optimisation of reinsurance arrangements. Retirement Income IRR at 14.6% (2013: 25%+) despite improvements in the competitiveness of the annuity proposition.

· Positive net fund flows in Corporate Benefits of £0.6 billion despite the previously announced loss of one very large scheme, taking assets under administration to £22.0 billion.

· IFRS based operating profit up £65 million to £105 million driven by a revision to long-term longevity assumptions.

International division

· Sustainable free surplus generation has increased to £25 million (2013: £20 million) due to favourable movements in investment in new business and operating variances, which more than offset a reduction in expected returns.

· International assets under administration continue to grow and total £7.0 billion (31 December 2013: £6.6 billion).

· Full year performance in 2014 continues to reflect the difficult market conditions throughout the business' regions. As a result, sales volumes have fallen by 13% to £110 million. However, sales volumes in the second half of the year are up 34% compared with the first half of 2014 to £63 million.

· VNB is also lower at £12 million (2013: £21 million) as a result of the difficult trading conditions.

· IFRS based operating profit of £54 million is £9 million lower than in 2013 due to reduced in-force surplus resulting from increased expenses and adverse experience.

· Following the re-platforming of new business, the International division is on track for re-platforming in-force business during 2015.

Cash today

Sustainable free surplus generation

(i) Operating free surplus generation excludes corporate costs relating to the Friends Life Group Limited holding company.

(ii) 2013 results have been restated to reflect the transfer of OLAB from the International to Heritage division and to exclude the results of Lombard, which has been classified as discontinued in the year.

Heritage

The Heritage sustainable free surplus generation of £462 million is £17 million higher than 2013 due to higher expected returns from in-force business and an improvement in investment in new business.

Expected return from in-force business at £481 million is £19 million higher than 2013 with the run-off of in-force business being more than offset by the ongoing benefits from the first phase of the with-profits annuity reallocation programme, FLI asset recaptures, the benefit of 2013 being the last year of repayment of a previous loan with a with-profits fund, together with improved economic conditions and increased recognition of tax relief on expenses.

The £17 million improvement in investment in new business reflects the cessation of new business sales within the transferred OLAB business.

Other operating variances include a positive impact from modelling changes offset by the day one cost of completing the second phase of the with-profits fund annuity reallocation programme with this resulting in a free surplus cost of £(11) million in 2014. A further £(4) million impact is also reflected as a result of a recapture of £1.6 billion of assets backing annuities in November 2014.

Operating assumption changes of £79 million principally reflect a change to annuitant longevity assumptions.

UK

Sustainable free surplus of £(27) million represents a £13 million improvement on 2013, driven by a £13 million increase in underlying free surplus generation, as set out in the table below.

Underlying free surplus generation by UK business unit

UK underlying free surplus of £14 million is £13 million higher than 2013, due to a significant improvement in the contribution from Corporate Benefits resulting from growth in assets under administration and strong cost control. The investment in new business within the Protection business has improved by £7 million reflecting a disciplined approach to pricing and optimisation of reinsurance arrangements, including the use of a modest amount of financial reinsurance. These impacts more than offset the increased cost of writing new business in Retirement Income which reflects improvements made to the competitiveness of the annuity offering as we entered the open market in December 2013.

The 2014 sustainable free surplus reflects £(14) million lower operating experience variances than 2013, driven by a reduced utilisation of brought forward tax losses which resulted from a reduction in Retirement Income free surplus generated and adverse claims experience within the Protection business. This is more than offset by a £23 million improvement in other income and charges due to non-recurrence of 2013 provisioning within Sesame.

Operating assumption changes of £52 million principally reflect a change to annuitant longevity assumptions.

International

Sustainable free surplus generation has increased to £25 million (2013: £20 million), principally reflecting a favourable movement in operating variances.

Expected returns have decreased due to lower volumes of regular premium savings business written in 2013 compared with 2012. The surplus emergence on the regular premium savings business is weighted towards the early years of such contracts.

The decrease in expected returns is partially offset by a lower investment in new business of £(29) million (2013: £(39) million) which is partly due to lower sales volumes, but also the benefit of recognising indemnity commission over the initial period of each policy.

Operating assumption changes of £(18) million principally relate to a change to maintenance expense assumptions.

Corporate

The sustainable free surplus contribution from Corporate principally reflects the debt costs (net of tax) incurred by the Group. The 2014 result of £(87) million represents a £13 million improvement on 2013 primarily due to a lower level of holding company costs in sustainable free surplus in 2014 and a higher expected investment return as a result of the syndicated loan investments made in the year.

Cash tomorrow

New business profitability

2014 Group IRR of 16.7% includes the benefit of discretionary investment of shareholder assets in the with-profits annuity reallocation and the recapture of £1.6 billion of assets backing annuities. Excluding these, the Group IRR is 10.5%.

The open insurance business (UK Protection, UK Retirement Income and International) IRR in 2014 is 15.1% (2013: 18.1%), in line with the performance ambition of 15% set a year ago.

(i) 2013 results have been restated to reflect the transfer of OLAB from the International to Heritage division and to exclude the results of Lombard, which has been classified as discontinued in the year.

(ii) 2013 Group IRR includes the benefit of discretionary investment of shareholder assets in the with-profits annuity reallocation. Excluding this, the Group IRR was 11.0%.

UK

The UK division delivered good growth in volumes during 2014, with APE up 5% to £759 million. Growth has been delivered in the Corporate Benefits and Protection business units, up 7% and 6% respectively. Retirement Income volumes are showing a smaller fall than expected, outperforming the market.

