Final Results

Resolution Limited

26 March 2013

Preliminary results for the year ended 31 December 2012

Improved cash generation, strong capital base, dividend up 6.3%

·; Sustainable free surplus £300 million (2011: £291 million)

·; Available shareholder cash £850 million (2011: £853 million)

·; FLG IGCA surplus £2.0 billion, coverage ratio 214% (2011: £2.1 billion, 219%)

·; FLG economic capital surplus(i) £3.4 billion, coverage ratio 182%

·; Full year dividend per share 21.14 pence (2011: 19.89 pence); scrip dividend discontinued

·; Full year dividend covered 117% by cash up‑streamed to Resolution holding companies

Continuing growth in new business

·; Value of new business up 28% to £194 million, including 125% increase in UK division

·; Group new business APE £1,211 million; UK division sales up 19% to £669 million (2011: £564 million)

Good financial performance

·; IFRS based operating profit before tax of £274 million, £309 million excluding one-offs (2011: £681 million; £277 million, excluding one-offs)

·; MCEV operating profit before tax of £382 million, £420 million excluding one-offs (2011: £517 million; £377 million, excluding one-offs)

Operating highlights

·; Friends Life Investments successfully launched and now managing £11 billion of fixed interest assets

·; Outsourcing deal with Diligenta completed and progressing well

·; Run-rate savings of £86 million (2011: £45 million); 88% of the 2015 £160 million target secured

Simplified governance

·; Streamlined governance including unified membership of Resolution Limited and FLG boards announced

·; Operating agreement with Resolution Operations LLP ends 27 March 2013

Commenting on the results, Andy Briggs, CEO designate of Resolution Limited, said:

The Group has made good operational and financial progress in 2012 and, importantly, sustainable free surplus has improved. Our dividend is 117% covered by cash up-streamed to Resolution holding companies. The UK division performance has been especially strong with a 125% increase in the value of new business from sales up 19% and this has been achieved whilst reducing new business strain by 56%. Our UK and Heritage divisions are progressing strongly through their transformations. The strategic review of our International division was communicated to shareholders last November and has required some difficult, but right, decisions to be made, and the impact of this is reflected in that division's 2012 performance, in line with previous guidance.

Our strategic outlook is attractive, we have scale businesses and our delivery in 2012 has given us competitive advantage so we are well placed for the key market trends. I am confident that we are creating a sustainable business that will improve returns for shareholders.

Mike Biggs, Chairman of Resolution Limited, said:

These results evidence the financial benefits of strategic decisions taken in 2011, particularly in the UK. Following the International strategic review in 2012 the Board believes the Group is well positioned for future success.

(i) Estimated, unaudited

Enquiries:

Investors/analysts

Neil Wesley, Resolution Operations LLP +44 (0)7584 219213

Media

Alex Child-Villiers, Temple Bar Advisory +44 (0)7795 425580

Forward-looking statements

This announcement includes statements that are, or may be deemed to be, "forward-looking statements" with respect to Resolution, its subsidiary undertakings and their outlook, plans and current goals. In some cases, these forward-looking statements can be identified by the use of forward-looking terminology, including the terms "targets", "believes", "estimates", "anticipates", "expects", "intends", "may", "will" or "should" or, in each case, their negative or other variations or comparable terminology. By their nature, forward-looking statements involve risks and uncertainties because they relate to events and depend upon circumstances that may or may not occur in the future. Forward-looking statements are not guarantees of future performance. Resolution's actual performance, results of operations, internal rate of return, financial condition, liquidity, distributions to shareholders and the development of its acquisition, financing and restructuring and consolidation strategies may differ materially from the impression created by the forward-looking statements contained in this announcement. Forward-looking statements in this announcement are current only as of the date of this announcement. Resolution undertakes no obligation to update the forward-looking statement it may make. Nothing in this announcement should be construed as a profit forecast.

Media

There will be a conference call today for wire services at 07.30 (GMT). Dial in telephone number: UK FreeCall 0800 6940257, UK Standard International +44 (0) 1452 555566 Passcode: 20851136.

Analysts/Investors

A presentation to analysts will take place at 09.00 (GMT) at the Andaz Hotel, Liverpool Street, London, EC2M 7QN. Dial in telephone number: 0800 634 5205, UK standard International +44 (0) 208 817 9301, confirmation number: 10300845. A webcast of the presentation and the presentation slides will be available on Resolution's website, www.resolution.gg.

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

Financial calendar

2012 final dividend

Contents

Chairman's statement

Overview

The year was marked by good operational progress against a clear strategy and solid progress towards the simplification of the Company's governance structure.

The results in the second half of 2012 demonstrate that the UK division has continued to make strong progress with its cost reduction programme and in improving the value of new business. The Heritage division, which contains the UK book of business of products no longer marketed, has delivered further capital releases and was successful in reducing its expense risk through an outsourcing of a large part of its cost base. The success of the Group's separation and integration programme has allowed the target for cost reductions to be raised, albeit at higher costs to complete. The International division reported the outcome of a significant strategic review that refocused the business on its core segments of domestic affluent and global expatriate in the Friends Provident International business and high net worth individuals in the Lombard business. The overall returns on new business written have improved on the prior year.

The Company remains focused on extracting synergies from the acquisitions made and improving the underlying cash generation from the Group. I am pleased to report that the sustainable free surplus generated by the Group, which is a key driver of cash generated by the Group's life companies, improved steadily over the full year.

The net Market Consistent Embedded Value ("MCEV") of the Group as at 31 December 2012 was £5,831 million, an increase of 0.6%, after cash dividends paid to shareholders of £193 million.

The Operating Report and Business Review that follow this statement contain a comprehensive account of the full year results in 2012.

Cash and capital

Dividend

The Company's dividend policy can be summarised as being an absolute amount determined by the Board, currently 21.14 pence per share from 2012 onward, with the expectation that a progressive dividend would be considered once sustainable cash generation reached the £400 million per annum distributable cash target. The Company expects to pay one-third of the total annual dividend as an interim dividend and two-thirds of the total annual dividend as the final dividend. The existing scrip dividend alternative is being discontinued and, in its place, shareholders will be offered a dividend reinvestment plan ("DRIP"). The Board has proposed a final dividend for 2012 of 14.09 pence per share, subject to shareholder approval.

Capital

The capital position of the Company remains strong. The Board is confident that the Group remains well capitalised on both regulatory and economic bases. The Company remains focused on maintaining a robust, low risk balance sheet and on improving the underlying cash generation of the Group.

Simplifying the governance structure

The Company's UK Life Project, which was focused on the consolidation and restructuring of assets in the UK financial services sector, has resulted in the creation of a financially disciplined, value focused Group. On 15 August 2012, following a review undertaken by the Company and Resolution Operations LLP ("ROL") of the UK Life Project, the Company and ROL concluded and announced that shareholder value going forward would be best delivered by moving from the externally advised project based structure to a more conventional, simplified governance structure. As part of those changes, the Company confirmed, among other things, that it would no longer actively seek acquisitions or target a specific exit event, but would rather continue to focus on maximising the value of the Group.

Progress on simplifying the governance structure

On 15 August 2012 the Company announced a proposal to adopt a more conventional governance structure by unifying membership of the boards of the Company and the main UK holding company for its regulated life insurance group, Friends Life Group plc ("FLG"), transferring many of the skills from ROL to the Company and ceasing to receive services from ROL under the Operating Agreement.

The Company believes that adopting a more conventional, simplified structure is appropriate for a company no longer seeking acquisitions or a specific exit event. It will also ensure that there is no risk to the Company's premium listing from the amendments made to the Listing Rules regarding "externally managed companies" which come into effect from 1 January 2014.

Details of the proposed composition of the board of directors of both the Company and FLG were announced on 19 October 2012. On 10 December 2012 the Company confirmed that, subject to implementation of the proposed amendments to the articles, changes to the Board membership would take effect by the end of March 2013. These amendments were approved by shareholders on 20 March 2013. The Company expects to appoint an additional independent non-executive director, not drawn from either of the existing boards, in due course and a search process is under way.

On 19 October 2012 the Company also announced that I had informed the Board that, whilst I remain committed to chairing the new Board to oversee this period of change, I had decided that it would be appropriate to hand over to a new chairman once the transition has been completed. The Company commenced an appointment process for the new chairman and the additional independent non-executive director. On 21 January 2013 the Company announced that Sir Malcolm Williamson would be appointed as chairman when I step down later this year. I intend to step down, and Sir Malcolm's appointment is expected to become effective, immediately after the close of the annual general meeting of the Company on 16 May 2013.

On 10 December 2012 the Company announced that it had finalised arrangements regarding the final phase of the simplification of the governance of the Company and entered into a Business Sale Agreement with ROL under which ROL will, on 27 March 2013, transfer to the Company business activities that relate to the services it currently provides to the Company and the ROL employees who provide these services. ROL will cease to provide services to the Company, and the Company's payments to ROL under the Operating Agreement will terminate, at the same time.

Outlook

The Company expects that its clear value philosophy will deliver shareholder value going forward. The simplified governance structure should allow investors to focus on and value the considerable operational progress being made in the Group.

While I am looking forward to continuing to chair the Board until the annual general meeting of the Company on 16 May 2013, I would like to take this opportunity to thank my fellow members of the Board, the staff at ROL and at Friends Life for their support and hard work over the course of my chairmanship.

Operating report

1. Executive summary

2012 was another important year for the Company and the Group as a whole. Overall, the Group is pleased to report significant progress with measurable improvements towards its financial and operational targets. The Group has significantly reduced its UK new business strain (2013 target achieved one year early), delivered considerable progress in the value of new business written, improved the rates of return on new business, increased its expected cost savings target, achieved a cash remittance from its International business, materially de-risked the Group's dividend-supporting cash flows and increased its sustainable free surplus generation - a key driver of cash generation of the Group.

This was against a backdrop of macroeconomic uncertainty over the course of the year and a sizeable regulatory agenda impacting the UK life sector. The progress in 2012 has been possible because of the tough strategic and financial decisions taken over the last eighteen months that have prioritised value over volume and focused the Group on profits, returns and cash generation.

2. Strategy

The Company's overall strategic aim remains unchanged: to create a sustainable business that meets customers' needs while also delivering cash and returns to shareholders. When the Company was formed this strategic aim was expected to be fulfilled within a project based structure. On 15 August 2012, the Company announced that while the project based structure was appropriate at the time the Company was launched, shareholder value going forward will be best delivered by moving from an externally advised project based structure to a more conventional, simplified governance structure. As part of that announcement, the Company confirmed, among other things, that it would no longer seek acquisitions or a specific exit event. The Company retains its focus on cash emergence and maximising value for shareholders.

The Group is focused on continuing its disciplined management of the existing book of business to deliver cash and capital synergies and on writing profitable new business in its UK and International divisions. Its approach to managing the business is unchanged, with its three financial priorities remaining: maintaining a robust, low risk balance sheet; improving sustainable cash flow generation; and writing profitable new business to ensure future cash flow generation.

In the UK, the Group has a selective new business focus on three core product areas (Corporate Benefits, Protection and Retirement Income), where the Group believes it has, and can sustain, competitive advantage and scale and thereby achieve appropriate returns. In addition, through the Heritage division, the Group is focused on a disciplined approach to management of closed books of business.

The Group also completed a major strategic review of the International division which was set out in a detailed investor update in November 2012. As a result, Friends Provident International ("FPI") will refocus on two core areas of serving expatriates globally and affluent customers in selected markets, principally Hong Kong, Singapore and Dubai. Lombard will continue its existing strategy with increasing focus on private bank distribution in Europe and explore opportunities for targeted expansion in Asia.

3. Economic and regulatory environment

The economic environment in 2012 was characterised by continued uncertainty globally and the UK economy undergoing a further period of recession. This resulted in volatility across asset classes, especially equities and corporate bonds, and to a lesser degree top-tier government bonds. Growth was weaker than expectations particularly in the euro zone, UK and Japan but exceeded initial expectations in emerging markets. European economies and sentiment, were impacted by ongoing sovereign debt concerns, which together with the impact of the UK Government's austerity programme, negatively affected UK consumer demand and sentiment. Asia continued to benefit from its favourable demographics and relatively healthy fiscal position. The Group's businesses were impacted primarily by the events in Europe and the UK and its selective participation in Asia with the International division impacted by economic uncertainty that dented consumer confidence, resulting in clients postponing many investment decisions. The UK division was also subject to the impacts of the upcoming regulatory changes.

The Group has made good progress preparing for regulatory changes - the Retail Distribution Review ("RDR"), gender neutral pricing and the auto-enrolment of pensions - by making the product and systems changes necessary to meet the new regulatory requirements. In the UK division, Corporate Benefits expects that it will be a beneficiary from the structural shift from defined benefit to defined contribution schemes, the introduction of auto-enrolment of pensions and RDR with selective participation in profitable schemes and leveraging its position of scale in this market. In Protection, the market has seen pricing adjustments to reflect the implementation of gender neutral pricing. The International division will navigate the economic uncertainty in its markets by continuing to focus on its niche offerings and selective market participation although customer sentiment improvements are important.

4. Business performance

(i) 2010 baseline includes an estimate of 12 months BHA and AXA UK Life Business results.

(ii) UK run-rate savings targeted to be £160 million by end 2015.

4.1 Operating results

Financial performance in the year shows continued strong new business performance, progress in sustainable free surplus generation - a key driver of cash generation, and higher returns on new business written, but was impacted by the negative financial impacts of the International strategic review.

The overall improvement in new business performance has been driven by the UK division, with new business written achieving higher returns at a lower cost. Good progress has been made towards UK new business targets with value of new business ("VNB") more than double that achieved in 2011. This improvement in financial performance validates the actions taken to date, with Retirement Income VNB already above its 2013 target and the Corporate Benefits VNB target within sight. The Protection business has also performed well in 2012 and has delivered strong VNB growth. The IFRS based operating profit of the UK and Heritage divisions reflects the benefits of reduced operating costs but lower investment returns given the weaker economic environment. As a result, the UK and Heritage divisions' IFRS based operating profit of £300 million (£253 million excluding one-off items) reflects a robust performance against that achieved in 2011 (31 December 2011: £672 million; £256 million excluding one-off items). Similarly, the UK and Heritage divisions' MCEV operating profit of £502 million (£440 million excluding one-off items) reflects the significant improvement in new business contribution with further benefits accruing as expense reductions are recognised (31 December 2011: £507 million; £360 million excluding one-off items).

