1. Individual Capital Assessment David King 8 th September 2004 # !@

2. # Contents Regulatory Requirements: Pillar 1 vs Pillar 2 ICA: Implementation Progress ICA: Assumptions ICA: Implications

3. # !@ Regulatory Requirements: Pillar 1 vs Pillar 2

4. # !@ Pillar 1 vs Pillar 2 Capital Requirements Admissible assets Mathematical reserves Regulatory Peak Resilience Capital Requirement Long-term Insurance Capital Requirement WPICC Regulatory Surplus Realistic Value Liabilities Realistic Surplus Market Value Assets Market (Fair) Value Liabilities ICA Realistic Peak Pillar 1 Pillar 2 Realistic Value Assets Risk Capital Margin WPICC is set so that regulatory surplus equals realistic surplus if the former is higher; zero otherwise If realistic assets equal admissible assets, WPICC is the amount of capital to bring the regulatory peak up to the realistic level Pillar 2 Surplus

5. # !@ Risks Covered: Peak 1 vs Peak 2 vs ICA Peak 1 (LTICR + RCR + WPICC) ICA Peak 2 (RCM) Market Risk Credit Risk Insurance Risk Mortality Persistency Expenses Operational Risk Liquidity Risk Group Risk Liquidity Risk Operational Risk Insurance Risk Credit Risk Market Risk Group Risk Liquidity Risk Operational Risk Insurance Risk Mortality Persistency Expenses Credit Risk Market Risk Mortality Persistency Expenses

6. # !@ Capital Requirement Rules: Peak 1 Resilience Capital Requirement Long-Term Insurance Capital Requirement Risk CategoryAssetsLiabilities Market Risk Equity Property Fixed Interest 10-25% fall depending on: - Current to 90-day average FTSE All Share level - Earnings yield of FTSE All Share after fall equal to 4/3rds long-term gilt yield 10-20% fall depending on: - Current to 3 -year average real estate index level 20% rise or fall in long-term gilt yield Divided yield assumed unchanged Earnings yield assumed to fall by 10% Running yield assumed to fall by 10% 20% rise or fall in long-term gilt yield Market Risk-3% mathematical reserves where firm bears some investment risk, reduced by up to 15% for reinsurance Insurance Risk Expense-1% mathematical reserves where firm bears some investment risk, reduced by up to 15% for reinsurance 25% previous years net administration expenses where firm bears no investment risk Mortality-0.3% aggregate capital at risk reduced by up to 50% for reinsurance

7. # !@ Risk Capital Margin Capital Requirement Rules: Peak 2 Risk CategoryAssets and asset share* * Taking into account management and p/h actions Value of contractual guarantees Market Risk Equity 10-20% rise or fall depending on: - Current to 90-day average FTSE All share level Dividend yield assumed unchanged Earnings yield assumed unchanged Property12.5% rise or fallRunning yield assumed unchanged Fixed Interest17.5% rise or fall in long-term gilt yield Value of In-Force for non-profit contracts Outside with-profit fund: unchanged Inside with-profit fund: stress tested Unchanged Credit Risk Credit spreads increased by: (Spread Factor) x sq rt (Current Spread in Basis Points) where: Rating Spread Factor AAA 3.0 AA 5.25 A 6.75 BBB 9.25 Risk free yields assumed unchanged Insurance Risk Persistency Risk For with-profit contracts, 35% increase or decrease in realistic lapse, surrender and PUP assumptions, excluding at policy guarantee dates

8. # !@ Calculation of Capital Resource Requirements (CRR) PRU 2.1.35 defines a firms CRR to be: Resilience Capital Requirement + Long-Term Insurance Capital Requirement + With-Profit Insurance Capital Component FSA will issue Individual Capital Guidance (FSAs view of appropriate capital resources for a firm), based on the firms ICA To compare ICA with CRR, adjustment is needed for any differences in valuing assets and liabilities under Pillar 2. Possible approach: Adjusted ICA = ICA – Max (0, Realistic Value Reserves – Market Value Liabilities) – (Market Value Assets – Realistic Value Assets) Additional capital required as a result of ICA is Max (0, Adjusted ICA – CRR)

