4. The Role of the Independent Expert Existing Court-Approved Schemes Capital Requirements and Risk Appetite Framework 61

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2 Contents 1. Introduction 4 2. Summary and Conclusions Outline of the Scheme The Role of the Independent Expert Existing Court-Approved Schemes Capital Requirements and Risk Appetite Framework Implications for Transferring SW Policyholders Implications for Transferring CMIG Policyholders Implications for Existing CMIG Policyholders Ongoing Governance, Administration and Investment Management Tax Considerations Policyholder Communications 110 Appendix 1: Independent Expert Terms of Reference 113 Appendix 2: SUP 18 and PRA Statement of Policy Cross Reference 115 Appendix 3: Background to SW 118 Appendix 4: Background to CMIG 124 Appendix 5: Summary Pillar 1 Financial Information 129 Appendix 6: Description of Reinsurance Arrangements 132 2

3 Appendix 7: SW WPF PFM Mapping 141 Appendix 8: CMIG WPF PFM Mapping 149 Appendix 9: Data and Reliances 159 Appendix 10: Glossary 164 3

4 Introduction 1. Introduction The Independent Expert 1.1. When a scheme for the transfer of insurance business from one company to another is submitted to the High Court of Justice of England and Wales (the Court ) for approval, it has to be accompanied by a report from an Independent Expert. This is a requirement of Section 109 of Part VII of the Financial Services and Markets Act 2000 ( FSMA ) and the report must be made in a form approved by the Prudential Regulation Authority ( PRA ) having consulted the Financial Conduct Authority ( FCA, together with the PRA, the Regulators ) I have been appointed as the Independent Expert to provide the required report on a proposed scheme for the transfer of the entire long-term insurance business of Scottish Widows plc ( SW ), Scottish Widows Annuities Limited ( SWA ), Pensions Management (S.W.F.) Limited ( PMSWF ), Scottish Widows Unit Funds Limited ( SWUF ), Clerical Medical Management Fund ( CMMF ), Halifax Life Limited ( HLL ) and St Andrew s Life Limited ( SAL ) (the Transferring Companies ) to Clerical Medical Investment Group ( CMIG ). All of the companies involved in this proposed scheme of transfer (the Scheme ) are entities within the insurance division of Lloyds Banking Group plc (Lloyds Banking Group Insurance ( LBGI ), a division of LBG and part of the group of entities comprising the LBG Group ) I have been appointed jointly by the Transferring Companies and CMIG (together, the Companies ). My appointment has been approved by the PRA, having consulted with the FCA I am a Fellow of the Institute and Faculty of Actuaries, having qualified in 1989, and am a Partner in the Actuarial and Advanced Analytics practice of Deloitte MCS Limited ( Deloitte ). I am an approved person under the PRA Register and between 2002 and 2015 I have carried out the different regulated roles of With-Profits Actuary, Actuarial Function Holder and Appointed Actuary for various UK insurers. I have been the Independent Expert on more than ten Part VII schemes that have been approved by the Court. I have also acted as an Expert Witness, as the PRA-appointed Skilled Person in investigations of the management and solvency of with-profits funds, and have advised many UK companies on the management of with-profits funds. Independence 1.5. Neither I, nor my immediate family hold any policies, investments, shareholdings or have any other financial interests with any of the Companies. I have not advised the Companies on any significant projects in the past Partners and staff of Deloitte have advised, and continue to advise, the Companies on various assignments. However, we have not acted as external auditor or performed any regulatory roles. We have not acted for the Companies in developing any aspects of the Scheme, and have not carried out any of the calculations (or the development of any of the underlying financial models) connected with the Scheme. I do not believe that any of these assignments compromise my independence, create a conflict of interest, or compromise my ability to report on the proposed Scheme. The assignments were disclosed to the PRA prior to their approval of me as the Independent Expert. 4

5 Introduction Regulatory and Professional Guidance 1.7. This Report has been prepared in accordance with The Prudential Regulation Authority s approach to insurance business transfers PS7/15 (the PRA Statement of Policy ), which came into effect on 2 April The Report is also consistent with the guidance contained in Chapter 18 of the Supervision Manual of the Regulators Handbook of Rules and Guidance ( SUP 18 ) for scheme reports relating to the transfer of long-term insurance business. Appendix 2 details how these requirements have been met in the Report through cross-references between the PRA Statement of Policy and SUP The Financial Reporting Council ( FRC ) has issued standards which apply to certain types of actuarial work. I have prepared this Report, with the intention that it, and the actuarial work underlying it, should meet the requirements of Technical Actuarial Standards TAS D, TAS M, TAS R (which cover, respectively, data, modelling, and reporting actuarial information), the Insurance TAS and the Transformations TAS. I believe that it does so in all material respects and I have applied all of the principles outlined in the Transformations TAS in reaching the opinions stated in this Report. The Scope of my Report 1.9. My terms of reference have been agreed with the Companies and seen by the Regulators and are set out in Appendix The Scheme will be submitted to the Court for sanction under Section 111 of Part VII of the FSMA. If approved, it is expected that the Scheme will become operative and take effect on 31 December 2015 (the Effective Date ). This report (my Report ) and any supplementary report (my Supplementary Report and, together with my Report, my Reports ) will be presented to the Court at a hearing (the Sanction Hearing ) and it is likely that the Court will consider the contents of these Reports in deciding whether to sanction the Scheme The Scheme will have the effect of replacing a number of existing schemes, including two which were sanctioned by the Court of Session in Scotland (the Court of Session ). Separate applications (the Court of Session Applications ) are to be made regarding these replacements for the approval of the Court of Session This Report considers the consequences of the Scheme for the policyholders of each of the Companies, and sets out my findings. I am not required to, and do not, consider the position of each policyholder, but I have reviewed the consequences for each class of policyholders at the level I regard necessary to satisfy the requirements of the PRA Statement of Policy and SUP I am required to comment on the proposed Scheme, and my Report is not concerned with possible alternatives to the Scheme To the best of my knowledge, I have taken account of all material facts in assessing the impact of the Scheme and in preparing this Report. In order to reflect any updated financial information or circumstances nearer to the date of the Sanction Hearing, I expect to provide a Supplementary Report setting out my updated opinions in respect of the Scheme In reporting on the Scheme as the Independent Expert, I recognise that I owe a duty to the Court to assist on matters within my expertise. This duty overrides any obligation to the Companies from 5

6 Introduction whom I have received instructions. I believe that I have complied, and confirm that I will continue to comply, with this duty. I also confirm that I am aware of the duties and requirements regarding experts set out in Part 35 of the Civil Procedure Rules, Practice Direction 35 Experts and Assessors and the Protocol for Instruction of Experts to give evidence in Civil Claims Readers of my Report may find it helpful to read some of the other related Scheme documents (see paragraph 12.6 for details on these documents, which can be obtained online or will be mailed on request). I have considered each of these in coming to my opinions, but have not relied on any opinions therein. Reliances and sources of information In performing my review and preparing this Report, I have relied on the accuracy and completeness of data and information provided to me, both written and oral, by the Companies. I have reviewed the information for consistency and reasonableness using my knowledge of the UK life insurance industry but have not otherwise verified it My analysis of the solvency position of the Companies is based on Pillar 1 calculations, the requirements for which are set out in UK regulations. I have reviewed estimates of what the pre- and post-scheme financial position would have been had the Scheme been implemented as at 31 December The estimates have been produced by the Companies and are referred to in later Sections and in Appendix 5. I have not checked these estimates or the processes used to calculate them and have relied on them in carrying out my analysis. I believe this is reasonable since the models, processes, data and assumptions used to produce the pre-scheme position of the various Companies are well established, are used to produce published results and are audited. The post- Scheme position has been produced using the same processes, data and models, but with a different aggregation of the results to reflect the new proposed structure Although I did not check the figures, I asked the Companies to explain, check and/or clarify any results that seemed to me unreasonable or inconsistent with other data all such queries have been answered to my satisfaction The Report also comments on a second set of solvency calculations, known as the Pillar 2 or Individual Capital Adequacy Standard ( ICAS ) calculations. These are not audited, but are submitted to and can be reviewed by the PRA These calculations are produced using established processes, are checked by the Companies and are used by them in practice as an important input to decision making. A material error in these figures would be a significant matter, and so I believe it is reasonable to rely on their accuracy, subject to reasonableness checking as stated above The Report also considers a set of solvency calculations based on the Companies expected positions under the new regulatory solvency regime expected to come into force on 1 January 2016 ( Solvency II ). These are not yet subject to audit, but will be submitted to the PRA in the lead-up to Solvency II. The majority of the underlying calculations are produced using a consistent process and methodology to the Pillar 2 results. A material error in these figures would be a significant matter, and so I believe it is reasonable to rely on their accuracy, subject to reasonableness checking as stated above. There are areas of the Solvency II calculation where the Companies will require approval from the PRA in order to adopt a particular approach. As set out in Section 6, I have 6

7 Introduction considered sensitivities to two material approval decisions as part of my analysis of the impact of the Scheme on a Solvency II basis I note that the economic position at the Effective Date cannot be predicted with certainty. The absolute solvency level at the Effective Date will therefore differ from that shown in the Report, but I would not expect the impact of the Scheme to vary significantly from the estimates shown and it is this impact which is my primary consideration (alongside the Companies continuing to satisfy regulatory solvency requirements, as is currently the case). As part of my analysis, I have considered projections provided by the Companies of the expected solvency position at the Effective Date. I will continue to keep the position under review in the period leading up to the Sanction Hearing, and will prepare further information in my Supplementary Report Selected financial information, data and written information which I have relied on is listed in Appendix 9. Limitations This Report has been prepared solely for the use of the Companies and the Court, and solely for the purpose of assisting in determining whether the Scheme should be permitted. It should not be used for any other purpose. Policyholders, reinsurers and any others affected by the Scheme may also place reliance on the Report (when it is finalised), as stated in paragraph 2.31 of the PRA Statement of Policy and in SUP , but it may not be relied upon by any other party for any purpose whatsoever. Neither I nor Deloitte, its partners and staff owe or accept any duty to any other party and shall not be liable for any loss, damage or expense (including interest) of whatever nature which is caused by any other party s reliance on representations in this Report This Report should be considered in its entirety, as parts taken in isolation may be confusing. A copy of the final version of my Report may be provided to the following parties: The Court, to assist in determining whether the Scheme should be permitted. The Court of Session, to assist in determining whether the Court of Session Applications should be approved. The Regulators, for the purposes of the performance of their statutory obligations under FSMA. Legal advisers of the Companies in connection with the Scheme provided that the Companies inform them that neither Deloitte nor I accept any responsibility or liability to them in respect of any use they may make of the Report. Tax advisers of the Companies (internal and external), subject to the external tax advisers signing an agreed release letter. Any other person who has or asserts a right to receive a copy of this Report, as provided for under the terms of the FSMA, the PRA Statement of Policy and SUP 18.2, or any Jersey, Guernsey or other non-eea resident policyholder who has or asserts a right to receive a copy of the Report under the terms of local legislation (an Interested Party and collectively the Interested Parties ). 7

8 Introduction Other insurance regulators who have a legitimate interest in the Scheme and the local schemes in Jersey and Guernsey (the Channel Islands Schemes, see paragraphs 3.19 and 3.20 below). The relevant court in Jersey or Guernsey, solely in connection with the Scheme or the Channel Islands Schemes The Companies have been advised that, in order to transfer insurance business carried on in, or from within, Jersey and to transfer policies issued to residents of the Bailiwick of Guernsey, local schemes ( the Channel Island Schemes or the local schemes ) will also need to be effected, subject to the sanction of the Royal Court of Jersey or Royal Court of Guernsey (the Channel Islands Courts ). The terms of the transfers under the local schemes are based on (and are in all material respects the same as) the Scheme and the local schemes are expected to take effect on the same date as the Scheme. The local schemes are conditional upon the Scheme becoming effective. In the event that the transfer under a local scheme is delayed, the policies intended to be transferred thereunder (if any) will be fully reinsured pursuant to the Scheme until the relevant local scheme transfer is effected In writing this Report, I have also considered the effect of the Channel Islands Schemes on policyholders. My Report and conclusions apply equally to business carried on in, or from within, Jersey or Guernsey and to policies issued to residents of the Bailiwick of Guernsey as they do to business comprising policies held by residents in the UK or any other territory, and this Report may therefore be used to satisfy the requirement for a report by an independent actuary on the terms of the local schemes in Jersey and Guernsey. I will, as necessary, provide additional reports or commentary in respect of Jersey and Guernsey to assist the Channel Islands Courts A copy of this Report may be published on the websites of the Companies and made available for inspection at the offices of the Companies solicitors. Otherwise, this Report (or any extract from it) should not be published without the prior written consent of Deloitte. A summary of the Report, approved by me, will be made available by the Companies to the policyholders of the Companies with an interest in the Scheme. No other summary of this Report may be made without the prior written consent of Deloitte. Form of my Report Section 2 is a summary describing what the Scheme is designed to do, and setting out the key considerations and my conclusions Section 3 describes the various Companies involved in the Scheme, and how they are impacted Section 4 explains the role of the Independent Expert and the approach I have taken in carrying out my analysis and reaching my conclusions Section 5 describes the schemes of demutualisation of SW and CMIG, how I have considered these in reaching my conclusions, and my view as to whether policyholder protections in those schemes are retained in the Scheme Section 6 provides the key information relating to the security of policyholder benefits before and after the Scheme. 8

9 Introduction Sections 7, 8 and 9 deal with policyholders transferring under the Scheme and existing (nontransferring) policyholders of CMIG, and set out my analysis and conclusions on how they are affected by the Scheme in respect of benefit security and benefit expectations. Each section is written so that a policyholder in the relevant Company can understand the significant implications of the Scheme for them by reading it. This approach means there is some repetition across these Sections Section 10 explains the effect of the Scheme on the service standards and investment management services provided to policyholders Section 11 considers any implications the Scheme has on tax matters Section 12 deals with the plans for communicating the Scheme to policyholders, and my opinion on those plans Further background information is given in the appendices, which include my terms of reference and a glossary. 9

10 Summary and Conclusions 2. Summary and Conclusions Introduction 2.1. I have been appointed as the Independent Expert to provide the required report on the Scheme for the proposed transfer of long-term insurance business from SW, SWA, PMSWF, SWUF, CMMF, HLL and SAL to CMIG. I have been appointed jointly by the Companies. My appointment has also been approved by the PRA, having consulted with the FCA I am a Fellow of the Institute and Faculty of Actuaries, having qualified in 1989, and am a Partner in the Actuarial and Advanced Analytics practice of Deloitte. I have acted as the Independent Expert on more than ten previous Part VII schemes that have been approved by the Court I am independent of the Companies involved in the Scheme, and neither I nor any partner or member of staff of Deloitte has acted for the Companies in developing any aspects of the Scheme I have considered the effect which the proposed Scheme is expected to have on the different groups of policyholders in the Companies, and whether the position of any group is, or is likely to be, materially adversely affected. Paragraph 4.3 explains how I have interpreted this. This Report sets out my findings, to assist the Court in deciding whether or not to allow the Scheme to go ahead The Scheme will be submitted to the Court at the Sanction Hearing expected to be held in November If approved, it is expected to become effective on 31 December I will continue to review the implications of the Scheme for policyholders, and I expect to provide a Supplementary Report for the Court shortly in advance of the Sanction Hearing, providing updated analysis and stating my final conclusions regarding the impact of the Scheme on policyholders. Purpose of the Scheme 2.6. The Scheme will transfer the entire long-term insurance business held by SW and its subsidiaries, namely SWA, PMSWF, SWUF, CMIG, CMMF, HLL and SAL into one consolidated company, without affecting the terms and conditions of the policies, the benefits payable or how the policies are managed. This will simplify the corporate structure of LBGI, leading to improved liquidity and capital efficiency. Rebranding 2.7. Following the Scheme, it is intended that CMIG will be renamed as Scottish Widows Ltd ( SW Ltd ). For clarity, I refer to the post-scheme company as SW Ltd, not CMIG, other than where I describe the transfers of assets, liabilities and policies effected by the Scheme in Section The change of name is dependent on clearance from Companies House, as the word Scottish is a reserved word when used in the context of a company name. Approval has been received in principle, but cannot be confirmed until near the date of the Sanction Hearing. I am not aware of any reason why this approval would not be confirmed in due course, but will continue to monitor this and will provide an update in my Supplementary Report on the Scheme. 10

11 Summary and Conclusions 2.9. It is important to note that this rebranding will not be applied retrospectively. Existing policies will retain their branding of Scottish Widows, Clerical Medical or Halifax Financial Services, reflecting the origin of the business writer. Policyholders should not notice a significant change in their interactions with the Companies Future new business will be sold only through the Scottish Widows brand name. This does not represent a change to the current position, where only very limited volumes of incremental business are written outwith SW. As a result, I am satisfied that this change should not materially affect the volumes or mix of new business sold or the interests of existing policyholders I understand that inclusion or otherwise of the word Scottish in the company name may stir the emotions of some policyholders, especially in the light of the Scottish independence issue, but I am satisfied that, whatever the decision from Companies House, it will not affect their actual position, policy terms or rights. Description of the Scheme A diagram outlining the transfers of assets, liabilities and policies under the Scheme is provided in Figure 2.1. Figure 2.1: Transferring policies under the Scheme HLL, CMMF and SAL are wholly-owned subsidiaries of the CMIG shareholder fund (the CMIG SHF ). CMIG and its subsidiaries are wholly-owned subsidiaries of the shareholder fund of SW (the 11

12 Summary and Conclusions SW SHF ). SW has three other regulated insurance subsidiaries: PMSWF and SWUF, which are subsidiaries of the non-profit fund in SW (the SW NPF ); and SWA which is a subsidiary of the SW SHF At the Effective Date, all of the assets, liabilities and policies within the SW NPF and the long-term funds of SWA, SWUF, PMSWF, HLL, CMMF and SAL will be transferred to the non-profit fund in CMIG (the CMIG NPF ). The assets and any liabilities of the shareholder funds will be transferred to the CMIG SHF, with the exception of assets required to meet the remaining regulatory capital requirements At the Effective Date, the assets and liabilities relating to all business in the SW with-profits fund (the SW WPF ) will be transferred into a newly created fund in SW Ltd (the Scottish Widows WPF ), which will be ring-fenced from the CMIG with-profits fund (the CMIG WPF ). The CMIG WPF will continue to operate in the post-transfer entity as a distinct, ring-fenced with-profits fund In addition to the subsidiaries listed above, the smaller regulated SW subsidiaries, Scottish Widows Administration Services Limited and Scottish Widows Unit Trust Managers Limited, will also transfer to CMIG as assets of SW. The Scheme will not result in the ownership of the subsidiaries changing from a with-profits fund to the shareholder fund or vice versa I have provided an overview of the pre- and post-scheme entity structure in Figures A3.2 and A3.3 within Appendix Following the implementation of a new solvency regime called Solvency II, the requirement to maintain separation between the CMIG SHF and the CMIG NPF will fall away, and there will be no benefit in doing so. The Scheme allows for these funds to be combined into the Combined Fund at the Combination Date, which has been set to coincide with the implementation of Solvency II. Main considerations As the Independent Expert, I am required to consider the effect of the Scheme on each class of policyholder. In all cases, in arriving at my opinion I have discussed the Scheme s documentation and intended operation with the management of the Companies as part of my review I have considered the implications of the Scheme for the following groups of policyholders separately, as the analysis differs in each case: Policyholders transferring from any subsidiaries of CMIG, namely CMMF, HLL and SAL (the Transferring CMIG Policyholders ), and their policies (the Transferring CMIG Policies ). Policyholders transferring from SW and the direct subsidiaries of SW other than CMIG i.e. SWA, SWUF and PMSWF (the Transferring SW Policyholders ), and their policies (the Transferring SW Policies ). Existing policyholders of CMIG (the Existing CMIG Policyholders ), and their policies (the Existing CMIG Policies ). Within the groups above, I have considered with-profits policies, non-profit policies and unitlinked policies separately. 12

13 Summary and Conclusions Within the groups above I have also considered different generations of policyholders. For many issues, there are no generational differences, but for a few specific points there are. In particular, I have considered whether the impact of the Scheme differs for policyholders in the SW WPF and CMIG WPF, depending on whether their policies were written before or after the formation of those funds under the respective demutualisation schemes. I note that SWUF has no policyholders of its own, but accepts reinsurance of unit-funds of pension policies in SW. I have considered policy-related liabilities in SWUF as part of the Transferring SW Policies The Scheme does not change the terms and conditions of any policy. However, as policies move from one fund to another, other factors can change, such as the level of benefit security. I have considered the likely impacts of the Scheme on the security of policyholder benefits, the reasonable benefit expectations of policyholders, service standards, investment management, and the governance arrangements in place to ensure policyholder interests are protected in future. Provisions of existing Court-approved schemes There are a number of historical schemes that affected various groups of policyholders that I consider as part of this Report. These Existing Schemes are either replaced or transferred under the Scheme and, where applicable, I have considered whether the replacement of their provisions results in an adverse effect for policyholders. Within my analysis, I have paid particular attention to the SW Scheme and the CMIG Scheme (as defined in Section 5), which were demutualisation schemes and which are important in defining how the SW WPF and the CMIG WPF (together the WPFs ) currently operate Section 5 sets out my detailed analysis of the Existing Schemes but, in summary, I am satisfied that the provisions of the Existing Schemes are either: Historical, with no ongoing relevance. Satisfactorily replicated in the Scheme. Can be removed with no material effect on policyholders In particular, I have concluded that the Scheme: Preserves the accounts and arrangements in place to provide ongoing support to the SW WPF (for solvency and investment strategy purposes), subject to updates in respect of Solvency II which are required regardless of the Scheme. Removes the concept of a Bonus Deficit Account in respect of the CMIG WPF, but the need for this account would have lapsed at the end of 2016 anyway and it is extremely unlikely to be utilised before that point, as it has never previously been utilised since its inception in 1996 and the test to determine whether it was required showed an excess of 1.3bn at 31 December Does not change the principles as to when support will be provided to the WPFs or the terms on which the support will be provided. I note that the tests for determining when support is 13

14 Summary and Conclusions provided have been updated to reflect Solvency II, but that was required regardless of the Scheme. Preserves the key principles of how the SW WPF and CMIG WPF are managed, with the remaining original principles now covered by being the relevant PPFM document, or being unnecessary in light of regulatory developments since the SW Scheme and CMIG Scheme were approved. Brings governance of the SW WPF in line with current regulatory guidance. Preserves the requirement for regular certification in respect of the proper operation of the SW and CMIG WPFs, which are stated in the SW and CMIG Schemes respectively. After the Transfer certification will be made annually to the Transferee Board, rather than being included in the PRA Returns Where provisions have been included in the Scheme that update references to the current solvency regime to equivalent references under Solvency II, I am satisfied that the changes are reasonable and note that they would have been required absent the Scheme A number of the Existing Schemes included a provision that requires certification from an independent actuary in the event of any changes to them. I will provide this certification, if it is justified, in my Supplementary Report. Policyholder benefit expectations In considering policyholder benefit expectations, I would be concerned if the Scheme was likely to materially adversely affect the level of benefits expected to be paid under any policy, but I have concluded that this is not the case. This view extends to any changes as a result of the Scheme replacing or transferring the Existing Schemes I confirm that for all groups of policyholders the Scheme does not change the: Value of any policy. Death, maturity or other contingent benefits payable under any policy. Surrender value of any policy. Premiums payable under any policy. Current or expected level of charges under any policy. Asset mix underlying any policy or the range of investment choices available. Range of options available under any policy and the guarantees included in the contract. Charges made for tax under any policy, or their eligibility for any favourable tax treatment. Terms and conditions of any policy. 14

15 Summary and Conclusions There are some further points to consider, and these vary by company and policy type. Accordingly, I discuss separately the impact of the Scheme on the benefit expectations of each group of policyholder outlined in paragraph With-profits policies The following key considerations apply to with-profits policies in the SW WPF and the CMIG WPF. Taking account of these, I am satisfied that the Scheme will not have any material effect on the benefit expectations of holders of those policies: None of the key considerations relevant to with-profits policies will change as a result of the Scheme, including the basis on which asset shares are determined, the current level of asset shares and guaranteed benefits, the expected level of emerging profits or how they are shared, expected bonus rates and payout levels, or the smoothing of payouts. All of the assets, liabilities and policies of the SW WPF transfer to the Scottish Widows WPF, and all of the assets, liabilities and policies of the CMIG WPF remain in place, unchanged. Hence, immediately following the Scheme, the Scottish Widows WPF and CMIG WPF will have an identical financial position to that of the SW WPF and the CMIG WPF respectively immediately before the Scheme. The sizes of the Additional Account and the Retained Account within the SW WPF will also be unchanged by the Scheme. With-profits policies will continue to participate in emerging profits and losses from business written in the SW WPF and the CMIG WPF, including any non-profit business written in each. The Scheme will not result in any changes to the expected level of those emerging profits or losses, or how they are shared. The Scheme replicates the option (not currently exercised) for the Scottish Widows WPF to write future vesting annuity business in the Combined Fund or within another entity of the Group. As at 31 December 2014 there were non-profit liabilities of approximately 2.7bn in the SW WPF. This amount has decreased significantly following the transfer in June 2015 of non-profit annuity business with reserves of c. 2.5bn as at 31 December 2014 from the SW WPF to the SW NPF. Further details can be found in Section There is not a significant volume of non-profit business in the CMIG WPF. With-profits policyholders have a contingent interest in any surplus assets in their particular fund, and will receive a share of any such assets that are distributed in the future (paid to policyholders remaining in the fund at the time). The level of surplus assets is unchanged by the Scheme, and so the value of this contingent interest is unaffected in each case. In particular, the with-profits policies which were in force at the effective date of the SW Scheme will continue to have a contingent interest in any surplus assets in the Additional Account and the Retained Account. I note that the level of surplus may change as a result of the introduction of Solvency II, but this is not a Scheme-related change. There will be no changes to the investment policy or asset mix of either with-profits fund as a result of the Scheme. There may be small changes to the investment policy of the SW WPF as a result of Solvency II, but these are not the result of the Scheme. 15

16 Summary and Conclusions The key elements relating to the ongoing management of the SW WPF and the CMIG WPF, as set out in their respective existing schemes and PPFMs, are replicated by the Scheme and revised PPFMs in the new Scottish Widows WPF and CMIG WPF respectively. The expenses that will be charged to the Scottish Widows WPF are unchanged from those charged to the SW WPF, other than a small potential change in investment expenses due to the move to Solvency II, which would have occurred absent the Scheme. The expenses that will be charged to the CMIG WPF are unchanged by the Scheme. The SW WPF benefits from various support accounts and arrangements that support the investment strategy. These may provide extra capital in defined circumstances. I am satisfied that there are no adverse changes to these as a result of the Scheme. The Scheme does not change the way in which the estate of the CMIG WPF is operated, including the way in which it is expected to be distributed. The Scheme introduces the power for SW Ltd to close the Scottish Widows WPF or the CMIG WPF should the liabilities of either fall beneath 500m, or to merge them in those circumstances. I am satisfied that the Scheme includes various strong protections to prevent an adverse policyholder impact should such action be taken, and I consider this to be the most important aspect of my analysis of the potential impact of these clauses on policyholder interests. I am also satisfied that the proposed threshold of 500m is reasonable, being comparable to similar arrangements that I have seen for peer companies. I note that both funds are projected to remain well above the threshold until beyond None of the costs of the Scheme will be borne by the SW WPF or the CMIG WPF before the Scheme or by the Scottish Widows WPF or the CMIG WPF thereafter. Unit-linked policies The following key considerations apply to all unit-linked policies in the Companies. Taking account of these, I am satisfied that the Scheme will not have an effect on the benefit expectations of holders of those policies: The unit-linked policies will remain invested in the same unit-linked funds as previously, with the same number and value of units, and with the same range of fund choice available to them. The pricing principles used for each unit-linked and unitised with-profits fund will be unchanged by the Scheme. There will be no change to the investment mandates, charges or taxation of any unit-linked fund as a direct result of the Scheme. The Scheme will give SW Ltd the power to merge, split or close unit-linked funds, where this is not precluded by the terms and conditions of the affected policies or by regulation (including the Treating Customers Fairly ( TCF ) regulations). Such powers are important tools for insurers to facilitate the effective ongoing management of the unit-linked funds. While the Companies have confirmed that there are no plans in place to exercise these powers as a direct result of the 16

17 Summary and Conclusions Scheme, there are internal governance procedures that protect policyholders if the powers are exercised in future, by requiring the consideration of appropriate actuarial advice and the obligations of the Companies under TCF. The committees within the Companies with responsibility for the management, administration and investment of unit-linked funds have confirmed (where it is within their remit) that these important aspects will be unchanged by the Scheme and that they are not aware of any operational changes that will be driven by the Scheme. I view this as a useful additional assurance that the benefit expectations of policyholders with unit-linked policies will not be affected by the Scheme. Other non-profit policies The following key considerations apply to all non-linked, non-profit policies (referred to as non-profit within this Report) in the Companies. Taking account of these, I am satisfied that the Scheme will not have an effect on the benefit expectations of holders of those policies: Non-profit policies have guaranteed benefits and specified premiums, and these do not change under the Scheme. There will also be no change to the terms and conditions of these policies. Some non-profit policy terms have reviewable terms such as premiums, which can be triggered by certain conditions. These conditions and the decision-making process for these reviews will not be changed by the Scheme. Policies with investments reinsured to the WPFs There are a number of policies within LBGI which gain exposure to unitised with-profits funds through a reinsurance or inter-fund agreement. On the basis of the analysis below, I am satisfied that the Scheme will not have any material effect on the benefit expectations of these policies: Access to the relevant with-profits fund will continue post-scheme, under the same terms, either by way of the same arrangement as now, or a new inter-fund agreement between that fund and SW Ltd. As set out in paragraph 2.30, I am satisfied that the Scheme will not have a materially adverse effect on the benefit expectations of the with-profits policyholders currently in CMIG or SW. These conclusions apply equally to the reinsured unitised with-profits investments. Other than the unitised with-profits investment link, the policies with such an investment are directly comparable to the other unit-linked policies and my conclusions above in respect of those set out in paragraph 2.31 are equally applicable. Conclusion on benefit expectations For the reasons stated above, I am satisfied that the Scheme will not have a material effect on the benefit expectations of any group of policyholders. 17