Protection

The Protection business has delivered growth in sales volumes of 6% compared to 2013, with much of this driven through strengthened relationships with financial advisers. VNB is 8% lower than 2013 driven by an increase in the start of year long-term interest rates compared to 2013 (meaning future profits are worth less in today's terms) as well as changes in the mix of new business written in Group Protection, with lower volumes of Income Protection and higher volumes of Life business which is typically less profitable. These impacts have also led to a lower PVNBP margin. The IRR has improved significantly from 13.8% to 19.2% driven by pricing discipline and optimisation of reinsurance arrangements, including the use of a modest amount of financial reinsurance. Investment in new business has improved by £7 million compared to 2013 despite the growth in volumes, for similar reasons as for the growth in IRR.

Retirement Income

The Retirement Income business has delivered strong new sales, with volumes down just 15% on the previous year, despite changes announced in the UK Chancellor's 2014 Budget. This compares favourably to the market where overall annuity sales were down 38% in the first three quarters of 2014 compared to the equivalent period last year. The favourable comparison partly reflects the relatively high proportion of vesting pension policies with guarantees, which represented 51% of new business volumes in 2014. We continue to believe that annuity volumes will fall further and in the fourth quarter Retirement Income sales volumes were 14% down on the third quarter. In addition to the fall in volume, the more competitive pricing position has, as expected, led to adverse VNB and INB compared to 2013, although IRR and PVNBP margins remain satisfactory.

Corporate Benefits

VNB of £21 million is 19% lower than 2013, following some cost and pricing pressure on new scheme wins and the impact of low initial premium levels on auto-enrolment business. Nevertheless policies in force and assets under administration have shown strong growth, supported by this increase in auto-enrolment activity.

Investment in new business has improved by £4 million compared to 2013, principally due to a restructuring of commission terms for new entrants to existing schemes.

Volumes are 7% higher than 2013, driven by good growth in the size of the existing book from higher increments, new entrants to existing schemes and increased single premium business.

Corporate Benefits assets under administration

The Corporate Benefits business has delivered positive net fund flows of £0.6 billion contributing to assets under administration reaching £22.0 billion. This is despite the previously communicated disinvestment of one very large scheme for £0.4 billion which left to pursue an investment only proposition. Even allowing for this disinvestment, outflows have reduced compared to 2013.

Inflows have benefitted from strong new business volumes, in particular regular premiums have grown from £1,760 million in 2013 to £1,946 million in 2014, in part resulting from auto-enrolment activity which has contributed to a net increase in members of 169,000in the year taking the total member count to 1,312,000.

Corporate Benefits underlying free surplus

Corporate Benefits underlying free surplus income has increased by £12 million to £122 million as a consequence of growth in assets under administration. At the same time outgoings have fallen reflecting actions taken to contain commission spend and management of investment expenses, including the benefit from the appointment of Schroders as asset managers for a large proportion of the book and increased use of the lower cost My Money platform. "Other" has improved by £4 million which primarily reflects the reclassification of scheme-level expense on new policies in existing schemes from new business to in-force policies, which had a favourable impact on non-unit reserves.

Heritage

The Heritage division specifically focuses on those products no longer actively marketed. Despite not actively seeking new business, the Heritage book delivers ongoing incremental business written across all product types. The reduction in investment in new business and APE reflects the lower sales volumes following the cessation of new business sales within the transferred OLAB business.

International

APE volumes have fallen by 13% to £110 million reflecting difficult market conditions across the regions, especially in the first half of 2014. However, volumes in the second half of the year are up 34% compared with the first half of 2014 to £63 million due to higher bond sales and regulatory changes in UAE and Hong Kong. 

VNB has decreased 43% to £12 million, reflecting lower sales volumes and the impact of adverse operating assumption changes, particularly in respect of maintenance expenses.

Recent regulatory changes in the Middle East to prevent sales by unlicensed companies are expected to strengthen our competitive position in that region. Elsewhere, the regulators in Hong Kong and Singapore have initiated changes to their respective unit-linked markets which will see a move away from upfront commission. Whilst we see this as a positive move for the long term benefit of both customers and providers, it will cause some challenges and market disruption in the short term.

Returns

IFRS based operating profit

(i) 2013 results have been restated to reflect the transfer of OLAB from the International to Heritage division and to exclude the results of Lombard, which has been classified as discontinued in the year.

Heritage

The 2014 Heritage IFRS based operating profit of £421 million is £91 million higher than in 2013. This improvement has been driven by lower new business strain, higher in-force surplus and improved long-term investment return as a result of higher expected rates of return.

The reduction in new business strain reflects the cessation of new business sales within the transferred OLAB business.

In-force surplus is favourable compared to 2013 with the run-off of the closed book of business being more than offset by the benefit from the first phase of the with-profits annuity reallocation programme, the benefit of partial repayment of a previous loan to a with-profits fund and higher management charges, due to improved economic conditions. In-force surplus has been further increased by a reduction in the level of provision movements in respect of operational items, arising from the review of the legacy business, noted in 2013.

Principal reserving changes and one-off items are higher than in 2013 with the key items in 2014 being a recapture of £1.6 billion of assets backing annuities generating a £90 million benefit, alongside £19 million from the second phase of the with-profits annuity reallocation programme. There was a favourable impact from assumption changes, principally resulting from changes to annuitant longevity assumptions (£65 million). 

UK

IFRS based operating profit of £105 million has increased by £65 million compared to 2013 driven by a revision to the long-term longevity assumptions in the Retirement Income business, higher in-force surplus due to the growth of the business and lower development costs. This is partly offset by an increase in new business strain principally driven by improvements made to the competitiveness of the Retirement Income business' annuity proposition.

International

IFRS based operating profit was lower in 2014 at £54 million (2013: £63 million) due to reduced in-force surplus primarily as a result of increased expenses and adverse experience. This was partially offset by a £3 million reduction in new business strain due to lower volumes.

