Our business priorities UK Retail Banking • grow income from existing customer base • grow income from new customers • improve productivity
†† Excluding volatility, pension schemes related credit and, in 2005, profit on sale and closure of businesses, customer redress provisions and strengthening of reserves for mortality.
• Excellent progress in growing the current account customer franchise, with a 59 per cent increase in target customer current account recruitment.
The impact of the implementation of International Financial Reporting Standards (‘IFRS’) in 2005, and in particular the increased use of fair values, has led to greater earnings volatility than was previously the case under UK GAAP. In order to provide a more comparable representation of underlying business performance, this volatility has been separately analysed for the Group’s insurance and banking businesses. In addition, the profit and loss on the sale and closure of businesses in 2005 has been separately analysed in the Group’s results. A reconciliation of this basis of presentation to the statutory profit before tax is shown on page i. Certain commentaries separately analyse the impact in 2006 of the one-off pension schemes related credit and, in 2005, of customer redress provisions and the strengthening of reserves for annuitant mortality.
We recognise the challenge posed by global climate change and we are committed to making meaningful reductions in our carbon footprint. We have already set a target to reduce property related CO2 emissions by 30 per cent, and we aim to enhance this plan through the introduction of a carbon management programme and other initiatives. In addition, through Lloyds TSB Corporate Markets, we continue to invest in renewable energy projects.
The results reflect a strong performance across each of our three divisions, as we delivered good profitable growth in each, and once again we delivered positive jaws as the rate of growth in income exceeded that of costs.
We have established a strong track record of driving efficiency improvements and I am pleased that in 2006 we improved our cost:income ratio to 50.8 per cent, from 52.8 per cent in 2005. This was achieved by our continued commitment to a range of quality improvement programmes such as lean manufacturing, which enable us to enhance the service we deliver to our customers at a lower cost. We have extended our group wide efficiency programme that is also allowing us to structurally reduce our cost base. As we continue to improve our efficiency and effectiveness, we are creating additional capacity for further investment to support our future growth plans.
As we expected, we have seen signs of stabilisation in the unsecured consumer portfolio, which resulted in a reduction in retail impairments in the second half of the year. This reflects our long established focus on lending to existing customers, where we have better information, and tightening in our credit criteria in previous periods. Our secured consumer portfolios remain in good shape, reflecting our traditional emphasis on the prime mortgage market place. In the Corporate sector, asset quality has remained strong, with the increase in impairments reflecting a reduction in recoveries, compared to last year.
The Retail Bank delivered a 5 per cent improvement in profit before tax, as the rate of revenue growth accelerated from 3 per cent in the first half to 6 per cent in the second. The strong growth in the trading surplus, up 10 per cent, was underpinned by positive jaws of 6 percentage points as income growth of 4 per cent was accompanied by productivity improvements that led to costs being reduced by 2 per cent.
Our Corporate Markets business delivered another excellent performance, with a 13 per cent improvement in profits, supported by a 48 per cent increase in cross-selling income. The improvement in profitability reflects the success of our strategy of integrating our product and relationship businesses to meet our customers’ needs. We are continuing to receive external recognition for our achievements and we were especially pleased to be awarded the CBI Corporate Bank of the Year Award for the second year running in 2006. We are maintaining our focus on building relationships and this is helping us to sustain strong asset quality performance in this portfolio.
In Wholesale and International Banking we are growing our earnings by deepening relationships with our business and corporate customers
We are a customer focused organisation, and our improved customer satisfaction scores are an important factor in our continued success. In 2007, we will implement a further range of new products and services that meet the needs of our customers, which are underpinned by our ‘treating customers fairly’ principles and that reinforce our strategy of developing deep, longlasting customer relationships.
Wholesale markets have shown strong growth over the past several years, and cyclically low levels of bad debt. Our opportunities in these markets centre on deepening our customer relationships and cross-selling more fee-based products to our corporate and small business customers. Over the last few years, we have increased cross-selling income substantially, and we believe there is still a great opportunity.
We believe that successful banks benefit from operating in a vibrant and healthy society. Many thousands of our staff participate in activities that make a significant contribution to the communities in which they live and work. In addition, the four Lloyds TSB Foundations have played a significant role in supporting a broad range of charities, across the United Kingdom, and make a critical difference to many thousands of people.
Finally, let me again express my continued thanks to all of the staff who work for the Lloyds TSB Group. They deliver great service for our customers and their wonderful efforts drive our growing success. Many thousands of our staff are also shareholders in the Group, and I am delighted that they continue to participate in the success of the Company.
Other income, net of insurance claims and excluding insurance grossing, increased by £425 million, or 9 per cent, to £5,056 million. This reflected an improvement in fees and commissions receivable as a result of higher income from strong growth in added value current accounts and private banking fees, and an increase in Open Ended Investment Company (‘OEIC’) sales. In addition, good growth was achieved in cross-selling income from sales and structuring, and debt capital markets activities within Corporate Markets.
The Group continues to make significant investment in improving levels of service quality and processing efficiency, the benefits of which are seen in an excellent cost performance. During 2006, operating expenses increased by only 2 per cent to £5,429 million. Over the last 12 months, staff numbers have fallen by 4,167 (6 per cent) to 62,630, largely as a result of greater efficiency in back office processing centres, where the unit costs of transaction processing continue to fall, and the increased automation of administration carried out in the branch network. These improvements in operational effectiveness have resulted in a Group cost:income ratio which is 2 percentage points lower at 50.8 per cent.
On an IFRS basis, Scottish Widows’ 2006 profit before tax, excluding volatility, totalled £730 million, whilst on an EEV basis 2006 profit before tax, excluding volatility and other non-recurring items, was £852 million. Similarly, the embedded value on an EEV basis at 31 December 2006 was £6,413 million (2005: £6,386 million), compared to the embedded value on an IFRS basis of £5,368 million (2005: £5,478 million).
UK Retail Banking UK Retail Banking provides banking, financial services, mortgages and private banking to some 16 million personal customers through our multi-channel distribution capabilities.
International corporate banking. Serves the corporate and institutional market in Europe, the Middle East and Japan through offices in Belgium, France, the Netherlands, Spain, Dubai and Japan.
– Policyholder interests – – – – – 311 311 Profit (loss) on sale and closure of businesses – – (6) 56 50 – 50
In the summarised segmental analysis above, and on pages 14 to 23, the results of the Goldfish business, which was sold in December 2005, are included in Central group items.
Total assets £108.4bn £102.9bn Risk-weighted assets – post securitisation £59.1bn £60.4bn Risk-weighted assets – pre securitisation £64.2bn £60.4bn Customer deposits £75.7bn £71.0bn
Operating expenses, excluding provisions for customer redress, remained very well controlled, decreasing by 2 per cent. The significant improvements made in the rationalisation of back office operations to improve efficiency have been combined with a substantial improvement in the levels of customer service and satisfaction. We continue to increase the proportion of front office to back office staff in the branch network and have substantially improved our sales productivity.
During 2006 we have made significant progress in reducing levels of administration and processing work carried out in branches, and increasing the number of branch network staff in customer facing areas and activities. This has resulted in a significant increase in sales and service resource, a higher level of product sales and a reduction of approximately 1,900 branch back-office administration roles. In addition, substantial progress has been made in improving and streamlining sales processes leading to a significant increase in seller effectiveness, with more product sales per customer interview, and significant reductions in the time taken to, for example, open a current account or transfer an account to us from another banking provider.
Profit before tax increased by £46 million, or 7 per cent, to £701 million. In December 2005, Scottish Widows repatriated £800 million of surplus capital to the Group as part of a capital restructuring programme. This capital repatriation has the effect of reducing investment earnings and increasing funding charges by a total of £38 million in 2006. Adjusting 2005 for this impact, profit before tax increased by 14 per cent.
In 2006, Scottish Widows’ bancassurance sales increased by 62 per cent, building on the success of the simplified product range for distribution through the Lloyds TSB branch network, Business Banking and Wealth Management channels. Sales of OEICs were particularly strong, more than doubling year-on-year through the bancassurance channel. Towards the end of 2006, Scottish Widows launched a new protection product platform ‘Protection for Life’, which is expected to result in an increase in protection sales during 2007. In addition, in early 2007 a new protected OEIC product was launched in the bancassurance market to support sales of savings and investment products.