18 Summary and Conclusions Benefit security Another key part of my considerations is the security of policyholders benefits. I would be concerned if the Scheme meant that some policies move from a financially strong company to a weak one which has a significant chance of not honouring its obligations to policyholders The Regulators are responsible, amongst other things, for the supervision of UK authorised insurance companies. Each company is managed to meet or exceed minimum capital requirements set out in regulations. There are two main requirements, known as Pillar 1 and Pillar 2. These set a strong standard for example, the Pillar 2 requirement is that a company must have enough capital to continue to meet the best estimate of policyholder liabilities following the most onerous event or combination of events of a severity expected to occur only once in every 200 years. Based on my review, I confirm that there is expected to be a large surplus in SW Ltd in excess of the requirements under both Pillars immediately following the Scheme While the immediate impact of the Scheme is an important consideration in my assessment, it is arguably more important to consider the expected level of capital held in the longer term. Companies will usually choose to hold a level of capital in excess of these minimum requirements, so that they can continue to meet them after suffering losses during adverse conditions. The Companies approach to accepting and managing risk is set out in their Risk Appetite Framework which includes Capital Targets which they aim to meet. These targets exceed the regulatory requirements, providing extra ongoing security for policyholders. I have considered the ability of SW Ltd to meet its Capital Target following the Scheme and the relative strengths of the Capital Targets applicable before and after the Scheme. The Risk Appetite Framework and the Capital Targets are described in detail in Section 6, and are already applied consistently across all of the Companies (with minor exceptions where some Capital Targets are set as a minimum absolute amount). I believe these provide a strong level of protection for policyholders against the risk of their benefits not being paid I consider comparisons of solvency ratios, such as the ratio of capital resources to capital requirements under Pillar 1 and Pillar 2, to be a useful indicator of the immediate impact of the Scheme on the level of benefit security provided to policyholders, especially where the before and after ratios are calculated using consistent methods and assumptions, as is the case in this Report. While this is helpful, I would be concerned if subsequent actions meant that a fund could be weakened in future, for example through the payment of dividends to shareholders. For many firms, including SW and CMIG, the constraint on such action is their risk appetite framework, which I consider in more detail below. In considering the level of benefit security afforded to policyholders, I have placed heavy emphasis on this Where the Companies hold capital in excess of the minimum level targeted under the Risk Appetite Framework, I place limited reliance on this capital in my consideration of policyholder benefit security. This is because it can typically be removed easily (potentially in the form of dividends) and, as such, may not be available to provide benefit security on an ongoing basis Before considering the different groups of policyholders in turn, I comment on the generic issues of contagion risk and whether the Scheme will expose policyholders to new types of risk. 18

19 Summary and Conclusions Contagion risk When several funds exist in the same company or group of companies, it may be possible for capital resources to flow from one to another in the event that one of the funds has insufficient assets to meet its liabilities. I refer to the risk of a fund having to provide capital in this way as contagion risk. This could impact adversely on the security of policies in the fund from which the capital resources have moved On the basis of the analysis below, I am satisfied that the Scheme will not have a material adverse impact on the extent to which any group of policyholders is exposed to contagion risk: The WPFs are unchanged by the Scheme, and will still have access to the capital support arrangements set out in Section 5. Should the assets of one of these funds, including any support arrangements, be insufficient to meet the liabilities of the fund the likelihood of which is unchanged by the Scheme they will have access to support from the entire financial resources of the Companies. The Companies allow for this potential requirement to support the WPFs (which is often referred to as burn-through risk ) in both the base financial position and the Pillar 2 capital requirements. The Pillar 2 capital requirement is based on the support required under extreme stress scenarios, and so this capital and the additional capital held as part of the Capital Target provide a strong level of protection to the policyholders in the Combined Fund against this contagion risk. The Existing Schemes include provisions limiting the extent to which transactions or arrangements can be entered into by the with-profits funds with other funds. These are replicated in the Scheme, limiting the extent to which the policies in the with-profits funds are exposed to this contagion risk. The Scheme actually minimises contagion risk (other than in relation to the WPFs referred to above), as the notion that one fund fails and would need to be bailed out by another fund from within the group will disappear when there is only a single fund. This is helpful but I do not regard it as a significant benefit for policyholders, because I would expect that if any of the current funds got into trouble, LBGI would make every effort to make its capital resources available to help, rather than allowing a reduction in benefits for any group of policyholders. Changes to intra-group reinsurance There are a number of reinsurance arrangements between the Companies that will collapse as a result of the Scheme. Following the Scheme, the policies in the ceding entity will rank pari passu with all the other policies in SW Ltd and will lose first call on any collateral held in respect of the reinsurance. I have reviewed these collateral arrangements and am satisfied that the collapse of the intra-group reinsurance arrangements under the Scheme does not lead to a materially adverse effect on the benefit security of any group of policyholders. Risk profile By bringing several funds together, the Scheme changes the extent of the exposure that policies have to different types of risk. Based on the rationale set out below, I am satisfied that this does not have a material adverse effect on policyholder benefit security. 19

20 Summary and Conclusions In most cases, the Scheme results in an improved diversification of risk, which is helpful to benefit security. In my view, the most significant change in risk profile is related to CMIG s exposure to mis-selling claims in respect of policies written by CMIG, but sold overseas by intermediaries during the late 1990s and early 2000s. CMIG has a good understanding of this risk, informed in part by various court judgements which have helped to clarify how claims should be evaluated. Transferring Policyholders will become exposed to this risk, but will benefit from the capital that is held against it. The ultimate cost of the claims is unknown as a result of uncertainty as to the number of claims that could be made against CMIG, and the average cost of settlement, but the company has estimated the range of possibilities allowing for these factors. The best estimate cost of these claims, shown as a provision in CMIG s accounts, is 197m. However, the amount of capital actually held in respect of this risk is sufficient to meet the estimated cost of an outcome at the 99.5% level (i.e. a very severe adverse outcome) plus a substantial additional buffer on top of that amount. In my view, the capital held gives very strong policyholder protection against unexpected increases in both the number of claims upheld and the average cost of settlement. In summary, I believe there is a very high likelihood (estimated at over 99.5%) that the amount held will exceed the actual cost incurred, leading to an expected surplus from this source. Importantly, the CMIG Board has resolved that any claims from this source in excess of the payment that would normally have been made under the policy will not be met by the CMIG WPF. Similarly, it would not be possible under the Scheme or the relevant regulations, for such costs to be charged to the Scottish Widows WPF, following the Scheme. As a result, the policyholders in CMIG before the Scheme and SW Ltd following the Scheme are only directly exposed to this risk to the extent that it could result in the insolvency of the company they are in. As discussed below, I view this outcome as highly unlikely. I have also considered scenarios constructed by the Companies to be more severe than the 99.5% level, and I have assessed the potential impact on policyholders in those situations. Even in the highly unlikely event that the cost of this risk exceeded the level of capital held against it, SW Ltd has access to other internal capital resources that are measured in billions of pounds which are available to absorb strains from this or any other source. Even though the Transferring Policyholders are not part of CMIG currently, I expect that any such extreme outcome would create problems for them pre-scheme too. This is because in practice I would expect any resulting shortfall of capital in CMIG pre-scheme to be made good by transfers of capital from the other funds, where not precluded by the Risk Appetite Framework. With this understanding, and given that the circumstances in which any problem could arise post-scheme are so remote, I do not consider exposure to this risk to be a material adverse change for any group of policyholders. The Scheme leads to some policyholders becoming exposed to the risks associated with the staff pension schemes and new business. However, the policyholders continue to be protected by the Risk Appetite Framework and gain access to the capital supporting these risks. I do not consider this a material adverse change for any group of policyholders. 20

21 Summary and Conclusions Expected impact of the Scheme on the reported solvency position In reaching my view on the Scheme s impact on policyholders benefit security I have considered changes that are specific to different groups of policyholders. This includes considering the estimated impact of the Scheme on the Pillar 1 solvency position of the Companies shown in Table 2.2 below, with a more detailed breakdown in Tables A5.1 to A5.3 of Appendix The figures shown below have been produced based on the actual financial position at 31 December The actual financial position of the Companies at the Effective Date will differ from that shown below, but I do not expect the impact of the Scheme to be significantly different. This is also true of the Pillar 2 and Solvency II positions, which I have considered as part of my analysis but do not disclose in the Report. I have also considered projections to 31 December 2015 of the Pillar 2 and Solvency II positions and have commented on these within my analysis. The projections capture the expected changes in the business over the period between the date on which the financial analysis is based and the Effective Date. Table 2.2: Estimated impact of the Scheme on Pillar 1 solvency as at 31 December 2014 (including with-profits funds) m Total Assets Capital Resources (1) Capital Resources Requirement (2) (including any WPICC) Surplus (3) Solvency Coverage (4) SAL 9, % HLL 6, % CMMF % Pre-Scheme CMIG 22,545 3,212 1,695 1, % SWUF 28, % SWA % PMSWF 1, % SW 35,056 8,571 5,963 2, % Post- Scheme SW Ltd 99,933 8,774 5,861 2, % Source: Financial analysis provided by the Companies Notes: The financial position shown for SW and CMIG includes the value of the subsidiaries. CMIG s surplus is shown within SW s Capital Resources in the published Pillar 1 statements, as it is currently a subsidiary of SW. As a result, the position of SW pre-scheme is the most like-for-like comparator for the position of SW Ltd following the Scheme. The surplus has been split into the underlying Capital Resources and the Capital Resources Requirement for comparison of the solvency position pre- and post-scheme. (1) Admissible assets less Pillar 1 liabilities (both calculated under Regulatory Peak), subject to the Regulators rules on capital tiers. (2) Long-Term Insurance Capital Requirement plus With-Profits Insurance Capital Component plus CRR of regulated subsidiary. (3) Capital Resources less Capital Requirements (where the latter is that part of the entity-level requirements that arises in respect of the relevant fund). (4) Capital Resources divided by Capital Resources Requirement. 21

22 Summary and Conclusions Transferring SW Policyholders Policyholders in the SW NPF On the basis of the analysis below, I am satisfied that the Scheme will not have a materially adverse effect on the benefit security of the Transferring Policyholders in the SW NPF: Following the Scheme, the Pillar 1 solvency coverage ratio is expected to increase modestly from 144% to 150%, based on the position at 31 December The impact on a Pillar 2 basis is consistent with this. All else being equal, these increases in the solvency ratio following the Scheme represent a modest strengthening of policyholder benefit security for these policyholders. Following the Scheme, the benefit security of policyholders in SW will continue to be protected by a Capital Target well in excess of the regulatory capital requirement, and which is set in an exactly consistent way as before the Scheme with reference to the same overarching Risk Appetite Framework. As a result of the Scheme, the SW policyholders will become directly exposed to the risks held in all of the other entities involved in the transfer. As these entities are currently subsidiaries (direct or indirect) of SW, I consider that there is already a degree of exposure for the SW policyholders to these risks. Other than the mis-selling risks referred to in paragraph 2.44, the Scheme does not result in a material exposure to any new risk types. The post-scheme risk position is well diversified, with no single type of risk dominating. Policyholders in the SW WPF On the basis of the analysis in paragraph 2.44 and the analysis below, I am satisfied that the Scheme will not have a materially adverse effect on the benefit security of the Transferring Policyholders in the SW WPF: The Scheme will not change the assets, liabilities or risks within the SW WPF, how the fund is expected to be managed in future or the availability of the Support Account and Further Support Account. Hence the solvency position is unchanged. While the Scheme will result in any further capital support (if needed) being provided by the SW Ltd Combined Fund, rather than the SW NPF or SW SHF, that fund is expected to have a higher solvency coverage ratio than the SW NPF and SW SHF. As a result, I consider it likely that the Scottish Widows WPF will be able to access support when required, in all but the most extreme scenarios. Policyholders in SWA On the basis of the analysis below, I am satisfied that the Scheme will not have a materially adverse effect on the benefit security of the Transferring Policyholders in SWA: Following the Scheme, SWA s Pillar 1 solvency coverage ratio is expected to decrease modestly from 162% to 150%, based on analysis as at 31 December 2014, but this is still well in excess of statutory requirements. On the Pillar 2 and Solvency II bases, the level of solvency coverage ratio following the Scheme 22

23 Summary and Conclusions is expected to be well in excess of statutory requirements, although the reduction in the coverage ratio is expected to be a much larger reduction than the Pillar 1 change. This arises because the policy liabilities in SWA are fully reinsured to SW and the Pillar 1 capital requirement calculation cannot take full credit for this transfer of risk. In turn, the level of capital currently held in SWA is significantly higher than that required on a Pillar 2 basis or under its Capital Target, because of the need to cover the Pillar 1 capital requirement. That technical limitation will fall away under Solvency II, and the Companies have confirmed that, absent the Scheme, they would expect to reduce the level of capital held in SWA accordingly. I believe that would be reasonable. Allowing for that expected change, the pre-scheme solvency coverage ratio would be lower, and so any reduction in the coverage ratio applicable to these policies as a result of the Scheme would be much smaller indeed, depending on the level of capital retained in SWA in this situation, there may be very little change. The Capital Target for SWA is currently set as an absolute amount, which is higher as a percentage of the Pillar 2 capital requirement than the percentage of the SW Ltd Capital Target following the Scheme. This absolute value is driven by the Pillar 1 capital requirement, which will fall away under Solvency II. Based on discussions with the Companies, I expect that the Capital Target would be adjusted to a lower absolute level, reflective of the fact that minimal risks are retained in SWA and in line with the approach taken for CMMF, PMSWF and SWUF. With that understanding, I expect that the ongoing protection provided by the Capital Target in SW Ltd would be comparable to that which would exist in future without the Scheme. The liabilities in SWA are fully reinsured to SW. As a result, the policyholders in SWA are currently exposed to the risk that SW becomes insolvent, though this is mitigated by the collateral held. Post-Scheme the reinsurance falls away and the wider exposure is to SW Ltd, which is expected to have a stronger solvency coverage ratio than SW on all bases. I have reviewed the collateral arrangement in respect of this reinsurance and am satisfied that the Scheme does not cause a material adverse effect on benefit security. The Scheme will result in the policies in SWA becoming exposed to all of the risks within the other Companies and I have considered the balance of risks in SWA compared to that expected in SW Ltd following the Scheme. The main change is to introduce exposure to the mis-selling risks referred to in paragraph The policyholders in SWA will benefit from a more diversified pattern of risk exposure post-scheme. These risks will be reflected in the SW Ltd Capital Target. Policyholders in PMSWF On the basis of the analysis below, I am satisfied that the Scheme will not have a materially adverse effect on the benefit security of the Transferring Policyholders in PMSWF: Following the Scheme, the Pillar 1 solvency coverage ratio in relation to PMSWF is expected to decrease from 166% to 150%, based on analysis as at 31 December 2014, but this is still well in excess of statutory requirements. There is only 2m of surplus in PMSWF. This is all that is needed to comfortably cover the capital requirements, as very few risks are retained in PMSWF. Post-Scheme, the policies will be in a fund with Pillar 1 surplus of around 2.9bn, albeit there are more risks too. 23

24 Summary and Conclusions The Capital Target for PMSWF is currently set as a minimal absolute target, as there are very few risks retained in PMSWF. The Capital Target in SW Ltd post-scheme represents a higher percentage of the Pillar 2 capital requirements (including the minimum level of capital required under the regulations) than is currently the case in PMSWF, which is helpful. The main new risk exposure is to mis-selling risks discussed in paragraphs Post-Scheme, the risk profile for PMSWF policyholders will be well diversified, and all of the risks will be reflected in the SW Ltd Capital Target. Policy-related liabilities in SWUF As noted above, SWUF has no policyholders of its own, but accepts reinsurance of unit-funds of pension policies in SW. On the basis of the analysis below, I am satisfied that the Scheme will not have a materially adverse effect on the benefit security of the policy-related liabilities in SWUF: Following the Scheme, the Pillar 1 solvency coverage ratio in relation to the policy liabilities in SWUF is expected to decrease substantially from 3648% to 150%, based on the position at 31 December While this is a large change, 150% is still well in excess of statutory requirements, and the expected post-scheme surplus available to support risks attaching to these liabilities is 2.9bn. The capital held currently is not intended to provide long-term benefit security it is a liquidity facility to help ensure that tax-rebate payments to unit-funds that SWUF has reinsured can be paid promptly without recourse to other Companies. Appropriate levels of liquid assets will be available in SW Ltd to allow this approach to continue post-scheme. The position on the Pillar 2 and Solvency II bases is consistent with that on Pillar 1 above. The Capital Target for SWUF is set as a minimal absolute amount, reflective of the fact that it only holds unit funds and no material associated risks. The Capital Target in SW Ltd post- Scheme represents a higher percentage of the Pillar 2 capital requirements (including the minimum capital required under the current solvency regime) than is currently the case in SWUF (excluding an amount held temporarily in respect of a potential tax liability). As a result of the Scheme, the SWUF policy-related liabilities will become directly exposed to the risks held in all of the other entities involved. As these entities are also currently subsidiaries (direct or indirect) of SW, I consider that there is already a degree of exposure for the SWUF policy-related liabilities to these risks. As the Capital Target is based on a risk-based capital measure, I am satisfied that any change in risk exposure will be reflected in the level of capital targeted. 24

25 Summary and Conclusions Transferring CMIG Policyholders Policyholders in SAL On the basis of the analysis below, I am satisfied that the Scheme will not have a materially adverse effect on the benefit security of the Transferring CMIG Policyholders in SAL: As shown in Section 6, following the Scheme, the Pillar 1 solvency coverage ratio in relation to the policyholders in SAL is expected to decrease substantially from 890% to 150%, based on the position at 31 December The current solvency ratio is unusually high and far in excess of that required by the regulations and the internal Capital Targets, and I note that the excess capital can be reduced relatively easily - indeed the Companies have confirmed that the current position is not reflective of the expected level of capital that would be held in future. I place little value on the extra capital currently held in my assessment of the impact of the Scheme on ongoing benefit security as I do not expect it to remain in place. The impact of the Scheme on the Pillar 2 and Solvency II solvency coverage ratios is consistent with that shown for Pillar 1 above, but, adjusting for the expected capital reduction that I expect would be made in the absence of the Scheme, there is not a significant change. Following the Scheme, the solvency position for these policyholders will be comfortably in excess of that required by regulations. They will continue to be protected by a Capital Target in excess of the regulatory capital requirement that is set in exactly the same way as before the Scheme, and with reference to the same overarching Risk Appetite Framework. The Scheme will result in the policies in SAL becoming exposed to all of the risks within the other Companies and I have considered the balance of risks in SAL compared to that expected in SW Ltd following the Scheme. The main change is to introduce exposure to the mis-selling risks referred to in paragraph 2.44 and longevity risk. However, the capital held in respect of these risks is well in excess of the expected costs of these risks, even in severe scenarios. The post-scheme risk position is well diversified, with no single type of risk dominating indeed, the risk profile is more diversified in SW Ltd than in SAL, reducing concentration risk. As the Capital Target is based on a risk-based capital measure, I am satisfied that any change in risk exposure will be reflected in the level of capital targeted. Policyholders in HLL On the basis of the analysis below, I am satisfied that the Scheme will not have a materially adverse effect on the benefit security of the Transferring CMIG Policyholders in HLL: Following the Scheme, the Pillar 1 solvency coverage ratio in relation to the policyholders in HLL is expected to decrease substantially from 607% to 150%, based on the position at 31 December As for SAL, the current capitalisation is far in excess of the required level because HLL recognises the excess capital held in SAL within its own capital position, as SAL is its direct subsidiary. This position would be expected to change, for exactly the reasons set out above in relation to SAL. The position on the Pillar 2 and Solvency II bases is consistent with that on Pillar 1 above. 25

26 Summary and Conclusions Following the Scheme, the solvency position for these policyholders will be comfortably in excess of that required by regulations. They will continue to be protected by a Capital Target in excess of the regulatory capital requirement that is set in an exactly consistent way to before the Scheme, and with reference to the same overarching Risk Appetite Framework. The Scheme will result in the policies in HLL becoming exposed to all of the risks within the other Companies and I have considered the balance of risks in HLL, on a standalone basis, compared to that expected in SW Ltd following the Scheme. Other than the mis-selling risks referred to in paragraph 2.44, the Scheme does not result in a material exposure to any new risk types. The post-scheme risk position is well diversified, with no single type of risk dominating indeed, the risk profile is more diversified in SW Ltd than in HLL, reducing concentration risk. Policyholders in CMMF On the basis of the analysis below, I am satisfied that the Scheme will not have a materially adverse effect on the benefit security of the Transferring CMIG Policyholders in CMMF: As shown in Section 6, following the Scheme, the Pillar 1 solvency coverage ratio in relation to the policyholders in CMMF is expected to decrease substantially from 881% to 150%, based on the position at 31 December As for SAL and HLL, the current capitalisation is far in excess of the required level. The Companies have confirmed that they are currently reviewing the level that will be held in CMMF, and that there is no expectation that levels of capital significantly above the Capital Target will be retained. Therefore, as above, I place little value on the extra capital currently held in my analysis of the impact of the Scheme. The position on the Pillar 2 and Solvency II bases is consistent with that on Pillar 1 above. Following the Scheme, the solvency position for these policyholders will be comfortably in excess of that required by regulations. They will continue to be protected by a Capital Target in excess of the regulatory capital requirement that is set in an exactly consistent way to before the Scheme, and with reference to the same overarching Risk Appetite Framework. The Capital Target for CMMF is currently set as a minimal absolute amount, as there are very few risks retained in CMMF. The Capital Target in SW Ltd post-scheme represents a higher percentage of the Pillar 2 capital requirements than is currently the case in CMMF. The Scheme will result in the policies in CMMF becoming exposed to all of the risks within the other Companies and I have considered the balance of risks in CMMF compared to that expected in SW Ltd following the Scheme. The main new risk exposure is to mis-selling risks discussed in paragraphs The post-scheme risk position is well diversified, with no single type of risk dominating indeed, the risk profile is more diversified in SW Ltd than in CMMF, reducing concentration risk. As the Capital Target is based on a risk-based capital measure, I am satisfied that any change in risk exposure will be reflected in the level of capital targeted in SW Ltd. 26

27 Summary and Conclusions Existing CMIG Policyholders Policyholders in the CMIG NPF On the basis of the analysis below, I am satisfied that the Scheme will not have a materially adverse effect on the benefit security of the Existing CMIG Policyholders in the CMIG NPF: Following the Scheme, the Pillar 1 solvency coverage ratio in relation to the policyholders in CMIG is expected to decrease from 190% to 150%, based on the position at 31 December However, CMIG currently recognises the excess capital held in SAL within its own capital position, as SAL is an indirect subsidiary. This is not expected to be maintained in the long term, as explained in paragraph The position on the Pillar 2 and Solvency II bases is consistent with that on Pillar 1 above. Following the Scheme, the solvency position for these policyholders will be comfortably in excess of that required by regulations. They will continue to be protected by a Capital Target in excess of the regulatory capital requirement that is set in an exactly consistent way to before the Scheme, and with reference to the same overarching Risk Appetite Framework. As a result of the Scheme, the Existing CMIG Policyholders will become directly exposed to the risks held in all of the other entities involved. As HLL, SAL and CMMF are subsidiaries of CMIG, I consider that the Existing CMIG Policyholders already have exposure to these risks. In particular, while it is able to meet its regulatory capital requirements and Capital Target, I would consider it highly unlikely that it would allow HLL, SAL or CMMF to become insolvent. I have also considered the balance of risks in CMIG, as a standalone entity, compared to that expected in SW Ltd following the Scheme. The Scheme does not result in a material exposure to any new risk types indeed the risk profile is more diversified in SW Ltd than in CMIG. Policyholders in the CMIG WPF On the basis of the analysis below, I am satisfied that the Scheme will not have a materially adverse effect on the benefit security of the Existing CMIG Policyholders in the CMIG WPF: The Scheme will not change the assets, liabilities or risks within the CMIG WPF or how the fund is expected to be managed in future. Hence the solvency position is unchanged. If capital support is required for the CMIG WPF in the future, it will be provided by the SW Ltd Combined Fund, rather than the CMIG NPF or CMIG SHF at present. The SW Ltd Combined Fund has a strong solvency coverage ratio, with an expected surplus of 2.9bn on a Pillar 1 basis, and the same Capital Targets as CMIG currently to provide ongoing protection. As a result, I consider it likely that the CMIG WPF will be able to access support when required, in all but the most extreme scenarios consistent with the current position. I note that the Scheme does not replicate the requirement to maintain a Bonus Deficit Account, but this account has no material bearing on the benefit security of the policies in the CMIG WPF, since, under the CMIG Scheme, it does not have to be retained beyond the end of 2016, and my analysis indicates that it is extremely unlikely to be utilised before that point. 27

28 Summary and Conclusions Conclusion on benefit security I am satisfied that the Scheme will not materially adversely impact the benefit security of any group of policyholders. Solvency II The current regulatory solvency regime is expected to be replaced, on 1 January 2016, by Solvency II. The principles of how this will operate are known, but there are some elements of the solvency calculation that are subject to approval by the PRA approvals that are not expected to be received before the Sanction Hearing Notwithstanding the importance of the Companies being able to meet their regulatory capital requirements, it is important to realise that Solvency II does not change any of the assets, liabilities or risks in the Companies. These are the main determinants of benefit security. The new regime is intended to improve oversight of such risks, and to ensure strong minimum standards for the capital that must be held against each risk. It will also involve operational changes for example, reporting and governance changes I note that Solvency II will impact the Companies irrespective of the Scheme if it has a significant effect on the reported solvency position of a particular company, the effect will apply whether or not the Scheme occurs I note that all of the Companies are expected to be able to meet the Solvency Capital Requirement (the expected level required under the new regulations) and the internal Capital Targets. The former hurdle is expected to be met even without the benefit of transitional adjustments that are subject to regulatory approval. While the internal targets might not be met if such approval was withheld (which I have no reason to believe is likely), there is a viable recovery plan which would not involve harmful actions to policyholders. I note that if approval was not granted, action would be needed whether or not the Scheme proceeds. Failure to achieve approval for the matching adjustment in addition to the transitional adjustments would result in SW and SW Ltd being unable to meet their Solvency Capital Requirement. This would be an issue whether or not the Scheme proceeds. However, I view it as an unlikely worst case scenario, as the Companies have submitted a preapplication for the matching adjustment to the PRA, the feedback from which should allow any significant barriers to approval to be addressed before formal application I will continue to monitor the impact of the Scheme in relation to Solvency II and will comment further in my Supplementary Report. Service standards and investment management All policies, including those which transfer, will continue to be administered on the same underlying systems as now, by staff from the same company The investment management of the funds will continue to be performed by the same fund managers, using the same processes as are currently in place, and the funds will have the same investment mandates and objectives as now. 28

29 Summary and Conclusions Accordingly, I consider that there will not be any impact on the quality of administration services or investment management for any group of policyholders as a consequence of the Scheme, or to the costs they bear in this respect. Tax considerations I have reviewed information provided to me by the Companies and, on the basis of this information, I am satisfied that there should be no adverse tax effects on Transferring SW Policyholders, Transferring CMIG Policyholders or Existing CMIG Policyholders on account of the implementation of the Scheme. This is subject to the clearances referred to in Section 11 being received and other confirmatory matters being satisfactorily concluded. It is possible that, in certain circumstances in the future, the Scheme will lead to the level of tax payable by the SW Ltd Combined Fund being lower than the tax that would otherwise have been paid by the various shareholder funds in the Companies. Any such benefit would be dependent on certain clearances being received. These matters are still being reviewed and I will continue to discuss them with the Companies and will provide an update in my Supplementary Report. Policyholder communications The Companies will inform all groups of policyholders about the Scheme through a direct mailing. The mailing will not include Scheme documents, as the Companies consider (and I agree) that this would be excessive information for most of the 5.8m policyholders being contacted. Instead, the mailing will guide policyholders to specific website content where further technical information can be easily obtained, and a contact for requesting additional printed material, free of charge. Costs of the Scheme All costs and expenses incurred in preparing and implementing the Scheme will be borne by the shareholder funds of the affected Companies. None of the costs will be borne by policyholders, or be charged to their policies in future. Governance arrangements As LBGI is largely managed as a single integrated insurance business, there is already a high degree of consistency in the governance and management of the companies. For example, the principal entities (SW, CMIG, SWA and SAL) are managed by an Insurance Board, with the remaining entities managed by a Life Tier 2 Board. Following the Scheme, there will be a single Board responsible for the management of SW Ltd. The Board will be based on the current Insurance Board and I have no reason to believe that this will lead to any discernible change in the way that it will exercise its powers and fulfil its responsibilities in relation to the policyholders. I am satisfied that changes to governance processes or responsibilities as a result of the Scheme do not have a materially adverse effect on any of the groups of policyholders. Objections Any policyholder or other person who feels they would be adversely affected by the Scheme may put their objections to the Company and/or the Court or the Court of Session, in relation to the Court of Session Applications. I will consider these in coming to my view on the appropriateness of the Scheme, and will report as appropriate on the issues that are raised in my Supplementary Report. 29

30 Summary and Conclusions Conclusions For the reasons set out above, I am satisfied that the Scheme will not materially adversely impact any group of policyholders All of my conclusions take into account the effect of the Channel Island Schemes, and apply equally to business carried on in or from within Jersey and to policies issues to residents of the Bailiwick of Guernsey as they do to business comprising policies held by residents in the UK or any other territory. Similarly, all of my conclusions apply equally to any Excluded Policies (as defined in paragraph 3.17 below) I will keep these matters under review until the date of the Sanction Hearing and will draw any significant developments or changes that may affect policyholders to the attention of the Court in my Supplementary Report. 30

31 Outline of the Scheme 3. Outline of the Scheme Background and Purpose of the Scheme 3.1. As a result of various mergers and acquisitions most notably the merger between HBOS Plc and Lloyds TSB in January 2009 and intra-group reinsurance arrangements, there are a number of separate life insurance entities within LBGI. While these entities remain legally separate, they are managed using consistent management structures and governance frameworks The main purposes of the Scheme are to: Simplify the entity structure within LBGI, more closely reflecting the way in which the businesses are currently managed. Improve liquidity and capital efficiency within LBGI by removing any potential barriers to moving capital around the group, particularly in light of the introduction of Solvency II (see Section 5 for further details). The Scheme does not change any policy s terms and conditions, and is not intended to change the benefits payable under any policy or to affect how the policies are managed If approved, the Scheme will transfer the entire long-term insurance business currently held by SW, SWA, PMSWF, SWUF, CMMF, HLL and SAL into the entity that is currently named CMIG. Following the transfer, CMIG will be renamed SW Ltd and it is intended that the other entities will be de-authorised as insurance companies in due course The existing with-profits funds within LBGI (specifically the with-profits funds within CMIG and SW), will continue to be maintained as separate funds within SW Ltd. The remaining assets and liabilities will be held in the CMIG SHF and CMIG NPF, which will be combined to form the Combined Fund as soon as Solvency II takes effect this is expected to happen immediately after the Effective Date In addition to the subsidiaries listed above, the smaller regulated SW subsidiaries, Scottish Widows Administration Services Limited and Scottish Widows Unit Trust Managers Limited, will also transfer to CMIG as assets of SW. The Scheme will not result in the ownership of the subsidiaries changing from a with-profits fund to the shareholder fund or vice versa The effect of the Scheme in transferring assets, liabilities and policies is illustrated in Figure 3.1. I have provided an overview of the pre- and post-scheme entity structure in Figures A3.2 and A3.3 within Appendix 3. 31

32 Outline of the Scheme Figure 3.1: Transfers under the Scheme Summary of the business affected 3.7. If approved, the Scheme, together with the Channel Islands Schemes, will transfer all of the policies, assets and liabilities of SW, SWA, PMSWF, SWUF, CMMF, HLL and SAL (other than a small amount of assets to meet the regulatory capital requirements until the transferor companies can be de-authorised) into the entity currently named CMIG. Tables 3.1A to 3.1C below show the number of policies in-force and the corresponding statutory reserves for each of the Companies. 32