The International division's performance in 2012 has been dominated by the impact of the strategic review conducted in 2012. Overall, Lombard has performed well despite a challenging economic environment in its core markets in Europe. Lombard's sales volumes have grown by 7% and funds under management are now £19 billion (€23 billion) an 11% increase in euro balances year on year. Selective changes to distribution channels introduced by management during 2012 means more business is sold through the lower margin but more stable private bank channels and less through IFAs. Lombard's restructuring programme is expected to remove over 20% of head office costs and has resulted in some restructuring charges in 2012.

Within International's other business, Friends Provident International ("FPI"), the German business unit was the primary driver of the poor financial performance in 2012. The performance relates mainly to low interest rates increasing the costs of guarantees on German products, together with lapse and expense assumption changes as the Group moves towards a distribution model in Germany rather than a model combining distribution and product manufacture.

In November 2012, the Group set out its expectations for a £50-£100 million reduction in MCEV as a result of the International strategic review. This reflected the expected impact of the annual review of assumptions across the International division including a positive £46 million benefit in the Lombard business unit arising from the head office restructuring. The Group also highlighted the ongoing review of the German and Japanese businesses but had not concluded on the financial implications at that point. These reviews have since been completed and, when combined with the annual basis review, the overall impact on the result is an MCEV reduction of £(94) million. Whilst this impact is clearly disappointing, it is pleasing that the overall impact is within expectations despite now including adjustments relating to the German and Japanese businesses.

4.2 Cash and capital

The Group continues to maintain a robust low risk balance sheet and deliver improvements in sustainable free surplus generation. The Group remains committed to increasing sustainable free surplus, which is a key driver of cash generation of the Group, to meet its target of £400 million per annum. However, in August 2012, the Group set out that achieving this target had become circa £50 million per annum more challenging than when the target was set due to the lower interest rate environment. In addition to the sustainable free surplus generated of £300 million in 2012, the Group completed its 2012 capital optimisation programme in December 2012. As a result, the number of active life companies in the Group was reduced from five to four and this generated additional free surplus of £101 million.

The Group took a significant step to de-risk the cash flow available to shareholders with the issue in November 2012 of US$575 million Reset Perpetual Subordinated Notes. The proceeds were used to make early repayment of the remaining £363 million deferred consideration notes ("DCNs") issued to AXA UK in connection with the acquisition of the AXA UK life business. Following the repayment of the DCNs, the Group's external cash commitments reduced by approximately £60 million per annum as a result of the removal of the requirement to amortise the DCNs, providing increased dividend security. The Group's gearing level at 31 December 2012 was 21.5% calculated as debt as a percentage of gross Group MCEV.

The scrip dividend alternative is being discontinued in respect of the 2012 final dividend. Shareholders will be offered a dividend reinvestment plan ("DRIP") in its place.

4.3 Separation, integration and outsourcing

The separation, integration and outsourcing programmes have seen significant delivery in 2012 including the commencement in March of the Diligenta outsourcing contract. As this work has continued, further cost efficiency opportunities have been identified. As a result, in November 2012 the Group increased its target for UK run-rate cost reductions by £14 million to £126 million by the end of 2013, and by £17 million to £160 million by the end of 2015. The Group remains confident of reaching these targets with run-rate savings of £86 million per annum achieved and a further £54 million secured at December 2012.

In November 2012, the Group announced that the costs of completing certain of the more complex elements, including the migration from the AXA systems hosting environment and the overall outsourcing project, would be higher than originally expected. The Group continues to believe these programmes can be completed within the revised cost guidance given in November 2012.

5. Outlook

A low interest rate environment is expected to persist as central banks around the world retain an accommodative stance with respect to monetary policy to combat weak global economic growth. This presents a significant challenge as persistent lower rates of return impact the ability of the business to generate cash and free surplus. Notwithstanding this, the Group's full year results demonstrate good operational progress and the benefits of disciplined execution of a clear strategy. The progress reflects the Group's focus and capital deployment on attractive growth markets where the Group has a sustainable competitive advantage.

The Group is confident that focusing on applying rigorous financial discipline and maintaining an appropriate balance between risk and return will allow it to continue to make good progress in the coming year. As a result, the Board is confident that the Group is on track to meet its financial targets, whilst creating a sustainable business that meets customers' needs and delivering cash and returns to shareholders.

Business review

1 Key performance indicators

The Group uses the following key performance indicators:

KPI: IFRS based operating profit

IFRS based operating profit before tax of £274 million is lower than the £681 million reported in 2011 principally reflecting the one-off benefits of £404 million included in the prior year. Excluding one-off items (comprising the impact of the International strategic review and principal reserving changes), the 2012 underlying result of £309 million is up 12% on 2011 (31 December 2011, excluding principal assumption changes: £277 million), reflecting the reduction in new business strain due to cost savings achieved.

KPI: IFRS loss after tax

IFRS loss after tax of £(41) million (31 December 2011: £(31) million) principally reflects one-off project costs as the Group integrates the businesses, as well as the amortisation of the acquired intangible assets. These are partially offset by favourable investment return variances as corporate bond spreads narrowed in the year.

KPI: MCEV operating profit before tax

Segment results comprise covered and non-covered businesses.

MCEV(i) operating profit before tax of £382 million (31 December 2011: £517 million) is lower than the 2011 result, reflecting the significant one-off benefits totalling £140 million in the prior year, principally due to the benefit of the outsourcing agreement with Diligenta. Excluding one-off items (comprising the impact of the International strategic review and other assumption changes), the 2012 underlying result of £420 million is 11% higher than 2011 (31 December 2011, excluding assumption changes: £377 million). The improvement principally reflects the significant growth in the UK division's value of new business.

(i) The MCEV basis is in compliance with the European Insurance CFO Forum MCEV Principles ("MCEV Principles") (Copyright© Stichting CFO Forum Foundation 2008), issued in June 2008, and reissued in amended form in October 2009.

KPI: MCEV profit/(loss) after tax

MCEV profit after tax of £268 million is significantly higher than the £(295) million loss reported in 2011 principally reflecting the recovery of equity markets and narrowing of corporate bond spreads in 2012.

KPI: Group embedded value on an MCEV basis

Group embedded value on an MCEV basis of £5,831 million (31 December 2011: £5,796 million) is up by £35 million with the operating performance partially offset by dividend payments.

KPI: FLG return on embedded value

FLG(i) operating ROEV of 5.1% has been negatively impacted by the International division strategic review.

(i) FLG operating ROEV is calculated as the MCEV operating return, after tax and financing, divided by the start of period net embedded value, and is adjusted to allow for the timing of significant capital movements such as dividends and acquisitions.

KPI: Asset quality (corporate debt and asset-backed securities)

The Group has maintained high asset quality, with 97% of shareholder-related corporate debt and asset backed securities at investment grade or above (31 December 2011: 97%). The Group has no significant shareholder exposure to sovereign debt or corporate bonds of higher risk European economies. No defaults were recorded in the year and the shareholder share of default provisions amounted to £0.5 billion.

KPI: Available shareholder cash

Group available shareholder cash of £850 million (31 December 2011: £853 million) is in line with 2011 with dividends paid to shareholders and the impact of refinancing largely offset by the contribution from the life companies.

KPI: IGCA

FLG IGCA surplus capital of £2.0 billion (31 December 2011: £2.1 billion) represents a coverage ratio of 214% (31 December 2011: 219%). Surplus capital has remained strong over 2012 with the cost of debt financing and dividends paid to the Resolution holding companies largely offset by the operating performance of the Group.

2 Group results

2.1 Group IFRS results

The Group's IFRS results are set out below, including a reconciliation from IFRS based operating profit to the IFRS result after tax. The Group uses the operating profit measure as its key IFRS metric as the Board considers that this better represents the underlying performance of the business and the way in which it is managed.

(i) Full year 2011 results comprise 12 months results for Friends Provident and the AXA UK Life Business, 11 months for BHA, ten months for GOF and TIP and two months for the acquired WLUK business.

Operating profit

The Group IFRS based operating profit in the year to 31 December 2012 totalled £274 million, £407 million lower than the full year 2011 result. The principal driver of the year on year reduction is the £404 million one-off benefit reported in the 2011 result. On an underlying basis, excluding the impact of the International strategic review and increased cost of guarantees of £(82) million and favourable assumption changes of £47 million within the UK and Heritage divisions, the 2012 IFRS based operating profit of £309 million compares to £277 million for 2011. The International strategic review has impacted both new business strain (£(12) million) and principal reserving changes and one-off items £(70) million).

The improvement largely reflects the good progress made in delivering operating cost savings within the UK and Heritage divisions, notwithstanding the need to increase development spend as the Group prepared for the significant regulatory driven change (RDR, auto-enrolment and gender neutral pricing) implemented towards the end of 2012.

Further details of the operating performance of the Group are included in the relevant operating reviews below.

Non-operating items

Short-term fluctuations in investment returns, on assets backing the shareholder and non-profit funds, were a favourable £275 million in the year to 31 December 2012. This benefit mainly reflects a reversal of the negative variances experienced in 2011, and principally includes:

·; £118 million benefit as confidence returned to bond markets, resulting in lower credit default assumptions and the application of a higher valuation interest rate;

·; £99 million benefit from the release of unit-linked tax loss provisions as a result of updated fund growth estimates; and

·; £45 million release of credit default allowances, as credit defaults have been lower than assumed in the long-term investment return.

Non-recurring items of £(258) million include:

·; separation and integration programme costs of £(124) million;

- costs, net of provision releases, of the separation and integration programmes totalled £(124) million in the year and take cumulative spend on these projects to £(257) million (31 December 2011: £(133) million). In November 2012, the Group provided an update on the costs of completing these programmes with extensive re-planning undertaken to assess the impacts of addressing the complexities and necessary remediation work arising from the proposed migration from AXA systems hosting environment. Including these incremental elements the total lifetime costs for the separation and integration programme are now expected to be approximately £(280) million.

·; finance transformation costs of £(76) million largely relating to Solvency II;

·; outsourcing implementation costs of £(41) million;

- costs of £(84) million relating to the Diligenta outsourcing implementation were provided for as at 31 December 2011. In 2012, a further £(82) million of costs have been incurred, offset by a £31 million provision release and £10 million pension scheme curtailment gain following the transfer of outsourced employees. Costs incurred to date total £(125) million with total implementation costs expected to be in the region of £(280) million, incurred in the period to the end of 2014.

·; costs of £(16) million relating to the separation from ROL, principally comprising £(7) million for the transfer of the ROL operating agreement, £(3) million in connection with property costs and £(6) million of legal, restructuring and other costs; and

·; other net non-recurring costs of £(1) million including costs of the capital optimisation programme (£(17) million), curtailment gain of £22 million following the closure to further accrual of a Friends Life pension scheme and other non-recurring costs of £(6) million.

Interest payable on the FLG STICS of £(31) million is included as a £(22) million deduction to corporate long-term investment return in the operating profit analysis, and a £(9) million adverse short-term fluctuation in investment return. As the STICS are accounted for as equity in IFRS (with interest being recorded as a reserve movement), £31 million is added back to the non operating result to reflect the requirements of IFRS.

Acquisition accounting adjustments, totalling £(514) million, represent the amortisation and impairment of the intangible assets recognised on acquisitions. These charges comprise £(417) million of amortisation and impairment of acquired in-force business, and £(97) million of amortisation and impairment of other intangible assets (including £(14) million in respect of impairment of International assets, mainly goodwill). The amortisation of acquired in-force business in 2011 included a one-off charge of £(201) million (£(130) million for the AXA UK Life Business, £(71) million for BHA) which reflected the accelerated run-off of in-force surplus following the recognition of negative reserves in these businesses. The Group continues to monitor the expected run-off profile of the acquired in-force business with this adjusted in 2012 to reflect changes to the expected run-off profile of the International division's acquired in-force book.

A shareholder tax credit of £151 million is recognised for the year. This is higher than the loss before tax of £(192) million would imply. The actual tax credit includes £61 million in respect of the reduction in the rate of UK corporation tax, and net tax credits of £78 million in relation to tax reliefs, charges and expenses predominantly in relation to the life insurance companies in the Group which are taxed on the "I minus E" basis.

The tax credit in relation to the amortisation and impairment of AVIF and other intangibles in the year, including the associated impact of the reduction in the corporation tax rate, is £164 million.

Summary IFRS balance sheet

(i) Shares in issue at 31 December 2011 were adjusted to exclude Resolution Limited shares held by subsidiaries of 2,661,384 (31 December 2012: nil).

At 31 December 2012, IFRS total equity was £5,698 million (31 December 2011: £5,995 million), with equity attributable to equity holders of the parent of £5,377 million (31 December 2011: £5,672 million). IFRS net assets per share attributable to shareholders were £3.79 (31 December 2011: £4.13) based on shares in issue at the balance sheet date, excluding, at 31 December 2011, the Company's shares held by subsidiaries. The change in shares in issue in 2012 reflects the impact of scrip dividends taken up and the disposal of the Company's shares held by subsidiaries.

Financial assets are predominantly invested in listed shares, other variable yield securities, corporate bonds, asset-backed securities and government securities. Asset quality has been maintained with 97% of shareholder-related corporate bonds and asset-backed securities held at investment grade or above and there is limited exposure to European sovereign debt.

At 31 December 2012, the ratio of debt to IFRS equity attributable to equity holders of the parent, gross of debt, was 17.0% (31 December 2011: 17.4%), with the impact of the repayment of the DCNs in the year offsetting the reduction in equity.

2.2 Group MCEV results

MCEV is an alternative accounting basis to IFRS for life assurance companies. MCEV reporting is designed to recognise profit as it is earned over the lifetime of each policy and reflects the future cash flows that are expected to arise from sales in the period, together with the effect of updating the previous period's assumptions on existing business for the actual experience. The total profit recognised under both MCEV and IFRS will be the same over the life of each policy, it is the timing of the recognition of that profit which differs.

The results and financial position of the Group's life and pensions business ("covered business") are presented on the MCEV basis with all other businesses included on an IFRS basis.

(i) Full year 2011 results comprise 12 months results for Friends Provident and the AXA UK Life Business, 11 months for BHA, ten months for GOF and TIP and two months for the acquired WLUK business.

Operating profit

The Group MCEV operating profit in the year to 31 December 2012 was £382 million, down £135 million on the prior year reflecting the inclusion of significant one-off benefits in 2011 relating to the Diligenta outsourcing. Excluding one-off items in both years (comprising, for 2012, the impacts of the International division strategic review and other operating assumption changes), the 2012 result of £420 million (31 December: £377 million) represents a good performance. This improvement is underpinned by the UK and Heritage divisions where actions to reduce costs and migrate new business to the target platforms has significantly increased the value of new business.