Sales through the IFA distribution channel increased by 14 per cent, largely reflecting the introduction of improved product and service offerings for corporate pensions which, together with increased promotional activity, resulted in excellent growth in corporate pension sales via the IFA channel, and good levels of post A-Day growth in retirement income products. Scottish Widows has also developed a new pensions platform for launch in early 2007 to support future pre and post retirement sales, and continues to increase its segmental focus on the IFA market to ensure maximum value is obtained from this market.
Individual pensions 2,219 2,197 Corporate and other pensions 1,961 1,517 Retirement income 960 658 Managed fund business 348 535
Profit before tax, adjusted for capital repatriation* 714 138 852 621 68 689 Impact of £800 million capital repatriation to Group – – – 38 – 38
Existing business profit increased by 50 per cent. Expected return has increased by 12 per cent to £403 million reflecting higher earnings on the larger value of in-force business at the start of the year. Positive experience variances were driven by lower than expected take-up rates on guaranteed annuity options in Life and pensions and by favourable lapse experience in OEICs. These were more than offset by negative assumption changes, primarily in respect of lapse assumptions in Life and pensions, and resulted in an overall net charge for experience variances and assumption changes, on an EEV basis, of £64 million. The equivalent net charge on an IFRS basis was £7 million. The expected return on shareholders’ net assets has decreased, largely as a result of lower assumed rates of return on free assets.
Analysis of shareholders’ net assets on an EEV basis on covered business Required Free Shareholders’ capital surplus net assets £m £m £m
For OEIC business, the lapse assumption is based on experience which has been collected over a 20 month period. To recognise that this is a shorter period than that normally available for life and pensions business, and that this period has coincided with favourable investment conditions, management have used a best estimate of the long-term lapse assumption which is higher than indicated by this 20 month experience. In management’s view, the approach and lapse assumption are both reasonable.
In scenarios (3) to (6) assumptions have been flexed on the basis used to calculate the value of in-force business and the realistic and the statutory reserving bases. A change in risk discount rates is not relevant as the risk discount rate is not an input to a market consistent valuation.
Excluding the impact of lower creditor insurance business, new sales through the UK Retail Bank have been robust, with a 42 per cent increase in home insurance gross written premiums. Our presence in the small business insurance market continues to improve with an increase of 10 per cent in new business gross written premiums. Internet sales are becoming increasingly important and now represent 33 per cent of direct sales volumes.
5 This sensitivity shows the impact on our annuity and deferred annuity business of reducing mortality rates to 95 per cent of the expected rate.
7 Under a market consistent valuation, changes in assumed equity and property returns have no impact on the EEV.
Profit before tax by business unit* Corporate Markets 1,105 976 Business Banking 247 196 Asset Finance 190 219 International Banking and other businesses 98 133
Loss before tax, excluding volatility and profit on sale and closure of businesses (321) (424)
As a result of the requirement contained in IFRS to consolidate the Group’s life and pensions businesses on a line by line basis, the Group’s income statement includes amounts attributable to policyholders which affect profit before tax; the most significant of these items is policyholder tax.
In an increasingly competitive market where customers are able to exercise choice among providers, we believe that shareholder value creation is closely linked to customer value creation. It is only by meeting our customers’ needs that we will win the right to a bigger share of their total financial services spend.
In a poll of Finance Directors across the UK, Lloyds TSB Corporate was voted ‘Bank of the Year’ for the second year running at the Real Finance/CBI FD’s Excellence Awards, in recognition of our quality of service and understanding of our customers’ businesses. In 2006 we were also voted ‘Adviser of the Year’; in this category we were not only competing against other banks but also leading accountants and lawyers.
The majority of Lloyds TSB’s charitable giving is channelled through the four Lloyds TSB Foundations, which cover England and Wales, Scotland, Northern Ireland and the Channel Islands. Their mission is to improve the lives of people in local communities, especially those who are disadvantaged.
Foundation funding supports charities working to meet social and community needs. The main grants programmes are designed to address essential community needs and, in particular, to support small ‘under funded’ charities. 38 per cent of the charities supported by the England and Wales Foundation in 2006 had a total income of £100,000 or less and 70 per cent had an income of £500,000 or less.
In addition to the Foundations’ support for local community causes, thousands of our employees volunteer to help in their communities, raise funds for the Group’s Charity of the Year or make direct donations to charity using the UK’s Give As You Earn system. In 2006, the Foundations provided matched funding for over 40,000 hours of time volunteered by Lloyds TSB employees in the community.
Lloyds TSB first introduced a formal environmental policy in 1996 and was also one of the first UK banks to develop an environmental risk assessment system for all of our business lending.
The UK Government has stated its belief that climate change is the greatest long-term challenge facing the world today. Measures to tackle climate change will have potential implications for regulation, taxation and public policy and will carry both risks and opportunities for companies and the public.
The board reviews overall corporate responsibility performance annually and individual issues are subject to board discussion throughout the year. Our corporate responsibility steering group is chaired by the deputy group chief executive and comprises senior executives from all business divisions and relevant group functions. The steering group meets quarterly to recommend strategy and provide direction.
We have adopted the European Foundation of Quality Management’s Corporate Responsibility Framework to help us align corporate responsibility with business strategy and also with individual balanced scorecard priorities. As part of the process we have a network of almost 40 representatives across all business divisions, through whom we conduct an annual self-assessment of our performance with independent oversight and assurance. This allows us to identify strengths and areas for improvement and to prioritise actions and objectives. It also provides a benchmark against which we can compare our performance both internally and externally.
†† We have reported our greenhouse gas emissions arising from our operations since 1999 using the DEFRA Guideline for Reporting Greenhouse Gas Emissions. The key activities which contribute to our Global Warming Impact are energy used in managing our buildings – lighting, building controls and IT; and in business travel – road, rail and air.
Lloyds TSB Group continues with the development of the risk framework through close alignment of risk capabilities to objectives. Substantial progress has been made in 2006 in embedding our approach across the business. This has included a focus on enhancing our capabilities in providing both qualitative and quantitative data to the board on risks associated with strategic objectives and facilitating more informed and effective decision making. The Group‘s ability to take risks which are well understood, consistent with our strategy and plans and appropriately remunerated, is a key driver of shareholder return.
Lloyds TSB Group maintains a risk governance structure that strengthens risk evaluation and management, whilst also positioning the Group to manage the changing regulatory environment in an efficient and effective manner.
Directors of the Group’s businesses have primary responsibility for measuring, monitoring and controlling risks within their areas of accountability and are required to establish control frameworks for their businesses that are consistent with the Group’s high level policies and within the parameters set by the board, group executive committee and Group Risk. Compliance with policies and parameters is overseen by the risk oversight committee, the group business risk committee, the group asset and liability committee, Group Risk and the divisional risk officers.
Detailed policy and authorities – Group, divisions and business units, including metrics and quantitative measures
A common approach is applied across the Group to assess the creation of shareholder value. This is measured by economic profit (the profit attributable to shareholders, less a notional charge for the equity invested in the business). The focus on economic profit allows the Group to compare the returns being made on capital employed in each business. The use of risk-based economic capital and regulatory capital is closely monitored at business and group level. The Group’s economic capital model covers credit, market, insurance, business and operational risks.
A product is defined as a solution that can be offered to a customer or counterparty that might satisfy a want or a need in order to generate revenue streams or gains (not necessarily financial) for the Group. In line with defined policy, businesses provide divisional risk management with details of new products at an early stage of product or service development to seek to ensure compliance with the Group’s risk appetite and strategy. Businesses are required to demonstrate that new products meet clearly defined customer needs and that the sales process mitigates the risks of unsuitable sales. Where appropriate, technical advice and approval is sought from specialist functions.
