Lloyds Banking Group Life Insurance Operations 'A' Ratings Affirmed; Outlook Negative

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1 Research Update: Lloyds Banking Group Life Insurance Operations 'A' Ratings Affirmed; Outlook Negative Primary Credit Analyst: Oliver Herbert, London (44) ; Secondary Contact: Mark Button, London (44) ; Table Of Contents Overview Rating Action Rationale Outlook Ratings Score Snapshot Related Criteria And Research Ratings List MAY 29,

2 Research Update: Lloyds Banking Group Life Insurance Operations 'A' Ratings Affirmed; Outlook Negative Overview We now have a more favorable view of Scottish Widows PLC's financial risk profile as we have greater clarity around the company's capital strategy. We observe further evidence that Scottish Widows PLC has strengthened its enterprise risk management. As a result, we are affirming our 'A' ratings on Lloyd's Banking Group's (LBG's) life insurance operations, Scottish Widows PLC and Clerical Medical Investment Group Ltd. The negative outlook reflects that on the ultimate parent, LBG. This reflects the possible removal of potential extraordinary government support from the long-term counterparty credit rating on Lloyds Bank PLC by year-end Rating Action On May 29, 2014, Standard & Poor's Ratings Services affirmed its 'A' insurer financial strength and counterparty credit ratings on U.K.-based Lloyds Banking Group's (LBG) life insurance operations--scottish Widows PLC and its subsidiary, Clerical Medical Investment Group Ltd. (collectively SWplc). The outlook on the long-term ratings is negative. Rationale The affirmation of the ratings on SWplc incorporates our more favorable view of its financial risk profile and enterprise risk management (ERM). We have improved our assessment of SWplc's financial risk profile to very strong from strong, which we combine with a strong assessment of the company's business risk profile to derive an anchor of 'a+' or 'a'. Despite the improving financial risk profile and ERM assessment we use the lower of the two outcomes based on our view of risks relating to the competitive position. New business margins have fallen below our previous expectations and we believe they will remain between 2%-3%. Ongoing regulatory changes are likely to depress the value of new business written, increasing the group's reliance on corporate pension sales. We observe greater clarity surrounding shareholder distribution risks, capital strategy, and legacy exposures associated with Clerical Medical Investment Group Ltd.'s (CMIG) mis-selling compensation claims. Due to our improved view of the representativeness of modelling, we have revised our assessment of capital and earnings to very strong from strong. According to Standard & MAY 29,

3 Research Update: Lloyds Banking Group Life Insurance Operations 'A' Ratings Affirmed; Outlook Negative Poor's risk-adjusted capital model, we view SWplc's capital as being in the 'AAA' range and believe it will remain so over our two-year rating horizon. Our overall assessment is constrained by the quality of capital. In common with many U.K. life peers, a significant proportion of total adjusted capital comprises softer items such as future profits and hybrid equity. We expect SWplc to generate International Financial Reporting Standards (IFRS) profit before tax of around 400 million- 500 million a year. We believe that the majority of this will be up-streamed to the ultimate parent in the form of dividends. However, we expect the payouts will be sensitive to the stable risk appetite of SWplc on an economic basis and its own capital needs. Where SWplc's capital requirements grow faster than presently anticipated, the dividend will be reduced. Any further dividends resulting from potential restructuring of operating entities within the life insurance operations are likely to be relatively small scale and will not change our overall assessment. In our assessment of capital adequacy, we recognize a stressed level of claims relating to ongoing litigation in Germany. In our view, equity held on an IFRS basis in respect of this exposure is not a permanent component of SWplc's capital structure. Where the provision is not utilized we believe the capital will be up-streamed to the ultimate parent. Nonetheless, we consider financial leverage to be below 30% as at year-end Following improved understanding of the depth and seasoning of SWplc's ERM capability, we have revised our assessment of ERM to strong from adequate. The breadth and depth of SWplc's risk governance, risk reporting and risk appetite statements means we consider its risk management culture as positive. The insurer has demonstrated the strength of its controls for managing interest rate and market risk; as well as operational, demographic, and persistency risk. In addition, risk-adjusted return metrics are incorporated into the strategic and capital planning process indicating that strategic risk management is positive. We continue to believe the importance of ERM to the ratings is low given the risk profile of the group relative to peers. Over recent years, SWplc has broadened its management team, showing its ability to attract experienced individuals from across the U.K. insurance market. In line with our improved assessment of ERM we have seen greater evidence of the comprehensiveness of financial standards. We also believe the Board is active in providing robust challenge. We expect this to continue. As a result, we have revised our assessment of management and governance to satisfactory from fair. Looking forward, key challenges for the management team will be capturing and retaining Auto-Enrolment volumes as well as recalibrating its annuity strategy following the Budget reforms. Outlook The negative outlook on SWplc reflects that on the ultimate parent, LBG. This reflects the possible removal of potential extraordinary government support MAY 29,