Increased development costs relate to investment in the new International IT platform.

Corporate

The Corporate IFRS based operating result is principally driven by external finance costs and corporate costs, offset by interest on internal debt. The £7 million improvement in 2014 is primarily due to a lower level of holding company costs in 2014.

MCEV operating profit

For details of VNB please see "new business profitability" section.

(i) 2013 results have been restated to reflect the transfer of OLAB from the International to Heritage division and to exclude the results of Lombard, which has been classified as discontinued in the year.

Heritage

The Heritage MCEV operating profit of £403 million is in line with the £410 million reported in 2013, with an increase in other operating variances offsetting a reduction in operating assumption changes.

Expected existing business contribution is in line with 2013 with the ongoing benefit from the first phase of the with-profits annuity reallocation programme and improved economic conditions offsetting the general run off of in-force business.

Other operating variances of £228 million include a £68 million benefit from the second phase of the with-profits annuity reallocation, the £97 million impact of a recapture of £1.6 billion of assets backing annuities and £63 million of benefits from modelling changes primarily as a result of revised modelling of the Time Value of Options and Guarantees.

UK

MCEV operating profit before tax of £154 million is £38 million lower than 2013 largely driven by a reduction in the value of new business, as referred to earlier, partially offset by a £13 million increase in expected existing business contribution due to growth in the business.

Adverse operating experience variances of £(35) million are driven by higher than expected claims in Protection, adverse persistency in Group Protection and re-pricing activity in Corporate Benefits in response to increasing competition in the market.

International

MCEV operating profit has decreased to £24 million (2013: £40 million). This reflects a £(9) million reduction in VNB, adverse experience variances of £(13) million primarily driven by adverse persistency, and the non-recurrence of favourable assumption changes from 2013. This is offset by an improvement in the expected existing business contribution from £16 million to £21 million reflecting higher assets under administration combined with higher rates of expected return on all assets.

Corporate

The Corporate MCEV operating result is principally driven by expected external finance costs and corporate costs. The 2014 operating profit of £(83) million represents a £24 million improvement on 2013 due to lower expected debt servicing costs as a result of a reduction in spreads on the debt in 2013 and a lower level of corporate costs.

Cash Return

The cash return ratio of 25.1% is calculated by dividing the Group sustainable free surplus of £373 million by the shareholder net worth (that is, total free surplus and required capital). The 15% growth in sustainable free surplus was partially offset by a higher shareholder net worth in 2014, primarily as a result of positive economic variances during 2013 which increased the 2014 opening position.

(i) 2013 results have been restated to exclude the results of Lombard, which has been classified as discontinued in the year.

(ii) Adjusted shareholder net worth is calculated as the opening position (1 January 2014: £1,608 million, 1 January 2013: £1,504 million) with allowance for the timing of dividend payments, the receipt of the Lombard sale proceeds in October 2014, the share buyback programme in November 2014 and the AmLife sale in January 2013.

Operating expenses

(i) 2013 results have been restated to reflect the transfer of OLAB from the International to Heritage division and to exclude the results of Lombard, which has been classified as discontinued in the year.

(ii) As reported under IFRS.

Consistent with previous communications, the costs associated with new retirement income product and platform development have been reported within non-recurring items and are therefore excluded from the table above.

Heritage

2014 acquisition costs are lower than 2013, mainly driven by the cessation of new business sales within the transferred OLAB business.

Maintenance costs of £225 million are lower than 2013 due to contractual savings in expenses achieved through the Diligenta partnership and a reduction in costs following the successful completion of the separation programme to move all IT infrastructure and business applications hosted by AXA to Friends Life in 2013.

Development spend of £14 million is higher than 2013 reflecting the cost of the transfer of investment management of assets to Schroders and FLI, together with improvements to existing products and systems to support the in-force business.

UK

Acquisition costs have increased by £13 million compared to 2013 driven by structural changes within the UK division to build capability pending the new pension related freedoms from April 2015, and an expected movement in overheads from maintenance to acquisition as the Heritage book runs off. Maintenance costs have increased by £15 million reflecting growth in each of the three business units. This increase is in line with our expectations as the business grows. The growth is enabling increased operational leverage, as can be seen by the significant improvement in underlying free surplus generation in the year.

Despite reduced overall development spend, there has been considerable investment in the Retirement Income proposition and in enhancing the Protection proposition and the auto-enrolment hub in Corporate Benefits. As mentioned above, the costs associated with new retirement income product and platform development have been reported within non-recurring items and are therefore excluded from the table above.

International

Acquisition and maintenance costs have increased marginally despite lower new business volumes, reflecting increases in regional branch costs and maintenance project spend.

Development expenses amounting to £13 million principally reflect investment in the new International IT platform. Following the re-platforming of new business, the division is on track for re-platforming in-force business during 2015.

Corporate

Corporate expenses are those incurred at holding company level. Lower costs were incurred in 2014 principally due to changes made to the corporate governance structure during 2013.

Non-operating results

(i) 2013 results have been restated to exclude the results of Lombard, which has been classified as discontinued in the year.

(ii) Step-up Tier one Insurance Capital Securities.

Group IFRS: non-operating results

Short-term fluctuations in investment returns on assets backing the shareholder and non-profit funds amounted to £(207) million in 2014. This principally reflects £(104) million due to the incomplete trading of gilt assets into higher yielding assets as part of the recapture of £1.6 billion of assets backing annuities in November 2014 (this variance is expected to reverse as the assets are reinvested in 2015). There was a further negative impact due to reductions in long-term interest rates during the year.