Credit risk appetite is described and reported through a suite of metrics derived from a combination of accounting and economic equity model parameters which in turn uses the various credit risk rating systems as inputs. These metrics are supplemented by a variety of policies, sector caps and limits to manage concentration risk at an acceptable level.
The following are the principal control mechanisms through which the Group manages credit risk: • Credit rating systems. All business units operate appropriate rating system(s) for their portfolio(s). All rating systems, which are authorised by executive management, comply with the Group’s standard methodology. The Group uses a ‘Master Scale’ rating structure with ratings corresponding to a range of probabilities of future default. The Group uses rating systems as an integral part of the credit process deployed within the credit life cycle. Whilst divisional risk teams have responsibility for monitoring rating model performance, Group Risk reviews new models and material changes to existing models, seeking executive management approval as necessary.
• Cross-border and cross-currency exposures. Country limits are authorised and managed by a dedicated unit taking into account economic and political factors.
• Facilities database. A database is maintained of all non-retail customer relationships to assist in the identification and aggregation of cross-business unit commitments. The Group uses a system known as parent company executives, under which there is a central person responsible for each non-retail customer relationship, to whom other business units wishing to do business with the same customer must apply for credit limits.
Market risk appetite is defined as the quantum and composition of market risk that exists currently in the Group and the direction in which the Group wishes to manage this.
The Group’s insurance activities also expose it to market risk, encompassing interest rate, exchange rate, property and equity risk.
• Unit-linked liabilities are matched with the same assets that are used to define the liability but future fee income is dependent upon the performance of those assets
• For other insurance liabilities the aim is to invest in assets such that the cash flows on investments will match those on the projected future liabilities. It is not possible to eliminate risk completely as the timing of insured events is uncertain and bonds are not available at all of the required maturities. As a result the cash flows cannot be precisely matched and so sensitivity tests are used to test the extent of the mismatch
The primary market risk measure used within the Group is the Value at Risk (‘VaR’) methodology, which incorporates the volatility of relevant market prices and the correlation of their movements. Although an important measure of risk, VaR has limitations as a result of its use of historical data, assumed distribution, holding periods and frequency of calculation. The use of confidence levels does not convey any information about potential loss when the confidence level is exceeded. VaR is also not well suited to options positions. The Group recognises these limitations and supplements its use with a variety of other techniques. These reflect the nature of the business activity, and include interest rate re-pricing gaps, open exchange positions and sensitivity analysis. Stress testing and scenario analysis are also used in certain portfolios and at group level, to simulate extreme conditions to supplement these core measures.
Trading: Based on the commonly used 95 per cent confidence level, assuming positions are held overnight and using observation periods of the preceding three years, the VaR for the years ended 31 December 2006 and 2005 based on the Group’s global trading positions was as detailed in the table below (the table also aggregates potential loss measures from options portfolios).
It is estimated that a hypothetical immediate and sustained 100 basis point increase in interest rates on 1 January 2007 would decrease net interest income by £237.8 million for the 12 months to 31 December 2007, while a hypothetical immediate and sustained 100 basis point decrease in interest rates would increase net interest income by £237.4 million. An analysis by currency is shown below.
For the insurance businesses, the composition and value of surplus assets held in excess of liabilities are reported to Group Risk on a monthly basis. The figures quoted below are the sum of the two portfolios with no allowance for diversification between portfolios or asset classes and represents the potential loss in earnings.
Banking activity: • Trading is restricted to a number of specialist centres, the most important centre being financial markets division in London. These centres also manage market risk in the wholesale banking books, both in the UK and internationally. The level of exposure is strictly controlled and monitored within approved limits. Active management of the wholesale book is necessary to meet customer requirements and changing market circumstances
• Market risk in the Group’s retail portfolios and in the Group’s capital funds is managed within limits defined in the detailed group policy for interest rate risk in the banking book, which is reviewed annually by the group asset and liability committee. The structural foreign exchange position is managed having regard to the currency composition of the Group’s risk-weighted assets. The objective is to limit the effect of exchange rate movements on the published risk asset ratio
The Group’s whistleblowing arrangements, reviewed and supported by the independent charity Public Concern at Work, encourage staff to speak up if they have concerns about any possible wrongdoing.
The Group’s business is regulated primarily by the UK Financial Services Authority (‘FSA’), the Banking Code Standards Board (‘BCSB’) and the Office of Fair Trading (‘OFT’) and additionally by local regulators in offshore and overseas jurisdictions. Each business has a nominated individual with ‘compliance oversight’ responsibility under FSA rules. The role of such individuals is to advise and assist management to ensure that each business has a control structure which creates awareness of the rules and regulations to which the Group is subject, and to monitor and report on adherence to these rules and regulations.
Trends across all the CARE Index categories are monitored and fed into a programme of continuous customer service improvement. The Group also provides its staff with clear FSA compliant guidelines and processes for dealing with customer complaints.
The risk of reductions in earnings and/or value, through financial or reputational loss, resulting from inadequate or failed internal processes and systems, people-related events, damage to resources (excluding human resources), and deficiencies in the performance of external suppliers/service providers.
Business units and group functions have primary responsibility for identifying and managing fraud risk at a local level in consultation with the Group Financial Crime Unit. Additionally the group fraud strategy and policy committee is responsible for monitoring fraud risk as well as ensuring that fraud risks are effectively identified and assessed and that strategies for fraud prevention are effectively coordinated. This includes external scanning of the threat environment across all service delivery channels and translation mechanisms with particular focus on card payment and internet transactions.
• Training and development. The Group believes that long-term success depends on the quality and skills of its staff and that it has a joint responsibility with employees for their personal and career development to improve current performance and to enhance future prospects.
The international standard for measuring capital adequacy is the risk asset ratio, which relates to on- and off-balance sheet exposures weighted according to broad categories of risk. The Group’s capital ratios, calculated in line with the requirements of the FSA, are set out in detail on page 39.
The Lloyds TSB Group’s capital management policy is focused on optimising value for shareholders. There is a clear focus on delivering organic growth and expected capital retentions are sufficient to support planned levels of growth. However, management also wishes to maintain the flexibility to make value enhancing ‘in market’ acquisitions and therefore, at this stage, there are no plans to return capital to shareholders other than by way of dividend payments. Management will keep all options for the utilisation of capital under review.
The Group is making good progress in its preparations for the introduction of Basel 2, and our credit risk waiver application was submitted in December 2006. Whilst our work is well advanced, some uncertainty remains with regard to the regulatory treatment of certain issues for capital purposes. The Group expects to maintain satisfactory capital ratios throughout the transition to Basel 2 in 2008, and continues to expect no deduction of investments in insurance subsidiaries from tier 1 capital until at least 2012.
In addition to the complying with the FSA’s regulatory reporting framework, and similar regulatory/statutory requirements in other jurisdictions, the Group uses a number of internal tools to measure and control liquidity risk, detailed in the liquidity policy. These range from shorter term tactical measures (which include net cash flow profiles and various liquidity ratios) to longer term, more strategic analyses of the overall liquidity of the balance sheet. The reporting framework ensures that the relevant risk control functions have appropriate oversight, and the group asset and liability committee provides strategic direction for liquidity risk management.
Each life assurance company must retain sufficient capital to meet the regulatory capital requirements mandated by the FSA; the basis of calculating the regulatory capital requirement is given below. For Abbey Life Assurance Company Limited (‘Abbey Life’), the regulatory capital requirement is a combination of amounts held in respect of actuarial reserves, sums at risk and maintenance expenses (the Long-Term Insurance Capital Requirement) and amounts required to cover various stress tests. The regulatory capital requirement is deducted from the available capital resources to give ‘statutory excess capital’.
The estimated financial position of the With Profit Fund of Scottish Widows at 31 December 2006, calculated on a ‘realistic’ basis, is given in the following table, in the form reported to the FSA. As a result of the capital support arrangements, it is considered appropriate to also disclose the estimated ‘realistic’ financial position of the Long Term Fund of Scottish Widows as a whole, which consists of both the With Profit Fund and the Non-Participating Fund.
