Half Yearly Report

15 August 2012

Resolution Limited (the "Company")

Results for the half year ended 30 June 2012

Integration and business optimisation at Friends Life delivering results

·; Operational delivery on track to meet key performance targets:

- UK VNB of £67 million, exceeded whole of 2011, driven by operating synergies, migration to higher margin platforms and outsourcing arrangements

- Annualised synergies of £65 million achieved in the first half of 2012; on track to hit the published target

- Improved group new business IRR of 10% as UK business migrates to higher margin target platforms

- Material outsourcing contract and launch of in-house asset manager successfully delivered in Heritage business

- Friends Provident International (FPI) and Lombard impacted by challenging economic environment; FPI strategic review to rebalance value, volume and risk

·; IFRS based operating profit before tax of £163 million (including £27 million of one-off items) (30 June 2011: £390 million, including £216 million of one-off items) reflecting lower expected investment returns on the in-force book, a disappointing performance in the international businesses partly offset by reduction in costs of new business

·; MCEV operating profit before tax of £235 million (30 June 2011: £180 million) reflecting growth in profitable new business, partly offset by reduction in expected existing business contribution

Confidence in underlying operations and improving cash generation allows increase in interim dividend

·; Robust capital position:

- Estimated FLG IGCA surplus of £1.9 billion, representing a coverage ratio of 204% (before interim dividend)

- Significant progress to improve economic capital position with an estimated FLG economic capital surplus of £3.0 billion, representing a coverage ratio of 174% (before interim dividend)

·; Focus on returning excess capital to shareholders continues; excess capital is defined as capital in excess of both working capital requirements and after ensuring that capital buffers are maintained in specific stress scenarios; £400 million prudence buffer held

·; Although the capital position remains robust, the decision not to return £250 million to shareholders in July 2012 was based on the expected future capital requirements of the Group against a backdrop of heightened investment, economic and regulatory uncertainty

·; Balance sheet has minimal exposure to higher risk sovereign debt and retains a highly rated corporate bond portfolio

·; Underlying cash flow generation has improved despite challenging economic environment:

- Sustainable free surplus generation in the first half of £120 million, reflecting good progress in reducing UK new business strain, offset by lower investment returns and targeted investment costs

- Available shareholder cash of £619 million has also been impacted by lower returns but maintains a £400 million prudence buffer and underpins longer term confidence in the dividend

·; Interim dividend raised by 5% to 7.05 pence per share, supported by underlying cash generation from operational improvements and a robust balance sheet

·; The Company envisages moving to a progressive dividend and will consider doing so when sustainable cash generation meets its £400 million per annum distributable cash target

Simplifying the governance structure and focus on delivering shareholder value

·; The Company and Resolution Operations LLP ("ROL") continue to focus on the ways in which value can best be delivered to shareholders. The Board and ROL believe that whilst the current structure of the Group was appropriate to launch the Company, shareholder value can now best be delivered by moving from an externally advised project based structure to a more conventional, simplified governance structure

·; Further details of the changes to the Company's governance arrangements and relationship with ROL are under discussion and implementation of the agreed changes is expected to be completed in the next six months. In the meantime, the market will be updated on these changes as they are completed

·; The Company, having received advice from ROL, now confirms that:

- The Company will no longer seek acquisitions

- The Company will continue to focus on securing maximum value from each part of the Group

- The focus on cash emergence and financial discipline will continue

- The Company will no longer seek a specific exit event and consequently the previously announced self-managed exit plan of separate IPOs of the UK Go to Market and Heritage business units is no longer envisaged

·; Specifically:

- The boards of the Company and Friends Life Group plc will be streamlined and conventional governance adopted to include individuals, to maintain continuity, from both current boards

- The Company and ROL have agreed that the Operating Agreement under which ROL has provided mergers and acquisitions, strategic and oversight services and skills to the Company will end at the latest on 10 December 2013, which is the earliest date on which the Operating Agreement could be ended in accordance with its original and current terms

- The Company and ROL expect to agree changes to the Operating Agreement and the various other commercial agreements between their respective groups which would mean that ROL would cease to provide services to the Company on or before that date. It is envisaged that many of the skills from ROL will be in-sourced to the Company, with Jim Newman and appropriate ROL personnel transferring to the Company

·; Subject to legal and regulatory processes (including a shareholder vote to change the Company's constitution), it is expected that:

- Mike Biggs will remain as chairman of the Company

- Sir Malcolm Williamson will become the deputy chairman of the Company

- Clive Cowdery will join the Board

- Andy Briggs will become CEO and Tim Tookey will become CFO of the Company

·; Once the changes to the Company's governance arrangements have been finalised, John Tiner has indicated his intention to retire as a partner with ROL and step down from the board of Friends Life Group plc; John Tiner intends to build on his non-executive roles

·; The Company and ROL are committed to maintaining the Company's premium listing and as a result of the changes announced today, there appear to be no reasons why the outcome of CP12/2 would have any material impact on the Company

·; The Company will retain the value focus and philosophy under which it was originally formed by The Resolution Group managing its assets to secure maximum value for shareholders

·; To date the Company has approved and remains committed (on the terms of the Operating Agreement) to funding £5.0 million (£1.1 million of which has already been spent) for ROL's research and development activities, subject to such expenditure complying with the Operating Agreement. This funding is for two on-going financial services projects outside the scope of the UK Life Project which relate to:

- The acquisition and consolidation of closed life insurance businesses in Western Europe, ex-UK; and

- The acquisition of captive asset managers

ROL has confirmed to the Company that it will not make any further requests for funding out of the balance of £15 million of the £20 million funding available under the current Operating Agreement

Mike Biggs, Chairman of Resolution Limited, said:

"Despite the ongoing market and regulatory uncertainty, the underlying business continues to make good operational progress in line with the clear strategy and value agenda of the Company. With the acquisition phase ended and to avoid the expectation of a specific exit event and time, the Board and ROL believe that now is the right time to agree to end the Operating Agreement between them and move to a more conventional governance and operating structure for the Company.

The Company will continue to deliver against the value philosophy and financial discipline under which it was founded by The Resolution Group which will remain as a supportive shareholder."

Enquiries:

Investors/analysts

Neil Wesley, Resolution Operations LLP +44 (0)203 372 2928

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 (BST). Dial in telephone number: UK National call 0871 700 0345, UK Standard International +44 (0) 1452 555 566 Passcode: 16370052.

Analysts/Investors

A presentation to analysts will take place at 09.30am (BST) at the London Stock Exchange, 10 Paternoster Square, London EC4M 7LS. Dial in telephone number: 0800 634 5205, UK standard International +44 (0)208 817 9301, confirmation number: 8243343. 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 interim dividend

Website www.resolution.gg

Contents of the interim results statement

Chairman's statement

Overview

In the first half of 2012, the Company remained focused on delivering value from the acquired businesses and can report good progress in the operational performance of Friends Life against a backdrop of economic, investment and regulatory uncertainty.

The results in the first half of 2012 demonstrate good progress made in reducing new business acquisition costs and a material improvement in the value of new business. The UK Go to Market business, which comprises the Protection, Corporate Benefits and Retirement Income businesses, has made good progress towards the financial targets set as business has migrated to targeted platforms driving margins, further cost savings and profitable increases in volume. The Heritage business, which contains the existing book of business, has made progress against its initiatives including the outsourcing arrangements and further work on capital optimisation. The international businesses still face some challenges and FPI is undergoing a strategic review that will look to rebalance the business with a focus on value, volume and risk. The key headwind in the first half of 2012 was lower than expected investment returns which have offset some of the good operational progress made in the businesses.

Core projects were successfully delivered in the first half of 2012. The significant outsourcing agreement with Diligenta was to make costs more variable in order to secure the delivery of cash returns from the existing book of business, and the successful launch of Friends Life Investments ("FLI"), an in-house asset manager that will help save on fees paid to external managers and add value through more optimal asset allocation.

The net Market Consistent Embedded Value ("MCEV") of the Group as at 30 June 2012 was £5,939 million.

The operating report and business review that follow this statement contain a more comprehensive account of the first half of 2012.

Cash and capital

Dividend

The Company's dividend policy remains unchanged and consistent with the policy of dividends being paid one-third in respect of the interim dividend and two-thirds in respect of the final dividend, the Board has proposed an interim dividend of 7.05 pence per share, up 5%. The full year dividend guidance is similarly for an increase of 5% which would equate to 14.09 pence per share, subject to shareholder approval. The increase in dividend reflects the Board's confidence in the operational cash generation and robust capital position of the Group.

The Company envisages moving to a progressive dividend and will consider doing so when sustainable cash generation meets its £400 million per annum distributable cash target.

Returns of capital

On 20 July 2012, the Company cancelled the targeted £250 million capital return expected by shareholders.

Although the capital position remains robust, the decision to cancel the targeted £250 million capital return to shareholders was based on the estimated capital position of the Group as at the end of June 2012 after careful consideration of the expected future capital requirements and applying stresses to both Pillar I and economic capital against a backdrop of heightened investment, economic and regulatory uncertainty.

Today, the Company has provided a detailed update on its cash and capital position and associated sensitivities as at 30 June 2012. A summary of the key points is below.

The Company maintains a robust capital position:

·; the estimated FLG IGCA surplus of £1.9 billion represents a coverage ratio of 204%, before the interim dividend;

·; significant progress was made in the first half of 2012 to improve the economic capital position with an estimated economic surplus at FLG of £3.0 billion, representing a coverage ratio of 174%, before the interim dividend; and

·; the Group's balance sheet has minimal exposure to higher risk sovereign debt and retains a highly rated corporate bond portfolio.

The Company's focus on returning excess capital to shareholders continues. Excess capital is capital in excess of both working capital requirements and after ensuring that capital buffers are maintained in specific stress scenarios. Future returns of excess capital remain subject to market conditions and regulatory approval, and will also consider the more challenging regulatory environment, especially with respect to Solvency II.

Future value creation

The Company will continue to deliver against the clear value philosophy and strategy which drove the creation of the Company. These include:

·; rationalising new business to products and channels where the enlarged Group benefits from competitive advantages, can meet its financial targets and deliver sustainable and acceptable returns and cash flow for investors;

·; driving out cost reductions from reducing overlap, rationalising and streamlining operations and outsourcing key functions and activities as appropriate;

·; optimising the balance sheet and reducing operational risks in the Company; and

·; identifying and delivering capital synergies and returning excess capital to shareholders.

The Company expects that the separation of the UK Go to Market businesses from the UK Heritage back book of business will continue because the Company believes this will drive greater financial discipline and focus on cost reduction and cash generation.

The Board believes that the Company is now well placed to deliver the financial targets and operational objectives, under the team at Friends Life, and augmented by the addition of proposed resources from ROL. The Company's operating agenda is clear:

·; deliver the target synergies;

·; deliver the capital optimisation programme;

·; deliver ongoing operational improvements in the UK business; and

·; deliver the operational turnaround of the international businesses.

Simplifying the governance structure and delivering shareholder value

Background

The Company and ROL continue to focus on the ways in which value can best be delivered to shareholders and with this in mind have been jointly undertaking a fundamental review of the UK life consolidation project. To date, the Company's UK life consolidation project has been focused on creating value for shareholders from the consolidation of larger UK life groups. The UK Life Project has resulted in a financially disciplined, sustainable and value focused business which is making good operational progress and is on track to meet its financial targets. We believe that the project based structure we adopted was appropriate to launch the Company, but shareholder value can now best be delivered by moving from this externally advised project based structure to a more conventional, simplified governance structure.

As part of these changes I can confirm:

·; The Company will no longer seek acquisitions;

·; The Company will continue to focus on securing maximum value from each part of the Group;

·; The focus on cash emergence and financial discipline will continue; and

·; The Company will no longer seek a specific exit event and consequently the previously announced self-managed exit plan of separate IPOs of the UK Go to Market and Heritage business units is no longer envisaged.