33 Outline of the Scheme Table 3.1A Transferring business of SW and its direct subsidiaries as at 31 December 2014 Company Product Type Number of policies Gross Mathematical reserves ( m) Reinsured Mathematical reserves ( m) Net Mathematical reserves ( m) WPF Life UK 60,766 1, ,394 WPF Pensions UK 1 119,869 9, ,606 WPF Overseas Sub-Total: WPF 180,641 11, ,023 NPF Life UK Unit-Linked 167,052 4,264-4,264 NPF Pensions UK Unit-Linked 2,291,031 44,096 40,930 3,166 SW NPF Overseas Unit-Linked 1, Sub-Total NPF Unit-Linked 2,459,724 48,383 40,930 7,453 NPF Life UK Non-Unit-Linked 3,704,028 1, NPF Pensions UK Non-Unit- Linked 1 691,696 7, ,464 NPF Overseas Non-Unit-Linked Sub-Total NPF Non-Unit- Linked 4,396,283 8, ,989 Total SW 7,036,648 68,136 41,672 26,464 SWA SWUF LTF Pensions UK 136,133 1,889 1,889 - Total SWA 136,133 1,889 1,889 - LTF Pensions UK Unit-Linked N/A 28,225-28,225 Total SWUF N/A 28,225-28,225 LTF Pensions UK Unit-Linked N/A 2 1,702-1,702 PMSWF LTF Pensions UK Non-Unit- Linked Total PMSWF 315 1, ,702 Total 7,173,096 99,960 43,569 56,391 1) These figures are before the transfer of annuity business from the SW WPF to the SW NPF. This transfer would have the approximate effect of moving 41,400 policies and c. 2.5bn of reserves between these two lines, with the totals remaining unchanged. An updated table, as at 30 June 2015, will be included in my Supplementary Report, including the impact of this transfer. 2) Excludes 441 pension schemes, not reflected in PRA Return policy count. 33

34 Outline of the Scheme Note: The reinsured total comprises of c. 30.5bn intra-group reinsurance and c. 13.1bn external reinsurance Source: AFH Report, 2014 regulatory returns Table 3.1B Transferring business of the CMIG subsidiaries as at 31 December 2014 Company Product Type Number of policies Gross Mathematical reserves ( m) Reinsured Mathematical reserves ( m) Net Mathematical reserves ( m) LTF Pensions UK Unit-Linked N/A CMMF LTF Pensions UK Non-Unit-Linked Total CMMF LTF Life UK Unit-Linked LTF Pensions UK Unit-Linked 91,091 3,023-3,023 Sub-Total NPF Unit-Linked 91,216 3,071-3,071 HLL NPF Pensions UK Accumulating with-profit Sub-Total NPF - Accumulating with-profit 1, , LTF Life UK Non-Unit-Linked 28, LTF Pensions UK Non-Unit-Linked 12, Sub-Total NPF Non-Unit-Linked 40, Total HLL 132,700 3, ,549 LTF Life UK Unit-Linked 241,134 9, ,158 Sub-Total NPF Unit-Linked 241,134 9, ,158 SAL LTF Life UK Non-Unit-Linked 514, LTF Overseas Non-Unit-Linked Sub-Total NPF Non-Unit-Linked 514, Total SAL 755,714 9, ,243 Total 888,432 13, ,532 1) Excludes 33 pension schemes, not reflected in PRA return policy count. Note: The reinsured total comprises of 128m intra-group reinsurance and 82m external reinsurance Source: AFH Report, 2014 regulatory returns 34

35 Outline of the Scheme Table 3.1C Non-transferring business of CMIG as at 31 December 2014 Company Product Type Number of policies Gross Mathematical reserves ( m) Reinsured Mathematical reserves ( m) Net Mathematical reserves ( m) WPF Life UK 57,346 1, ,293 WPF Pensions UK 67,808 2,244-2,244 WPF Overseas 89,053 2,105-2,105 Sub-Total: WPF 214,206 5, ,642 NPF Life UK Unit-Linked 54,650 2, ,949 NPF Pensions UK Unit-Linked 281,570 7, ,874 CMIG NPF Overseas Unit-Linked 38, Sub-Total NPF Unit-Linked 374,575 10, ,161 NPF Life UK Non-Unit-Linked 26, NPF Pensions UK Non-Unit-Linked 95,132 2,696-2,696 NPF Overseas Non-Unit-Linked 2, Sub-Total NPF Non-Unit-Linked 123,755 3, ,529 Total CMIG 712,536 20,336 1,004 19,332 Note: The reinsured total comprises of 752m intra-group reinsurance and 252m external reinsurance Source: AFH Report, 2014 regulatory returns 3.8. Additional details on the policies affected by the Scheme are set out in the following paragraphs. Further details of the business in the Companies can be found in Appendices 3 and 4. Although in each case reference is made to certain policies, assets and liabilities transferring to the CMIG NPF or the CMIG SHF, as mentioned in paragraph 3.4, the two funds will be combined when Solvency II takes effect, which is expected to be immediately after the transfer. Transferring business of SW and its direct subsidiaries SW 3.9. There are approximately 7 million policies held directly by SW, totalling 26.5bn of reserves (net of reinsurance) as at 31 December The main types of business in SW are unit-linked policies (both pensions and savings policies), with-profits business (conventional and unitised with-profits), protection business and annuities in payment. SW remains open to new business and the vast majority of new life business in LBGI is written in SW. All of these policies will transfer under the Scheme, as set out below. 35

36 Outline of the Scheme All of the policies, assets and liabilities of the SW WPF will transfer to a newly created withprofits fund in CMIG (the Scottish Widows WPF). As at 31 December 2014, there were approximately 180,000 policies in the fund, with reserves of 11bn. Further details on the impact of the Scheme on the operation of the fund in which these policies are held is provided in paragraphs 5.15 to The policies held in the SW NPF will transfer to the CMIG NPF, along with backing assets and liabilities. The remaining assets and liabilities in SW, being those in the SW SHF, will transfer to the CMIG SHF, other than assets required to meet the minimum regulatory solvency requirement and a small margin, which will be retained in SW until such time that it can be de-authorised. Following de-authorisation, the remaining assets will be transferred to the CMIG SHF or the Combined Fund (if, as expected, the de-authorisation takes place after the introduction of Solvency II). SWA policies SWA is a wholly-owned subsidiary of the SW SHF, with approximately 136,000 policies in force as at 31 December The policies are a mix of annuities and term assurance policies and the benefits payable are wholly reinsured to the SW NPF. As a result, the reserves net of reinsurance are zero. Historically, SWA accepted reinsurance of annuity business from SW, but this reinsurance was recaptured on 1 January 2013 and SWA is closed to new reinsurance. The policies are all non-profit and are currently held in the long-term fund of SWA (the SWA LTF ). These policies will transfer to the CMIG NPF, along with any assets and liabilities allocated to the fund immediately prior to the Effective Date. The remaining assets and liabilities in SWA, being those in the SWA shareholder fund (the SWA SHF ), will transfer to the CMIG SHF, other than assets required to meet the minimum regulatory solvency requirement and a small margin, which will be retained in SWA until such time that it can be de-authorised. Following de-authorisation, the remaining assets will be transferred to the CMIG SHF or the Combined Fund. The reinsurance will no longer be needed, as the Scheme will result in the liabilities being both ceded and accepted by the CMIG NPF. SWUF policy-related liabilities SWUF is a wholly-owned subsidiary of the SW NPF, and accepts reinsurance of some of the unitlinked funds underlying the unit-linked pension policies in SW. As a result, while it has no directly held policies, it had reserves of around 28.2bn in respect of these unit-liabilities as at 31 December The reinsurance liabilities are all unit funds and are held in the long-term fund of SWUF (the SWUF LTF ). These liabilities will transfer to the CMIG NPF, along with any assets and other liabilities allocated to the fund immediately prior to the Effective Date. 36

37 Outline of the Scheme The remaining assets and liabilities in SWUF, being those in the SWUF shareholder fund (the SWUF SHF ), will transfer to the CMIG SHF, other than assets required to meet the minimum regulatory solvency requirement and a small margin, which will be retained in SWUF until such time that it can be de-authorised. Following de-authorisation, the remaining assets will be transferred to the CMIG SHF or the Combined Fund. The reinsurance will no longer be needed, as the Scheme will result in the liabilities being both ceded and accepted by the CMIG NPF. PMSWF policies PMSWF is a wholly-owned subsidiary of the SW NPF, which had net reserves of 1.7bn as at 31 December The policies in PMSWF have predominantly been issued directly to pension scheme trustees and are not counted as individual policies in Table 3.1A above. PMSWF also has a small number of directly written annuities in payment which are reinsured to SW. The policies are all non-profit and are held in the long-term fund of PMSWF (the PMSWF LTF ). These policies will transfer to the CMIG NPF, along with any assets and liabilities allocated to the fund immediately prior to the Effective Date. The remaining assets and liabilities in PMSWF LTF, being those in the PMSWF shareholder fund (the PMSWF SHF ), will transfer to the CMIG SHF, other than assets required to meet the minimum regulatory solvency requirement and a small margin, which will be retained in PMSWF until such time that it can be de-authorised. Following de-authorisation, the remaining assets will be transferred to the CMIG SHF or the Combined Fund. The intra-group reinsurance will no longer be needed, as the Scheme will result in the liabilities being both ceded and accepted by the CMIG NPF. Transferring business of the CMIG subsidiaries HLL policies HLL is a wholly-owned subsidiary of the CMIG SHF, with approximately 133,000 policies in force, with net reserves of 3.5bn, as at 31 December The policies are primarily unit-linked pension policies, but there are also annuities (both deferred and immediate), unit-linked savings policies and protection business. There are a small number of policies with unitised with-profits investments, where this exposure is provided by reinsurance into the CMIG WPF. In addition, as at 31 December 2014 HLL reinsured the liabilities in respect of a block of unit-linked business (including attached rider benefits) written by The Equitable Life Assurance Society, another UK insurer. This reinsurance was partially recaptured in March 2015 and I have adjusted the figures in Table 3.1B to reflect this. I also include the pre-adjustment figures in Appendix 4. HLL is closed to new business, other than in respect of increments on existing policies. All of these policies are held in the long-term fund of HLL (the HLL LTF ) and will transfer to the CMIG NPF, along with any assets and liabilities allocated to the fund immediately prior to the Effective Date. 37

38 Outline of the Scheme The remaining assets and liabilities in HLL, being those in the HLL shareholder fund (the HLL SHF ), will transfer to the CMIG SHF, other than assets required to meet the minimum regulatory solvency requirement and a small margin, which will be retained in HLL until such time that it can be de-authorised. Following de-authorisation, the remaining assets will be transferred to the CMIG SHF or the Combined Fund. The remaining parts of the external reinsurance agreement will continue (although the accepting party will become CMIG). The intra-group reinsurance to the with-profits fund in CMIG will be replaced with an equivalent inter-fund agreement. SAL policies SAL is a wholly-owned subsidiary of the HLL SHF, with approximately 756,000 policies in force, with net reserves of 9.2bn, as at 31 December The policies are a mix of unit-linked savings policies and protection business. SAL is closed to new business, other than in respect of increments on existing policies. The policies are all non-profit and are held in the long-term fund of SAL (the SAL LTF ). These policies will transfer to the CMIG NPF, along with any assets and liabilities allocated to the fund immediately prior to the Effective Date. The remaining assets and liabilities in SAL, being those in the SAL shareholder fund (the SAL SHF ), will transfer to the CMIG SHF, other than assets required to meet the minimum regulatory solvency requirement and a small margin, which will be retained in SAL until such time that it can be de-authorised. Following de-authorisation, the remaining assets will be transferred to the CMIG SHF or the Combined Fund. CMMF policies CMMF is a wholly-owned subsidiary of the CMIG SHF, with 18 directly written policies in force and some reinsured unit funds, with total net reserves of 740m, as at 31 December The directly written policies are annuity policies, which are wholly reinsured to CMIG, and some managed fund liabilities. CMMF also accepts reinsurance from The Equitable Life Assurance Society. Other than where the funds were invested in property units, these liabilities are then retroceded to CMIG. The policies are all non-profit and are held in the long-term fund of CMMF (the CMMF LTF ). These policies will transfer to the CMIG NPF, along with any assets and liabilities allocated to the fund immediately prior to the Effective Date. The remaining assets and liabilities in CMMF, being those in the CMMF shareholder fund (the CMMF SHF ), will transfer to the CMIG SHF, other than assets required to meet the minimum regulatory solvency requirement and a small margin, which will be retained in CMMF until such time that it can be de-authorised. Following de-authorisation, the remaining assets will be transferred to the CMIG SHF or the Combined Fund. The external reinsurance agreement will continue (although the accepting party will become CMIG), but the intra-group reinsurance will no longer be needed, as the Scheme will result in the liabilities being both ceded and accepted by the CMIG NPF. 38

39 Outline of the Scheme Non-transferring business of CMIG CMIG policies CMIG is a direct subsidiary of the SW SHF, with approximately 713,000 policies, totalling 19.3bn of reserves net of reinsurance as at 31 December CMIG sells limited volumes of new business, with the majority relating to increments on existing policies or new annuities bought with the maturity proceeds of existing policies. CMIG has a wide range of policy types, including unit-linked, withprofits, annuities and protection business. These policies will not transfer under the Scheme. CMIG has a with-profits fund (the CMIG WPF), which is managed in line with a scheme of demutualisation (the CMIG Scheme ). Further details on the impact of the Scheme on the operation of this fund are provided in Section 5. The remaining policies are held in the CMIG NPF, along with the assets backing these policies and other liabilities allocated to the CMIG NPF. The remaining assets and liabilities in CMIG are held in the CMIG SHF. CMIG had around 130,000 policies written outside of the UK at 31 December 2014, representing the vast majority of the overseas exposure to life insurance in LBGI. These policies were written through branches in Europe (most notably Germany) and Hong Kong. CMIG has a significant amount of capital held against mis-selling risk. This relates to claims from policies written by CMIG, but sold by intermediaries in Germany during the later 1990s and early 2000s. This matter was the subject of a decision in July 2012 by the Federal Court of Justice in Germany, but there is still uncertainty relating to the final size of the total claims. Excluded Policies The Scheme provides for any Transferring Policies which it is not possible to transfer to CMIG at the Effective Date (for legal, regulatory or other reasons) to be excluded from the Scheme ( Excluded Policies ). This could happen, for example, if the Channel Islands Schemes are not approved by the Effective Date or if certain required approvals from non-uk regulatory bodies are not received in time for the liabilities to transfer as planned. Any Excluded Policies will be fully reassured to CMIG from the Effective Date, allowing them to be treated as far as possible in the same way as if they had transferred under the Scheme I understand from the Companies that there are not expected to be any Excluded Policies. If there are, I am satisfied that the proposed treatment is fair to policyholders and that my conclusions in respect of the policyholders transferring under the Scheme apply equally to them. Many other schemes have used the same approach. Overseas Policies The Scheme and the Channel Islands Schemes will result in the transfer of policies as set out above. For policies written in EEA states other than the UK, it is necessary to obtain consent for such a transfer (or at least non-objection to such a transfer within three months of notification) from the 39

40 Outline of the Scheme relevant local regulatory body. The Companies have requested that the PRA contacts these regulatory bodies to obtain this consent The transfer of the business written in Jersey and Bailiwick of Guernsey will be effected by way of the Channel Islands Schemes as well as the Scheme. These schemes provide for the transfer of policies on equivalent terms to the Scheme and are expected to have the same effective date as the Scheme. As a result, my analysis and conclusions apply equally to these policies. Changes to existing Court-approved schemes The Scheme replaces or transfers the Existing Schemes that were approved by the Court or, equivalently, the Court of Session. I pay particular attention to the situation where such schemes are replaced, especially where they confer protections on a group or groups of policyholders, influence the benefit expectations of policyholders or have a bearing on how the policies are managed. This is particularly relevant for the business held in the with-profits funds of SW and CMIG, as the SW Scheme and CMIG Scheme respectively created the funds and play a key role in defining how they currently operate. I consider these Existing Schemes and, where relevant, the equivalent local schemes, in Section 5, highlighting the important features and how these are affected by the Scheme. Additional powers conferred by the Scheme Management of unit-linked business Following the Scheme, SW Ltd will have the power to merge, split or close unit-linked funds, where this is not precluded by the terms and conditions of the affected policies or the relevant regulations (including the TCF regulations). This power can only be exercised if the Board have taken account of appropriate actuarial advice. Where a policy is affected by such a change, the policyholder will be entitled to a free switch in the following year, even where such a switch would normally attract a charge. The Companies have confirmed that there are no plans in place to exercise these powers as a direct result of the Scheme This is similar to a provision in the CMIG Scheme, which granted this power when allowed by the terms and conditions of the policy and the SWAS Scheme (as defined in 5.44 below). There is no corresponding provision in the SW Scheme. The Companies have stated that this provision is intended to formalise the existence of a power that has been used in the past I consider such powers to be important tools for management to allow the effective ongoing management of the unit-linked funds. In particular, it should help avoid the scenario where the funds are too small to be effectively managed on an ongoing basis, and/or to avoid maintaining numerous separate, near-identical funds. Holding units in a small fund can potentially lead to adverse policyholder outcomes, as dealing costs become increasingly significant in relation to the overall value of the fund, and holdings can become concentrated (such as in a property fund). Similarly, maintaining essentially identical separate funds may be confusing for customers. As a result, I am satisfied that there are good reasons for the Scheme to include these powers. They can only be exercised if the Board has taken account of appropriate actuarial advice, which would include external actuarial advice if the Board considers it appropriate, and so I am also satisfied that there is appropriate governance to prevent them being used in a way that was detrimental to policyholders. 40

41 Outline of the Scheme Merger and closure of the with-profits funds Following the Scheme, should the technical provisions of either the CMIG WPF or the Scottish Widows WPF fall below 500m, SW Ltd will have the power, but not the obligation, to close the relevant fund or to merge it with the other fund I am satisfied that the Scheme includes various strong protections to prevent an adverse policyholder impact should such action be taken, and I consider this to be the most important aspect of my analysis of the potential impact of these clauses on policyholder interests. For example, a merger or closure can only be effected in the event that an independent actuary has provided a certificate that such an action will not have a material adverse effect on the security and benefit expectations of the policyholders in the affected funds. The detailed terms of any such merger or closure are not set out in the Scheme, but would be decided at the time The Scheme requires CMIG to notify the Regulators in the event that they are considering exercising one of these powers. Closure or merger would not be possible if the Regulators were to object The Companies have provided me with analysis that shows that the CMIG WPF and Scottish Widows WPF are expected to remain significantly above the merger or closure threshold for at least 15 years from the Effective Date. I note that any merger or closure is potentially complex and will depend on the economic conditions and financial condition of the funds at the time, and so it is appropriate that the Scheme does not define the terms of any such merger or closure. To provide further flexibility in achieving a fund merger or closure that is effective, the Companies can make amendments to the terms of this Scheme, without the consent of the Court, that the SW Ltd Board considers to be necessary or desirable as a consequence of the merger or closure. As above, I am satisfied that there are sufficiently strong protections to prevent an adverse policyholder impact. In particular, any such amendments would have to be equitable in the opinion of the SW Ltd Board and would be subject to non-objection from the Regulators. I would also expect the independent actuary s consideration and certification of the merger or closure terms to take account of any change that he/she considered adverse or potentially adverse to policyholders Merging or closing funds can help promote the efficient management of the funds, particularly helping to avoid the situations where: A small number of policies are meeting substantial overhead costs; or The term of the non-profits policies held in the fund is significantly longer than that of the withprofits policies. This can result in the risk capital held in respect of the non-profits policies in the fund becoming disproportionate relative to the size of the with-profits liabilities potentially reducing the ability of the fund to declare appropriate bonuses. I therefore support the inclusion of these clauses, noting that they are a common part of many similar Part VII transfers I am also satisfied that the proposed threshold of 500m is reasonable, being comparable to similar arrangements that I have seen for peer companies. 41

42 Outline of the Scheme Other changes as a result of the Scheme Combination of CMIG NPF and CMIG SHF At present, and as mandated by the CMIG Scheme, CMIG maintains a separate shareholder fund in addition to the long-term fund (which in turn is subdivided into the CMIG WPF and the CMIG NPF). Following the implementation of Solvency II, the requirement to maintain separation between the CMIG SHF and the CMIG NPF will fall away, and there will be no benefit in doing so. As a result, the Scheme allows for these funds to be combined into the Combined Fund at the Combination Date, which has been set to coincide with the implementation of Solvency II. As set out in Figure 3.1, the CMIG WPF will continue to operate as a distinct fund and there will also be a new Scottish Widows WPF in respect of the business currently in the SW WPF I note that profits and losses in the CMIG NPF and CMIG SHF fall entirely to shareholders, and so combining them does not create any transfer of value between any of the parties to the Scheme. I also consider assets held in the CMIG SHF to be fully transferable to the CMIG NPF, without limitation, should they be required to support policyholder security and benefit payments a situation which is unchanged by merging the funds into the Combined Fund. Therefore, I am satisfied that there is no disadvantage to policyholders if this is enacted. I do not consider the combination of the CMIG NPF and CMIG SHF further, other than where explicitly referenced in relation to certain tests used to determine the requirement or availability of support to the CMIG WPF or Scottish Widows WPF. Put option As set out in the SW 2013 Annual Report and Accounts, during 2011, SW acquired the entire share capital of CMIG and also entered into an agreement with Scottish Widows Financial Services Holdings Limited ( SWFSH ) that it would have the right to sell CMIG to SWFSH at fair value (with a minimum value of zero) should there be an event related to litigation on the business sold by CMIG in Germany that reduced CMIG's capital to the regulatory requirement or below. This put option, essentially formalises the existing legal right of SW to allow a limited liability subsidiary to go insolvent without providing additional support Following the Scheme, SW Ltd will be a direct subsidiary of Scottish Widows Group ( SWG ) and the put option will cease to exist. The loss of this option might be considered to disadvantage the SW policyholders, but I am satisfied that it does not have a material bearing on them, as: Any value ascribed to it would be an asset of the shareholders it only has value for policyholders in terms of adding to their benefit security. The likelihood of the put option ever being exercised is extremely low, and significantly lower than at the time it was introduced, reflecting the much better understanding of the risks attaching to the German business in CMIG. Pre-Scheme, the CMIG put option will only have any value to SW in an extreme scenario, of highly remote likelihood. While the put option was designed with extreme scenarios in mind, I believe the circumstances where it has any value are now sufficiently remote as not to be a material concern. 42

43 Outline of the Scheme Whether or not the put options exists, I would not expect the Board of SW to provide support where doing so could result in it being unable to meet its own solvency capital requirement or capital targets under the Risk Appetite Framework (as set out in Section 6). Indeed, I believe that the Risk Appetite Framework and the Board s legal responsibilities in respect of the SW policyholders would prevent them from doing so. As a result, even in many adverse scenarios, the CMIG put option is currently of little relevance to the benefit security of the SW policyholders. The put option is ascribed a value of nil in the SW accounts as at 31 December 2013, reflecting my comments above. There is no automatic legal imperative for a parent company to provide support to a subsidiary and, as such, I have not relied upon the availability of such support in my analysis. Nonetheless, in practice I consider it unlikely that SWFSH would not provide capital to avoid an adverse impact on policyholder benefit security, while it remained able to do so. Indeed, were such a situation to arise, it is possible, but not certain, that the PRA would direct the parent to provide the required support. Corporate reorganisation Immediately before the Effective Date, it is intended that the corporate structure of SWG will be reorganised to include CMIG and its subsidiaries as subsidiaries of SWG. I consider the reorganisation to be part of the wider process of the Scheme (although it is not effected by the Scheme itself) and my analysis is based on the pre-scheme position before the reorganisation. Diagrams A3.2 and A3.3 in Appendix 3 show the expected pre- and post-scheme corporate structures I have discussed the reorganisation with the Companies and am not aware of reason why it could not be completed as intended. The Companies have confirmed that the Scheme is not directly dependent on the reorganisation and can be carried out even if the reorganisation is not completed as intended. As a result, I am satisfied that the reorganisation will not introduce significant risk to the Companies ability to effect the Scheme at the Effective Date. WPFs under Solvency II The SW WPF currently benefits from a waiver which allows it to recognise certain assets in the SW NPF in meeting the requirement for the realistic assets in the SW WPF to be at least as large as the realistic liabilities. It has not been confirmed whether a similar waiver will be required following the Scheme or whether the current waiver would remain valid under Solvency II. I will provide an update on this in my Supplementary Report, but note that this waiver does not change the economic position of the policyholders in the SW WPF or their benefit expectations. Additionally, I note that if the Companies require a waiver under Solvency II, this would be the case whether the Scheme is approved or not More generally, the way that with-profits funds are valued and reported under Solvency II may differ to the equivalent approach under the current solvency regime. The PRA published supervisory statements in March 2015 setting out the principles to be followed and the Companies are reviewing their existing methodologies in light of this. Importantly, the Scheme does not change the assets, policies and liabilities in the WPFs and any changes to how these are valued or reported are a result 43

44 Outline of the Scheme of the introduction of Solvency II not the Scheme, and will occur regardless of whether the Scheme is approved or not. Additional considerations external to the Scheme SW WPF annuity transfer Separate to the Scheme, in June 2015 the Companies transferred a block of non-profit annuity business, with reserves of c. 2.5bn (as at 31 December 2014), from the SW WPF to the SW NPF. This business will transfer to the CMIG NPF under the Scheme. This transfer is expected to support the efficient runoff of the SW WPF, by removing a block of business with a longer term than the average in the fund - this would otherwise tie up capital, preventing it from being distributed to policyholders. The expected financial impact of this change is allowed for in the Pillar 2 and Solvency II projections of the financial position of the Companies, which I have considered as part of my analysis, and I will monitor the expected position of the Companies in the run-up to the Sanctions Hearing, reporting on any material changes in my Supplementary Report as appropriate. The impact of the transfer is not included in the Pillar 1 financial position set out in this Report, but I will provide this information in my Supplementary Report, which will include the full Pillar 1 position as at 30 June I have not considered this further in my assessment of the Scheme. CMI Scheme and the sale of CMI As announced on 7 May 2015, LBG has agreed to sell CMI Insurance Company Limited ( CMI ) to the RL360 Group. The sale is subject to regulatory approval and is expected to complete before the Effective Date. CMI is not owned by any of the Companies and the sale is not related to the Scheme and I do not consider it further in this Report. However, another scheme (the CMI Scheme ), is expected to be effected to transfer a small number of policies (around 6,000) from CMIG to CMI as part of the wider sale process. The Scheme and the CMI Scheme are not dependent upon each other and the CMI Scheme is subject to an equivalent process in the Isle of Man court under which an independent expert will opine on the potential policyholder impact of the CMI Scheme. The CMI Scheme does not have a material impact on the financial position of CMIG or any of the other Companies involved in this Scheme and I have not considered it any further in my analysis or reflected its impact in the financial position shown. Reinsurance arrangements The Companies have a number of intra-group and external reinsurance arrangements relating to the policies affected by the Scheme. These are set out in Appendix 6. As a result of the Scheme, these treaties will either: Collapse, in the case of intra-group reinsurance between the Companies as the underlying policies will all be part of SW Ltd post-scheme. The With-Profits Funds retain separate identities, and so, where appropriate, the treaties will be replaced under the Scheme with interfund arrangements (for example between either of the ring-fenced With-Profit Funds and the Combined Fund), which replicate the features of the reinsurance; or Be transferred from the ceding entity to SW Ltd in the case of external treaties (note that this includes intra-group treaties between one of the Companies and any entity in LBG not involved in the Scheme). 44

45 Outline of the Scheme In the case of intra-group reinsurance, i.e. treaties between any of the Companies, the reinsured policy liabilities will rank pari passu with the directly-written policy liabilities already within CMIG in the event of insolvency. While only relevant in very remote scenarios, this represents a change from the current situation, where these liabilities would be met in the first place by the defined collateral arrangements. The only collateralised intra-group agreements are between SW and SWA and SW and CMIG, which are detailed in paragraph I discuss the impact of these arrangements further in my assessment of the impact of the Scheme on benefit security. Debt issued SW has issued three tranches of debt where the repayment is subordinated to meeting policyholder liabilities ( Subordinated Debt ), totalling 2.06bn. One of these tranches is due to be repaid prior to the Effective Date, but the Companies intend to replace it with similar debt issued by SWG and to use the proceeds of the issuance to repay various internal loans to SW, with a limited, positive, net impact on the solvency position of SW pre-scheme and SW Ltd post-scheme. The other two tranches will be transferred to CMIG under the Scheme on identical terms (although the issuer will no longer be SW). These tranches include provisions anticipating a transfer of business such as that effected by the Scheme and which the Companies believe are applicable in this situation, under which there is no requirement for prior approval from the debt holders or their trustee. I have reviewed extracts of the relevant clauses and see no reason to disagree with this assessment The Solvency II regulations (and an associated supervisory statement released by the PRA) have changed the conditions for such debt to be eligible as a source of capital. This is not a Schemerelated change and will impact the Companies regardless of whether the Scheme (or the related corporate restructuring) occurs. The Solvency II figures provided by the Companies reflect the revised eligibility criteria, and so I do not consider this further in my analysis. Staff pension schemes As a result of the Scheme, the principal employer of the Scottish Widows Retirement Benefit Scheme (the SW Pension Scheme ) will change from SW to SW Ltd. The Scheme will not change the assets or liabilities in the SW Pension Scheme, nor will it change the level of contributions payable. SW Ltd is expected to be able to meet its regulatory capital requirements at the Effective Date and there is a Risk Appetite Framework in place to help protect against SW Ltd failing to meet its capital requirements in future. As part of my assessment of the Scheme, I have considered whether the transfer from SW to SW Ltd has a material adverse effect on the benefit security of policyholders currently in SW, and have concluded that this is not the case. Though I have not carried out a detailed review, as it is beyond my scope, I believe the same conclusion applies for members of the staff pension schemes. (Note: I discuss the potential impact on policyholders of the change in exposure to pension scheme risks associated with the Scheme in Section 6.) Service arrangements The Scheme will not change the administration or investment management arrangements for any of the groups of policyholders. Further details can be found in Section

46 Outline of the Scheme Costs of the Scheme All costs and expenses incurred in preparing and implementing the Scheme will be borne by the shareholder funds of the affected Companies prior to the Effective Date and the CMIG SHF or, if relevant, the Combined Fund following the Effective Date. None of the costs will be borne by the Transferring SW Policyholders, Transferring CMIG Policyholders or Existing CMIG Policyholders, or be charged to those policies in future (including in respect of charges to the Scottish Widows WPF and the CMIG WPF) Should the Scheme not be approved the financial positions of the Companies will be materially consistent with the pre-scheme Position. Where costs associated with the Scheme have already been incurred, these will be allocated to the various shareholder funds within the Companies. The precise form of such an allocation would be determined in the event that the Scheme is not approved, but I have no reason to believe that it would materially affect policyholder benefit security. 46

47 The Role of the Independent Expert 4. The Role of the Independent Expert Overview 4.1. For Schemes of this type, the Independent Expert is required to prepare a scheme report in a form approved by the PRA, having consulted the FCA, and in accordance with the requirements in the PRA Statement of Policy and the guidance contained in SUP 18. Its purpose is to assist the Court in deciding whether to sanction the Scheme. This Report is the scheme report for the Scheme As Independent Expert, I need to consider the effect that the Scheme may have on the various classes of policyholders in the Companies which are affected by the Scheme. In doing so, I consider separately the groups of policyholders set in the list below. Policyholders transferring from any subsidiaries of CMIG, namely CMMF, HLL and SAL (the Transferring CMIG Policyholders ), and their policies (the Transferring CMIG Policies ). Policyholders transferring from SW, any subsidiaries of SW, not within CMIG i.e. SWA, SWUF and PMSWF (the Transferring SW Policyholders ), and their policies (the Transferring SW Policies ). Existing policyholders of CMIG (the Existing CMIG Policyholders ), and their policies (the Existing CMIG Policies ). Within the groups above, I have considered with-profits policies, non-profit policies and unit-linked policies separately, as part of my analysis of the impact of the Scheme on the security and benefit expectations of policyholders. Where relevant, I have also considered whether the effect of the Scheme differs for different generations of policyholders, particularly policyholders written before and after the effective dates of the SW Scheme and the CMIG Scheme For any group of policyholders affected by a scheme of transfer, there may be some changes for the better and some for the worse. If there are some changes for the worse, this does not necessarily mean that the Scheme is unfair or unreasonable, as they might be outweighed by other benefits, or their impact might be extremely small. The test I have applied in considering this Scheme is whether the position of any group is, in the round, materially adversely affected. The definition of what is material depends on the matter being discussed, and so where there are adverse changes I have attempted to give some context as to their size and/or the likelihood of them occurring. Unless otherwise stated, if a potential effect is very unlikely to happen and does not have a large impact, or if it is likely to happen but has a very small impact, I do not consider it material In considering the effect of the Scheme on any group of policyholders as required by the PRA Statement of Policy and SUP 18, I have reviewed in particular the likely impact on: Policyholders benefit expectations, including the level of guaranteed benefits, charges, tax effects, preservation of any options available under a policy and, for with-profits policyholders, the expected level of discretionary benefits, investment freedom and bonus prospects. In 47