4 Research Update: Lloyds Banking Group Life Insurance Operations 'A' Ratings Affirmed; Outlook Negative from the long-term counterparty credit rating on Lloyds Bank PLC by year-end If we revised down the group credit profile then we would lower the ratings on SWplc. This could arise if we consider that potential extraordinary government support is less predictable under the new EU legislative framework (The EU Bank Recovery and Resolution Directive). We could also lower the ratings on SWplc by up to one notch if: We believed that shareholder distribution risks were to increase, particularly if we felt that risk appetite at SWplc were to change and dividends were up-streamed beyond our current expectations. If we believed that further debt issuance were to reduce fixed-charge coverage to below 4x. We believed the underlying risks in the illiquid loan portfolio were to deviate from our current low risk assumptions. A revision of the outlook to stable is likely to be dependent on a similar action on the group credit profile of LBG. Beyond that, we see limited upside potential for the ratings given our view of SWplc's strategic importance to LBG. Ratings Score Snapshot Financial Strength Rating SACP Anchor Business Risk Profile IICRA* Competitive Position Financial Risk Profile Capital & Earnings Risk Position Financial Flexibility A/Negative a a Strong Low Risk Strong Very Strong Very Strong Intermediate Risk Adequate Modifiers 0 ERM and Management 0 Enterprise Risk Management Strong Management & Governance Satisfactory Holistic Analysis 0 Liquidity Exceptional Support 0 Group Support 0 Government Support 0 *Insurance Industry And Country Risk Assessment. MAY 29,

5 Research Update: Lloyds Banking Group Life Insurance Operations 'A' Ratings Affirmed; Outlook Negative Related Criteria And Research Insurers: Rating Methodology, May 7, 2013 Group Rating Methodology, Nov. 19, 2013 Enterprise Risk Management, May 7, 2013 Management And Governance Credit Factors For Corporate Entities And Insurers, Nov. 13, 2012 Refined Methodology And Assumptions For Analyzing Insurer Capital Adequacy Using The Risk-Based Capital Model, June 7, 2010 Use of CreditWatch And Outlooks, Sept 14, 2009 Ratings List Ratings Affirmed Scottish Widows PLC Clerical Medical Investment Group Ltd. Counterparty Credit Rating Local Currency Financial Strength Rating Local Currency Scottish Widows PLC Junior Subordinated A/Negative/-- A/Negative/-- BBB+ Clerical Medical Finance PLC Junior Subordinated* BBB+ *Guaranteed by Clerical Medical Investment Group Ltd. Additional Contact: Insurance Ratings Europe; Complete ratings information is available to subscribers of RatingsDirect at and at spcapitaliq.com. All ratings affected by this rating action can be found on Standard & Poor's public Web site at Use the Ratings search box located in the left column. Alternatively, call one of the following Standard & Poor's numbers: Client Support Europe (44) ; London Press Office (44) ; Paris (33) ; Frankfurt (49) ; Stockholm (46) ; or Moscow 7 (495) MAY 29,

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