Scottish Widows continues to be well capitalised with the working capital ratios for the With Profit Fund and the Long Term Fund being an estimated 5.8 per cent (31 December 2005: 5.5 per cent in the final FSA returns) and 18.9 per cent (31 December 2005: 17.7 per cent in the final FSA returns) respectively.
The financial information calculated on a ‘realistic’ basis reconciles to the Capital statement as follows: With Profit Long Term With Profit Long Term Fund Fund Fund Fund £m £m £m £m
As at 31 December 2006 With Profit Fund liabilities 17,827 116 17,943 Unit-linked business (excluding that accounted for as investment contracts) – 12,734 12,734 Other life assurance business – 10,181 10,181
The most significant options and guarantees provided from within the With Profit Fund are in respect of guaranteed minimum cash benefits on death, maturity, retirement or certain policy anniversaries, and guaranteed annuity options on retirement for certain pension policies. For those policies written pre-demutualisation containing potentially valuable options and guarantees, under the terms of the Scheme a separate memorandum account was set up within the With Profit Fund of Scottish Widows called the Additional Account which is available, inter alia, to meet any additional costs of providing guaranteed benefits in respect of those policies. The Additional Account had a value at 31 December 2006 of £1.8 billion (2005: £1.7 billion). The eventual cost of providing benefits on policies written both pre and post demutualisation is dependent upon a large number of variables, including future interest rates and equity values, demographic factors, such as persistency and mortality, and the proportion of policyholders who seek to exercise their options. The ultimate cost will therefore not be known for many years.
Ewan Brown CBE FRSE�**+ Chairman of Lloyds TSB Scotland Joined the board in 1999. A non-executive director of Lloyds TSB Scotland since 1997. Joined Noble Grossart in 1969 and was an executive director of that company until December 2003. A non-executive director of Noble Grossart and Stagecoach Group and a member of the court of the University of St Andrews. A former chairman of tie and non-executive director of John Wood Group. Aged 64.
Gavin J N Gemmell CBE�* Chairman of Scottish Widows Joined the board in 2002. A non-executive director of Scottish Widows, having been appointed to the board of that company before it became a member of the Lloyds TSB Group. Retired as senior partner of Baillie Gifford in 2001, after 37 years with that firm. A non-executive director of Archangel Informal Investment. Chairman of the Court of Heriot-Watt University. Aged 65.
(retiring on 9 May 2007) Joined the board in 2001. Held a number of senior appointments in the UK and USA with the World Bank, Royal Dutch/Shell Group and British Airways, before membership of the Bank of England Monetary Policy Committee from 1997 to 2001. Chaired HM Treasury’s banking services consumer codes review group in 2000/1. Chairman of the Royal Institute of International Affairs. A non-executive director of BP, Serco Group and Roche Holdings SA. A former non-executive director of the Bank of England. Aged 57.
Helen A Weir Group Finance Director Joined the board in 2004. Group finance director of Kingfisher from 2000 to 2004. Previously finance director of B&Q from 1997, having joined that company in 1995, and held a senior position at McKinsey & Co from 1990 to 1995. Began her career at Unilever in 1983. A non-executive director of Royal Mail Holdings and a member of the Accounting Standards Board. Aged 44.
Principal activities, business review, future developments and financial risk management objectives and policies The Company is a holding company and its subsidiary undertakings provide a wide range of banking and financial services through branches and offices in the UK and overseas. A review of the development and performance of the business during the financial year and an indication of likely future developments are given on pages 2 to 44. Key performance indicators are shown on pages i and ii. Information regarding the financial risk management objectives and policies of the Company and its subsidiary undertakings, in relation to the use of financial instruments, is given on pages 28 to 38 and in note 47 on pages 113 to 117.
Mr M A van den Bergh and Mrs A A Knight left the board on 11 May 2006 and 31 October 2006, respectively. Dr Julius will retire at the annual general meeting in 2007.
In accordance with the articles of association, Dr Berndt, Mr Brown, Mr Daniels and Mrs Weir retire at the annual general meeting and offer themselves for re-election.
The board and its committees The Group is led by a board comprising executive and non-executive directors with wide experience. The appointment of directors is considered by the board and, following the provisions in the articles of association, they must stand for election by the shareholders at the first annual general meeting following their appointment and must retire, and may stand for re-election by the shareholders, at least every three years. Independent non-executive directors are appointed for three-year renewable terms, which may be terminated without notice or payment of compensation.
The roles of the chairman, the group chief executive and the board and its governance arrangements, including the schedule of matters specifically reserved to the board for decision, are reviewed annually. The matters reserved to the board for decision include the approval of the annual report and accounts and any other financial statements; the payment of dividends; the long term objectives of the Group; the strategies necessary to achieve these objectives; the Group’s budgets and plans; significant capital expenditure items; significant investments and disposals; the basis of allocation of capital within the Group; the organisation structure of the Group; the arrangements for ensuring that the Group manages risks effectively; any significant change in accounting policies or practices; the appointment of the Company’s main professional advisers and the approval of their fees; and the appointment of senior executives within the organisation and related succession planning.
The resolutions to be considered at the annual general meeting in 2007 will also be decided on a poll. Details of the results will be announced immediately after the meeting and will be displayed on our website, www.lloydstsb.com and will also be available from the company secretary.
During the year, the audit committee received reports from, and held discussions with, management and the auditors. In discharging its duties, the committee has approved the auditors’ terms of engagement, including their remuneration and, in discussion with them, has assessed their independence and objectivity (more information about which is given in note 10 to the accounts, in relation to the procedure for approving fees for audit and non-audit work) and recommended their re-appointment at the annual general meeting. The committee also reviewed the financial statements published in the name of the board and the quality and acceptability of the related accounting policies, practices and financial reporting disclosures; the scope of the work of the group audit department, reports from that department and the adequacy of its resources; the effectiveness of the systems for internal control, risk management and compliance with financial services legislation and regulations (more information about which is given in the note about internal control on page 51); the results of the external audit and its cost effectiveness; and reports from the external auditors on audit planning and their findings on accounting and internal control systems. Procedures for handling complaints regarding accounting, internal accounting controls or auditing matters and for staff to raise concerns in confidence were established by the committee. The committee also had a meeting with the auditors, without executives present, and a meeting with the director of group audit alone.
The committee may have specific powers delegated to it by the board from time to time and following the exercising of these powers, it reports to the board. To comply with the Group’s articles of association, only committee members who are also directors of the company participate in the exercising of any powers delegated by the board.
Internal control The board of directors is responsible for the establishment and review of the Lloyds TSB Group’s system of internal control, which is designed to ensure effective and efficient operations, quality of internal and external reporting, internal control, and compliance with laws and regulations including the Turnbull Guidance published in 2005. It should be noted, however, that such a system is designed to manage, rather than eliminate, the risk of failure to achieve business objectives. In establishing and reviewing the system of internal control the directors have regard to the nature and extent of relevant risks, the likelihood of a loss being incurred and the costs of control. It follows, therefore, that the system of internal control can only provide reasonable but not absolute assurance against the risk of material loss.
Sir Victor Blank, a non-executive director, joined the committee in August 2006 as permitted by the combined code on corporate governance issued by the Financial Reporting Council in June 2006.
In addition, in 2006, Alithos Limited provided information for the testing of the total shareholder return (TSR) (calculated by reference to both dividends and growth in share price) performance conditions for the Group’s long-term incentive schemes.
• The overall package reflects market practice and takes account of the terms and conditions applying to other employees of the Group.
The chairman’s salary is reviewed annually, usually in December, taking into account performance and market information and then adjusted from 1 January of the following year. His salary from 1 January 2007 is £600,000.
Audit committee chairmanship £50,000 (£40,000) Audit committee membership £15,000 (£15,000) Nomination committee membership £5,000 (£5,000) Remuneration committee chairmanship £25,000 (£20,000) Remuneration committee membership £15,000 (£15,000) Risk oversight committee membership £15,000 (£15,000)
Independent non-executive directors who serve on the boards of subsidiary companies may also receive fees from the subsidiaries. These are included in the table shown on page 56.