48 The Role of the Independent Expert opining on the effect on policyholders benefit expectations I have in mind what would happen in normal conditions, and typical variations in those conditions. It may be that in very extreme conditions, a fund may be forced to take unexpected actions that could change benefit levels. My opinions are not given in that context. However, I am not aware of anything in the Scheme which would cause a systematic reduction in benefit expectations in such circumstances relative to what would have happened in its absence. The security of policyholders benefits, including a review of the levels of financial support available to the different groups in normal and stressed conditions. For unit-linked policies, the level of charges, the approach to unit pricing and any changes to the investment fund mandates or the choice of funds. Service levels, covering both administration and investment management I have also considered: The adequacy of safeguards in the Scheme to protect the ongoing interests of different groups of policyholders. The impact of the Scheme on reinsurance contracts. The adequacy of the communications made to policyholders concerning the Scheme. Any other matters drawn to my attention by the Regulators or required by the Regulators to be addressed within the Report In my role as the Independent Expert I am not required to consider the possible effects on new policyholders (if any) entering into contracts after the Effective Date, and I do not do so in this Report Except where I have commented on the forthcoming Solvency II regime, all of my considerations are made in the context of the current UK regulatory regime for life insurance companies I have considered the Scheme only in the form in which it is to be presented to the Court. I am not required to, and do not, consider any possible alternative schemes or arrangements I have considered whether there are any previous Court schemes that created particular rights or protections for Transferring Policyholders which might be lost as a result of the Scheme. I discuss this in Section As the Independent Expert I was not directly involved in the formulation of the proposed Scheme. During the evolution of the detailed proposals, I have highlighted to the Companies any issues which were of concern to me, or which I considered unsatisfactory. All of the issues raised have been addressed to my satisfaction. 48

49 Existing Court-Approved Schemes 5. Existing Court-Approved Schemes 5.1 This section provides an overview of the Existing Schemes and how they have affected my conclusions in respect of the Scheme. I put particular focus on aspects of these Existing Schemes which could have a bearing on the management of a fund or the ongoing security of the policyholders in those funds. The SW Scheme 5.2 The SW Scheme became effective on 3 March 2000 and transferred all of the long-term insurance business then in force from Scottish Widows Fund and Life Assurance Society ( SWFLAS ) to SWA and SW. The Scheme effected the demutualisation of SWFLAS and included provisions that: Set out how compensation was to be paid to the members of SWFLAS and the extent to which shareholders would share in future profits. Established the SW WPF and set out the Principles of Financial Management ( PFM ) by which it would be run. Established the SW NPF and SW SHF. Created various accounts and capital support arrangements in respect of the SW WPF and set out the conditions under which support could be given to the fund. 5.3 Some of these provisions are no longer relevant as they are historical and refer to clauses required to effect the original transfer particularly those relating to payments to the members of SWFLAS at the time of the transfer or have been superseded by regulatory developments in relation to the management of with-profits business. 5.4 Key elements of the SW WPF PFM are included in the Scheme, and the Companies consider that the remainder are either covered by the Principles and Practices of Financial Management ( PPFM ) of the fund or have been superseded by regulatory developments. I have reviewed a mapping of the original PFM provided by the Companies to the Scheme, the PPFM and the relevant regulations and am satisfied that the key provisions from the SW Scheme are covered. A summary of this mapping and my analysis is provided in Appendix 7. The PPFM is easier to change than the Court-approved PFM, but I am satisfied that the existence of the With Profits Actuary ( WPA ) and the With Profits Committee ( WPC ), together with the TCF regulatory requirements, provide appropriate protection to policyholders in the event of any future changes. 5.5 The remaining provisions of the SW Scheme are largely replicated in the Scheme, including the key provisions relating to profit sharing and the support available to policyholders (which are discussed later in this section). However, there are updates in respect of the change in regulatory solvency regime to Solvency II (as discussed in paragraphs 5.33 and 5.35 below). 49

50 Existing Court-Approved Schemes 5.6 Since the SW Scheme was implemented, there have been changes to the regulations governing the level and type of costs that can be charged to a with-profits fund. The current regulations prohibit charging compensation or redress costs to a with-profits fund, unless not doing so would be inconsistent with an existing approved arrangement or where the payments are made to a policyholder of the fund and the event took place before 31 July In line with the SW Scheme, the Scheme will allow certain compensation costs to continue to be charged to the Scottish Widows WPF. These costs relate to events before the effective date of the SW Scheme so I am satisfied that they can still be charged under the transitional measures for the current regulations and note that this does not represent a change for policyholders. The SW Scheme included a provision allowing (but not requiring) any such costs that related to policies allocated to the SW WPF since the effective date of the SW Scheme to be charged to the SW WPF. The provision also prevented these costs being charged to the asset shares of with-profits policies written before the effective date of that scheme, the Additional Account or the Retained Account. This clause is not replicated in the Scheme, but I am satisfied that this does not reduce the protections for the policyholders in the fund, as: The Companies have confirmed that only increments to existing policies have been written directly in the SW WPF since the effective date of the SW Scheme, so no new policies have been allocated. Since the WPF will not bear any such costs, there is no need to replicate the provision that prevents them being charged to asset shares. More generally, SW Ltd will be required to manage the Scottish Widows WPF in line with the requirements under the TCF regulations and subject to oversight from the WPC and WPA. The CMIG Scheme 5.7 The CMIG Scheme became effective on 1 January 1997 and transferred all the long-term business of Clerical, Medical and General Life Assurance Society ( CMGLAS ) to CMIG under Schedule 2C to the Insurance Companies Act. The CMIG Scheme included provisions that: Set out how compensation was to be paid to the members of the CMG Society and the extent to which shareholders would share in future profits. Established the CMIG WPF and set out the PFM by which it would be run. Established the CMIG NPF and CMIG SHF. 5.8 Similar to the SW Scheme, some of these provisions are no longer relevant, as they are historical and refer to clauses required to effect the original transfer, or have been superseded by regulatory developments in relation to the management of with-profits business. 5.9 In 2005, the CMIG Scheme was modified to remove references to the role of the Appointed Actuary and to bring the governance processes in respect of the CMIG WPF in line with the prevailing regulatory guidance. This modification was approved by the Court and I have based my analysis on the modified version of the CMIG Scheme. 50

51 Existing Court-Approved Schemes 5.10 Key elements of the CMIG WPF PFM are included in the Scheme, and the Companies consider that the remainder have been superseded by regulatory developments. I have reviewed a mapping of the original PFM provided by the Companies and am satisfied that the key provisions from the CMIG Scheme are covered. A summary of this mapping and my analysis is provided in Appendix As set out in paragraph 5.8, changes to the regulations governing the level and form of costs that can be charged to a with-profits fund have occurred since the CMIG Scheme was implemented,. In line with the CMIG Scheme, the Scheme allows certain compensation costs to continue to be charged to the CMIG WPF. I am satisfied that these costs relate to events before the effective date of the CMIG Scheme, so can still be charged. Capital support and restrictions introduced by Existing Schemes CMIG Scheme 5.12 The CMIG Scheme includes a provision requiring the establishment and maintenance of a Bonus Deficit Account which is used to help meet the cost of any bonus declaration if the CMIG WPF is unable to meet the cost itself. It is not replicated in the Scheme, but I am satisfied that this does not materially disadvantage policyholders because: Under the CMIG Scheme, this account is only operational until the end of Given the financial position of the CMIG WPF, I agree with the Companies view that it is extremely unlikely that the account will be utilised within that timeframe. It has never been used since its inception in 1996 (including in times of significant financial macroeconomic volatility) and the test for assessing its use had an excess of 1.3bn at 31 December The CMIG Scheme sets out that financial assistance can only be provided to the CMIG WPF where it is subordinated to the liabilities of the policies in the fund. This means that the CMIG WPF will only repay such support where such a repayment did not result in the fund being unable to meet policyholder benefit expectations. These provisions are replicated in the Scheme and help support the benefit security of the policyholders in the CMIG WPF. Applicability of opinion to pre- and post-demutualisation policies 5.14 Certain clauses in the CMIG Scheme relate specifically to the interests of the with-profits policies written before the effective date of that Scheme (although this distinction is not as prominent as it is in the SW Scheme). I am satisfied that these clauses have been retained where not covered by the wider regulations in respect of treating with-profits policyholders fairly. As a result, I am satisfied that my conclusions in respect of the impact of the Scheme on the Existing CMIG Policyholders, as set out in Section 9, apply equally to all policyholders in the CMIG WPF. SW Scheme 5.15 The SW Scheme included provisions which created certain accounts in SW to support the management and ongoing security of the SW WPF. In addition, the SW Scheme included provisions restricting the removal of capital from SW and introduced various inter-fund arrangements. The remainder of this sub-section sets out the details of these arrangements and explains how they will 51

52 Existing Court-Approved Schemes change under the Scheme. Figure 5.1 provides an overview of the accounts and where they are held within SW at present. Figure 5.1: SW Scheme accounts Additional Account 5.16 The SW Scheme introduced the requirement to create and maintain a memorandum account in the SW WPF called the Additional Account. The initial size of the Additional Account and the items that can be credited to / debited from it were set out in the SW Scheme If, allowing for the value of expected future debits, there is expected to be an excess in the Additional Account, that excess must be distributed over time to the with-profits policies still in force, which were also in force before the effective date of the SW Scheme. No shareholder transfers are made in respect of the cost of these additional bonuses In the event there is a deficit, this is met first by a deduction from the asset share (as defined in Appendix 10) of the with-profits policies still in force, which were also in force before the effective date of the SW Scheme, to the extent that such a deduction is not inconsistent with policyholder reasonable expectations, and then by the SW NPF or SW SHF. Subsequent to the SW Scheme, it was decided that the cost of Guaranteed Annuity Options ( GAOs ) would be met by the Additional Account, rather than asset shares. This change increased the likelihood of the Additional Account being exhausted. The then shareholders provided a public undertaking that any such deficit would be met by the SW NPF or SW SHF and not charged to asset shares The Scheme includes provisions to create a memorandum account in the Scottish Widows WPF to replicate the provisions from the SW Scheme relating to the ongoing management of the Additional Account, with the exception of: Provisions relating to a mechanism designed to share certain tax benefits that were available at the time of the SW Scheme, but which are no longer available. Moving responsibility for decision making from the now superseded Appointed Actuary role to the Board, having taken account of appropriate actuarial advice. Changing the concept of Policyholder Reasonable Expectations ( PRE, also now outdated) to that of TCF. This change does not reduce policyholder protections, as the Companies interpretation of the requirements needed to meet PRE is a subset of those needed to satisfy TCF. 52

53 Existing Court-Approved Schemes Retained Account 5.20 The SW Scheme included provisions for compensation payments to be made to members under the terms of the demutualisation. The Retained Account is a memorandum account created in the SW WPF to hold the interest accrued on these payments between the SW Scheme effective date and the date they were paid. At the time of the SW Scheme, there were some uncontactable members and their compensation was held in a separate Members Account until 2010, following which the balance was transferred to the Retained Account. In addition, any residual amounts from the With Profits Fund Provision (as described later in this sub-section) are allocated to the Retained Account. The Retained Account is distributed to the with-profits policyholders who were in force at the time of the SW Scheme and are still in force through a modest uplift to final payouts. No shareholder transfers are made in respect of the cost of these additional bonuses The Scheme includes provisions to create a memorandum account in the Scottish Widows WPF and to replicate the provisions from the SW Scheme relating to the ongoing management of the Retained Account, with the exception of the provisions relating to the Members Account, which are no longer relevant. The Members' Account related to the payment made to members of SWFLAS at demutualisation and is no longer maintained (consistent with the terms of the SW Scheme as set out above). With Profits Fund Provision 5.22 The With Profits Fund Provision was an amount established in the SW WPF to meet the expected cost of a number of specified liabilities payable by the SW WPF (including industry levies and misselling costs). Any surplus is transferred to the Retained Account, while deficits are also met by the Retained Account (up to the value of the historical transfers to that account) and then by the Additional Account The Scheme includes provisions continuing the operation of the With Profits Fund Provision in line with the SW Scheme. Support Account and Further Support Account 5.24 The SW Scheme included provisions designed to ensure that sufficient capital was held in the SW NPF to support the investment policy of the SW WPF. The first of these, the Support Account, is a memorandum account in the SW NPF that holds tangible assets set at a level such that the total value of the Additional Account and the Support Account are not less than 10% of the current level of asset shares of the with-profits policies still in force, which were also in force at the effective date of the SW Scheme Should the sum of the Additional Account and the Support Account exceed 20% of this asset share, then, subject to the provisions of the SW Scheme, the Support Account can be reduced, via a payment to the Further Support Account. Should the total fall below 10%, then a payment would be made from the Further Support Account to the Support Account The Further Support Account is also a memorandum account created in the SW NPF. Under the SW Scheme, it was set at an agreed initial level and runs down to zero over a period of 30 years in a prescribed manner. 53

54 Existing Court-Approved Schemes 5.27 The Scheme includes provisions to establish memorandum accounts in the CMIG NPF (and subsequently the Combined Fund) in respect of the Support Account and the Further Support Account. The provisions from the SW Scheme relevant for the ongoing operation of these accounts have been replicated in the Scheme. Opinion on the Additional Account, Retained Account, With Profits Fund Provision, Support Account and Further Support Account 5.28 I am satisfied that the Scheme replicates the operation of the Additional Account, Retained Account, With Profits Fund Provision, Support Account and Further Support Account. To the extent that there are any changes, these are cosmetic in nature, and I confirm that in my view they do not adversely affect policyholders. Requirement for support and limitations of support 5.29 The SW Scheme sets out the conditions under which support will be provided (subject to the limitations set out later in this sub-section) by the SW NPF to the SW WPF. The requirement for support is set out in two tests: The PRE Test which tests whether there are sufficient assets in the SW WPF to meet the reasonable expectations of policyholders in the fund. The amount required to meet these expectations is denoted the Required Amount and is compared to the assets in the SW WPF to determine whether support is required. The Statutory Test which tests whether there are sufficient assets in the SW WPF to meet the regulatory liabilities of the fund. This amount is known as the Regulatory Value and is compared to the assets in the SW WPF to determine whether support is required As at 31 December 2014, the PRE Test showed no excess and the Statutory Test showed a modest deficit, but no transfers were made in respect of either test. This reflects established practice to allow for the value of the waiver discussed in paragraph 3.37 in the Statutory Test. It is important to note that the fact that neither test shows an excess does not imply that the fund requires support or would be unable to absorb losses. Both tests make allowance for the reported realistic liabilities of the fund, including future discretionary benefits and shareholder transfers in the event that losses occurred, these amounts would be expected to reduce to remedy the position Where support is provided, it is repayable contingent on the SW WPF recovering and being able to meet the above tests The SW Scheme prevents the SW NPF from making such support available if it could lead to the SW NPF being insolvent on a statutory basis The Scheme replicates the principles of these tests, although there are some necessary changes as a consequence of the move to Solvency II and changes in the wider regulatory environment: The PRE Test is replaced by a TCF Test. The Companies have confirmed to me that this will not lead to any changes in how the Required Amount is calculated in practice. 54

55 Existing Court-Approved Schemes The Statutory Test will refer to regulatory liabilities and assets under the Solvency II regime. The Regulatory Value will be calculated using similar principles to now, but with an added margin specified under Solvency II. The Companies are still determining their view on the correct calculations for the SW WPF (the Scottish Widows WPF post-scheme) under Solvency II, but it is possible, depending on the extent to which certain discretionary benefits are included within the liability calculation, that the change will trigger the Statutory Test to bite. This could lead to a relatively small transfer into the Scottish Widows WPF, which I would view as a strengthening of policyholder security, but a very modest one given the contingent nature of such a transfer. I would expect a negligible net impact on the reported solvency position of the Combined Fund. The limitation on the availability of support is changed by the Scheme to refer to the Combined Fund and the definition of insolvency has been revised to reflect the Solvency II regulatory environment. The wording in the Scheme allows for the Combined Fund to provide support where doing so would cause it to have a deficit against its regulatory capital requirements, but, importantly, does not require this support to be given. All else being equal, these small changes are expected to increase the likelihood of support being available to the Scottish Widows WPF, but I view the change as immaterial for the same reasons as above. I will continue to monitor this situation in advance of the Sanction Hearing and will provide more information in my Supplementary Report to highlight the Companies expectation of how Solvency II will affect the Scottish Widows WPF. Transfers from the SW NPF 5.34 The SW Scheme includes three restrictions on the transfer of capital from the SW NPF to the SW SHF (or anywhere else other than the SW WPF). These state that an amount could not be removed from the fund if it would result in: The remaining assets, including the expected present value of future profits, being less than the sum of the liabilities of the fund, the Support Account and the Further Support Account. The remaining assets recognisable under solvency regulations being less than the sum of the liabilities of the fund and the Support Account. The remaining assets being less than the value required to meet the reasonable expectations of all policyholders in SW and holders of policies expected to be written as new business in the coming year Under the Scheme, equivalent restrictions are imposed, other than: The assessment is made in relation to the Combined Fund and relates to restrictions on paying dividends. This reflects the fact that there is no regulatory imperative to maintain a separate shareholder fund under Solvency II. The liabilities in relation to the first test are defined as the technical provisions under Solvency II and any other liabilities of the fund. This change ensures that the test is reflective of the liabilities under the solvency regime that is expected to be applicable when the Scheme is operative. 55

56 Existing Court-Approved Schemes Under Solvency II, there is no restriction in recognising the expected value of future profits as an asset (technically, a reduction in the liabilities) in the solvency calculation. As a result, the excess of assets over liabilities will be the same in the first two tests. As the threshold of the first test is at least as high as that of the second test, the second test will never bite and has been dropped. The concept of policyholder reasonable expectations has been replaced with TCF and the test is applied to business in the Combined Fund, the CMIG WPF and the Scottish Widows WPF (this includes all policies where the Combined Fund would be expected to support policyholder benefits, either directly or through support to one of the WPFs) I am satisfied that the changes to these tests appropriately reflect the changes to the fund structure and the regulatory regime and are set in such a way as to prevent unreasonable distributions which could adversely impact policyholder security. Given these restrictions and the expected solvency position of the Combined Fund following the Scheme, I am satisfied that support will be available for the with-profits funds in all but the most extreme of scenarios. I view these tests and restrictions as complementary to the Capital Targets, which restrict the amount of capital that can be removed from SW Ltd following the Scheme. Other arrangements 5.37 The SW Scheme introduced the requirement to consider an amount called the Cumulative Operative Charge, which aims to protect the investment freedom of the SW WPF should it incur any material operational losses due to activities that took place before the effective date of the SW Scheme. This amount is required to be held as part of the Support Account. The Scheme replicates the relevant provisions in relation to this. As at 31 December 2014, the Cumulative Operative Charge was zero The SW Scheme created a memorandum account called the Capital Reserve, which facilitated the computation of tax payable on the repatriation of the then shareholder s initial capital investment in the company. Following changes to tax regulation since the demutualisation this account is no longer needed for such a computation and there is no need to carry forward equivalent provisions in the Scheme Under the SW Scheme, a contingent loan was made from the SW NPF to the SW WPF in respect of future profits on non-profit business attributable to the SW WPF, which were not ordinarily recognisable in the SW WPF regulatory solvency position. The loan has no economic effect, as its payments are circular (transfers of the SW WPF attributable profits arising in the SW NPF are immediately used as a repayment to the SW NPF, with a net impact of zero, so policyholders are not disadvantaged by omitting it. The SW Scheme also stipulated a tax sharing arrangement between the SW WPF and SW NPF in respect of these amounts. This also has no ongoing economic impact as a result of subsequent changes to the tax regulation. Notional Mutual Company 5.40 The SW Scheme introduced the concept of a Notional Mutual Company ( NMC ) consisting of the asset shares of the with-profits policies in force at the date of the SW Scheme, the Additional Account, the Retained Account and the Support Account (to the extent the SW NPF has sufficient regulatory assets to cover it). It is allowed for in setting the investment strategy of the assets backing 56

57 Existing Court-Approved Schemes SWFLAS s pre-demutualisation SW WPF with-profits policies, and is intended to provide the same level of investment freedom the policies would have had had the former not demutualised. This concept is retained in the Scheme, although the solvency of the Notional Mutual is defined in relation to Solvency II Solvency II will introduce a Risk Margin which is required to be included in the value of the liabilities of the Notional Mutual Company, when determining investment freedom. The impact this will have on investment freedom will depend on the extent that transitional arrangements are available. Investment freedom is projected to improve in the future but the implementation of Solvency II may slow the rate of improvement. Any such change is a result of the implementation of Solvency II; there will be no change as a result of the Scheme. Opinion on availability and limitations on support, restrictions on the removal of assets from the Combined Fund and other arrangements in the SW Scheme 5.42 I am satisfied that the Scheme replicates the key provisions in relation to when support will be provided to the Scottish Widows WPF, the restrictions on this support and the limits on the removal of assets from the Combined Fund. To the extent that there are any changes, these are required to reflect the revised solvency and regulatory environment, and I confirm that in my view they do not materially adversely affect policyholders. I am also satisfied that changes to the other arrangements set out in the SW Scheme have no material effect on policyholder benefit expectations or security. Applicability of opinion to pre- and post-demutualisation policies 5.43 A number of the protections, clauses and accounts in the SW Scheme relate specifically to withprofits policies written before the effective date of that scheme. These include the Additional Account, the Retained Account, the Support Account, the Further Support Account and the concept of the Notional Mutual. I am satisfied that these are replicated by the Scheme and, for the avoidance of doubt, have not been extended to apply to other policies in the fund in a way that could reduce their effectiveness. As a result, I am satisfied that my conclusions in respect of the impact of the Scheme on the Transferring SW Policyholders, as set out in Section 7, apply equally to all policyholders in the SW WPF. Existing Schemes other than the SW Scheme and the CMIG Scheme SWAS Scheme 5.44 The SWAS Scheme became effective on 31 December 2004 and transferred all the long-term business of Scottish Widows Administration Services Limited (formerly known as Lloyds TSB Life Assurance Company Limited) to SW and SWA. Other than as set out below, the SWAS Scheme just effected that transfer, and has no ongoing relevance to policyholders. The SWAS Scheme gave the power for unit-linked funds under 1m to be closed. Any units in those funds would move to another fund, and affected policyholders could switch from that fund to another free of any charges that would otherwise have applied. As set out in paragraphs 3.22 to 3.24 above, this power will be replaced in the Scheme by a more general power relating to the ongoing management of the unit-linked funds. The right to a free switch has been replicated in the Scheme. 57

58 Existing Court-Approved Schemes The SWAS Scheme set out the basis on which some policies were to be converted to nonprofit, including the scales for annual and final increases to the value of the policies. This has already taken place and the terms are unchanged by the Scheme. The SWAS Scheme includes requirements in respect of future modifications. As noted in paragraph 5.50, these powers are replaced by a substantially equivalent provision in the Scheme. Other Existing Schemes 5.45 The Companies have provided me with an overview of the other Existing Schemes replaced by the Scheme and have confirmed that none of these have any ongoing impact on policyholder protections or how the policies within LBGI are managed. I have reviewed the other Existing Schemes at a high level and agree with this conclusion One previously approved scheme (which transferred business from Halifax Assurance Ireland Limited to SAL) is being transferred under the Scheme. This has the effect of maintaining the provisions of that scheme and I do not consider it further. Local versions of the Existing Schemes 5.47 I have also reviewed the local scheme for Jersey that related to the SW Scheme and the local schemes for Jersey and the Bailiwick of Guernsey that related to the SWAS Scheme. Other than in respect of governance on future changes as discussed below, I am satisfied that these local versions of the Existing Schemes do not introduce any factors that are relevant to my considerations in addition to those in the Existing Schemes themselves. I am satisfied that my conclusions in respect of the SW Scheme and the SWAS Scheme apply equally to these local versions of the schemes. Governance requirements of the Existing Schemes 5.48 The Scheme places responsibility for the management of business on the Board, often with the requirement to take appropriate actuarial advice. This is in contrast to the SW Scheme, which includes a reference to decisions being made by the Appointed Actuary. The role of the Appointed Actuary has been superseded by the WPA and the Actuarial Function Holder ( AFH ) (which itself will be superseded by the Chief Actuary role under Solvency II). Regulatory guidance has also clarified that it is the Board which is expected to take overall responsibility for the management of insurance business, including the with-profits funds (albeit subject to consultation with the WPC). I consider whether this represents a change in policyholder protection in my discussion on governance in Section 10. The governance arrangements set out in the CMIG Scheme (as a result of the modification in 2005), the SWAS Scheme and the other Existing Schemes replaced by the Scheme are consistent with those set out in the Scheme Both the SW Scheme and the CMIG Scheme require a certification in the annual PRA Returns that certain aspects of the respective schemes have been complied with. Equivalent provisions are included in the Scheme in relation to the CMIG WPF and SW WPF, although certification will be provided to the Insurance Board rather than in the PRA Returns. The Scheme also includes the requirement for the WPA to report to the Regulators any concerns that actions taken (or the failure to take actions) by the Insurance Board may result in the Scheme not being implemented properly or that may result in SW Ltd failing to meet its requirements under the TCF regulations in respect of the 58

59 Existing Court-Approved Schemes policyholders with with-profits policies. The existing certification in respect of the SW Scheme relates to all policyholders in SW, not just the policyholders in the WPFs. The majority of the provisions in the Scheme relate to the WPFs, and are covered by the certifications, or are provisions to facilitate the transfer itself, with no ongoing relevance. I am satisfied that a certification in relation to the remaining provisions, such as those relating to the management of unit-linked funds, would not provide a significant additional protection to policyholders over and above the protections built into the Scheme, the general legal obligation for SW Ltd to comply with the Scheme and its obligations under TCF The Existing Schemes include provisions requiring that any proposed modifications are: In respect of the SW Scheme: o o approved by the Court of Session; and supported by an opinion from an independent actuary that they do not adversely affect the reasonable expectations of, or reduce the protection conferred by the SW Scheme on, the with-profits policyholders in force at the effective date of the SW Scheme. In respect of the CMIG Scheme: o approved by the Court - but the Companies have been advised that there is no requirement for an opinion from an independent actuary similar to that for the SW Scheme. In respect of the other Existing Schemes replaced by the Scheme: o o approved by the court where they were originally approved (either the Court of Session or the Court); and supported by an opinion from an independent actuary that they do not adversely affect the reasonable expectations of, or reduce the protections conferred by the Existing Scheme on, the policyholders transferred under that scheme. In respect of the local versions of the SW Scheme and the SWAS Scheme: o o approved by the court where they were originally approved (either the Royal Court in Guernsey or the Royal Court of Jersey) or, in the case of the Jersey scheme related to the SW Scheme, the Finance and Economics Committee; and supported by an opinion from an independent actuary equivalent to that required under the equivalent Existing Scheme The Scheme includes an equivalent provision, although the independent expert must now confirm that changes do not adversely affect the security or benefit expectations of [policyholders of SW Ltd] and the provision is applicable to all policyholders held in SW Ltd following the Scheme. I am satisfied that this revised wording maintains an equivalent level of protection against inappropriate future changes As the Scheme will be submitted to the Court and not the Court of Session, the Companies intend to submit the Court of Session Applications to obtain the consent of the Court of Session to modify, and 59

60 Existing Court-Approved Schemes in effect replace, the SW Scheme and the SWAS Scheme. The Court of Session Applications will not have any effect on the provisions of the Scheme and I do not consider them further. I will monitor progress on the applications and provide an update in my Supplementary Report, Existing Schemes certification 5.53 The Companies have asked me to provide the required opinions for the purposes of satisfying the requirement in the SW Scheme regarding the changes introduced by this Scheme. The Companies have also asked me to provide the required opinion for the purposes of satisfying the requirement in the SWAS Scheme (and the equivalent local schemes), as set out above. The Companies have been advised that certification is not required for the other Existing Schemes. I expect to provide the required certifications in my Supplementary Report, if justified, based on the final version of the Scheme that will be presented to the Court for approval. To date I have not identified any reason why I would be unable to give the required opinions. 60

61 Capital Requirements and Risk Appetite Framework 6. Capital Requirements and Risk Appetite Framework Introduction 6.1 As the Independent Expert, a central part of my considerations is the security of policyholder benefits and the impact of the Scheme on this security. For example, I would be concerned if the Scheme moved some policies from a financially strong fund to a weak one which might not be able to honour its obligations to policyholders. 6.2 My analysis of the impact of the Scheme on policyholder security depends heavily on the level of capital available to the Companies, and their ability to satisfy their respective solvency requirements now and in the future. In addition to holding assets sufficient to meet expected claims and payments on policies, life insurance companies maintain additional assets, known as available capital or capital resources. These resources provide additional security to policyholders by acting as a buffer against losses. If the experience of a company is worse than expected, for example due to investment losses or annuitants living longer than expected, the level of available capital they maintain is intended to be sufficient to absorb the resultant losses whilst still leaving sufficient assets to meet expected policyholder liabilities. 6.3 To protect policyholders, the UK regulatory system mandates certain minimum levels of capital that are required to be held at all times. The regulations place restrictions on the use of such capital (for example, it is unlikely to be permissible to distribute such capital in the form of dividends), particularly where it is part of a with-profits fund in which discretionary benefits are expected to be paid beyond the minimum policy guarantees. 6.4 I discuss these matters at an entity level in this Section of the Report, and my overall conclusions in respect of each different group of policyholders are set out in Sections 7, 8 and 9. Background to the Current Supervisory Regime 6.5 The Regulators are responsible, amongst other things, for the supervision of UK authorised insurance companies. A key aim of the PRA s supervisory regime is to contribute to the securing of an appropriate degree of protection for policyholders, ensuring that there is a sufficiently high probability that an insurer is able to meet claims from, and material obligations to, policyholders as they fall due. Since life insurance business can be very long-term, with some contracts lasting for 30 years or more, it is necessary to set solvency standards and monitor insurance companies regularly against those standards. No supervisory regime can ensure that every company will remain solvent in all possible circumstances, but a good one will ensure that the chance of an insurance company becoming insolvent is remote. Furthermore, a good regime acts as an early warning system, permitting remedial action to be taken if a company starts to get into financial difficulty. 6.6 Under the current regulatory solvency regime, UK insurance companies are required to report their solvency positions to the PRA in two ways, referred to as Pillar 1 and Pillar 2. 61