Other non-recurring items of £(184) million include:

· outsourcing implementation costs, net of provision releases, of £(71) million;

· finance transformation costs, largely relating to Solvency II and net of provision movements, of £(36) million;

· costs relating to the Sesame strategic review, of £(25) million;

· project costs incurred in responding to significant regulatory changes in the year, of £(21) million;

· separation and integration programme costs of £(11) million; and

· other strategic project costs of £(20) million, including costs incurred in relation to the Proposed Acquisition by Aviva.

The costs reported above in respect of separation and integration complete this programme and no future costs are anticipated relating to the activities of bringing together the entities and operations that form Friends Life today.

We are pleased with the progress on the outsourcing implementation work which is being undertaken in conjunction with Diligenta and a number of successful migrations have completed in 2014. Total spend under this programme to date amounts to £261 million. As a result of the new pensions and annuity legislation, we have decided to defer parts of the programme until later in 2015. This deferral is expected to result in a modest increase in total programme spend compared to the most recent guidance given in March 2013 of circa £280 million.

As communicated in August 2014, the Group's intention is to report the costs associated with the new retirement income product and platform development within non-recurring items. Given the UK Chancellor referred to the changes announced in his 2014 Budget as "the most far-reaching reform to the taxation of pensions since the regime was introduced in 1921", the Group believes this approach is appropriate in this instance. In accordance with this intention, £21 million of costs associated with responding to significant regulatory changes in the year have been reported within other non-recurring items. In addition to this, for free surplus and MCEV reporting only, a further provision of £45 million has been established for the anticipated future costs in response to significant regulatory changes in the year.

Group free surplus generation: non-operating results

Total economic variances had a £(144) million impact on free surplus in the year, principally as a result of falls in long-term interest rates during the year which increased liabilities and subsequently, required capital. Similar to the IFRS result, there was a £(104) million impact due to the incomplete trading of gilt assets into higher yielding assets as part of the recapture of £1.6 billion of assets backing annuities in November 2014 (this variance is expected to reverse as the assets are reinvested in 2015). Offsetting positive variances arose from gains in equities and bonds over the period, which have allowed historic taxable losses to be valued, and a decrease in expense inflation assumptions.

Other non-operating items of £(158) million include £(184) million of non-recurring items, consistent with those reported within the IFRS result. In addition, there is a net impact of £26 million from items specific to free surplus, including £21 million benefit from the release of required capital due to a lower level of non-recurring expense in 2013.

Friends Life Group Limited ("FLGL") income and charges of £(21) million relate to costs incurred within the FLGL holding company.

Group MCEV: non-operating results

Total economic variances had a £(143) million impact on MCEV profit before tax. This principally reflects a £(119) million impact due to the incomplete trading of gilt assets into higher yielding assets as part of the recapture of £1.6 billion of assets backing annuities in November 2014 (this variance is expected to reverse as the assets are reinvested in 2015). A negative impact from an increase in the market value of the Group's external debt is largely offset by favourable movements in interest rates and expense inflation.

Non-recurring costs had a £(211) million impact on MCEV profit before tax, £(184) million of which is consistent with that reported within the IFRS result. In addition, there was a £(27) million impact from net costs specific to MCEV. This includes £(57) million due to the establishment of a provision to cover anticipated future costs in response to significant regulatory changes in the year (being a provision of £45 million notionally grossed up for tax).

Other non-recurring items and non-operating variances of £(66) million include, as announced in our interim results, a £50 million provision established to cover the anticipated impact of the imposition of a charge cap of 0.75% per annum on default funds for qualifying auto-enrolment schemes and a £10 million provision established to cover the anticipated impact on future profits from the removal of Active Member Discounts ("AMD") on existing schemes.

Group net assets and shares in issue

(i) Adjusted to exclude 3,872,431 FLGL shares held by the Employee Benefit Trust ("EBT") at 31 December 2014 (31 December 2013: 600,877). The increase reflects additional purchases made by the EBT to deliver shares to employees under various Share Based Payment schemes of the Group. 9,057,000 shares were purchased as part of the share buy-back programme which commenced on 31 October 2014 and was suspended as of 21 November 2014.

At 31 December 2014, IFRS total equity was £5,115 million (31 December 2013: £5,549 million), with equity attributable to equity holders of the parent of £4,796 million (31 December 2013: £5,229 million). IFRS net assets per share attributable to equity holders of the parent were £3.41 (31 December 2013: £3.69) based on shares in issue at the balance sheet date.

Net Group MCEV was £5,529 million (31 December 2013: £6,065 million) giving MCEV per share of £3.93 (31 December 2013: £4.28).

Cash and Capital

Introduction

The Group remains committed to the optimisation of capital within the business. The Group has established cash and capital frameworks which are used to evaluate and monitor excess cash and capital, driven by strong governance and subject to regulatory approval. The cash and capital position of the Group at 31 December 2014 remains strong with Available Shareholder Assets ("ASA") of £1,066 million and an IGCA(i) surplus of £2.3 billion resulting in a coverage ratio, excluding WPICC(ii) ("With Profits Insurance Capital Component") of 240%. At 31 December 2014 the estimated and unaudited economic capital(iii) surplus at Group level was £3.7 billion corresponding to a coverage ratio of 196%.

Cash and capital definitions

(i) The IGCA position at 31 December 2014 of the Group and its subsidiaries is estimated and unaudited.

(ii) WPICC represents the difference between the surplus capital calculated on a regulatory basis and that on a realistic basis, in accordance with regulations, and is excluded from both IGCA capital resources and capital resources requirements under the CMP.

