Phase 2 – build customer franchises • extending reach and depth of customer relationships • enhancing product capabilities to build competitive advantage • improving processing efficiency • working capital harder
Wholesale and International Banking • grow the Corporate Markets business • build on the growth momentum in Business Banking
• Balanced and continuing trading momentum with income up 6 per cent and trading surplus up 11 per cent.†
1,549 1,320 Insurance and Investments - Before strengthening of reserves for mortality 973 880 - Strengthening of reserves for mortality – (155)
** On a statutory basis, profit on sale and closure of businesses in 2005 relates to UK Retail Banking (profit of £76 million), Wholesale and International Banking (loss of £6 million) and Central group items (loss of £20 million).
We are building our business by • deepening customer relationships • enhancing product capabilities • improving processing efficiency • working capital harder
In the Retail Bank, we have a leading market share of current accounts, with 21 per cent of the UK market. We also have a strong position in many other key product areas, such as savings, mortgages and credit cards, and an excellent distribution network, with over 2,000 branches and one of Europe’s leading telephone and internet banks. Our Insurance and Investments division benefits from having one of the UK’s most recognised life and pensions brands in Scottish Widows, and we also have a very successful general insurance business. In our Wholesale and International Banking division, we have strong customer portfolios in both corporate banking, where Lloyds TSB was once again rated the best corporate bank in the UK by the Confederation of British Industry, and in small business banking, where we have maintained a leading position in the key small business start-up sector, an important feeder market. All of these businesses are focused on better meeting the needs of all our customers, and ensuring that Lloyds TSB is a bank that continues to build life-long customer relationships.
The board has declared a final dividend of 23.5p per share, making a total for the year of represents a dividend yield of 6 per cent, calculated using the 31 December 2006 share price of 571.5p.
Alongside our twin objectives, the Group looks to benefit the broader community. Lloyds TSB staff continue to support a wide range of community programmes, giving of their time and energy as well as providing financial resource. We are immensely proud of the work that the Lloyds TSB Foundations do throughout the UK, making a significant difference to the lives of so many thousands of people each year. In 2006 we gave £34 million in support of the work of the Lloyds TSB Foundations and this figure will increase to £37 million in 2007. Over the last 10 years, we have given a total of over £300 million to the Foundations, making Lloyds TSB one of the largest charitable donors in the United Kingdom.
For me, one of the real delights of the last few months has been the opportunity to get to know so many people at all levels in Lloyds TSB. What I have found is a tremendous ‘buzz’ around the Group created by the enthusiasm, the dedication, the professionalism and the desire to succeed of all the staff I have met. An example, of course, is set from the top by our very high calibre senior management team, a number of whom have recently joined the Group, who are so committed to growing our businesses successfully, and they encourage what is already a high performance culture across the organisation. We operate in a highly complex, ever changing environment and in a challenging and competitive world. It is the continuing and committed endeavours of our staff that enable us to achieve success. On behalf of the whole of the board, I would like to thank the whole of the Lloyds TSB team most sincerely for their continued commitment and hard work.
Angela Knight left at the end of October following her appointment as chief executive of the British Bankers’ Association. In that role she will provide great leadership to our industry, but we will miss her contribution on the board. We wish her great success in her new role. DeAnne Julius has decided to retire from the board at the annual general meeting, having served as a non-executive director for more than five years. We shall miss her wide experience and wise counsel.
We continue to invest in the quality of service we give to our customers and in the quality of the people we employ to serve them. As a result, we have seen improvements in our customer satisfaction and customer advocacy scores, in our employee engagement scores and in our sales performance. Taken together with our balance of quality performing businesses, I believe this puts Lloyds TSB in great shape for 2007 and beyond.
The success is reflected, for instance, in increased levels of new target current account customer recruitment, which rose 59 per cent year-on-year. In addition, total sales volumes in the Retail Bank grew by 16 per cent, led by a 30 per cent increase in branch sales. Of particular note has been the change in the sales mix and the development of better quality, more annuity-like revenue streams through increased volumes of savings and bancassurance products.
In Insurance and Investments, profit before tax on a like-for-like basis increased by 15 per cent. We have excellent income growth, of 12 per cent, and firm cost control, which resulted in positive jaws of 6 percentage points. Each of the businesses within the division performed strongly and we saw good profitable growth through both the branch network and IFA distribution channels.
Scottish Widows delivered another very good performance, with sales rising 24 per cent on the prior year and we increased our new business profit by 36 per cent. We continue to deliver on our bancassurance performance, with a 62 per cent increase in sales, supported by our simplified product range and new customer offers. In the IFA channel, our emphasis is on growing the business profitably and we saw an increase in sales of 14 per cent.
In Wholesale and International Banking, we made further excellent progress in our core businesses with the division delivering an 8 per cent increase in profit before tax. This has been built on our two key franchises, Corporate Markets and Business Banking, and they again delivered excellent levels of profitable growth. Whilst we are continuing to invest in these franchises to support our growth ambitions, this was achieved within our discipline of positive jaws with income growth of 8 per cent whilst costs grew by 4 per cent. The division also includes the Asset Finance business, which was affected by the market-wide slowdown in consumer lending and increased impairments in its retail portfolios.
The performance in Business Banking is again underpinned by a very good performance in sales, as we continue to attract a market leading share of business start-ups. We are delivering on our strategy of building deeper customer relationships, with good levels of growth in customer lending and deposits, as well as continuing to raise the level of fee income. This helped to drive growth in profits of 26 per cent.
business model. Whilst we are likely to face challenges in terms of the slower rate of growth in the unsecured consumer credit market and the increasing cost of regulation, each of the divisions has now established a strong track record for delivering enhanced customer satisfaction and an improved sales performance, which is resulting in profitable business growth. We will also continue to deliver on our productivity programmes across the business. In addition to improving our efficiency and effectiveness, these also result in better customer satisfaction and enhance our ability to fund increased investment for future growth.
In the competitive financial services market, and with customers able to exercise choice amongst alternative providers, shareholder and customer value creation are closely linked. Shareholder value is created by attracting and retaining customers and winning a greater share of their financial services business. We have a significant opportunity to leverage our customer relationships to build market share in other products. We have significant strengths, in our portfolio of high quality brands, our customer franchises, our multi-channel distribution capability, our high levels of customer satisfaction and our knowledge and understanding of our customers. Our growth will come from leveraging these key strengths.
In summary, 2006 was another strong year for the Group. We have delivered a good financial performance whilst continuing to build our customer franchises to support future earnings growth. We will continue to extend the reach and depth of our customer relationships whilst improving productivity and efficiency in 2007 and beyond. In doing so, I believe that we can deliver sustained double-digit economic profit growth over time.
Factors that could cause actual results to differ materially from the plans, objectives, expectations, estimates and intentions expressed in such forward looking statements made by Lloyds TSB Group or on Lloyds TSB Group’s behalf include, but are not limited to, general economic conditions in the UK and internationally; inflation, deflation, interest rate, policies of the Bank of England and other G-7 central banks, exchange rate, market and monetary fluctuations; changing demographic developments including consumer spending, saving and borrowing habits, technological changes, natural and other disasters, adverse weather and similar contingencies outside the Lloyds TSB Group’s control; inadequate or failed internal or external processes, people and systems; terrorist acts and other acts of war or hostility and responses to those acts; changes in laws, regulations, taxation, government policies or accounting standards or practices; changes in competition and pricing environments; the inability to hedge certain risks economically; the adequacy of loss reserves; the ability to secure new customers and develop more business from existing customers; the ability to achieve value-creating mergers and/or acquisitions at the appropriate time and prices and the success of the Lloyds TSB Group in managing the risks of the foregoing.
Lloyds TSB Group plc may also make or disclose written and/or oral forward looking statements in reports filed with or furnished to the US Securities and Exchange Commission, Lloyds TSB Group plc’s annual review, half year announcement, proxy statements, offering circulars, prospectuses, press releases and other written materials and in oral statements made by the directors, officers or employees of Lloyds TSB Group plc to third parties, including financial analysts. The forward looking statements contained in this annual report are made as of the date hereof, and Lloyds TSB Group undertakes no obligation to update any of its forward looking statements.
Overall income growth of 6 per cent reflects good progress in delivering our strategies of increasing income from both new and existing customers, with good growth in both assets and liabilities, as well as increased fee income.
Group net interest income, excluding insurance grossing, increased by £192 million, or 4 per cent. Strong levels of customer lending growth in Business Banking and Corporate Markets, and good growth in mortgages, more than offset the expected slowdown in the rate of growth in unsecured personal lending. Total assets increased by 11 per cent to £344 billion, with an 8 per cent increase in loans and advances to customers. Customer deposits increased by 6 per cent to £139 billion, supported by good growth in current account credit balances and savings balances in the retail bank.