62 Capital Requirements and Risk Appetite Framework 6.7 Pillar 1 is based on existing European Union regulatory requirements. Assets are taken at market value and reserves are set up to cover each fund s liabilities. These liabilities (which for the base Pillar 1 calculations exclude non-guaranteed discretionary payments) are valued using assumptions that include prudent margins. Solvency capital, expressed as a percentage of reserves and of sums at risk (the excess of guaranteed benefits over reserves held), must be held in addition to the base reserves. The additional solvency capital is known as the Long Term Insurance Capital Requirement ( LTICR ). This set of calculations is commonly referred to as the regulatory peak, or Peak Companies such as SW and CMIG, which have with-profits liabilities in excess of 500m, are also required by UK regulations to report under Pillar 1 on a realistic basis. In this second calculation, assets are again taken at market value, while liabilities include allowance for any non-guaranteed benefits that are expected to be paid. The liabilities are valued using best estimate assumptions. A Risk Capital Margin ( RCM ) is held in addition to the realistic liabilities, reflecting the additional capital that would be needed in moderately adverse scenarios specified in the regulations. These calculations are referred to as the realistic peak, or Peak If the excess assets under the realistic peak are less than the excess assets under the regulatory peak, then an addition called the With-Profits Insurance Capital Component ( WPICC ), is made to the regulatory peak capital requirements to ensure that the more onerous requirement of the two peaks is met under Pillar 1 reporting (subject to an adjustment to allow for any liability to pay shareholder transfers) The Pillar 2 solvency rules require that each company undertakes its own Individual Capital Assessment ( ICA ). The ICA is based on an analysis of the various risks affecting the company (including market, credit, insurance, operational and liquidity risks), the strains that would arise under various adverse stress and scenario tests, and an overall assessment of the amount and type of capital required to meet those risks. Companies can set their own risk tolerance which must be based on a confidence level at least as high as the PRA s minimum standard of a 99.5% solvency confidence level over one year. The ICA analysis is typically reported to the PRA each year. The PRA may issue Individual Capital Guidance ( ICG ) if it feels that the ICA is insufficient to meet the minimum 99.5% confidence level. This adds to the company s capital requirement and may occur, for example, if the PRA is not satisfied with the severity of the stress scenarios used by the company, or if it is not satisfied that the company has fully taken into account all of its risks. The result is that a company with sufficient capital to meet its ICA and ICG should (at least) be able to withstand an event, or combination of events, equivalent to a once-in-200-year shock, and still be able to meet its best estimate of the value of its liabilities Companies are required to publish their Pillar 1 calculations each year and these are externally audited. Pillar 2 figures are not published or audited and are commercially sensitive; however, the Companies have made their Pillar 2 figures available to me in my role as the Independent Expert for the Scheme, and I have reviewed the Companies estimated Pillar 1 and Pillar 2 figures pre- and post-scheme, to assess the impact of the Scheme on the security of policyholders benefits. Although the Pillar 2 calculations are not shown in my Report, I have included a qualitative summary of the relevant findings from the Pillar 2 analysis On 1 January 2016, a new regulatory regime called Solvency II is expected to become operative in the UK (and across the EU). Although the regulations in relation to Solvency II are substantially finalised, there remains significant uncertainty as to how some provisions will be interpreted, the 62

63 Capital Requirements and Risk Appetite Framework availability of transitional measures to avoid a sudden increase in capital requirements, and elements of the solvency calculation that are subject to regulatory approval. Nevertheless, given that the implementation of Solvency II is essentially coincident with the expected Effective Date of the Scheme, and will be used to determine solvency in the future, I have paid particular attention to the expected solvency position of the Companies under Solvency II in forming my opinion on the impact of the Scheme Once Solvency II is operative, the Companies will be required to disclose their solvency position publicly, but until that point the results are private and I do not consider it appropriate to disclose them in this Report. Instead, I comment on whether the Companies expect to meet the Solvency II requirements, and the extent of any differences in expected solvency pre- and post-scheme. Comparing benefit security and risk appetite 6.14 Failing to meet the regulatory capital requirements would be a very serious matter for any company, and would severely damage its reputation. To avoid this, most insurers, including the Companies, hold capital in addition to the level required by the regulations. The minimum that they aim to hold is often set out in their risk appetite framework and internal capital policy. The Companies Risk Appetite Framework is explained later in this Section I consider the use of solvency ratios, such as the ratio of available capital to capital requirements, to be a useful indicator of the immediate impact of the Scheme on the level of benefit security provided to policyholders, especially where the before and after ratios are calculated using consistent methods and assumptions, as is the case in this Report. Where these ratios increase, it might imply, other things being equal, more security for policyholders immediately following the Scheme. The Companies have estimated these ratios on a Pillar 1 and Pillar 2 basis for each Company, and I have considered these in forming my opinion. I have also considered similar results on the estimated Solvency II position, albeit that there is more uncertainty relating to these Whilst the impact on the solvency position at the time of the Scheme is important, I would be concerned if subsequent actions meant that any of the Companies could be weakened in future. This could happen, for example, through the payment of excessive dividends to shareholders. The constraint on the extent of such action in any of the Companies is the capital target in the Risk Appetite Framework, since this is set at a higher level than any of the regulatory requirements. Hence, in considering the level of benefit security afforded to policyholders, I have placed heavy emphasis on the strength of the relevant capital targets in each company Having capital in excess of the risk appetite of any company is helpful, but where it could potentially be removed at any future point, for example, via the payment of dividends, I have placed limited weight on it. If a group of policies moves to a company with lower current solvency ratios but these are still well in excess of regulatory requirements and the new company has a stronger or equivalent risk appetite framework to the transferor, I would generally not consider that to be materially adverse, as long as the capital targets under the risk appetite framework provide an acceptable minimum ongoing level of financial strength and cannot be weakened arbitrarily in future When considering benefit security I have analysed the position of each separate fund within the entities. I note that the SW Scheme established certain accounts whose availability and operation provide extra security for some of the Transferring SW Policyholders. In addition, the Existing Schemes include limits on the amount of capital that can be removed from the long-term funds. I 63

64 Capital Requirements and Risk Appetite Framework have considered these arrangements and how they are changed by the Scheme in reaching my conclusions on the impact of the Scheme on the various groups of policyholders. Date of Solvency Calculations 6.19 The estimated impact of the Scheme on the Pillar 1 solvency positions of the Companies has been determined with reference to the Companies assets and liabilities and the market conditions as at 31 December All Pillar 2 analysis is based on the estimated position as at 31 December I have also considered a projection of this position to the Effective Date to allow for known or expected changes in the solvency position of the Companies (including, for example, the expected impact of the transfer of annuity business from the SW WPF, planned dividends and expected earnings) The Solvency II position is based on the estimated position as at 31 December 2014 and projected to 1 January 2016 (using an approach similar to that under Pillar 2) The solvency positions set out in this Report exclude the impact of the partial recapture of The Equitable Life Assurance Society inward reinsurance that took place in March The Companies have confirmed that this had a positive impact on the solvency position and I am satisfied that this does not alter my conclusions in respect of benefit security I note that the economic position at the Effective Date cannot be predicted with certainty. The absolute solvency level at the Effective Date will therefore differ from that shown in the Report, but I would not expect the impact of the Scheme to vary significantly from the estimates shown and it is this impact which is my primary consideration (alongside the Companies continuing to satisfy regulatory solvency requirements, as is currently the case). I will continue to keep the position under review in the period leading up to the Sanction Hearing, and will prepare further information in my Supplementary Report. Estimated impact of the Scheme on solvency 6.24 The estimated impact of the Scheme on the Pillar 1 solvency position of the Companies is shown in Table 6.1 below, with a more detailed breakdown in Tables A5.1 to A5.3 of Appendix 5. 64

65 Capital Requirements and Risk Appetite Framework Table 6.1: Estimated impact of the Scheme on Pillar 1 solvency as at 31 December 2014 (including with-profits funds) m Total Assets Capital Resources (1) Capital Resources Requirement (2) (including any WPICC) Surplus (3) Solvency Coverage (4) SAL 9, % HLL 6, % CMMF % Pre-Scheme CMIG 22,545 3,212 1,695 1, % SWUF 28, % SWA % PMSWF 1, % SW 35,056 8,571 5,963 2, % Post- Scheme SW Ltd 99,933 8,774 5,861 2, % Source: Financial analysis provided by the Companies Notes: (1) Admissible assets less Pillar 1 liabilities (both calculated under Regulatory Peak), subject to the Regulators rules on capital tiers. (2) Long-Term Insurance Capital Requirement plus With-Profits Insurance Capital Component plus CRR of regulated subsidiary. (3) Capital Resources less Capital Requirements (where the latter is that part of the entity-level requirements that arises in respect of the relevant fund). (4) Capital Resources divided by Capital Resources Requirement The reported position of SW in Table 6.1 includes the surplus capital of the other Companies, as they are all subsidiaries of SW. As a result, the position of SW pre-scheme is the most like-for-like comparator for the position of SW Ltd following the Scheme. The solvency position of SW Ltd is higher than that for SW, reflecting the removal of certain restrictions on the value of assets recognised, consolidation inefficiencies and the capital inefficiencies in respect of the reinsurance The figures in Table 6.1 are based on the total position of each company including the assets and liabilities in the SW WPF and the CMIG WPF. In practice, those funds are ring-fenced. Capital can only move from one of the WPFs to another fund in extremis i.e. to prevent insolvency. Even in insolvency, it is not clear that assets from the WPFs would be fully available to support the benefits of other policies as set out in paragraphs 6.63 to As a result, I have also presented Table 6.2, which excludes the capital resources and capital requirements for the with-profits funds, which, subject to the following paragraph, I believe provides a more realistic view of the solvency of each fund, consistent with how they would be managed in practice. 65

66 Capital Requirements and Risk Appetite Framework 6.27 I do not make any adjustment to the figures in Table 6.2 to reflect the Support Account or the Further Support Account in SW. These accounts are held in the SW NPF to support the investment freedom attaching to certain policies in the SW WPF but are not available to support benefit security in the fund (other than potentially in extremis), and so I do not view them as part of the ring-fenced SW WPF for the purpose of my analysis of benefit security. Table 6.2: Estimated impact of the Scheme on Pillar 1 solvency as at 31 December 2014 (allowing for the ring-fenced nature of the with-profits funds) m Total Assets Capital Resources Capital Resources Requirement Surplus Solvency Coverage Pre- Scheme CMIG 15,488 1, , % SW 19,045 3,604 1,201 2, % Post- Scheme SW Ltd 78,225 3,753 1,099 2, % Source: Financial analysis provided by the Companies Notes: The financial position shown for SW and CMIG includes the value of the subsidiaries. CMIG s surplus is shown within SW s Capital Resources in the published Pillar 1 statements, as it is currently a subsidiary of SW. This surplus has been split into the underlying Capital Resources and the Capital Resources Requirement to provide a like-for-like comparison of the solvency position pre- and post-scheme. My view on benefit security 6.28 The following section sets out my general considerations in relation to the impact of the Scheme on the benefit security of the policyholders in the Companies. In Sections 7, 8 and 9, I build on these general conclusions with analysis that is specific to each class of policyholders in the Companies. Non-profit and unit-linked policies 6.29 For non-profit policies such as term assurances and annuities, policyholders pay specified premiums and receive specified benefits. The benefits are guaranteed whatever the performance of the firm and wider investment markets. If the company loses money and its financial strength is eroded, there is no impact on the benefits payable while the company remains solvent. Hence, the whole issue of benefit security resolves into one question: Will the firm have enough money to meet the liability i.e. is it solvent and will it stay solvent? 6.30 The same is true for unit-linked policies: policyholders pay specified premiums and receive specified benefits. The benefits are not guaranteed, because they depend on the performance of the underlying investment funds, but they follow directly from that performance. As above, if the company loses money and its financial strength is eroded, there should be no impact on such policies until the point of insolvency losses of that type can t be passed on, and the investment policy of the underlying funds should not change. Hence, benefit security comes down to the same question as above. 66

67 Capital Requirements and Risk Appetite Framework 6.31 The analysis in the preceding two paragraphs is a slight over-simplification. If a firm becomes weak, but not insolvent, it could look to raise revenues by increasing charges on existing policies. For nonprofit policies this is not possible, except for a small minority which have reviewable premiums or charges. For unit-linked policies, it may be possible, though it is unusual and could attract a lot of criticism. In addition, the Companies are restricted in their ability to change such charges by the TCF regulations. Subject to these points, which I return to in my discussion on the Risk Appetite Framework below, benefit security for non-profit and unit-linked policies is simply a question of whether or not the firm is solvent CMIG and SW have significant volumes of non-profit and unit-linked policies and all of the policies in SAL, HLL, CMMF, SWUF, SWA and PMSWF are non-profit or unit-linked (with the exception of a small amount of unitised with-profits policies in HLL, which I consider in my assessment of the withprofits funds below). Following the Scheme, all of these policies will be held in SW Ltd. For most of these, the immediate result of the Scheme will be a fall in the level of solvency cover of the entity in which they are held, e.g. for SAL from 890% to 150% based on the position as at 31 December The exception to this is for policies in SW, where the level of cover is expected to increase slightly. I do not believe that these falls in solvency cover are materially adverse because: SW Ltd will have solvency cover well in excess of that required by the Pillar 1 regulations. The cover ratio of 150%, i.e. around 50% more that regulations require, is a strong level. On a more like for like comparison, excluding the ring-fenced WPFs within SW Ltd, the post- Scheme coverage is around 340% which is extremely strong. The high levels of surplus currently held in many of these funds, e.g. SAL s 890% coverage, are of limited relevance to the ongoing benefit security of the policyholders, as capital in excess of the Capital Target could be paid out as a dividend, except where this is specifically disallowed. Based on the detailed analysis in Sections 7, 8 and 9, I have concluded that where such blockages exist they would be simple to remove indeed the Companies have confirmed that actions to remove such blockages would be expected to be taken absent the Scheme. Excluding these surplus amounts, there is very little difference between the solvency ratios of each fund pre and post-scheme. SW Ltd is expected to have around 2.9bn of surplus with which to absorb losses and unfavourable experience before it is unable to meet its regulatory capital requirements on a Pillar 1 basis. Even following such a loss, the capital requirements and prudence within the Pillar 1 calculation would provide an additional buffer before SW Ltd was unable to meet its expected liabilities. It is difficult to envisage losses on this scale. Although total funds in SW Ltd will be c. 100bn, it would be wrong to conclude that a 3% fall in investment markets would eliminate the surplus over regulatory requirements because non-profit assets and liabilities are closely matched, and losses on unit-linked policies are borne by policyholders, not the firm. As an illustration, the firm estimates that a market scenario, combining a range of moderately severe stresses (including a 30% fall in equities), would have an approximate impact on a proxy to the Pillar 1 available capital of around 0.6bn compared to the surplus of 2.9bn discussed above. 67

68 Capital Requirements and Risk Appetite Framework The Pillar 2 solvency results are confidential. However, I have reviewed them, and the impact of the Scheme is similar to that under Pillar 1. As above, there is expected to be a large surplus in excess of the regulatory requirements within SW Ltd post-scheme. Even if SW Ltd was unable to meet its regulatory capital requirements, it would discuss the situation with the Regulators and determine actions to repair its capital position. In the event that internal actions were unlikely to restore the position within an acceptable timeframe, I consider that it is likely that its parent would inject capital (although there is no legal imperative to do so, and I have not relied on this in coming to my view), as it would be enormously damaging to the LBG brand if any part of the LBG Group was unable to meet its obligations to customers. At the end of 2014, the LBG Group had shareholder equity of 43bn. It is clearly possible that the events that led to such extensive losses in SW Ltd could also affect the wider LBG Group, but the business models are different, and there is diversification in their risks, so I expect that the LBG Group could offer support in many scenarios. The PRA has powers allowing it to direct the activities of parent companies in circumstances where the PRA s objectives (including in relation to the protection of policyholders) are in danger of being missed. I expect that this could include requiring a capital injection to SW Ltd in these types of circumstances CMIG and SW s with-profits funds both contain non-profit policies, as well as with-profits policies. For the former company, there is a drop in Pillar 1 coverage due to the Scheme, while for the latter there is an improvement. I reach the same conclusion as above for these policyholders, based on the highly remote chance of there being insufficient funds to pay their liabilities I have also considered the effect of the Scheme under Pillar 2 solvency. While I do not include these private numbers within this Report, the impact of the Scheme is very similar to that shown in the Pillar 1 analysis (with the exception of SWA, as outlined below). Similar to Pillar 1, there would have to be extremely large losses in SW Ltd before the Pillar 2 solvency position was undermined, and even larger losses before the assets were insufficient to meet a best estimate of the value of contractual benefits. Indeed, reflective of the approach taken to setting the Pillar 2 capital requirement, these losses would have to be of a severity expected to be incurred only once in every 200 years, before the Pillar 2 capital required by the regulations was exhausted and SW Ltd s post- Scheme surplus will be substantially higher than that The Pillar 2 position of SW Ltd includes an allowance for the capital resources and requirements of the other Companies, as subsidiaries of SW. As a result, the position of SW pre-scheme is the most like-for-like comparator to the position of SW Ltd following the Scheme and is useful in assessing the impact of the Scheme itself. The Pillar 2 solvency position of SW Ltd post-scheme is higher than that for SW pre-scheme, reflecting greater diversification from a more balanced risk profile and some minor additional synergies from combining the Companies. I regard these effects as a benefit of the Scheme. The like-for-like solvency position on a Pillar 1 basis also improves, though this is due mainly to the removal of certain restrictions regarding consolidation, asset eligibility and reinsurance, rather than genuine synergies All of the Companies other than SW were able to meet their Capital Targets as at 31 December 2014, resulting in a green rating under the Risk Appetite Framework (as described below) for this metric. SW was slightly under its Capital Target, resulting in an amber rating. Had the Scheme taken place at this date, SW Ltd would have been able to meet its Capital Target. These Capital 68

69 Capital Requirements and Risk Appetite Framework Targets are set with reference to Pillar 2, although they are amended to reflect Pillar 1 where that is the more onerous basis (as is the case for SWA). The targets have been set with the intention that the Companies could withstand a combination of losses expected to occur only once every 10 years, and still have enough capital to be able to then withstand a combination of losses of a severity expected to happen only once every 200 years. Policies would not be paid out in full only if losses exceeded this and the LBG Group was unable to provide support. I consider this eventuality to be highly remote As noted above, at 31 December 2014, SW was unable to fully meet its Capital Target. However, the Companies have provided projections, which show that the level of capital is expected to recover and exceed the Capital Target in the medium term, even with sizeable dividends being paid and without recourse to actions that would impact the benefits payable on any policies. Indeed, early estimates of the Pillar 2 position as at 31 March 2015 show excess capital in SW over the Capital Target and that SW would now be expected to be able to meet its Capital Target at the Effective Date. I will continue to monitor this position and any plans for restoring the capital position should there be an expected shortfall, and will comment on any developments in my Supplementary Report For the reasons stated above, I do not consider that the immediate impact of the Scheme will have a material adverse effect on the benefit security of non-profit and unit-linked policies. It remains to consider with-profit policies, the changes to the risk profile of the funds, and the ongoing protection available to policyholders through the Risk Appetite and Capital Targets. I discuss these below. Policies in the with-profits funds 6.39 The principal determinants of the benefit security of the policies in the with-profits funds in CMIG and SW are the financial position of the fund itself and the availability of support from outwith the fund, including through formal support arrangements. Table 6.3 summarises the Pillar 1 position as at 31 December

70 Capital Requirements and Risk Appetite Framework Table 6.3: Estimated impact of the Scheme on Pillar 1 solvency as at 31 December 2014 (fund level split) m Capital Resources Capital Resources Requirement (including any WPICC) Surplus Solvency Coverage Solvency Coverage excluding WPICC Pre- Scheme SW Pre- Scheme CMIG NPF + SHF 4,964 2,561 2, % SW WPF 3,607 3, % 1080% Total SW 8,571 5,963 2, % NPF + SHF 1, , % CMIG WPF 1,414 1, % 609% Total CMIG 3,212 1,695 1, % Post- Scheme SW Ltd Combined NPF and SHFs 3,753 1,099 2, % CMIG WPF 1,414 1, % 609% Scottish Widows WPF 3,607 3, % 1080% Total SW Ltd 8,774 5,861 2, % Source: Financial analysis provided by the Companies Notes: The financial position shown for SW and CMIG includes the value of the subsidiaries. CMIG s surplus is shown within SW s Capital Resources in its published results 6.40 We see that the financial position of the CMIG WPF is unchanged by the Scheme. All of the assets, liabilities and policies currently held in the CMIG WPF will remain in the fund. As discussed in Section 5, there are no material changes to the way in which the CMIG WPF will be managed in future or the expenses or payments that it will be expected to meet as they fall due The Scheme results in the transfer of all the assets, liabilities and policies currently held in the SW WPF to the newly created Scottish Widows WPF. The financial position of the Scottish Widows WPF is identical to the SW WPF. As discussed in Section 5, the Scottish Widows WPF will be managed in the same way following the Scheme as the SW WPF was before the Scheme, with no change in the expenses or payments that are expected to be met by the fund as they fall due There is no change to the existence, management or funding level of the Additional Account, the Retained Account, the Support Account or the Further Support Account in relation to the Scottish Widows WPF, relative to the corresponding arrangements for the SW WPF. The CMIG Scheme included the requirement to create a Bonus Deficit Account should certain circumstances occur before 31 December This requirement is removed by the Scheme. I considered this in Section 5 and concluded that this change has no material effect on policyholders, given the low likelihood that it would have been used before 31 December Table 6.3 shows that both with-profits funds have a modest surplus, but it is important to realise that this largely reflects the substantial WPICC that both funds hold. This reflects the fact that all assets in the with-profits funds are expected to be distributed over the lifetime of the policies currently in force. These future discretionary distributions are allowed for in the capital requirements of the 70

71 Capital Requirements and Risk Appetite Framework funds, resulting in a low reported level of Pillar 1 surplus, which represents only the expected value of future shareholder transfers, net of the expected cost in respect of possible future scenarios where the with-profits funds require shareholder support to meet their liabilities (known as the burn-through cost ). Excluding the WPICCs (which were 3.1bn and 1.1bn at 31 December 2014 for the SW WPF and CMIG WPF respectively), on the grounds that they primarily represent non-guaranteed liabilities, the solvency coverage for both funds is higher than 600%, indicating a high level of benefit security. The Scheme does not change this In the event that either of the with-profits funds requires support to meet policyholder benefit payments, which the various capital support accounts cannot fund, further support will come from the Non-Profit Fund and Shareholder Fund (which will merge to form the Combined Fund) following the Scheme. The Combined Fund will be well capitalised and I am satisfied it will be able to provide such support in all but the most extreme scenarios. As noted above in relation to the non-profit policies, I believe it is likely that yet further support, if needed, would be provided by the wider LBG Group, and that the PRA could potentially direct the parent companies in the LBG Group to inject additional capital There are a small number of policies in HLL where the policyholders have invested part of their policy in unitised with-profits funds. This is achieved by reinsurance into the CMIG WPF. The Scheme does not change this arrangement (except that the reinsurance will be replaced by an equivalent inter-fund arrangement, identical to the approach used in relation to policies within SW and CMIG where the policyholder has chosen to invest in unitised with-profits funds). The benefit security of these policies will continue to rely on the financial position of the CMIG WPF and the Combined Fund. Ongoing benefit security: the Risk Appetite Framework and Capital Targets 6.46 LBGI has a Risk Appetite Framework, the principles of which are applicable to all of the Companies. It sets out how risk will be managed and measured within the group, using a number of qualitative and quantitative indicators, and covers different types of risks, including financial risks (such as falling investment markets or adverse mortality experience) and non-financial risks (such as losses from operational failures or mis-selling). While the statements are primarily set at an LBGI level, some entity-specific targets are set including in relation to the target level of solvency In addition to setting out statements on the target level of exposure to each risk, the Risk Appetite Framework sets out actions that would be taken if these targets were not met Where a target is not met, the Companies are required to report this red status breach to the Board and explicit action is required to attempt to regain compliance with the target. Where a target is narrowly met, the status of the target is amber, and certain restrictions are put in place to try and stop the target being missed in future. Where a target is met comfortably, the status is green The protection afforded to policyholders by a Risk Appetite Framework depends on whether it is possible to weaken the targets in future. Risk appetite is reviewed at least annually by the Insurance Board, with proposed changes reviewed by the Insurance Risk Committee ( IRC ) and subsequently by the Insurance Risk Oversight Committee ( ROC ). Any out-of-cycle changes must be approved by the Insurance Board. This provides a reasonable degree of policyholder protection, given the requirement for the Board to meet its obligations in respect of TCF. 71

72 Capital Requirements and Risk Appetite Framework 6.50 The governance requirements and extent of scrutiny and challenge are unchanged by the Scheme Of particular relevance to my consideration of the level of ongoing benefit security afforded by the Risk Appetite Framework are the targets relating to the solvency position of the Companies (the Capital Targets), which state the minimum level of capital that is expected to be held in the Companies at any time. The Capital Targets are set with reference to the Pillar 2 capital requirement at the LBGI level, and are set at a level expected to allow LBGI to continue to meet its Pillar 2 capital requirement after a combination of events considered to be of a severity seen once every 10 years The Capital Targets at the LBGI level are expressed as a percentage of the Pillar 2 capital requirement, with different percentages relating to green, amber and red statuses. Unless otherwise stated, where I refer to a Capital Target being met, this means that the status of this test is green. This percentage is subject to review, in order to ensure that it remains an appropriate reflection of the expected losses under an adverse scenario of a severity expected to occur only once every 10 years. This calibration is similar to those I have seen at several other leading insurance companies, and more prudent than at several others. They are also interpreted at an entity level in a consistent manner (subject to some specific differences set out below) Full risk appetite reporting is conducted on a quarterly basis to the IRC with other reports issued by exception (monthly to the IRC, quarterly to the ROC and biannually to the Insurance Board). Reporting focuses on the demonstration of compliance with risk appetite limits and the Capital Targets. Where any breaches occur, clear plans and timescales for restoring the risk profile to within the agreed limits must be included. All significant breaches are escalated to the Insurance Board The Companies do not set out a fixed list of all the potential actions that would be considered in the event of a risk appetite limit or Capital Target being breached, a position that I consider reasonable given the wide range of targets considered in the Risk Appetite Framework. However, the Companies have provided me with details of the principal actions that would be expected to be used in the event of a Capital Target being breached. The main one is to restrict the level of dividends payable. The level of dividends assumed in projections provided by the Companies is substantial, and so this is a meaningful action, and it is likely that the capital position could be managed without recourse to further actions in many moderate-level stress scenarios. Further actions relate primarily to reducing the level of risk in the business, including reviewing the extent of reinsurance, hedging investment risk and changes to the investment strategy for the assets backing non-linked business in the non-profit funds or in the shareholder funds. None of these actions would be expected to have any impact on policy benefits There are other, more extreme, actions to improve the capital position that the Companies could theoretically take, which might impact the level of benefits payable for example, they could choose to increase discretionary charges where policy conditions allow it. Such actions could only be taken where they would be consistent with TCF and would be expected to apply across all the Companies. This is unchanged by the Scheme Capital Targets are also set at an entity level. For SW, CMIG, HLL and SAL, the target is set in an exactly consistent manner to the approach used at LBGI. For the other entities, it is an absolute amount that must be held above the biting regulatory capital requirement. This is because, on the risk-based Pillar 2 basis, there is minimal capital required due to the low level of retained risk in each entity (for example, SWUF only contains unit funds, the liabilities for which rise and fall directly in line with the assets). For SWUF, PMSWF and CMMF, the absolute amount represents a smaller 72

73 Capital Requirements and Risk Appetite Framework percentage of the Pillar 2 capital requirements (including the minimum capital that is required to be held by all authorised life insurance companies) than would be held under the LBGI target. For SWA it is higher, because the Pillar 1 regulatory capital requirements are more onerous, and the target reflects this Taken together, I consider that the Risk Appetite Framework, Capital Targets and governance arrangements provide a strong level of security over and above that required by regulations. Risk Appetite Framework and Capital Targets post-scheme 6.58 There will be no change to the Risk Appetite Framework as it applies to LBGI as a result of the Scheme, and it will continue to be subject to the same regular review. Any future changes will be subject to the governance arrangements set out above Similarly, the Capital Target, when expressed as a percentage of the regulatory capital requirements, will not change as a result of the Scheme. Indeed, the Capital Target will continue be set to provide protection against a one in 10 year event following the Scheme. Hence, there will be no change to the way the Capital Target held in respect of the Transferring Policies from SW, HLL and SAL or the Existing CMIG Policies is set. However it should be noted that the Capital Target will change as a result of the implementation of Solvency II, further details of which can be found in paragraphs For SWUF, PMSWF and CMMF, the Scheme will result in an increase to the percentage of Pillar 2 capital targeted. For SWA, it will reduce. I do not regard this as adverse because the Scheme will collapse the reinsurance arrangement in respect of the SWA policies, and hence removes the driver that led to the higher target used currently Given the above, I consider that the Scheme will preserve the strong level of security currently provided, at the point of transfer and in the future. I do not consider that policyholders are disadvantaged by changes under the Scheme, and I place heavy emphasis on this in my consideration of the Scheme s impact on benefit security. Impact of the Scheme on shareholder transfers 6.62 A comparison between the solvency position of SW pre-scheme and SW Ltd post-scheme highlights that the Scheme is expected to improve the overall solvency position of LBGI by a modest amount. All else being equal, this increases the ability of the Companies to pay a dividend. The payment of dividends is subject to compliance with the restrictions set out in the Scheme (as detailed in paragraph 5.35 above) and the constraints of the Risk Appetite Framework, and these are not weakened by the Scheme. Contagion risk 6.63 When several funds exist in the same company or group of companies, it may be possible for capital resources to flow from one to another in the event that one of the funds has insufficient assets to meet its liabilities. I refer to the risk of a fund having to provide capital in this way as contagion risk. This could impact adversely on the security of policies in the fund from which the capital resources have moved. 73

74 Capital Requirements and Risk Appetite Framework 6.64 Post-Scheme, there will be the two WPFs and one other fund, which will hold all of the other business of the Companies. Therefore, contagion risk can only exist in relation to the scenario where there is a transfer between one of the WPFs and the Combined Fund or between the WPFs The WPFs are unchanged by the Scheme, and will still have access to the capital support arrangements set out in Section 5. Should the assets of the funds and the support arrangements be insufficient to meet the liabilities of the fund the likelihood of which is unchanged by the Scheme - they will have access to support from the entire financial resources of the Companies. The Companies allow for this potential requirement to support the WPFs in both the base financial position and the Pillar 2 capital requirements. The Pillar 2 capital requirement is based on the support required under extreme stress scenarios, and so this capital and the additional capital held as part of the Capital Target provide a strong level of protection to the policyholders in the Combined Fund against this contagion risk Contagion risk is also relevant to the policyholders in the WPFs under the scenario where the Combined Fund or the other WPF required support. The Existing Schemes include provisions limiting the extent to which transactions or arrangements can be entered into by the with-profits funds with other funds. These are replicated in the Scheme, limiting the extent to which the policies in the with-profits funds are exposed to this contagion risk The Scheme actually minimises contagion risk (other than in relation to the WPFs referred to above), as the notion that one fund fails and would need to be bailed out by another fund from within the group will disappear when there is only a single fund. This is helpful but I do not regard it as a significant benefit for policyholders, because although there is no legal imperative to do so, I would expect that if any of the current funds got into trouble, LBGI would make every effort to make its capital resources available to help, rather than allowing a reduction in benefits for any group of policyholders. In practice, there are some aspects of the current structure which restrict complete freedom of movement of capital, but a large amount of capital is already fungible and able to move freely. The Scheme removes these remaining restrictions, which is a benefit, but the advantages are small as they accrue only in remote scenarios. Changes to intra-group reinsurance 6.68 There are a number of intra-group reinsurance arrangements (i.e. treaties between any of the separate legal entities within SWG) that will collapse as a result of the Scheme. In some cases, particularly where the reinsurance only relates to unit-funds with no collateral, this collapse helpfully reduces the exposure of the ceding entity to the risk of the reinsurer defaulting. However, where there are collateral arrangements in place, the ceding entity would typically have first call on that collateral in the unlikely event of insolvency. Following the Scheme, the policies in the ceding entity will rank pari passu with all the other policies in SW Ltd and will lose first call on that collateral. The Companies have provided details of the collateral arrangements below. For the reinsurance between SW and CMIG, the arrangement has been structured to achieve pari passu ranking for the reinsurance liabilities with the direct policy liabilities in the event of the insolvency of CMIG. As a result, the Scheme has no material impact on policyholder security in an insolvency situation. For the reinsurance between SWA and SW, the collateral is set at a level consistent with the regulatory liabilities and capital requirements and is updated at least annually to reflect 74