The Group set out at the November 2012 investor day an expected £50-100 million adverse impact on the MCEV result of the International strategic review, which principally related to expense overruns and embedded value costs in FPI's OLAB business. At that time, the Group also highlighted that it was undertaking a review into the viability of the OLAB business (principally in Germany) as well as assessing assumptions for the Japanese book, with any costs of these reviews expected to be additive to the November range. These reviews have since been concluded and whilst the outcomes (which include the exit of product manufacturing in Germany) have been incrementally negative, it is notable that total International strategic review impacts, including related basis changes, of £(94) million remain within the original range. The impact of the International division strategic review is reflected in the value of new business (£(27) million), operating assumption changes (£(65) million) and other operating variances (£(2) million).

Notwithstanding the outcomes of the International division strategic review, the UK and Heritage divisions' operating result highlights the significant improvements in the value of new business, offset by the market driven lower expected returns.

Further details on the operating performance of the Group are included in the relevant divisional operating reviews below.

Non-operating items

Economic variances combine the impact of changes to economic assumptions with the investment return variances over the year. Total economic variances in 2012 had a £154 million positive impact on MCEV profit before tax (2011: £600 million adverse). The key positive variances arose from the narrowing of corporate bond spreads and the higher than expected movement in the equity markets. Corporate bond spreads narrowed by circa 70bps over 2012 which resulted in an increase in MCEV of £306 million, primarily in respect of annuity business written in the UK. The equity market movements increased the value of future annual management charges on unit-linked business, resulting in an increase of £157 million. These positives were offset by the change in the market value of Group debt of £(303) million. Other minor variances including those from foreign exchange movements and interest rates totalled £(6) million.

Non-recurring costs in 2012 total £(255) million and include costs of £(258) million, consistent with those reported within the IFRS result, offset by net items of £3 million specific to MCEV. The £3 million MCEV-specific element includes the release of a £34 million provision, originally set aside for the costs of implementing Solvency II, principally offset by the difference between the actual tax relief expected and the notional tax gross up applied to all non-recurring costs under MCEV. The application of these different tax rates results in a higher cost, gross of notional tax, under MCEV than under IFRS.

Other non-recurring items and non-operating variances of £128 million include a benefit of £62 million from the amalgamation of certain profits and losses under the New Life Tax Regime and a £70 million benefit principally from the impact on the UK and Heritage VIF of changing the ultimate corporation tax rate effective from April 2014 from 23% to 21%, following the Chancellor's Autumn Statement in December 2012.

MCEV balance sheet

(i) Includes IFA distribution and management services businesses including the pension asset of FPPS.

(ii) RSL 2011 net assets include the internal LT2 subordinated debt which was redeemed in November 2012.

(iii) Shares in issue at 31 December 2011 have been adjusted to exclude Resolution Limited shares held by subsidiaries of 2,661,384 (31 December 2012: nil).

At 31 December 2012, net Group MCEV was £5,831 million (31 December 2011: £5,796 million) giving MCEV per share of £4.11 (31 December 2011: £4.22). The fall in year on year MCEV per share, despite an increase in net Group MCEV, reflects the increased shares in issue following the fulfilment of the 2012 scrip dividend.

At the end of the year the ratio of debt to gross Group MCEV was 21.5% (31 December 2011: 19.3%), with the change primarily reflecting the increase in Group MCEV combined with the repayment of the DCNs. The ratio of debt to gross FLG MCEV has increased to 21.9% (31 December 2011: 16.3%), principally reflecting the increased market value of debt held at the FLG level and the successful raising of US $575 million (£356 million) of UT2 reset perpetual subordinated debt partially offset by the repayment of £200 million debt to Resolution holding companies in November 2012.

The Resolution holding companies' net worth increased by £285 million reflecting the payment of cash dividends of £(193) million and corporate costs incurred in the year of £(29) million, offset by the receipt of £500 million dividends from FLG and the disposal of £7 million of Company shares previously held by subsidiaries.

Resolution Limited shares held by Group subsidiaries are excluded from Resolution holding companies' net worth (in accordance with IFRS) therefore the disposal of these shares increases the Resolution holding companies' net worth.

The FLG operating ROEV, after tax, for the year to 31 December 2012 was 5.1% (31 December 2011: 6.5%). The year on year reduction highlights the inclusion of significant one-off benefits in the 2011 result, principally driven by revised expense assumptions following the completion of the Diligenta outsourcing. In 2012, whilst improvements have been made to the contribution from new business, particularly in the UK division, returns have been adversely affected by low expected returns on the in-force book and the strategic review of the International division.

2.3 Group free surplus generation

The generation of free surplus, net of movements in required capital, underpins the declaration of future dividends. The table below analyses the free surplus result after tax for the year.

(i) 2011 result excludes the GOF/TIP profit of £41 million, following the sale of this business in November 2011.

(ii) 2011 result excludes PS06/14 impact.

(iii) Other income and charges excludes the coupon on internal debt.

Sustainable free surplus

Sustainable free surplus generated in the year of £300 million (31 December 2011: £291 million) is up 3% on the 2011 result. This reflects the benefit from migrating new business onto the target platforms and reducing operating costs which has more than offset the lower return generated from the in-force book reflecting the current economic environment.

In addition, the higher than normal volume of regulatory change towards the end of 2012, including the implementation of RDR, auto-enrolment and gender neutral pricing, has resulted in additional development spend as the Group prepared for these changes.

Debt costs within sustainable free surplus are broadly flat year on year at £85 million (31 December 2011: £82 million). Going forward, debt costs within sustainable free surplus will increase by circa £7 million and reflect the refinancing of the deferred consideration notes and successful de-risking of the Group's dividend servicing capability.

Favourable other operating items in the year comprise £35 million release of unit-linked tax loss provisions as a result of updated fund growth estimates, £27 million benefit related to the refinement of capital allocation between with-profits and non-profits funds and £24 million of benefits principally resulting from refinements to models across the UK and Heritage divisions.

Non-sustainable items

Operating assumption changes, primarily in respect of expenses and persistency, reduced free surplus by £68 million, this includes £(73) million in the International division following the implementation of the strategic review. In 2011 the free surplus was increased significantly by the combined impacts of completing the implementation of PS06/14 and the benefits from the Diligenta outsourcing deal.

In the year to 31 December 2012, positive economic variances of £120 million increased free surplus, primarily driven by the impact of the narrowing of corporate bond spreads on assets backing the annuity business. In addition, the implementation of the Part VII transfers within the UK life companies in December 2012 reduced capital requirements and increased free surplus by £101 million. Other non-operating items reduced free surplus by £(208) million, broadly consistent with MCEV non-recurring costs, net of tax and excluding required capital.

Available shareholder cash

Available shareholder cash represents cash available to cover corporate costs, to service debt issued by holding companies and, subject to shareholder approval, to pay dividends.

The good delivery of free surplus in the UK and Heritage divisions, and Lombard, supported the declaration of £350 million of dividends from FLL together with the payment of £4 million from Lombard in 2012. Dividends actually paid by life companies in 2012 totalled £454 million, however £350 million of this was included in opening ASC as it had been declared at that point. The remaining £104 million, along with £250 million of FLL dividends declared at 31 December 2012, gives the contribution to the distributable cash target ("DCT") of £354 million. The issue of £348 million of UT2 reset perpetual debt (net of costs) and dividends from FLG enabled the repayment of the DCNs and the payment of the external dividend to shareholders. Other movements in ASC comprise corporate cash flows, including external interest payments net of interest received from life companies, and an increase in the amount of cash set aside at FLG holding company level to fund working capital requirements, relating to the funding for the pension scheme deficit.

Dividends

The Company's dividend policy can be summarised as being an absolute amount determined by the Board, currently 21.14 pence per share from 2012 onward, with the expectation that a progressive dividend would be considered once sustainable cash generation reaches the £400 million per annum distributable cash target. The Company expects to pay one-third of the total annual dividend as an interim dividend and two-thirds of the total annual dividend as the final dividend. In addition, the Board has decided that, the current scrip alternative will be discontinued and, subject to shareholder approval, will be replaced with a dividend reinvestment plan ("DRIP") thereby allowing shareholders to retain optionality regarding the method of receipt of dividends. Elimination of the scrip will remove shareholder dilution and further improves the clarity of cash flows and dividends.

Dividends from life companies to be up-streamed to Resolution holding companies in respect of 2012 are £350 million. The total cost of the dividend to shareholders is expected to be £298 million, comprising £98 million in respect of the interim 2012 dividend and £200 million in respect of the proposed final dividend, subject to shareholder approval. This gives a coverage ratio of 117%.

3 UK and Heritage divisions

Structure

The transformation of the UK business has continued throughout 2012 with the management structures now in place for the UK and Heritage divisions.

The Heritage division forms the bulk of the UK business by assets and in-force value and as a result is the principal driver of the Group's surplus generation. The division is focused on the management of products that are no longer actively marketed and is therefore distinct from the activities undertaken by the UK division.

The UK division combines the Corporate Benefits, Protection and Retirement Income business units which were formerly identified as 'Go to Market' businesses. These business units are focused on scale markets where good margins are generally available and where the Group has strong market positions enabling access to those margins.

The operational reviews of these stand alone divisions are set out in the sections that follow. However, whilst the transformation of these businesses is progressing well, until this is complete the financial results of the UK and Heritage divisions will continue to be presented as a combined unit although certain financial information is split between the divisions. The financial metrics for the combined UK and Heritage divisions are shown below.

2012 operational highlights

·; UK and Heritage IFRS based operating result of £300 million; £253 million excluding one-off items (2011: £672 million; £256 million excluding one-off items) principally reflects a focused operating performance with IFRS new business strain reduced by 47%.

·; UK and Heritage MCEV operating profit of £502 million is in line with the £507 million result in 2011, despite the reduced impact of one-off positive items (2012: £62 million, 2011: £147 million). The 2012 result reflects a material increase in the value of new business as the business focuses new business onto the target platforms and reduces operating costs.

·; UK sustainable free surplus generation up to £423 million from £374 million in 2011 reflecting reduced levels of free surplus invested in new business.

·; Run-rate cost savings achieved up to £86 million. Together with the £54 million now contractualised, savings totalling £140 million have been secured, equivalent to 88% of the 2015 cost saving target.

·; Targeted £200 million reduction in new business cash strain achieved a year early; total UK and Heritage new business cash strain now at £(91) million.

(i) Dividends of £450 million were paid by FLL in 2012, comprising £350 million regular dividends and £100 million additional dividends.

3.1 UK and Heritage divisions, financial performance

UK and Heritage divisions IFRS based operating profit

(i) Full year 2011 results comprise 12 months results for Friends Provident and the AXA UK Life Business, 11 months for BHA, ten months for GOF and TIP and two months for the acquired WLUK business.

The 2012 UK IFRS based operating profit of £300 million is £372 million lower than in 2011 mainly reflecting the £416 million one-off benefits reported in the prior year. The 2012 UK result reflects the significant reduction in new business strain, following a focus on target new business platforms and lower costs, partially offset by lower expected returns than 2011 due to lower interest rates and the higher internal debt costs paid to the Corporate segment.

A split of the £300 million IFRS based operating profit between the Heritage and UK divisions has been estimated as a £332 million profit and a £(32) million loss respectively. An estimate of this split is not available for the comparative period.

New business strain and in-force surplus

Details of new business strain and in-force surplus for the UK business are set out below.

Reconciliation of new business cash strain to IFRS new business strain

In the year, IFRS new business strain has been reduced by 47% to £59 million (31 December 2011: £112 million) reflecting the Group's actions to reduce acquisition expenses. The reduction in IFRS new business strain is principally driven by the underlying new business cash strain which is detailed in the respective UK and Heritage reviews that follow.

Deferred acquisition costs ("DAC") are recognised on pensions and investment new business with the lower level of deferral compared to 2011 reflecting the reduced commissions paid following the decision to stop selling investment bonds during 2011.

Reconciliation of in-force cash surplus to IFRS in-force surplus

The overall contribution to in-force surplus of the acquired Friends Life WL Limited ("FLWL") business formerly Winterthur Life UK Limited ("WLUK") business is £28 million in 2012 following the acquisition of this business in November 2011. This contribution is offset in the IFRS in-force surplus by a reduction in other IFRS adjustments mainly relating to the reversal of investment contract reserve movements which are not allowable under IFRS and some adverse experience variances.

Long-term investment return

The decrease in long-term investment return in the UK business reflects the increased cost of debt compared to 2011. The increase in debt costs in 2012 (£33 million) reflects a full year's interest charge on the internal LT2 subordinated debt issued by FLL to Friends Life holding companies in 2011 (with £500 million issued in April 2011 and a further £200 million issued in December 2011). The benefit of the interest received is reflected in the Corporate segment's operating result.

Principal reserving changes and one-off items

Principal reserving changes and one-off items of £47 million include £30 million of assumption changes, largely related to expense assumptions, including the benefit of reduced investment fees following the set up of FLI. Other one-off items of £17 million include modelling changes and revised transfers on guaranteed annuity options triggered by the vesting of pensions business within the with-profits funds.

Operating expenses

In November 2012, the Group announced an increase in the cost savings target to £160 million by the end of 2015 (previously £143 million), with savings to be achieved by the end of 2013 also increased to £126 million (previously £112 million). At the end of 2012, the UK and Heritage divisions have achieved run-rate saving of £86 million (31 December 2011: £45 million) with a further £54 million secured through contractual arrangements with outsource providers.

The delivery of the £126 million run-rate savings target requires a further £40 million to be achieved in 2013. The Group expects these run-rate cost savings to be delivered equally from both savings already contractualised and savings embedded in the 2013 operating budgets. In 2014 and 2015, the delivery of the £160 million target is expected to be achieved entirely through the contractualised savings already secured.

(i) 2010 full year baseline includes an estimate of 12 months operating expenses for AXA UK Life Business, BHA and the acquired WLUK business.

UK and Heritage divisions total operating expenses, which exclude commission payments and non-recurring costs, amounted to £485 million in 2012.

Acquisition and maintenance costs amounted to £443 million in the year, in line with 2011. After adjusting for the inclusion of the acquired WLUK and BHA businesses (£22 million), inclusion of FLI (£8 million) and inflation (£13 million), costs in the year have been reduced by £41 million principally reflecting the in year cost savings achieved.