In UK Retail Banking, impairment losses on loans and advances increased by £173 million, or 16 per cent, to £1,238 million, reflecting more customers with higher levels of indebtedness experiencing repayment difficulties, as well as higher levels of customer insolvency. As a result of tightening our credit criteria the quality of new business written over the last two years has improved. This, as well as improvements in the Group’s collection procedures and better than assumed recoveries, has resulted in a reduction in the retail impairment charge in the second half of 2006, compared to the first half.
Towards the end of 2006 we experienced some signs of stabilisation in the rate of our customers filing for bankruptcy and a slowdown in the rate of growth in Individual Voluntary Arrangements (IVAs). In addition, the increased sharing of industry-wide customer data, particularly with regard to credit card use, has improved our customer understanding further and this has led to a reduction in a number of credit limits. Whilst the rate of growth in the number of customers filing for bankruptcy and IVAs remains a key factor in the outlook for retail impairment, we expect that the rate of growth in the unsecured retail lending impairment charge in 2007 will be significantly lower than that experienced in 2006.
Scottish Widows remains strongly capitalised and, at the end of December 2006, the working capital ratio of the Scottish Widows Long Term Fund was an estimated 18.9 per cent (page 42) and the risk capital margin was covered over 17 times. In the second half of 2006, an additional capital repatriation of £540 million was made to the Group, bringing the total for the year to approximately £750 million. This is in addition to capital repatriation of £1 billion in 2005. We continue to examine opportunities to improve our capital efficiency and have work under way that we believe will allow Scottish Widows to repatriate further capital to the Group in 2007, whilst maintaining a strong capital position.
The Group is making good progress in its preparations for the introduction of Basel 2. We commenced parallel running at the end of 2006, 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.
During 2006, the Group has delivered strong and balanced trading momentum, with good sales growth, across all of the divisions. Substantial improvements in productivity and operational efficiency have resulted in excellent cost control and widened positive jaws. Asset quality remains satisfactory, our post-tax return on equity remains high, economic profit continues to increase and we have a robust capital position.
Telephone banking. Telephone banking continues to grow and Lloyds TSB Group now provides one of the largest telephone banking services in Europe. At the end of 2006, some 5.3 million customers had registered to use the services of PhoneBank and the automated voice response service, PhoneBank Express. Lloyds TSB Group’s telephone banking centres handled some 62 million calls during 2006.
Cash machines. Lloyds TSB Group has one of the largest cash machine networks of any leading banking group in the UK and, at 31 December 2006, personal customers of Lloyds TSB Bank and Lloyds TSB Scotland were able to withdraw cash and check balances through some 4,100 ATMs at branches and external locations around the country. In addition, our personal customers have access to over 60,000 cash machines via LINK in the UK and to cash machines worldwide through the VISA and MasterCard networks.
Current accounts. Lloyds TSB Bank and Lloyds TSB Scotland offer a wide range of current accounts, including interest-bearing current accounts and a range of added value accounts.
Mortgages. Cheltenham & Gloucester is Lloyds TSB Group’s specialist residential mortgage provider, offering a range of mortgage products to personal customers through its own branches and those of Lloyds TSB Bank in England and Wales, as well as through the telephone, internet and postal service, Mortgage Direct. Lloyds TSB Group also provides mortgages through Lloyds TSB Scotland and Scottish Widows Bank. Lloyds TSB Group is one of the largest residential mortgage lenders in the UK on the basis of outstanding balances, with mortgages outstanding at 31 December 2006 of £95.3 billion, representing a market share of 8.8 per cent.
UK Wealth Management. Wealth Management provides financial planning and advice for Lloyds TSB‘s affluent customers, providing financial solutions across investments, retirement planning and income, trusts, tax and estate planning as well as share dealing. Expert advice is provided through a large population of Lloyds TSB financial planners who can be accessed via the retail branch network and Private Banking offices nationwide. Customers are also provided with access to relationship banking as part of Lloyds TSB Private Banking, one of the largest private banks in the UK.
Corporate Markets, combining the respective strengths of circa 3,000 people in Corporate Banking, Structured Finance and Financial Markets, plays an integral role in leveraging and expanding the customer franchise and building deep, long-lasting relationships with around 18,000 corporate customers.
Corporate Banking manages the core customer franchise, providing a relationship-based financial and advisory service to the corporate market place through dedicated regional teams throughout the UK and key strategic locations abroad, including New York. Customers have access to expert advice and a broad range of financial solutions. Relationship Managers act as a conduit to product and service partners in Corporate Markets and other parts of the Group.
Financial Markets provides market access to sources of liquidity, hedging tools and investment products on behalf of Lloyds TSB Group and its customers. Financial Markets also provides risk management solutions to corporate customers. Through its Debt Capital Markets capability, Financial Markets delivers a range of solutions across a number of markets encompassing debt origination and syndication, securitisation, structured credit, credit derivatives and private placements.
Customer redress provisions (150) – – – (150) – (150) Strengthening of reserves for mortality – (155) – – (155) – (155)
** The Group’s income statement includes substantial amounts of income and expenditure which are attributable to the policyholders of the Group’s long-term assurance funds. These items have no impact upon the profit attributable to equity shareholders and are separately analysed within the segmental analysis in order to provide a clearer representation of the underlying trends within the Insurance and Investments segment.
In addition to growing product sales from existing customers, the Group has made excellent progress in expanding its customer franchise. Target customer current account recruitment increased by 59 per cent, compared with last year. With a renewed focus on the student and graduate market, the Group has also made considerable progress, and this has led to a 133 per cent increase in student account recruitment and a doubling of market share in this market.
The rate of growth in the number of our customers filing for bankruptcy and IVAs remains a key factor in the outlook for retail impairment. Towards the end of 2006 we experienced some signs of stabilisation in the rate of customer bankruptcies and a slowdown in the rate of growth in IVAs. As a result, we believe that the rate of growth in the retail lending impairment charge in 2007 will be significantly lower than that experienced in 2006.
Industry practice has historically been to measure new business sales on a weighted Annual Premium Equivalent (‘APE’) basis, where APE is calculated as the value of regular premium sales plus 10 per cent of single premium sales. Industry practice is moving towards an alternative basis of calculation – Present Value of New Business Premiums (‘PVNBP’). This is calculated as the value of single premiums plus the discounted present value of future expected regular premiums. An analysis of new business sales on a PVNBP basis can be found in the following table.
** Other items represent amounts not considered attributable to the underlying performance of the business. The figure in 2006 represents the benefits of the FSA’s Policy Statement 06/14 and an intra-Group transfer of a portfolio of OEICs. The figure in 2005 represents a similar intra-Group transfer of OEICs, the capitalisation impact of a lower cost of capital following debt issuance, and an increase in the value of deferred tax assets.
Risk-free rate (value of in-force) 4.72 4.22 Risk-free rate (financial options and guarantees) 3.91 to 5.41 3.9 to 4.3 Retail price inflation 3.23 2.89 Expense inflation 4.13 3.79
An allowance for non-market risk is made through the choice of best estimate assumptions based upon experience, which generally will give the mean expected financial outcome for shareholders and hence no further allowance for non-market risk is required. However, in the case of operational risk and the with-profits fund these are asymmetric in the range of potential outcomes for which an explicit allowance is made.
Commission receivable 629 681 Commission payable (664) (695) Underwriting income (net of reinsurance) 600 562 Other income 35 18
Net operating income 600 566 Claims paid on insurance contracts (net of reinsurance) (200) (197)
Profit before tax from our general insurance operations increased by £34 million, or 16 per cent, to £243 million. Operating income, net of claims, increased by 8 per cent whilst costs fell by 2 per cent. Good progress continues to be made in implementing new platforms for underwriting and claims processes.
1 In this sensitivity the impact takes into account the change in the value of in-force business, financial options and guarantee costs, statutory reserves and asset values.
2 The reduction in market values is assumed to have no corresponding change in dividend or rental yields. The impact on EEV of £(228) million comprises a £177 million reduction in the value of in-force business and a £51 million reduction in the shareholders’ net assets.
Net interest income increased by £120 million, or 5 per cent, reflecting higher income from strong growth in customer lending and customer deposits. The banking net interest margin reduced, largely reflecting the mix effect of slower growth in the wider margin Asset Finance business, and lower Corporate Markets and Business Banking margins reflecting a higher proportion of finer margin secured lending being written. Other income increased by £199 million, or 12 per cent, as a result of good levels of growth in financial markets product sales and credit structuring. In addition, fee and other transactional income throughout the division benefited from volume growth across a broad range of customer activity. Costs were 4 per cent higher at £2,264 million, reflecting higher staff costs resulting from the continuing investment in people, processes and systems, as the Group builds up its Corporate Markets product capability and expertise. This increased investment was mitigated by operational efficiencies achieved in Business Banking and Asset Finance.