75 Capital Requirements and Risk Appetite Framework movements in this amount. In the highly unlikely event that SW became insolvent, the amount of collateral recovered by SWA would be dependent on the level of collateral held immediately before insolvency. It is not clear that the value of this collateral would exceed the value of the policy liabilities in such an event that will depend on the events that caused the insolvency. In particular, an insolvency event caused by a longevity or credit risk event two of the most important risks in SW (and SW Ltd following the Scheme) would also be expected to have an adverse impact on the sufficiency of the collateral. Overall, I am satisfied that the scenarios under which policyholders in SWA could suffer an adverse impact on their benefit security are of very low probability and are not material. The remaining intra-group treaties are not collateralised. Risk profile 6.69 By bringing several funds together, the Scheme changes the extent of the exposure that policies have to different types of risk. For the reasons set out above, the change in the level of this exposure depends on the extent to which capital within these funds is already fungible and able to be removed to prevent a reduction in benefits within another fund. I consider the general changes in the risks to which policyholders are exposed to later in this subsection, but draw my conclusions on the impact of the scheme on each specific group in Sections 7, 8 and The Companies have provided me with a breakdown of the Pillar 2 capital requirement, split by type of risk. This enables a comparison of the risks to which policyholders in an entity are exposed to before and after the Scheme. I discuss the change in risk profile in my consideration of each group of policyholders in Sections 7, 8 and 9. In most cases, the Scheme results in an improved diversification of risk, which is helpful to policyholders benefit security as it reduces the concentration of their exposure to single risk types under scenarios of a severity required by the Pillar 2 regulations. However, as part of my analysis, I have also considered the risks most likely to dominate in even more adverse scenarios than required by the regulations In my view, the most significant change in risk profile is related to CMIG s exposure to mis-selling claims in respect of policies written by CMIG, but sold overseas by intermediaries during the late 1990s and early 2000s. CMIG has a good understanding of this risk, informed in part by various court judgements which have helped to clarify how claims should be evaluated. Transferring Policyholders will become exposed to this risk, but will benefit from the capital that is held against it. The ultimate cost of the claims is unknown as a result of uncertainty as to the number of claims that could be made against CMIG, and the average cost of settlement, but the company has estimated the range of possibilities allowing for these factors. The best estimate cost of these claims, shown as a provision in CMIG s accounts, is 197m. However, the amount of capital actually held in respect of this risk is sufficient to meet the estimated cost of an outcome at the 99.5% level (i.e. a very severe adverse outcome) plus a substantial additional buffer on top of that amount. In my view, the capital held gives very strong policyholder protection against unexpected increases in both the number of claims upheld and the average cost of settlement. In summary, I believe there is a very high likelihood (estimated at over 99.5%) that the amount held will exceed the actual cost incurred, leading to an expected surplus from this source Importantly, the CMIG Board has resolved that any claims from this source in excess of the payment that would normally have been made under the policy will not be met by the CMIG WPF. Similarly, it would not be possible under the Scheme or the relevant regulations, for such costs to be charged to 75

76 Capital Requirements and Risk Appetite Framework the Scottish Widows WPF, following the Scheme. As a result, the policyholders in CMIG before the Scheme and SW Ltd following the Scheme are only directly exposed to this risk to the extent that it could result in the insolvency of the company they are in. As discussed below, I view this outcome as highly unlikely I have also considered scenarios constructed by the Companies to be more severe than the 99.5% level, and I have assessed the potential impact on policyholders in those situations. Even in the highly unlikely event that the cost of this risk exceeded the level of capital held against it, SW Ltd has access to other internal capital resources that are measured in billions of pounds which are available to absorb strains from this or any other source Even though the Transferring Policyholders are not part of CMIG currently, I expect that any such extreme outcome would create problems for them pre-scheme too. This is because in practice I would expect any resulting shortfall of capital in CMIG pre-scheme to be made good by transfers of capital from the other funds, where not precluded by the Risk Appetite Framework. With this understanding, and given that the circumstances in which any problem could arise post-scheme are so remote, I do not consider this a material adverse change for any group of policyholders. Note: In paragraphs 3.33 and 3.34, I discussed a put option that is currently in place within SW, relating to the scenario where CMIG became insolvent as a result of this exposure. I do not consider this to have any material impact on policyholder security A further consideration in regarding risk profile is the extent to which the Scheme changes the exposure to the staff pension scheme risks in SW (the SW Pension Scheme). The main risks are investment risk and longevity, similar to the risks generally run in SW (and SW Ltd Post-Scheme). The SW Pension Scheme is funded from within LBGI and any funding deficit is recognised on the Pillar 2 (and Solvency II) balance sheets of SW. In addition, capital is held to mitigate the risk of potential future increases to the deficit under a range of stresses. This will continue to be the case following the Scheme, both in terms of the obligation to fund the SW Pension Scheme and its recognition on the SW Ltd balance sheet The capital requirement is based on stresses to many of the same risk drivers as the main insurance business, although the behaviour of the deficit under stress will depend on the accounting rules for valuing a pension scheme. Due to the similarity of the underlying risks associated with the SW Pension Scheme and the risks within SW Ltd generally, the inclusion of the SW Pension Scheme does not materially change the overall risk profile of SW Ltd While the policies currently outwith SW become directly exposed to these risks, they also gain access to the capital supporting the risks, and I do not consider this a material adverse change for any group of policyholders I also note that the Companies have engaged with the trustees of the SW Pension Scheme to discuss the Scheme. I am not aware of any significant concerns being raised to date. I will continue to review this and will comment in my Supplementary Report if the position changes There are two further pension schemes relating to the staff of the Companies. These relate to eligible insurance employees of the wider banks in which these companies have been held (one relating to Lloyds Bank and the other to Halifax Bank of Scotland). Funding of these pension schemes is met by the wider LBG Group. SW and CMIG currently hold a modest amount of capital 76

77 Capital Requirements and Risk Appetite Framework in respect of the risk that support is required by the pension schemes in extreme scenarios in respect of members who were previously employed by the Companies Following the Scheme, funding of these schemes will continue to be met by the wider LBG Group, and capital will be held by SW Ltd against the risk that support is required in extreme scenarios. These risks are not significant in relation to the overall risk profile (the total amount of capital held is c.2% of the expected Pillar 2 capital requirement of SW Ltd) and capital will transfer to support these risks. As a result, I do not consider this a material adverse change for any group of policyholders It is important to note that the Scheme does not change the way in which the pension schemes are allowed for in the solvency calculations (other than the entity in which the risks are held). However, the introduction of Solvency II will change the way that pension schemes are allowed for and how the capital held in respect of them is calculated. These changes are reflected in the Solvency II figures that the Companies have provided me and will occur whether the Scheme is approved or not Significant levels of new business are currently being written in SW, but not its subsidiaries. After the Scheme, SW Ltd will write new policies using the Scottish Widows brand. New business is priced to be profitable and so should generate additional surplus over time. Indeed projections show that, overall, SW plc is able to generate capital through writing new business. However, to the extent that there are short-term capital strains, and/or unexpected losses, the Risk Appetite Framework will require capital to be held in SW Ltd to cover these, plus a margin, and so I am satisfied that exposure to new business risk will not materially adversely impact any policyholders outwith SW There are around 15,000 policies in the CMIG WPF, written in Germany and Austria, under which the CMIG WPF expects to provide with-profits annuity policies in the future. The Scheme does not change how the CMIG WPF is managed, either immediately after the Scheme or into the future, so does not change the risks associated with these policies. While such liabilities, being of a long expected term, may become significant in the context of the CMIG WPF at some point in the future as the shorter duration business in the fund runs off, I do not believe that that any risks associated with these policies will become significant in the context of the wider SW Ltd Overall, I am satisfied that any changes in the risk profile of the funds will not have a materially adverse effect on the security of policyholder benefits. By bringing all of the risks of the Companies together, along with all of the capital to back them, the Scheme should actually improve diversification of risk overall. Protection in the event of insolvency 6.85 In my review of policyholders benefit security I have also considered what might happen in the highly unlikely event that an insurer is unable to meet its liabilities and is subject to a winding up order. This is influenced by the current Financial Services Compensation Scheme ( FSCS ) and the Insurers (Winding Up) Rules In the event of insolvency of an insurance company, the FSCS pays 90% of insurance claims on UK long-term life insurance policies held by individuals. The Scheme does not impact the cover provided by FSCS for any policy The PRA announced in April 2015 that, from 3 July 2015, this coverage is increased to 100%. This change is unaffected by the Scheme and I have not considered it further in forming my conclusions. 77

78 Capital Requirements and Risk Appetite Framework 6.88 In a winding up scenario the claim in respect of each type of business would be set out in line with the Insurers (Winding Up) Rules 2001, as follows: For non-linked policies (including with-profits policies) the value of the policy is the sum of the present value of guarantees including the accrued bonus; the present value of any bonus expectations; and the present value of any options, less the present value of future premiums. For with-profits policies, it is unclear whether bonus expectations would be considered to extend to likely distributions of the estate of a particular fund. If so, any surplus assets within the fund are unlikely to be available to support payouts to policies in other funds. For linked policies, the value of the policy is the sum of the unit value and any non-linked liabilities (for example, reserves in respect of expense or any additional risk cover that applies to the policy), less the present value of expected future unit fund deductions. I consider whether the Scheme will result in any significant changes to the expected treatment of any group of policyholders in the event of a winding-up in Sections 7, 8 and 9. Solvency II 6.89 Although firms Solvency II positions will be public from 2016 onwards, they are not currently. The information is commercially sensitive and is not quoted in this Report Some important aspects of the calculations are subject to approval from the PRA, including the use of transitional measures which can be used by the Companies to stagger the move from the current solvency regime to the new one, and calculation of a matching adjustment which can significantly reduce the size of the liabilities for certain types of business. The Companies have estimated the Solvency II position pre- and post-scheme based on their current understanding of the rules. The results were given with and without the benefit of the adjustments noted above. As I would expect, those adjustments have a significant impact on the reported solvency position The Companies intend to calculate their Solvency Capital Requirement under Solvency II, using an internally developed model (an Internal Model ) rather than the regulatory-prescribed Standard Formula. Use of such a model is subject to approval by the PRA and the approval process is not likely to be concluded until shortly before the Effective Date. Despite this uncertainty, I consider it reasonable to base my analysis on the Internal Model results, as certain risks within the Companies would not be captured by the Standard Formula (particularly the risks associated with the mis-selling claims on overseas policies) Notwithstanding the importance of the Companies being able to meet their regulatory capital requirements, it is important to realise that Solvency II does not change any of the assets, liabilities or risks in the Companies. These are the main determinants of benefit security. The new regime is intended to improve oversight of such risks, and to ensure strong minimum standards for the capital that must be held against each risk. It will also involve operational changes for example, reporting and governance changes I note that Solvency II will impact the Companies irrespective of the Scheme if it has a significant effect on the reported solvency position of a particular company, the effect will apply whether or not the Scheme occurs. Where Solvency II increases the amount of capital required in respect of a 78

79 Capital Requirements and Risk Appetite Framework particular policy relative to the current regulatory regime then, all else being equal, I view this as an increase in the benefit security of policyholders over the longer-term. Nevertheless, I would be concerned if a proposed Scheme meant that a group of policyholders moves from a company comfortably able to meet its Solvency II capital requirements to one that is significantly less able to do so. For example, this might happen if a particular fund contained product types which incur heavier capital requirements under the new rules, meaning that its reported solvency position falls significantly The Companies have defined Capital Targets under the Risk Appetite Framework in relation to the Solvency II regulatory capital requirements. These are designed to be consistent with the existing Capital Targets and are being used to monitor the expected solvency position in the lead-up to Solvency II I note that all of the Companies are expected to be able to meet the Solvency Capital Requirement (the expected level required under regulation) and the internal Capital Targets. The former hurdle is expected to be met even without the benefit of transitional adjustments that are subject to regulatory approval. While the internal targets might not be met if such approval was withheld (which I have no reason to believe is likely), there is a viable recovery plan which would not involve harmful actions to policyholders. I note that action would be needed whether or not the Scheme proceeds. Failure to achieve approval for the matching adjustment in addition to the transitional adjustments would result in SW and SW Ltd being unable to meet their Solvency Capital Requirement. However, I view this is an unlikely worst case scenario, as the Companies have submitted a pre-application for the matching adjustment to the PRA, the feedback from which should allow any significant barriers to approval to be addressed before formal application The expected impact of the Scheme on the Solvency II position of the Companies is very similar to the expected impact on a Pillar 2 basis. As a result, I am satisfied that my conclusions in respect of the relative security of benefits before and after the Scheme remain valid There could be a risk to policyholders if they were moving from a company that was well prepared for the move to Solvency II, and understood the implications for its solvency, to one that was poorly prepared. That is not the case under this Scheme. The Companies are all part of the LBG Group and are part of the same implementation programme, and so no group of policyholders should be disadvantaged on this account. While I have not reviewed the readiness of the Companies in any detail, I have not come across anything that makes me think they are poorly prepared and I am aware that they have commissioned an external review of readiness. I will comment further in my Supplementary Report if that review highlights any issues that are pertinent to my assessment of the Scheme. 79

80 Implications for Transferring SW Policyholders 7. Implications for Transferring SW Policyholders Introduction 7.1 In this section I consider the likely impact of the Scheme on Transferring SW Policyholders. This includes the policyholders with policies held in SW, and those with policies in SW s direct subsidiaries: SWA, SWUF and PMSWF. My conclusions in this section focus on my analysis of the potential impact of the Scheme on the benefit expectations and benefit security of these policyholders. 7.2 As described in Section 3, the broad effect of the Scheme will be to transfer the entire long-term insurance business from SW and its subsidiaries, excluding that business currently held in the SW WPF, to a single merged fund in CMIG. The SW WPF will also transfer into CMIG, but will remain as a separate ring-fenced fund within it. 7.3 I have split my conclusions in respect of the policyholders transferring under the Scheme, by grouping my conclusions on the Transferring SW Policyholders separately from those in respect of the Transferring CMIG Policyholders. This reflects the fact that CMIG and SW are the two largest entities in terms of policyholders and, prior to the merger of HBOS plc and Lloyds TSB in 2009, operated as separate insurance groups. 7.4 I group my conclusions in respect of benefit expectations by the principal policy types of unit-linked, with-profits and non-profit, reflecting the fact that it is the individual policy type that is the key determinant of how the Scheme can affect benefit expectations. Range of Transferring SW Policies 7.5 The following bullet points provide an overview of the Transferring SW Policies more details of which were given in Section 3. The large majority of the Transferring SW Policies are written directly in SW and represent a wide range of policy types, including unit-linked pensions, unit-linked savings, non-profit protection, with-profits business and non-profit annuities. SWA holds a relatively small number of non-profit protection policies and non-profit annuities. All of the liabilities are reinsured to SW. SWUF does not hold any directly written policies; it accepts reinsurance of a large amount of unit fund liabilities held by unit-linked pension policies written in SW. PMSWF holds a small number of directly written non-profit annuities, the liabilities of which are reinsured to SW. The remaining directly written policies have been issued to pension scheme trustees, with no individual policyholders. 80

81 Implications for Transferring SW Policyholders Benefit Expectations for Transferring SW Policyholders General considerations 7.6 As noted above, the Transferring SW Policies include with-profits, unit-linked and non-profit policies. The factors pertinent to the benefit expectations of policyholders in each category of business are substantially different, and I consider them separately below. This reflects the varying extents to which management discretion can play a part in determining the level of benefits payable. 7.7 Before considering those three categories of policies in turn, I confirm that the Scheme will not change the: Value of any policy. Death, maturity or other contingent benefits payable under any policy. Surrender value of any policy. Premiums payable under any policy. Current or expected level of charges under any policy. Asset mix underlying any policy or the range of investment choices available. Range of options available under any policy and any guarantees included in the contract. Charges made for tax under any policy, or their eligibility for any favourable tax treatment. Terms and conditions of any policy. As discussed below, the move to Solvency II may result in certain small changes to how the business is managed, but this would have been the case absent the Scheme. With-Profits policyholders 7.8 All of the with-profits Transferring SW Policies are currently held in the SW WPF, within SW. The Scheme will establish a new fund called the Scottish Widows WPF in CMIG, into which all of the assets, liabilities and policies of the SW WPF will be transferred. 7.9 Immediately following the Scheme, the Scottish Widows WPF is expected to have an identical financial position to that of the SW WPF immediately before the Scheme, and the sizes of the Additional Account and the Retained Account are expected to be unchanged by the Scheme None of the key considerations relevant to with-profits policies will change as a result of the Scheme, including the basis on which asset shares are determined, the current level of asset shares and guaranteed benefits, bonus rates, expected payout levels, charges and smoothing of payouts With-profits policies will continue to participate in emerging profits and losses from business written in the SW WPF. The Scheme will not result in any changes to the expected level of those emerging profits or losses, or how they are shared. 81

82 Implications for Transferring SW Policyholders 7.12 The extent to which the with-profits policyholders have a contingent interest in any surplus amount in the SW WPF and would receive a share of any such assets that are distributed in the future is unchanged by the Scheme. In particular, the with-profits policies which were in force at the effective date of the SW Scheme will continue to have a contingent interest in any surplus assets in the Additional Account and the Retained Account. The assets and liabilities of the funds, and hence the level of surplus assets, are unchanged by the Scheme and so the value of these contingent interests are unaffected There will be no changes to the investment policy or asset mix of the SW WPF as a result of the Scheme. The asset mix may vary over time, as for any with-profits fund, but the Scheme does not cause any change in future expectations. Minor changes may result from the amendments from the SW Scheme to reflect Solvency II, as the investment strategy will now reflect the solvency position under Solvency II, but these changes are not expected to be material and would have been required absent the Scheme. Consistent with the wider clarification of responsibilities in relation to the withprofits funds, discussed in Section 5, future investment strategy will be at the discretion of the SW Ltd Board, taking into account the advice of the AFH, WPA and SW Ltd WPC, whose role is to ensure that the interests of with-profits policyholders are appropriately considered The fund also contains a significant volume conventional non-profit business, including annuities written when pension policies in the SW WPF matured. The profits or losses from that business stay in the fund. None of this business is being transferred out of the SW WPF by the Scheme, and so there is no change in benefit expectations from this source. However, as noted in Section 3, SW intends to transfer annuity business out of the SW WPF to the SW NPF in advance of the Effective Date. The expected impact of this change is allowed for in the Companies assessment of the likely financial impact of the Scheme. The change is contingent on a separate governance process which includes consideration of the potential impact on policyholders The Scheme includes a provision allowing the Scottish Widows WPF the option to write any new immediate annuity business, where it arises as a result of a deferred annuity contract in the fund, in the Combined Fund, or any other entity in the LBG group. This replicates an existing option available to the SW WPF (an option which, I note, is not currently taken up) The key elements relating to the ongoing management of the SW WPF, as set out in the SW Scheme and the PPFM, are replicated in respect of the new Scottish Widows WPF by the Scheme and a revised PPFM. As noted in Section 3 and detailed in Appendix 7, I am satisfied that the key aspects of the original PFM are replicated by the Scheme or the PPFM The Scheme will not change the process for allocating investment returns or the manner in which investment strategy is set, or the extent to which it is set with reference to the existence of the Support Account The Scheme does not change the shareholders share of future bonus declarations. However, as a result of the move to Solvency II, the definition of one of the elements of the calculation (the cost of bonus ) will change. Such a change would have been required absent the Scheme, as the original methodology would not be consistent with the principles of Solvency II The way expenses will be charged to the Scottish Widows WPF is unchanged from the way they are charged to the SW WPF. However, in line with changes in the applicable regulations since the SW Scheme was approved, any expense savings can only be shared to the extent that they do not result 82

83 Implications for Transferring SW Policyholders in the Scottish Widows WPF being charged more than it would cost to operate the fund. I note that as a result of Solvency II, the investment expenses will be charged as a percentage of the technical provisions under Solvency II, rather than the current mathematical reserves for certain policies. This could have a small impact on the total level of expenses charged to the fund (0.07% of any difference), but it is not expected to be material and is a change that I would have expected to occur absent the Scheme The SW WPF benefits from various support accounts and arrangements that support the investment strategy and provide extra capital in defined circumstances. As explained in Section 5, I am satisfied that there is no adverse effect on policyholders benefit expectations or benefit security from the changes to these The Scheme introduces the powers for SW Ltd to close the Scottish Widows WPF should the liabilities fall beneath 500m or to merge it with the CMIG WPF should the liabilities of either fund fall beneath 500m. I am satisfied that the proposed threshold of 500m is reasonable, being comparable to similar arrangements that I have seen for peer companies. As set out in Section 3, I am also satisfied that this does not materially adversely affect policyholder benefit expectations, as: The Scheme includes various strong protections intended to prevent an adverse policyholder impact. Both funds are still expected to be significantly above the threshold level of 500m beyond Such clauses can support the efficient running of a with-profits fund, helping to avoid an adverse effect on policyholders None of the costs of the Scheme will be borne by the SW WPF before the Scheme or the Scottish Widows WPF thereafter For the reasons set out above, I am satisfied that the Scheme does not have any material effect on the benefit expectations of the Transferring SW Policyholders who hold with-profits policies My conclusions apply equally to policies in the SW WPF that were written before and after the effective date of the SW Scheme. Unit-linked policyholders 7.25 The benefits payable under unit-linked polices are dependent on the value of the underlying unitlinked funds and the charges taken from the funds. The Scheme does not change the assets underlying any of the unit-linked funds or the investment strategy for these funds. Nor will it change the range of funds available, the level of investment management charges or other discretionary charges that are taken from the policies. These are the key determinants of benefit expectations for the unit-linked policies The committees within the Companies with responsibility for the management, administration and investment of unit-linked funds have confirmed (where it is within their remit) that these important aspects will be unchanged by the Scheme and that they are not aware of any operational changes 83

84 Implications for Transferring SW Policyholders that will be driven by the Scheme. I view this as a useful additional assurance that the benefit expectations of policyholders with unit-linked policies will not be affected by the Scheme However, the Scheme will give SW Ltd the power to merge, split or close unit-linked funds, where this is not precluded by the terms and conditions of the affected policies or by regulation (including the TCF regulations). The Companies have confirmed that there are no plans in place to exercise these powers as a direct result of the Scheme. As discussed in paragraphs 3.22 to 3.24, such powers are important tools for insurers to facilitate the effective ongoing management of the unitlinked funds and there are internal governance procedures that require the consideration of appropriate actuarial advice and the obligations of the Companies under TCF For the reasons set out above, I am satisfied that the Scheme does not have any effect on the benefit expectations of the Transferring SW Policyholders with unit-linked policies. Other non-profit policyholders 7.29 Non-profit policies have guaranteed benefits and specified premiums, and these do not change under the Scheme. There will also be no change to the terms and conditions of these policies Some non-profit policy terms have reviewable premiums, triggered by certain conditions. These conditions and the decision-making process for these reviews will not be changed by the Scheme For the reasons set out above, I am satisfied that the Scheme does not have any effect on the benefit expectations of the Transferring SW Policyholders with non-profit policies. Policies with investments reinsured to the SW WPF 7.32 There are some policies within SW where the policyholder has the option of investing in unit-linked funds, unitised with-profits or a combination of the two. The unitised with-profits exposure is achieved by means of an inter-fund agreement between the SW NPF and the SW WPF. This arrangement will be maintained following the Scheme by way of an equivalent inter-fund arrangement between the Combined Fund and the Scottish Widows WPF Similarly, some policies in Scottish Widows International Limited (which are not transferring under the Scheme) achieve unitised with-profits exposure by means of a reinsurance arrangement which will be transferred under the Scheme. Similar arrangements also exist with Aviva Life & Pensions UK Limited and LCL Assurance Company Limited, outwith the LBG Group, and these are also unchanged by the Scheme I have concluded above that the Scheme has no material effect on the benefit expectations of Transferring SW Policyholders with policies in the SW WPF. My conclusions apply equally in respect of the unitised with-profits element of the policies that invest in both unit-linked and unitised with-profits. Similarly, my conclusions in respect of unit-linked policies apply equally to the unitlinked element of policies that invest in both unit-linked and unitised with-profits. Conclusion on benefit expectations 7.35 Based on the analysis above, I am satisfied that the Scheme will not have any material effect on the benefit expectations of any of the Transferring SW Policyholders. 84

85 Implications for Transferring SW Policyholders Benefit Security for Transferring SW Policyholders 7.36 In Section 6, I set out my general considerations and conclusions in respect of the impact of the Scheme on the benefit security of the affected policyholders. These set out the elements of my analysis that applied to all of the policyholders, including the Transferring SW Policyholders This analysis considered: The impact of the Scheme on the Pillar 1 and Pillar 2 solvency coverage ratios, and consideration of the likely impact under Solvency II. The continuation of the Risk Appetite Framework and Capital Targets, how these protect policyholder benefit security in the short and longer term and the potential policyholder impact of actions taken to repair any shortfalls in the capital position. Changes in the risk profile of the funds. The effect of the Scheme on contagion risk The remainder of this sub-section considers points that are specific to the benefit security of particular groups of Transferring SW Policyholders and provides my conclusions in respect of each group. Policyholders in SW Policyholders in the SW NPF 7.39 As shown in Section 6, following the Scheme, the Pillar 1 solvency coverage ratio in relation to the policyholders in SW is expected to increase modestly from 144% to 150%, based on the position at 31 December This increase reflects the removal of certain restrictions on the value of assets recognised, consolidation inefficiencies and the capital inefficiencies in respect of the reinsurance. The estimated post-scheme solvency coverage ratio is strong, representing a surplus of around 50% over the level of capital required by the regulations Adjusting for the fact that the SW WPF and CMIG WPF will continue to be run as ring-fenced funds, which are expected to be able to meet their own capital requirements, the post-scheme ratio is expected to be 341% (up from 300% pre-scheme on an equivalent basis). This is extremely strong. I place limited weight on the surplus above the Capital Targets, as it could be removed by paying dividends, but these ratios demonstrate that the Scheme does not disadvantage benefit security for these policyholders, as measured by Pillar The impact on a Pillar 2 basis is consistent with the impact on a Pillar 1 basis. Solvency improves, reflecting the improved diversification of risk within SW Ltd and other synergies expected to be realised as a result of the Scheme The expected impact under Solvency II is also consistent, although there is greater uncertainty in relation to the absolute solvency position on this basis All else being equal, these increases in the solvency ratio following the Scheme represent a modest strengthening of policyholder benefit security for these policyholders. 85

86 Implications for Transferring SW Policyholders 7.44 Following the Scheme, the benefit security of policyholders in SW will continue to be protected by a Capital Target well in excess of the regulatory capital requirement, and which is set in an exactly consistent way as before the Scheme with reference to the same overarching Risk Appetite Framework I have also considered the balance of risks in SW currently, compared to that expected in SW Ltd following the Scheme. Other than the mis-selling risk referred to in paragraphs 6.71 to 6.74, the Scheme does not result in a material exposure to any new risk types and the capital held in respect of that risk is well in excess of the expected settlement costs. The post-scheme risk position is well diversified, with no single type of risk dominating As a result of the Scheme, the SW policyholders will become directly exposed to the risks held in all of the other entities involved in the transfer. As these entities are currently subsidiaries (direct or indirect) of SW, I consider that there is already a degree of exposure for the SW policyholders to these risks In particular, while SW, on a standalone basis, is able to meet its regulatory capital requirements and Capital Target, I would consider it unlikely that it would allow SWA, SWUF, PMSWF or CMIG (including its subsidiaries) to become insolvent In addition, SW is already exposed to some of the risks related to the policies in PMSWF, SWA and CMIG as a result of reinsurance arrangements. The Scheme will result in the policies in these subsidiaries ranking pari passu with the policies written in SW, resulting in a potentially different situation under insolvency, depending on the value of the collateral in place at that time relative to the liabilities. I have reviewed the collateral arrangements in place and am satisfied that the Scheme does not lead to a material change in exposure Overall, I am satisfied that the Scheme does not result in a material adverse effect on the benefit security of the Transferring SW Policyholders with policies in the SW NPF. Policyholders in the SW WPF 7.50 As discussed in Sections 5 and 6, the Scheme will not change the assets, liabilities or risks within the SW WPF, how the fund is expected to be managed in future or the availability of the Support Account and Further Support Account. Hence the solvency position is unchanged While the Scheme will result in any further capital support (if needed) being provided by the SW Ltd Combined Fund, rather than the SW NPF or SW SHF, that fund is expected to have a higher solvency coverage ratio than the aggregate position of the SW NPF and the SW SHF. As a result, I consider it likely that the Scottish Widows WPF will be able to access support when required, in all but the most extreme scenarios Based on the rationale set out above, I am satisfied that the Scheme does not result in a material adverse effect on the benefit security of the Transferring SW Policyholders with policies in the SW WPF My conclusions apply equally to policies in the SW WPF that were written before and after the effective date of the SW Scheme. 86

87 Implications for Transferring SW Policyholders Policyholders in SWA 7.54 As set out in Section 6, following the Scheme, the Pillar 1 solvency coverage ratio applicable to policies within SWA is expected to decrease modestly from 162% to 150%, based on analysis as at 31 December Excluding the SW WPF and the CMIG WPF (see Table 6.2), the post-scheme ratio is expected to be 341% On the Pillar 2 and Solvency II bases, the level of solvency coverage ratio following the Scheme is expected to be well in excess of statutory requirements, although the reduction in the coverage ratio is expected to be a much larger reduction than the Pillar 1 change. This arises because the policy liabilities in SWA are fully reinsured to SW and the Pillar 1 capital requirement calculation cannot take full credit for this transfer of risk. In turn, the level of capital currently held in SWA is significantly higher than that required on a Pillar 2 basis or under its Capital Target, because of the need to cover the Pillar 1 capital requirement. That technical limitation will fall away under Solvency II, and the Companies have confirmed that, absent the Scheme, they would expect to reduce the level of capital held in SWA accordingly. I believe that would be reasonable. Adjusting for that expected change, the impact of the Scheme on solvency would be much smaller The Capital Target for SWA is currently set at a level that is higher as a percentage of the Pillar 2 capital requirement than the percentage of the SW Ltd Capital Target following the Scheme. This again reflects the Pillar 1 capital requirement, which will fall away under Solvency II. I expect that the Capital Target would be adjusted to a lower absolute level, reflective of the fact that minimal risks are retained in SWA and in line with the approach taken for CMMF, PMSWF and SWUF. With that understanding, I expect that the ongoing protection provided by the Capital Target in SW Ltd would be comparable to that which would exist in future without the Scheme The risks in SWA are fully reinsured to SW. As a result, the policyholders in SWA are currently exposed to the risk that SW becomes insolvent, although this is mitigated by the collateral held. The Scheme will result in these policyholders ranking pari passu with the other policyholders in SW Ltd, which represents a change in the extent of exposure to the risks currently in SW and introduces direct exposure to the risk associated with other policies that will be held in SW Ltd. The collateral held by SWA in respect of the reinsurance, is based on the technical provisions and capital requirements of the reinsured business and I discuss this in paragraph I am satisfied that the collapse of this reinsurance under the Scheme does not materially adversely affect the benefit security of the SWA policyholders The Scheme will result in the policies in SWA becoming exposed to all of the risks within the other Companies and I have considered the balance of risks in SWA compared to that expected in SW Ltd following the Scheme. The main change is to introduce exposure to the mis-selling risks referred to in paragraphs 6.71 to The policyholders in SWA will benefit from a more diversified pattern of risk exposure post-scheme. These risks will be reflected in the SW Ltd Capital Target As a result of the rationale set out above, I am satisfied that the Scheme does not result in a material adverse effect on the benefit security of the Transferring SW Policyholders with policies in SWA. Policyholders in PMSWF 7.60 As set out in Section 6, following the Scheme, the Pillar 1 solvency coverage ratio applicable to policies in PMSWF is expected to decrease modestly from 166% to 150%, based on analysis as at 87