The Company will retain the value focus and philosophy under which it was originally formed, managing its assets to maximise value for shareholders.

Proposals

The key elements of the change to the governance structure we have announced today are that:

·; subject to necessary regulatory approvals, the boards of the Company and Friends Life Group plc will be streamlined and conventional governance structures adopted;

·; the Company envisages that the same directors will sit on the boards of the Company and of Friends Life Group plc, including individuals, to maintain continuity, from both current boards;

·; the Company and ROL have agreed that the Operating Agreement under which ROL has provided mergers and acquisitions, strategic and oversight services to the Company will end on 10 December 2013 at the latest;

·; many of the skills from ROL will be in-sourced to the Company, and Jim Newman and appropriate ROL personnel will transfer to the Company.

Subject to legal and regulatory processes, including a shareholder vote to change the Company's constitution, it is expected that I will be Chairman of the Company and Sir Malcolm Williamson will become Deputy Chairman. Clive Cowdery will join the Board. Andy Briggs will be Chief Executive Officer and Tim Tookey will be Chief Financial Officer of the Company.

Given the proposed changes to the arrangements between RSL and ROL, it is anticipated that Ian Maidens will shortly cease to be an ROL partner and will move to working with ROL and RSL on a consultancy basis. John Tiner has indicated his intention to retire as a partner with ROL and step down from the board of Friends Life Group plc. John intends to build on his non-executive roles.

Implementation

Further details of the changes to the Company's governance arrangements and relationship with ROL are under discussion and implementation of the agreed changes is expected to be completed in the next six months. We will update the market as these changes are completed.

The Company and ROL are committed to maintaining the Company's premium listing and as a result of the changes announced today, there appear to be no reasons why the outcome of the FSA's consultation paper CP12/2 would have any material impact on the Company.

Outlook

The economic, investment and regulatory backdrop remain uncertain. Against this, the Company is making good operating progress but this is being offset by lower than expected investment market returns. At Friends Life, the achievement of the 10%+ ROEV and the distributable cash target of £400 million from sustainable cash flow sources, both of which are reliant on investment income, remain targets but over the medium term, should current economic conditions and investment market volatility persist.

The Company expects that going forward, as it moves to having a more conventional and simplified governance structure with the clear value philosophy under which it was originally formed, it will be valued as a financially disciplined and cash generative group with a balance sheet that does not contain undue risks for its investors. The concept of mid-teens returns over the course of the project will no longer be appropriate.

The Board would like to thank all staff in Friends Life and ROL for their continued hard work.

Operating report by Resolution Operations LLP

Introduction

ROL is pleased to report that in the first half of 2012 good progress has been made towards achieving the financial targets of Friends Life. This progress is against a continued backdrop of investment market volatility and what the Company believes is a tougher and less certain regulatory environment. This operating report will provide an update on:

·; the strategic aims of the Company;

·; the UK Life Project, including the key achievements in the first half of 2012, the economic and regulatory environment impacting the performance of the business, the key reporting metrics and drivers of the results in the period, the cash and capital position of the group, the M&A and exit options for shareholders; and

·; the outlook.

Strategy

As stated previously, the Company's strategic aim for its UK Life Project is the creation of a sustainable business or businesses which meet customers' needs while also delivering cash returns to shareholders. ROL continues to believe that maximisation of shareholder value can best be achieved through the ongoing development of both the new and in-force activities of Friends Life. These activities should be pursued without disadvantaging any element of the Group's capital structure whilst continuing to ensure that the interests of policyholders remain protected.

Friends Life is focused on the disciplined management of the back book of business to deliver cash from existing policies, and writing profitable new UK business in the product areas of Corporate Benefits, Protection and Retirement Income. In writing new business in these areas, Friends Life is prioritising value over volume by controlling costs, leveraging its efficient target platforms and distribution arrangements, employing pricing discipline and utilising its scale to deliver returns on capital. Outside the UK, Friends Life has a similarly focused and disciplined approach to managing existing and new business sales through its International and Lombard businesses.

UK Life Project

The Company continues to make good progress in the pursuit of its strategic objectives in the first half of 2012. Friends Life has improved the underlying performance of the operating businesses, particularly in the UK, where management actions have driven strong growth in new business profits with reduced cash strain. This improved operating performance has however been impacted by the challenging economic environment resulting in weaker investment markets and lower interest rates compared to the previous period and the Company's expectations. These have adversely affected overall returns.

On 20 July 2012 the Company announced the cancellation of the targeted £250 million capital return originally expected to be returned to shareholders in the first half of 2012. It was determined that against the current backdrop of heightened investment, economic and regulatory uncertainty and after careful consideration of the expected future capital requirements of Friends Life Group that it would be inappropriate to complete the capital return. The Group's capital position remains robust with Friends Life Group having an estimated IGCA surplus at 30 June 2012 of £1.9 billion.

Notwithstanding the more challenging environment a number of core projects were delivered in the first half of the year, including the previously announced Diligenta outsourcing transaction, which commenced successfully at the beginning of March 2012. The separation and integration activity is also making good progress with separation from Bupa completed at the end of January 2012. The separation from AXA remains on track with three quarters of transitional service arrangements now exited. Synergy delivery as part of the integration process has achieved £65 million of run-rate cost savings, up from the £45 million at the end of 2011. As expected, the bulk of the additional synergies recognised in the first half of 2012 reflect the realisation of contractualised savings through the Diligenta outsourcing transaction, with the closure of a number of the Friends Life offices also contributing to the improved run-rate. Total run-rate and contractualised synergies amount to £112 million at 30 June 2012, up from the £105 million reported in the 2011 full year results.

On 2 July 2012 Friends Life launched an in-house asset management business, Friends Life Investments ("FLI") with £6 billion of fixed interest assets. This business has been built around the current in-house investment team augmented with key hires bringing to the Group the capability and expertise needed to manage these asset portfolios. FLI will continue to accumulate fixed interest assets over time and is expected to add value to the Group through savings on external management fees, VAT and improved investment portfolio construction over time.

Economic and regulatory environment

The economic environment over the last twelve months has remained uncertain with lower than expected global growth exacerbated by the debt crisis and political uncertainty in Europe. In the UK, the uncertainty in Europe has had an adverse impact on customer confidence and growth, taking the UK back into recession.

In the first half of 2012, lower than expected market levels reduced returns from the in-force funds in the form of lower annual management charges compared to prior periods. In the debt markets, short and medium term Gilt yields, a key driver of future expected returns, remained at or around 2011 year end levels driven in part by the UK's position as a relative safe haven. Corporate bond spreads have remained elevated over the same period.

Friends Life's business units have all been impacted by reduced consumer confidence with customers in the international businesses postponing decisions regarding investing or saving for the future. This has been compounded in some regions, notably Asia, by increased competition levels which have led to overall margin pressures. Friends Life's UK product markets remain relatively stable with the principal challenges resulting from the changing regulatory agenda.

The UK business's preparations are on track for the forthcoming regulatory changes towards the end of 2012 including the inception of the Retail Distribution Review ("RDR"), auto-enrolment and gender neutral pricing. The Group continues to believe that it is well-positioned to benefit from the opportunities expected to be generated by these regulatory changes.

The corporate benefits market is large and continues to be a fast-growing but lower margin, market. Competition on price remains intense with the current market continuing to have a bias to paying commissions in a pre-RDR environment. Nevertheless opportunities in this market are promising driven by the ongoing shift from defined-benefit to defined-contribution schemes, whilst the advent of auto-enrolment and the RDR are likely to widen the market and level the competitive playing field.

The UK protection market is mature, concentrated and has remained relatively stable over the past few years despite the weak macroeconomic climate. In the period following the introduction of the RDR, the Group expects to benefit from any shift in the business models of distributors to focus more on protection products. Further changes regarding gender neutral pricing and life tax reforms will have an effect on the price of individual protection and are expected to increase market pricing volatility in the early part of 2013. Friends Life's protection business is well positioned to succeed in this scenario as it operates a value-based proposition, focused on product quality.

The environment in the retirement income market also remains positive with continued growth expected to be driven by population demographics as 'baby boomers' retire. Further to this the competitive market reflects the expectations for future capital demands, in light of Solvency II, as well as persisting low Gilt rates. Despite these factors the Group does not expect the current cautious pricing levels and associated margins to be maintained in the second half of 2012 in which lower margins are assumed. On the regulatory front the business is meeting the drive for increased transparency in the retirement income sector by implementing the ABI Code of Conduct, which is due in March 2013. This aims to improve the customer's understanding of their options at retirement, and highlights the importance of the strategy to develop a broader product range in the retirement income space. 

The implications of Solvency II remain a key focus with the Group monitoring the regulations and likely impacts as they develop. As stated in March, the uncertainty around a number of the key issues, including the treatment of matching adjustments, could have a material impact on future capital requirements. Over the coming period the Group will continue to monitor legislative developments in Europe and input to the UK's implementation plans.

Business performance

Friends Life's results in the first half of 2012 reflect two key elements: improved financial discipline and the effects of the macroeconomic environment. Friends Life has continued to make good progress in delivering against those elements of the published strategy within management's control; however, economic uncertainties have impacted the results with lower investment market levels and expected returns reducing surplus generation.

The Group delivered a robust IFRS operating performance in the first half of 2012, with an operating profit of £163 million in the period principally reflecting good progress towards reducing acquisition expense levels offset by the macro economic factors impacting surplus generation. On an MCEV basis, operating profits of £235 million reflect the strong performance in the UK where the value of new business ("VNB") of £67 million already exceeds that generated in the whole of 2011 (year ended 31 December 2011: £59 million). Despite this improvement the contribution from existing business continues to be constrained with lower opening value of in-force, following market falls in the second half of 2011, combining with persistent low rates of return.

Cash generation remains a key focus of the Group although this has also been impacted by the low level of returns in the first half of 2012. Sustainable free surplus of £120 million generated in the first half reflects Friends Life's ongoing drive to reduce new business cash strain. UK new business cash strain of £60 million in the first half of 2012 has been reduced by an annualised £183 million from the £303 million baseline in 2010, representing 92% of the £200 million targeted new business cash strain reduction. The activity to migrate the Go to Market businesses to their respective target platforms has supported this improvement alongside the continued focus on operating costs and the delivery of targeted synergies.

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

(ii) Target IRRs for the Go to Market businesses are set out in the relevant sections of the UK operating review

(iii) The 2011 Lombard IRR (and therefore the blended group IRR) now takes account of the Luxembourg regulatory regime in which DAC is an allowable asset.

The International results are relatively disappointing although they demonstrate a resilient performance, with stable funds under management, against a challenging economic and competitive background. Pricing discipline and shift in new business mix to higher margin products have largely maintained the value of new business in a period when market and competitive pressures have reduced the overall level of new business volumes.

Lombard's first half performance is also subdued with lower economic returns and one-off costs impacting the result. Lombard's sales are up 4% on a constant currency basis (2% down in sterling) in a highly uncertain market environment although the mix of business has resulted in reduced new business contribution levels in the period.

The Business Review that follows this report will cover the operating performance in detail.