(iii) Economic capital represents management's internal risk-based estimate of the amount of capital needed to be held to mitigate the risk of insolvency to a minimum of a 99.5% confidence level over a one year period. The coverage ratio represents the proportion of capital resources to capital resource requirements. The economic capital position at 31 December 2014 of the Group and its subsidiaries is estimated and unaudited.

Capital management policies and monitoring buffers

The Group's capital management policies ("CMPs") that apply at a life company level and at the Group level were set out in the 2013 full year results. These policies remain unchanged and are summarised below.

Life companies CMP

The CMP of FLL ("Friends Life Limited"), the principal UK life company, is to meet the higher of:

· 150% of Pillar 1 requirements, excluding WPICC and Friends Provident International Life ("FPIL"); and

· 125% of Pillar 2 requirements, including any ICG and excluding FPIL.

In addition to the above, capital within FLL is held to cover at least one year of the FLL debt servicing costs (currently £101 million per annum) and any debt repayment requirements in the following year.

Group CMP

The CMP at Group level is to meet 150% of IGCA requirements, excluding WPICC. In order to protect the CMP in the highly remote event that payment of debt costs would lead to a breach of the policy, the Group has an additional requirement in respect of debt servicing costs. This requirement is to hold excess capital, over 150%, in the form of cash or cash equivalents at holding company level sufficient to pay at least the next year's gross annual interest cost (currently £120 million per annum) and any mandatory repayments of principal that fall due on debt in the next year.

Capital monitoring buffers

The Group has a robust monitoring system and in addition to the amounts held to meet its CMPs, it holds a prudence buffer together with a monitoring buffer held within working capital.

The prudence buffer is broadly designed to cover an additional year of the Company's current dividend and the holding companies' corporate costs and is currently £325 million, reflecting the current level of dividends and corporate costs.

The monitoring buffers for the Group and life companies are reviewed regularly alongside the Group and life company solvency risk appetites. At 31 December 2014 the biting capital constraint is the Group IGCA position, and a monitoring buffer of 10% of the IGCA requirements, excluding WPICC, is held within working capital.

Cash and capital management framework

The Group's cash and capital management framework is based on MCEV as this comprises the discounted value of expected future cash flows on a market consistent basis. Shareholder resources comprise the free surplus, required capital and inadmissible assets of the business. For the Friends Life holding companies and other non-regulated businesses, free surplus is defined as IFRS net assets less required capital and inadmissible assets on an IGCA basis (for MCEV, where these assets relate to non-covered business, they are all included within free surplus).

The following table outlines the key movements in each of the components of total MCEV during the period:

(i) Required capital at 31 December 2014 includes £257 million in respect of non-covered business required capital and inadmissible assets which are classified as free surplus in MCEV.

Working capital and other assets and liabilities

Working capital represents assets set aside to cover known future requirements and amounts necessary to maintain sufficient flexibility to facilitate compliance with the Group capital policy and additional regulatory requirements. In addition, any assets subject to restriction in their availability to shareholders will be designated as working capital.

The working capital at 31 December 2014 of £447 million has decreased from £534 million at 31 December 2013 and is held in both the life companies and the holding companies.

The working capital comprises:

· amounts required to meet current estimates of future non-recurring costs and discretionary working capital allowances offset by related benefits that are expected in the short term;

· additional capital requirements (at the CMP of 150% of Pillar 1 requirements) expected to arise in relation to the Department of Work and Pensions "charge cap", which will be introduced in April 2015;

· an appropriate monitoring buffer to facilitate ongoing compliance with the Group's CMPs;

· restricted assets included within free surplus e.g. illiquid or intangible assets and any assets in excess of the CMP held within the life companies after declaration of dividends.

Available shareholder assets

ASA represents the cash and other assets available to cover Friends Life's corporate costs, to service debt issued by holding companies and, subject to shareholder approval, to pay dividends or return to shareholders. As such, ASA is stated after the deduction of working capital from free surplus.

The ASA of £1,066 million comprises £861 million of shareholder cash at Friends Life holding company level (including the £150 million interim dividend declared by FLL), and £205 million of investments in syndicated loans. Total dividends included from FLL relating to 2014 are £270 million, inclusive of the £120 million paid in the second half of the year

The following table outlines the key components of ASA by reference to the expected utilisation of the cash balances:

(i) Assumes the Proposed Acquisition by Aviva completes. In the event that the Proposed Acquisition does not complete, Friends Life expects that its 2014 final dividend and therefore its 2014 full year dividend would be in line with Friends Life's 2013 final dividend and 2013 full year dividend, respectively.

The ASA balance as at 31 December 2014 is held to cover the costs of the second interim dividend which is payable subject to the approval of the Proposed Acquisition by regulators and shareholders; and to maintain a prudence buffer of £325 million, designed to cover approximately an additional year of the Company's current dividend cost (based on the 2013 full year dividends); and the holding companies corporate costs. The Group CMP requirement to hold cash at FLGL sufficient to meet one year of FLGL's debt servicing costs is expected to be met from capital retained in the life companies. As this requirement is not considered a restriction on the availability of FLGL cash, no reduction has been made to the ASA in respect of it.

Cash remittances to the ultimate holding company in 2014 amount to £610 million, comprising £350 million from principal subsidiaries and £260 million of proceeds from the sale of Lombard.

Economic capital position

The UK life operations perform a risk-based assessment of economic capital, incorporating management's estimate of the capital required to mitigate the risk of insolvency to a minimum of a 99.5% confidence level over a one year period.

The Group's CMP is to maintain capital resources at the life company level to cover 125% of the capital requirements on an economic capital basis.

The Group also monitors a pro forma economic capital position at a Group level, which comprises:

· the surplus of FLL, excluding FPIL, on an economic capital basis;

· the surplus of FPIL on an economic capital basis; and

· the fungible net assets of the other operating and holding companies.