From 2007, and to align performance and vesting periods, the TSR performance period will start on the date awards are granted, and average the share price over three months before the grant date. This replaces the current approach of calculating the TSR in line with the financial year, taking an average share price over the preceding three months.
Other companies in the comparator group: Alliance & Leicester Aviva Banco Santander Barclays Bradford & Bingley Friends Provident HBOS HSBC Holdings Legal & General Northern Rock Prudential Royal Bank of Scotland Royal & Sun Alliance Standard Chartered
Awards in any one financial year will not normally exceed three times basic salary at the time of award. In exceptional circumstances this may be increased up to four times basic salary. Awards will lapse at the end of the performance period to the extent that the performance conditions have not been satisfied. There will be no retesting.
The executive directors and the chairman are also eligible to participate in the Group’s ‘sharesave’ scheme and the Group’s ‘shareplan’. These are ‘all-employee’ share schemes and performance conditions do not apply.
External appointments The Group recognises that executive directors may be invited to become non-executive directors of other companies and that these appointments may broaden their knowledge and experience, to the benefit of the Group. Fees are normally retained by the individual directors as the post entails personal responsibility. Executive directors are generally allowed to accept one non-executive directorship.
During 2006, Ms Dial and Mrs Weir received fees of $159,475 and £36,000 respectively, which were retained by them, for serving as non-executive directors of other companies. In addition Mrs Weir received and retained £15,000 for serving as a member of the Accounting Standards Board in 2006.
Salaries/ related for loss of 2006 2005 fees Cash Non cash payments office Total Total
Mr Fairey waived fees payable to him as a director of Lloyds TSB Group Pension Trust (No.1) Limited and Lloyds TSB Group Pension Trust (No.2) Limited, which totalled
The cash column under ‘other benefits’ includes flexible benefits payments (4 per cent of basic salary), the tax planning allowances for Mr Daniels and Ms Dial, the housing allowance and pension scheme allowance for Ms Dial, payments to certain directors who elect to take cash rather than a company car under the car scheme, cash balance of pension allowance for Mr Tate and Mrs Weir and an additional payment in respect of the contribution to the separate fund relating to Mr Fairey’s pension. The separate fund, which was mentioned in previous annual reports, was established to cover pension obligations of those who joined the Group after 1 June 1989 and who are subject to the earnings cap relating to pensions, introduced by the Finance Act 1989.
In addition, the following unfunded benefits have accrued for Mr van den Bergh instead of a salary increase in 2002: The disclosures in columns (a) to (d) are as required by the Companies Act 1985 Schedule 7A.
Column (d) is the equivalent transfer value, but calculated as at 31 December 2005 on the assumption that the director left service at that date.
Major changes to the legislation governing the provision of pensions in the UK (known as pension simplification) came into effect in April 2006. Benefits from an approved pension scheme will be limited to the Lifetime Allowance, currently £1.5 million which is equivalent to an annual pension of £75,000. Any benefit in excess of this amount will incur a tax charge for the individual. The Group has agreed that if an executive director has benefits in excess of the Lifetime Allowance they may cease to accrue benefits in the Scheme and receive a salary supplement as an alternative. This will not cost the Group more than the current arrangements. The Group will not compensate any individual in respect of any increased tax liability arising from pension simplification. To date, the executive directors affected have elected to continue to accrue benefits in the approved scheme.
† The changes in beneficial interests between 31 December 2006 and 22 February 2007 related to ‘partnership’ and ‘matching’ shares acquired under the Lloyds TSB Group shareplan.
i) Market price on day of exercise was 515.5p. In that regard Mr Daniels made a gain of £7,702. Market price on days of exercise was 545p, 565p, 515.5p and 560.5p respectively. In that regard Mr Fairey made an overall gain of £34,473. Market price on days of exercise was 565p. In that regard Mr Kane made a gain of £83,000. This is the difference between the market price of the shares on the day on which the share option was exercised and the price paid for the shares.
Bonus shares Performance shares Bonus shares release and At Purchased At At Conditional At performance 1 January during the 31 December 1 January award during 31 December Award share award 2006 year 2006 2006 the year 2006 price date
Ms Dial is the only participant in this plan and holds an option, granted to her in June 2005, to acquire 242,825 ordinary shares in Lloyds TSB Group plc for a total price of £1. The option was granted as part of the remuneration package considered necessary to attract her from the USA and is designed to encourage her to remain with Lloyds TSB Group plc. The option is not, therefore, subject to any performance condition but will normally become exercisable only if she remains an employee, and has not given notice of resignation, on 31 May 2008. Full details of the plan were set out in the 2005 annual report.
The register of directors’ interests, which is open to inspection, contains full particulars of directors’ shareholdings and options to acquire shares in Lloyds TSB Group.
To the members of Lloyds TSB Group plc We have audited the consolidated financial statements of Lloyds TSB Group plc for the year ended 31 December 2006 which comprise the consolidated income statement, the consolidated balance sheet, the consolidated statement of changes in equity, the consolidated cash flow statement and the related notes. These consolidated financial statements have been prepared under the accounting policies set out therein.
Respective responsibilities of directors and auditors The directors’ responsibilities for preparing the annual report and the consolidated financial statements in accordance with applicable law and International Financial Reporting Standards (‘IFRSs’) as adopted by the European Union are set out in the statement of directors’ responsibilities on page 51.
We report to you our opinion as to whether the consolidated financial statements give a true and fair view and whether the consolidated financial statements have been properly prepared in accordance with the Companies Act 1985 and Article 4 of the IAS Regulation. We also report to you whether, in our opinion, the information given in the directors’ report is consistent with the consolidated financial statements. The information given in the directors’ report includes that specific information presented in the Group key performance indicators, the chairman’s statement, the group chief executive’s review and the business review that is cross referred from the principal activities, business review, future developments and financial risk management objectives and policies section of the directors’ report.
Opinion In our opinion: • the consolidated financial statements give a true and fair view, in accordance with IFRSs as adopted by the European Union, of the state of the Group’s affairs as at 31 December 2006 and of its profit and cash flows for the year then ended; • the consolidated financial statements have been properly prepared in accordance with the Companies Act 1985 and Article 4 of the IAS Regulation; and
Net fee and commission income 5 2,270 2,148 Net trading income 6 6,341 9,298 Insurance premium income 7 4,719 4,469 Other operating income 8 806 1,140
Items in course of transmission to banks 781 658 Trading and other liabilities at fair value through profit or loss 29 1,184 – Derivative financial instruments 16 5,763 6,396 Debt securities in issue 30 54,118 39,346 Liabilities arising from insurance contracts and participating investment contracts 31 41,445 40,550 Liabilities arising from non-participating investment contracts 32 24,370 21,839 Unallocated surplus within insurance businesses 33 683 518
Attributable to equity shareholders Share capital Other Retained Minority and premium reserves profits Total interests Total £ million £ million £ million £ million £ million £ million
Movement in available-for-sale financial assets, net of tax – 8 – 8 – 8 Movement in cash flow hedges, net of tax – 11 – 11 – 11
Movement in available-for-sale financial assets, net of tax – (31) – (31) – (31) Movement in cash flow hedges, net of tax – 1 – 1 – 1
Purchase/sale of treasury shares – – (35) (35) – (35) Employee share option schemes: – value of employee services – – 65 65 – 65 – proceeds from shares issued 105 – – 105 – 105 Repayment of capital to minority shareholders – – – – (151) (151)
Cash flows from investing activities: Purchase of available-for-sale financial assets (23,448) (10,108) Proceeds from sale and maturity of available-for-sale financial assets 18,106 10,266 Purchase of fixed assets (1,724) (1,843) Proceeds from sale of fixed assets 1,257 1,073 Acquisition of businesses, net of cash acquired 49(f) (20) (27) Disposal of businesses, net of cash disposed 49(g) 936 (4)
(iv) IFRIC Interpretation 4 ‘Determining Whether an Arrangement Contains a Lease’. The Group has reviewed the terms of all contracts potentially affected by this interpretation; its adoption has had no material effect upon the Group’s financial statements.