Path to achieving targets

The Company set out targets for the Friends Life businesses in February 2011, focused on a combination of business unit operating performance and overall group returns. In the UK:

·; Corporate Benefits business - Friends Life has targeted reducing cash new business strain to £75 million per annum, increasing VNB to £25 million per annum and delivering a new business IRR in double figures by 2013. In the period to 30 June 2012, sales were £291 million on an annual premium equivalent ("APE") basis across the Corporate Benefits proposition, with 79% of this written on the target new generation pension platform ("NGP") and the recently launched Corporate platform ("My Money"). Progress towards delivering the targeted cash strain reduction has been good with new business strain of £32 million lower than that in the first half of 2011 whilst at the same time doubling VNB levels (£10 million). IRR of 6.8% also shows an upward trend from 6.6% in the first half 2011 although the result reflects the current small scale of the new corporate platform and inclusion of WLUK at the end of 2011. We expect the favourable IRR trajectory to continue and for 2013 market commitments to be hit through continued cost savings and pricing discipline and the benefits of the volumes of auto-enrolment business;

·; Protection business - Friends Life has targeted reducing new business cash strain to £30 million per annum, increasing VNB to £80 million per annum and achieving a new business IRR of 20% per annum by 2013. In the first half of 2012, sales were £44 million APE, with 81% of this business now written on the targeted Individual and Group protection platforms. In the first half of 2012, VNB was £28 million and new business strain reduced to £23 million. The value generated from this new business and corresponding IRR, at 9.8%, reflects a significant improvement in the performance of this proposition and highlights progress towards the financial targets. The ongoing priority for the business includes the migration of strategic partners such as Countrywide to the target platforms, which are expected to further enhance returns giving increased confidence in achieving the required targets;

·; Retirement Income business - Friends Life has targeted increasing retention rates on vesting pension funds to 50% and increasing VNB to £50 million per annum by 2013. The business continues to focus on developing the required capability with early steps towards the delivery of an enhanced annuity proposition taken in the first half of 2012. Consequently there has been limited change in the proportion of internal vesting rates with these not expected to reflect the benefit of revised product offerings until 2013. Notwithstanding this, the Retirement Income business delivered gross VNB of £25 million in the first half of 2012 providing confidence that the £50 million per annum VNB target can be delivered by the end of 2013.

The International and Lombard businesses are targeted to achieve new business IRR of 20% by the end of 2013. In addition, the International business is targeted to deliver £20 million of dividends to the group by end 2013 with Lombard expected to deliver £30 million by the end of 2014. An update on the strategic review of the international businesses and targets will be provided before the end of 2012.

As noted above, Friends Life has made substantial progress towards the targeted £200 million reduction in new business strain. This reflects the successful efforts to reduce expense levels in the UK businesses with a significant element of the £65 million run-rate synergies (targeted £143 million by 2015) contributing to a reduction in UK acquisition costs. The strain reduction also reflects the cessation of certain new business sales, and the migration of new business to the target platforms in addition to the action in 2011 to recognise negative reserves on all Protection business lines.

The challenging economic conditions and investment market volatility over the last year or so have created a difficult environment for financial services companies in general. These conditions also impact Friends Life's customers and clients and their behaviour with respect to buying products or investing savings. As a result the Company has reassessed its underlying assumptions with respect to interest rates and asset returns. As reported in March 2012, achieving the ROEV target (10%+ by 2013) requires the outperformance of the business in many areas to offset the impact of economic conditions which continue to be adverse to those incorporated within the previously stated target returns. This situation is unchanged and thus should current economic conditions and investment market volatility persist, including the market view of future interest rates, then attaining both the distributable cash target from sustainable activities, and the ROEV target, both of which are reliant on investment income, will be over the medium term.

Cash and capital

Friends Life has maintained a robust balance sheet in the first half of 2012 despite continuing difficult economic conditions. At 30 June 2012, Friends Life had an estimated IGCA surplus of £1.9 billion (31 December 2011: £2.1 billion) reflecting the payment of the £250 million dividend to Resolution Holdings (Guernsey) Limited in March 2012. The June 2012 position represents a coverage ratio of 204%, before the payment of the interim dividend, over the Group capital resource requirement (excluding WPICC). In addition the Group also retains a highly rated corporate bond portfolio and has limited exposure to higher risk European sovereign debts. Friends Life has made good progress with improving its economic capital position and has an estimated economic capital surplus of £3.0 billion as at 30 June, representing a coverage ratio of 174%, before the payment of the interim dividend.

The business review that follows this report covers the cash and capital position of the Group in detail.

M&A and exit

In today's announcement, the Company has announced that shareholder value can best be delivered by moving to a more conventional, simplified governance structure. As part of the proposed changes, the Company has also confirmed that it will no longer seek acquisitions and will focus instead on securing maximum value from each part of the Group. The Company also confirmed that it will no longer seek a specific exit event.

Outlook

The Company is making good operating progress in an uncertain economic, investment and regulatory environment. The key challenge facing the group is lower than expected returns as a result of the weaker economic environment. The Company believes that it has a sustainable, cash generative and financially disciplined business that should navigate the economic and regulatory challenges to deliver shareholder value.

Business review

Key performance indicators

The Group uses the following key performance indicators.

·; IFRS based operating profit before tax of £163 million is £227 million lower than the first half of 2011 principally reflecting the one-off benefits of £216 million reported in 2011. On a comparable basis, after the removal of one-off items in 2012, positive £27 million, the result reflects a fall of £38 million as good progress in reducing UK new business strain is offset by difficult economic conditions and one-off costs. The current economic environment in which interest rates remain low has adversely impacted surplus generation, particularly in International, while lower funds under management have impacted levels of fee generation in the UK business. The results also reflect a number of one-off costs including costs incurred as the business invests in operational capability for the future.

·; IFRS loss after tax of £(58) million (30 June 2011: £45 million profit) principally reflects the costs of separation and integration activities, delivering the Diligenta outsourcing and preparing for Solvency II. Other non-operating items include a marginally reduced amortisation charge compared to the original run-off on acquired intangibles reflecting revised expectations for International acquired VIF ("AVIF") run-off, while the comparative period includes the gain on the acquired BHA business offset by one-off amortisation and impairment of AVIF.

·; MCEV operating profit before tax of £235 million (30 June 2011: £180 million) reflects the significant progress made, led by the UK business, in improving the value of new business. The good progress made on new business returns has however been partially offset by sustained low expected returns combined with the impact of the lower opening value of in-force on expected return, reflecting the adverse economic conditions in 2011.

·; MCEV profit after tax of £296 million (30 June 2011: £54 million) reflects the good operating performance as well as favourable economic variances principally driven by a narrowing of corporate bond spreads. These are partially offset by non-recurring costs incurred, in line with IFRS.

·; Group embedded value on an MCEV basis of £5,939 million is up £143 million in the six month period (31 December 2011: £5,796 million). The improvement reflects the good operating performance offset by dividend payments.

·; FLG operating ROEV(ii) of 6.4% (30 June 2011: 4.5%) reflects the operating MCEV result with the improved returns arising from UK new business offset by continued low returns on the existing book of business.

·; Group available shareholder cash of £619 million decreased by £234 million from 31 December 2011 (£853 million) impacted primarily by Resolution Limited dividends and debt payments.

·; Estimated FLG IGCA surplus capital of £1.9 billion (31 December 2011: £2.1 billion) represents a coverage ratio of 204% (31 December 2011: 219%). The reduction principally reflects the payment of a £250 million dividend to Resolution Holdings (Guernsey) Limited in March 2012 which underpinned the payment of the 2011 final dividend to shareholders.

·; 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 period and the shareholder share of default provisions remained unchanged at £0.6 billion.

(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 re-issued in amended form in October 2009.

(ii) FLG operating ROEV is calculated as the annualised 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.

(iii) Corporate debt and asset-back securities at investment grade or above.

IFRS results

Group IFRS profit

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 the Board considers that this better represents the underlying performance of the business and the way in which it is managed.

(i) Half year 2011 results comprise six month results for Friends Provident and the AXA UK Life Business, five months for BHA, six months for GOF and TIP. The GOF and TIP businesses were sold on 1 November 2011.

(ii) 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 WLUK.

The Group IFRS based operating profit in the period to 30 June 2012 totalled £163 million, a reduction of £227 million on the same period in 2011 (30 June 2011: £390 million). After the removal of principal reserving changes and one-off items (30 June 2012: £27 million, 30 June 2011: £216 million) the 2012 half year result is £38 million lower than the first half of 2011 reflecting the Group's focus on financial discipline within the operating companies in a challenging macroeconomic environment. The economic conditions, in which expected returns remain low, have adversely affected the results with the International business in particular impacted by lower interest rate levels. The results also reflect a number of one-off costs in both the International and Lombard businesses, including the strategic review, while other one-off development costs have been incurred in the UK as the business invests in operating capabilities for the future.

The result comprises the operating profit of the life businesses of £168 million, £10 million of corporate income for FLG and £(15) million of corporate costs for the Resolution holding companies. Further details of the operating performance of the Group are included in the relevant business unit operating sections.

Non-operating items

Short-term fluctuations in investment returns, on assets backing the shareholder and non-profit funds, were a favourable £18 million in the period to 30 June 2012. This benefit principally reflects the release of credit default allowances as default experience on assets backing annuity liabilities was better than assumed. In addition, an £8 million benefit has resulted from annuity portfolio mismatches reflecting the fact that these liabilities are matched on a realistic basis as opposed to the reported regulatory basis. Partially offsetting these positive items is a £(7) million adverse variance on shareholder assets, which mainly reflects the difference between actual and expected longer term return on the external debt.

Non-recurring items of £(118) million include:

·; separation and integration programme costs of £(39) million;

- Costs, net of provision releases, on the separation and integration programmes totalled £(39) million in the period and take cumulative spend on these projects to £(89) million and £(83) million respectively (31 December 2011: £(72) million and £(67) million before £6 million provision release).

·; outsourcing implementation costs of £(27) million;

- Costs of £(84) million relating to the Diligenta outsourcing implementation were provided for as at 31 December 2011. In the period, £13 million of these provisions have been released against costs of £(40) million, resulting in net costs in the period of £(27) million. The costs incurred to date therefore amount to £(111) million. Total implementation costs are expected to be £(250) million with the remainder being incurred in the period to the end of 2014.

·; finance transformation costs of £(48) million largely relating to Solvency II;

·; capital optimisation project costs of £(13) million and other non-recurring costs of £(1) million; and

·; other non-recurring income of £10 million relating to a curtailment gain on the Friends Life pensions scheme.

Interest payable on the FLG STICS of £(16) million is included as a £(11) million deduction to corporate long-term investment return in the operating profit analysis, and a £(5) million adverse investment fluctuation. As the STICS are accounted for as equity in IFRS (with interest being recorded as a reserve movement), £16 million is added back to the non-operating result to reflect the requirements of IFRS.

Acquisition accounting adjustments, totalling £(246) million, represent the amortisation of the intangible assets recognised on the acquisitions. These charges comprise £(204) million of amortisation of acquired in-force business, and £(42) million of amortisation of other intangible assets. 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 business's acquired in-force book.

A shareholder tax credit of £109 million has been recognised in the period and is higher than the loss before tax of £(167) million would imply. The principal differences between the implied and actual shareholder tax credit relate to:

·; £47 million shareholder tax credit for tax reliefs, expenses and exemptions predominantly in relation to the life insurance companies in the Group which are taxed on the 'I minus E' basis;

·; £30 million shareholder tax credit relating to the reduction in the UK corporation tax rate; offset by

·; £(9) million shareholder tax charge in respect of provisions and the non-taxable result of the Resolution holding companies.

The tax credit includes £87 million credit in respect of the amortisation and impairment of AVIF and other acquired intangibles in the period.

Summary IFRS balance sheet

(i) Shares in issue at 31 December 2011 have been adjusted to exclude Resolution Limited shares held by subsidiaries of 2,661,384 (30 June 2012: nil).

At 30 June 2012, IFRS total equity was £5,783 million (31 December 2011: £5,995 million), with equity attributable to equity holders of the parent of £5,453 million (31 December 2011: £5,672 million). IFRS net assets per share attributable to shareholders were £3.92 (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 2012 reflects the scrip dividend 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 debts.

At 30 June 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 deferred consideration notes ("DCNs") in the period offsetting the reduction in equity.

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.

Group MCEV profit

(i) Half year 2011 results comprise six month results for Friends Provident and the AXA UK Life Business, five months for BHA, six months for GOF and TIP. The GOF and TIP businesses were sold on 1 November 2011.