The estimated and unaudited Group economic capital surplus above capital requirements as at 31 December 2014 is strong at £3.7 billion (a coverage ratio of 196%). The decrease in capital surplus since 31 December 2013 (surplus of £3.9 billion, coverage ratio 193%) reflects adverse operating variances during the year.

The sensitivities to market shocks show that economic capital surplus at a Group level at 31 December 2014 would change by:

· an estimated £(0.5) billion in the event of a combined 40% fall in equity markets and a 30% fall in property markets;

· an estimated £0.3 billion in the event of a 200bps rise in interest rates; and

· an estimated £(0.6) billion in the event of a widening of corporate bond spreads of 200bps (of which one-third is assumed to relate to defaults).

The sensitivities reflect investment activities, the recapture of £1.6 billion of assets backing annuities, the with-profits annuity reallocation and modelling changes implemented since 31 December 2013.

Insurance Groups Capital Adequacy

In addition to individual company requirements, the Group is required to meet the IGCA requirements of the Insurance Groups Directive. The Group's capital policy is to maintain sufficient Group capital resources to cover 150% of the Group Capital Resource Requirement ("CRR") (excluding WPICC).

The balance sheet remains strong with an estimated and unaudited IGCA surplus of £2.3 billion at 31 December 2014 (1 January 2014: £2.2 billion), with Group capital resources being 240% of the CRR (1 January 2014: 238%) (excluding WPICC of £4.3 billion (1 January 2014: £4.2 billion)).

(i) Finance costs and other movements include the £(30) million impact of the share buyback programme prior to its suspension upon the announcement of the Proposed Acquisition.

At 31 December 2014 the capital held to meet CMPs was £836 million (1 January 2014: £812 million) and the excess over the CMPs was £1,504 million (1 January 2014: £1,424 million).

The sensitivities to market shocks show that IGCA surplus at 31 December 2014 would change by:

· an estimated £(0.1) billion in the event of a combined 40% fall in equity markets and a 30% fall in property markets;

· an estimated £0.3 billion in the event of a 200bps rise in interest rates; and

· an estimated £(0.5) billion in the event of a widening of corporate bond spreads of 200bps (of which one-third is assumed to relate to defaults).

The sensitivities reflect investment activities, the recapture of £1.6 billion of assets backing annuities, the with-profits annuity reallocation and modelling changes implemented since 31 December 2013.

Financial strength ratings

The Group targets financial strength ratings in the single "A" range for its principal life business and expects them to remain there for the foreseeable future. Current financial strength ratings are set out below.

Financing and interest costs

The Group has a number of debt instruments and the operating costs of financing these for the year ended 31 December 2014 are presented below.

(i) Market value is based on listed ask price, at 31 December 2014, excluding accrued interest.

(ii) The UT2 reset perpetual subordinated debt is a $575 million US Dollar denominated instrument. The principal and clean market values represent Sterling equivalent values as at 31 December 2014. The finance cost of £28 million is based on the Sterling equivalent principal on the day of issue of £356 million.

(iii) Finance costs within sustainable free surplus amount to £(94) million, being the IFRS amount of £(120) million net of tax.

Corporate gearing and liquidity

(i) IFRS debt gearing excludes the 2003 and 2005 STICS, as these securities are classified as equity in IFRS.

At 31 December 2014, the ratio of debt to IFRS equity attributable to equity holders of the parent, gross of debt, was 18.0% (31 December 2013: 16.7%), with the fall in equity principally reflecting the payment of dividends in the period and the loss after tax for the year.

The MCEV gearing of 24.0% (31 December 2013: 21.1%) is up over the period reflecting an increase in the market value of the Group's debt and the decrease in gross Group MCEV, primarily as a result of the Lombard sale.

Discontinued operations - Lombard

On 30 October 2014 the Group completed the sale of its Luxembourg based business, Lombard. The financial impact of the sale, including the operating and non-operating results for the period, is included below:

Financial performance

(i) Free surplus is presented net of tax.

(ii) 2014 figures are up to and including 30 October 2014.

Lombard generated an IFRS based operating profit before tax of £23 million in the first ten months of 2014, £11 million lower than in 2013. The decrease principally reflects one-off costs incurred as a result of the expected sale of the business and lower fee income. The lower fee income results from lapses experienced in 2013 and 2014 and also that the 2014 profit only relates to ten months of the year.

The IFRS non-operating result of £(88) million principally reflects the £(46) million recycling of cumulative foreign exchange adjustments required on disposal and £(35) million amortisation of acquired value of in-force business and other intangible assets.

Sustainable free surplus of £7 million in the first ten months of 2014 is £1 million higher than 2013. Lower investment in new business is offset by reduced expected returns from in-force business.

Lombard generated a MCEV operating profit of £13 million in the first ten months of 2014 (2013: £(46) million). The operating loss in 2013 was principally due to the impact from basis changes to strengthen persistency assumptions. MCEV operating profit was higher in the second half of 2014 principally due to the adverse lapse experience seen in the first two quarters (notably in Belgium) not being repeated in the second half of the year.

Within the MCEV result and consistent with CFO Forum principles, a closing adjustment totalling £(283) million has been made for the remeasurement of the carrying value amount of Lombard. This is excluded from the above table as it does not form part of the profit and loss statement.

Principal risks and uncertainties

The Group actively identifies, assesses and monitors current and emerging principal risks. These are regularly reviewed by the Executive and Risk and Compliance Committees. The following risks present the principal risks deemed to be facing the Group at the current time:

As stated in note 1 to the IFRS consolidated financial statements, the Directors have considered the Group's risk and uncertainties and are satisfied that the Group has sufficient resources to continue in operation for the foreseeable future. Accordingly, they continue to adopt the going concern basis in preparing the consolidated financial statements.