In Corporate Markets, profit before tax grew by 13 per cent, driven by strong levels of income growth. Income increased by 15 per cent, supported by significantly higher levels of cross-selling income. By building new product revenue streams in areas such as structured products and debt capital markets, and targeting and developing relationships in selected corporate customer segments, Corporate Markets has created a broader, more diversified stream of revenues to underpin future revenue growth. There has also been significant progress in the delivery of our strategy focused on improved origination and distribution capabilities in the mid-sized corporate business. Operating expenses increased by 9 per cent to £722 million, reflecting further investment in people, premises and systems to support ongoing business growth. The trading surplus increased by 19 per cent. The net impairment credit reduced to £13 million, reflecting the lower level of releases and recoveries.
In accordance with IFRS, it is the Group’s policy to recognise all derivatives at fair value. The banking businesses manage their interest rate and other market risks primarily through the use of intra-Group derivatives, with the resulting net positions managed centrally using external derivatives. IFRS does not, however, permit the intra-Group derivatives to be used in a hedge relationship for reporting purposes. Although fair value accounting can have a significant impact on reported earnings, it does not impact on the business fundamentals or cash flows of the businesses. The Group has, therefore, implemented an internal pricing arrangement whereby divisions transfer to Central group items the volatility associated with marking to market derivatives held for risk management purposes where, as far as possible, the effect is minimised by establishing IAS 39 compliant hedge accounting relationships. The net result is separately disclosed as banking volatility.
The Group’s insurance businesses have liability products that are supported by substantial holdings of investments, including equities, property and fixed interest investments, all of which have a volatile fair value. The liabilities and supporting investments do not move exactly in line as the fair value of investments changes, yet IFRS requires that the changes in both the value of the liabilities and investments be reflected within the income statement. As these investments are substantial and movements in their fair value can have a significant impact on the profitability of the Insurance and Investments division, management believes that it is appropriate to disclose the division’s results on the basis of an expected return in addition to the actual return. The difference between the actual return on these investments and the expected return based upon economic assumptions made at the beginning of the period is included within insurance volatility.
Changes in market variables also affect the realistic valuation of the guarantees and options embedded within products written in the Scottish Widows With Profit Fund, the value of the in-force business and the value of shareholders’ funds. Fluctuations in these values caused by changes in market variables are also included within insurance volatility.
Regulation In the UK and elsewhere, there is continuing political and regulatory scrutiny of financial services. On 7 February 2007, the Office of Fair Trading (‘OFT’) published its decision to refer the Payment Protection Insurance market to the Competition Commission, which will report within two years. The OFT is also carrying out a review of undertakings given by some banks in 2002 regarding the supply of banking services to SMEs, a fact find into certain current account charges and an inquiry into interchange fees charged by some card networks. The European Commission is also conducting an inquiry into retail banking services across the EU. It is not presently possible to assess the cost or income impact of these inquiries or any connected matters on the Group until the outcome is known. In addition, a number of EU directives, including the Markets in Financial Instruments Directive (‘MiFID’) and the Capital Requirements Directive, are currently being implemented in the UK. The EU is also considering regulatory proposals for, inter alia, a Consumer Credit Directive, Payment Services Directive and capital adequacy requirements for insurance companies (Solvency II).
We continue to develop financial services especially tailored to tackle the problem of financial exclusion. These include basic bank accounts, support for community credit unions and other community finance initiatives and, loan and venture capital funds. Our partnership with the Post Office allows our customers access to the UK network of post offices as well as over 2,000 of our own branches and 4,100 ATMs. At the end of 2006 we had over 400,000 basic bank accounts.
We also believe in the importance of financial education. We have collaborated with the Financial Services Authority to lead the development and delivery of their Financial Capability in the Workplace programme.
In addition to our financial contribution we recognise that it is in our long-term interest to help improve the social and commercial fabric of local communities where we operate. That is why we have one of the largest community investment programmes in the UK.
In respect of our own direct environmental impacts our immediate priority is to reduce our carbon emissions. We have introduced a five-year carbon management programme which, through a series of energy saving projects and other initiatives, will not only reduce our carbon footprint but also deliver cost savings. In 2005 we set a target to reduce property related emissions by 30 per cent from 2004 levels by 2010. We are exploring other opportunities in relation to waste reduction and business travel (see page 27).
We are in the process of establishing a group wide Climate Forum, led by the deputy group chief executive, to develop a holistic approach to managing climate related risks and opportunities.
The objective remains to go beyond risk mitigation and control to developing risk capabilities as a key strategic differentiator for Lloyds TSB.
The group executive committee, assisted by its sub-committees, the group business risk committee and the group asset and liability committee, supports the group chief executive in ensuring the development, implementation and effectiveness of the Group’s risk management framework and the clear articulation of the Group’s risk policies, and reviews the Group’s aggregate risk exposures and concentrations of risk. The group executive committee’s duties are described more fully on page 50.
Divisional risk officers provide oversight of risk management activity within each of the Group’s operating divisions. Reporting directly to the group executive directors responsible for the divisions and the chief risk director, their day-to-day contact with business management, business operations and risk initiatives seeks to provide an effective risk oversight mechanism. The direct reporting line to the chief risk director enables the Group to maintain a wide ranging and current perspective on material risks facing the Group and provides a mechanism to share best risk management practice.
The director of group audit provides the required independent assurance to the audit committee and the board that risks within the Group are recognised, monitored and managed within acceptable parameters. Group Audit is fully independent of Group Risk, seeking to ensure objective challenge to the effectiveness of the risk governance framework.
During the year an enhanced Control Self-Assessment process has increased the focus of management at all levels on risk management and reinforced accountabilities. All business units, divisional risk offices and group functions have completed a Control Self-Assessment, reviewing the effectiveness of their internal controls and putting in place enhancements where appropriate. Managing directors and group executive directors have certified the accuracy of their assessment.
Lloyds TSB Group uses an enterprise-wide framework for the identification, assessment, measurement and management of risk, designed to meet its customers’ needs and maximise value for shareholders over time by aligning risk management with the corporate strategy; assessing the impact of emerging risks from new technologies or markets; and developing risk tolerances and mitigating strategies. The framework strengthens the Group’s ability to identify and assess risks; aggregate group wide risks and define the corporate risk appetite; develop solutions for reducing or transferring risk, where appropriate; and exploit risks to gain competitive advantage, thereby seeking to increase shareholder value.
The Group’s risk language is designed to capture the Group’s principal risks referred to as the ‘primary risk drivers’. A description of each risk, including definition, appetite, control and exposures is included in the detail to this report. These are further broken down into 13 more granular risk types to enable more detailed review and facilitate appropriate reporting and analysis of root causes, as set out below.
In enhancing our risk framework in 2005, we articulated the Group’s strategic vision and the desired outcomes for our key stakeholders. The risk implications are expressed in high level risk principles and risk appetite measures and metrics for the primary risk types. These are then translated into more detailed policies and measures which are applied to the businesses. A key focus in 2006 has been the enhancement of policy and development of risk appetite across our business and this work will continue throughout 2007.
A key component of the risk management framework is the policy framework. The Group has continued to embed this further during 2006.
Group and divisional risk functions have responsibility for overseeing effective implementation of policy. Group Audit provides independent assurance to the board about the effectiveness of the Group’s control framework and adherence to policy.
Divisional risk functions use the standard language when reporting risks centrally, to enable risk aggregation, and when assessing risk levels of new products, change initiatives or business plans. Divisions monitor their risk levels against their risk appetite seeking to ensure effective mitigating action is being taken where appropriate. Divisional risk reports are reviewed by divisional executive committees to ensure divisional senior management are satisfied with the overall risk profile, risk accountabilities and progress on any necessary mitigating actions.
Strategy risk is encapsulated as the budget and medium-term plan sanctioned by the board on an annual basis. Divisions and business units subsequently align their plans to the Group’s overall strategic risk appetite.
The risk of loss, both financial and reputational, from the inherent design, management or distribution of products, or from the failure to meet or exceed customer expectations, competitor offerings or regulatory requirements
The Group is strongly committed to the fair treatment of its customers. This is embedded into the processes and risk assessment which takes place to seek to ensure businesses have developed customer centric strategies for product and business development, marketing, selling and after sales service. Businesses maintain a range of products to meet customers’ needs and the business strategy and are responsible for managing and controlling product risks and complying with applicable regulations.
The principal sources of credit risk within the Group arise from loans and advances to retail customers, financial institutions and corporate clients. The credit risk exposures of the Group are set out in note 47 to the financial statements.