(ii) 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 WLUK.

Operating result

The Group MCEV operating profit in the period to 30 June 2012 was £235 million, up from the £180 million reported in the first half of 2011. The results reflect a good operating performance highlighting the successful focus on profitable growth, synergy delivery and platform migration across the UK business. The value of new business ("VNB") has grown significantly from £66 million to £97 million period on period, whilst the impact of lower expected returns resulting from economic movements in 2011 has partially offset this benefit. Expected rates of return applied to equities and properties have both fallen compared to 2011, although this is partially offset by an increase in expected returns on corporate bonds.

Further details on the operating performance of the Group are included in the relevant business unit operating sections.

Non-operating items

Economic variances combine the impact of changes to economic assumptions with the investment return variances over the period. Economic variances in the first half of 2012 had a £242 million favourable impact on results (30 June 2011: £(48) million adverse) reflecting the continued volatility in investment markets. The widening in corporate bond spreads in the second half of 2011, driven by volatile economic conditions, has reversed to a degree over the first half of 2012 benefiting the result by £145 million. In addition, lower future inflation assumptions have benefited the MCEV by £40 million and lower interest rates have improved MCEV by £48 million. Equity markets have broadly matched expectations, and generated only a small surplus on unit-linked business.

Non-recurring costs in the first half of 2012 total £(115) million (30 June 2011: £(79) million) and include costs of £(91) million, consistent with those included in IFRS after excluding Diligenta costs. A further £(24) million, net of reserve releases, relate to the implementation of the outsourcing agreement with Diligenta. The charge incurred on the outsourcing implementation differs between IFRS and MCEV as it reflects the differing reserving approaches taken on these bases. The total implementation costs for the outsourcing will be the same across both bases over the period in which they are incurred.

Other non-recurring items and non-operating variances of £24 million relate to tax items including the 1% reduction in the corporation tax rate announced in the 2012 budget.

MCEV balance sheet

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

(ii) Shares in issue at 31 December 2011 have been adjusted to exclude Resolution Limited shares held by subsidiaries of 2,661,384 (30 June 2012: nil).

At 30 June 2012, net Group MCEV was £5,939 million (31 December 2011: £5,796 million) giving MCEV per share of £4.27 based on shares in issue at the balance sheet date (31 December 2011: £4.22).

At the end of the period the ratio of debt to gross Group MCEV (excluding internal debt) was 17.7% (31 December 2011: 19.3%), with the change primarily reflecting the increase in Group MCEV combined with the part repayment of the deferred consideration notes. The ratio of debt to gross FLG MCEV was 15.7% (31 December 2011: 16.3%).

The Resolution holding companies' net worth, including internal and external debt, increased by £92 million reflecting the payment of cash dividends of £150 million and corporate costs, offset by the receipt of a £250 million dividend 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 annualised FLG operating ROEV, after tax, for the period to 30 June 2012 was 6.4% and compares to the full year 2011 ROEV of 6.5%, which included the benefit of year end assumption changes including the impact of the Diligenta outsourcing arrangement. Compared to the 2010 baseline of 5.5% the half year result represents steady progress, and a significantly better performance than the previous half year annualised return of 4.5%. The improvement in operating ROEV principally reflects the period on period improvements made to the contribution of new business although the low expected returns, particularly on shareholder assets, continue to provide a challenging environment in which to deliver increased returns.

UK operating review

The UK business has evolved rapidly since 2009, making good progress separating and integrating the acquired businesses and subsequently reorganising the business units into the Heritage and Go to Market units. The Heritage business unit forms the bulk of the UK business by assets and in-force value, as illustrated below, while the Go to Market 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.

Key financial metrics for the UK business are shown below with further details included in the financial result section.

Profitability of new business

The profitability of new business delivered in the first half of 2012 reflects the significant progress made in delivering operating cost synergies, continued migration of new business to target platforms and the outsourcing arrangement with Diligenta.

The value of UK new business, totalling £67 million in the period to 30 June 2012, already exceeds that generated in the whole of 2011 (31 December 2011: £59 million) and continues to progress towards the target levels. Similarly new business cash strain has also decreased period on period with a 39% improvement compared to the first half of 2011. These improvements combined are a reflection of the material progress made by each of the business units as they drive forward their respective strategies.

The profitability of UK new business with an IRR of 9.4% similarly reflects the good underlying business unit performance with the improvement in Protection and Retirement Income feeding into the overall result. Corporate Benefits profitability also reflects an upward trend on the first half 2011 although the improvement has been partly offset by the lower IRR on the current not-yet-scale new corporate platform and the acquired WLUK business which has not yet transferred to the target platform.

Financial performance

UK IFRS based operating profit

(i) Half year 2011 results comprise six month results for Friends Provident and the AXA UK Life Business, five months for BHA, six months for GOF and TIP. The GOF and TIP businesses were sold on 1 November 2011.

(ii) 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 WLUK.

The interim 2012 UK operating profit of £137 million is £227 million lower than the same period in 2011 (30 June 2011: £364 million) mainly reflecting the significant one-off benefits reported in the comparative period. After the removal of principal reserving changes and one-off items (30 June 2012: £27 million, 30 June 2011: £222 million) the UK result is £32 million lower than 2011. This underlying result reflects a number of factors with strong progress made in reducing the costs of writing new business offset by the impacts of a low return environment, increased intragroup interest costs and one-off costs. One-off costs of £(3) million have been incurred in respect of the establishment of Friends Life Investments ("FLI"), with £3 million benefits being recognised through reduced levels of reserves for future investment management fees. The increase in development costs incurred in the period includes an increase in spend as the business invests in the retirement income strategy as well as operational capabilities in the lead up to Retail Distribution Review and auto-enrolment implementation.

UK 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 period, IFRS new business strain has been reduced by 38% to £(41) million (30 June 2011: £(66) million) reflecting the Group's actions to reduce acquisition expense levels. The reduction in IFRS new business strain is principally driven by the underlying new business cash strain which is detailed in the Go to Market and Heritage operating sections that follow.

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

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

In-force surplus of £196 million reduced from £214 million in the first half of 2011 principally reflecting the impact of the challenging economic environment. The reduced level of funds under management, driven by both low period on period market levels and net outflows from the Heritage business, reduced the amount of fees generated in the first half of 2012. In addition, the effect of year end basis changes made at 31 December 2011 has resulted in the non-recurrence of the benefit of favourable experience variances included in the first half of 2011.

The overall contribution to in-force surplus of the acquired WLUK business is £12 million in the first six months of 2012 following the business's acquisition in November 2011. Maintenance expenses incurred by WLUK were £11 million, excluding these maintenance expenses are flat period on period.

The £(1) million net amortisation of DAC and deferred front end fees ("DFF") reflects the relatively small value of these costs that have been capitalised in the post-acquisition period.

The other IFRS adjustments mainly relate to the reversal of investment contract reserve movements which are not allowable under IFRS.

Longer-term investment return

The decrease in longer-term investment return in the UK business is a reflection of the reduced expected rates of return combined with the increased cost of debt compared to the same period in 2011. In the first half of 2012 rates of expected return for gilts, corporate bonds and cash have reduced significantly resulting in a £8 million reduction in investment return.

The increased debt costs in the first half of 2012 reflect a full six month'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 business unit's operating result.

Principal reserving changes and one-off items

Principal reserving changes and one-off items include a benefit of £17 million relating to revised transfers on guaranteed annuity options triggered by the vesting of pensions business within the with-profit funds. Other one-off items of £10 million mainly reflect the favourable impact of a refinement of the reserving for attributable expenses as well as the recognition of benefits to be achieved following the set up of FLI.

UK operating expenses

(i) 2011 half year operating expenses do not include the acquired WLUK business as this was acquired on 7 November 2011, but include BHA from the date of acquisition.

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

UK operating expenses, which exclude commission payments and non-recurring costs, totalled £236 million in the period, up £7 million on the same period in 2011. The increase in development spend, up £8 million in the period, is the principal driver of this period on period increase and reflects preparations by the UK business for the forthcoming regulatory changes such as the Retail Distribution Review and auto-enrolment. Development costs also include expenditure associated with the recently launched corporate platform 'My Money' as well as the Retirement Income strategy.

Acquisition and maintenance costs amounted to £218 million in the period, marginally lower than the same period in 2011. After adjusting for the inclusion of the acquired WLUK business (£15 million) and inflation (£7 million), costs in the period have been reduced by £23 million principally reflecting the in year delivery of £65 million run-rate savings.

Maintenance expenses have increased in the period by £11 million, largely reflecting the inclusion of the acquired WLUK business in the 2012 results. In addition, costs of £3 million have been incurred in relation to the set up of FLI although these costs have been offset by a benefit in principal reserving changes and one-off items. Excluding these impacts, maintenance expenses are lower than the comparative 2011 period with further reductions expected as the business completes the integration process and delivery of the target £143 million synergies by 2015.

UK other income and charges

Other income and charges of £(1) million include the trading profit of £1 million in Sesame Bankhall Group ("SBG"). SBG is a broad-based financial services group and the UK's largest distributor of retail financial advice, operating three market leading brands. Sesame is the leading appointed representative network, Bankhall is the largest support service provider for directly regulated IFAs and PMS is the biggest mortgage club for intermediaries. SBG's result is in line with expectations in the first six months as the business continues to make significant investments in its technology infrastructure and in a range of new services for its customers to strengthen its market-leading position in advance of the RDR implementation.

UK MCEV operating profit

(i) Half year 2011 results comprise six month results for Friends Provident and the AXA UK Life Business, five months for BHA, six months for GOF and TIP. The GOF and TIP businesses were sold on 1 November 2011.

(ii) 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 WLUK.

The increase in the UK MCEV operating profit to £249 million (30 June 2011: £184 million) results from the Group's focus on profitable growth, synergy delivery and platform migration driving improved levels of new business profitability.

Value of new business

The contribution from new business has improved significantly over recent periods with the £67 million reported in the first half of 2012 representing a 139% increase on the same period in 2011. The improvement in new business profitability has been driven by the ongoing delivery of cost synergies, including the outsourcing transaction, 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 UK 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.

The expected return on the value of in-force has remained broadly stable compared to the same period in 2011. The adverse economic environment continues to adversely impact expected rates of return with the rates applied to equities and properties falling since 2011. This reflects a fall in the reference rate for such assets where the ten year risk free swap rate is 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 for one year cash and gilts swaps and illiquidity premium, and the expected returns applied to corporate bonds are also higher reflecting the higher yields in the current market. As detailed in the 2011 full year results, the illiquidity premium was increased from 75bps to 90bps reflecting the widening of corporate bond spreads observed.

The WLUK business, acquired in November 2011 and therefore not a component of the first half result in 2011, contributed £6 million to the expected existing business contribution in 2012.

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.

Operating experience variances

The positive operating experience variance of £3 million consists of positive mortality and morbidity experience offset by small negative variances relating to operating exceptional expenses, such as the set up of FLI, and taxation.

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. In the first half of 2012 experience has been inside expectations with £16 million of the provision utilised in the period leaving £72 million in place as at 30 June 2012.

Operating assumption changes

A favourable operating assumption change of £9 million has been included resulting from the capitalisation of VAT savings following the repatriation of £6 billion of assets from external fund managers to the newly formed in-house investment company, FLI.

Other operating variances

Favourable other operating variances of £19 million include a £17 million benefit following revised transfers related to guaranteed annuity options on the vesting of pensions business from within the with-profit funds as well as £2 million of other small operating variances.

UK Heritage

Market environment

The Heritage business is making good progress in preparing for the significant number of changes facing the UK life and pensions market.

The Heritage business has a broad range of products that will be impacted by the Retail Distribution Review, gender neutral pricing and auto-enrolment of pensions. Consequently the Heritage business is undertaking the product and systems enhancements necessary to fulfil the Group's regulatory obligations in particular Treating Customers Fairly. In doing so, the business is applying commercial judgement to the need for investment, taking account of the scale of products and planned longer term outsourced platform developments.