Directors' statement of responsibilities

The financial information set out in this report does not constitute the Company's statutory accounts for the years ended 31 December 2014 or 2013, but is derived from those accounts. The statutory accounts for the year ended 31 December 2013 have been delivered to Companies House (in accordance with the requirements of the Overseas Companies Regulations 2009) and those for 2014 will be delivered in due course. The Auditor has reported on those accounts; its Reports were unqualified and did not draw attention to any matters by way of emphasis without qualifying its Report.

The directors are responsible for preparing the Annual Report and the consolidated financial statements in accordance with applicable Guernsey law and International Financial Reporting Standards ("IFRS") adopted for use in the European Union and have disclosed their responsibilities in this regard in the 2014 Annual Report and Accounts.

Pursuant to the Disclosure and Transparency Rules (DTR 4), the directors confirm that, to the best of each director's knowledge:

· the financial statements of the Company, prepared in accordance with the applicable set of accounting standards, give a true and fair view of the assets, liabilities, financial position and profit and loss of the Company and the Group as a whole; and

· the Strategic report, the Directors report and the Corporate governance report include a fair review of the development and performance of the business, and the position of the Company and the undertakings included in the consolidation taken as a whole, together with a description of the principal risks and uncertainties that it faces.

On behalf of the Board

Tim Tookey

Chief Financial Officer

4 March 2015

IFRS FINANCIAL INFORMATION

Consolidated income statement

For the year ended 31 December 2014

The consolidated income statement includes the results of Lombard as a discontinued operation. A single amount is shown on the face of the income statement representing the operation's post-tax result. 2013 results have also been restated to reflect this classification.

The notes 1 to 14 form an integral part of these financial statements.

Consolidated statement of comprehensive income

For the year ended 31 December 2014

Consolidated statement of IFRS based operating profit

For the year ended 31 December 2014

Consolidated statement of financial position

At 31 December 2014

The financial statements were approved by the Board of Directors on 4 March 2015.

Consolidated statement of changes in equity

For the year ended 31 December 2014

Consolidated statement of cash flows

For the year ended 31 December 2014

Notes to the consolidated accounts

1. Accounting policies

1.1 Basis of preparation

The financial statements of the Company as at and for the year ended 31 December 2014 comprise the consolidated financial statements of the Company and its subsidiaries (together referred to as "the Group") and the Group's interests in its associates.

The consolidated financial statements as at and for the year ended 31 December 2014 have been prepared in accordance with International Financial Reporting Standards ("IFRS") as adopted by the European Union ("EU").

The presentation currency of the Group is Sterling. Unless otherwise stated the amounts shown in the consolidated financial statements are in millions of pounds Sterling (£ million).

The preparation of the financial statements under IFRS requires management to make judgements, estimates and assumptions that affect the application of policies and the reported amounts of assets and liabilities, income and expenses. The estimates and associated assumptions are based on historical experience and other factors that are believed to be reasonable under the circumstances, the results of which form the basis of making the judgements about carrying values of assets and liabilities that are not readily apparent from other sources. Actual results may differ from these estimates.

The estimates and underlying assumptions are reviewed on an ongoing basis. Revisions to accounting estimates are recognised in the period in which the estimate is revised if the revision affects only that period or in the period of the revision and future periods if the revision affects both current and future periods.

Following its classification as held for sale as at 30 June 2014 and subsequent disposal, the Lombard operating segment has been presented as a discontinued operation. A single amount is shown on the face of the consolidated income statement, comprising the post-tax result of the discontinued operation, the post-tax loss recognised on the remeasurement to fair value less costs to sell and associated corporate non-recurring costs of disposal. The consolidated income statement, consolidated statement of comprehensive income and consolidated statement of IFRS based operating profit comparatives have been restated.

The 2013 consolidated income statement includes the results of AmLife Insurance Berhad and AmFamily Berhad (collectively "AmLife") up until the date of their disposal on 4 January 2013.

The directors have, at the time of approving the financial statements, a reasonable expectation that the Company and the Group have adequate resources to continue in operational existence for the foreseeable future. Thus they continue to adopt the going concern basis of accounting in preparing the financial statements.

The International Accounting Standards Board ("IASB") issued the following new standards and changes to existing standards which are relevant to the Group and have been adopted in the Group financial statements with effect from 1 January 2014.

· IFRS 10: Consolidated financial statements. This standard provides a single consolidation model that identifies control as the basis for consolidation for all types of entities. It replaces the requirements in IAS 27: Consolidated and separate financial statements and SIC 12: Consolidation - special purpose entities. Under IFRS 10, an investor controls an investee when it has exposure, or rights, to variable returns from involvement with the investee and has the ability to affect those returns through its power over the investee. The application of IFRS 10 has not had a material impact on the Group.

· IAS 28 (revised): Investments in associates and joint ventures. This standard supersedes IAS 28: Investments in associates and sets out the requirements for the application of the equity method when accounting for investments in associates and joint ventures. The application of IAS 28 (revised) has no impact on the Group.

· IFRS 12: Disclosure of interests in other entities. This standard combines, enhances and replaces disclosure requirements for subsidiaries, joint arrangements, associates and structured entities. Relevant disclosures are included in note 8.

Amendments to IAS 32: Financial instruments: Presentation relating to offsetting financial assets and financial liabilities. These amendments clarify the meaning of 'currently has a legally enforceable right to set-off' and the criteria for non-simultaneous settlement mechanisms of clearing houses to qualify for offsetting.