• Portfolio monitoring and reporting. With Group Risk, businesses and divisions identify and define portfolios of credit and related risk exposures and the key benchmarks, behaviours and characteristics by which those portfolios are managed in terms of credit risk exposure. This entails the production and analysis of regular portfolio monitoring reports for review by Group Risk. Group Risk in turn produces an aggregated review of credit risk throughout the Group, which is presented to the group business risk committee.
• Credit principles and policy. Group Risk sets out the group credit principles according to which credit risk is managed. These form the basis of the group credit policy, which in turn is the basis for divisional and business unit credit policy. Principles and policy are reviewed regularly and any changes are subject to a review and approval process. Business unit policy includes lending guidelines which define the responsibilities of lending officers and seek to provide a disciplined and focused benchmark for credit decisions.
• Counterparty limits. Exposure to individual counterparties, groups of counterparties or customer risk segments is controlled through a tiered hierarchy of delegated sanctioning authorities. Approval requirements for each decision are based on the transaction amount, the customer’s aggregate facilities, credit risk ratings and the nature and term of the risk. Regular reports on significant credit exposures are provided to the group executive committee and board.
Lloyds TSB Group also uses a range of approaches to mitigate credit risk. In the case of individual exposures, the Group makes use of credit enhancement techniques such as netting and collateralisation, where security is provided against the exposure. The Group also undertakes asset sales, securitisations and credit derivative-based approaches as appropriate for the nature of the assets and market conditions.
Where it is efficient and likely to be effective (generally with counterparties with which it undertakes a significant volume of transactions), the Group enters into master netting arrangements. Although master netting arrangements do not generally result in an offset of balance sheet assets and liabilities, as transactions are usually settled on a gross basis, they do reduce the credit risk to the extent that if an event of default occurs, all amounts with the counterparty are terminated and settled on a net basis. The Group’s overall exposure to credit risk on derivative instruments subject to master netting arrangements can change substantially within a short period since it is affected by each transaction subject to the arrangement.
This statement of the Group’s overall appetite for market risk is reviewed and approved annually by the board. The group chief executive allocates this risk appetite across the Group. Individual members of the group executive committee ensure that market risk appetite is further delegated to an appropriate level within their areas of responsibility.
Insurance risk appetite is defined as the quantum and composition of insurance risk that exists currently in the Group and the direction in which the Group wishes to manage this.
Persistency rates of life assurance policies, which relate to the rate of policy termination and the rate at which policies cease to pay regular premiums, are regularly assessed by reference to appropriate risk factors.
The Group’s policy is to maintain strong corporate governance arrangements, as it believes this is consistent with the Group’s objective of maximising shareholder value over time. This includes the means by which risks are effectively managed in order to enable successful implementation of the Group’s strategy. The Group’s high level governance arrangements are described on pages 49 to 51. These arrangements reflect the Group’s policy which is that the board adheres to the principles contained in the Combined Code on corporate governance, issued by the Financial Reporting Council, when determining and reviewing its governance arrangements. The directors review the application of the principles and provisions of the Code annually.
The group compliance director and the group chief legal adviser have access to the chairman and group chief executive.
The Group is committed to the fair treatment of its customers. It is an essential part of the way the Group conducts its business and develops deep long-lasting relationships with its customers. A range of management information measures is in place across the Group to support the tracking of key customer treatment indicators. Group Risk and Group Audit are required to report regularly on customer treatment risk, management information trends and on compliance with the Group’s standards.
All advertising and marketing material is required to comply with the Group’s governing policy on business conduct. Businesses are required to have procedures in place to seek to ensure that the material is clear, fair and not misleading bearing in mind the knowledge and sophistication of the customer. Any statement of fact should be substantiated through documentary evidence; any comparison should be made in a fair and balanced way; and any reference to past performance should clearly state the basis of measurement.
The risk of reductions in earnings and/or value, through financial or reputational loss, resulting from frauds carried out against the Group, and/or theft of the Group’s assets, and other criminal acts.
The Chief Security Office establishes policy for the security of the people, premises and assets, including identifying and developing countermeasures to minimise the impact of physical threats to the Group. Business unit management seek to ensure that the level of security risk applicable to each site they occupy is assessed, and that the appropriate security countermeasures are determined in order to protect people, premises and assets.
Liquidity risk is defined as the risk that the Group will be unable to meet its financial obligations as they fall due. These obligations include the repayment of deposits on demand or at their contractual maturity; the repayment of loan capital and other borrowings as they mature; the payment of insurance policy benefits, claims and surrenders; the payment of lease obligations as they become due; the payment of operating expenses and taxation; the payment of dividends to shareholders; the ability to fund new and existing loan commitments; and the ability to take advantage of new business opportunities.
The principal financial soundness risk uncertainties relate to liquidity and capital adequacy and each of these sources of risk is described in more detail below.
The ratings outlook from Moody’s, Standard & Poor’s and Fitch for Lloyds TSB Bank is stable. These credit ratings are not a recommendation to buy, hold or sell any security; and each rating should be evaluated independently of every other rating.
Statutory basis. Assets are generally valued on a basis consistent with that used for accounting purposes (with the exception that, in certain cases, the value attributed to assets is limited) and which follows a market value approach where possible. The liabilities are calculated using a projection of future cash flows after making prudent assumptions about matters such as investment return, expenses and mortality. Discount rates used to value the liabilities are set with reference to the risk adjusted yields on the underlying assets in accordance with the FSA rules. Other assumptions are based on recent actual experience, supplemented by industry information where appropriate. The assessment of liabilities does not include future bonuses for with-profits policies that are at the discretion of the Company, but does include a value for policyholder options likely to be exercised.
For Scottish Widows, no amount is required to cover the impact of stress tests on the actuarial reserves. However, a further test is required in respect of the With Profit Fund which compares the level of ‘realistic excess capital’ to the ‘statutory excess capital’ of the With Profit Fund. In circumstances where the ‘realistic excess capital’ position is less than ‘statutory excess capital’, the Company is required to hold additional capital to cover the shortfall but only to the extent it exceeds the value, calculated in a prescribed way, of internal transfers from the With Profit Fund. Any additional capital requirement under this test is referred to as the With Profit Insurance Capital Component. The ‘realistic excess capital’ is calculated as the difference between realistic assets and realistic liabilities of the With Profit Fund with a further deduction to cover various stress tests.
Requirement to maintain a Support Account: The Scheme requires the maintenance of a ‘Support Account’ within the Non-Participating Fund. The quantum of the Support Account is calculated with reference to the value of assets backing current with-profits policies which also existed at the date of demutualisation and must be maintained until the value of these assets reaches a minimum level. Assets can only be transferred from the Non-Participating Fund if the value of the remaining assets in the fund exceeds the value of the Support Account. Scottish Widows has obtained from the FSA permission to include the value of the Support Account in assessing the realistic value of assets available to the With Profit Fund. At 31 December 2006, the estimated value of surplus admissible assets in the Non-Participating Fund was £2,208 million (31 December 2005: £2,163 million) and the estimated value of the Support Account was £964 million (31 December 2005: £1,115 million).
(in accordance Other long- Total life with FRS 27) term funds business £m £m £m
As at 31 December 2005 With Profit Fund liabilities 18,720 133 18,853 Unit-linked business (excluding that accounted for as investment contracts) – 10,779 10,779 Other life assurance business – 10,324 10,324
Assets held in excess of those backing actuarial reserves are invested across a range of investment categories including fixed interest securities, equities, properties and cash. The mix of investments is determined in line with the policy of Lloyds TSB Group to optimise shareholder risk and return. The value of the investments is sensitive to prevailing conditions in the markets selected.
As noted above, under the realistic capital regime of the FSA, the liabilities of the With Profit Fund are valued using a market-consistent stochastic simulation model. This model is used in order to place a value on the options and guarantees which captures both their intrinsic value and their time value.
In both Abbey Life and Scottish Widows, certain personal pension policyholders, for whom reinstatement to their occupational pension scheme was not an option, have been given a guarantee that their pension and other benefits will correspond in value to the benefits of the relevant occupational pension scheme. The key assumptions affecting the ultimate value of the guarantee are future salary growth, gilt yields at retirement, annuitant mortality at retirement, marital status at retirement and future investment returns. There is currently a provision, calculated on a deterministic basis, of £98 million (31 December 2005: £108 million) in respect of those guarantees. If future salary growth were 0.5 per cent per annum greater than assumed, the liability would increase by some £6 million. If yields were 0.5 per cent lower than assumed, the liability would increase by some £17 million.
Five year financial summary 1 Annual dividends comprise both interim and estimated final dividend payments. Under IFRS, the total dividend for the year represents the interim dividend paid during the year and the final dividend which will be paid and accounted for during the following year. Under UK GAAP, final dividends are included in the year to which they relate rather than in the year in which they are paid.