Strategy implementation

The UK Heritage business unit 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 the UK Go to Market businesses. Good progress continues in embedding a dedicated management team focused on the Heritage business, consistent with the aim to be the UK's leading legacy business manager with the knowledge and expertise to maximise the value created from these books.

The value drivers for the Heritage business are:

·; management of an efficient cost base in line with business scale;

·; minimisation of capital required for the business; and

·; retention of in-force business.

The Heritage business has previously identified six 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 is operating as expected. 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 and smooth transition of work to Diligenta with effect from 1 March 2012, implementation of the deal has continued to progress well. The customer services work of circa 400 full time employees ("FTE") transitioned seamlessly from WIPRO (an existing outsource provider) to TCS (Indian parent company of Diligenta) in May, again on schedule and with no disruption to service. The IT application and support work of circa 200 FTE also transferred to TCS in May without disruption.

Building an in-house asset manager

Building in-house asset management capability supports the aim of running a lean cost base with the expectation that assets can be managed more efficiently in the longer term. FLI successfully launched on 2 July 2012 with £6 billion of fixed interest assets under management. This successful development of in-house capability demonstrates the opportunity to deliver more value from the existing book through optimised investment strategies at lower cost. The VAT savings from reduced fees payable to third party asset managers have benefited MCEV operating profit by £9 million, offset by setup costs of £3 million referred to above.

FLI is set to continue growing and aims to recapture a further £3-£5 billion of assets over the remainder of 2012. The current phase of development is focused on the recapture of the core non-linked and shareholder assets of the Group. Subsequent phases are expected to focus on fixed income assets currently managed in the Group's with-profits and unit-linked funds.

To achieve maximum business efficiency, FLI's middle and back office support functions are outsourced. This also provides the benefits of future scalability and flexibility while achieving certainty on costs.

Capital optimisation programme and with-profits fund management

The current capital optimisation programme ("COP") to simplify the legal structure of the business and remove capital inefficiencies continues to progress well. Friends Life has five UK life companies within the Group and the ultimate result of the programme will be to reduce these in order that they are broadly aligned to the Heritage business and Go to Market business lines. The most significant steps of this project are expected to be completed by the end of 2012. The Group is confident that the costs to be incurred to deliver this restructure will be exceeded by benefits.

The programme to develop and implement a uniform capital management framework for the six with-profits funds within the Heritage business is currently underway. This programme is closely linked to the COP, as a number of with-profits funds are included in the planned COP transfers of business.

Financial performance

Value of in-force business

The UK Heritage business represents a significant proportion of the Group's in-force value. 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.

·; with-profits: typically the value of the shareholders' 10% share of the cost of bonus on 90/10 with-profits business and the value of charges less expenses on other with-profits business. Relative to other products lines, these policies require significant regulatory capital on both bases.

UK Heritage unit-linked funds under management

The challenging economy over the first half of 2012 has not had a significant negative impact on the Heritage results. The operating performance to date during 2012 indicates the lapse experience of the book is performing in line with the business's assumptions including the provision set aside for increased scheme re-broking activity prior to RDR becoming effective on 1 January 2013.

The business has seen net outflows of both unit-linked pensions and investment business. Unit-linked investment business, primarily single premium bonds, reflects the positive action taken in 2011 to close Investment Bond products and the maturity of this book. Whilst net outflows are significant, the Heritage business expects to be able to manage these books of business within the current assumptions.

New business

The Heritage business specifically focuses on those products no longer actively marketed. It does not actively drive new business, but the book delivers a significant level of ongoing incremental business written across all product types.

New business strain is £(20) million compared to £(30) million in the first half of 2011 reflecting the closure of bond products to new business in the second half of 2011.

The contribution from UK Heritage new business in the first half of 2012 was a profit of £4 million representing a fall of £4 million from the first half of 2011. This change reflects:

·; a marginal increase in Department of Work and Pensions ("DWP") rebate business which contributed £8 million to Heritage pensions VNB in the first half of 2012 (30 June 2011: £7 million). Further rebates have been received in July but thereafter are expected to be minimal. The UK Government has determined that 2012 is the final year in which DWP rebates will be provided.

·; the closure of bond products referred to above, leading to a reduction in sales and value generated. In the first half of 2011 the bonds contributed £4 million VNB to the UK result with a marginal contribution in 2012.

IRR of 4.2% reflects the same drivers as VNB.

Key priorities

The key priorities for the Heritage business for the remainder of 2012 are the successful delivery of the Capital Optimisation Programme and continued expansion of Friends Life Investments whilst continuing to deliver value from the in-force portfolio.

Go to Market: Corporate Benefits

Market environment

Corporate Benefits operates in a large, fast-growing but relatively low-margin market with intense price competition and, currently, commission bias.

Friends Life believes opportunities exist as a result of the ongoing shift from defined benefit to defined contribution schemes, auto-enrolment, demographic changes and the advent of the RDR.

Strategy implementation

Friends Life will continue to improve profitability through four key levers:

·; retaining and developing the existing portfolio of schemes through dedicated Client Relationship Managers and workplace marketing operation focusing on key clients and distributors;

·; cost reduction 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;

·; positioning the business optimally for the forthcoming auto-enrolment and RDR market changes: the development 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. The timing of this business depends upon scheme size and Friends Life, with a balanced portfolio of mid to large schemes, expects the flow of auto-enrolment for its schemes to commence in January 2013, slightly after the very earliest staging schemes in the last quarter of 2012; and

·; selectively writing profitable new business within the Friends Life target range of mid to large schemes; these will be primarily through a small number of key distribution relationships. Friends Life have observed increased pressure on pricing, reflecting the competition for commission-paying business before RDR closes this opportunity, but expects a normal environment from 2013. 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 and not just non commission-paying business.

Financial performance

Corporate Benefits again delivered improved new business results with value of new business of £10 million, 100% up on the first half of 2011. This result reflects the increased level of business written (up 33% on the first half of 2011, including 15% from the transfer of WLUK business), the more commercial pricing approach and the benefits of cost reduction. Expectations are that the market commitment of £25 million VNB will be achieved in 2013. New sales include £19 million APE on "My Money", the new corporate platform launched on 31 January. In this period, 79% of new business was written on the target platforms, NGP and My Money.

New business cash strain of £32 million is at a higher run rate than the £26 million implied from the full year 2011 results (noting the step-down between first and second half of the 2011 numbers being due to modelling improvements which were introduced in December). This reflects the higher sales volumes in 2012 including the introduction of the WLUK business but offset by cost reductions. Sales volumes of £291 million in the first half of 2012 in turn reflect the healthy pipeline of business built up following the successful merger of the Friends Provident and AXA UK Life Business and the recognition, including by NMG and Greenwich Associates, of the quality of the Friends Life proposition. In addition, the workplace marketing operation has had a successful first half through the attention given to key relationships by the Client Relationship Management team and buoyed by the seasonal peak of employer-driven salary reviews in January and April. The results also include £2 million VNB in respect of DWP receipts which are significantly weighted towards the first half of the year.

Cost savings and increased volumes continue to drive the IRR on Corporate Benefits business with an IRR of 6.8% in the first half of 2012 up from 6.6% in the first half of 2011. The steady upward trajectory through the second half of 2011 has however been offset by the lower IRR on the transferred-in WLUK business (which is not yet on target platform) and the lower initial IRR on the not-yet-scale My Money platform. FLG expects the favourable IRR trajectory to continue and for 2013 market commitments to be achieved through continued cost savings and pricing discipline and the benefits of the volumes of auto-enrolment business. 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.

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 the first half of 2012 is in line with expectations.

Corporate Benefits funds under management

Net fund inflows of £0.4 billion have been generated in the first half of 2012 whilst investment markets have been flat over that period.

Key priorities

Friends Life will continue the development and promotion of My Money (already rated best corporate platform in a platform survey of 70 advice firms) to achieve scale on this platform. The business will continue to champion the NGP platform to deliver growth through the workplace marketing operation and write profitable new business governed by robust pricing discipline.

The Corporate Benefits business is on track to complete and prove the auto-enrolment hub as well as the supporting business processes in time for the arrival of the first tranches of this business. Similarly, preparation continues to ensure that systems and processes are updated to be ready for the regulations and opportunities arising from RDR.

The business continues to focus on moving existing business onto the target platforms but following the clear message from clients that they do not want to manage a migration at the same time as the legislative requirements of auto-enrolment, together with the opportunity to extend the Embassy platform servicing arrangement with AXA, the business has decided not to migrate the book of business from this platform in the short term and is concentrating on ensuring the auto-enrolment solution will also support these clients. This is not expected to have a material effect on the business or delivery of financial targets.

Go to Market: Protection

Market environment

The UK protection market is mature and has remained relatively stable over the past few years despite the turbulent macroeconomic climate. In 2011 the market size was circa £1 billion APE, of which three-quarters consisted of individual protection and one-quarter group protection. The protection market is forecast to have modest growth over the next few years with a number of key factors driving increases for example the RDR, recovery in the mortgage market, and growth in the Whole of Life market.

Protection products are not directly impacted by RDR, nevertheless there is expected to be a positive impact on Protection sales. The industry consensus view is that there is likely to be a short term growth in sales of advised protection products as distributors transition their business model to the post-RDR landscape. The business expects other growth, in the medium term, to come from non-advised sales and this trend is starting to be evidenced. Changes regarding gender neutral pricing (effective from 21 December 2012) and life tax reforms (implemented on 1 January 2013) will almost certainly have an effect on the price of Individual Life Protection; as a result the business expects to see increased market pricing volatility in the early part of 2013.

Over the next year the group protection proposition will be affected by a number of significant regulatory changes in addition to the RDR. These include the welfare reforms and pension auto-enrolment with the business continuing to monitor and develop towards the implementation of these.

Strategy implementation

Friends Life's overall approach is to deliver the strategic change agenda to fulfil the 2013 market commitments, whilst maintaining proposition quality and innovation. Delivery in 2012 to date includes the successful implementation of the partnership with Connells, which both increases the proposition's distribution footprint and provides capability on the Protect+ platform for migration of other strategic partners later in the year. The Protection business continues to deliver capability and proposition enhancements, including piloting an improved rehabilitation claims service within Group Protection and recent critical illness product enhancements within Individual Protection.

The business has also made progress in developing selective strategic distribution partnerships within both businesses, such as Intrinsic for Individual Protection and Mercer for Group Protection.

Friends Life Individual Protection has prepared for the expected outcome of the RDR, developing a selective range of distribution relationships as well as innovative propositions such as the new Simple range of products, which extend FLG's distribution capabilities with products that are suitable for non-advised sales through a variety of channels and partnerships. The Group Protection proposition is continuing its selective approach to the channels and products which offer acceptable levels of return, whilst continuing to innovate with proposition enhancements such as on-line scheme servicing and growing employee benefits consultant ("EBC") relationship strength.

As referred to above, the implementation of gender neutral pricing and life tax reforms is expected to result in some pricing volatility. The business's focus on a value-based high quality proposition in this market is expected to reduce its exposure to price volatility, compared to some other UK providers, when these changes are implemented.

Financial performance

The progress in financial performance achieved in the second half of 2011 has continued into 2012 with a new business contribution of £28 million (£(2) million in the first half of 2011), at an increased IRR of 9.8% and with new business strain reducing by almost half.

All intermediary partner individual protection new business has now migrated to the Protect+ proposition, continuing the business's strategy of focusing on value over volume and migrating new business capability to the target platforms to achieve productivity benefits. 81% of new business is now written on the three target platforms (Individual Protect+, Individual Simple and Group). Although new business APE is lower than the equivalent period for 2011, profitability is significantly improved. The focus remains on achieving value through product mix and managing profitability during continued subdued economic conditions.

