Financial review - Chief Financial Officer's report
Financial strength
Financial strength
The overall financial position of the Group continues to be strengthened with further action taken during 2005 on the balance sheet, capital position, pension fund deficit and the Group's credit rating. The following section discusses these actions as well as the Group's investment policy.
Balance sheet
The strength of the Group's balance sheet and capital position has further improved during 2005, capitalising on the good work already done in 2003 and 2004.
Shareholders' funds for the Group has risen by 18% to £2.7bn at 31 December 2005. This reflects a 21% increase in shareholders' funds for the Core Group to £2.3bn, whilst the value of the US business remained stable at £0.4bn.
The improvement in the Core Group shareholders' funds reflects the increase in retained profits and the positive impact of the pension fund changes. We have also strengthened reserves during the year and reserves for the Core Group are now over 200% of net earned premium.
Investment policy
The Group continues to operate a low risk investment policy. In accordance with this policy the structure of the investment portfolio remains dominated by high quality fixed income and cash assets which, when combined with equity and property, are held to provide a broad match to the duration of our insurance liabilities.
Group investments now total £15.6bn. In line with our investment policy, £11.6bn or 74% of this is invested in bonds. Bond holdings are typically of a relatively short term to maturity, with the average duration of the portfolio being just under three years, reflecting the short tail nature of the Group's insurance portfolio. 81% of the fixed interest portfolio was invested in AA grade or better assets and less than 1% is held in non investment grade.
The Group's holding in equities has remained stable for a number of years with approximately £1.7bn or 11% of the Group's investment portfolio invested in equities. We do not envisage any significant change to the Group's investment strategy.
Capital position
As I discussed in last year's report, there were a number of regulatory changes that came into effect from 1 January 2005. We were fully compliant with the FSA's new capital requirements on introduction and have strengthened our position further during the year.
For the Group, compliance with the Insurance Groups Directive (IGD) is one of the main requirements. As at 31 December 2005, the Group had surplus capital of approximately £1.0bn on the IGD basis, an increase of 0.4bn in the year. This surplus gives a coverage ratio of 1.6 times the requirement.
We are comfortable with the level of capital and have sufficient capital to deliver our operational plans.
The other principal capital measure for the Group is the Individual Capital Assessment (ICA). In accordance with the new Prudential requirements we have satisfactorily agreed our ICA with the FSA, which at their request, and in common with the rest of the industry, remains confidential. The ICA is a forward looking, economic assessment of the capital requirements of the Group based on our assessment of the risks that we are exposed to. The models used to determine the ICA have been integrated into the Group's business processes and are used to enhance the management of the Group.
We continue to push forward with a number of ongoing initiatives targeted at improving balance sheet and capital efficiency. We have successfully renegotiated our senior debt facility on better terms and conditions, shorter duration and at a lower cost. We have also repaid the senior debt in full.
We are streamlining the Group's regulatory structure and reducing legal entities. We are also looking at ways to improve the capital efficiency of some of our discontinued lines of business.
TopPension fund
As I have already mentioned, under IFRS the Group has to recognise the pension fund deficit on the balance sheet. At 31 December 2005 the net of tax pension fund deficit has been reduced by £174m to £370m reflecting a number of actions taken by the management team.
Set out below is a table which shows the main movements in the net of tax pension fund deficit during 2005:
| Core Group | ||||
|---|---|---|---|---|
| £m | UK | Other | US | Total |
| As at 1 January 2005 | (370) | (23) | (151) | (544) |
| Market movement, exchange and other | (27) | (5) | (6) | (38) |
| Scheme design | 126 | – | – | 126 |
| Deficit funding | 60 | – | 26 | 86 |
| As at 31 December 2005 | (211) | (28) | (131) | (370) |
In July 2005, we announced some significant changes to our main UK pension schemes. Following discussions with staff and unions, it was agreed that the schemes would be changed from being based on final salary to ones based on average career earnings. The impact of this change was to reduce the UK pension fund deficit by £180m gross of tax (£126m net of tax).
In addition, the Group also replaced its UK deficit funding plan with an accelerated programme. Under this programme, the Group contributed £86m gross of tax (£60m net of tax) in 2005 and has committed to contribute the same amount in each of 2006 and 2007.
Action has also been taken to reduce the impact of future interest rate and inflation movements on the pension fund. The pension funds will, however, remain subject to short term market movements.
Rating agencies
Rating agencies such as Standard & Poor's (S&P), AM Best and Moody's Investor Service provide insurer financial strength ratings for the Group and its principal subsidiaries. These ratings are based on both quantitative and qualitative assessments of the Group's current position and future direction.
During 2005, the ratings from S&P and AM Best remain unchanged at A- (stable) and A- (negative) respectively. In March 2006, Moody's upgraded their outlook for the Group from Baa1 (stable) to Baa1 (positive).
We are committed to returning the Group's rating with all of the major agencies to 'A'.
Details of the Group's ratings can be found in the Investor Relations section under Bond Investor Information on the Group's website.