Income statement data for the year ended 31 December (£m) Total income, net of insurance claims 11,104 10,540 9,661 9,343 9,672 8,658
Profit for the year attributable to equity shareholders 2,803 2,493 2,392 2,421 3,254 1,790 Total dividend for the year1 1,927 1,915 1,914 1,914 1,911 1,908 31 December 31 December 1 January 31 December 31 December 31 December
Share information Basic earnings per ordinary share 49.9p 44.6p 42.8p 43.3p 58.3p 32.1p Diluted earnings per ordinary share 49.5p 44.2p 42.5p 43.0p 58.1p 32.0p Total dividend per ordinary share1 34.2p 34.2p 34.2p 34.2p 34.2p 34.2p Market price (year-end) 571.5p 488.5p 473p 473p 448p 446p
Sir Victor Blank ��†++ Chairman Joined the board in March 2006 as deputy chairman and became chairman in May 2006. Former partner in Clifford-Turner (now Clifford Chance) from 1969 to 1981 and chairman and chief executive of Charterhouse until 1997. Director of The Royal Bank of Scotland from 1985 to 1993 and of GUS from 1993 to 2006 (chairman from 2000). Chairman of Trinity Mirror from 1999 to 2006. A member of the Financial Reporting Council and of the Council of Oxford University. Chairs two charities, WellBeing of Women and UJS Hillel, as well as the Council of University College School. Aged 64.
Joined the board in 2003. Joined Procter and Gamble in 1967 and held a number of senior and general management appointments in Europe, South America and North America, before retiring in 2001. A non-executive director of Cadbury Schweppes, GfK AG and Telekom Austria. Board member of the Institute for the Future. Aged 64.
Chairman of BUPA and Intrinsic Financial Services and a non-executive director of Paternoster and United Business Media. Former chairman of the National Employment Panel. Aged 59.
Michael E Fairey Deputy Group Chief Executive Joined TSB Group in 1991 and held a number of senior and general management appointments before being appointed to the board in 1997 and deputy group chief executive in 1998. Joined Barclays Bank in 1967 and held a number of senior and general management appointments, including managing director of Barclays Direct Lending Services from 1990 to 1991. President of The British Quality Foundation. Aged 58.
Results and dividends The consolidated income statement on page 63 shows a profit attributable to equity shareholders for the year ended 31 December 2006 of £2,803 million.
Directors Biographical details of directors are shown on pages 46 and 47. Particulars of their emoluments and interests in shares in the Company are given on pages 52 to 61.
Donations The income statement includes a charge for charitable donations totalling £37,335,000 (2005: £34,870,000), including £37,133,000 (2005: £34,450,000) under deeds of covenant to the four Lloyds TSB Foundations, which will be paid during 2007.
The board meets at least nine times a year. It has a programme designed to enable the directors regularly to review corporate strategy and the operations and results of the businesses and discharge their duties within a framework of prudent and effective controls relating to the assessing and managing of risk.
The remuneration committee reviewed the performance of the chairman, the group chief executive and the other group executive directors, when considering their remuneration arrangements. The nomination committee reviewed the performance of all the directors. Like all board committees, the nomination committee and remuneration committee report to the board on their deliberations, including the results of these performance evaluations.
The audit committee comprises Mr Brown (chairman), Mr du Plessis, Mr Gemmell and Lord Leitch. The committee’s terms of reference are available from the company secretary and are displayed on the Company’s website www.lloydstsb.com.
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.
The nomination committee, comprising Sir Victor Blank (chairman), Dr Berndt, Mr du Plessis, Sir Julian Horn-Smith and Lord Leitch, reviews the structure, size and composition of the board, taking into account the skills, knowledge and experience of directors and considers and makes recommendations to the board on potential candidates for appointment as directors. The committee also makes recommendations to the board concerning the re-appointment of any independent non-executive director by the board at the conclusion of his or her specified term; the re-election of any director by the shareholders under the retirement provisions of the articles of association; any matters relating to the continuation in office of a director of the company; and the appointment of any director to executive or other office in the company, although the chairman of the company would not chair the committee when it was dealing with the appointment of a successor to the chairmanship of the company.
The risk oversight committee comprises Sir Victor Blank (chairman), Mr Brown, Sir Julian Horn-Smith and Lord Leitch. All non-executive directors are also invited to attend meetings if they wish. The risk oversight committee’s duties include overseeing the development, implementation and maintenance of the Group’s overall risk management framework and its risk appetite, strategy, principles and policies, to ensure they are in line with emerging regulatory, corporate governance and industry best practice. The committee also oversees the Group’s risk exposures; facilitates the involvement of non-executive directors in risk issues and aids their understanding of these issues; oversees adherence to group risk policies and standards and considers any material amendments to them; and reviews the work of the group risk division.
The attendance of directors at board meetings and at meetings of the audit, nomination, remuneration and risk oversight committees during 2006 was as follows: Audit Nomination Remuneration Risk oversight Board committee committee committee committee
Company law requires the directors to prepare financial statements for each financial year. Under that law the directors have prepared the consolidated and parent company financial statements in accordance with International Financial Reporting Standards (IFRSs) as adopted by the European Union. The financial statements are required by law to give a true and fair view of the state of affairs of the Company and the Group and of the profit or loss of the Group for that period. The directors consider that in preparing the financial statements on pages 63 to 127, the Company and the Group have used appropriate accounting polices, consistently applied and supported by reasonable and prudent judgements and estimates, and that all accounting standards which they consider applicable have been followed.
3 Left the nomination committee on 1 August 2006. 4 Appointed to the nomination committee from 1 August 2006 and risk oversight committee from 1 March 2006. 5 Left the board on 31 October 2006. 6 Left the board on 11 May 2006.
Advisers to the committee Towers Perrin and Kepler Associates were engaged by the committee to advise on matters relating to executive remuneration. Towers Perrin also provides the management of the Group with competitive market data relating to other employees.
• Basic salaries positioned to reflect the relevant market median and total direct compensation (basic salary, annual incentives and the value of long-term incentives) designed to enable upper quartile performance to be rewarded with upper quartile remuneration levels.
The fees of the independent non-executive directors are agreed by the board within a total amount determined by the shareholders. Directors may also receive fees, agreed by the board, for membership of board committees. The fees are designed to recognise the various responsibilities of a non-executive director’s role and to attract individuals with relevant skills, knowledge and experience. The fees are neither performance related nor pensionable and are comparable with those paid by other companies. The annual fees from 1 January 2007 are listed below with the figures applicable since the previous review in April 2005 in brackets.
Following the adoption of the new long-term incentive plan, and the discontinuation of the performance share plan, awards under the annual incentive scheme are made in cash only.
PricewaterhouseCoopers LLP check the calculation of the annual incentive payments for executive directors based on the achievement of performance against targets set. In respect of performance in 2006, the bonus percentages awarded to the directors are shown in the table below: Name J E Daniels M E Fairey T A Dial A G Kane G T Tate H A Weir
These payments reflect the significant progress made by the Group against its key performance indicators. Both the profit before tax and economic profit exceeded the amounts required for payment of the maximum award relating to corporate performance. The tables on pages i and ii demonstrate the considerable progress made by the Group and each division.
EPS is the Group’s normalised earnings per ordinary share as shown in the Group’s report and accounts, adjusted if necessary for consistency.
Mr Tate is a member of a defined contribution scheme. During the year to 31 December 2006, the employer has made contributions to the defined contribution scheme in respect of him totalling £79,825.
Columns (a) and (b) represent the deferred pension to which the directors would have been entitled had they left the Group on 31 December 2006 and 2005, respectively (ignoring the two-year requirement to qualify for a deferred pension).
Column (c) is the transfer value of the deferred pension in column (a) calculated as at 31 December 2006 based on factors supplied by the actuary of the relevant Lloyds TSB Group pension scheme in accordance with actuarial guidance note GN11. The underlying bases used to arrive at the factors have not changed during the year.
None of the other directors at 31 December 2006 had options to acquire shares in Lloyds TSB Group plc or its subsidiaries.
March 2002 – August 2004 That the Company’s ranking based on TSR over the relevant period against a comparator group (17 UK and international financial services companies including Lloyds TSB) must be at least ninth, when 14 per cent of the option will be exercisable. If the Company is ranked first in the group, then 100 per cent of the option will be exercisable and if ranked tenth or below the performance condition is not met. At the end of 2006 Lloyds TSB Group was ranked: 17th after four years of the performance period for options granted in 2003; and 10th after three years of the performance period for options granted in 2004.
At Awarded At 1 January during the 31 December Year of 2006 year 2006 vesting
May 2006 For 50 per cent of the award (the ‘EPS Award’) - the percentage increase in EPS of the Group (on a compound annualised basis) over the relevant period must be at least an average of 6 percentage points per annum greater than the percentage increase (if any) in the retail price index over the same period. If it is less than 3 per cent per annum the EPS Award will lapse. If the increase is more than 3 but less than 6 per cent per annum then the proportion of shares released will be on a straight line basis between 17.5 per cent and 100 per cent.