Group protection has benefited both from increased volumes during the (traditionally strong) first half of the year, following early integration of the business, and also from an increased proportion of higher value group income protection business where Friends Life has strong claims management capability.

Key priorities

New business profitability and IRR in the first half of 2012 continues to progress towards the 2013 market commitments. Further improvements will be driven by a clear focus on key priorities, including the migration of strategic partners, such as Countrywide, to the target Friends Life platforms by the end of 2012. The Protection business continues to target improvements in existing relationships and selected new partnership opportunities, and to maintain the overall quality of the Group and Individual propositions. During the second half of 2012 the Group will also seek to manage and benefit from the high volume of impending regulatory and tax changes in both the Individual and Group Protection businesses.

Go to Market: Retirement Income

Market environment

The annuity market continues to show underlying growth with the first quarter of 2012 up 16% on the same period in 2011. The market is proving to be resilient in the face of the volatile economic environment and the associated fall in annuity rates driven by falling UK gilt yields. Growth in baby boomer retirements is expected to contribute to additional annuity sales in 2012 and over the coming years.

Sales in the open market continue to show the trend towards enhanced annuities which now account for half of total open market sales. The strong growth in enhanced annuities over recent years supports the Retirement Income strategy to broaden the product proposition to take account of lifestyle and medical factors in pricing.

The regulatory environment continues to evolve with the ABI Code of Conduct due to come into force in March 2013. This will require all providers to prominently highlight enhanced annuities and the higher income they can potentially offer. The Code will ensure that providers continue to explain the benefits of advice and support, including the benefits of shopping around. The Code also seeks to increase transparency in the annuity market so that customers have a clear picture of how individual providers' product offerings fit in with the wider market.

Solvency II requirements and timing remain uncertain although the industry focus on efficient use of capital is expected to ensure a rational commercial response to the final rules.

Strategy implementation

Progress on each of the five key strategic initiatives has been in line with the strategic plan over the first half of 2012 providing confidence over delivery of the 2013 financial commitments for Retirement Income. A series of further improvements to the proposition are set to be delivered over the next few quarters that will progressively improve the business's ability to retain retiring customers.

Provision of broader product proposition

At the beginning of June 2012 Retirement Income launched an annuity product incorporating lifestyle and medical underwriting. This is expected to be rolled out to maturing pension policyholders over the second half of 2012 leading to an expected increase in retention rates towards target over the course of 2013. The development of the enhanced annuity product ensures that maturing pension policyholders can take advantage of this option when appropriate. The growth in the enhanced annuity market over recent years and the promotion of this option within the ABI Code of Conduct illustrate the importance of this component of the Retirement Income strategy.

Development of sophisticated pricing and underwriting

The longevity team was strengthened further in the first half of 2012 and has now developed the lifestyle underwriting capability required to support the enhanced annuity proposition. In addition, the business is partnering with Swiss Re on the medical proposition thereby benefiting from their underwriting expertise and tools in this field.

Improving customer engagement

The launch of an enhanced annuity follows a number of successful pilot initiatives during the first half of 2012. The pilots have helped to inform product development and the approach to customer engagement in the run up to retirement. With this proposition becoming established, the business will increasingly focus on enhancing operational capability to raise customer awareness and encourage customer engagement in this important option that can enhance their income for life.

Optimising and developing the investment strategy

The launch of FLI will enable the business to leverage its investment and asset liability management capability to support the growth of core product areas such as annuities. The Retirement Income business will benefit from the fixed income investment expertise within the FLI team to ensure that the asset strategy supports competitive rates for customers whilst managing investment risk within appetite.

Development of capabilities to support an open market offering

The next phase of the strategic plan involves developing the operational and technological capacity to support additional business derived from the enhanced annuity products. These developments create the capability for a potential future entry into the open market. Competition in the open market remains concentrated among a small number of established and specialist players. The opportunity to enter into the open market remains additive to the Retirement Income 2013 full year targets. The timing of any launch has not been decided and will take account of impending regulatory changes, including the RDR and gender neutral pricing.

Financial performance

Annuity new business contributed £25 million of VNB in the first half compared to £17 million in the same period of 2011 and a full year 2011 contribution of £32 million. Uncertainty in fixed income markets throughout the first half of 2012 led to cautious pricing levels that resulted in strong new business margins over the period. However, whilst the business remains cautious, margins are expected to reduce to more normal levels over the second half of 2012.

Sales volumes of £19 million in the period reflect stable retention rates and the acquisition of the WLUK business in November 2011.

New business cash strain has also benefited from the cautious pricing levels and strong volumes in the first half of 2012 resulting in a cash release of £15 million compared to a full year contribution of £13 million in 2011.

Key priorities

The Retirement Income business has a number of key priorities which will lead the business towards the 2013 financial targets. These include the promotion of the new enhanced annuity propositions to a significant proportion of Friends Life customers as they prepare for retirement. This is expected to benefit the level of internal vestings although retention rates are not expected to start increasing materially until 2013 due to the lead time and the gradual nature of the roll out.

In order to support the additional business derived from the enhanced annuity products, operational and technological capacity will be developed. These developments will also underpin the development of an option for the business to enter the open market in the future.

International operating review

The International segment comprises:

·; Friends Provident International Limited ("FPIL"), an Isle of Man based company manufacturing unit-linked savings and single premium bond products with a focus on affluent expatriates via hubs in Hong Kong, Singapore, Dubai, as well as serving UK customers with offshore products;

·; Overseas Life Assurance Business ("OLAB"), the overseas branch business of Friends Life Limited, benefiting from EU freedom of services rules which allow regulated EU insurers to trade anywhere within its borders;

·; Financial Partners Business AG ("fpb"), a German distributor of OLAB unit-linked pensions business;

·; 30% interests in both AmLife Insurance Berhad ("AmLife"), a Malaysian life insurance company, and AmFamily Takaful Berhad ("AmFamily"), a Malaysian family takaful business. Both businesses are majority owned by AmBank Berhad, a major Malaysian banking group.

IFRS based operating profit of £21 million in the first half of 2012 reflects a £20 million reduction from £41 million reported in the same period of 2011. This reduction largely reflects the impact of lower valuation interest rates which have increased new business reserving strain and increased the cost of guarantees on some German business. The 2011 full year result is a better comparator in assessing operating performance as these factors are also reflected in the 2011 full year result. In addition to these economically driven factors, the 2012 half year result also includes one-off costs for strategic reorganisation and implementation.

MCEV operating profit has increased from £15 million to £18 million reflecting efforts to improve new business value as a proportion of volume, whilst also reflecting the non-recurrence of adverse modelling changes reported in 2011. Expenses related to strategic reorganisation and implementation are also reflected in the 2012 result.

Operating free surplus generation has reduced due to higher financial reinsurance repayments in the half year from the 2011 scheme which supported the cash generation in that year. Financial reinsurance continues in 2012, however at a lower level. The cash flow profile of the business supports a continued positive cash trajectory by the end of 2012. This improved cash projection includes the impact of one-off costs of the strategic reorganisation implementation.

Profitability of new business

The new business result in the period to 30 June 2012 principally reflects the focus on profitability rather than sales volume. As a result International VNB has only reduced by 10% in the period compared to a 22% drop in sales APE. This has been achieved through increasing margins, through new product structures, and an increase in higher margin protection business.

Sales volumes are 22% lower than the equivalent period in 2011, driven mainly by a significant reduction in regular premium business. This has been due to maintenance of pricing discipline and increased controls around business acceptance. Single premium business is below last year in most regions due to reduced investor confidence, although the UK offshore business has performed above expectations. Protection business has had a particularly strong first half year as a result of IFAs moving away from savings to risk products.

New business cash strain is lower principally due to the reduced volumes, but has increased relative to premiums due to an increase in higher strain protection products and negative economic impacts.

The International IRR has reduced from 13.5% to 10.5% due to the adverse impact of lower new business volumes, increased expenses due to improved controls, as well as year end basis and modelling changes.

Future improvements are expected to be driven by the completion of the continued roll-out of the new higher margin product structures to all international regions and a review of the cost base as part of the strategic review described below.

Market environment

The business is facing challenging economic and market conditions in most of its key markets. The economic environment in Europe is continuing to prove challenging and is impacting sentiment in Asia affecting single premium sales in particular. Protection business has however had a particularly strong first half year with growth in most regions.

The largest market is the North Asia region. This is a relatively mature and competitive market. The region has strong medium term growth prospects, however in the short-term, due to the current economic environment and its impact on investment markets, there is a shift towards non-linked business and sales are likely to remain under competitive pressure.

The South East Asia region is managed through Singapore. Singapore continues to evolve as a wealth management hub and offers good growth potential. Singapore's economic and competitive backdrop appears to be more benign than North Asia but 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 immature local markets, however they have a large number of high net worth expatriates and continue to provide good growth prospects.

In Germany, the business participates in the unit-linked individual pensions market. The market environment is challenging in the short term, as low investment market confidence drives consumers towards the still dominant traditional with-profits business. Guaranteed rates of return on traditional products are expected to reduce due to the impact of the introduction of Solvency II. In the medium-term the unit-linked sector has good prospects through demand for private sector savings and investments and the move from state to private pension provision.

AmLife participates in the Malaysian market through both an agency and the bancassurance channel. This is a fast moving market which is currently closed to further entrants through the rationing of available licences. AmFamily was established in 2011 but is not expected to contribute materially to results in 2012.

Strategy implementation

The International business is currently in the process of a strategic review, the results of which will be announced before the end of 2012. The aim of the review is to enhance value by developing a sustainable portfolio of international businesses in regions with sound regulatory positions, focusing on the growth of profits and cash delivery. Reducing unit costs by implementing process improvements, increased outsourcing and a narrower geographical footprint will underpin the new strategy.

The business has continued to invest in building capability and four new executives and a new non-executive chairman have been appointed.

The roll-out of new higher margin product structure continues. The launch into Singapore in the second quarter of 2012 was successful and the Middle East and Hong Kong launches will be completed by the end of 2012.

Key priorities

Key priorities for the business include the completion of the roll out of the new higher margin product structures, completion of the strategic review to build a sustainable portfolio with sound regulatory positions, focused on growth in profits and cash delivery, and the reduction of unit costs.

Financial performance

International IFRS based operating profit

The 2012 half year IFRS based operating profit has reduced from £41 million to £21 million largely due to the impact of the low interest rate environment. The current low level of rates, similarly reflected in the 2011 full year profit, has resulted in an increase in new business reserving strain and an increase in the cost of return of premium guarantees on certain German policies. In addition IFRS profits are impacted in 2012 by one-off costs including costs for strategic reorganisation and implementation.

Notwithstanding the challenging economic conditions the International business has maintained funds under management levels at £6.2 billion with net inflows of £0.2 billion offset by market movements in the period.

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

New business cash strain has reduced by £4 million, as a result of lower new business volumes, offset by an increase in higher strain (but higher margin) protection products with increased reserving requirements due to the effect of lower valuation interest rates, as well as an increase in acquisition expenses, due to an increased focus on new business related risk and controls.

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

Other IFRS adjustments include the elimination of new financial reinsurance, the benefits of which are included in cash strain but are not recognised as profit under IFRS. The level of financial reinsurance in new business strain in the first half of 2012 is broadly consistent with the first half of 2011. This line also includes the elimination of positive actuarial funding and Sterling reserve impacts which have reduced because of the lower sales volumes.

The net increase in IFRS new business strain of £4 million mainly results from increased reserving due to the shift in mix to protection products, exacerbated by the impact of lower valuation interest rates and increased acquisition expenses.

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

In-force cash surplus has reduced by £24 million compared to the same period in 2011, mainly reflecting the higher levels of financial reinsurance funding repayments in addition to the impact of lower valuation interest rates increasing the costs of guarantees. In addition in-force surplus is reduced by one-off costs relating to the strategic reorganisation and review, as set out below.