The assets, liabilities and results of Group undertakings (including special purpose entities) are included in the financial statements on the basis of accounts made up to the reporting date. Group undertakings include all entities over which the Group has the power to govern the financial and operating policies which generally accompanies a shareholding of more than one half of the voting rights. The existence and effect of potential voting rights that are currently exercisable or convertible are considered when assessing whether the Group controls another entity. Group undertakings are fully consolidated from the date on which control is transferred to the Group; they are de-consolidated from the date that control ceases. Open Ended Investment Companies (‘OEICs’) and unit trusts where the Group, through the Group’s life funds, has a controlling interest are consolidated; the unit holders’ interest is reported in other liabilities. Intra-Group transactions, balances and unrealised gains and losses on transactions between Group companies are eliminated.
Interest income and expense are recognised in the income statement for all interest-bearing financial instruments, except for those classified at fair value through profit or loss, using the effective interest method. The effective interest method is a method of calculating the amortised cost of a financial asset or liability and of allocating the interest income or interest expense. The effective interest rate is the rate that exactly discounts the estimated future cash payments or receipts over the expected life of the instrument or, when appropriate, a shorter period, to the net carrying amount of the financial asset or financial liability. The effective interest rate is calculated on initial recognition of the financial asset or liability, estimating the future cash flows after considering all the contractual terms of the instrument but not future credit losses. The calculation includes all amounts paid or received by the Group that are an integral part of the overall return, direct incremental transaction costs related to the acquisition, issue or disposal of a financial instrument and all other premiums or discounts. Once a financial asset or a group of similar financial assets has been written down as a result of an impairment loss, interest income is recognised using the rate of interest used to discount the future cash flows for the purpose of measuring the impairment loss (see j).
Financial assets and liabilities are designated as at fair value through profit or loss: • When doing so results in more relevant information because either: • – it eliminates or significantly reduces the inconsistent treatment that would otherwise arise from measuring the assets and liabilities or recognising gains or losses on them on a different basis; or
• Where the assets and liabilities contain one or more embedded derivatives that significantly modify the cash flows arising under the contract and would otherwise need to be separately accounted for.
The fair values of assets and liabilities traded in active markets are based on current bid and offer prices respectively. If the market is not active the Group establishes a fair value by using valuation techniques. These include the use of recent arm’s-length transactions, reference to other instruments that are substantially the same, discounted cash flow analysis, option pricing models and other valuation techniques commonly used by market participants.
Debt securities and equity shares, other than those classified as trading securities or at fair value through profit or loss, are classified as available-for-sale and recognised in the balance sheet at their fair value. Gains and losses arising from changes in the fair value of investments classified as available-for-sale are recognised directly in equity, until the financial asset is either sold, becomes impaired or matures, at which time the cumulative gain or loss previously recognised in equity is recognised in the income statement. Interest calculated using the effective interest method is recognised in the income statement; dividends on available-for-sale equity instruments are recognised in the income statement when the Group’s right to receive payment is established.
Derivatives embedded in financial instruments and insurance contracts (unless the embedded derivative is itself an insurance contract) are treated as separate derivatives when their economic characteristics and risks are not closely related to those of the host contract and the host contract is not carried at fair value through profit or loss. These embedded derivatives are measured at fair value with changes in fair value recognised in the income statement.
Financial assets and liabilities are offset and the net amount reported in the balance sheet when there is a legally enforceable right of set-off and there is an intention to settle on a net basis, or realise the asset and settle the liability simultaneously.
Current income tax which is payable on taxable profits is recognised as an expense in the period in which the profits arise.
During 2006 the Group has changed the way in which it calculates the value of in-force business. Under the new method each cash flow is valued using the discount rate consistent with that applied to such a cash flow in the capital markets. The new market consistent discount rates replace the single discount rate previously used. The new method also includes an explicit allowance made for non-market risk. The effect of this change in methodology has been to reduce profit before tax in 2006 by £18 million.
At each balance sheet date liability adequacy tests are performed to ensure the adequacy of insurance and participating investment contract liabilities. In performing these tests current best estimates of discounted future contractual cash flows and claims handling and administration expenses, as well as investment income from the assets backing such liabilities, are used. Any deficiency is immediately charged to profit or loss by establishing a provision for losses arising from liability adequacy tests.
The results and financial position of all the Group entities (none of which has the currency of a hyperinflationary economy) that have a functional currency different from the presentation currency are translated into the presentation currency as follows: (i) assets and liabilities for each balance sheet presented are translated at the closing rate at the date of that balance sheet; (ii) income and expenses for each income statement are translated at average exchange rates (unless this average is not a reasonable approximation of the cumulative effect of the rates prevailing on the transaction dates, in which case income and expenses are translated at the dates of the transactions); and
For the purposes of the cash flow statement, cash and cash equivalents comprise cash and non-mandatory balances with central banks and amounts due from banks with a maturity of less than three months.
At 31 December 2006 gross loans and advances to customers and banks totalled £231,117 million (2005: £208,672 million) against which impairment provisions of £2,194 million (2005: £2,073 million) had been made.
Impairment provisions for portfolios of smaller balance homogenous loans, such as residential mortgages, personal loans and credit card balances that are below the individual assessment thresholds, and for loan losses that have been incurred but not separately identified at the balance sheet date, are determined on a collective basis. Collective impairment provisions are calculated on a portfolio basis using formulae which take into account factors such as the length of time that the customer’s account has been out of order, historical loss rates, the credit quality of the portfolios and the value of any security held. The variables used in the formulae are kept under regular review to ensure that as far as possible they reflect current economic circumstances; however changes in interest rates, unemployment levels, particularly in the UK, and bankruptcy trends could result in actual losses differing from reported impairment provisions.
At 31 December 2006 the Group carried goodwill on its balance sheet totalling £2,377 million (2005: £2,373 million), substantially all of which relates to acquisitions made a number of years ago.
At 31 December 2006 the Group held a provision of £149 million (2005: £147 million) in respect of the estimated cost of claims notified but not settled and claims incurred but not reported at the balance sheet date. The provision for the cost of claims notified but not settled is based upon a best estimate of the cost of settling the outstanding claims after taking into account all known facts. In those cases where there is insufficient information to determine the required provision, statistical techniques are used which take into account the cost of claims that have recently been settled and make assumptions about the future development of the outstanding cases. Similar statistical techniques are used to determine the provision for claims incurred but not reported at the balance sheet date.
While management believes that the liability carried at year end is adequate, the application of statistical techniques requires significant judgment. An increase of 10 per cent in the cost of claims would result in the recognition of an additional loss of approximately £14 million. Similarly, an increase of 10 per cent in the ultimate number of such claims would lead to an additional loss of approximately £15 million. There is no relief arising from reinsurance contracts held.
Impairment losses on loans and advances (1,111) – – – (188) – – (1,299) Profit (loss) on sale and closure of businesses 76 – – – (6) (20) – 50
Net fee and commission income 2,270 2,148 6 Net trading income 2006 2005 £m £m
Life insurance Gross premiums 4,308 3,996 Ceded reinsurance premiums (189) (89) Net earned premiums 4,119 3,907 Non-life insurance Gross premiums written 608 575 Ceded reinsurance premiums (17) (22)
Life insurance gross written premiums can be further analysed as follows: 2006 2005 £m £m
The average number of persons on a headcount basis employed by the Group during the year was as follows: During the year the auditors earned the following fees: 2006 2005 £m £m
Fees payable for the audit of the Company’s current year annual report 6.0 6.3 Fees payable for other services: Audit of the Company’s subsidiaries pursuant to legislation 2.3 1.7 Additional fees in respect of the previous year’s audit of subsidiaries 0.6 Other services supplied pursuant to legislation 4.7 0.8 Total audit fees 13.6 8.8
During 2005, a net profit of £74 million arose on disposal of businesses, principally the Goldfish credit card business. This profit was partly offset by an adjustment to consideration received in respect of an earlier disposal and a provision for costs in respect of the closure of businesses, which together totalled £24 million. The businesses sold in 2005 were not material to the Group, and consequently they have not been treated as discontinued operations.