We have reported separately on the parent company financial statements of Lloyds TSB Group plc for the year ended 31 December 2006 and on the information in the directors’ remuneration report that is described as having been audited.
We review whether the corporate governance statement reflects the Company’s compliance with the nine provisions of the Combined Code (2003) specified for our review by the Listing Rules of the Financial Services Authority, and we report if it does not. We are not required to consider whether the board’s statements on internal control cover all risks and controls, or form an opinion on the effectiveness of the Group’s corporate governance procedures or its risk and control procedures.
• the information given in the directors’ report is consistent with the consolidated financial statements.
Net income recognised directly in equity – 12 24 36 – 36 Profit for the year – – 2,493 2,493 62 2,555
Purchase/sale of treasury shares – – 18 18 – 18 Employee share option schemes: – value of employee services – – 47 47 – 47 – proceeds from shares issued 26 – – 26 – 26 Capital invested by minority shareholders – – – – 329 329
Net income recognised directly in equity – (28) (31) (59) (4) (63) Profit for the year – – 2,803 2,803 104 2,907
(ii) Amendment to IAS 39 ‘Financial Instruments: Recognition and Measurement – The Fair Value Option’. This amendment, which was effective from 1 January 2006, changed the criteria for financial assets to be designated at fair value through profit or loss and permitted financial liabilities meeting certain criteria to be designated at fair value for the first time. The adoption of these requirements had no effect upon the classification or valuation of those financial assets that were designated at fair value through profit or loss prior to 1 January 2006; at 31 December 2006, £1.2 billion of financial liabilities had been designated at inception into this category during the year. This change has had no material effect upon the Group’s income statement.
Details of those IFRS pronouncements which will be relevant to the Group but which were not effective at 31 December 2006 and which have not been applied in preparing these financial statements are given in note 50.
Goodwill represents the excess of the cost of an acquisition over the fair value of the Group’s share of the identifiable net assets of the acquired entity at the date of acquisition. Goodwill is recognised as an asset at cost and is tested at least annually for impairment. If an impairment is identified the carrying value of the goodwill is written down immediately through the income statement and is not subsequently reversed. At the date of disposal of a Group undertaking, the carrying value of attributable goodwill is included in the calculation of the profit or loss on disposal except where it has been written off directly to reserves in the past.
Other intangible assets comprise capitalised software enhancements and customer lists. Capitalised software enhancements are amortised over periods not exceeding five years, being their estimated useful lives, using the straight-line method. Customer lists are amortised over periods not exceeding 15 years, being their estimated useful lives, in line with the income expected to arise from those customers and are subject to annual reassessment. All other intangible assets are reviewed for impairment whenever events or any changes in circumstances indicate that the carrying amount may not be recoverable. In the event that an asset’s carrying amount is determined to be greater than its recoverable amount, it is written down immediately.
Securities borrowed are not recognised in the financial statements, unless these are sold to third parties, in which case the obligation to return them is recorded at fair value as a trading liability.
The method of recognising the movements in the fair value of the derivatives depends on whether they are designated as hedging instruments and, if so, the nature of the item being hedged. Derivatives may only be designated as hedges provided certain strict criteria are met. At the inception of a hedge its terms must be clearly documented and there must be an expectation that the derivative will be highly effective in offsetting changes in the fair value or cash flow of the hedged risk. The effectiveness of the hedging relationship must be tested throughout its life and if at any point it is concluded that it is no longer highly effective in achieving its objective the hedge relationship is terminated.
The Group designates certain derivatives as either: (1) hedges of the fair value of the interest rate risk inherent in recognised assets or liabilities (fair value hedges); (2) hedges of highly probable future cash flows attributable to recognised assets or liabilities (cash flow hedges); or (3) hedges of net investments in foreign operations (net investment hedges). These are accounted for as follows: Notes to the group accounts
Borrowings are recognised initially at fair value, being their issue proceeds net of transaction costs incurred. Borrowings are subsequently stated at amortised cost using the effective interest method.
The Group operates a number of post-retirement benefit schemes for its employees including both defined benefit and defined contribution pension plans. A defined benefit scheme is a pension plan that defines an amount of pension benefit that an employee will receive on retirement, dependent on one or more factors such as age, years of service and salary. A defined contribution plan is a pension plan into which the Group pays fixed contributions; there is no legal or constructive obligation to pay further contributions.
Allocated premiums in respect of unit-linked contracts that are either insurance or participating investment contracts are recognised as liabilities. These liabilities are increased or reduced by the change in the unit prices and are reduced by policy administration fees, mortality and surrender charges and any withdrawals. The mortality charges deducted in each period from the policyholders as a group are considered adequate to cover the expected total death benefit claims in excess of the contract account balances in each period and hence no additional liability is established for these claims. Revenue consists of fees deducted for mortality, policy administration and surrender charges. Interest or changes in the unit prices credited to the account balances and excess benefit claims in excess of the account balances incurred in the period are charged as expenses in the income statement.
Any amounts in the With Profit Fund not yet determined as being due to policyholders are recognised as an unallocated surplus which is shown separately from other liabilities.
The underwriting business makes provision for 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.
Provisions are recognised in respect of present obligations arising from past events where it is probable that outflows of resources will be required to settle the obligations and they can be reliably estimated.
The Group regularly reviews its loan portfolios to assess for impairment. Impairment provisions are established to recognise incurred impairment losses in its loan portfolios carried at amortised cost. In determining whether an impairment has occurred at the balance sheet date the Group considers whether there is any observable data indicating that there has been a measurable decrease in the estimated future cash flows or their timings; such observable data includes whether there has been an adverse change in the payment status of borrowers or changes in economic conditions that correlate with defaults on loan repayment obligations. Where this is the case, the impairment loss is the difference between the carrying value of the loan and the present value of the estimated future cash flows discounted at the loan’s original effective interest rate.
The cost of the benefits payable by the schemes will also depend upon the longevity of the members. Assumptions are made regarding the expected lifetime of scheme members based upon recent experience, however given the rates of advance in medical science and increasing levels of obesity, it is uncertain whether they will ultimately reflect actual experience. An increase of one year in the expected lifetime of scheme members would increase the overall deficit by approximately £459 million and the annual cost by approximately £30 million; a reduction of one year would reduce the overall deficit by approximately £460 million and the annual cost by approximately £30 million.
The size of the overall deficit is also sensitive to changes in the discount rate, which is affected by market conditions and therefore potentially subject to significant variations. At 31 December 2006 the discount rate used was 5.1 per cent (2005: 4.8 per cent); a reduction of 0.2 per cent would increase the overall deficit by approximately £592 million and the annual cost by approximately £14 million, while an increase of 0.2 per cent would reduce the net deficit by approximately £570 million and the annual cost by approximately £13 million.
The Group carries in its balance sheet an asset representing the value of in-force business in respect of life insurance and participating investment contracts of £2,723 million at 31 December 2006 (2005: £2,922 million). This asset, which is presented gross of attributable tax, represents the present value of future profits expected to arise from the portfolio of in-force life insurance and participating investment contracts. To arrive at this value it is necessary for management to make assumptions about the future experience of the insurance portfolios which will be affected by factors such as stock market levels, rates of interest and price inflation, future mortality rates and future persistency rates. These factors are inherently uncertain. If actual experience differs from that assumed this could significantly affect the value attributed. The process for determining the key assumptions that have been made at 31 December 2006 is detailed in note 23.
Interest receivable: Available-for-sale financial assets 4.39 3.58 807 508 Loans and advances to customers 6.24 6.41 10,909 10,095 Loans and advances to banks 4.72 3.59 1,826 1,199 Lease and hire purchase receivables 7.42 7.07 774 787
Fee and commission income: Current accounts 652 593 Insurance broking 629 681 Credit and debit card fees 493 545 Other 1,342 1,171 3,116 2,990 Fee and commission expense: Credit and debit card fees (138) (182) Dealer commissions (217) (247)
Included within securities and other gains are net gains of £5,256 million (2005: £8,543 million) arising on assets held at fair value through profit or loss and net gains of £21 million (2005: £nil) arising on liabilities held at fair value through profit or loss.
Non-life insurance gross written premiums can be further analysed as follows: 2006 2005 £m £m
Life insurance gross claims can also be analysed as follows: Deaths 286 298 Maturities 1,385 1,197 Surrenders 3,081 2,204 Annuities 558 528 Other 65 52
The charge for tax on the profit for the year is based on a UK corporation tax rate of 30 per cent (2005: 30 per cent).