Guarantees are related to Return of Premium guarantees on the German product set. Due to changes in valuation interest rates, guarantee provisions increased by £8 million in the half year.

The DAC/DFF adjustments have increased due to the increased size of the in-force book of business.

Other IFRS adjustments include the elimination from IFRS surplus of the financial reinsurance repayments and the elimination of movements on Sterling reserves on investment business. The change in the adjustment compared to last year primarily relates to higher financial reinsurance payments in 2012.

The net decrease in in-force surplus of £18 million primarily results from lower valuation interest rates reducing the return on existing business and increasing the cost of guarantees.

International funds under management

Funds under management as at 30 June 2012 remain at £6.2 billion. The business has generated positive net inflows of £0.2 billion but these have been offset by market falls of £0.2 billion.

Principal reserving changes and one-off items

There were no principal reserving changes and one-off items in the period. In 2011 half year principal reserving changes and one-off items were £(6) million adverse and related to a number of small adjustments principally relating to FPIL, arising from the Group's review and enhancement of the business's financial infrastructure.

Operating expenses

International operating expenses, which exclude commission payments and non-recurring costs, have increased to £38 million from £31 million. Both acquisition and maintenance costs have increased largely as a result of strengthening the controls and governance infrastructure to meet the risk appetite of the business. In addition, maintenance expenses include £2 million of one-off costs related to strategic reorganisation and review with these expected to lead to expense savings in the future.

International MCEV operating profit

MCEV operating profit has increased from £15 million to £18 million principally reflecting the increased focus on new business profitability and the non-recurrence of adverse modelling changes from previous periods. As referred to above, despite the 22% reduction in period on period sales volumes, the reduction in VNB compares favourably, highlighting the steps taken to increase the new business profitability. The economic conditions in the first half of 2012 remain challenging, with a reduced contribution from existing business reflecting the lower expected equity and property returns. In addition, the result reflects the one-off costs related to strategic reorganisation, although this is expected to lead to operating benefits as the strategy is implemented.

Expected existing business contribution

The expected existing business contribution has decreased from £14 million to £12 million. The effect of the larger in-force book has been offset by lower rates of expected return on equity and property assets. The value of the in-force book at 31 December 2011 was £502 million compared to £473 million at 31 December 2010.

Operating experience variances

Adverse operating experience variances of £8 million included £(4) million from the AmLife business, being a £(3) million increase in mis-selling provisions and £(1) million for negative persistency experience. Expense variances relating to one-off costs of strategy implementation amounted to £(2) million, as well as an additional small expense overrun in relation to OLAB business.

Operating assumption changes

There were no operating assumption changes in the current period. In the first half of 2011 there was an adverse operating assumption change of £2 million in respect of AmLife mortality and expenses basis review.

Other operating variances

There were no other operating variances in the current period. In the first half of 2011 there was a charge of £(13) million in respect of modelling improvements.

Lombard operating review

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.

Lombard has continued to deliver strong growth in FUM in the period with balances reaching €22 billion at 30 June 2012. Despite this growth, operating performance has been impacted by a number of factors including the significant macroeconomic turbulence. Uncertainties in the tax and legal framework of several countries where Lombard operates are affecting client confidence further and are making case closure more challenging.

IFRS based operating profit of £10 million is 52% below the first half of 2011. Notwithstanding higher levels of FUM and stable business as usual expenses, profitability has been affected by one-off costs described below.

MCEV operating profit of £25 million is 38% below 2011 levels (33% on a constant currency basis) as a result of both lower VNB and the impact of lower expected returns on existing business contribution.

Operating free surplus generation is lower than in 2011 principally due to one-off expenses and the decrease in expected return from existing life business as a result of economic conditions in the second half of 2011.

Results to date reflect Lombard's profit profile, which remains materially weighted towards the latter part of the year with a largely fixed cost base. As such, extrapolation of the current period's results is unlikely to be indicative of the full year's results.

New business profitability

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

The value of new business in the first half of 2012 is 33% below the same period in 2011 (25% below on a constant currency basis). Despite APE volumes being at a similar level to 2011, the IRR and contribution from new business has been affected by product mix.

From a broader distribution perspective, new business is being sourced to an increasing extent from private banks rather than IFAs. This has the potential to bring significantly wider market access and more stable flows of business but is likely to impact short-term margins while distribution channels mature. The proportion of new business originated from private banks in the first half of 2012 was 46% (35% in the first half of 2011).

Despite the difficult economic conditions, several markets have performed strongly with Southern Europe, UK and Belgium (private bank distribution network) generating volumes above 2011 business levels. APE is 2% down on the first half of 2011 (although 4% up on constant currency basis). Growth in these regions also highlights the strength of Lombard's geographic diversity.

APE performance by region is as follows:

 Market environment

The macroeconomic environment in Europe remains extremely fragile and has worsened recently, with the resurgence of Greek issues and wider Eurozone troubles. There are also wider signs of slowdown in most economies and this is resulting in ongoing high volatility and nervousness on the primary stock markets. Although Lombard sales are not directly sensitive to stock market performance, unsettled market conditions have a corresponding effect on client confidence.

In addition to macroeconomic instability, elections and tax reforms announced in a number of Lombard's core markets (e.g. Spain, Italy, Belgium, France) have added uncertainty. There is a lack of momentum in the market with clients and partners reluctant to take decisions. In particular, more sophisticated, entrepreneurial HNWIs prefer to wait until proposed tax changes are on the statute books before committing to new investments.

Against this challenging backdrop, and in the absence of strong external drivers to generate new business, Lombard sales volumes in the first half of the year were relatively strong and the latest statistics from the Luxembourg regulator show that Lombard's market share of Luxembourg business rose from 19% in 2011 to 24% in the first quarter of 2012.

The longer-term drivers of demand for compliant Privatbancassurance solutions remain compelling and it is anticipated that activity will improve over the second half of 2012 reflecting the natural shift in the focus of the sales force from developing leads to closing business. The second half of the year also traditionally benefits from the December fiscal year end applicable in most markets and it is anticipated that Lombard will attract a significant share of its target high and ultra-high net worth market segment in that period.

Strategy implementation

Lombard FUM have grown strongly with a compound annual growth rate greater than 20% over the last 10 years, reaching €22 billion at 30 June 2012. In order to strengthen its operations and client/ partner servicing, and to enhance competitiveness and underlying profitability, an in-depth review began in April 2012 to define Lombard's development and growth strategy with a view to significantly increasing sales and profitability over the next two to five years. This strategic review is being carried out alongside the wider Friends Life International Division review.

As a fundamental part of the company's transformation, Lombard has announced substantial investment in the business, in the form of strategic development plans. These will involve significant improvements in back-office efficiency and the introduction of system upgrades taking advantage of new technology. Ultimately, these modifications will lead to a reduction in staff numbers in some areas over 2012 and 2013. Total expenses in relation to the strategic development plans, incurred in the first half of the year, amount to £5 million.

It is envisaged that these initiatives will contribute to the delivery of future financial outcomes (strong growth in profitable new business and cash generation) with IRR above 20% by 2013 and £30 million dividend from 2014.

An update on Lombard's strategic plans will be given as part of the Friends Life International Division strategy update before the end of 2012.

Key priorities

Whilst no significant improvements in market conditions are anticipated in the short-term, Lombard will continue to pursue a number of key sales initiatives currently underway, including the development of new products for selected core markets and the conclusion of revised strategy plans with key distribution partners. These are expected to derive maximum benefit from the natural shift to case closure in the second half of the year and the traditional increase in business towards fiscal year end. Benefits to operating profit from implementation of the strategic development plans are also expected for later in 2012 with the bulk of financial improvements being delivered over the next three years. In parallel, Lombard will continue to investigate the potential for greater market penetration and market/segment diversity with a view to maximising medium and longer-term profitability.

Financial performance

Lombard IFRS based operating profit

Lombard generated operating profit before tax of £10 million in the first half of 2012, 52% down on the same period in 2011. The period on period decrease is principally due to £9 million of one-off expenses as described below. Excluding these one-off items, operating profit is comparatively stable.

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

New business cash strain is marginally higher than in 2011 despite sales volumes being at a similar level. This is the result of a reduced proportion of acquisition cost deferral on a regulatory basis but should not be extrapolated for the full year as with sales volumes expected to increase in the second part of the year, the proportion of deferred acquisition cost is also expected to increase.

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

In-force cash surplus is down on 2011, affected by one-off costs and adverse exchange rate movements. Excluding these items, in-force cash surplus is stable on 2011; the higher income derived from the growing in-force book and expenses kept flat being offset by accelerated amortisation of deferred acquisition costs resulting from lapses.

Lombard funds under management

Average FUM have continued to increase in the first half of 2012. Continued positive net fund inflows over the last two years have driven this growth with FUM growing from £17.4 billion (€20.9 billion) at the end of 2011 to £17.8 billion (€22.0 billion) at 30 June 2012.

Operating expenses

The operating expenses set out above exclude both commission payments and non-recurring costs.

Included in maintenance expenses are £6 million in relation to Lombard incentive costs of which £4 million are one-off. Costs related to the strategic development plans, amounting to £5 million, have also been included in maintenance expenses with these included within operating experience variances in the MCEV operating result.

Lombard has retained tight control of recurring expense levels which, despite an increase in average funds under management, have remained in line with 2011 levels.

Lombard MCEV operating profit

MCEV operating profit of £25 million is below 2011, mainly driven by the lower contribution from new business, a lower expected existing business contribution due to reduced rates of return and one-off expenses in relation to the incentive scheme. The results also reflect the early impacts of the strategic development plans including the costs incurred to date of £5 million recognised in operating variances and a capitalised benefit of £5 million recognised in operating assumption changes.

Expected existing business contribution

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

Operating experience variances

Adverse operating experience variances of £(10) million include a £(2) million persistency charge relating to surrenders and a negative expense variance as a result of the incentive charge referred to above together with one-off costs of the strategic development plans of £(5) million, partly compensated by positive mortality experience.

Operating assumption changes and other operating variances

As referred to above, the operating assumptions changes of £5 million represent expected benefits from the strategic development plans. Further benefits are anticipated to be recognised by the end of 2012 as additional savings are realised.

Corporate operating review

FLG corporate segment

The FLG corporate segment includes the corporate holding and principal service companies of the Friends Life group.

Financing and interest costs

FLG has a number of debt instruments and the operating costs of financing these for the period ended 30 June 2012 are presented below.

(i) Market value is based on listed ask price, at 30 June 2012, excluding accrued interest and before tax on market valuation

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

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

In so much as these debts have been raised to support the ongoing growth and development of the life operating businesses, the cash raised has been loaned to the UK operating segment. The external cost attributable to each segment is shown below.

FLG corporate IFRS based operating result

The corporate result is primarily driven by the expected return on the external debt held in the Friends Life group, offset by the investment return on internal debt and other shareholder assets.

Other corporate net income of £1 million includes a £4 million benefit relating to the FLG long-term incentive scheme ("LTIP"). The LTIP credit reflects the change in the expected cost of the scheme driven by lapsed awards and changes to valuation assumptions to reflect current market conditions. This benefit is offset by £3 million in corporate overhead costs, being holding company costs incurred in supporting non-covered business.

FLG corporate MCEV operating results

The corporate business unit consists of both non-covered and covered business. The non-covered element relates to the net assets of the FLG corporate holding and service companies whilst the covered element principally represents the net debt liabilities held at the Friends Life group level.

The Friends Life corporate segment includes the interest on the external STICS and external LT2 subordinated debt instruments at the reference rate and expected return over reference rate.

The expected existing business contribution on debt amounted to £35 million in the first half of 2012 (30 June 2011: £21 million), reflecting the higher external interest payable following the raising of £500 million external LT2 debt by FLG in April 2011. This increased cost is offset by reduced interest payable to RHG following the subsequent repayment of £500 million internal LT2 debt in 2011.