Tax charge thereon at UK corporation tax rate of 30% 1,274 1,146 Factors affecting charge: Disallowed and non-taxable items (8) (47) Overseas tax rate differences (2) (1) Net tax effect of disposals and unrealised gains (78) (59) Policyholder interests and Open Ended Investment Companies 139 223 Other items 16 3
The effective tax rate of the Group excluding gross policyholder and Open Ended Investment Company interests from profit before tax and the tax charge was 28.0 per cent (2005: 27.0 per cent).
Profit attributable to equity shareholders £2,803m £2,493m Weighted average number of ordinary shares in issue 5,616m 5,595m Adjustment for share options and awards 51m 44m
Not later than 1 year 234 648 Later than 1 year and not later than 5 years 1,232 1,610 Later than 5 years 3,336 3,557
Debt securities: Government securities 393 1,083 Other public sector securities 189 47 Bank and building society certificates of deposit 1,615 1,470 Mortgage backed securities 5,662 4,161 Other asset backed securities 4,721 4,981 Corporate and other debt securities 4,817 3,065
Equity shares: Treasury bills and other bills: Treasury bills and similar securities 1,743 70 Other bills 23 17 88 LLOYDS TSB GROUP
Amortisation of premiums and discounts (65) – (65) Changes in fair value (note 41) 11 – 11
The asset in the consolidated balance sheet and movement recognised in the income statement are as follows: Gross value of in-force insurance and participating investment business 2006 2005 £m £m
Following the change in the methodology used to calculate the value of in-force business in 2006 the principal assumptions that it is necessary to make have changed.
A market consistent approach has been adopted for the valuation of financial options and guarantees, using a stochastic option pricing technique calibrated to be consistent with the market price of relevant options at each valuation date.
Risk-free rate (value of in-force) 4.72 Risk-free rate (financial options and guarantees) 3.91 to 5.41 Retail Price inflation 3.23 Expense inflation 4.13
Cost: Accumulated amortisation: At 1 January 2005 – 79 79 Charge for the year – 18 18
Acquisition costs deferred, net of amounts amortised to the income statement 14 136 27 Deposits from banks
Non-annuitant mortality 5% reduction 35 Annuitant mortality 5% reduction (124) Lapse rates 10% reduction 60 Maintenance expenses 10% reduction 64 Risk-free rate1 1% deduction 243 Guaranteed annuity option take up2 5% addition (22) Equity investment volatility3 1% addition (6)
2 Changes to the valuation of options and guarantees primarily reflect improved representation of the current regulatory regime and revised assumptions of future policyholder behaviours.
The movements in non-life insurance contract liabilities and reinsurance assets over the year have been as follows: Gross Reinsurance* Net Provisions for unearned premiums £m £m £m
Cash paid for claims settled in the year (221) – (221) Increase in liabilities: Arising from current year claims 239 – 239 Arising from prior year claims (12) – (12)
Cash paid for claims settled in the year (223) – (223) Increase in liabilities: Arising from current year claims 231 – 231 Arising from prior year claims (6) – (6)
Two years later 228 223 207 Three years later 224 221 Four years later 224
Change in unallocated surplus recognised in the income statement (note 9) 165 92 £m £m
At 1 January 17,320 14,866 Current service cost 325 292 Interest cost 817 775 Actuarial (gains) losses (434) 1,786 Benefits paid (555) (446) Past service cost 32 15 Curtailment (129) – Exchange and other adjustments 2 32
Employer contributions 550 419 Actuarial gains 314 1,538 Benefits paid (555) (446) Exchange and other adjustments 2 28
Life expectancy for member aged 60, on the valuation date: Life expectancy for member aged 60, 15 years after the valuation date: The mortality assumptions used in the scheme valuations are based on standard tables published by the Institute and Faculty of Actuaries which were adjusted in line with both current industry experience and the actual experience of the relevant schemes. The table shows that a member retiring at age 60 as at 31 December 2006 is assumed to live for, on average, 25.8 years for a male and 27.8 years for a female. In practice there will be much variation between individual members but these assumptions are expected to be appropriate across all members. It is assumed that younger members will live longer in retirement than those retiring now. This reflects the expectation that mortality rates will continue to fall over time as medical science and standards of living improve. To illustrate the degree of improvement assumed the table also shows the life expectancy for members aged 45 now, when they retire in 15 years time at age 60.
The expected return on scheme assets has been calculated using the following assumptions: 2006 2005
Experience adjustments history (since the date of adoption of IAS 19): 2006 2005 2004 £m £m £m
Present value of defined benefit obligation 17,378 17,320 14,866 Fair value of scheme assets (15,279) (14,026) (11,648)
The expense recognised in the income statement for the year ended 31 December comprises: 2006 2005 £m £m
The Group operates a number of schemes which provide post-retirement healthcare benefits to certain employees, retired employees and their dependent relatives. The principal scheme relates to former Lloyds Bank staff and under this scheme the Group has undertaken to meet the cost of post-retirement healthcare for all eligible former employees (and their dependents) who retired prior to 1 January 1996. The Group has entered into an insurance contract to provide these benefits and a provision has been made for the estimated cost of future insurance premiums payable.
At 1 January 112 104 Exchange and other adjustments – (3) Actuarial (gain) loss (1) 1 Insurance premiums paid (6) (6) Charge for the year 5 16 36 Deferred tax liabilities
Amounts released to the income statement in respect of cash flow hedges – 4
Amortisation of discount – – 4 4 Charge (release) for the year (5) – 5 –
At 31 December 2006 the remaining provisions held relate to past sales of a number of products, including mortgage endowment policies, sold through the branch networks of Lloyds TSB Bank, Lloyds TSB Scotland and Cheltenham & Gloucester and underwritten by life assurance companies within the Group and also by third parties. The principal assumptions that are made in the assessment of the adequacy of the provision relate to the number of cases that are likely to require redress, taking into account any time barring, and the estimated average cost per case. The ultimate cost and timing of the payments remains highly uncertain and will be influenced by external factors beyond the control of management, such as regulatory actions, media interest and the performance of the financial markets. However, it is expected that the majority of the remaining expenditure will be incurred over the next year.
Vacant leasehold property provisions are made by reference to a prudent estimate of expected sub-let income, compared to the head rent, and the possibility of disposing of the Group’s interest in the lease, taking into account conditions in the property market. These provisions are reassessed on an annual basis and will normally run off over the period of under-recovery of the leases concerned, currently averaging three years; where a property is disposed of earlier than anticipated, any remaining balance in the provision relating to that property is released.
Preferred securities 6.90% Perpetual Capital Securities callable 2007 (US$1,000 million) b, e 483 553 Fixed/Floating Rate Non-Cumulative Callable Preference Shares callable 2015 (£600 million) a 587 – Fixed/Floating Rate Non-Cumulative Callable Preference Shares callable 2016 (US$1,000 million) a 504 – 6% Non-cumulative Redeemable Preference Shares m – – 6.625% Perpetual Capital Securities callable 2006 (c750 million) b, d – 518 Euro Step-up Non-Voting Non-Cumulative Preferred Securities callable 2012 (c430 million) b, k 312 337 6.35% Step-up Perpetual Capital Securities callable 2013 (c500 million) b, d, i 345 371 Sterling Step-up Non-Voting Non-Cumulative Preferred Securities callable 2015 (£250 million) b, l 248 248 4.385% Step-up Perpetual Capital Securities callable 2017 (c750 million) b, d, i 478 522
In addition, during 2006 the Company issued 600,000 Fixed/Floating Rate Non-Cumulative Callable Preference Shares of 25 pence each with a liquidation preference of £1,000 per share and 1,000,000 Fixed/Floating Rate Non-Cumulative Callable Preference Shares of 25 cents each with a liquidation preference of US$1,000 per share. Both issues of preference shares are perpetual, although the two issues can be redeemed at the option of the Company on or after 25 August 2015 and 14 November 2016 respectively and carry the right to non-cumulative dividends which are fixed until those first redemption dates. The terms of these two issues of preference shares are such that the Company cannot declare and pay a dividend on any other junior class of share (including the mandatory dividend on the 400 6 per cent non-cumulative redeemable preference shares mentioned above) until the coupon has been paid on these preference shares. As the Company is effectively committed to the payment of a coupon on these shares they are classified as liabilities on the balance sheet in accordance with IFRS (see note 38).