88 Implications for Transferring SW Policyholders 31 December Excluding the SW WPF and the CMIG WPF (see Table 6.2), the post-scheme ratio is expected to be 341%. The solvency position in SW Ltd is expected to still be well in excess of statutory requirements The impacts on both a Pillar 2 and Solvency II basis are expected to be consistent with that above There is only 2m of surplus in in PMSWF. This is all that is needed to cover comfortably the capital requirements, as very few risks are retained in PMSWF. Post-Scheme, the policies will be in a fund with Pillar 1 surplus of around 2.9bn. Consistent with this, they move from a fund with very few risks (they have almost all been reinsured) to one with many and varied risks This change to the risks to which the policies in PMSWF are exposed is not quite as extreme as the previous paragraph suggests. While PMSWF's risks are reinsured or passed on through other agreements/indemnities (including agreements with SW and its subsidiaries), it would be wrong to think that they can be completely ignored because if SW got into financial difficulties and was unable to cover its liabilities, risks could fall back on PMSWF. Hence, the benefit security of PMSWF s policyholders is linked to that of SW. As we have seen from the analysis above, the post-scheme position of SW Ltd hardly changes from the pre-scheme position of SW if anything there is a slight improvement The main new risk exposure is to mis-selling risks discussed in paragraphs 6.71 to Post- Scheme, the risk profile for PMSWF policyholders will be well diversified, and all of the risks will be reflected in the SW Ltd Capital Target The Capital Target for PMSWF is currently set as a small absolute target, since there are very few risks retained in PMSWF. The Capital Target in SW Ltd represents a higher percentage of the Pillar 2 capital requirements (including the minimum capital required for any authorised life insurance company under the current solvency regime) than is currently the case in PMSWF As a result of the rationale set out above, I am satisfied that the Scheme does not result in a material adverse effect on the benefit security of the Transferring SW Policyholders with policies in PMSWF. Policy-related liabilities in SWUF 7.67 SWUF has no policyholders of its own, but accepts reinsurance of unit-funds of pension policies in SW. Following the Scheme, the Pillar 1 solvency coverage ratio in relation to the policy liabilities in SWUF is expected to decrease substantially from 3648% to 150%, based on the position at 31 December While this is a large change, 150% is still well in excess of statutory requirements, and the expected post-scheme surplus available to support risks attaching to these liabilities is 2.9bn I have discussed the current capital position of SWUF with the Companies and understand that the high level of capital held is to allow tax rebates to be credited to the unit-funds as soon as the Companies are aware that a rebate is due, even if that money is yet to be received. Hence, the capital is not intended to provide long-term benefit security it is a liquidity facility to help ensure that tax-rebate payments to unit-funds that SWUF has reinsured can be paid promptly without recourse to other Companies. Appropriate levels of liquid assets will be available in SW Ltd to allow this approach to continue post-scheme. The Risk Appetite Framework includes targets in respect of the level of liquidity maintained in LBGI and this will continue following the Scheme. 88

89 Implications for Transferring SW Policyholders 7.69 The solvency position and expected impact of the Scheme on the Pillar 2 and Solvency II bases is consistent with that shown for Pillar 1 above The Capital Target for SWUF is set as a minimal absolute amount, reflective of the fact that it only holds unit funds and no material associated risks. The Capital Target in SW Ltd post-scheme represents a higher percentage of the Pillar 2 capital requirements (including the minimum capital required under the current solvency regime) than is currently the case in SWUF (excluding an amount held temporarily in respect of a potential tax liability), which represents a modest benefit for policyholders in terms of their ongoing security As a result of the Scheme, the SWUF policy-related liabilities will become directly exposed to the risks held in all of the other entities involved. However, as SWUF is a subsidiary of SW, which is the parent of all the other Companies, it would be wrong to think that there is no exposure to the risks in the other Companies under the current structure. In the event of financial difficulties in any of these, I would expect the Companies to seek to move capital to where it is required - an example of the contagion risk discussed in paragraphs 6.63 to As the Capital Target is based on a risk-based capital measure, I am satisfied that any change in risk exposure will be reflected in the level of capital targeted As a result of the rationale set out above, I am satisfied that the Scheme does not result in a material adverse effect on the benefit security of the Transferring SW Policyholders with policies where the unit-funds are reinsured to SWUF. Conclusion on benefit security 7.74 Overall, for the reasons set out above, I am satisfied that the Scheme does not result in a materially adverse effect on the benefit security of any of the groups of Transferring SW Policyholders. Excluded Policies 7.75 In the event that any policies which would otherwise be Transferring SW Policies are unable to be transferred under the Scheme at the Effective Date, they will be reinsured to SW Ltd and transferred when the impediment to transfer is removed. I am satisfied that my conclusions in respect of the Transferring SW Policies apply equally to any such Excluded Policies. 89

90 Implications for Transferring CMIG Policyholders 8. Implications for Transferring CMIG Policyholders Introduction 8.1 In this section I consider the likely impact of the Scheme on Transferring CMIG Policyholders. These are the policyholders with policies held in the direct and indirect subsidiaries of CMIG, namely CMMF, SAL and HLL. My conclusions in this section focus on my analysis of the potential impact of the Scheme on the benefit expectations and benefit security of these policyholders. 8.2 As described in Section 3, the broad effect of the Scheme will be to transfer all of these policies into a single merged fund in CMIG. 8.3 I have split my conclusions in respect of the policyholders transferring under the Scheme, by grouping my conclusions on the Transferring SW Policyholders separately from those in respect of the Transferring CMIG Policyholders. This reflects the fact that CMIG and SW are the two largest entities in terms of policyholders and, prior to the merger of HBOS plc and Lloyds TSB in 2009, operated as separate insurance groups. Range of Transferring CMIG Policies 8.4 The following bullets provide an overview of the Transferring CMIG Policies. I provide a more detailed overview of the business in each of the entities in Section 3. The majority of the business written in HLL is unit-linked business (primarily pensions), but there are also annuities and protection policies and some non-profit policies reinsured from The Equitable Life Assurance Society. There are a small number of unitised with-profits policies with investments reinsured to the CMIG WPF. SAL holds a mix of unit-linked savings policies and protection policies. CMMF holds a small number of directly-written annuities, which are wholly reinsured to CMIG, and some directly-written fund management policies. There are also property unit fund liabilities, which are reinsured into CMMF from The Equitable Life Assurance Society. Benefit Expectations for Transferring CMIG Policyholders General considerations 8.5 The Transferring CMIG Policies are predominantly unit-linked in nature, with the remaining policies non-profit other than a small number of policies with investments reinsured to the CMIG WPF. The factors pertinent to the benefit expectations of policyholders in each category of business are different, and I consider them separately below. This reflects the varying extents to which management discretion can play a part in determining the level of benefits payable. 90

91 Implications for Transferring CMIG Policyholders 8.6 Before considering those three categories of policies in turn, I confirm that the Scheme will not change the: Value of any policy. Death, maturity or other contingent benefits payable under any policy. Surrender value of any policy. Premiums payable under any policy. Current or expected level of charges under any policy. Asset mix underlying any policy or the range of investment choices available. Range of options available under any policy and any guarantees included in the contract. Charges made for tax under any policy, or their eligibility for any favourable tax treatment. Terms and conditions of any policy. Unit-linked policyholders 8.7 The benefits payable under unit-linked policies are dependent on the value of the underlying unitlinked funds and the charges taken from the funds. The Scheme does not change the assets underlying any of the unit-linked funds or the investment strategy for these funds, nor will it change the range of funds available, the level of investment management charges or other discretionary charges that are taken from the policies. These are the key determinants of benefit expectations for the unit-linked policies. 8.8 The committees within the Companies with responsibility for the management, administration and investment of unit-linked funds have confirmed (where it is within their remit) that these important aspects will be unchanged by the Scheme and that they are not aware of any operational changes that will be driven by the Scheme. I view this as a useful additional assurance that the benefit expectations of policyholders with unit-linked policies will not be affected by the Scheme. 8.9 However, the Scheme will give SW Ltd the power to merge, split or close unit-linked funds, where this is not precluded by the terms and conditions of the affected policies or by regulation (including the TCF regulations). The Companies have confirmed that there are no plans in place to exercise these powers as a direct result of the Scheme. As discussed in paragraphs 3.22 to 3.24, such powers are important tools for insurers to facilitate the effective ongoing management of the unitlinked funds and there are internal governance procedures that require the consideration of appropriate actuarial advice and the obligations of the Companies under TCF For the reasons set out above, I am satisfied that the Scheme does not have any effect on the benefit expectations of the Transferring CMIG Policyholders with unit-linked policies. 91

92 Implications for Transferring CMIG Policyholders Other Non-profit policyholders 8.11 Non-profit policies have guaranteed benefits and specified premiums, and these do not change under the Scheme. There will also be no change to the terms and conditions of these policies Some non-profit policy terms have reviewable premiums, triggered by certain conditions. These conditions and the decision-making process for these reviews will not be changed by the Scheme For the reasons set out above, I am satisfied that the Scheme does not have any effect on the benefit expectations of the Transferring CMIG Policyholders with non-profit policies. Policies with investments reinsured to the CMIG WPF 8.14 There are a small number of policies in HLL where the policyholder has chosen to invest in a unitised with-profits fund. Such policies can invest in unit-linked funds, unitised with-profits or a combination. Where policies have invested in a combination, my conclusions in this sub-section and those in the unit-linked sub-section are applicable. There is no with-profits fund in HLL, so the unitised with-profits exposure is achieved by means of reinsurance to a unitised with-profits fund in the CMIG WPF. The Scheme enables an equivalent arrangement by extending the inter-fund arrangement that allows policies written in the CMIG NPF to gain unitised with-profits exposure, to include policies currently in HLL In Section 9, I conclude that I am satisfied that the Scheme will not have a materially adverse effect on the benefit expectations of the with-profits policyholders in CMIG. This conclusion primarily reflects the fact that the Scheme will not change the way that the CMIG WPF is managed, the financial position of the fund or the way in which future profits are allocated. These conclusions apply equally to the benefit expectations of the policyholders in HLL in respect of the reinsured unitised with-profits investments Other than the unitised with-profits investment link, the policies with such an investment are directly comparable to the other unit-linked policies and my conclusions in respect of those unit-linked policies are equally applicable. Conclusion on benefit expectations 8.17 Based on the analysis above, I am satisfied that the Scheme will not have any effect on the benefit expectations of any of the Transferring CMIG Policyholders. Benefit Security for Transferring CMIG Policyholders 8.18 In Section 6, I set out my general considerations and conclusions in respect of the impact of the Scheme on the benefit security of the affected policyholders. These set out the elements of my analysis that applied to all of the policyholders, including the Transferring CMIG Policyholders This analysis considered: The impact of the Scheme on the Pillar 1 and Pillar 2 solvency coverage ratios, and consideration of the likely impact under Solvency II. My assessment of why reductions in these ratios need not constitute a materially adverse effect. 92

93 Implications for Transferring CMIG Policyholders The continuation of the Risk Appetite Framework and Capital Targets, how these protect policyholder benefit security in the short and longer term and the potential policyholder impact of any actions taken to repair any shortfalls in the capital position. Changes in the risk profile of the funds. The effect of the Scheme on contagion risk The remainder of this sub-section considers points that are specific to the benefit security of particular groups of Transferring CMIG Policyholders and provides my conclusions in respect of each group. Policyholders in SAL 8.21 As shown in Section 6, following the Scheme, the Pillar 1 solvency coverage ratio in relation to the policyholders in SAL is expected to decrease substantially from 890% to 150%, based on the position at 31 December The current solvency ratio is unusually high and far in excess of that required by the regulations and the internal Capital Targets. I have discussed this matter with the Companies and they have confirmed that the current position is not reflective of the expected future level of capital that would be held in the absence of the Scheme. Distributions of capital from SAL have been restricted by the level of share capital - an accounting concept representing the nominal value of the shares issued. As SAL is a wholly-owned subsidiary, this amount has no economic relevance and can be reduced under the Companies Act This would require Court-approval but, as there are no third party shareholders, it is not expected that this would be difficult to achieve The Companies have confirmed that, absent the Scheme, the intention would be to reduce the level of share capital in SAL to some de minimis level, whereby the current restriction on distributions of dividends would be lifted and the level of capital would then reduce to a level close to the Capital Target. In my view such action would be reasonable; indeed I would regard it as standard practice, since it is inefficient for any firm to hold more capital than it needs to run its business. As a result, I am satisfied that the capital currently held in addition to the Capital Target cannot be expected to remain in place and would not be expected to provide benefit security for these policyholders on an ongoing basis, absent the Scheme Following the Scheme, the solvency position in SW Ltd, where these policies will be held, will be comfortably in excess of that required by regulations. They will continue to be protected by a Capital Target in excess of the regulatory capital requirement that is set in an exactly consistent way to before the Scheme, and with reference to the same overarching Risk Appetite Framework The position on the Pillar 2 and Solvency II bases is consistent with that on Pillar 1 above The Scheme will result in the policies in SAL becoming exposed to all of the risks within the other Companies and I have considered the balance of risks in SAL compared to that expected in SW Ltd following the Scheme. The main change is to introduce exposure to the mis-selling risks referred to in paragraphs 6.71 to 6.74 and longevity risk. However, the capital held in respect of these risks is well in excess of the expected costs of these risks, even in severe adverse scenarios. The post- 93

94 Implications for Transferring CMIG Policyholders Scheme risk position is well diversified, with no single type of risk dominating indeed, the risk profile is more diversified in SW Ltd than in SAL, reducing concentration risk As the Capital Target is based on a risk-based capital measure, I am satisfied that any change in risk exposure will be reflected in the level of capital targeted As SAL is a subsidiary of HLL, which is a subsidiary of CMIG, which in turn is a subsidiary of SW, it would be wrong to think that there is no exposure to the risks in the other Companies under the current structure. In the event of financial difficulties in SW (or indeed elsewhere in LBGI), I would expect the Companies to seek to move capital to where it is required - an example of the contagion risk discussed in paragraphs 6.63 to Overall, I am satisfied that the Scheme does not result in a material adverse effect on the benefit security of the Transferring CMIG Policyholders with policies in SAL. Policyholders in HLL 8.30 As shown in Section 6, following the Scheme, the Pillar 1 solvency coverage ratio in relation to the policyholders in HLL is expected to decrease substantially from 607% to 150%, based on the position at 31 December As for SAL, the current capitalisation is far in excess of the required level, which I have discussed with the Companies. The reason for this is that HLL recognises the excess capital held in SAL within its own capital position, as SAL is its direct subsidiary. Absent the Scheme, this position would be expected to change, for exactly the reasons set out above in relation to SAL The position on the Pillar 2 and Solvency II bases is consistent with that on Pillar 1 above As for SAL, following the Scheme, the solvency position for SW Ltd, where these policies will be held, will be comfortably in excess of that required by regulations. They will continue to be protected by a Capital Target in excess of the regulatory capital requirement that is set in an exactly consistent way to before the Scheme, and with reference to the same overarching Risk Appetite Framework The Scheme will result in the policies in HLL becoming exposed to all of the risks within the other Companies and I have considered the balance of risks in HLL, on a standalone basis, compared to that expected in SW Ltd following the Scheme. Other than the mis-selling risks referred to in paragraphs 6.71 to 6.74, the Scheme does not result in a material exposure to any new risk types and the capital held in respect of that risk is well in excess of the expected settlement costs. The post-scheme risk position is well diversified, with no single type of risk dominating indeed, the risk profile is more diversified in SW Ltd than in HLL, reducing concentration risk As the Capital Target is based on a risk-based capital measure, I am satisfied that any change in risk exposure will be reflected in the level of capital targeted As HLL is the parent of SAL and a subsidiary of CMIG, which in turn is a subsidiary of SW, it would be wrong to think that there is no exposure to the risks in the other Companies under the current structure. In the event of financial difficulties in SW (or indeed elsewhere in LBGI), I would expect the Companies to seek to move capital to where it is required - an example of the contagion risk discussed in paragraphs 6.63 to Further, HLL would expect to receive support from its parent 94

95 Implications for Transferring CMIG Policyholders companies in the event that it got into difficulty. The availability of this support is dependent on the financial position of the parents, introducing a limited exposure to the risks in those companies Overall, I am satisfied that the Scheme does not result in a material adverse effect on the benefit security of the Transferring CMIG Policyholders with policies in HLL. Policyholders in CMMF 8.38 As shown in Section 6, following the Scheme, the Pillar 1 solvency coverage ratio in relation to the policyholders in CMMF is expected to decrease substantially from 881% to 150%, based on the position at 31 December As for SAL and HLL, the current capitalisation is far in excess of the required level, which I have discussed with the Companies. The Companies have confirmed that they are currently reviewing the amount of surplus that would be held in CMMF in the absence of the Scheme, and that there is no expectation that levels of capital significantly above the Capital Target would be retained. As above, I consider such a reduction would be reasonable and, indeed, to be expected. As a result, I am satisfied that the capital currently held in addition to the Capital Target cannot be expected to remain in place and would not materially enhance benefit security for these policyholders absent the Scheme The impact on the Pillar 2 and Solvency II bases is consistent with the impact on a Pillar 1 basis and does not alter my conclusions As for SAL and HLL, following the Scheme, the solvency position for SW Ltd, where these policies will be held, will be comfortably in excess of that required by regulations. Following the Scheme, the benefit security of policyholders in CMMF will continue to be protected by a Capital Target in excess of the regulatory capital requirement that is set with reference to the same overarching Risk Appetite Framework The Capital Target for CMMF is currently set as a minimal absolute amount, as there are very few risks retained in CMMF. The Capital Target in SW Ltd post-scheme represents a higher percentage of the Pillar 2 capital requirements than is currently the case in CMMF The Scheme will result in the policies in CMMF becoming exposed to all of the risks within the other Companies and I have considered the balance of risks in CMMF compared to that expected in SW Ltd following the Scheme. The post-scheme risk position is well diversified, with no single type of risk dominating indeed, the risk profile is more diversified in SW Ltd than in CMMF, reducing concentration risk. The Scheme will introduce a risk exposure in the form of the mis-selling risk referred to in paragraphs 6.71 to 6.74, but the policyholders will benefit from the capital held against it. All the risks will be reflected in the SW Ltd Capital Target As for HLL, CMMF is a subsidiary of CMIG, which in turn is a subsidiary of SW, and so it would be wrong to think that there is no exposure to the risks in the other Companies under the current structure. In addition, certain policies in CMMF are reinsured to CMIG, introducing another exposure. At present, no collateral is held in respect of this reinsurance, and so the Scheme does not change the exposure of these policies to a failure of CMIG to meet its liabilities in respect of this business. In the event of financial difficulties in SW (or indeed elsewhere in LBGI), I would expect the Companies to seek to move capital to where it is required - an example of the contagion risk 95

96 Implications for Transferring CMIG Policyholders discussed in paragraphs 6.63 to Further, CMMF would expect to receive support from its parent companies in the event that it got into difficulty. The availability of this support is dependent on the financial position of the parents, introducing a limited exposure to the risks in those companies As a result of the rationale set out above, I am satisfied that the Scheme does not result in a material adverse effect on the benefit security of the Transferring CMIG Policyholders with policies in CMMF. Conclusion on benefit security 8.46 Overall, for the reasons set out in Section 6 and above, I am satisfied that the Scheme does not result in a materially adverse effect on the benefit security of the Transferring CMIG Policyholders. Excluded Policies 8.47 In the event that any policies which would otherwise be Transferring CMIG Policies are unable to be transferred under the Scheme at the Effective Date, they will be reinsured to SW Ltd and transferred when the impediment to transfer is removed. I am satisfied that my conclusions in respect of the Transferring CMIG Policies apply equally to any such Excluded Policies. 96

97 Implications for Existing CMIG Policyholders 9. Implications for Existing CMIG Policyholders Introduction 9.1 In this section I consider the likely impact of the Scheme on the Existing CMIG Policyholders. My conclusions in this section focus on my analysis of the potential impact of the Scheme on the benefit expectations and benefit security of these policyholders. Range of Existing CMIG Policyholders 9.2 CMIG has a wide range of policy types, including unit-linked, with-profits, annuities and protection business. These are held in two long-term business sub-funds: the CMIG NPF and the CMIG WPF. These will remain in place, with continued ring-fencing of the CMIG WPF. The Scheme will transfer a large number of policies into the CMIG NPF. Benefit Expectations General considerations 9.3 As noted above, the Existing CMIG Policies include with-profits, unit-linked and non-profit policies. The factors pertinent to the benefit expectations of policyholders in each category of business are substantially different, and I consider them separately below. This reflects the varying extents to which management discretion can play a part in determining the level of benefits payable. 9.4 Before considering those three categories of policies in turn, I confirm that the Scheme will not change the: Value of any policy. Death, maturity or other contingent benefits payable under any policy. Surrender value of any policy. Premiums payable under any policy. Current or expected level of charges under any policy. Asset mix underlying any policy or the range of investment choices available. Range of options available under any policy and any guarantees included in the contract. Charges made for tax under any policy, or their eligibility for any favourable tax treatment. Terms and conditions of any policy. 97

98 Implications for Existing CMIG Policyholders With-Profits policyholders 9.5 All of the with-profits Existing CMIG Policies are currently held in the CMIG WPF. The Scheme will not change this fund or the assets, liabilities and policies within it. 9.6 Immediately following the Scheme, the CMIG WPF is expected to have an identical financial position to that immediately before the Scheme. 9.7 None of the key considerations relevant to with-profits policies will change as a result of the Scheme, including the basis on which asset shares are determined, the current level of asset shares and guaranteed benefits, bonus rates, expected payout levels, charges and any smoothing of payouts. 9.8 With-profits policies will continue to participate in emerging profits and losses from business written in the CMIG WPF. The Scheme will not result in any changes to the expected level of those emerging profits or losses, or how they are shared. 9.9 The extent to which the with-profits policyholders have a contingent interest in any surplus amount in the CMIG WPF and would receive a share of any such assets that are distributed in the future is unchanged by the Scheme. The assets and liabilities of the funds, and hence the level of surplus assets, are unchanged by the Scheme, and so the value of these contingent interests is unaffected There will be no changes to the investment policy or asset mix of the CMIG WPF as a result of the Scheme. The asset mix may vary over time, as for any with-profits fund, but the Scheme does not cause any change in future expectations. Future investment strategy will be at the discretion of the SW Ltd Board, taking into account the advice of the Chief Actuary (the role which will supersede the AFH under Solvency II), WPA and SW Ltd WPC, whose role is to ensure that the interests of withprofits policyholders are appropriately considered The fund also contains a small amount of non-profit business and the profits or losses from that business stay in the fund. None of this business is being transferred out of the CMIG WPF by the Scheme, and so there is no change in benefit expectations from this source The key elements relating to the ongoing management of the CMIG WPF, as set out in the CMIG Scheme and the PPFM, are replicated by the Scheme and a revised PPFM. As noted in Section 3 and detailed in Appendix 8, I am satisfied that the key aspects of the original PFM are replicated by the Scheme or the PPFM The Scheme will not change the process for allocating investment returns or the manner in which investment strategy is set The Scheme does not change the shareholders share of future bonus declarations. However, as a result of the move to Solvency II, the definition of one of the elements of the calculation (the cost of bonus ) will change. Such a change would have been required absent the Scheme, as the original methodology would not be consistent with the principles of Solvency II The expenses that will be charged to the CMIG WPF are unchanged by the Scheme The Scheme does not change the way in which the estate of the CMIG WPF is operated. 98

99 Implications for Existing CMIG Policyholders 9.17 The Scheme does not replicate the requirement to maintain a Bonus Deficit Account, as introduced by the CMIG Scheme and as set out in Section 5. The CMIG Scheme only required this account to be maintained until the end of 2016 and it could only have had any benefit to the policyholders in the event that the CMIG WPF was unable to meet the expected total costs of a bonus declaration and the associated shareholder transfer. Analysis by the Companies show that this scenario is extremely unlikely to occur before the end of 2016, and so I am satisfied that the Bonus Deficit Account does not represent a material aspect of policyholder benefit expectations The Scheme introduces the powers for SW Ltd to close the CMIG WPF should the liabilities fall beneath 500m or to merge it with the Scottish Widows WPF should the liabilities of either fund fall beneath 500m. I am also satisfied that the proposed threshold of 500m is reasonable, being comparable to similar arrangements that I have seen for peer companies. As set out in Section 3, I am also satisfied that this does not materially adversely affect policyholder benefit expectations, as: The Scheme includes various strong protections intended to prevent an adverse policyholder impact. Both funds are still expected to be significantly above the threshold level of 500m beyond Such clauses can support the efficient running of a with-profits fund, helping to avoid an adverse effect on policyholders None of the costs of the Scheme will be borne by the CMIG WPF before or after the Scheme is effective For the reasons set out above, I am satisfied that the Scheme does not have any material effect on the benefit expectations of the Existing CMIG Policyholders who hold with-profits policies My conclusions apply equally to policies in the CMIG WPF that were written before and after the effective date of the CMIG Scheme. Unit-linked policyholders 9.22 The benefits payable under unit-linked polices are dependent on the value of the underlying unitlinked funds and the charges taken from the funds. The Scheme does not change the assets underlying any of the unit-linked funds or the investment strategy for these funds. Nor will it change the range of funds available, the level of investment management charges or other discretionary charges that are taken from the policies. These are the key determinants of benefit expectations for the unit-linked policies The committees within the Companies with responsibility for the management, administration and investment of unit-linked funds have confirmed (where it is within their remit) that these important aspects will be unchanged by the Scheme and that they are not aware of any operational changes that will be driven by the Scheme. I view this as a useful additional assurance that the benefit expectations of policyholders with unit-linked policies will not be affected by the Scheme However, the Scheme will give SW Ltd the power to merge, split or close unit-linked funds, where this is not precluded by the terms and conditions of the affected policies or by regulation (including 99

100 Implications for Existing CMIG Policyholders the TCF regulations). This is a slight extension of the existing power set out in the CMIG Scheme, where such actions are allowed where the terms and conditions permit it. The Companies have confirmed that there are no plans in place to exercise these powers as a direct result of the Scheme. As discussed in paragraphs 3.22 to 3.24, such powers are important tools for insurers to facilitate the effective ongoing management of the unit-linked funds and there are internal governance procedures that require the consideration of appropriate actuarial advice and the obligations of the Companies under TCF For the reasons set out above, I am satisfied that the Scheme does not have any effect on the benefit expectations of the Existing CMIG Policyholders with unit-linked policies. Other Non-profit policyholders 9.26 Non-profit policies have guaranteed benefits and specified premiums, and these do not change under the Scheme. There will also be no change to the terms and conditions of these policies Some non-profit policy terms have reviewable premiums, triggered by certain conditions. These conditions and the decision-making process for these reviews will not be changed by the Scheme For the reasons set out above, I am satisfied that the Scheme does not have any effect on the benefit expectations of the Existing CMIG Policyholders with non-profit policies. Policies with investments reinsured to the CMIG WPF 9.29 There are some policies within CMIG where the policyholder has the option of investing in unitlinked, unitised with-profits or a combination of the two. The unitised with-profits exposure is achieved by means of inter-fund agreement between the CMIG NPF and the CMIG WPF. This arrangement will be maintained following the Scheme by way of an equivalent inter-fund arrangement between the Combined Fund and the CMIG WPF Similarly, some policies in CMI and CMI Insurance (Luxembourg) S.A. (which are not transferring under the Scheme) achieve unitised with-profits exposure by means of a reinsurance arrangement. This will be maintained following the Scheme (although, in the case of CMI, the arrangement will now be with a company external to LBG, following its sale). A similar arrangement exists with Aviva Life & Pensions UK Limited and this is also unchanged by the Scheme I have concluded above that the Scheme has no material effect on the benefit expectations of existing CMIG Policyholders with policies in the SW WPF. My conclusions apply equally to benefit expectations in respect of the unitised with-profits element of the policies that invest in both unitlinked and unitised with-profits. My conclusions in respect of unit-linked policies apply equally to the unit-linked element of such policies currently held in CMIG. Conclusion on Benefit Expectations 9.32 Based on the analysis above, I am satisfied that the Scheme will not have any material effect on the benefit expectations of any of the Existing CMIG Policyholders. 100

101 Implications for Existing CMIG Policyholders Benefit Security for Existing CMIG Policyholders 9.33 In Section 6, I set out my general considerations and conclusions in respect of the impact of the Scheme on the benefit security of the affected policyholders. These set out the elements of my analysis that applied to all of the policyholders, including the Existing CMIG Policyholders This analysis considered: The impact of the Scheme on the Pillar 1 solvency coverage ratios, including a qualitative overview of how this analysis differs on a Pillar 2 basis, and my assessment of why reductions in these ratios need not constitute a materially adverse effect. The existence of the Capital Targets, how these protect policyholder benefit security in the short and longer term and the potential policyholder impact of actions taken to repair the capital position. My general view on contagion risk, including how the level of this risk could be changed by the Scheme The remainder of this sub-section addresses the remaining points that I have considered in my assessment of the impact of the Scheme on the benefit security that are specific to the Existing CMIG Policyholders. Policyholders in the CMIG NPF 9.36 As shown in Section 6, following the Scheme, the Pillar 1 solvency coverage ratio in relation to the policyholders in CMIG is expected to decrease from 190% to 150%, based on the position at 31 December Excluding the impact of the CMIG WPF and the Scottish Widows WPF, reflective of the fact that the with-profits funds are managed separately and are expected to be able to meet their own capital requirements, the ratio is expected to decrease from 537% to 341% as a result of the Scheme CMIG currently recognises the excess capital held in SAL within its own capital position, as SAL is an indirect subsidiary. This is one of the main drivers for the high reported capital position a position that is not expected to be maintained in the long term, for the same reasons as set out above in relation to SAL in Section The position on the Pillar 2 and Solvency II bases is consistent with that on Pillar 1 above Following the Scheme, the solvency position for these policyholders will be comfortably in excess of that required by regulations. They will continue to be protected by a Capital Target in excess of the regulatory capital requirement that is set in an exactly consistent way to before the Scheme, and with reference to the same overarching Risk Appetite Framework The impact on a Pillar 2 basis is consistent with the impact on a Pillar 1 basis The expected impact under Solvency II is also consistent, although there is greater uncertainty in relation to the absolute solvency position on this basis. 101