The Group, as a proxy for policyholders in the UK, is required to record taxes on investment income and gains each year. Accordingly, the tax attributable to UK life insurance policyholder earnings is included in income tax expense. The tax expense attributable to policyholder earnings was £222 million (2005: £298 million), including a prior year tax charge of £12 million (2005: tax credit of £25 million).
A reconciliation of the charge that would result from applying the standard UK corporation tax rate to profit before tax to the tax charge for the year is given below: £m £m
For the calculation of diluted earnings per share the weighted average number of ordinary shares in issue is adjusted to assume conversion of all dilutive potential ordinary shares. The Company has dilutive potential ordinary shares in respect of share options and awards granted to employees. The number of shares that could have been acquired at market price (determined as the average annual share price of the Company’s shares) based on the monetary value of the subscription rights attached to outstanding share options and awards is determined; the residual bonus shares are added to the weighted average number of ordinary shares in issue, but no adjustment is made to the profit attributable to equity shareholders. 2006 2005
Other asset backed securities 595 861 – 691 Corporate and other debt securities 4,146 13,170 4,667 8,469
Equity shares: The maximum exposure to credit risk at 31 December 2006 of the loans and advances to banks and customers designated at fair value through profit or loss was £451 million (31 December 2005: £450 million); the Group does not hold any credit derivatives or other instruments in mitigation of this risk. There was no significant movement in the fair value of these loans attributable to changes in credit risk; this is determined by reference to the publicly available credit ratings of the instruments involved.
The principal derivatives used by the Group are interest rate and exchange rate contracts; particular attention is paid to the liquidity of the markets and products in which the Group trades to ensure that there are no undue concentrations of activity and risk.
Interest rate contracts: Interest rate swaps 331,852 2,980 3,149 Forward rate agreements 40,876 17 18 Options purchased 17,034 68 – Options written 12,588 – 63
Unearned future finance income on finance leases (2,945) (2,954) Rentals received in advance (163) (200) Commitments for expenditure in respect of equipment to be leased (443) (117)
The net investment in finance leases represents amounts recoverable as follows: 2006 2005 £m £m
Equipment leased to customers under finance leases primarily relates to structured financing transactions to fund the purchase of aircraft, ships and other large individual value items. The allowance for uncollectable finance lease receivables included in the allowance for impairment losses is £7 million (2005: £4 million). The unguaranteed residual values included in finance lease receivables were as follows: Not later than 1 year – – Later than 1 year and not later than 5 years – 31 Later than 5 years 168 245
Amortisation of premiums and discounts 22 – 22 Changes in fair value (note 41) (10) – (10)
Changes in fair value (note 6) 631 430 Additions: Acquisitions of new properties 675 756 Additional expenditure on existing properties 75 51 Total additions 750 807
Risk discount rate 7.02 Return on equities 6.72 Return on fixed interest securities 4.12 Expense inflation 3.79
The principal features of the methodology and process used for determining key assumptions used in the calculation of the value of in-force business at 31 December 2006 are set out below: Economic assumptions
Future maintenance expenses, mortality, morbidity, lapse and paid-up rate assumptions are based on an analysis of past experience and represent management’s best estimate of likely future experience.
Liabilities held at fair value through profit or loss 1,156 – Trading liabilities 28 –
The Group’s With Profit Fund contains life insurance contracts and participating investment contracts. The calculation of With Profit Fund realistic liabilities uses best estimate assumptions for mortality and morbidity, persistency rates and expenses. These are calculated in a similar manner to those used for the value of in-force business as discussed in note 23. The persistency rates used for the realistic valuation of the With Profit Fund liabilities make an allowance for potential changes in future experience as the guarantees and options within with-profits contracts become more valuable under adverse market conditions.
Generally, assumptions used to value Non-Profit Fund liabilities are prudent in nature and therefore contain a margin for adverse deviation. This margin for adverse deviation is based on management’s judgement and reflects management’s views on the inherent level of uncertainty. The key assumptions used in the measurement of Non-Profit Fund liabilities are: • Interest rates
Allowance is made for future policy costs explicitly. Expenses are determined by reference to an internal analysis of current and expected future costs plus a margin for adverse deviation. Explicit allowance is made for future expense inflation.
1 This sensitivity shows the impact on the value of in-force business, financial options and guarantee costs, statutory reserves and asset values of reducing the risk-free rate by 100 basis points.
1 Lapse rates have been adjusted following a detailed review of the Group’s current and expected experience.
Increase in the year 575 – 575 Release in the year (584) – (584)
The liability of £139 million shown in the above table excludes £10 million of unallocated claims handling expenses.
32 Liabilities arising from non-participating investment contracts The movement in liabilities arising from non-participating investment contracts may be analysed as follows: Gross Reinsurance* Net £m £m £m
The expected return on scheme assets in 2007 will be calculated using the following assumptions: 2007 %
Equities 8.0 Fixed interest gilts 4.6 Index linked gilts 4.2 Non-government bonds 5.1 Property 6.5
* Following recent changes in age discrimination legislation, the Group has ceased to augment the pension entitlement of employees taking early retirement; this change has reduced the Group’s defined benefit pension liability by £129 million (£1 million of which is unrecognised) and resulted in a one-off credit to the 2006 income statement of £128 million.
For the principal post-retirement healthcare scheme, the latest actuarial valuation of the liability was carried out at 31 December 2000; this valuation has been updated to 31 December 2006 by qualified independent actuaries. The principal assumptions used were as set out above, except that the rate of increase in healthcare premiums has been assumed at 7.02 per cent (2005: 6.81 per cent).
Accelerated capital allowances 175 59 Pensions and other post-retirement benefits 134 44 Investment reserve 59 – Allowances for impairment losses 22 23 Unrealised gains 162 279 Tax on value of in-force business (59) 64 Other temporary differences 81 22
Deferred tax liabilities have not been recognised for tax that may be payable if earnings of certain subsidiaries were remitted to the UK. Such amounts are either reinvested for the foreseeable future or can be remitted free of tax. Unremitted earnings totalled £689 million (2005: £609 million).
Future transfers from Scottish Widows plc’s long-term business funds to its Shareholder Fund will be subject to a shareholder tax charge. Under IAS 12, no provision is required to be made to the extent that the timing of such transfers is under Scottish Widows plc’s control. Accordingly, deferred tax liabilities of £110 million (2005: £110 million) have not been recognised.
US dollars US$m US$m 160 million Preference shares of US$25 cents each 40 40
Japanese yen ¥m ¥m 50 million Preference shares of ¥25 each 1,250 1,250 a) These securities were issued during 2006 primarily to finance the development and expansion of the business of the Group. Any repayment of preference shares would require prior notification to the Financial Services Authority. The sterling preference shares can be redeemed at the option of the Company on 25 August 2015 or quarterly thereafter; at this call date, dividends will be reset at a margin of 1.28 per cent over 3 month LIBOR. The US dollar preference shares can be redeemed at the option of the Company on 14 November 2016 or every 10 years thereafter; at this call date, dividends will be reset at a margin of 1.035 per cent over 3 month LIBOR. In certain circumstances, the shares may be mandatorily exchanged for qualifying non-innovative tier 1 securities. The Company may declare no dividend or a partial dividend on these preference shares. Dividends may be reduced if the distributable profits of the Company are insufficient to cover the payment in full of the dividends and also the payment in full of all other dividends on shares issued by the Company.
b) In certain circumstances, these notes, bonds and securities would acquire the characteristics of preference share capital. Any repayments of undated loan capital would require prior notification to the Financial Services Authority. They are accounted for as liabilities since coupon payments are mandatory as a consequence of the terms of certain preference shares.
c) These notes bear interest at rates fixed periodically in advance based on London Interbank rates.
e) In certain circumstances the interest payments on these securities can be deferred although in this case neither Lloyds TSB Bank plc nor Lloyds TSB Group plc can declare or pay a dividend until payments are resumed. Any deferred payments will be made good on redemption of the securities. The securities can be redeemed at par at the option of Lloyds TSB Bank plc on or after 22 November 2007.
m) Throughout 2005 and 2006, the Company has had in issue 400 6 per cent non-cumulative preference shares of 25p each. The shares, which are redeemable at the option of the Company at any time, carry the rights to a fixed rate non-cumulative preferential dividend of 6 per cent per annum; no dividend shall be payable in the event that the directors determine that prudent capital ratios would not be maintained if the dividend were paid. Upon winding up, the shares rank equally with any other preference shares issued by the Company.