The £8 million costs incurred in relation to the set up and ongoing running costs of FLI have been more than offset by a higher benefit from lower ongoing investment management costs in principal reserving changes and one-off items.

The higher level of development spend includes circa 40% relating to preparations for the significant volume of regulatory change such as the Retail Distribution Review, auto-enrolment and gender neutral pricing. Development costs also include expenditure associated with the corporate platform 'My Money' as well as the Retirement Income strategy.

UK and Heritage divisions MCEV operating profit

(i) Full year 2011 results comprise 12 months results for Friends Provident and the AXA UK Life Business, 11 months for BHA, ten months for GOF and TIP and two months for the acquired WLUK business.

The UK and Heritage MCEV operating profit of £502 million is in line with the £507 million reported in 2011 and reflects the good performance and material increase in value of new business in the UK and Heritage division.

A split of the £502 million MCEV operating profit between the Heritage and UK divisions has been estimated as £359 million and £143 million respectively. An estimate of this split is not available for the comparative period.

Value of new business

The contribution from new business has improved significantly with the £144 million reported in 2012 representing a 144% increase on 2011. The improvement in new business profitability has been driven by strong customer propositions and distribution relationships, underpinned by the ongoing delivery of cost savings, including those resulting from the March 2012 outsourcing to Diligenta, as well as the ongoing drive to increase the proportion of business written on the target new business platforms.

Expected existing business contribution

The expected existing business contribution for the UK and Heritage divisions includes the expected return on the value of in-force business, the expected return on shareholders' net assets and an allowance for the release of the cost of non-hedgeable risk capital as the business matures.

Expected return comprises two components:

·; expected earnings on all opening assets assuming a reference rate based on the one-year swap return set at the beginning of the period, plus an illiquidity premium which is applied to annuity business only; and

·; additional expected earnings consistent with management's long-term expectation of the asset returns on the business.

The expected return on the value of in-force has remained broadly stable compared to 2011. The lower expected long-term rates of return continue to adversely impact the expected existing business contribution with the rates applied to equities having fallen materially. This reflects a fall in the ten year risk free swap rate, used as a reference rates for equities, to 2.4% at 31 December 2011 (31 December 2010: 3.7%). This reduction has however been partially offset by an increase in the reference rate used for cash, gilts and corporate bonds, reflecting the higher one year swap rates and the widening of corporate bond spreads observed in 2011.

The WLUK business, acquired in November 2011 and therefore only a two-month component of the 2011 result, contributed £14 million to the expected existing business contribution in 2012.

Operating experience variances

As reported in the 2011 year end results, the Group established a provision of £88 million in respect of short-term adverse corporate pensions persistency experience, in the lead up to RDR implementation. The Group expects this experience to be driven by increased 'churn' of new business by the commission-paying market. Actual 2012 experience has been broadly in line with expectations, with a small negative impact of £(10) million compared to assumptions; £55 million of the provision has been utilised in the year leaving £33 million remaining as at 31 December 2012.

Operating experience variances of £(21) million also include the £(6) million cost of setting up FLI with other net experience variances of £(5) million including better than expected mortality and morbidity experience, offset by a number of smaller tax and expense variances.

Operating assumption changes

Favourable operating assumption changes of £62 million have been included principally resulting from improved mortality experience on investment bond and life protection business (£32 million) and reduced expense assumptions (£35 million), including the benefit of reduced investment fees following the set up of FLI.

Other operating variances

Favourable other operating variances of £19 million principally relate to the benefit from the release of unit-linked tax loss provisions as a result of updated fund growth estimates partially offset by refinements to models across the UK and Heritage divisions.

3.2 Heritage division

2012 operational highlights

·; New Heritage management team now in place and focused on driving cash generation.

·; Outsourcing deal with Diligenta implemented in March 2012 and progressing well.

·; Capital optimisation programme delivered £101 million of capital benefits. The completion of Part VII transactions in 2012 have further optimised the capital structure of the Group.

·; Friends Life Investments now managing £11 billion of fixed interest assets. Potential for further asset recaptures during 2013.

Market environment

The end of 2012 has been a significant time for regulatory change for the UK life and pensions market, with the Heritage division's broad range of products being impacted by the Retail Distribution Review, gender neutral pricing and auto-enrolment of pensions. Preparations for these have been completed, with commercial judgement being applied to the need for product and system investment, taking account of the scale of products and planned migration of product servicing to new outsourced platforms.

Strategy

The Heritage division serves over four million customers. It manages a significant proportion of the value of in-force of the Group, relating to a large suite of products that are no longer actively marketed and are administered on complex legacy systems. Consequently the business is very different to that of the UK division. A dedicated management team focused on the Heritage business has been established, with the aim to be the United Kingdom's leading legacy business manager with the knowledge and expertise to maximise the value created from legacy books.

The value drivers for the Heritage division are:

·; operational excellence - focused customer service within an efficient cost base in line with business scale;

·; capital efficiency - minimisation of capital required for the business;

·; strong product management - maximisation of value generated and retention of business;

·; robust financial risk and balance sheet volatility management; and

·; in-house asset management - utilising the recently created internal asset management capability to maximise returns and lower costs.

The Heritage division has previously identified a number of strategic themes to begin to harness these value drivers. Progress on the themes prioritised in 2012 is set out below. The Heritage business expects to address the remaining strategic themes, fund rationalisation and customer value management, over a longer timeframe.

Outsourcing

The significant policy administration and IT outsourcing deal with Diligenta which commenced on 1 March 2012 continues to operate in line with expectations. Combined with the existing outsource arrangement with Capita, materially all of Heritage policy administration is now outsourced. This means a considerable part of the Heritage cost base is now directly variable, and will decrease as policies run off. The resulting certainty around administration costs reduces the risk of expense assumptions in the embedded value coming under pressure.

Since the initial transfer of 1,900 staff to Diligenta, implementation of the deal has continued to progress well. In addition, the customer services work of circa 400 full time employees ("FTE") transitioned seamlessly from WIPRO (an existing outsource provider) to TCS (the Indian parent company of Diligenta) in May, again on schedule and with no disruption to service. This was followed in September by a further transfer of circa 150 FTE from AXA Business Services (another existing outsource provider) to TCS, on schedule and with no disruption to service. The IT application and support work of circa 200 FTE also transferred to TCS from WIPRO over the year.

Building an in-house asset manager

Friends Life Investments successfully launched in July 2012 and has £11 billion of fixed interest assets under management at 31 December 2012, through recaptures of £6 billion of assets in July 2012, £3 billion in September 2012 and £2 billion in December 2012. The formation of FLI supports the aspiration of delivering increased value from the existing book through optimised investment strategies at lower cost, for both the Heritage and UK divisions.

The reduction in overall fees payable to FLI compared with those charged by third party asset managers, has benefited MCEV operating profit by £11 million. FLI itself has broken even for the year to 31 December 2012, before set up costs of £6 million.

The 2012 recaptures have focused on fixed interest assets within the Group's core non-linked and shareholder funds. FLI is set to continue growing and anticipates the recapture of a further £7 billion of assets in 2013 focused on fixed income assets managed in the Group's with-profits funds.

To continue to achieve maximum business efficiency, FLI adopts an outsource model for its middle and back office support functions, which provides the benefit of future scalability and flexibility while achieving certainty on costs.

Capital optimisation programme and with-profits fund management

The 2012 capital optimisation programme ("COP") aimed to align the business with the separate UK and Heritage divisions while removing solvency capital inefficiencies, constraints and taking advantage of cost savings. The project largely achieved this through the Part VII transfer of the majority of the acquired AXA UK Life Business into FLL, including three with-profits funds. This has resulted in an increase in free surplus of £101 million, largely as a result of reduced capital requirements and removed capital restrictions. In addition, the capital optimisation programme in 2012 has enabled further simplification of the arrangements for managing the with-profits funds, together with improved risk management of these funds. These actions resulted in the additional release to free surplus of £88 million.

In addition, the programme to develop and implement a uniform capital management framework for the six with-profits funds within the Heritage business is currently underway.

Financial performance

Value of in-force business

The Heritage business represents a significant proportion of the Group's in-force value and regulatory capital. This is distributed across a range of products within the following broad categories:

By product line, the primary drivers of future profit and cash are expected to be:

·; unit-linked pensions and investments: the value of charges (mostly annual management charges) less costs of administration and any renewal or trail commission. Profits are therefore sensitive to the levels of investment markets and, to a lesser extent, lapse and expense experience. Relative to other product lines, these policies require little regulatory capital on both Pillar 1 and Pillar 2 bases;

·; annuities: the value of the investment margins expected on the assets and the release of reserving margins, in particular in relation to longevity. Profits are affected by changes in long-term longevity assumptions and the return achieved on the assets. Relative to other product lines, these policies require significant regulatory capital on both Pillar 1 and Pillar 2 bases;

·; protection: the value of the margins assumed in the premiums less the best estimate expected costs of claims, expenses and renewal commission. Relative to other product lines, these policies require modest amounts of regulatory capital on a Pillar 2 basis but more significant amounts on a Pillar 1 basis; and

·; with-profits: typically the value of the shareholders' share of the cost of bonus on 90/10 with-profits business and the value of charges less expenses on other with-profits business (primarily legacy non-profits business written in the with-profits funds). Relative to other products lines, these policies require significant regulatory capital on both bases, albeit provided in the main by the with-profits funds themselves.

Heritage unit-linked funds under management

The operating performance during 2012 indicates that the lapse experience of the book is performing broadly in line with the business's assumptions other than for unit-linked group pensions, where lapse experience has been worse than expected in the long term due to increased scheme re-broking activity prior to RDR becoming effective on 1 January 2013 and the new auto-enrolment requirements in 2012-14. This worsened experience is largely covered by a provision set aside for this purpose in 2011.

Heritage unit-linked funds under management were down 4% due to net outflows relating to the maturity of products and in line with expectations of the Heritage division's business run-off strategy.

 New business

The Heritage division specifically focuses on those products no longer actively marketed. Despite not actively seeking new business the Heritage book delivers a significant level of ongoing incremental business written across all product types.

New business cash strain at £(40) million is 26% lower than in 2011 reflecting the closure of bond products to new business in the second half of 2011.

The contribution from UK Heritage new business in 2012 was a value of new business profit of £2 million compared to £(4) million in 2011. This change reflects:

·; an increase in Department of Work and Pensions ("DWP") rebate business in what is the final year of this business (due to regulatory changes); offset by

·; the closure of bond products referred to above, leading to a reduction in sales and value generated.

In future years, the value of new business for Heritage is expected to be lower given that DWP rebate business will no longer be written. The value of new business for DWP rebate business in 2012 was £13 million.

Outlook

The key priorities for the Heritage division in 2013 include continuous delivery of service improvements with Diligenta, the continued expansion of Friends Life Investments by recapturing additional assets, an additional Part VII transfer to further align the Group structure with the UK and Heritage divisions and the delivery of additional capital efficiency savings, including further risk management of with-profits funds.

3.3 UK division

2012 operational highlights

·; Value of new business up 125% to £142 million representing good progress towards the £155 million 2013 target.

·; New business cash strain down 56% with continued strong performance in the second half of 2012 driven by the protection business.

·; APE up 19% at £669 million, with good Corporate Benefits sales reflecting a strong post-merger pipeline and successful workplace marketing. Preparations complete for auto-enrolment and RDR.

·; Successful completion of Protection platform migrations following migration of strategic partners in the fourth quarter of 2012; virtually 100% of new business on target platform from 2013.

·; Strong new business margins and volume growth have led to Retirement Income exceeding 2013 targets in 2012.

·; Corporate Benefits funds under management up 16% to £17.8 billion with net inflows of £0.4 billion.

Structure

The UK division comprises three business lines:

·; Corporate Benefits specialising in Trust-Based and Contract-Based Employer-Sponsored pension schemes;

·; Protection specialising in Individual and Group Life Cover, Critical Illness and Income Protection products; and

·; Retirement Income specialising in Retirement Annuity and other retirement products.

The division brings together the UK-based, market-facing businesses and will enable better operational efficiencies and management of costs and capital between these business lines as Friends Life rationalises and optimises pricing, capital and channel management functions. Additionally the UK division expects to take advantage of the natural synergies between Corporate Benefits and Retirement Income in the savings and retirement life-cycle and between Protection and Corporate Benefits in the management of our corporate customers.

Market environment

The UK businesses operate in markets with distinct features and different recent regulatory and economic impacts. Themes for 2012 include the poor UK economic backdrop, preparations for the introduction of RDR (principally affecting Corporate Benefits), the introduction of auto-enrolment and the implementation of gender neutral pricing (affecting Protection and Annuity business).

Corporate Benefits operates in a large, fast-growing but relatively low-margin market with intense price competition and, until the introduction of the RDR at the start of 2013, the influence of commission on sales. Market activity has focused on the preparation for auto-enrolment which was introduced in the UK in the latter part of 2012; Friends Life has completed these preparations.

The UK protection market is mature, and has remained relatively stable over the last few years despite the turbulent macro-economic climate. Implementation of gender neutral pricing (on 21 December 2012) and life tax reforms (on 1 January 2013) have generally resulted in a rise in average market prices although impacts have varied by product. In the lead up to these regulatory changes there has been a noticeable boost to protection volumes as customers choose to buy policies in advance of the expected price increases.

The annuity market continues to grow, with sales in the first three quarters of 2012 up 21% on the full year 2011, driven by demographic trends in particular the retirement of the baby boomer generation. Sales in the open market continue to show a trend towards enhanced annuities which account for more than half of total open market sales.

Strategy

Friends Life presented its strategic agenda at an investor briefing in November 2011 and good progress has been made across the UK business in progressing this agenda.

Corporate Benefits

The Friends Life Corporate Benefits business has made strong progress and seen profitability improve as a result of developments in a number of key areas. Client Relationship Managers and workplace marketing operations continue to focus on key clients and distributors. These relationships have been leveraged to deliver a much improved value of new business from increments or new entrants to the existing portfolio. Cost reduction has been achieved through focusing on the business's more efficient, cost-effective target platforms, including the new, "My Money" Corporate Wrap platform, the deployment of a small, focused new sales team and the benefits secured from the outsourcing deal with Diligenta. These have contributed to increased value generation in 2012.

