Interim Report - 20 of 28

The majority of the risk in our insurance business derives from manufacturing activities and can be categorised as insurance risk and financial risk. Insurance risk is the risk, other than financial risk, of loss transferred from the holder of the insurance contract to the issuer (HSBC). Financial risks include market risk, credit risk and liquidity risk.

There have been no material changes to our policies and practices for the management of risks arising in the insurance operations.

HSBC's bancassurance model

We operate an integrated bancassurance model which provides insurance products principally for customers with whom we have a banking relationship. Insurance products are sold through all global businesses, but predominantly by RBWM and CMB, through our branches and direct channels worldwide.

The insurance contracts we sell relate to the underlying needs of our banking customers, which we can identify from our point-of-sale contacts and customer knowledge. The majority of sales are of savings and investment products and term and credit life contracts. By focusing largely on personal and SME lines of business we are able to optimise volumes and diversify individual insurance risks.

Where we have operational scale and risk appetite, mostly in life insurance, these insurance products are manufactured by HSBC subsidiaries. Manufacturing insurance allows us to retain therisks and rewards associated with writing insurance contracts by keeping part of the underwriting profit, investment income and distribution commission within the Group.

Where we do not have the risk appetite or operational scale to be an effective insurance manufacturer, we engage with a handful of leading external insurance companies in order to provide insurance products to our customers through our banking network and direct channels. These arrangements are generally structured with our exclusive strategic partners and earn the Group a combination of commissions, fees and a share of profits.

We distribute insurance products in all of our geographical regions. We have core life insurance manufacturing entities, the majority of which are direct subsidiaries of legal banking entities, in seven countries (Argentina, Brazil, Mexico, France, the UK, Hong Kong and Singapore). There are also life insurance manufacturing subsidiaries in mainland China, Ireland (in run-off), Malaysia and Malta.

Risk management of insurance operations in the first half of 2014

The risk profile of our life insurance manufacturing businesses did not change materially during the first half of 2014 despite the increase in liabilities under insurance contracts to US$75bn (2013: US$74bn). This growth in liabilities largely resulted from new premiums received during 2014 and market value gains on underlying financial assets, partially offset by the transfer of some of these liabilities to 'Liabilities of disposal groups held for sale' during the period when HSBC entered into an agreement to sell its UK Pensions business.

Asset and liability matching

A principal tool used to manage exposures to both financial and insurance risk, in particular for life insurance contracts, is asset and liability matching. In many markets in which we operate it is neither possible nor appropriate to follow a perfect asset and liability matching strategy. For long-dated non‑linked contracts, in particular, this results in a duration mismatch between assets and liabilities. We therefore structure portfolios to support projected liabilities from non-linked contracts.

In the absence of insurable events occurring, unit-linked contracts match assets more directly with liabilities. This results in the policyholder bearing the majority of the financial risk exposure.

The table below shows the composition of assets and liabilities by contract type and demonstrates that there were sufficient assetsto cover the liabilities to policyholders in each case at 30 June 2014.

Balance sheet of insurance manufacturing subsidiaries by type of contract

For footnotes, see page 172.

Our most significant life insurance products are investment contracts with DPF issued in France, insurance contracts with DPF issued in Hong Kong and unit-linked contracts issued in Latin America, Hong Kong and the UK.

Our exposure to financial risks arising in the above balance sheet varies depending on the type of contract issued. For unit-linked contracts, the policyholder bears the majority of the exposure to financial risks whereas, for non-linked contracts, the majority of financial risks are borne by the shareholder (HSBC). For contracts with DPF, the shareholder is exposed to financial risks to the extent that the exposure cannot be managed by utilising any discretionary participation (or bonus) features within the policy contracts issued.

During the period HSBC entered into an agreement to sell its UK Pensions business, and the related balances are reported as a disposal group held for sale under IFRS 5 (and therefore included within the 'Other assets' column in the table above). The disposal group comprises liabilities under unit-linked investment contracts, unit-linked insurance contracts and annuity contracts, financial and reinsurance assets backing these liabilities, and the associated PVIF on these contracts. The transfer is subject toregulatory approvals and is expected to complete in the second half of 2015. As part of the transaction we have also entered into a reinsurance agreement transferring certain risks and rewards of the business to the purchaser from 1 January 2014 until completion of the transaction.

Insurance risk

Insurance risk is principally measured in terms of liabilities under the contracts in force.

A principal risk we face is that, over time, the cost of acquiring and administering a contract, claims and benefits may exceed the aggregate amount of premiums received and investment income. The cost of claims and benefits can be influenced by many factors, including mortality and morbidity experience, lapse and surrender rates and, if the policy has a savings element, the performance of the assets held to support the liabilities.

The following table analyses our life insurance risk exposures by geographical region and by type of business. The insurance risk profile and related exposures remain largely consistent with those observed at 31 December 2013.

Analysis of life insurance risk - liabilities under insurance contracts56

For footnotes, see below.

Footnotes to Risk

Credit risk

1 From 1 January 2014, non-trading reverse repos and repos are presented as separate lines in the balance sheet. Previously, non-trading reverse repos were included within 'Loans and advances to banks' and 'Loans and advances to customers' and non-trading repos were included within 'Deposits by banks' and 'Customer accounts'. Comparative data have been re-presented accordingly.

2 The loans and advances offset relates to customer loans and deposits and balances where there is a legally enforceable right of offset in the event of counterparty default and where, as a result, there is a net exposure for credit risk management purposes. However, as there is no intention to settle these balances on a net basis under normal circumstances, they do not qualify for net presentation for accounting purposes. The effects of collateral held are not taken into account.

3 The amount of the loan commitments reflects, where relevant, the expected level of take-up of pre-approved loan offers made by mailshots to personal customers. In addition to those amounts, there is a further maximum possible exposure to credit risk of US$60bn (30 June 2013: US$48bn; 31 December 2013: US$34bn), reflecting the full take-up of such irrevocable loan commitments. The take-up of such offers is generally at modest levels.

4 The US includes residential mortgages of HSBC Bank USA and HSBC Finance. Other regions comprise Middle East and North Africa and Latin America.

5 First lien residential mortgages include Hong Kong Government Home Ownership Scheme loans of US$3.3bn at 30 June 2014 (30 June 2013: US$3.1bn; 31 December 2013: US$3.2bn).

6 HSBC Finance lending is shown on a management basis and includes loans transferred to HSBC USA Inc. which are managed by HSBC Finance.

7 Property acquired through foreclosure is initially recognised at the lower of the carrying amount of the loan or its fair value less estimated costs to sell ('Initial Foreclosed Property Carrying Amount'). The average gain or loss on sale of foreclosed properties is calculated as the Initial Foreclosed Properties Carrying Amount less cash proceeds divided by the unpaid loan principal balance prior to write-down (excluding any accrued finance income) plus certain other ancillary disbursements that, by law, are reimbursable from the cash proceeds (e.g. real estate tax advances) and were incurred prior to our taking title to the property. This ratio represents the portion of our total loss on foreclosed properties that occurred after we took title to the property.

8 The average total loss on foreclosed properties includes both the loss on sale of the foreclosed property as discussed in footnote 6 and the cumulative write-downs recognised on the loans up to the time we took title to the property. This calculation of the average total loss on foreclosed properties uses the unpaid loan principal balance prior to write-down (excluding any accrued finance income) plus certain other ancillary disbursements that, by law, are reimbursable from the cash proceeds (e.g. real estate tax advances) and were incurred prior to our taking title to the property.

9 From 1 January 2014, the geographical region 'Asia' replaced the geographical regions previously reported as 'Hong Kong' and 'Rest of Asia-Pacific' (see Note 23 on the Financial Statements for further details). Comparative data have been re-presented to reflect this change.

10 'Other commercial loans and advances' includes advances in respect of agriculture, transport, energy and utilities.

11 For the purpose of this disclosure, retail loans which are past due up to 89 days and are not otherwise classified as impaired in accordance with our disclosure convention (see page 185 in the Annual Report and Accounts 2013), are not disclosed within the expected loss ('EL') grade to which they relate, but are separately classified as past due but not impaired.

12 Impairment allowances are not reported for financial instruments whereby the carrying amount is reduced directly for impairment and not through the use of an allowance account.