Premium arising on issue of shares under share option schemes 96 25 £m £m
Currency translation differences arising in the year (108) 24 Foreign currency gains on net investment hedges 110 – Current tax (33) –
The Bank of New York Nominees have waived the right to all dividends on the Lloyds TSB Group plc shares that they hold (holding at 31 December 2006: 10 shares).
In addition, the trustees of the following holdings of Lloyds TSB Group plc shares in relation to employee share schemes retain the right to receive dividends but chose to waive their entitlement to the dividends on those shares as indicated: the Lloyds TSB Group Shareplan (holding at 31 December 2006: 1,138,311 shares, waived right to all dividends), the Lloyds TSB Group Employee Share Ownership Trust (holding at 31 December 2006: 898,320 shares, waived right to all dividends), Lloyds TSB Group Holdings (Jersey) Limited (holding at 31 December 2006: 41,801 shares, waived right to all but a nominal amount of 1 penny in total) and the Lloyds TSB Qualifying Employee Share Ownership Trust (holding at 31 December 2006: 1,364 shares, waived right to all but a nominal amount of 1 penny in total).
March 1996 Growth in earnings per share which is equal to the aggregate percentage change in the Retail Price Index plus two percentage points for each complete year of the relevant period.
Movements in the number of share options outstanding under the SAYE schemes are set out below: Weighted average Weighted average Number of exercise price Number of exercise price options (pence) options (pence)
Outstanding at 1 January 268,918 Nil 206,647 Nil Granted 165,395 Nil 62,271 Nil Exercised (77,190) Nil – –
Weighted average Weighted average Number of exercise price Number of exercise price options (pence) options (pence)
The remaining 50 per cent of the award will be based on earnings per share growth calculated on a compound annualised basis. For the award to vest in full, the earnings per share growth over the performance period must be at least equivalent to an average of the Retail Price Index plus 6 per cent per annum. 8.75 per cent of the award will vest where earnings per share growth is an average of the Retail Price Index plus 3 per cent per annum and vesting will be on a straight-line basis between these points. Where the earnings per share growth is less than an average of the Retail Price Index plus 3 per cent per annum this part of the award will lapse.
Weighted Weighted Weighted Weighted Weighted Weighted average average average average average average exercise remaining Number of exercise remaining Number of exercise remaining Number of price (pence) life (years) options price (pence) life (years) options price (pence) life (years) options
Loans At 1 January 3 3 Advanced – 1 Interest – – Repayments (1) (1)
No provisions have been recognised in respect of loans given to key management personnel (2005: nil).
At 31 December 2006, the Group provided guarantees totalling £19,744 in respect of one director (2005: £19,744 in respect of one director).
During the ordinary course of business the Group is subject to threatened or actual legal proceedings. All material cases are periodically reassessed, with the assistance of external professional advisors where appropriate, to determine the likelihood of the Group incurring a liability. In those instances where it is concluded that it is more likely than not that a payment will be made, a provision is established to management’s best estimate of the amount required to settle the obligation at the balance sheet date.
Other items serving as direct credit substitutes include standby letters of credit, or other irrevocable obligations, serving as financial guarantees where the Lloyds TSB Group has an irrevocable obligation to pay a third party beneficiary if the customer fails to repay an outstanding commitment; they also include acceptances drawn under letters of credit or similar facilities where the acceptor does not have specific title to an identifiable underlying shipment of goods.
Where a Group company is the lessee the future minimum lease payments under non-cancellable premises operating leases are as follows: £m £m
Not later than 1 year 1 1 Later than 1 year and not later than 5 years – – Later than 5 years 15 15
The Group establishes two types of hedge accounting relationships for interest rate risk: fair value hedges and cash flow hedges. The Group is exposed to fair value interest rate risk on its fixed rate customer loans, its fixed rate customer deposits and the majority of its subordinated debt, and to cash flow interest rate risk on its variable rate loans and deposits together with its floating rate subordinated debt. The majority of the Group’s hedge accounting relationships are fair value hedges where interest rate swaps are used to hedge the interest rate risk inherent in the fixed rate mortgage portfolio. At 31 December 2006 the aggregate notional principal of interest rate swaps designated as fair value hedges was £37,378 million (2005: £39,568 million) with a net fair value liability of £110 million (2005: £245 million) (see note 16). In addition the Group has a small number of cash flow hedges which are primarily used to hedge the variability in the cost of funding within the wholesale business. These cash flows are expected to occur over the next six years and will be reported in the income statement as they take place. The notional principal of the interest rate swaps designated as cash flow hedges at 31 December 2006 was £569 million (2005: £648 million) with a net fair value liability of £8 million (2005: £18 million) (see note 16).
Liabilities arising from insurance and investment contracts – – – – – 62,907 62,907 * Derivative financial instruments which are exposed to interest rate risk are carried in the balance sheet at fair value and for the purposes of this analysis have been treated as non-interest bearing.
2,804 2,643 Trading and other financial assets at fair value through profit or loss 29,568 26,869
The Group’s policy requires that each business unit meets its financial obligations as they fall due, that the Group complies with the Financial Services Authority Sterling Stock Liquidity Policy in the UK and that all local regulatory requirements are met.
Maturities of assets and liabilities Up to 1-3 3-12 1-5 Over 5 1 month months months years years Total £m £m £m £m £m £m
Financial assets Trading and other financial assets at fair value through profit or loss 67,695 60,374 67,695 60,374
Trading and other liabilities at fair value through profit or loss 1,184 – 1,184 –
Loans and advances to customers – 803 Goodwill – 93 Other net assets and liabilities – (946)
Cash and cash equivalent consideration received – – Cash and cash equivalents disposed of – –
The following pronouncements will be relevant to the Group but were not effective at 31 December 2006 and have not been applied in preparing these financial statements.
3 Pending EU endorsement, the Group has not yet made a final decision as to whether it will apply these pronouncements in the 2007 financial statements.
Our responsibility is to audit the parent company financial statements and the part of the directors’ remuneration report to be audited in accordance with relevant legal and regulatory requirements and International Standards on Auditing (UK and Ireland). This report, including the opinion, has been prepared for and only for the Company’s members as a body in accordance with section 235 of the Companies Act 1985 and for no other purpose. We do not, in giving this opinion, accept or assume responsibility for any other purpose or to any other person to whom this report is shown or into whose hands it may come save where expressly agreed by our prior consent in writing.
We report to you our opinion as to whether the parent company financial statements give a true and fair view and whether the parent company financial statements and the part of the directors’ remuneration report to be audited have been properly prepared in accordance with the Companies Act 1985. We also report to you whether, in our opinion, the information given in the directors’ report is consistent with the parent company financial statements. The information given in the directors’ report includes that specific information presented in the chairman’s statement, the group chief executive’s review and the business review that is cross referred from the principal activities, business review, future developments and financial risk management objectives and policies section of the directors’ report.
We planned and performed our audit so as to obtain all the information and explanations which we considered necessary in order to provide us with sufficient evidence to give reasonable assurance that the parent company financial statements and the part of the directors’ remuneration report to be audited are free from material misstatement, whether caused by fraud or other irregularity or error. In forming our opinion we also evaluated the overall adequacy of the presentation of information in the parent company financial statements and the part of the directors’ remuneration report to be audited.
Purchase/sale of treasury shares – (2) (2) Employee share option schemes: Value of employee services – 47 47 Proceeds from shares issued 26 – 26
Change in cash and cash equivalents 1,106 (101) Cash and cash equivalents at beginning of year 107 208
The above investment is carried at cost; there has been no impairment of the Company’s investment in subsidiaries.
* Includes 913 million shares (16.19%) registered in the names of some 840,000 individuals. 266 million shares (4.72%) are held by over 66,000 staff and Group pensioners, or on their behalf by the trustee of the staff shareplan scheme.
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