The £7 million of other net charges principally reflects the £9 million interest on the remaining £200 million internal LT2 debt issued to RHG. This is partially offset by the £1 million expected return on the pension asset and £1 million corporate net income (in line with the IFRS results).

Resolution corporate segment

The operating results of the Resolution holding companies are summarised in the table below. These are presented consistently in the IFRS financial statements and MCEV supplementary information.

FLG issued £700 million LT2 fixed rate unsecured loan notes to RHG in September 2010 to fund the acquisition of the AXA UK Life Business; £500 million was repaid in the first half of 2011. Interest received from FLG in the half year to 30 June 2012, representing 9% interest on the outstanding principal of £200 million, was £9 million.

Financing and interest costs of £13 million are analysed in the following section.

Other operating items mainly comprise fees payable to ROL of £9 million, directors fees and other corporate costs, net of external investment income, of £2 million.

Financing and interest costs

External financing within Resolution holding companies is summarised in the following table:

Deferred consideration notes of £500 million were issued in September 2010 in connection with the acquisition of the AXA UK Life Business. Repayments to date comprise scheduled repayments of £63 million in June 2011 and £60 million in May 2012 and an additional accelerated repayment of £14 million in August 2011, triggered by the incremental cash distributed to shareholders during the 2011 share buy-back programme.

The acquisition finance facility was a term loan facility agreement also issued in September 2010 to fund part of the consideration payable for the acquisition of the AXA UK Life Business; this loan was repaid in April 2011.

Cash and capital

Introduction

The Group remains committed to the optimisation of capital within the business and the return of excess capital to shareholders. 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 30 June 2012 remains robust with available shareholder cash ("ASC") of £619 million and an estimated FLG IGCA surplus(i) of £1.9 billion resulting in a coverage ratio, excluding WPICC, of 204%. At the end of 2011, the Group was on the cusp of economic capital (based on UK life companies' Pillar 2 requirements) being the biting constraint. Significant progress has been made in the first half of the year to improve the economic capital position, resulting in an estimated surplus(i) at the FLG level of £3.0 billion corresponding to a coverage ratio of 174% at 30 June 2012.

Capital management policies and monitoring buffers

Principles

The Group has established capital management policies ("CMPs"), which 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

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 with-profits insurance capital component ("WPICC")(ii) and FPIL; and

·; 125% of economic capital(iii) requirements, including any Individual Capital Guidance ("ICG") and specifically excluding FPIL.

The CMPs of the other main life companies in the Group (including FPIL and Lombard) are aligned with that of FLL. The International and Lombard 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.

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 introduced an additional requirement in respect of debt servicing costs. This new 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 £110 million per annum) and any repayments of principal that fall due on FLG debt in the next year. A similar requirement has also been introduced at the FLL level and is discussed below.

(i) FLG IGCA and the economic capital position of FLG and its subsidiaries (including FLL on an economic capital basis, see (iii) below) at 30 June 2012 are estimated and unaudited.

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

(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 Individual Capital Guidance "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 as well as amounts for working capital in both the holding companies and the life companies.

An additional requirement has been implemented for FLL, similar to that introduced for the Group, to ensure that additional capital is held in FLL over and above the CMP in order to cover at least one year of the FLL debt servicing costs (currently £107 million per annum). Immediately following the payment of any dividend by FLL, this amount must be held in cash or cash equivalents in its shareholder fund. This requirement provides additional protection to the FLL CMP for the potential impact of debt costs.

In light of this requirement and reflecting the Group's perception of the hardening of the overall regulatory approach, the Group has allocated resources from within working capital as specific monitoring buffers to enable all appropriate capital requirements to be met. Previously the Group assumed that the amounts carried as working capital (but not specifically allocated) were sufficient to avoid a breach of the CMPs. The monitoring buffers are as follows:

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

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

The monitoring buffers for FLL are designed to provide broadly similar levels of protection against the risk of breach of the CMP minimums plus debt servicing requirements. In addition to these monitoring buffers held within the life companies, £400 million of ASC is currently held as a prudence buffer in the Friends Life holding companies. This amount is sufficient to cover one year's external dividend costs, DCN debt repayments and interest and Resolution corporate costs. The requirement to hold cash at FLG level in respect of FLG debt costs is covered by the prudence buffer as the Group expects the internal loan arrangements between FLG and FLL to provide sufficient funding to meet FLG's debt servicing requirements.

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 £0.3 billion stronger than the equivalent IGCA surplus. This reflects actions taken in the first half of 2012 to improve the economic capital position of FLL (excluding FPIL), 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 derisking 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 the capital position of the Group. However, the current weak and uncertain economic environment, which the Group believes has worsened since December, remains a concern. The Group believes 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. For example, a 200 bps widening in corporate bond spreads would reduce FLG's IGCA surplus by £0.4 billion but would reduce the FLL economic capital surplus (excluding FPIL), above CMP, by approximately £1.0 billion as at 30 June 2012. The impact of the sensitivity assumes that one-third of the widening in spreads is in respect of defaults, with the remainder representing a movement in the illiquidity premium. This demonstrates the potential for the biting constraint on capital to change in stress scenarios and the fact that, despite significant progress in improving the Group's economic capital position, the uncertain economic environment continues to be a key factor in the Group's capital management activities and underpins the Group's decision to cancel the second £250 million return of capital to shareholders.

In addition to the economic environment, the decision not to return capital reflects the ongoing working capital assessment including the establishment of monitoring buffers designed to take account of requirements emerging from a perceived hardening of the regulatory environment and to facilitate compliance with the Group's CMPs. However, despite the continuing economic and regulatory uncertainty, in the light of the Group's robust capital position and current cash flow assessments, the Board has increased the interim dividend by 5%.

Looking forward, the Group believes there is heightened uncertainty around the future requirements of Solvency II both as regards its structure and timing of implementation. The implementation date for Solvency II has been delayed to 1 January 2014 and the Group expects that it will be delayed further. The capital requirements of the regime for UK life businesses have increased as the framework has developed and the outcome in some of the remaining areas of debate could materially impact the Group's future capital requirements. Hence prudence is required in assessing likely future capital requirements.

Cash and capital management framework

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 30 June 2012, reconcile to ASC.

(i) Incorporating requirement for FLG to hold one year's debt servicing costs in cash

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 £355 million, LT2 subordinated debt 2021 of £175 million and LT2 subordinated debt 2022 of £460 million (debt values include accrued interest and the tax impact of any market valuation). DCNs of £363 million issued by Resolution Limited to AXA UK as part of the acquisition of the AXA UK Life Business are offset against free surplus.

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

The closing free surplus balance of £824 million comprises £619 million of ASC and £568 million of amounts designated as working capital, offset by the DCNs liability of £363 million. 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 regulatory and other restrictions on the availability of cash resources. 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 represents cash available to cover Resolution's corporate costs, to service debt issued by Resolution 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, and accordingly the significant components and drivers of ASC for the first half of 2012 are detailed in the following sections.

a) Free surplus - £824 million

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) The expected return from in-force business is shown net of the expected return on FLG external LT2 subordinated debt. In order to provide greater clarity on the impact of debt on free surplus generation, the coupon on this debt of £35 million has been added back to underlying free surplus generation in the analysis above.

(ii) The 2011 other operating variances included a £161 million benefit arising from the implementation of certain elements of PS06/14.

Total free surplus of the Group amounts to £824 million at 30 June 2012, reduced from £929 million at the end of 2011. This movement reflects the free surplus generated in the period of £29 million offset by net capital and dividend flows of £(134) million, described below.

Operating free surplus generation

FLG operating free surplus generated in the period was £120 million (30 June 2011: £283 million). The reduction of £163 million compared to the prior year is principally the result of the implementation of certain aspects of PS06/14 in 2011, which accelerated the recognition of £161 million of free surplus in that year.

The key driver of the free surplus generation is the expected return from in-force business net of the investment in new business ("underlying free surplus generation"). This has contributed £191 million of free surplus generation in the period (30 June 2011: £169 million) reflecting the progress made in the UK business to reduce new business cash strain (discussed further below), partially offset by the reduced contribution from the in-force book as a result of lower expected rates of return in a challenging economic environment. The improved underlying free surplus result has been broadly offset by the net adverse impact of operating experience and other operating items which include a £(9) million free surplus impact of the increase in development costs, and £(9) million of one-off project costs, including set-up costs for FLI and costs of the International and Lombard strategic reviews.

Economic variances and non-operating items

In the period to 30 June 2012, economic variances and non-operating items reduced free surplus generation by £76 million, principally driven by non-recurring costs of £(103) million. The impact of economic variances on free surplus has been £6 million positive in the period, with other net positive non-operating items of £21 million principally reflecting the free surplus impact of management actions taken to reduce capital requirements in the life companies.

The positive MCEV non-operating result after tax of £124 million reflects the free surplus impacts described above, together with the positive economic variances on the VIF and required capital components as a result of narrowing corporate bond spreads in the period, marginally better than expected equity performance and lower inflation assumptions.

Net capital and dividend flows

The net capital and dividend outflows in the period to 30 June 2012 of £(134) million comprise £(150) million of external cash dividends, a £7 million inflow in respect of the reduction in the number of Company shares held by subsidiaries (where the disposal increases the equity of the Company) and £9 million net positive impact of other reserve movements, primarily actuarial gains on the Group pension scheme.

In-force business expected return and investment in new business

At product level, in-force surplus and new business drivers are monitored on a "cash strain" and "cash surplus" basis which excludes movements in required capital and is stated before tax and other adjustments. Tax and other items include the cumulative adjustments for tax and long-term investment return which use different assumptions across the MCEV, regulatory (or "cash") and IFRS bases. The reconciliation of MCEV free surplus to cash strain/surplus is set out below.

(i) Movement in required capital for in-force surplus is shown before the impact of the £35 million coupon on FLG external LT2 subordinated debt

The following table provides a segmental analysis of in-force surplus and new business strain on both the MCEV free surplus and cash bases.

The Group has set a target for the UK business to reduce cash strain, the measure used to manage individual products, by £200 million, by the end of 2013. This target is set against a full year baseline of £392 million, of which the UK accounted for £303 million. The UK new business cash strain of £60 million in the period represents an annualised reduction of £183 million compared to this baseline, equivalent to 92% of the £200 million target. The remaining gap in achieving this targeted reduction is expected to be achieved through the continued migration of new business to target platforms and synergy delivery as set out in the UK operating section. International and Lombard have not been set specific targets for reductions in new business strain, but are targeted to deliver annual dividends of £30 million by the end of 2014 for Lombard and £20 million by the end of 2013 for International.

Segmental analysis of sustainable free surplus generation

The Company has set a distributable cash target of £400 million per annum at Friends Life group 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 the payment of dividends from the life operating companies to the Friends Life holding companies.

As discussed above, the Group expects to reduce UK cash new business strain by £200 million by the end of 2013, and in addition to this, has targeted the delivery of £50 million of dividends from the overseas businesses by the end of 2014. The Group therefore expects that in the future, the £400 million DCT will be met predominantly from operational cash flows and related releases of required capital. However, under current economic conditions, it is expected to be particularly challenging for this target to be met from sustainable sources in the short term.

To demonstrate the progress in delivery of the DCT, the Group reports a "sustainable free surplus" measure so as to provide a baseline for measuring the growth of operational cash flows towards the Group's targets. As dividends from the life operating companies are normally only expected to be declared on an annual basis following the completion and approval of actuarial valuations, sustainable free surplus provides an indication of the Friends Life group DCT contribution by showing the movements in free surplus which would be expected to be available to fund future dividends. Sustainable free surplus reflects the FLG operating free surplus generation metric, adjusted so as to remove the impact of operating assumption changes and any other items considered to be one-off in nature.

A segmental analysis of sustainable free surplus generation for the period is provided below together with a reconciliation to FLG operating free surplus generation: