22nd Nov 2006 13:00
Lloyds TSB Group PLC22 November 2006 LLOYDS TSB GROUP PLC TRANSITION TO EUROPEAN EMBEDDED VALUE AT SCOTTISH WIDOWS 22 NOVEMBER 2006 CONTENTS Page1. Executive summary 1 2. EEV methodology 3 3. EEV assumptions 5 4. Summary of financial impact for Scottish Widows of adoption of EEV 7 for supplementary reporting 5. EEV supplementary reporting results for year to 31 December 2005 9 6. Sensitivity analysis 11 7. Traditional embedded value equivalent risk discount rate 12 8. Additional information 13 9. Directors' attestation 15 10. Pro-forma impact of EEV on Lloyds TSB Group statutory accounts 15 11. Audit opinion 16 12. Glossary of terms 18 13. Contacts for further information 21 FORWARD LOOKING STATEMENTS This announcement contains forward looking statements with respect to thebusiness, strategy and plans of the Lloyds TSB Group, its current goals andexpectations relating to its future financial condition and performance. Bytheir nature, forward looking statements involve risk and uncertainty becausethey relate to events and depend on circumstances that will occur in the future.The Group's actual future results may differ materially from the resultsexpressed or implied in these forward looking statements as a result of avariety of factors, including UK domestic and global economic and businessconditions, risks concerning borrower credit quality, market related risks suchas interest rate risk and exchange rate risk in its banking business and equityrisk in its insurance businesses, changing demographic trends, unexpectedchanges to regulation or regulatory actions, changes in customer preferences,competition and other factors. Please refer to the latest Annual Report on Form20-F filed with the US Securities and Exchange Commission for a discussion ofsuch factors. TRANSITION TO EUROPEAN EMBEDDED VALUE AT SCOTTISH WIDOWS 1. EXECUTIVE SUMMARY Introduction In May 2004, the Chief Financial Officers Forum ('CFO Forum') published itsEuropean Embedded Value ('EEV') Principles (the 'Principles') and Guidance whichset out a series of agreed standards for embedded value reporting. ThesePrinciples establish a consistent treatment for the financial informationprovided for insurance and investment contracts and, in our view, allow a fullerrecognition of the economic value being created. Compared with 'TraditionalEmbedded Value' ('TEV'), EEV Principles also provide a more appropriatevaluation of in-force business which explicitly takes into account the cost offinancial options and guarantees, and required capital, as well as non-marketrisks, such as mortality. Since the publication of these EEV Principles, anumber of companies have adopted EEV. Lloyds TSB will continue to report under International Financial ReportingStandards ('IFRS') in its statutory accounts. However, in line with industrybest practice, the Group intends to introduce supplementary financial reportingrelating to Scottish Widows Group ('Scottish Widows') on an EEV basis from the2006 year end. In addition, the accounting for those products which arerecognised on an embedded value basis under IFRS will also move to a basisconsistent with relevant EEV Principles. Clearly, because the adoption of EEV Principles is purely a reporting change, ithas no impact on the business fundamentals, economics or cash flows. The totalprofit recognised over a contract's lifetime is the same as that recognisedunder the IFRS basis of accounting, however the timing of profit recognition isdifferent. EEV provides for improved clarity, transparency and comparability offinancial information disclosures. The Group believes that EEV represents themost appropriate measure of long-term value creation in the life assurance andinvestment businesses. The EEV results included in this document have been prepared in accordance withthe CFO Forum's EEV Principles and Guidance. The methodology adopted byScottish Widows has been developed in conjunction with consulting actuaries,Tillinghast, who have made the following statement: 'We have worked closely with Scottish Widows to develop their European EmbeddedValue methodology and are satisfied that the approach is robust and is based onmarket consistent principles.' This document describes the EEV methodology adopted and provides details of the2005 results, together with a reconciliation to TEV. Impact on the Lloyds TSB Group statutory accounts Lloyds TSB Group will continue to report its statutory accounts under IFRS withonly insurance policies and discretionary participating investment business, asdefined in IFRS 4, being accounted for on an embedded value basis. The embeddedvalue basis will however move to a basis consistent with relevant EEVPrinciples, although the impact on the Group's statutory accounts is minimal.Under IFRS, the value of the Group's in-force business at 31 December 2005 was£2,922 million. Had the Group been reporting on the basis consistent with EEVthe value of in-force business would have been £2,921 million, a reduction of £1 million (see section 10). There is no impact within the 2005 income statement,and the impact at 31 December 2006 is not expected to be material. Supplementary reporting - Impact of adopting EEV principles For supplementary reporting purposes, in line with industry best practice,Scottish Widows has adopted a market consistent, bottom-up approach whichincorporates an allowance for risk including the cost of financial options andguarantees, non-market risk and, to comply with EEV Principles, the cost ofholding required capital. In addition, the covered business reported on an EEVbasis now includes the retail OEICs and managed fund business of ScottishWidows, which were not covered under TEV. Page 1 of 21 TRANSITION TO EUROPEAN EMBEDDED VALUE AT SCOTTISH WIDOWS 1. EXECUTIVE SUMMARY (continued) The table below shows the overall impact of the transition from TEV to EEVreporting on a supplementary basis. A detailed reconciliation of these numbersis contained in section 4. Year to 31 December 2005 Scottish Widows TEV EEV Change £m £m % New business profit before tax 224 254 13Profit before tax* 616 727 18Embedded value (year end) 6,334 6,386 1Post-tax return on embedded value 6.8% 8.0% *excluding volatility, the strengthening of reserves for annuitant mortality and other items (see section 5). The overall impact of the move to EEV, including the changes in coveredbusiness, on the 2005 supplementary results of Scottish Widows is to increasenew business profit before tax by 13 per cent to £254 million and profit beforetax, excluding volatility, the strengthening of reserves for annuitant mortalityand other similar items, by 18 per cent to £727 million. At 31 December 2005,the embedded value of Scottish Widows on this basis totalled £6,386 million,broadly unchanged from that under TEV. This reflects the reduction in embeddedvalue as a result of the inclusion of the cost of financial options andguarantees and the cost of holding required capital being more than offset bychanges in the amount of covered business, primarily the retail sales of OEICs(see section 4). The table below highlights the difference between Lloyds TSB Group's reportedIFRS financial information relating to Scottish Widows, and that undersupplementary EEV reporting. Year to 31 December 2005 Reported SupplementaryScottish Widows IFRS EEV £m £mNew business profit before tax 123 254Profit before tax* 655 727Embedded value (year-end) 5,478 6,386 *excluding volatility, the strengthening of reserves for annuitant mortality and other items (see section 5). Compared to Lloyds TSB Group's reported IFRS accounts for the year ended 31December 2005, Scottish Widows' new business profit before tax under EEV is £131 million higher at £254 million, reflecting the earlier timing of profitrecognition. Profit before tax, excluding volatility, the strengthening ofreserves for annuitant mortality and other items, is £72 million higher at £727million, as higher new business profit before tax is partially offset by theconsequent lower profit on existing business. Similarly, the embedded value is£908 million higher at £6,386 million, largely reflecting the inclusion ofcertain investment products under EEV. The Group believes that EEV reportingbetter represents the economic value of Scottish Widows' in-force business. Page 2 of 21 TRANSITION TO EUROPEAN EMBEDDED VALUE AT SCOTTISH WIDOWS 2. EEV METHODOLOGY The EEV results included in this document have been prepared in accordance withthe CFO Forum's EEV Principles and Guidance. In preparing this transition document, the directors of Scottish Widows haveapplied the policies expected to be adopted when the first set of supplementaryfinancial information on an EEV basis for the year ended 31 December 2006 isprepared. The covered business reported on an EEV basis includes all of the lifeinsurance, retail OEICs and managed fund business of Scottish Widows. RetailOEICs and the managed fund business were not covered under TEV reporting but areincluded in the EEV definition of covered business. This inclusion isconsistent with this business being managed on an embedded value basis. Asimilar approach to modelling OEIC business has been used as that employed forlife and pensions business. In accordance with the EEV Principles, Scottish Widows' EEV is the sum of • the shareholders' net assets and • the value of the in-force business taking account of the cost of: - financial options and guarantees - non-market risk, and - required capital. The EEV shareholders' net assets are equal to the IFRS shareholders' net assetsadjusted for deferred income reserve, deferred acquisition costs and statutory 'sterling reserve' adjustments together with their associated deferred taxbalances. The allowance for risk in shareholder cash flows is a key feature of the EEVPrinciples and has been determined using a 'bottom-up' approach applied on amarket consistent basis. Accordingly, each cash flow is valued using thediscount rate consistent with that applied to such a cash flow in the capitalmarkets. For example, an equity cash flow is valued using an equity riskdiscount rate, and a bond cash flow is valued using a bond risk discount rate.In using cash flow specific discount rates, the EEV methodology differs from theTEV approach which uses a single 'top down' risk discount rate. In practice, where the cash flows are either independent of or move linearlywith market movements, a method has been applied known as the 'certaintyequivalent' approach whereby it is assumed that all assets earn the risk-freerate and all cash flows are discounted using the risk-free rate. This gives thesame result as applying the method in the previous paragraph. The risk-freerate assumption is consistent with the rates used by Scottish Widows forreporting under the FSA's realistic reporting regime. Page 3 of 21 TRANSITION TO EUROPEAN EMBEDDED VALUE AT SCOTTISH WIDOWS 2. EEV METHODOLOGY (continued) - Financial options and guarantees A market consistent approach has been adopted for the valuation of financialoptions and guarantees, using a stochastic option pricing technique calibratedto be consistent with the market price of relevant options at each valuationdate. The valuation and economic models used are the same as those used byScottish Widows for reporting under the FSA's realistic reporting regime and, inaccordance with FRS 27, in the Group's consolidated accounts. The majority of Scottish Widows' financial options and guarantees are in theWith Profits Fund. If experience in the With Profits Fund is significantlyadverse then the shareholder will bear the full cost under the requirements ofthe Scheme of Transfer. However, if the experience is positive, the benefit tothe shareholder is shared with policyholders. The cost of this asymmetry isknown as 'burn-through cost'. - Non-market risk An allowance for non-market risk is made through the appropriate choice of bestestimate experience assumptions relating to risks such as mortality, and throughthe cost of the corresponding capital required. Generally, the best estimateassumptions will give the mean expected financial outcome to shareholders, andhence no further allowance for non-market risk is required. However, in thecase of operational risk and the With Profits Fund there are asymmetries in therange of potential outcomes around the best estimates. These are allowed for inthe EEV provision for non-market risk. Operational risk refers to the risk of direct or indirect loss resulting frominadequate or failed internal processes, people and systems or external events.The operational risk cost has been calculated by comparing the mean impact ofvariations in operational risk, as modelled in the economic capitalcalculations, with the existing allowance for operational risk in specificaccounting provisions and embedded value projection assumptions. For the risk cost associated with the With Profits Fund non-economicassumptions, the impact on burn-through cost of a range of risk events has beenconsidered. - Required capital and cost of capital An allowance is made in the valuation for the cost of holding required capitalfor covered business and not therefore immediately available for distribution tothe shareholder. In determining the amount of required capital on both thein-force business and on new business, allowance has been made for the highest,determined at the entity level, of the following: • The minimum amount of capital required to meet FSA capitaladequacy requirements, including the Individual Capital Assessment. • The amount retained to satisfy the requirements of the Schemeof Transfer. • Management's view of the economic capital requirements of thebusiness. The cost of capital is the difference between the amount of required capital andthe present value of future releases of that capital, allowing for theinvestment expenses and taxation on the required capital until it can bereleased. Whilst this cost of capital adjustment is made in the Scottish Widowssupplementary EEV financial information, for Lloyds TSB statutory reportingpurposes no adjustment is made in order to maintain consistency with therequired treatment of capital in the Group's banking businesses. Page 4 of 21 TRANSITION TO EUROPEAN EMBEDDED VALUE AT SCOTTISH WIDOWS 3. EEV ASSUMPTIONS This transition document has been prepared using the information available andassumptions considered appropriate at 31 December 2005, and thereforeincorporates the assumptions applied within the financial statements for thatperiod. The additional assumptions required for EEV reporting reflect theconditions that existed at 31 December 2005. Economic assumptions As outlined in section 2, a bottom-up approach is used to determine the economicassumptions for valuing the business in order to determine a market consistentvaluation. The risk-free rate assumed in valuing in-force business is 10 basis points overthe 15-year gilt yield. In valuing financial options and guarantees therisk-free rate is derived from gilt yields plus 10 basis points, in line withScottish Widows' FSA realistic balance sheet assumptions. The table below showsthe range of resulting yields and other key assumptions. 31 December 31 December 2004 2005 % % Risk-free rate (value of in-force) 4.67 4.22Risk-free rate (financial options and guarantees) 4.3 to 4.7 3.9 to 4.3Retail Price inflation 2.86 2.89Expense inflation 3.76 3.79 While the market consistent methodology used does not involve the use of asingle TEV risk discount rate, equivalent risk discount rates are provided insection 7. In calculating the EEV total profit before tax, a set of expected investmentreturns has been assumed. These are also used in calculating the equivalentrisk discount rate (see section 7). The expected investment returns are basedon prevailing market rates and published research into historic investmentreturn differentials. These are set out in the table below. 31 December 31 December 2004 2005 % % Gilt yields (gross) 4.57 4.12Equity returns (gross) 7.57 7.12Dividend yields 3.00 3.00Property returns (gross) 7.57 7.12Corporate bonds (gross) 5.17 4.72 On adopting EEV the existing TEV expected investment returns were reviewed. Theonly change is in the assumed equity and property returns which previouslyexceeded the assumed gilt return by 2.6 per cent, now by 3.0 per cent. Theimpact of this change on EEV reporting is not material. Page 5 of 21 TRANSITION TO EUROPEAN EMBEDDED VALUE AT SCOTTISH WIDOWS 3. EEV ASSUMPTIONS (continued) Non-economic assumptions Future mortality, morbidity, lapse and paid-up rate assumptions are reviewedeach year and are based on an analysis of past experience and on management'sview of future experience. These assumptions are intended to represent a bestestimate of future experience as at 31 December 2005 and, for life and pensionsbusiness, remain unchanged in the transition to EEV. For OEIC business, the lapse assumption is based on experience which has beencollected over a 20 month period. To recognise that this is a shorter periodthan that normally available for life and pensions business, and that thisperiod has coincided with favourable investment conditions, management have useda best estimate of the long-term lapse assumption which is higher than indicatedby this 20 month experience. In management's view, the approach, and lapseassumption, are both reasonable. Page 6 of 21 TRANSITION TO EUROPEAN EMBEDDED VALUE AT SCOTTISH WIDOWS 4. SUMMARY OF FINANCIAL IMPACT FOR SCOTTISH WIDOWS OF ADOPTION OF EEV FOR SUPPLEMENTARY REPORTING The following tables set out in more detail the adjustments made to reconcileTEV to EEV. Impact of EEV on embedded value for supplementary reporting 31 December 2005 £m TEV 6,334Impact of revised allowance for risk Certainty equivalent valuation 103 Financial options and guarantees (193) Non-market risk (70) Cost of capital (262)Changes to covered business - Pensions Management 18Life and pensions 5,930Changes to covered business - OEICs 456EEV 6,386 Impact of EEV on profit before tax* for supplementary reporting 31 December 2005 £m TEV 616Impact of revised allowance for risk Certainty equivalent valuation (32) Financial options and guarantees 32 Non-market risk (6) Cost of capital 34Tax grossing adjustment 13Changes to covered business - Pensions Management 2 Life and pensions 659Changes to covered business - OEICs 68EEV 727 *excluding volatility and the strengthening of annuitant mortality reserves and other items (see section 5). Page 7 of 21 TRANSITION TO EUROPEAN EMBEDDED VALUE AT SCOTTISH WIDOWS 4. SUMMARY OF FINANCIAL IMPACT FOR SCOTTISH WIDOWS OF ADOPTION OF EEV FOR SUPPLEMENTARY REPORTING (continued) Impact of EEV on new business profit before tax for supplementary reporting 31 December 2005 £m TEV 224Impact of revised allowance for risk Certainty equivalent valuation 25 Financial options and guarantees - Non-market risk (10) Cost of capital (13)Changes to covered business - Pensions Management 5Life and pensions 231Changes to covered business - OEICs 23EEV 254 There are no material unhedged financial options and guarantees in new business. Present value of new business premiums ('PVNBP') The PVNBP is calculated as the value of single premiums plus the discountedpresent value of future expected regular premiums, allowing for lapses and otherassumptions made under EEV. Previously new business margins were calculated asthe new business profit before tax divided by the Annual Premium Equivalent ('APE'), where the APE was the value of regular premiums plus 10 per cent ofsingle premiums. For comparison purposes, EEV margin as a percentage of APE isalso provided. Year to 31 December 2005 EEV new business New business Margin profit before tax volume PVNBP PVNBP £m £m % Life and Pensions 231 6,627 3.5OEICs 23 1,215 1.9Total 254 7,842 3.2 Year to 31 December 2005 New business New business New business profit before tax volume APE margin APE £m £m % TEV Life and pensions(excluding Pensions Management) 224 754 29.7EEV Life and pensions 231 804 28.7 Page 8 of 21 TRANSITION TO EUROPEAN EMBEDDED VALUE AT SCOTTISH WIDOWS 5. EEV SUPPLEMENTARY REPORTING RESULTS FOR YEAR TO 31 DECEMBER 2005 This section provides further details of the Scottish Widows' EEV financialinformation. Composition of EEV balance sheet Life and Pensions OEICs Total £m £m £m Value of in-force business (certainty equivalent) 3,214 252 3,466Value of financial options and guarantees (193) - (193)Cost of capital (262) - (262)Non-market risk (70) - (70)Total value of in-force business 2,689 252 2,941Shareholders' net assets 3,241 204 3,445Total EEV of covered business 5,930 456 6,386 Reconciliation of opening EEV balance sheet to closing EEV balance sheet oncovered business Value of Shareholders' in-force Total net assets business £m £m £m As at 1 January 2005 3,880 2,581 6,461Total profit after tax 565 360 925Dividends (1,000) - (1,000)As at 31 December 2005 3,445 2,941 6,386 Analysis of shareholders' net assets on an EEV basis on covered business Required Free Shareholders' capital surplus net assets £m £m £m As at 1 January 2005 3,058 822 3,880Total profit after tax (105) 670 565Debt issued (560) 560 -Dividends - (1,000) (1,000)As at 31 December 2005 2,393 1,052 3,445 The table above shows the shareholders' required capital needed to support thecovered business has reduced from £3,058 million to £2,393 million over theyear. Page 9 of 21 TRANSITION TO EUROPEAN EMBEDDED VALUE AT SCOTTISH WIDOWS 5. EEV SUPPLEMENTARY REPORTING RESULTS FOR YEAR TO 31 DECEMBER 2005 (continued) Detailed Scottish Widows EEV balance sheet 31 December 2005 £m Investments 75,299Value of in-force business 2,941Debtors 463Other assets 1,310Total assets 80,013 Technical provisions net of reinsurance 59,190Other creditors 14,181Net tax payable 77Net creditors with other Lloyds TSB Group entities 179Total liabilities 73,627Total equity 6,386Total equity and liabilities 80,013 2005 summary income statement on an EEV basisYear to 31 December 2005 Life and Pensions OEICs Total £m £m £m New business profit 231 23 254Existing business profit Expected return 359 31 390 Experience variances 5 7 12 Assumption changes (147) - (147)Expected return on shareholders' net assets 211 7 218Profit before tax, excluding volatility andother items 659 68 727Volatility 584Strengthening of annuitant mortality assumptions (162)Other items 172Total profit before tax 1,321Attributed shareholder tax (396)Total profit after tax 925 The assumption changes above largely reflect the impact of changes in financialoptions and guarantee modelling and lapse assumptions. Other items comprise thecapitalisation impact of a lower cost of capital following debt issuance during2005, the benefit of an intra-Group transfer of a portfolio of OEICs and anincrease in the value of deferred tax assets, recognised in profit before taxunder EEV. These items have been separately identified in order to provide afairer representation of the underlying performance of the business. Page 10 of 21 TRANSITION TO EUROPEAN EMBEDDED VALUE AT SCOTTISH WIDOWS 6. SENSITIVITY ANALYSIS The table below shows the sensitivity of the EEV and the new business profitbefore tax to movements in some of the key assumptions. The impact of a changein the assumption has only been shown in one direction. The impact can beassumed to be reasonably symmetrical. Impact on new Impact business profit on EEV before tax £m £m 2005 EEV/new business profit before tax 6,386 254 (1) 100 basis points reduction in risk-free rates 173 6(2) 10% reduction in market values of equity and property assets (240) n/a(3) 10% reduction in maintenance expenses 76 34(4) 10% reduction in lapses 75 14(5) 5% reduction in annuitant mortality (115) (4)(6) 5% reduction in mortality and morbidity (excluding annuitants) 39 4(7) 100 basis points increase in equity and property returns nil nil (1) In this sensitivity the impact takes into account the change in the valueof in-force, financial options and guarantee costs, statutory reserves and assetvalues. (2) The reduction in market values is assumed to have no corresponding changein dividend or rental yields. The impact on EEV of £(240) million comprises a£192 million reduction in the value of in-force and a £48 million reduction inthe shareholders' net assets. (3) This sensitivity shows the impact of reducing maintenance expenses to 90per cent of the expected rate. (4) This sensitivity shows the impact of reducing lapse and surrender rates to90 per cent of the expected rate. (5) This sensitivity shows the impact on annuity and deferred annuity businessof reducing mortality rates to 95 per cent of the expected rate. (6) This sensitivity shows the impact of reducing mortality and morbidityrates on non-annuity business to 95 per cent of the expected rate. (7) Under a market consistent valuation, changes in assumed equity andproperty returns have no impact on the EEV. In scenarios (3) to (6) assumptions have been flexed on both the realistic basisand the statutory reserving basis. A change in risk discount rates is notrelevant as the risk discount rate is not an input to a market consistentvaluation. Page 11 of 21 TRANSITION TO EUROPEAN EMBEDDED VALUE AT SCOTTISH WIDOWS 7. TRADITIONAL EMBEDDED VALUE EQUIVALENT RISK DISCOUNT RATE The following comparison shows that new business products sold are considerablyless risky than in-force products; the equivalent risk discount rate beforededucting a cost of capital is significantly lower on new business than onin-force business. This is primarily driven by the negligible cost of financialoptions and guarantees on new business. There is a smaller difference between the equivalent risk discount rates on thein-force business and the new business, after allowing for the cost of capital.This reflects the fact that the total return on the in-force business includesthe expected return on the large amount of capital required by the in-forcebusiness. The large amount of capital required arises principally from theScheme of Transfer and allowing for the expected return on this capital has theeffect of lowering the equivalent risk discount rate. End 2005 2005 In-force New business business % % Risk free rate 4.2 4.2Allowance for market risk 2.5 2.0Allowance for financial options and guarantees 0.9 0.0Allowance for non-market risk 0.3 0.3Equivalent risk discount rate (pre cost of capital) 7.9 6.5Allowance for cost of capital (1.4) (0.5)Equivalent risk discount rate 6.5 6.0 The traditional embedded value risk discount rates shown were derived bycalculating the risk discount rate which, when used within a traditionalapproach (net of the traditional cost of capital and with no allowance for thetime value cost of financial options and guarantees), gives the same value asthat arising from the market-consistent approach (net of the time value cost offinancial options and guarantees, the additional allowance for non-market riskand the frictional cost of capital). Page 12 of 21 TRANSITION TO EUROPEAN EMBEDDED VALUE AT SCOTTISH WIDOWS 8. ADDITIONAL INFORMATION Definition of new business New business encompasses both insurance and investment contracts and includes: • Premiums from the sale of new contracts, and increments to existing contracts. • Escalation on existing regular premiums, which is counted as new business when the escalation is received. Escalation on existing regular premiums is not anticipated in advance of being received. • New entrants to existing corporate pension schemes who have joined during the reporting period. • Department of Work and Pensions (DWP) rebates received during the reporting period. Future DWP rebates are not anticipated in advance of being received. This approach is consistent with our previous TEV approach. Pensions Management new business sales were excluded from reported APE underTEV. Under EEV this business is treated as covered business and is now includedwithin new business. Definition of total profit before tax Total profit before tax is the sum of the new business profit, the existingbusiness profit, the expected return on shareholders' net assets and volatility. New business profit is defined as the contribution to total profit from writingnew business. New business profit is calculated as at the end of the reportingperiod, based on the start period economic and non-economic assumptions, andallows for all direct costs from writing new business, and an appropriateallocation of overheads. Existing business profit comprises the expected return on business writtenbefore the start of the reporting period, experience variations and the impactof non-economic assumption changes. The expected return on shareholders' net assets is the investment return on theassets in question assuming that they earn the expected returns as detailed insection 3. Volatility is defined to be the impact on profit from changes in economicassumptions and market movements in excess of, or shortfall to, the expectedinvestment return. This includes the shortfall or excess return on theshareholders' net assets, and the VIF (including the cost of financial optionsand guarantees and the cost of capital). To provide a clearer representation ofthe underlying performance of the business, the effect of excess or shortfallfrom market movements is separately analysed as volatility. Valuation of debt issued by Scottish Widows During September 2005 Scottish Widows plc issued £560 million of step-upperpetual subordinated notes. Redemption of these notes is at the option of thecompany and is generally not allowable prior to the first call date on 24September 2015. This debt is valued at cost adjusted for the gain or lossattributable to the hedged risks. Page 13 of 21 TRANSITION TO EUROPEAN EMBEDDED VALUE AT SCOTTISH WIDOWS 8. ADDITIONAL INFORMATION (continued) Pension schemes The defined benefit pension scheme deficits calculated in accordance with IAS 19are recognised within the TEV and EEV balance sheet amounts. Pension schemeassets are included at their fair value and scheme liabilities are measured onan actuarial basis using the projected unit credit method. The liabilities arediscounted using rates equivalent to the market yields at the balance sheet dateon high-quality corporate bonds that have terms to maturity approximating to theterms of the related pension liability. Treatment of expenses Allocations of expenses are based on detailed activity-based assessments ofcosts. These involve the allocation of costs between new business, existingbusiness and where appropriate non-recurring development costs. All of thecosts of the life and pensions business are considered on a look-through basis.This treatment is unchanged from the previous treatment of expenses. The disclosed EEV profit before tax is net of development costs. Tax EEV profits are calculated net of tax and then grossed up at the effective rateof shareholder tax. The full standard rate of UK corporation tax has been usedto gross up profits. Deferred tax has been recognised, where appropriate, in respect of alldifferences where transactions or events resulting in an obligation to pay moretax in the future or a right to pay less tax in the future have occurred beforethe period end. Where appropriate, deferred tax balances have been discountedat the risk-free rate over the total period in which it is estimated that thetiming difference to which they relate will reverse. Dividend recognition Consistent with the treatment under IFRS, dividends are recognised when paid,and not when declared. With-profits bonuses Future bonus rates on participating business are set at levels which would fullyutilise the assets supporting the with-profits business. Page 14 of 21 TRANSITION TO EUROPEAN EMBEDDED VALUE AT SCOTTISH WIDOWS 9. DIRECTORS' ATTESTATION The Directors of Scottish Widows Group acknowledge their responsibility for thepreparation of the supplementary information in accordance with the twelve EEVPrinciples and the assumptions underpinning the 2005 results. Scottish WidowsGroup and Lloyds TSB Group approved the EEV supplementary information on 21November 2006. 10. PRO-FORMA IMPACT OF EEV ON LLOYDS TSB GROUP STATUTORY ACCOUNTS The table below reconciles the 31 December 2005 published value of in-forcebusiness ('VIF') on a TEV basis, which is reported in the Lloyds TSB Groupstatutory accounts, to the equivalent value on a market consistent basisapplying relevant EEV Principles. Pro-forma as at 31 December 2005 £m Gross VIF for insurance and participating investmentbusiness (TEV basis) 2,922IAS 12 tax (including policyholder tax) (934)Total net VIF (TEV basis) 1,988Impact of allowance for risk Certainty equivalent valuation 52 Financial options and guarantees (8) Non-market risk (45)Total net VIF (EEV consistent basis) 1,987IAS 12 tax grossing adjustment 934Total gross VIF (EEV consistent basis) 2,921 The cost of capital is not reflected in the Lloyds TSB Group accounts tomaintain consistency with the required treatment of capital in the Group'sbanking business. The pro-forma value of the in-force insurance business at 31 December 2005 on abasis consistent with the relevant EEV Principles was £2,921 million, comparedto the reported figure of £2,922 million. As this reflects a change inmethodology rather than a change in accounting policy, the Group's financialstatements will not restate 2005 comparatives; the impact of this change will bereported within the 2006 income statement. The impact at 31 December 2006 isalso not expected to be material. Page 15 of 21 TRANSITION TO EUROPEAN EMBEDDED VALUE AT SCOTTISH WIDOWS 11. AUDIT OPINION Special Purpose Audit Report of PricewaterhouseCoopers LLP to the directors ofScottish Widows Group Limited on its European Embedded Value ('EEV')Supplementary Financial Information for year ended 31 December 2005 We have audited the accompanying consolidated EEV balance sheet of ScottishWidows Group Limited as at 31 December 2005, the related consolidated EEV incomestatement for the year then ended and the related notes (hereinafter referred toas 'the EEV supplementary financial information') set out in sections 2 to 6 and8 to 9. Respective responsibilities of directors and PricewaterhouseCoopers The directors of the Scottish Widows Group are responsible for the preparationof the EEV supplementary financial information which have been prepared as partof the Scottish Widows Group's conversion to EEV. Our responsibilities, as independent auditors, in relation to the supplementaryfinancial information are, as set out in our letter of engagement agreed withyou dated 27 October 2006, to report to you our opinion as to whether thesupplementary financial information has been properly prepared in accordancewith the European Embedded Value basis. We also report to you if we have notreceived all the information and explanations we require for our audit of thesupplementary financial information. This report, including the opinion, hasbeen prepared for and only for the Scottish Widows Group in accordance with ourletter of engagement dated 27 October 2006 and for no other purpose. We do not,in giving this opinion, accept or assume responsibility for any other purpose orto any other person to whom this report is shown or in to whose hands it maycome save where expressly agreed by our prior consent in writing. We also read the other information in the transition document and consider theimplication for our report if we become aware of any apparent misstatements ormaterial inconsistencies with the supplementary financial information. The maintenance and integrity of the Scottish Widows Group Limited website isthe responsibility of the directors; the audit work does not involveconsideration of these matters and, accordingly, we accept no responsibility forany changes that may have occurred to the supplementary financial informationsince it was initially presented on the website. Legislation in the United Kingdom governing the preparation and dissemination ofsupplementary financial statements may differ from legislation in otherjurisdictions. Page 16 of 21 TRANSITION TO EUROPEAN EMBEDDED VALUE AT SCOTTISH WIDOWS 11. AUDIT OPINION (continued) Basis of opinion We conducted our audit in accordance with International Standards on Auditing ('ISA') (UK and Ireland) issued by the Auditing Practices Board. Our auditincluded examination, on a test basis, of evidence relevant to the amounts anddisclosures in the supplementary financial information. This evidence includedan assessment of the significant estimates and judgements made by the directorsin the preparation of the supplementary financial information, and of whetherthe EEV methodology is appropriate to the Scottish Widows Group's circumstances,consistently applied and adequately disclosed. We planned and performed our audit so as to obtain all the information andexplanations which we considered necessary in order to provide us withsufficient evidence to give reasonable assurance that the supplementaryfinancial information is free from material misstatement, whether caused byfraud or other irregularity or error. In forming our opinion, we also evaluatedthe overall adequacy of the presentation of information in the supplementaryfinancial information. Opinion In our opinion, the accompanying EEV supplementary financial information for theyear ended 31 December 2005 has been prepared, in all material respects, inaccordance with the basis set out on pages 3 to 5, which describes that thesupplementary financial information has been prepared in accordance with thetwelve European Embedded Value principles as set out in 'European Embedded ValuePrinciples'. This section includes the assumptions made by the directors ofScottish Widows Group about the policies expected to be adopted when theyprepare the first set of supplementary financial statements of the ScottishWidows Group on an EEV basis for the year to 31 December 2006. PricewaterhouseCoopers LLP Chartered Accountants Edinburgh 22 November 2006 Page 17 of 21 TRANSITION TO EUROPEAN EMBEDDED VALUE AT SCOTTISH WIDOWS 12. GLOSSARY OF TERMS Best estimate assumption Best estimate is defined as the mean financial outcome to shareholders. CFO Forum The CFO Forum is a high-level discussion group formed and attended by the ChiefFinancial Officers of major European insurance companies. The CFO Forum wascreated in 2002. Covered business The contracts to which the EEV methodology has been applied. EEV Guidance Guidance providing preferred interpretation of the EEV Principles, as set outunder each Principle. Compliance with guidance is preferred but not compulsoryin order to comply with the EEV Principles. EEV Principles Compliance with the EEV Principles requires compliance with each of the 12Principles. The Principles provide a framework for the derivation of valuationassumptions, calculation and reporting of embedded value results. EEV shareholders' net assets The EEV shareholders' net assets are the total assets less the regulatoryreserves. This is also equal to the required capital plus free surplus. Embedded value This is the sum of: free surplus allocated to the covered business; requiredcapital less any costs of holding required capital; and the present value offuture shareholder cash flows from in-force covered business. European Embedded Value An embedded value calculation which complies with the European Embedded ValuePrinciples. Experience variance The impact on embedded value of a variation during the reporting period in theexperience in performance of the covered business when compared to projectionassumptions used for that area of experience. Fair value The International Accounting Standards definition of fair value is 'the amountfor which an asset could be exchanged or a liability settled betweenknowledgeable, willing parties in an arm's length transaction'. Financial options and guarantees Features of the covered business conferring potentially valuable guaranteesunderlying, or options to change, the level or nature of policyholder benefitsand exercisable at the discretion of the policyholder, whose potential value isimpacted by the behaviour of financial variables. Page 18 of 21 TRANSITION TO EUROPEAN EMBEDDED VALUE AT SCOTTISH WIDOWS 12. GLOSSARY OF TERMS (continued) Free surplus The amount of any capital and surplus allocated to, but not required to support,the in-force business covered by the EEV methodology as defined in Principle 4. IAS International Accounting Standard. IFRS International Financial Reporting Standards, developed by the InternationalAccounting Standards Board. Look-through basis A basis via which the impact of an action on the whole group, rather than on aparticular part of the group, is measured. LTICR Long Term Insurance Capital Requirement. Market Consistent Embedded Value ('MCEV') This is an embedded value calculation where each projected cash flow isdiscounted using a discount rate appropriate to the risk associated with thatcash flow, as measured by the market. OEIC Open Ended Investment Company. Participating business Covered business in which policyholders have the right to participate (receiveadditional benefits) in the performance of a specified pool of assets orcontracts, fund or company within the group. Present value The value of a future cash flow at the valuation date, discounted at a discountrate appropriate to that cash flow. Required capital The amount of assets, over and above the value placed on liabilities in respectof covered business, whose distribution to shareholders is restricted, definedin Principle 5. Risk-free rates Prospective yields on securities of suitable term considered to be materiallyfree of default or credit risk. Scheme of Transfer The Court approved Scheme of Transfer which created Scottish Widows followingthe demutualisation of Scottish Widows Fund and Life Assurance Society in 2000. Stochastic techniques Techniques that incorporate the potential future variability in assumptionsaffecting their outcome. Page 19 of 21 TRANSITION TO EUROPEAN EMBEDDED VALUE AT SCOTTISH WIDOWS 12. GLOSSARY OF TERMS (continued) Supplementary reporting Reporting within financial statements that is a) produced using a methodologyother than that on which the primary financial statements are based, and b) notcovered by the primary financial statement's audit opinion. Traditional Embedded Value This is an embedded value calculation where the projected cash flows arediscounted using a single risk discount rate across the entire business. Value of in-force business The present value of future payments to shareholders arising from contracts thatare in-force at the valuation date and part of the covered business. Page 20 of 21 TRANSITION TO EUROPEAN EMBEDDED VALUE AT SCOTTISH WIDOWS CONTACTS For further information please contact:- Michael Oliver Director of Investor Relations Lloyds TSB Group plc 020 7356 2167 E-mail: [email protected] Sarah Pollard Senior Manager, Investor Relations Lloyds TSB Group plc 020 7356 1571 E-mail: [email protected] Mary Walsh Director of Corporate Relations Lloyds TSB Group plc 020 7356 2121 E-mail: [email protected] Page 21 of 21 This information is provided by RNS The company news service from the London Stock ExchangeRelated Shares:
Lloyds