Friends Life is ready for the opportunities presented by the regulatory and market changes; for example, good progress has been made on the development and launch of the auto-enrolment hub which will seek to ease the legislative and administrative burden on employers for the significant volumes of business expected from this change over the next few years. Finally, Friends Life has continued to selectively write profitable new business within its target range of mid to large schemes; these have been and will continue to be primarily written through a small number of key distribution relationships. Friends Life has observed increased pressure on pricing during 2012, reflecting the competition for commission-paying business before RDR closed this opportunity at the end of 2012 and, as a result, a more normal environment is expected in the future. Indeed, as a business which does not currently pay commission in respect of new schemes, Friends Life expects a greater number of opportunities from 2013 from when it can compete for all business having previously chosen not to tender for initial commission-paying business.

Protection

The Protection business has achieved a successful transformation over the last two years, with significant improvements in efficiency, proposition quality and distribution footprint. Ongoing profitable volume has been secured with increased distribution in strategic segments of estate agency and intermediary panel partners.

The strategy of migrating all new business capability to the low cost target platforms was completed in the fourth quarter of 2012 with the migration of strategic partners such as Countrywide and AXA and banking partners including the co-operative bank and National Australia Group. Following the migration of Individual IFA and Group Protection business in 2011, 82% of Protection new business sales in 2012 were written on the target platforms and this figure will rise to virtually 100% from January 2013.

The quality of the highly regarded protection proposition, particularly for Income Protection and Critical Illness, was demonstrated in 2012 by further improvements to both Group and Individual propositions. Examples include extending the coverage of the award-winning Individual Critical Illness product, and supporting early intervention and rehabilitation for potential long-term absences with the Group Income Protection product. The Group has also launched innovative propositions such as the new range of simple access products to equip Friends Life to meet the needs of a wide range of distribution partners following the implementation of RDR at the end of 2012.

Friends Life Individual Protection successfully implemented the distribution partnership with Connells in 2012 and is continuing to develop a selective range of profitable distribution relationships. These have extended Friends Life's distribution capabilities through a variety of channels and partnerships. For example, the growth of the partnerships with Connells and Countrywide has further developed the Group's leading position in the estate agent sector.

Retirement Income

The Retirement Income strategy presented in November 2011 identified five key strategic initiatives. The focus in 2012 was on broadening the product proposition and developing more sophisticated pricing and underwriting, culminating in the launch of the lifestyle and medical underwriting options towards the end of the first half of 2012.

The focus in 2013 will switch to the remaining three initiatives to capitalise on the work completed in 2012. Capabilities, including market testing, for an open market offering are well advanced for a possible launch in the second half of 2013. Investment into new asset classes in 2013 will improve both shareholder returns and our ability to compete in the open market. Equally important to these two initiatives is improving customer engagement to raise awareness of the broader proposition which can enhance their income for life.

Progress on the strategic initiatives taken together with positive results from the initial roll-out of the broader product proposition provide confidence over delivery of the 2013 financial commitments for Retirement Income.

Financial performance

The UK division delivered improved new business results with new business sales up 19% and the value of new business up 125% on 2011, new business cash strain down 56% and a strongly improving IRR of 13.3%.

Corporate Benefits

Corporate Benefits again delivered improved new business results with value of new business of £21 million, up 40% on 2011. This result reflects the increased level of business written (up 22% to £535 million APE, including 12% from the acquired WLUK business) in addition to the benefit delivered by the Diligenta outsourcing deal. New sales include £26 million APE on My Money, the new corporate platform launched on 31 January 2012. The proportion of new business volumes on the target NGP and My Money platforms continues at circa 80% and will increase in due course when the business is transitioned from the Embassy administration platform.

New business cash strain of £57 million reflects the higher sales volumes in 2012 offset by cost reductions. These strong volumes have resulted from the healthy pipeline of business built up following the successful merger of the Friends Provident and AXA UK Life Business and the recognition of the quality of the Friends Life proposition. In addition, the workplace marketing operation has had a successful year through the attention given to key relationships by the Client Relationship Management team.

Cost savings and increased volumes continue to drive the IRR on Corporate Benefits business with an IRR of 7.2% for 2012, up from 6.8% in the first half of the year. When compared to the full year 2011, the increasing IRR trajectory has been offset by the lower IRR on the transferred-in WLUK business (which is not yet on target platform). Friends Life expects the favourable underlying IRR trajectory to continue and for 2013 market commitments to be achieved through continued cost savings, pricing discipline and the benefits from additional volumes of auto-enrolment business. Reflecting this, Corporate Benefits continued to move away from high volume low margin business lines with £34 million APE written in such lines in 2012.

The Group expects an increase in new business activity as a result of both auto-enrolment itself and auto-enrolment consultancy activity triggering scheme reviews. This is expected to result in a change in market focus with the quality providers, with comprehensive auto-enrolment solutions, taking market share.

Fund inflows of £2.6 billion in 2012 and healthy investment returns have resulted in a strong increase in total funds under management. Outflows have been higher than in recent years, as expected, with the re-broking of business in the lead up to RDR a key factor.

A provision was made at the end of 2011 to allow for an expected peak of adverse persistency experience driven by corporate pensions business being re-broked prior to the rule changes taking place from 1 January 2013 as a result of RDR. Experience of scheme losses to commission-paying providers in 2012 is broadly in line with expectations with some £33 million of provision retained to cover any continuation of this experience across the UK and Heritage divisions into the first half of 2013.

Protection

The successful delivery of improved financial returns for the Protection business has been driven by the migration of new business capability to the efficient target platforms. The value of new business of £62 million compares to £16 million in 2011, with other contributing factors including increased pricing focus on value over volume, and an improved product mix towards the more profitable Critical Illness and Income Protection products. New business cash strain reduced primarily due to the cost efficiencies resulting from migration of business to the target platforms. In addition, harmonisation of modelling across the Friends Life companies in the fourth quarter has improved both new business cash strain and IRR for the full year.

Group Protection has continued to achieve growth in sales in the higher margin Group Income Protection and Group Critical Illness product segments during 2012. New business APE for Group Protection overall has increased by nearly 50%, from £22 million in 2011 to £32 million in 2012.

Retirement Income

Annuity new business contributed £59 million of VNB in 2012 compared to a 2011 contribution of £32 million and thus has already exceeded its 2013 target profitability. Uncertainty in fixed income markets throughout 2012 led to cautious pricing levels that resulted in strong new business margins.

Sales volumes of £44 million in 2012 reflect stable retention rates and the acquisition of the WLUK business in November 2011 which together resulted in sales up 38% in APE terms.

New business cash strain has also benefited from the cautious pricing levels and strong volumes resulting in a cash release of £33 million compared to a contribution of £13 million in 2011.

The fourth quarter results include the full year impact of a modelling change relating to policies with guaranteed annuity options. The new business results now include the premium in respect of the cost of the guarantee in addition to the maturing fund value. This change will result in an ongoing benefit and affects all new business metrics.

The full year 2012 results exceed the 2013 targets reflecting the benefits from the strategic focus on Retirement Income. The challenge in 2013 will be to deliver improved financial results against a backdrop of increasing market competitiveness as the evolution towards a more open and sophisticated marketplace continues.

Outlook

Despite the challenging economic background, Friends Life remains optimistic about the outlook following good progress in delivering its strategic agenda and a successful positioning of the UK division business lines as the Group enters 2013. Friends Life will continue the development and promotion of the My Money platform to achieve scale on this platform and seek to take advantage of the opportunities arising as a result of the ongoing shift from defined benefit to defined contribution schemes, demographic changes and auto-enrolment. In 2013, the UK division expects an initial 150,000 additional members through the introduction of auto-enrolment. Of the schemes administered by Corporate Benefits and due to stage in 2013, some 60% are expected to enrol with the Group.

The Protection business continues to target growth in profitable segments of both the Individual and Group Protection markets, particularly through its highly regarded Critical Illness and Income Protection propositions. It will also continue to build selected strategic relationships to take advantage of opportunities in the post-RDR environment. The Retirement Income business will promote the new enhanced annuity propositions to a significant proportion of Friends Life customers as they prepare for retirement.

4 International division

2012 operational highlights

·; Strategic review of International division completed; confirm exit of businesses now considered non‑core.

·; FPI to cease writing new regular premium business in Germany and Sweden, has ceased writing Corporate pensions, and is no longer selling to Japanese nationals.

·; Sale of Malaysian joint venture, AmLife, completed on 4 January 2013 for cash consideration of £50 million.

·; Lombard increasing focus on Private Bank distribution in Europe and exploring opportunities for targeted expansion in high net worth markets in Asia.

·; International division dividend targets reiterated; Lombard paid its first ever dividend to Group of £4 million in November 2012.

New business

·; International VNB reduced to £50 million in 2012 (31 December 2011: £92 million) reflecting the strategic change in Lombard's new business mix towards the private bancassurance channel and a £(27) million impact from poor German performance, worsening guarantee costs in Germany and market exits in FPI.

·; Lombard APE up 7% in constant currency to £254 million (£238 million actual currency) reflecting strong growth across a number of regions.

·; International FUM of £25.6 billion (2011: £23.6 billion) reflects net inflows of £1.3 billion as well as positive market movements in the year.

Financial performance

·; International IFRS based operating loss of £(9) million (31 December 2011: £78 million profit) impacted by £(82) million of one-off charges as a result of strategic review impacts and higher guarantee costs.

·; International MCEV operating profit of £1 million (31 December 2011: £111 million profit) reflecting the £(94) million impact (being £(140) million in FPI, offset by £46 million in Lombard) of the strategic review and related basis changes. Impact in line with the £50-£100 million guidance provided at November 2012.

·; International sustainable free surplus of £(28) million (2011: £8 million) includes restructuring costs in FPI and Lombard and a £(21) million impact from the strategic review, reflecting an increase in the cost of German guarantees and higher financial reinsurance costs in FPI.

Structure

The International division comprises two business units, Lombard and FPI.

Lombard is the leading pan-European specialist in compliant estate and succession planning solutions for high and ultra-high net worth individuals ("HNWIs") using life assurance. Based in Luxembourg, the business offers innovative solutions and superior service through a well-established distribution network of private banks and independent financial advisers to HNWIs across Europe and selected markets in Latin America and Asia. Solutions offered by Lombard are typically based on single premium, whole of life, unit-linked life assurance structures with limited levels of reinsured life cover. The business is well placed to benefit from increasing demand for fully compliant structured solutions for HNWIs that are both robust and portable.

FPI sells unit-linked savings, single premium bonds and protection products with a focus on affluent domestic and affluent expatriates via branches in Hong Kong, Singapore and Dubai, as well as serving UK customers with offshore products. It also sells insurance products under the EU freedom of services rules which allow regulated EU insurers to trade anywhere within its borders, known as Overseas Life Assurance Business or "OLAB". OLAB new business is largely regular premium German pensions business sold by the Group's German distributor, Financial Partners Business AG ("fpb"). Until 4 January 2013, the FPI business also included a 30% interest in AmLife, a Malaysian life insurance company, and AmFamily, a Malaysian family takaful business. Both businesses were majority owned by AmBank Berhad, a major Malaysian banking group. The Group's interests were sold to AmBank on 4 January 2013. The Group's share of the results of AmLife are included in the result of FPI in 2012.

International strategy

The International strategy was presented to the market in November 2012. The new strategy is expected to enhance value creation through a sustainable portfolio of international businesses in regions with sound regulatory frameworks, focusing on profitable growth and cash generation. The priorities of the division are to:

·; selectively grow the business and generate an IRR of new business of 20% for the division as a whole (core International division IRR of 15.1% at 31 December 2012);

·; improve the efficiency of the back-office; and

·; increase the dividends to £50 million by 2015 (£33 million in 2013).

Lombard is a strong business which has achieved sufficient scale to pay dividends, with £4 million paid in November 2012. It will look to grow profitably, expanding its reach further into Privatbancassurance and selected other geographical markets, including Asia. FPI, however, is in a turnaround situation with its core business being repositioned whilst other parts are exited. FPI will focus on two core markets (1) the global expat market and (2) domestic affluent customers in key selected markets, principally Hong Kong, Singapore and Dubai. It will close to new business in markets that are unprofitable, sub-scale or which do not fit with its new risk and value-focused strategy. As a result, the company is no longer accepting business from Japanese nationals, has closed to corporate pensions business and some product lines in the European business and has sold the 30% stake in the Malaysian joint venture, AmLife.

In November 2012, the Group announced that FPI's participation in Germany was under review. This review has been completed and, as a result, the Group will withdraw from writing new regular premium pensions business in Germany in 2013. It will continue to service the existing customers and it will focus on profitably growing its distribution business, fpb. The Group expects a modest amount of operating performance drag as it undertakes an orderly withdrawal from these business lines.

Market environment

The business continues to face challenging economic and market conditions in most of its key markets. The macroeconomic environment in Europe remains uncertain. Although Lombard's sales are not directly linked to stock market performance, these uncertain market conditions have a corresponding effect on client confidence. In addition, frequent changes to tax legislation in a number of Lombard's core markets, including Spain, Italy, Belgium, and France have added to the uncertainty. Against this challenging backdrop, and in the absence of strong external drivers to generate new business, Lombard's sales volume in 2012 was relatively strong. Notwithstanding the challenging short-term market conditions, the longer term drivers of the demand for individually structured Privatbancassurance solutions remain compelling.

North Asia is the largest market FPI participates in and is a relatively mature and competitive market. The region has strong medium-term growth prospects, however in the short term, due to the volatility of the investment markets, there is a shift towards non-linked business. The affluent market is increasingly competitive with more companies offering a wealth proposition in the region.

The South East Asia region is centred in Singapore. Singapore continues to evolve as a wealth management hub and offers good long-term growth potential, both for FPI and for Lombard although the current economic uncertainty is still expected to constrain growth in the short term.

The United Arab Emirates and the wider Middle East region are relatively immature local markets, however they have a large number of high net worth expatriates and continue to provide good growth prospects.

Operating review

The consolidated results of the International division are set out below. The results of the Lombard and FPI businesses are set out in the following sections, including a split of the core and non-core elements in FPI.

The International division results include a good result from Lombard and good performance from the core FPI business, given the challenging market conditions. However, the overall results for the division reflect the poor performance of the German business and the costs of restructuring FPI.

The International division's IFRS based operating loss of £(9) million in 2012 largely reflects one-off impacts from the strategic review totalling £(82) million. The majority of this relates to the OLAB business and reflects assumption changes as a result of the strategic review and the poor performance in this business, as well as an increase in the cost of German guarantees due to improved modelling and changes to assumptions.

International MCEV operating profit of £1 million includes a loss of £(103) million for the FPI business which has been significantly affected in the second half of 2012 by £(140) million relating to the strategic review and associated basis changes, primarily reflecting the impact on OLAB business. The £(140) million adverse impact is partially offset by £46 million of benefits recognised on the cost reduction programme in Lombard. In total, these impacts amount to £(94) million and are within the £(50)-£(100) million guidance provided in November 2012.

Sustainable free surplus of £(28) million includes the £(21) million impact of the International strategic review, principally reflecting higher financial reinsurance costs and adverse impacts from increases in the cost of German guarantees in FPI. In addition, the reduction includes the £(12) million costs of executing the strategic review across both FPI and Lombard.

Outlook

Notwithstanding the poor performance of the German business, the Group is confident that the actions taken following the strategic review of the International division will result in more focused businesses capable of profitable and cash generative growth. As such, the Group remains confident that the International businesses will deliver their dividend targets in 2013 and beyond.

4.1 Lombard operating review

Overall and despite turbulence in the Euro-zone throughout most of 2012, Lombard's operating performance has been good. Whilst significant macroeconomic uncertainty persisted and there were important changes in the tax and legal framework of several key markets in which Lombard operates, Lombard has continued to deliver strong growth in MCEV operating profits and funds under management in 2012. Funds under management totalled £19 billion (€23 billion) at 31 December 2012 (an increase of 11% on a constant currency basis). The results were also impacted by the weakening of the Euro against GBP by 3% in the year.

New business profitability

(i) Since 2011, Lombard IRR has taken into account the Luxembourg regulatory regime in which DAC is an allowable asset.

The sales performance has been strong with APE up 7% on a constant currency basis. Several markets have performed strongly with Southern Europe, UK, Belgium (Privatbancassurance sales) and Latin America generating volumes above 2011 levels. Growth in these regions also highlights the strength of Lombard's brand and geographic diversity.

In line with Lombard's strategy, the mix of new business sales is increasingly coming from private banks (57% in 2012 compared with 39% in 2011) rather than IFAs. Whilst margins on the revised business distribution mix are lower, in the longer term Lombard expects increasing the access to the Privatbancassurance market will provide more potential and stability for new business generation. As a result of the different mix, the value of new business in 2012 is 13% below 2011. The IRR and contribution from new business has similarly been affected by mix, whilst cash strain has remained stable despite the sales volume increase.

Seasonality of new business is in line with 2011 with the ratio of business between the first half and second half of the year at 40%/60% (2011: 41%/59%).

APE performance by region is as follows:

IFRS based operating profit

Lombard generated an IFRS based operating profit before tax of £28 million in 2012, 26% down on 2011. The year on year decrease is principally due to £11 million of one-off restructuring costs. Excluding restructuring costs, IFRS based operating profit is £39 million, 3% above 2011 and benefited from the continued growth in FUM whilst maintaining a strong focus on cost management.

New business strain: reconciliation of new business cash strain to IFRS

IFRS new business strain is lower than that in 2011 principally reflecting the weakening Euro over 2012 partially offset by a reduced benefit from first year annual management charges as a result of mix as well as seasonality of sales.

In-force surplus: reconciliation of in-force cash surplus to IFRS

Despite growth in the in-force book and the continued tight control of maintenance expenses, the in-force cash surplus is down 18% on 2011, mainly due to £(11) million of one-off restructuring costs incurred as part of the strategic review.

Funds under management

Average FUM has continued to increase in 2012. Continued positive net fund inflows over the last two years and positive investment return in 2012 have driven FUM which has grown from £17.4 billion (€20.9 billion) at the end of 2011 to £18.9 billion (€23.3 billion) at 31 December 2012.

Operating expenses

Operating expenses exclude both commission payments and non-recurring costs.

Included in maintenance expenses are costs of £11 million related to the strategic review of the business. Adjusting for these one‑off costs, expenses are 3% below 2011.

MCEV operating profit

MCEV operating profit is up 27% on 2011 as positive operating assumption changes, largely resulting from the strategic reorganisation (£46 million), have been partially offset by the lower contribution from new business, as mix effects are reflected, and lower expected returns on existing business contribution.

Expected existing business contribution

Lower expected existing business contribution reflects the lower opening in-force book together with reduced economic assumptions.

Adverse operating experience of £(23) million arises from the investment made in improving the efficiency of back-office operations. These are more than offset by reduced expense assumption changes reflecting the efficiencies gained and reduction in staff numbers. In addition, the result reflects the impact of some negative lapse experience in the Belgium and Spanish markets.

In line with guidance provided in November 2012, operating assumption changes include a £46 million benefit reflecting savings and efficiencies arising from the strategic reorganisation and the resulting lower expenses in this business.

Other operating assumption changes resulting from the normal annual review of the basis include a marginal strengthening of lapse assumptions and a provision made for anticipated short-term lapse experience in the Belgium and Asian markets (£(14) million), partially offset by a weakening of mortality assumptions reflecting improved longevity trends of Lombard's high net worth policyholders (£4 million).

Other positive operating variances principally arise from tax benefits from a lower tax rate for the Lombard companies.

4.2 FPI operating review

The results of the FPI business have been dominated by the impact of one-off charges relating to market exits and assumption changes, principally in the non-core businesses. The FPI results are shown in the IFRS and MCEV sections below split between the core and non-core business with additional detail shown at the end of this section. The core businesses are those which are the focus of strategic growth plans in 2013 and beyond, excluding AmLife and OLAB (mainly Germany).

The outcome of the strategic review and assumption changes are reflected across each of the operating bases with the impacts on each shown below:

In November 2012 the Group guided towards a £(50)-£(100) million MCEV impact, with this being net of a £46 million positive change in Lombard. The stand alone impact in FPI amounts to £(140) million. The charge largely relates to revisions to expense assumptions, persistency experience and the increased cost of guarantees in the German business with these principally a result of the Group's decision to withdraw from a number of markets and the removal of expense overruns previously deemed to be short term in nature. At a business unit level, the impacts stem from FPI's OLAB business, principally Germany, which now has an embedded value of £100 million at the end of 2012. The Group has also decided to cease writing new business to Japanese nationals with this resulting in a £5 million provision against the MCEV of this business (31 December 2012: £59 million).

New business profitability

Sales volumes are 20% lower than in 2011, driven mainly by a significant reduction in FPI regular premium business. This has been due to strategic exits (particularly new business with Japanese nationals), maintenance of pricing discipline and increased controls around business acceptance. Single premium business is below last year's level in most regions due to reduced investor confidence, although the UK offshore business has performed well. Protection business was also particularly strong, especially in the first half year, as a result of IFAs moving away from savings to risk products sales.

The value of new business and IRR have been impacted by this reduction in volumes, changes in assumptions relating to worsening volume and persistency experience mostly in the German business and the impact of interest rate movements and assumption changes on the cost of embedded German guarantees. These impacts more than offset improvements from new regular premium products.

New business cash strain is higher than 2011 despite reduced volumes due to increases in the cost of German guarantees, the impact of assumption changes relating to the OLAB business and negative economic impacts, largely due to lower interest rates.

The table below shows the new business profitability of the remaining core FPIL business excluding AmLife and OLAB business.

Core and non-core new business metrics

Core FPI VNB decreased by 23%, reflecting the decrease in volume but also increased acquisition expenses from improvements to new business infrastructure and controls. Sales volumes of £146 million have decreased by 12%, principally as a result of the challenging savings market environment in Asia. The ratio of new business cash strain to APE has improved to 25% (31 December 2011: 31%), despite expense increases as a result of new product structures introduced in 2012. IRR is negatively impacted by these volume reductions and the increase in expenses.

IFRS based operating result

IFRS based operating result has reduced to a loss of £(37) million in 2012 due to the impact of £(82) million of one-off charges largely related to the strategic review of the OLAB business and an increase in the cost of the German guarantees. The impact of these items is included within new business strain (£(12) million) and in principal reserving changes and one-off items (£(70) million).

Core and non-core impacts

On an adjusted basis, after removing the impact of principal reserving changes on the results, the 2012 FPI IFRS based operating result equates to a £33 million profit. This result highlights the poor performance within the non-core businesses. Going forward, and notwithstanding the actions taken to date to stabilise the results in these businesses, the Group continues to expect the non-core businesses to act as a drag on the combined FPI operating performance. The Group expects this operating drag to continue while the actions taken to withdraw from these markets are completed.

New business strain: reconciliation of new business cash strain to IFRS

New business cash strain is higher than in 2011 reflecting increased reserves due to the higher cost of German guarantees and higher protection sales, a lower benefit from financial reinsurance partially offset by positive mortality assumption changes.

DAC adjustments relate to the deferral of acquisition costs including initial commission and enhanced unit allocations. DFF adjustments relate to the deferral of set up charges on portfolio bond business. Reduced sales volumes in the year have resulted in a reduction in the level of this adjustment.

Other IFRS adjustments include the elimination of positive actuarial funding and Sterling reserve impacts on investment contract business which have reduced because of the lower sales volumes. The financial reinsurance benefit within new business cash strain is also removed through these adjustments as it is not allowable under IFRS.

The net increase in IFRS new business strain of £17 million includes £12 million mainly from strategic review impacts and higher guarantee costs. The remainder relates to increased reserving requirements on protection products due to the effect of lower valuation interest rates and higher volumes.

In-force surplus: reconciliation of in-force cash surplus to IFRS

In-force cash surplus of £68 million (2011: £79 million) reflects higher financial reinsurance payments, strategic review costs of £(5) million partially offset by an increased surplus from the larger in-force book.

The DAC/DFF adjustments have increased due to the larger in-force book of business and modelling improvements.

Other IFRS adjustments include the elimination of movements on Sterling reserves and actuarial funding on investment business as well the removal of the financial reinsurance repayments which are incurred in the in-force cash surplus. The increased adjustment in 2012 compared to the prior year primarily relates to the higher financial reinsurance payments in in-force cash surplus.

The net decrease in IFRS in-force surplus of £2 million primarily results from higher profits (net of DAC) from the larger in-force book, offset by strategic review costs.

Funds under management

Funds under management as at 31 December 2012 have increased to £6.7 billion. The business has generated positive net inflows of £0.5 billion before market movements.

Principal reserving changes and one-off items

Principal reserving changes of £(70) million comprise £(59) million impact of the OLAB strategic review, £(15) million relating to the increase in the cost of German guarantees offset by £4 million of positive mortality basis changes in relation to other parts of FPI's business.

Operating expenses

Operating expenses, which exclude commission payments and non-recurring costs, have increased to £73 million from £68 million in 2011. Acquisition costs have increased largely as a result of actions to strengthen the controls and governance infrastructure while maintenance costs include one-off strategic review costs of £(5) million.

MCEV operating result

MCEV operating loss principally reflects £(107) million of assumption changes and a £(35) million reduction in VNB compared to the prior year. Assumption changes and VNB reductions relate largely to revisions to actuarial assumptions reflecting the outcome of the OLAB strategic review and recent poor German business performance including the increased cost of guarantees (£(27) million within the value of new business, £(111) million operating assumption changes and £(2) million other operating variances). Operating assumption changes include £4 million favourable assumption changes in respect of AmLife.

Core and non-core impacts

On an adjusted basis, after removing the impact of assumption changes on the results, the 2012 FPI MCEV operating result equates to a £4 million profit. This compares to a £29 million operating result in 2011 with the underperformance in 2012 principally driven by the loss from the non-core businesses. Despite the actions taken to date the Group continues to anticipate some drag on FPI's MCEV operating performance as the Group completes the withdrawal from these markets, notably German product manufacture. The embedded value of the non-core businesses amounts to £202 million (including AmLife).

Expected existing business contribution

The expected existing business contribution has reduced from £27 million to £23 million. The effect of the larger opening in-force book has been offset by lower rates of expected return on equity and property assets.

Operating experience variances

Adverse operating experience variances of £(12 )million include £(5) million of one-off costs of restructuring following the strategic review, £(4) million relating to worsening persistency in the FPI regular premium savings product, £(3) million relating to other items.

Operating assumption changes

Operating assumption changes of £(107) million relate to revisions to assumptions to reflect the outcome of the strategic review and recent business performance. Changes in the approach to setting assumptions which are now based on planned levels of expenditure rather than a long-term trajectory, with allowance for short-term overruns, have led to a significant increase in per policy expenses and a £(27) million impact on MCEV. In addition to the base assumptions, the impact of deteriorating experience in non-core business and the decision to close certain lines to new business has resulted in a further negative impact of £(77) million. Small offsetting assumption changes of £(3) million reflect updates for mortality, persistency and fund rebate assumptions on core business.

Other operating variances

Other operating variances of £(5) million include £(2) million relating to the increase in German guarantee provisions as a result of improvements in modelling and £(3) million in relation to changes in the cost of non-hedgeable risk.

FPI additional information

IFRS based operating profit

MCEV operating profit

Sustainable free surplus

5 Corporate review

The Corporate segment includes the corporate holding and service companies of the Group.

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 2012 are presented below.

(i) Market value is based on listed ask price, at 31 December 2012, excluding accrued interest.

(ii) Finance cost is operating profit impact, before tax.

(iii) On 8 November 2012 the Group issued a $575 million US Dollar denominated reset perpetual subordinated debt instrument. The principal and clean market values represent Sterling equivalent values as at 31 December 2012.

(iv) On 20 November 2012 the Group repaid the remaining £363 million of deferred consideration notes from AXA Group.

The finance cost included within operating profit differs between the two bases, reflecting the short-term expected rate of return applied in the MCEV results.

On 8 November 2012, the Group issued a $575 million (£356 million) US Dollar denominated reset perpetual subordinated debt instrument, utilising the funds to repay the remaining £363 million of medium-term funding from AXA Group, originally provided on the acquisition of the AXA UK Life Business.

In so much as debt issued by holding companies supports the ongoing growth and development of the life operating businesses, the cash raised has been loaned to the UK and Heritage divisions. The cost attributable to each division is shown below.

Corporate IFRS based operating result

(i) net finance costs within the Resolution holding companies, reflecting the receipt of interest from FLG and payment of DCN interest.

The Corporate result is principally driven by the expected return expense attributed to external debt liabilities of the Group and corporate costs, offset by internal asset income. The increase in investment return reflects the longer period of interest accrual on the debts issued to the UK and Heritage divisions in April and December 2011. The year on year fall in expected return on external debt is a result of the lower opening market value of the external debt liabilities, on which the expected return is calculated.

Net finance costs of £(7) million were paid by the Resolution holding companies in 2012 reflecting the payment of interest on the DCNs, partially offset by the income on the internal LT2 with FLG.

Other corporate net costs of £(27) million comprise fees payable to ROL of £(18) million and other corporate costs.

Corporate MCEV operating results

The Corporate segment consists of both non-covered and covered business. The non-covered element relates to the net assets of the corporate holding and service companies whilst the covered element principally represents the net debt liabilities held at the Group level.

The expected existing business contribution on debt has increased by £29 million to £75 million in 2012 reflecting the additional interest expense on the £356 million UT2 reset perpetual subordinated debt issued in November 2012, a full 12 months interest cost on the £500 million LT2 (raised in April 2011) combined with a significant increase in the short-term rate of return applied to the corporate debt. The impact of the higher interest cost on the £500 million LT2 debt is however offset by an equal and opposite £17 million reduction in other income and charges, reflecting the reduced interest costs incurred by the non-covered businesses.

Other income and charges include the £(23) million interest paid on the DCNs that were repaid in November 2012. The remaining costs principally comprise fees payable to ROL of £(18) million in addition to other corporate costs.

6 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 2012 remains strong with available shareholder cash ("ASC") of £850 million and an FLG IGCA surplus of £2.0 billion resulting in a coverage ratio, excluding with-profits insurance capital component ("WPICC")(i), of 214%. At 31 December 2012 the estimated economic capital surplus(ii) at the FLG level was £3.4 billion corresponding to a coverage ratio of 182%.

6.1 Capital management

Principles

The capital management policies ("CMPs") that the Group has established remain in place and are set out in detail below. In addition to the CMPs, the Group also considers the following when managing capital:

·; the maintenance of financial strength within the life operating companies sufficient to support new business growth targets, including rating agency requirements;

·; the need to have strong liquidity to cover expected and unexpected events, which includes access to an undrawn facility with a consortium of banks;

·; management of the with-profits business of the Group in accordance with agreed risk appetites and all regulatory requirements; and

·; the availability of transfers from long-term business funds and dividends from entities that support the cash generation requirements of the Group.

Capital management policies and monitoring buffers

The Group's CMPs that apply at a life company level and at the Group level are set out below.

Life companies CMP:

The CMP of FLL, the principal UK life company, is to meet the higher of:

·; 150% of Pillar 1 requirements, excluding WPICC, FPIL and Lombard; and

·; 125% of Pillar 2 requirements, including any Individual Capital Guidance ("ICG") and specifically excluding FPIL and Lombard.

The CMPs of the other main life companies in the Group (including FPIL and Lombard) are aligned with that of FLL. The International businesses, whilst not regulated by the FSA, are each included in the FLG IGCA surplus and the FLG economic capital surplus on an equivalent Pillar 1 or Pillar 2 basis respectively.

In addition to the above, capital within FLL is held to cover at least one year of the FLL debt servicing costs (currently £115 million per annum) and any debt repayment requirements in the following year.

Group CMP:

A capital management policy also operates at FLG level, as FLG is the ultimate European Economic Area ("EEA") parent insurance undertaking. The CMP at FLG 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 FLG holding company level sufficient to pay at least the next year's gross annual FLG interest cost (currently £120 million per annum) and any repayments of principal that fall due on FLG debt in the next year.

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

(ii) The economic capital position at 31 December 2012 of FLG and its subsidiaries (including FLL on an economic capital basis, see (iii) below) is estimated and unaudited.

(iii) Economic capital is based on the individual Pillar 2 capital assessments for the UK life companies. FLL's economic capital is derived from consolidating the individual life companies' Pillar 2 capital requirements including making appropriate allowance for the diversification of risk between the companies. Pillar 2 strictly only applies at individual life company level and is the Individual Capital Assessment "ICA" determined by management including any amounts set by the FSA as ICG.

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 in the Friends Life holding companies together with amounts for working capital in both the holding companies and the life companies. The key monitoring buffers held are set out below (note that these are not additive requirements):

·; working capital to cover specific monitoring buffers, over and above the CMP (excluding the additional requirement in FLL to hold capital to cover one year of debt servicing costs and any expected debt repayments), to enable all appropriate capital requirements to be met. The monitoring buffers are as follows:

- for FLL (excluding FPIL and Lombard): 20% of Pillar 1 requirements (excluding WPICC, FPIL and Lombard) and 10% of economic capital requirements (including any ICG and excluding FPIL and Lombard); and

- for FLG: 10% of IGCA requirements (excluding WPICC).

·; a £400 million prudence buffer within the ASC is designed to cover one year's external dividend costs, debt interest and corporate costs.

Consideration of return of capital

IGCA is currently the biting solvency constraint for the Group, with the FLG economic capital surplus, net of CMP and working capital, approximately £1.4 billion stronger than the equivalent IGCA surplus. This reflects actions taken in 2012 to improve the economic capital position of FLL (excluding FPIL and Lombard), including:

·; enhanced economic capital modelling capabilities resulting in the identification and release of unintended prudence margins at the life company level;

·; implementation of equity hedges within certain with-profits funds;

·; selective de-risking of corporate bond portfolios backing shareholder business; and

·; improved UK financial systems and controls resulting in a release of operational risk capital.

The Group continues to take actions to optimise its capital position. However, the current weak and uncertain economic environment remains a concern and the Group continues to believe that the economic uncertainty has the potential to materially increase investment volatility and corporate bond spreads. Whilst the Group has a highly rated corporate bond portfolio, with minimal direct exposure to higher risk sovereign debt, an increase in corporate bond spreads would have a material impact on the capital position. The relative sensitivities of IGCA and economic capital to a widening of corporate bond spreads indicate that there remains the potential for the biting constraint on capital to change in stressed scenarios. When combined with the uncertain economic environment these are key factors in the Group's capital management activities and also underpinned the Group's decision in July 2012 to cancel the second £250 million return of capital to shareholders.

The Group's cash and capital management framework is based on the movement in MCEV, reflecting the basis of MCEV as the discounted value of expected future cash flows on a market consistent basis. The chart below shows how the core components of MCEV within this framework, and their respective values as at 31 December 2012, reconcile to ASC.

6.2 Cash and capital management framework

The total MCEV is split between the net worth, or shareholder resources, and the VIF. Shareholder resources comprise the free surplus, required capital and inadmissible assets of the business. Required capital is based on the most onerous CMP for the Group, currently the IGCA. For Resolution and 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). VIF comprises the value of the future cash flows arising from the policies currently in-force.

External debt issued by FLG is offset against required capital in the life businesses as this debt has been guaranteed by life operating companies and has been used to support their activities. This debt comprises STICS of £458 million, LT2 subordinated debt 2021 of £211 million, LT2 subordinated debt 2022 of £562 million, and £380 million of UT2 reset perpetual subordinated debt and the associated currency swap (debt values include accrued interest and the tax impact of any market valuation).

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.

ASC consists of cash held by the Friends Life and Resolution holding companies, together with any dividends declared and approved by the operating companies that are yet to be remitted. As such, ASC is stated after the deduction of working capital from free surplus. ASC represents cash available to cover Resolution's corporate costs, to service debt issued by holding companies and, subject to shareholder approval, to pay dividends or return to shareholders. The generation of ASC therefore represents a key performance metric of the Group.

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

(i) Required capital at 31 December 2012 includes £229 million in respect of non-covered business required capital and inadmissible assets which are classified as free surplus in MCEV.

The free surplus generated in the year of £215 million is explained in section 2.3.

The capital and dividend flows contribution to free surplus of £169 million comprises £348 million net proceeds from the issue of the UT2 reset perpetual subordinated debt, £14 million in respect of other internal debt movements offset by the external dividend payments of £(193) million. Other free surplus reserve movements of £7 million relate to the reduction in the Company shares held by subsidiaries.

The required capital and inadmissible assets have fallen from £1,023 million to £269 million over 2012. This reflects £(229) million from the increase in value of the FLG external debt, which is offset against required capital, £101 million of reduced capital requirements following the implementation of the Part VII transfers in 2012 and £(356) million reduction following the issue of the UT2 reset perpetual subordinated debt. This is included within the £(359) million capital movements as it has been guaranteed by the life businesses. Other reserve movements in required capital include the adverse impact of foreign exchange movements and actuarial losses on the Group's pension scheme.

Working capital and other assets and liabilities

The working capital at 31 December 2012 of £470 million has reduced from £499 million at 31 December 2011.

Working capital comprises:

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

·; an appropriate monitoring buffer to facilitate ongoing compliance with the Group's Capital Management Policies;

·; amounts to cover the necessary funding to protect against any temporary shortfall in delivery of cash generation relative to Group targets; and

·; restricted assets (eg. illiquid or intangible assets) included within free surplus.

The largest components are the monitoring buffer (£175 million) and amounts set aside to meet non-recurring costs (£151 million).

Working capital is held in both the life companies and the holding companies. Working capital held in the life companies has decreased in the year, reflecting utilisation of working capital to fund non-recurring spend in the year, partially offset by identification of additional working capital requirements in respect of increased future separation and integration costs as announced in November 2012. The amount of working capital held in the holding companies has increased over the year, primarily relating to the provision for deficit reduction contributions for the Group's pension scheme.

Available shareholder cash

Available shareholder cash of £850 million comprises £714 million of shareholder cash at Friends Life holding company level (including £250 million final dividend proposed by FLL), together with £136 million held by Resolution holding companies. Details on ASC movements are set out in section 2.3.

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

The ASC balance as at 31 December 2012 is held to cover the costs of the 2012 final dividend and to maintain a prudence buffer, within FLG ASC, of £400 million which is designed to cover an additional year of the Company's dividend cost, debt interest and Resolution holding companies corporate costs. This prudence buffer is also designed to cover the Group CMP requirement to hold cash at FLG sufficient to meet one year of FLG's debt servicing costs. As this is expected to be met from capital retained in the life companies, this is not considered to be a restriction on the availability of FLG cash.

Emergence of cash

The Group set a Distributable Cash Target ("DCT") of £400 million per annum at FLG level, after interest costs and without reducing the MCEV of Friends Life group (excluding investment variances and non-recurring items). The DCT is satisfied by dividends from the life operating companies to the Friends Life holding companies. Dividends declared by life companies in respect of 2012 were £354 million and FLG MCEV operating profit after tax (a proxy for the amount which could be repaid without reducing the FLG MCEV, based on the definition above) was £290 million, including the impact of the International strategic review and related basis changes.

Since the DCT was set in 2010, returns on shareholder assets, in particular interest rates have fallen significantly and reduce the emergence of surplus from the in-force book. As at 30 June 2012 this was estimated to have reduced the emergence of surplus by approximately £50 million per annum, and the position has not materially changed since then. Whilst the DCT remains a target, it is recognised that until economic conditions improve this target will only be achievable from sustainable sources in the medium term.

The emergence of surplus from the UK and Heritage divisions' in-force book over the next five years has been estimated in the table below.

These unaudited estimates are undiscounted and are based on operating, economic and tax assumptions at 31 December 2012 and only relate to the UK and Heritage divisions' in-force business. The economic assumptions underlying the estimates are in line with those assumed in the calculation of expected return within MCEV. Hence, for example, an equity return of 4.9% p.a. and a property return of 3.9% p.a. has been assumed.

Actual emergence of surplus in any particular year will differ from that expected as a result of operating experience variances, assumption changes, development costs, and crucially, the level of new business strain.

(i) Excludes £34 million return on shareholder net assets.

6.3 Economic capital position

Under FSA rules, the UK life operations are required to 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 ICA"). At an individual life company level this is referred to as the Pillar 2 basis of capital management.

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 the FLG level, which comprises:

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

·; the surpluses of the International life companies on an economic capital basis; and

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

As noted in the "Capital management policies and monitoring buffers" section above, a number of actions have been taken in the year to improve the FLL economic capital position, and as a result, the estimated FLG economic capital surplus as at 31 December 2012 is strong at £3.4 billion (a coverage ratio of 182%).

The estimated sensitivities of economic capital surplus to market shocks were provided as part of the half year report and remain appropriate. In summary the sensitivities showed that economic capital surplus would have reduced by:

·; an estimated £0.4 billion in the event of a 40% fall in equity markets;

·; an estimated £0.1 billion in the event of a 200bps fall in interest rates; and

·; an estimated £1.0 billion in the event of a widening of corporate bond spreads of 200bps (of which one-third is assumed to relate to defaults).

6.4 Insurance Groups Capital Adequacy

In addition to individual company requirements FLG, as the ultimate European Economic Area ("EEA") parent insurance undertaking, is required to meet the IGCA requirements of the Insurance Groups Directive. IGCA is monitored at FLG level and does not include the assets or liabilities of the Resolution holding companies. The Group's capital policy is to maintain sufficient Group capital resources to cover 150% of Group CRR (excluding WPICC).

The balance sheet remains strong at FLG level, with an IGCA surplus of £2.0 billion at 31 December 2012, with Group capital resources being 214% of Group CRR (excluding WPICC of £3.4 billion).

Group capital resources were £1.1 billion in excess of the amount required to satisfy the FLG CMP. The IGCA surplus would reduce by around £0.1 billion for a 40% fall in equity markets or £0.2 billion if interest rates were to fall by 200bps across the yield curve from 31 December 2012 levels. The IGCA surplus would reduce by approximately £0.4 billion if corporate bond spreads were to rise by 200bps (of which one-third is assumed to relate to defaults).

The movement in IGCA surplus over the period largely reflects the £500 million dividend paid to Resolution holding companies partially offset by the generation of surplus and the debt refinancing. The surplus emerging of £300 million reflects the £526 million of in-force surplus partially offset by £(251) million of new business strain, positive economic variances of £146 million, and adverse other non-operating items of £(121) million (mainly non-recurring costs).

Included within the £300 million surplus emerging are benefits from COP 2012 management initiatives. The Part VII transfers implemented in the year have reduced Pillar 1 capital resources requirements by £68 million. The Part VII has also enabled the simplification of the arrangements for managing the FLC With-Profits Funds which generated a benefit of £103 million. The benefit to IGCA differs from free surplus impacts as free surplus includes the release of required capital at 150% (whereas IGCA is at 100%) but excludes the benefit of a release of with-profits fund support arrangements (as these did not previously restrict free surplus).

The surplus is also impacted by the external debt reorganisation in the period. The outstanding £200 million of internal LT2 subordinated debt issued to RHG has been repaid, following the external debt raising by FLG of £356 million UT2 subordinated debt, with £8 million of associated costs.

Finance costs and other movements comprise £(73) million of interest costs on the external LT2 subordinated debt, UT2 subordinated debt and STICS, partially offset by positive other reserve movements of £6 million.

At 31 December 2012 the capital held to meet FLG CMPs was £889 million (1 January 2012: £902 million) and the excess over the CMPs was £1,131 million (1 January 2012: £1,237 million).

The IGCA surplus is a prudent measure and excludes surplus capital not immediately available to shareholders, such as surplus capital held in long-term funds to the extent that this is not needed to cover the capital resource requirements of the long-term fund concerned. At 31 December 2012 the IGCA surplus excludes £23 million of long-term fund surpluses and excludes £443 million of UK with-profits funds surpluses.

As part of the simplification of the governance structure, the Company's head office, for regulatory financial resources rules purposes, is expected to move to the UK at which point the Company will be deemed to be the ultimate EEA parent undertaking of the Group. As a result the assets and liabilities of Resolution Limited and the other Resolution holding companies based in Guernsey will in the future be taken into account in calculating the IGCA surplus. At 31 December 2012 this would have increased the IGCA surplus to £2.2 billion, and to a coverage ratio of 221%.

6.5 Management of the with-profits funds

Friends Life manages six with-profits funds, with the five significant funds shown below. Asset allocation within these with-profits funds is actively managed with the proportion of equities and property backing assets shares (equity backing ratio or "EBR") managed to the target levels shown below:

(i) The target fund hedging ratio is the proportion of guarantees in the fund which are hedged against equity risk

These apply to the funds backing the majority of asset shares, although sub-funds within these may have different allocations. For Friends Life WL Limited, the benchmark applies to products with equity participation; there are some products invested wholly or partly in a purely fixed interest asset mix and these are not allowed for in the figures shown above.

The allocation for assets backing guarantees and options within the with-profits funds comprises a range of assets including gilts, bonds and hedging derivatives (equity put and call options, sold equity futures, interest rate swaps and swaptions). These apply to the funds as a whole and within companies individual policies may have different allocations.

Non-profit business in the with-profits funds, the majority of which is annuities, is backed by a mix of gilts and corporate bonds (some with credit default swap protection to hedge the default risk).

6.6 Asset quality and exposure

The Group's financial assets as at 31 December 2012, excluding cash, are summarised as follows:

Shareholder exposure to corporate bonds and asset-backed securities is analysed by fund and credit rating as follows:

Over 96% of the corporate bond and asset-backed securities to which the shareholder funds are exposed are investment grade. The Group controls its exposures to corporate issuers by rating, type of instrument and type of issuer. The sub-investment grade bonds held in investment portfolios are monitored closely in order to maximise exit values. Where asset-backed securities and other complex securities are held, the Group monitors closely its exposures to ensure that the relevant structure, liquidity and tail credit risks are well understood and controlled.

No defaults have been experienced in the year to 31 December 2012. The Group holds default reserves to cover the risk of defaults and credit rating downgrades on corporate bonds that back all annuity business within Friends Life group. The reserves reflect assumed defaults over the outstanding terms to maturity of the bonds. The shareholder share of default reserves at 31 December 2012 was £0.5 billion (31 December 2011: £0.6 billion). This represents a haircut of 43% of the overall corporate bond spreads over gilts of equivalent term (31 December 2011: 35%).

The vast majority of the Group's exposure to sovereign debt holdings is to UK gilts. The Group has £7 million shareholder exposure (including shareholder fund exposure to non-profit and with-profits funds) to the higher risk government debts of Spain, Portugal, Italy, Ireland and Greece (31 December 2011: £6 million).

In addition the Group's shareholder exposure to various corporate securities issued by companies domiciled in Spain, Portugal, Italy, and Ireland is £334 million (31 December 2011: £370 million). The Group's shareholder exposure to Greek corporate securities is less than £1 million. Some 61% by value of these corporate securities are issued by non-financial companies, which are in many cases less exposed to their domicile economy than to other countries. Where the Group holds securities issued by financial companies, 21% of these are not linked to the institution's domestic economy. In all cases the company's financial strength and the ability of the domicile government to provide financial support in the event of stress has been considered.

Sovereign and corporate exposure to these countries is shown below.

The Group's shareholder exposure to bank debt securities across the various geographic regions is shown below.

(i) Portugal, Ireland, Italy, Greece, Spain.

The disclosure above excludes a £1.8 billion collateralised HSBC Amortising Note set up as part of an annuity reinsurance transaction which took effect 1 January 2007.

6.7 Liquidity

The liquidity of the Group remains strong

FLG has an undrawn £500 million funding facility with a consortium of banks. This facility is due to run until June 2013 but can be extended at the option of FLG for a further two years.

Financial strength ratings

The following principal life business is attributed financial strength ratings. Following the corporate restructure activities undertaken as part of the capital optimisation programme, the Friends Life Company Limited and Friends Life Assurance Society Limited ratings have been removed.

The Group targets financial strength ratings in the single A range and expects them to remain there for the foreseeable future.

7 Principal risks and uncertainties

The Group actively manages its risk profile and the risk management framework drives the identification and mitigation of group, strategic, financial and operational risks to support the achievement of its objectives. The formalised risk management framework which the Company has developed to guide the management of risk is further described within the Governance section of the Annual Report and Accounts. A more detailed review of the Group's exposures to market, credit, liquidity and insurance risks together with the framework and instruments for their management are included in the notes to the accounts.

Following is a list of the principal inherent risks and uncertainties the Group was exposed to during 2012 and an overview of its approach to managing these exposures:

Economic conditions

Description

Changes in economic conditions give rise to changes in the values of the assets and liabilities of the Group's insurance businesses and may reduce the profitability of these businesses and/or their financial strength. Adverse or uncertain economic conditions also impact the willingness of consumers to buy and continue to hold the Group's products. The Group is particularly impacted by conditions in the UK and other European countries as a result of its operations and investment assets being focused in these countries.

Management

The Group's business model seeks to mitigate the impact of market conditions through measures including the matching of assets and liabilities, diversifying between asset classes and within asset classes and using derivatives to reduce the volatility of returns on assets, diversification of the product portfolio, and ensuring the operating companies within the Group are strongly capitalised. The Group also actively monitors changes in the economic environment to enable proactive management of impacts to relevant markets. Its exposure to sovereign debt from all but the strongest countries in the Eurozone is modest, is in line with the Group's risk appetite and has been managed down further in recent years. The Group faces significant credit risk exposure (both from credit default and credit spread widening) as a result of its use of corporate bonds to back non-profit business and for the investment of shareholder funds. However it seeks to mitigate these risks by adopting a conservative investment policy with investment skewed towards bonds with high credit ratings.

Sustained low interest rates

Description

The Group's insurance businesses can be adversely affected by sustained low interest rates as well as certain interest rate fluctuations. The Group's insurance businesses, including shareholders' funds are invested in a variety of investments including government debt, cash instruments and corporate bonds. In times of low interest rates the yields on these instruments typically decrease. This can mean that when the instruments mature, the sums realised are reinvested into instruments with lower yields, which, in turn, decrease investment returns. Sustained low interest rates could therefore have a material adverse effect on the business, results of operations and/or financial condition of the Group and could adversely impact the ability to generate free surplus and ultimately pay dividends to shareholders.

Management

The Group seeks to match the duration and return profile of its assets and liabilities in order to manage its exposure to interest rate movements. In the annuity books this is achieved by investing in bonds of appropriate duration and through swap overlays.

Within with-profits funds a combination of physical bonds, swap overlays and swaptions are used to manage the interest rate risk. The level of hedging is optimised in line with risk appetite and so that it does not result in an unacceptable increase in other categories of risk.

Other mitigants to a low interest rate environment are being investigated including review of the Group's investment strategy for shareholder assets which currently has a large cash exposure. Approaches such as diversification of the asset classes in which the Group invests are being considered as part of investigating the opportunities to increase the rate of return achieved without significantly increasing the investment risks taken.

Integration and restructuring

Description

The Group is exposed to the risk of failing to integrate and successfully restructure the financial services businesses that it has acquired.

Management

Substantial progress has been made in integrating the three acquired businesses with strategy, planning, and monitoring of risk and business performance being undertaken on an integrated basis.

Restructuring of the business to improve its capital efficiency and bring together in separate companies the business of the Heritage Division (within FLL) and the UK Division (within FLPL) is progressing to plan with the business transfers planned for 2012 completed during the year and the 2013 plans on track. There is one major component to complete before separation of the acquired AXA UK Life Business from its previous parent group is achieved at operational level. This work has been replanned and is now expected to complete in 2013.

The scale of the separation, integration and restructuring agenda, particularly when taken with the substantial regulatory change agenda faced by the Group (see below) poses particular challenges. Through the business planning process the Group determines the volume of change initiatives that can be delivered and prioritises initiatives for inclusion. The Group operates project management disciplines to identify and manage the interdependencies between initiatives, to set and monitor budgets, to manage the deployment of resources and to monitor delivery of outputs. In this way the Group aims to manage the risks of the change programme within its appetite.

Regulatory and taxation change and compliance

Description

The Group operates in a highly regulated financial services market both in the UK and internationally which has a significant impact and influence on both strategic decisions and ongoing day-to-day management of the business. Unanticipated changes in legal requirements (including taxation) and regulatory regimes, or the differing interpretation and application of regulation over time, may have detrimental effects on the Group. It is impossible to fully predict the nature of the regulatory changes which may occur in the future or the impact that such changes may have on the Group and its strategic objectives.

The Group may be affected by changes in tax legislation and interpretation of tax law, whether the changes impact the taxation of the companies in the Group at corporate level, or the taxation of the policyholders. In particular, the new corporate tax regime applicable to life insurers from 1 January 2013 continues the "I minus E" basis of taxation for relevant life business in the operating life companies, and while the Group assumes the continuation of that basis in the future, any change in that basis may have a significant impact on the Group.

Management

The Group successfully completed its preparation for regulatory driven requirements introduced in 2012 such as gender neutral pricing and the Retail Distribution Review. Systems have been developed to support the Group's occupational pension scheme customers in meeting the requirements of Auto Enrolment and further automation of the processes is planned during 2013 in order that the group is able to meet the needs of the increasing numbers of schemes that will become subject to Auto Enrolment requirements in late 2013 and 2014. As with any major change in UK regulatory requirements, it is expected that FSA (or its successors PRA and FCA) will want to review firms' interpretation of these new requirements and test that compliance has been achieved. Accordingly the Group expects its implementation of these new regulatory requirements to be reviewed over coming months.

It is expected that various regulatory bodies will begin thematic reviews in 2013, such as annuity pricing and unit linked pricing, the Group will adhere to these reviews as required.

The planned simplification of the Group's governance arrangements from the end of March will address the changes made to the UK listing rules in respect of "externally managed companies" and which could otherwise have threatened the continuation of the Company's premium listing.

The Group continues to monitor and prepare for the future regulatory developments such as the impending transfer of UK regulatory responsibilities for insurers from the FSA to dual prudential and conduct regulators, and longer term initiatives such as Solvency II and IFRS Phase II.

The Group bases its business strategy on prevailing regulation and known and planned change. To mitigate the risk of legislation or regulation adversely impacting its business, the Group and its operational businesses engage with regulatory and legislative authorities and support lobbying activity conducted by relevant industry groups. The Group has processes in place to identify regulatory and legislative change and to monitor the timely implementation of new requirements.

Principal valuation assumptions

Description

The writing of life assurance and pension business by the Group's insurance businesses necessarily requires the setting of assumptions for future experience of factors such as mortality and longevity, lapse and persistency rates, valuation interest rates, credit defaults and expense levels. Experience may vary from the rates assumed impacting the financial performance of the Group.

Management

During 2012, the continued economic uncertainty and impending introduction in the UK of FSA's Retail Distribution Review acted to increase the risk of lapses of life and pensions business as intermediaries looked to re-broke existing business ahead of the impending ban on the payment of commission and in the face of a scarcity of new business. The Group has in place customer value management activities to mitigate this risk and anticipates that over the course of 2013 that it will see some improvement in lapse rates following the implementation of the Retail Distribution Review.

The Group takes a prudent approach to evaluating the appropriate level of provisions and capital for each of its risks and the assumptions made are subject to rigorous and ongoing review. However events causing a substantial change in mortality/morbidity experience, lapse rates or other reserving assumptions could require assumptions to be recalibrated and could impact the profitability, earnings and capital position of the Group. Stress and scenario testing is used to validate the appropriateness of key assumptions to single events and combinations of extreme events including economic conditions, investment performance, lapse and mortality/morbidity events.

Outsourcing

Description

As part of the Group's strategy for increasing operational efficiency, it makes use of outsourcing. In March 2012 Friends Life group's outsource arrangements in respect of IT and customer services were materially extended by the coming into effect of a long-term contract with Diligenta. This substantially increased the reliance of the Friends Life group on outsource service providers. The risks of outsourcing include the risk that the outsourcer is or becomes unable to provide the expected services or does not provide them to the standards and quality expected.

In addition, the Group's insurance businesses currently benefit from the exemption from VAT of certain costs incurred under outsourcing contracts into which they have entered. The VAT exemption is subject to possible change and if narrowed could have the effect of increasing the costs of some of the outsourced services the Group has contracted to receive.

Management

The Group has comprehensive service level agreements in place with all its outsource service providers and actively monitors the standards of delivery against these agreements in order to mitigate the operational risks posed by the outsourcing. In relation to the newest partner, a dedicated team is overseeing Diligenta's delivery of a Service Improvement Plan in accordance with its contractual obligations. In addition, the financial strength and strategic position of the Group's major outsource service providers are actively monitored in order to manage the potential counterparty credit and continuity of service risks they pose.

The Group monitors discussions at European and UK level regarding the VAT exemption for outsourced services. However it remains uncertain when any changes might be made to the law, what form those changes might take, and hence what impact, if any, they might have on the Group.

Directors' responsibility statement pursuant to Disclosure and Transparency Rule 4 (extracted from the 2012 Annual Report and Accounts)

The Annual Report and Accounts contains the following statements regarding responsibility for the financial statements and the business review included in the Annual Report and accounts.

"Each of the directors confirms that to the best of their knowledge:

·; The financial statements, 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 Group; and

·; The business review included in the Annual Report and Accounts includes a fair review of the development and performance of the business and the position of the Group, together with a description of the principal risks and uncertainties that it faces."

By order of the Board

Fergus Dunlop

Director

25 March 2013

IFRS financial statements

Consolidated income statement

For the year ended 31 December 2012