Below is a list of new standards and changes to existing standards, relevant to the Group, that have been issued by the IASB with effective dates for annual accounting periods beginning on or after 1 January 2015, unless otherwise stated, but where earlier adoption is permitted. They have been endorsed by the EU unless otherwise stated. They have not been considered for early adoption by the Group. These changes are not expected to materially impact the Group unless otherwise stated.

New standards:

· IFRS 9: Financial instruments.This standard reflects all phases of the IASB's work on the replacement of IAS 39: Financial instruments: recognition and measurement. The standard introduces new requirements for classification and measurement, impairment and hedge accounting. Classification is dependent upon the entity's business model for managing its financial instruments and the contractual cash flow characteristics of the instruments. The adoption of IFRS 9 may have a material impact on the classification and measurement of the Group's financial assets. This standard is effective for accounting periods beginning on or after 1 January 2018; it is yet to be endorsed by the EU; and

· IFRS 15: Revenue from contracts with customers. The objective of this standard is to establish the principles that an entity shall apply to report useful information to users of financial statements about the nature, amount, timing and uncertainty of revenue and cash flows arising from a contract with a customer. This standard is effective for accounting periods beginning on or after 1 January 2017; it is yet to be endorsed by the EU.

The impact of these new requirements is currently being assessed by the Group.

Amendments to existing standards:

· Amendment to IAS 16: Property, plant and equipment and IAS 38: Intangible assets: In these amendments the IASB has clarified that the use of revenue-based methods to calculate the depreciation of assets and amortisation of intangible assets is not appropriate. This amendment is effective for annual periods beginning on or after 1 January 2016 but has not yet been endorsed by the EU;

· Improvements to IFRSs 2012: These annual improvements address seven standards in the 2010-2012 reporting cycle. They include changes to IFRS 2: Share-based payment, IFRS 3: Business combinations, IFRS 8: Operating segments, IFRS 13: Fair value measurement, IAS 16: Property, plant and equipment, IAS 24: Related party transactions and IAS 38: Intangible assets. Consequential amendments are also made to IFRS 9: Financial instruments, IAS 37: Provisions, contingent liabilities and contingent assets, and IAS 39: Financial instruments: recognition and measurement. The amendments are effective for annual periods beginning on or after 1 July 2014;

· Improvements to IFRSs 2013: These annual improvements address four standards in the 2011-2013 reporting cycle. They include changes to IFRS 1: First time adoption, IFRS 3: Business combinations, IFRS 13: Fair value measurement, and IAS 40: Investment property. The amendments are effective for annual periods beginning on or after 1 July 2014; and

· Improvements to IFRSs 2014: These annual improvements address four standards in the 2012-2014 reporting cycle. They include changes to IFRS 5: Non-current assets held for sale and discontinued operations, IFRS 7: Financial instruments: disclosures, IAS 19: Employee benefits, and IAS 34: Interim financial reporting. The amendments are effective for annual periods beginning on or after 1 January 2016 but have not yet been endorsed by the EU.

The impact of these amendments is currently being assessed by the Group.

The Group has not early adopted any other standard, interpretation or amendment that has been issued but is not yet effective.

The financial statements comply with the Statement of Recommended Practice issued by the Association of British Insurers in December 2005 (as amended in December 2006) insofar as these requirements do not contradict the requirements of IFRS.

The Group presents its consolidated statement of financial position in order of liquidity. Where applicable, for each asset and liability line item that combines amounts expected to be recovered or settled both within and beyond 12 months after the reporting date, disclosure of the amount due beyond 12 months is made in the respective note.

Financial assets and financial liabilities are not offset, unless there is a legally enforceable right to offset the recognised amounts and there is an intention to settle on a net basis, or to realise the assets and settle the liability simultaneously. Income and expenses are not offset in the income statement unless required or permitted by an accounting standard or interpretation, as specifically disclosed in the accounting policies of the Group.

2. Segmental information

a) Summary

Segmental information is presented on the same basis as internal financial information used by the Group to evaluate operating performance.

An operating segment is a component of the Group that engages in business activities from which it earns revenues and incurs expenses.

The Group's reportable segments under IFRS 8: Operating segments are as follows:

· UK comprising Corporate Benefits, Protection and Retirement Income market-facing businesses and Sesame Bankhall Group ("SBG"),

· Heritage, comprising the bulk of the UK business that is no longer actively marketed, the Overseas Life Assurance Business ("OLAB") within the UK life and pensions subsidiaries and Friends Life Investments ("FLI"), and

· FPI comprising Friends Provident International Limited ("FPIL").

Lombard has been classified as a discontinued operation with a single amount shown on the face of the consolidated income statement comprising the post-tax loss for the period, the post-tax loss recognised on the remeasurement of its net assets to fair value less costs to sell, loss on disposal, cumulative exchange difference arising on translation to Sterling, associated corporate non-recurring costs of disposal and any profit/loss on remeasurement of contingent consideration subsequent to disposal. Lombard's result has been excluded from IFRS based operating profit in 2013 and 2014, to better reflect the expected ongoing performance of the Group.

Corporate functions are not strictly an operating segment, but are reported to management and are provided in the analysis below to reconcile the Group's reportable segments to total profit.

In previous reporting periods, OLAB was managed and reported within the FPI segment. Following the decision to stop writing new business in 2013, OLAB was transferred to the Heritage segment in January 2014 and comparatives for the full year to 31 December 2013 have been restated.

b) Operating segment information

(i) IFRS based operating profit

(ii) Reconciliation of IFRS based operating result before tax to profit or loss after tax

(iii) Revenue and expenses

(iv) Products and services

Products and services are presented consistently with the disclosure of business segments, with each segment being broken down into the business units and products of which they comprise.

(v) Assets and liabilities