Capital management

Each UK life company must retain sufficient capital at all times to meet the regulatory capital requirements mandated by the FSA. These measures are also consolidated under the European Insurance Groups Directive (IGD) to calculate regulatory capital adequacy at an aggregate group level.

The IGD is the Group’s primary capital and solvency measure. The Group’s IGD assessment is made at the highest EEA level insurance group holding company, which is Phoenix Life Holdings Limited, where we have a regulatory obligation to have a positive position at all times.

IGD surplus

The estimated IGD surplus has increased by £0.1 billion to £1.3 billion at 30 June 2010 compared to £1.2 billion at
31 December 2009, despite the payment of the 2009 dividend and debt financing and repayments of £0.1 billion in the first half of 2010.

The key drivers of the movement in the solvency position are:

• Capital generation items of £0.2 billion including capital benefits from the National Provident Life restructure in the first quarter of 2010 and surpluses in the non-profit funds established during the period which are available for transfer to shareholders, offset by
• Dividend payments and debt financing and repayments of £0.1 billion.

The estimated IGD surplus at 30 June 2010 represents 135 percent coverage of regulatory requirements
(31 December 2009: 132 percent), compared to an ongoing target of 125 percent. This represents headroom of
£0.4 billion (31 December 2009: £0.2 billion) over our ongoing target.

Due to the Group’s current structure, certain of the Group’s subsidiaries are only included in the IGD calculation at
75 percent of their regulatory value. If 100 percent of the value of these subsidiaries were included in the PLHL IGD calculation, the overall IGD surplus would increase by approximately £0.2 billion based on the position as at
30 June 2010.

Sensitivity analysis

As part of the Group’s internal risk management processes the estimated IGD surplus is tested against a number of financial and non-financial scenarios to ensure it remains in excess of the 125 percent target in a range of reasonably foreseeable circumstances. The results of that stress testing are provided below:

1 10 year term: AAA – 48bps, AA – 77bps, A – 108bps, BBB – 162bps

The percentage margin can increase in stress scenarios because the Group Capital Resource Requirement (“GCRR”) includes a With-profits Insurance Capital Component (“WPICC”) which is matched by Group Capital Resources (“GCR”) in the with-profit funds. In stress scenarios the WPICC typically reduces as the regulatory surplus moves closer to the realistic surplus. As the value of GCR falls in stress scenarios, it is broadly offset by a corresponding decrease in the WPICC within the GCRR. Although both GCR and GCRR decline by broadly the same amount the percentage margin increases purely because the GCRR component of the calculation is a lower absolute number. Conversely, as markets improve, both the WPICC in the GCR and GCRR increase, thereby reducing the percentage margin.

Solvency II

The Group has a well-established group-wide Solvency II programme and has continued to progress its development of a Solvency II compliant internal model. Development of the internal model is on track and should allow the assessment of a fully operational internal model for various funds prior to the 2012 implementation date. Our actuarial IT systems transformation project is closely linked to the development of the internal model which will be developed in two further phases for the remaining funds between now and 2013.

In July 2010, the Group completed a key milestone of internal model development, submitting the pre-application process qualifying criteria template to the FSA, indicating the Group's readiness for entry into the Solvency II internal model pre-application process. Entry into the pre-application process will be a key step in achieving approval for use of a Solvency II internal model. If approved, this will enable use of the model to calculate the solvency capital requirement (SCR), rather than relying on the standard formula. The Group’s models better reflect the risks within the businesses than the “one-size-fits-all” standard formula and should therefore give a more appropriate assessment of the capital required to support the business, consistent with the way in which the business is managed.

Following the approval of the Solvency II directive in 2009, development of the Level 2 implementing measures
has continued, setting out technical Solvency II standards. The Group has been actively involved in supporting the consultation of these standards, both through formal consultation and participation in key industry forums. The fifth Quantitative Impact Study (QIS5) runs between August and November 2010 and will further support the development of these standards. The Group is participating in the QIS5 exercise recognising this as an important step in understanding the likely impact of Solvency II.