13 Impairment is not measured for assets held in trading portfolios or designated at fair value as assets in such portfolios are managed according to movements in fair value, and the fair value movement is taken directly to the income statement. Consequently, we report all such balances under 'Neither past due nor impaired'.

14 Loans and advances to customers include asset-backed securities that have been externally rated as strong (30 June 2014: US$1.8bn; 30 June 2013: US$2.0bn; 31 December 2013: US$1.7bn), good (30 June 2014: US$88m; 30 June 2013: US$348m; 31 December 2013: US$255m), satisfactory (30 June 2014: US$54m; 30 June 2013: US$338m; 31 December 2013: US$200m), sub-standard (30 June 2014: US$220m; 30 June 2013: US$493m; 31 December 2013: US$283m) and impaired (30 June 2014: US$321m; 30 June 2013: US$246m; 31 December 2013: US$259m).

15 Other personal loans and advances include second lien mortgages and other property-related lending.

16 Included in this category are loans of US$1.8bn (30 June 2013: US$2.1bn; 31 December 2013: US$1.9bn) that have been re-aged once and were less than 60 days past due at the point of re-age. These loans are not classified as impaired following re-age due to the overall expectation that these customers will perform on the original contractual terms of their borrowing in the future.

17 Impaired loans and advances are those classified as CRR 9, CRR 10, EL 9 or EL 10, retail loans 90 days or more past due, unless individually they have been assessed as not impaired (see page 272 in the Annual Report and Accounts 2013, 'Past due but not impaired gross financial instruments') and renegotiated loans and advances meeting the criteria to be disclosed as impaired (see page 130).

18 Collectively assessed loans and advances comprise homogeneous groups of loans that are not considered individually significant, and loans subject to individual assessment where no impairment has been identified on an individual basis, but on which a collective impairment allowance has been calculated to reflect losses which have been incurred but not yet identified.

19 Collectively assessed loans and advances not impaired are those classified as CRR1 to CRR8 and EL1 to EL8 but excluding retail loans 90 days past due and renegotiated loans and advances meeting the criteria to be disclosed as impaired.

20 Net of settlement accounts and stock borrowings.

21 As a percentage of loans and advances to banks and loans and advances to customers, as applicable.

22 Included within 'Exchange and other movements' is US$0.2bn of impairment allowances reclassified to held for sale (30 June 2013: nil; 31 December 2013: US$0.6bn).

23 'Currency translation adjustment' is the effect of translating the results of subsidiaries and associates for the previous period at the average rates of exchange applicable in the current period.

24 Negative numbers are favourable: positive numbers are unfavourable.

25 Equity securities not included.

26 Included within 'Total gross loans and advances to customers' is credit card lending of US$29.4bn (30 June 2013: US$28.9bn; 31 December 2013: US$30.6bn).

27 The impairment allowances on loans and advances to banks at 30 June 2014 and 30 June 2013 relate to the geographical regions, Europe and Middle East and North Africa (31 December 2013: Europe, Middle East and North Africa and North America).

28 Carrying amount of the net principal exposure.

29 Includes holdings of ABSs issued by The Federal Home Loan Mortgage Corporation ('Freddie Mac') and The Federal National Mortgage Association ('Fannie Mae').

30 'Directly held' includes assets held by Solitaire where we provide first loss protection and assets held directly by the Group.

31 'Effect of impairments' represents the reduction or increase in the reserve on initial impairment and subsequent reversal of impairment of the asset.

32 The gross principal is the redemption amount on maturity or, in the case of an amortising instrument, the sum of the future redemption amounts through the residual life of the security.

33 A credit default swap ('CDS') gross protection is the gross principal of the underlying instrument that is protected by CDSs.

34 Net principal exposure is the gross principal amount of assets that are not protected by CDSs. It includes assets that benefit from monoline protection, except where this protection is purchased with a CDS.

Liquidity and funding

35 The most favourable metrics are a smaller advances to core funding and a larger stressed one month coverage ratio.

36 HSBC UK comprises five legal entities; HSBC Bank plc (including all overseas branches), Marks and Spencer Financial Services Limited, HSBC Private Bank (UK) Ltd, HFC Bank Ltd and HSBC Trust Company (UK) Limited, managed as a single operating entity, in line with the application of UK liquidity regulation as agreed with the PRA.

37 The Hongkong and Shanghai Banking Corporation represents the bank in Hong Kong including all overseas branches. Each branch is monitored and controlled for liquidity and funding risk purposes as a stand-alone operating entity.

38 HSBC USA represents the HSBC USA Inc. consolidated group; predominantly HSBC USA Inc. and HSBC Bank USA, NA. The HSBC USA Inc. consolidated group is managed as a single operating entity.

39 The total shown for other principal entities represents the combined position of all the other operating entities overseen directly by the Risk Management Meeting of the GMB.

40 Estimated liquidity value represents the expected realisable value of assets prior to management assumed haircuts.

41 The undrawn balance for the five largest committed liquidity facilities provided to customers other than facilities to conduits.

42 The undrawn balance for the total of all committed liquidity facilities provided to the largest market sector, other than facilities to conduits.

Market risk

43 Trading portfolios comprise positions arising from the market-making and warehousing of customer-derived positions.

44 Portfolio diversification is the market risk dispersion effect of holding a portfolio containing different risk types. It represents the reduction in unsystematic market risk that occurs when combining a number of different risk types, for example, interest rate, equity and foreign exchange, together in one portfolio. It is measured as the difference between the sum of the VaR by individual risk type and the combined total VaR. A negative number represents the benefit of portfolio diversification. As the maximum and minimum occur on different days for different risk types, it is not meaningful to calculate a portfolio diversification benefit for these measures.

45 The total VaR is non-additive across risk types due to diversification effects.

46 Hypothetical profit and loss is calculated by applying the day's market moves to the previous day's portfolio. Hypothetical profit and loss excludes non-trading revenues such as fees and commissions, portfolio changes (e.g. new or expired deals) and carry (e.g. funding costs).

47 Investments in private equity are primarily made through managed funds that are subject to limits on the amount of investment. Potential new commitments are subject to risk appraisal to ensure that industry and geographical concentrations remain within acceptable levels for the portfolio as a whole. Regular reviews are performed to substantiate the valuation of the investments within the portfolio.

48 Investments held to facilitate ongoing business include holdings in government-sponsored enterprises and local stock exchanges.

49 Instead of assuming that all interest rates move together, we group our interest rate exposures into currency blocs whose rates are considered likely to move together.

Risk management of insurance operations

50 Other-long term includes term assurance, credit life insurance and universal life insurance.

51 Although investment contracts with DPF are financial instruments, HSBC continues to account for them as insurance contracts as permitted by IFRS 4.

52 The Other assets column shows shareholder assets as well as assets and liabilities classified as held for sale. The majority of the assets for insurance businesses classified as held for sale are reported as 'Other assets and investment properties' and totalled US$7.3bn at 30 June 2014 (30 June 2013: US$0.1bn; 31 December 2013: nil). The majority of these assets were debt and equity securities. All liabilities for insurance businesses classified as held for sale are reported in 'Other liabilities' and totalled US$7.4bn at 30 June 2014 (30 June 2013: US$0.1bn; 31 December 2013: nil). The majority of these liabilities were liabilities under insurance contracts and liabilities under investment contracts.

53 Present value of in-force long-term insurance contracts and investment contracts with DPF.

54 Deferred tax includes the deferred tax liabilities arising on recognition of PVIF.

55 Does not include associated insurance company SABB Takaful Company or joint venture insurance company Canara HSBC Oriental Bank of Commerce Life Insurance Company Limited.

56 HSBC has no insurance manufacturing subsidiaries in North America or the Middle East and North Africa.

57 Non-linked insurance includes remaining non-life business.

58 Insurance contracts and investment contracts with discretionary participation features ('DPF') can give policyholders the contractual right to receive, as a supplement to their guaranteed benefits, additional benefits that may be a significant portion of the total contractual benefits, but whose amount and timing are determined by HSBC. These additional benefits are contractually based on the performance of a specified pool of contracts or assets, or the profit of the company issuing the contracts.