102 Implications for Existing CMIG Policyholders 9.42 As a result of the Scheme, the Existing CMIG Policyholders will become directly exposed to the risks held in all of the other entities involved. As HLL, SAL and CMMF are subsidiaries of CMIG, I consider that the Existing CMIG Policyholders already have exposure to these risks. In particular, while it is able to meet its regulatory capital requirements and Capital Target, I would consider it highly unlikely that it would allow HLL, SAL or CMMF to become insolvent In addition, CMIG is already exposed to certain liabilities in CMMF, HLL and SW as a result of reinsurance arrangements. The Scheme will result in the policies in these subsidiaries ranking pari passu with the policies written in CMIG, causing a potentially different situation under insolvency, depending on the value of the collateral in place at that time relative to the liabilities. Of the reinsurance in force, only the reinsurance with SW is material and the collateral arrangement under that treaty is structured in such a way that the reinsured liabilities rank pari passu with the direct liabilities. This is equivalent to the post-scheme situation I have also considered the balance of risks in CMIG, as a standalone entity, compared to that expected in SW Ltd following the Scheme. The Scheme does not result in a material exposure to any new risk types indeed the risk profile is more diversified in SW Ltd than in CMIG, as a result of the reduction in the concentration of exposure to the mis-selling risks referred to in paragraphs 6.71 to As the Capital Target is based on a risk-based capital measure, I am satisfied that any change in risk exposure will be reflected in the level of capital targeted I concluded in Section 6 that I am satisfied that the introduction of risks in relation to the SW Pension Scheme does not materially change the expected risk profile of SW Ltd. As a result, and reflective of the fact that capital is held against these risks, I am satisfied that they do not have a material bearing on policyholder benefit security Overall, I am satisfied that the Scheme does not result in a material adverse effect on the benefit security of the Existing CMIG Policyholders with policies in the CMIG NPF. Policyholders in the CMIG WPF 9.47 As discussed in Sections 5 and 6, the Scheme will not change the assets or, liabilities or risks within the CMIG WPF or how the fund is expected to be managed in future. Hence the solvency position is unchanged As set out above, the Scheme does not replicate the requirement to maintain a Bonus Deficit Account. Based on analysis provided by the Companies, I concluded in Section 5 that this account had no material bearing on the benefit expectations or security of the policies in the CMIG WPF If capital support is required for the CMIG WPF in the future, it will be provided by the SW Ltd Combined Fund, rather than the CMIG NPF or CMIG SHF at present. The SW Ltd Combined Fund has a strong solvency coverage ratio, with an expected surplus of 2.9bn on a Pillar 1 basis, and the same ongoing Capital Targets as CMIG currently. As a result, I consider it likely that the CMIG WPF will be able to access support when required, in all but the most extreme scenarios consistent with the current position As a result of the rationale set out above, I am satisfied that the Scheme does not result in a material adverse effect on the benefit security of the Existing CMIG Policyholders with policies in the CMIG WPF. 102

103 Implications for Existing CMIG Policyholders 9.51 As highlighted in paragraph 5.14, I am satisfied that my conclusions apply equally to policies in the CMIG WPF that were written before and after the effective date of the CMIG Scheme. Conclusion on benefit security 9.52 Overall, for the reasons set out in Section 6 and above, I am satisfied that the Scheme does not result in a materially adverse effect on the benefit security of the Existing CMIG Policyholders. 103

104 Ongoing Governance, Administration and Investment Management 10. Ongoing Governance, Administration and Investment Management Introduction 10.1 In this Section, I consider the effect of the Scheme on the ongoing governance, administration and investment management of the Transferring SW Policies, the Transferring CMIG Policies and the Existing CMIG Policies. Governance 10.2 As LBGI is largely managed as a single integrated insurance business, there is already a high degree of consistency in the governance and management of the Companies. For example, the principal entities (SW, CMIG, SWA and SAL) are managed by an Insurance Board, with the remaining entities managed by a Life Tier 2 Board (reflecting the relative materiality and complexity of the businesses and the practical difficulty for one board to effectively manage eight separate legal entities). Similarly, there is a common risk management framework applicable to all of the Companies and commonality in the actuarial controlled functions (AFH and WPA) Following the Scheme, there will be a single Board responsible for the management of SW Ltd. The Board will be based on the current Insurance Board and I have no reason to believe that this will lead to any discernable change in the way that they will exercise their powers and fulfil their responsibilities in relation to the policyholders. There will be no change to the WPC, AFH or WPA as a direct result of the Scheme. The AFH role will be superseded by the Chief Actuary role under Solvency II, but this is not a Scheme-related change. Any future changes to the membership of the WPC or to the identity of the AFH or WPA will be subject to the same governance to which they are currently subject. Although it is not related to the Scheme, I have no reason to believe that the governance related to appointing the Chief Actuary or WPA under Solvency II will be any less rigorous than is currently applied The Scheme will result in the Companies currently governed by the Life Tier 2 Board being within the direct remit of the single SW Ltd Board, which is based on the Insurance Board. I note that there is a member who sits on both the Insurance Board and the Life Tier 2 Board, which will provide continuity in relation to the management of these Companies. Additionally, the current members of the Life Tier 2 Board are executive members and will be able to support the governance of SW Ltd following the Scheme, for as long as they remain in LBG. Similarly, the AFH is common across all of the Companies, providing a degree of continuity and helping to ensure that any expertise in relation to the Companies governed by the Life Tier 2 Board is not lost As noted in the Section 5, the Scheme does not include references to the role of the Appointed Actuary, as set out in the SW Scheme, and places greater emphasis on the Board s responsibility for the management of the business in general and the with-profits funds in particular (subject to oversight from the WPC). I am satisfied that this does not have a material effect on policyholders, as 104

105 Ongoing Governance, Administration and Investment Management the proposed arrangements are in line with the existing regulatory guidance on responsibility for a with-profits fund and the Board is required to take appropriate actuarial advice in respect of certain key decisions As noted in Section 5, the SW Scheme and CMIG Scheme set out the PFMs, which guide the management of the SW WPF and the CMIG WPF. Key elements of the PFMs are included in the Scheme, but some are considered to be adequately covered in the respective PPFMs of the funds. I have reviewed a mapping of the original PFMs provided by the Companies and am satisfied that the relevant provisions within them have been retained As noted in Section 5, the requirement to provide an annual certification in respect of the key elements of the operation of the Scheme has been retained For the reasons set out above and the analysis in Section 5 and Appendices 7 and 8, I am satisfied that changes to governance processes or responsibilities as a result of the Scheme do not have a materially adverse effect on any of the groups of policyholders. Service standards and administration 10.9 The Scheme will not change the way in which any of the policies are administered or the expected standard of servicing. Specifically: The Scheme will not change the teams that are responsible for performing the administration or the resources allocated to those teams. Targets in respect of the standard of servicing will be unchanged by the Scheme. There will be no change to the process (other than the legal entity name, as discussed below) by which policyholders can get in contact with the Companies As a result, I am satisfied that the Scheme will not have any effect on the service standards or administration experienced by policyholders. Rebranding Following the implementation of the Scheme, CMIG will be renamed as Scottish Widows Limited (SW Ltd) The change of name is dependent on clearance from Companies House, as the word Scottish is a reserved word when used in the context of a company name. Approval has been received in principle, but cannot be confirmed until near the date of the Sanction Hearing. I am not aware of any reason why this approval would not be confirmed in due course, but will continue to monitor this and will provide an update in my Supplementary Report on the Scheme It is important to note that this rebranding will not be applied retrospectively. Existing policies will retain their branding of Scottish Widows, Clerical Medical or Halifax Financial Services, reflecting the origin of the business writer. Policyholders should not notice a significant change in their interactions with the Companies. 105

106 Ongoing Governance, Administration and Investment Management Future new business will be sold only through the Scottish Widows brand name. This does not represent a significant change to the current position, where only very limited volumes of incremental business are written outwith SW. As a result, I am satisfied that this change should not materially affect the volumes or mix of new business sold or the interests of existing policyholders I understand that inclusion or otherwise of the word Scottish in the company name may stir the emotions of some policyholders, especially in the light of the Scottish independence issue, but I am satisfied that, whatever the decision from Companies House, it will not affect their actual position, policy terms or rights. Investment management The range of unit-linked and unitised with-profits funds available to policyholders will not change as a direct result of the Scheme The Scheme does not change the value of each policyholder s unit holding and the pricing principles and pricing bases are not changed by the Scheme itself. Similarly, the level of fund charges, the investment mandates and the principles governing the setting of investment strategies of each fund are unchanged by the Scheme itself As set out in Section 3, the Scheme clarifies powers in relation to the ongoing management of unitlinked funds. I have concluded that these changes are reasonable and do not adversely affect policyholders The Scheme does not change the investment managers of any of the funds Based on the above, I am satisfied that there will not be any effect on policyholders in respect of investment management as a result of the Scheme. 106

107 Tax Considerations 11. Tax Considerations Introduction 11.1 In this Section, I consider the effect of the Scheme on the tax borne by policyholders, and whether policyholders might be materially adversely affected by any changes in tax charged, or likely to be charged I have received information from the Companies, setting out the expected tax implications of the Scheme, both for the Companies and for policyholders. I have considered whether there are any tax considerations that could have a materially adverse impact on policyholder benefit expectations or security 11.3 Although my review has not identified any material adverse tax impacts for Transferring Policyholders or Existing CMIG Policyholders, there will always be some risk of an adverse tax effect due to changes to tax legislation between now and the Effective Date, or in relation to execution risks (for example, the obtaining of tax clearances and notification requirements). I am not aware of any proposed legislative or tax changes that would have an adverse effect at the present time. Company taxation 11.4 I have considered whether the taxation position of the Companies could be changed by the Scheme so as to adversely affect policyholders, either directly as a result of policyholders bearing extra costs or indirectly if the strength of CMIG were to be significantly weakened Currently, the tax charged to the SW WPF is in accordance with the SW Scheme (as adjusted for certain matters relating to changes in the tax regulations since the effective date of that scheme). Policies that were transferred to SW under the SW Scheme that remain in-force are allocated a share of tax calculated on the basis that all such policies constituted a separate mutual life insurance company. For assets, liabilities and operations arising since the effective date of the SW Scheme tax is charged to the SW WPF on a fair and equitable basis, taking account of the reasonable expectations of the policies written since the effective date of the SW Scheme. All other tax in SW is charged to the SW SHF or SW NPF. Taxation borne by SW on the transfers from the WPF to shareholders (the 1/9 th of bonuses) is not borne by the SW WPF, and is not reflected in payouts under with-profits policies The current basis of charging tax to the SW WPF will continue in respect of the Scottish Widows WPF following the implementation of the Scheme. In particular, the Separate Mutual Company calculation will continue for policies in the Scottish Widows WPF written before the effective date of the SW Scheme and tax will continue to be charged on a fair and equitable basis in respect of the post-sw Scheme assets, liabilities and operations of the Scottish Widows WPF, having regard for the obligation to treat the affected policyholders fairly Similarly, tax will continue to be charged to the CMIG WPF on the basis that it constitutes a separate mutual life insurance company, as now Based on discussions with the Companies, it is possible that, under certain circumstances, SW Ltd may achieve a reduction in future tax liability as a result of the offset of income and excess expenses 107

108 Tax Considerations that are currently maintained in separate companies in LBGI. There are a number of detailed points which require further clarification and/or discussion with HMRC before this can be confirmed. I understand from the Company that, if confirmed, this could reduce the tax borne by the Combined Fund in future years following the transfer i.e. it is a shareholder benefit. However, there may be a positive effect for the WPFs to the extent that tax reliefs that would otherwise remain unutilised are able to be offset against suitable taxable profits in the enlarged company. Even if confirmed, it is important to note that the likelihood of a benefit arising in any given year and the size of that benefit are heavily dependent on uncertain factors such as market movements. Given these uncertainties, the Companies do not intend to anticipate any future benefit in their financial statements The Companies expect to receive confirmation from HMRC that certain anti-avoidance provisions specific to transfers of life business will not apply to the Scheme. They also expect to receive confirmation from HMRC that the treatment of certain asset transfers should be neutral for the purposes of calculating the chargeable gains of the Companies. These confirmations are not expected to be received prior to the Directions Hearing; I will provide an update in my Supplementary Report The Companies do not expect the Scheme to reduce the ability of LBGI to receive tax recoveries (including Fokus reclaims and GLO claims), but are currently seeking confirmation as to the actions required to ensure this is the case. I will continue to monitor this situation and will provide an update in my Supplementary Report. Policyholder taxation The Companies full technical analysis is still to be finalised, but they do not expect there to be any change to: The underlying status and taxation of the long term funds i.e. BLAGAB, OLAB and With Profit Funds. The approved status of the registered pension schemes under FA04. The qualifying status of policies under Schedule 15 ICTA The Companies do not anticipate any changes to taxation that will impact the policyholder benefits. The position above will form part of discussions with HMRC alongside the formal clearances being applied for. The Companies are not envisaging any objections I have considered the draft policyholder taxation analysis noted and I am satisfied that the Scheme should have no material adverse impact on any group of policyholders in this respect. Stamp Duty, VAT and other matters As the Companies are under common ownership, they expect that there should be no UK stamp duty or related tax costs associated with the Scheme. Similarly, the Companies do not expect the Scheme to give rise to significant transaction taxes outside the UK, although this remains subject to more detailed confirmation The Companies expect that there should be no VAT costs associated with the Scheme on the basis that it is a transfer of a Going Concern. The Companies do not intend to seek clearance from HMRC in respect of this expected treatment. 108

109 Tax Considerations The Companies have considered whether FATCA regulations will require the reporting of individual policyholders as a result of the Scheme. Their conclusion is that the pre-existing status of each individual account should not be disturbed by the Scheme. Conclusion On the basis of the information above, I conclude that there should be no adverse tax effects on Transferring SW Policyholders, Transferring CMIG Policyholders or Existing CMIG Policyholders on account of the implementation of the Scheme. This is subject to the clearances referred to above being received and other confirmatory matters being satisfactorily concluded The Companies have confirmed that any unexpected tax charges arising as a result of the Scheme will not be borne by policyholders or by the WPFs. 109

110 Policyholder Communications 12. Policyholder Communications Introduction 12.1 Parties to a scheme made pursuant to Part VII of FSMA must comply with the notice requirements set out in the relevant regulations (the Transfer Regulations ). The PRA Statement of Policy (paragraphs 2.49 to 2.54) and SUP provide further guidance on the form and content of policyholder communications with respect to a scheme The Transfer Regulations require notice to be sent to all policyholders of the involved parties and for notice of the application to be published in, inter alia, the official gazettes and two national newspapers. The form of the notice must be approved by the relevant Regulator I summarise below the Companies communications plans and my view on whether these are appropriate. Notifications to policyholders Overview 12.4 Notice of the Part VII application will be published in the London, Edinburgh and Belfast Gazettes and seven newspapers: The Sun, The Mirror, The Daily Mail, Daily Telegraph and the Financial Times, as well as the international editions of the Financial Times and The Daily Mail. There will also be advertising in two newspapers in EEA states where there are 300 or more affected policyholders. Notice of the Court of Session Applications will also be published in the Edinburgh Gazette and The Herald (Scotland) newspaper The communications approach to achieve direct contact with different policyholder groups is based around a letter informing policyholders of the Scheme and providing them with a short summary of what it does, the potential impact on their policies and my views, as well as a summary of the legal notice for the Scheme. There will also be a question and answer section and details of what to do if the policyholder wants to obtain additional information or to object The letter will direct policyholders to further information on the Companies website, where a more detailed summary of this Report and the Scheme will be available, along with full versions of the legal notice, this Report, the Scheme, the reports of the AFH and WPA, changes to the Customer Friendly PPFM and the Court of Session Applications Policyholders will be able to telephone a call centre for free if they have questions about the Scheme. A German language call centre will also be operated, reflective of the relatively large number of policyholders in Germany Full copies of the various documents available on the website will be mailed to policyholders on request, without charge The contents of the physical policyholder mailing differ from the material that has typically been sent out for such transfers in the past. In particular, the volume of materials will be significantly less, with greater emphasis placed on the availability of information online and also through other channels. 110

111 Policyholder Communications Policyholders in the Channel Islands will be provided with specific information about their local court procedures in a tailored letter that will also include the items in paragraph I have reviewed drafts of the Companies proposed communication materials. In my opinion: The mailing provides sufficient information to enable policyholders to understand what is happening and, at a high level, the impact on their policy. Within this, my views are prominent, and there is sufficient information to enable policyholders to understand my conclusion on the impact. Notwithstanding the fact that the underlying material is technical in nature, the communication is designed to be easy for policyholders to understand. The communication attempts to maximise engagement from the affected policyholders. In particular, I note that a short pack may well be better in this regard than a thick, intimidating pile of paper. It is easy for policyholders to obtain additional information. This information is predominantly internet-based and I have no objection to this, provided that the information is prominently displayed and easy to access/download. I have checked that there is also appropriate provision for those who do not want to use this medium in particular there is a free phone number that can be used to ask questions and/or request information, and an address that people can write to. The right of policyholders to object is made clear, as well as how to do so. Communication plans Affected policyholders whose mailing details are available on LBGI s computerised records will be sent copies of the pack set out above, tailored to reflect their situation and the key impacts of the Scheme on them The style and branding of the mailing will be consistent with that received by the policyholders at present. This is consistent with the Companies intention to retain the current branding for its existing customers (although all future policyholders will use the Scottish Widows brand) The packs will be written in the language that is normally used to communicate to that policyholder Pension scheme trustees and scheme administrators will receive separate letters informing them of the Scheme and the actions that they can take The policyholder mailing will be phased, and a call centre will be appropriately staffed to deal with questions and complaints from policyholders throughout the mailing process. Uncontactable policyholders and other exemptions The Transfer Regulations require all policyholders of the Companies, which includes anyone with an indirect or beneficial interest in a policy, to be notified of this Scheme unless a dispensation is granted by the Court. 111

112 Policyholder Communications In some cases, the Companies do not hold a current address for some of the policyholders to be mailed. These include goneaway policyholders who are by definition not contactable by mail. There will also be situations where a policyholder (for instance a trustee in bankruptcy) has not notified the Companies of their interest in a policy In 2012, the Companies carried out an exercise to reduce the number of policies for which they did not hold accurate contact details. Given the fact that this exercise was carried out so recently, no further specific tracing exercise has been proposed for the purposes of the Scheme. I understand from the Companies that about 4.2% of policyholders are goneaways The Companies are seeking dispensation from the Court from notifying goneaways and uncontactable policyholders of the Scheme. I am satisfied that, given the proportion of such policyholders, the procedures already in place to contact them and the advertising that might bring the Scheme to their attention, this is an appropriate approach to use in this situation of an intra-group transfer of business that does not materially adversely affect the policyholders concerned The Companies are also seeking dispensation from the Court from notifying groups of policyholders who would not normally be contacted directly by the Companies (such as second lives on an annuity or members of a group policy where there is no individual contractual relationship). I note that there are practical procedures in place to help ensure that the groups of policyholders for which a dispensation is being sought are contacted where possible (such as requesting that a pension scheme trustee contacts the individual scheme members). I have reviewed the rationale behind seeking this dispensation, and I am satisfied that the request is reasonable and does not adversely affect policyholders. Reinsurers Information about the Scheme will also be sent to every reinsurer whose contracts of reinsurance will be transferred by the Scheme. Objections Any policyholder who feels they will be adversely affected by the Scheme may put their objections to the Court either in writing, by attending the Sanction Hearing or by asking a representative to raise their objection. In deciding whether to sanction the Scheme, the Court will consider any objections. I will also consider objections that have been made in writing sufficiently in advance of the Court date in coming to my view on the appropriateness of the Scheme, and will report as appropriate in my Supplementary Report. I will also consider any objections made to the Court of Session sufficiently in advance of the hearing of the Court of Session Applications. Conclusion Subject to additional review of the proposed packs, I am satisfied that the proposed approach to communicating the Scheme to all groups of policyholders impacted by the Scheme is reasonable and that the proposed communication pack adequately explains the material effects of the Scheme with respect to their policies. 112

113 Appendix 1: Independent Expert Terms of Reference Appendix 1: Independent Expert Terms of Reference Scope of the work of the Independent Expert in relation to the proposed scheme (the Scheme ) The Scheme Reports are to consider the terms of the Scheme generally and the effect which the Scheme will have on the holders of long-term policies of the Companies. In preparing the Scheme Reports, the Independent Expert must have regard to the duty that he owes to assist the Court (and, in relation to the Court of Session Applications, the Court of Session) on those matters within his expertise. This duty overrides any obligations to the Companies. The Scheme Reports apply equally to business written by the Companies in Jersey, the Bailiwick of Guernsey and the Isle of Man as they do to business written in the UK, and may therefore be used to satisfy the requirement for a report by an independent actuary on the terms of the local schemes in those jurisdictions (to the extent that any such local schemes are required). In particular the Scheme Reports should consider the following specific matters: The matters listed in SUP G, G and G 1. The impact of the Scheme on the security of the different groups of policyholders involved in the Scheme. The impact of the Scheme on the benefit expectations of the different groups of policyholders involved in the Scheme. Consideration of any change in tax that may be charged to policies or policyholder funds, or other loss of favourable tax status. A review of, and opinion on the adequacy of, the communications made to policyholders concerning the Scheme. The impact of the Scheme on the level of service (including administration and investment management services) provided to the different groups of policyholders involved in the Scheme. The adequacy of any safeguards in the Scheme to protect the ongoing interests of different groups of policyholders. 1 Please note that the Terms of Reference were agreed before the release of the PRA Statement of Policy. 113

114 Appendix 1: Independent Expert Terms of Reference Any other matters drawn to the attention of the Independent Expert by the Regulators or required by the Regulators to be addressed within the Scheme Reports. The Scheme Reports will be prepared with due regards to the guidance set out in SUP 18.32G, 18.34G, 18.35G, 18.37G, 18.40G and 18.41G. The review and Scheme Reports will address generally the way in which the Companies have conducted their long-term business but taking into account the particular circumstances of the class of business to be transferred. It will consider inter alia the following aspects of each Company: The Memorandum and the Articles of Association, at least insofar as these affect the rights, expectations and interests of policyholders. To the extent potential concerns arise, consideration of the terms of policies issued by each Company or otherwise held by policyholders of each Company. The existing and proposed internal working arrangements relating to the financial management of the long-term business funds of each Company, including the operational and administrative arrangements which will apply to the policies to be transferred under the terms of the Scheme. The terms and conditions expected to be imposed by the Scheme to be presented to the Court and the terms and conditions of any other schemes or arrangements in overseas jurisdictions which may be required to transfer certain of the policies, including the views expressed by the governing body or management of each Company. The terms of any previous schemes of transfer that created particular rights or protections for a class of policyholders within one or more of the Companies. The above list is not intended to be exclusive of any other aspects which may be identified during the completion of the project and which are considered to be relevant. The Independent Expert shall not be directly involved in the formulation of the proposed transfer although he will be expected to give guidance during the evolution of the detailed proposals on those issues which are of concern to him, or which he considers unsatisfactory. 114

115 Appendix 2: SUP 18 and PRA Statement of Policy Cross Reference Appendix 2: SUP 18 and PRA Statement of Policy Cross Reference The Regulators requirements relating to the transfer of long-term insurance business are set out in the PRA Statement of Policy and also Chapter 18 of the Supervision Manual of the Regulators Handbook of Rules and Guidance ( SUP 18 ). In particular, SUP 18.2 sets out the requirements of a scheme report in relation to the transfer of insurance business within the UK. The following table sets out these details, along with crossreferences to the sections in the main body of the Report which cover the required scope. Except where highlighted, the requirements in the PRA Statement of Policy are covered within SUP Table A2.1 SUP 18 and PRA Statement of Policy Cross Reference SUP 18.2 item number and details Corresponding paragraph in the PRA Statement of Policy Section and paragraph reference in this Report SUP G 2.30 (1) Who appointed the independent expert and who is bearing the costs of that appointment; (1) 1.3, 2.68, 3.47 (2) Confirmation that the independent expert has been approved or nominated by the appropriate regulator; (2) 1.3 (3) A statement of the independent expert's professional qualifications and (where appropriate) descriptions of the experience that fits him for the role; (3) 1.4 (4) Whether the independent expert has, or has had, direct or indirect interest in any of the parties which might be thought to influence his independence, and details of any such interest; (4) Also includes the employer of the independent expert (5) The scope of the report; (5) (6) The purpose of the scheme; (6) 2.6, 3.2 (7) A summary of the terms of the scheme in so far as they are relevant to the report; (7) Section 3 (8) What documents, reports and other material information the independent expert has considered in preparing his report and whether any information that he requested has not been provided; (8) , 6.15, Appendix 9 (9) The extent to which the independent expert has relied on: (9) (a) Information provided by others; and (a) , , Appendix 9 (b) The judgment of others; (b) Stated in various parts of the Report (10) The people on whom the independent expert has relied and why, in his opinion, such reliance is reasonable; (10) Stated in various parts of the Report 115

116 Appendix 2: SUP 18 and PRA Statement of Policy Cross Reference SUP 18.2 item number and details Corresponding paragraph in the PRA Statement of Policy Section and paragraph reference in this Report (11) His opinion on the likely effects of the scheme on policyholders (this term is defined to include persons with certain rights and contingent rights under the policies), distinguishing between: (a) Transferring policyholders; (b) Policyholders of the transferor whose contracts will not be transferred; and (c) Policyholders of the transferee; (11A) His opinion on the likely effects of the scheme on any reinsurance of the transferor, or any whose contracts of reinsurance are to be transferred by the scheme; (11) Sections 7, 8 and 9 (a) (b) (c) (12) 2.43, 6.68 (12) What matters (if any) that the independent expert has not taken into account or evaluated in the report that might, in his opinion, be relevant to policyholders' consideration of the scheme; and (13) 1.13 (13) For each opinion that the independent expert expresses in the report, an outline of his reasons. (14) Stated in various parts of the Report SUP G 2.32 (1) A description of any reinsurance arrangements that it is proposed should pass to the transferee under the scheme; and (1) , Appendix 6 (2) A description of any guarantees or additional reinsurance that will cover the transferred business or the business of the transferor that will not be transferred. (2) 3.17 SUP G 2.33 The independent expert's opinion of the likely effects of the scheme on policyholders should: 2.33 (1) Include a comparison of the likely effects if it is or is not implemented; (1) Stated throughout the Report (2) State whether he considered alternative arrangements and, if so, what; (2) 1.13, 4.8 (3) Where different groups of policyholders are likely to be affected differently by the scheme, include comment on those differences he considers may be material to the policyholders; and (3) , Section 7, 8 and 9 (4) Include his views on: (4) (a) The effect of the scheme on the security of policyholders' contractual rights, including the likelihood and potential effects of the insolvency of the insurer; (a) Sections 6 to 9, Appendix 5 (b) The likely effects of the scheme on matters such as investment management, new business strategy, administration, expense levels and valuation bases in so far as they may affect: (b) 116

117 Appendix 2: SUP 18 and PRA Statement of Policy Cross Reference SUP 18.2 item number and details Corresponding paragraph in the PRA Statement of Policy Section and paragraph reference in this Report (i) The security of policyholders' contractual rights; (i) Section 6 to 9 (ii) Levels of service provided to policyholders; or (ii) Section 10 (iii) For long-term insurance business, the reasonable expectations of policyholders; and (iii) Sections 6 to 9 (c) The cost and tax effects of the scheme, in so far as they may affect the security of policyholders' contractual rights, or for long-term insurance business, their reasonable expectations. (c) 2.66, 2.69, Section 11 SUP G 2.36 For a scheme involving long-term insurance business, the report should: 2.36 (1) Describe the effect of the scheme on the nature and value of any rights of policyholders to participate in profits; (1) 2.30, , , , , (2) If any such rights will be diluted by the scheme, how any compensation offered to policyholders as a group (such as the injection of funds, allocation of shares, or cash payments) compares with the value of that dilution, and whether the extent and method of its proposed division is equitable as between different classes and generations of policyholders; (2) N/A (3) Describe the likely effect of the scheme on the approach used to determine: (3) (a) The amounts of any non-guaranteed benefits such as bonuses and surrender values; and (a) 2.30, , , Appendix 7 and 8 (b) The levels of any discretionary charges; (b) 7.7, 7.19, 7.25, , 9.4, 9.15, 9.22, Appendix 7 and 8 (4) Describe what safeguards are provided by the scheme against a subsequent change of approach to these matters that could act to the detriment of existing policyholders of either firm; (4) 5.4, 5.10, 7.16, 9.12, (5) Include the independent expert's overall assessment of the likely effects of the scheme on the reasonable expectations of long-term insurance business policyholders; (5) Section 2, 7, 8 and 9 (6) State whether the independent expert is satisfied that for each firm the scheme is equitable to all classes and generations of its policyholders; and (6) Conclusions apply equally to all classes and generations (7) State whether, in the independent expert's opinion, for each relevant firm the scheme has sufficient safeguards (such as principles of financial management or certification by a with-profits actuary or actuarial function holder) to ensure that the scheme operates as presented. (7)

118 Appendix 3: Background to SW Appendix 3: Background to SW Introduction Scottish Widows plc was formed in 1815 as the Scottish Widow s Fund and Life Assurance Society. In 1999 the company was bought by Lloyds TSB for 7bn and demutualised in March 2000, as part of the acquisition. Subsequently, in 2009 Scottish Widows became part of the LBG Group. As at 31 December 2014 SW had around 7 million policies, with a combination of life, pensions and investment products. SW currently writes significant volumes of new (unit-linked, annuity and protection) business through intermediary, bancassurance and direct sales channels. For some time, the number of new SW WPF policies has been low and so the size of the SW WPF is expected to reduce over time. SW is the guarantor to the SW Retirement Benefits Scheme and liable for funding any deficit that is found. The scheme is closed to new entrants, although benefits can still be accrued for current, active members of the scheme. Corporate structure SW is a wholly-owned subsidiary of Scottish Widows Financial Services Holdings (SWFSH) which is wholly owned by Scottish Widows Group (SWG). Together with Lloyds Bank General Insurance Holdings Ltd and HBOS International Financial Services Holdings Ltd, SW makes up the LBG Insurance division (LBGI). SWG is a whollyowned subsidiary of Lloyds Banking Group plc (LBG). The following diagram illustrates the structure of LBGI. This diagram is simplified and does not show the full company structure. The entities shown in dark blue are regulated insurance entities. Figure A3.1 Simplified LBGI structure Scottish Widows Group Ltd (SWG) Lloyds Bank General Insurance Holdings Ltd Scottish Widows Financial Services Holdings (SWFSH) Scottish Widows plc (SW) HBOS International Financial Services Holdings Ltd its subsidiaries to Clerical Medical Investment Group 118

119 Appendix 3: Background to SW SW consists of a long-term fund, with three sub-funds: The Non-Profit Fund (the SW NPF) which owns 100% of the following subsidiaries: o o Pensions Management (S.W.F.) Ltd (PMSWF) Scottish Widows Unit Funds (SWUF). The With-Profits Fund (the SW WPF). The Shareholder Fund (the SW SHF) which owns 100% of the following subsidiaries: o o o Scottish Widows Annuities Ltd (SWA) Scottish Widows Unit Trust Managers ( SWUTM ) Clerical Medical Insurance Group (CMIG). Of these companies, all but SWUTM are party to this Scheme of transfer. SWUTM acts as an Authorised Corporate Director for the management of Open Ended Investment sub-funds. The CMIG SHF owns further subsidiaries which are detailed in Appendix 4. Figures A3.2 and 3.3 illustrate the structure of SW before and after the Scheme. They are simplified and do not show the full company structure. There are approximately 80 further subsidiaries not shown as they are not regulated insurance companies, and transfer to CMIG as assets. its subsidiaries to Clerical Medical Investment Group 119

120 Appendix 3: Background to SW Figure A3.2 Simplified Scottish Widows plc company structure pre-scheme Figure A3.3 Simplified Scottish Widows plc company structure post-scheme its subsidiaries to Clerical Medical Investment Group 120