Issued and fully paid ordinary shares 2006 2005 Number Number 2006 2005 of shares of shares £m £m
Cash flow hedging reserve At 1 January 11 – Change in fair value of hedging derivatives – 4 Deferred tax – (1)
At 1 January 7,222 6,554 Currency translation differences (see analysis below) (31) 24 Profit for the year 2,803 2,493 Dividends (1,919) (1,914) Purchase/sale of treasury shares (35) 18 Employee share option schemes – value of employee services 65 47
Final dividend for previous year paid during the current year 23.5 23.5 1,316 1,315
Executive and SAYE schemes: Options granted in the year 6 4 Options granted in prior years 25 27
Share incentive plan: Shares granted in the year 12 24 Shares granted in prior years 15 21
During the year ended 31 December 2006 the Group operated the following share based payment schemes, all of which are equity settled.
The Executive share option schemes were long-term incentive schemes available to certain senior executives of the Group, with grants usually made annually. Options were granted within limits set by the rules of the schemes relating to the number of shares under option and the price payable on the exercise of options. The last grant of executive options was made in March 2005. These options were granted without a performance multiplier and the maximum limit for the grant of options in normal circumstances was three times annual salary. Between April 2001 and August 2004, the aggregate value of the award based upon the market price at the date of grant could not exceed four times the executive’s annual remuneration and, normally, the limit for the grant of options to an executive in any one year would be equal to 1.5 times annual salary with a maximum performance multiplier of 3.5. Prior to 18 April 2001, the normal limit was equal to one year’s remuneration and no performance multiplier was applied.
Under the performance share plan, introduced during 2005, participating executives will be eligible for an award of free shares, known as performance shares, to match the bonus shares awarded as part of their 2004 and 2005 bonus. The maximum match will be two performance shares for each bonus share, awarded at the end of a three year period. The actual number of shares awarded will depend on the Group’s total shareholder return performance measured over a three year period, compared to other companies in the comparator group. The maximum of two performance shares for each bonus share will be awarded only if the Group’s total shareholder return performance places it first in the comparator group; one performance share for each bonus share will be granted if the Group is placed fifth; and one performance share for every two bonus shares if the Group is placed eighth (median). Between first and fifth, and fifth and eighth, sliding scales will apply. If the total shareholder return performance is below median, no performance shares will be awarded. There will be no retest. Whilst income tax is deducted from the bonus before deferral into the plan, where a match of performance shares is justified, these shares will be awarded as if income tax had not been deducted.
The fair value of the matching element of the performance shares awarded during 2006 was £1.92 (2005: £1.78).
The weighted average fair value of options granted during the year was £nil (2005: £0.67) for executive options and £1.00 (2005: £0.98) for SAYE options. The values for executive options have been determined using a binomial model that uses a stochastic projection model to determine the effect of the market based conditions. The values for the SAYE options have been determined using a standard Black-Scholes model. The fair value calculations are based on the following assumptions: Notes to the group accounts
Notes to the group accounts 44 Share based payments (continued) Other option Other share
Risk-free interest rate 4.44% 4.55% 4.79% Expected life 3.5 years 2.9 years 3.0 years
The number of shares awarded relating to free shares in 2006 was 7,725,195 (2005: 8,748,521), with an average fair value of £5.28 (2005: £4.57), based on the market price at the date of award.
The table below details, on an aggregated basis, key management personnel compensation: 2006 2005 £m £m
Acceptances and endorsements arise where the Lloyds TSB Group agrees to guarantee payment on a negotiable instrument drawn up by a customer.
Performance bonds and other transaction-related contingencies (which include bid or tender bonds, advance payment guarantees, VAT Customs & Excise bonds and standby letters of credit relating to a particular contract or non-financial transaction) are undertakings where the requirement to make payment under the guarantee depends on the outcome of a future event.
Where the guarantees are issued on behalf of customers, Lloyds TSB Group usually holds collateral against the exposure or has a right of recourse to the customer.
Contingent liabilities Acceptances and endorsements 63 35 Guarantees –* 9,373 Other: Other items serving as direct credit substitutes 618 550 Performance bonds and other transaction-related contingencies 2,096 1,737
* As indicated in note 1, since 1 January 2006 all of the Group’s financial guarantee contracts have been accounted for as financial instruments and measured at fair value on the Group’s balance sheet.
Not later than 1 year 212 216 Later than 1 year and not later than 5 years 733 784 Later than 5 years 835 1,016
Excluding commitments in respect of investment property (see note 21), capital expenditure contracted but not provided for at 31 December 2006 amounted to £75 million (2005: £223 million). Of this amount, £74 million (2005: £215 million) related to assets to be leased to customers under operating leases. The Group’s management is confident that future net revenues and funding will be sufficient to cover these commitments.
The Group accepts deposits from and makes loans to commercial and retail customers at both fixed and floating rates and for various periods. Such exposures to customers involve both on-balance sheet loans and advances and guarantees and other commitments such as letters of credit and irrevocable commitments.
The interest rate risk arising from the Group’s retail banking activities is managed centrally, in part by the use of internal interest rate swaps. For accounting purposes IAS 39 does not permit the use of internal derivatives in hedge relationships and, although economically the position is hedged, this leads to volatility in the income statement. In response to this the Group has created a function the purpose of which is to establish accounting hedge relationships in order to reduce the volatility arising in the income statement.
Liabilities arising from insurance and investment contracts – – – – – 66,498 66,498 treated as non-interest bearing.
Functional currency of Group operations: US dollar 97 102 Swiss franc 70 56 Other non-sterling 188 183
222,531 200,185 Available-for-sale debt securities and treasury bills 19,163 14,894 Contingent liabilities 2,777 11,695 Financial guarantees 8,139 – Undrawn irrevocable formal standby facilities, credit lines and other commitments to lend2 51,288 43,094 Derivative assets, before netting 5,565 5,878 Amounts available for offset under master netting arrangements1 (2,761) (3,235)
Loans and advances to banks 22,491 1,349 1,539 9,807 5,452 40,638 Loans and advances to customers 28,099 8,223 10,716 40,633 100,614 188,285 Available-for-sale financial assets 652 1,301 3,446 6,919 6,860 19,178
Listed securities are valued at current bid prices. Unlisted securities and other financial assets are valued based on discounted cash flows, market prices of similar instruments and other appropriate valuation techniques.
Loans and advances to banks 40,638 31,655 40,641 31,691 Loans and advances to customers 188,285 174,944 187,977 175,554 Available-for-sale financial assets 19,178 14,940 19,178 14,940
Change in deposits from banks 5,222 (8,168) Change in customer accounts 8,523 4,619 Change in debt securities in issue 15,068 10,280 Change in derivative financial instruments, trading and other liabilities at fair value through profit or loss 556 (3,937) Change in investment contract liabilities 3,795 6,094 Change in other operating liabilities (95) 1,151
(d) Analysis of cash and cash equivalents as shown in the balance sheet 2006 2005 £m £m
Cash and balances with central banks 1,898 1,156 Less: mandatory reserve deposits1 (300) (288)
Net cash outflow from acquisitions in the year* 16 16 Payments to former members of Scottish Widows Fund and Life Assurance Society acquired during 2000 4 11
1 Mandatory reserve deposits are held with local central banks in accordance with statutory requirements; these deposits are not available to finance the Group’s day-to-day operations.
Net cash outflow from disposals in the year – – Consideration for 2005 disposal settled in cash 936 – Adjustment to consideration received in respect of prior period disposals – (4)
The consolidated financial statements were approved by the directors of Lloyds TSB Group plc on 22 February 2007.
Profit before tax 1,893 1,882 Dividend income (1,918) (1,913) Fair value adjustment 3 9 Change in other assets (44) (72) Change in other liabilities 156 (44) Tax received 46 12
These comprise short-term lending to subsidiaries, repayable on demand. The fair values of amounts owed by subsidiaries are equal to their carrying amounts. No provisions have been recognised in respect of amounts owed by subsidiaries.
The key management personnel of the Group and parent company are the same. The relevant disclosures are given in note 45 to the consolidated financial statements.
Internet and telephone dealing services are available between 8.00am and 4.30pm, Monday to Friday.
Details of any dealing costs are available when you log on to shareview or when you call one of the above numbers. They are also available on www.lloydstsb.com/investorrelations
American Depositary Receipts (‘ADRs’) Lloyds TSB shares are traded in the USA through an NYSE-listed sponsored ADR facility, with The Bank of New York as the depositary. The ADRs are traded on the New York Stock Exchange under the symbol LYG. The CUSIP number is 539439109 and the ratio of ADRs to ordinary shares is 1:4.
Corporate responsibility A copy of the Group’s corporate responsibility report may be obtained by writing to Corporate Responsibility, Lloyds TSB Group plc, 25 Gresham Street, London EC2V 7HN. This information together with the Group’s code of business conduct is also available on the Group’s website.
Shareholder enquiries The Company’s share register is maintained by Lloyds TSB Registrars, The Causeway, Worthing, West Sussex BN99 6DA. Telephone 0870 600 3990; Contact them if you have enquiries about your Lloyds TSB shareholding, including those concerning the following matters: • change of name or address