9. # !@ ICA: Implementation Progress

10. # !@ Typical ICA Methodologies: end 2004 Overall approach Time zero stress tests or projection to run off Market Risk Proprietary Economic Scenario Generator (ESG) used to inform stress tests Credit Risk Modelled by ESG Assets assumed held to maturity to capture liquidity risk premium Insurance Risk Stress tests for mortality, longevity, persistency and expenses A few companies are investigating stochastic mortality for annuities Operational Risk Characterised by lack of data Reluctant to build models without data Broad metrics used (eg x% assets) Liquidity Risk Mitigated by contingency funding arrangements (if necessary) rather than capital Group Risk Contagion risk from other group companies depends on group structure Closure to new business from contagion likely to reduce capital Aggregation Approach Market and credit risk use correlations implied by ESG Correlation matrix assumed for the other risks (assumes Normal distribution)

11. # !@ Methodology enhancements for 2005? Overall approach Projected Realistic Balance Sheets modelled Run off projections with intermediate solvency testing Market Risk Development of in-house ESG expertise; own calibration Credit Risk More sophisticated approach to credit risk modelling Insurance Risk Stochastic mortality models developed for annuities Dynamic linking of persistency and market risk Operational Risk Since this is a material component of ICAs, companies develop stochastic models of risks and controls Liquidity Risk None Group Risk Deeper consideration of contagion risk Aggregation Approach Since this has a material impact on capital requirements, development of more sophisticated approaches

12. # !@ Current Implementation Issues Overall approach Projected one-year RBS vs run-off projections Determination of additional Pillar 1 capital requirement from ICA Assumptions for recalculating ICA after a market fall Market Risk Calibration of ESG to produce real world scenarios that reflect historic data Credit Risk Identifying the liquidity risk premium component of corporate bond credit spreads Allowing for credit risk in inter-group reinsurance arrangements Managing credit risk concentration risk with reinsurance arrangements Insurance Risk Allowance for longevity improvements Operational Risk Treatment of final salary pension schemes Data to support risk capital calculations Liquidity Risk Group Risk Allowance for capital support from other group companies Treatment of ICA for overseas subsidiaries Aggregation Approach Understanding sensitivity of correlation assumptions Justification of partial correlations, especially in extreme scenarios

13. # !@ ICA: Assumptions

14. # !@ Typical ICA Stress Tests vs RCM RCMTypical ICA Stress Tests Market Risk Equity Property Fixed Interest Yields - +/- 0.9% Value +/- 10% +/- 12.5% +/- 6.5% * Yields - -1.0% Value -40% -25% -7.5% Credit RiskChange in credit spread Change in market value* Companies are mainly considering changes in market value for the portfolio; typically this is a fall of around 10% AAA 21-10.6% AA44-3.3% A 68-5.1% BBB 113-8.3% Insurance Risk Mortality+20% Persistency +/-35%+/-50% Expenses +10% and increase in expense inflation * Based on 10-year gilts

15. # !@ Typical Correlation Assumptions Correlations MarketCreditInsuranceOperationalLiquidityGroup Equity Fixed interest PropertyMortalityPersistencyExpenses Equity 1.000.000.300.650.000.500.650.500.25 Fixed interest 1.000.300.650.000.50 0.25 Property 1.000.650.000.500.650.500.25 Credit 1.000.000.400.650.200.100.25 Mortality 1.000.00 0.300.10 Persistency 1.000.40 0.250.40 Expenses 1.000.500.250.10 Operational 1.00.100.25 Liquidity 1.000.10 Group 1.00 Typically, companies are reporting diversification benefits of around 25-30%

16. # !@ ICA: Implications

17. # !@ Shareholder Value Implications of ICA Product Development Price new business using ICA (large impact on annuities and products with guarantees) Redefine commission structures Reduce Risk-Based Capital Better matching to reduce market risk De-risking with-profit funds (lower EBR, charging for guarantee costs, hedging) Reinsurance Arrangements Manage credit risk exposure Review efficiency of existing reinsurance arrangements Group Structure Revise group structure to optimise capital position Consider combining operating companies Portfolio Mix Buy and sell portfolios of business to maximise diversification benefits Performance Management Align performance measures to Risk-Based Capital Reward management according to these measures

18. # !@ Top Ten Management Actions From ICA 1.Ensure the firms ICA calculation is consistent with its risk policies 2.Collect and analyse company/market data to justify volatilities and correlations 3.Build management information systems to understand risk exposures 4.Understand key drivers of ICA and develop mitigations to reduce capital requirements 5.Develop analysis of change in ICA over the period 6.Take ownership of calibration of the ESG 7.External review of ICA to negotiate Pillar 1 waivers 8.Develop management information to ensure ICA known at all times 9.Price new business to reflect ICA capital costs 10.Manage business on the basis of risk based capital