MCEV

Group MCEV operating earnings*

The Group generated MCEV operating earnings after tax of £216 million for the half year ended 30 June 2010, an increase of £238 million on the pro forma comparative period (an increase of £179 million on a consistent basis, using a longer-term rate of return in both half year periods).

The Board is pleased to report that embedded value performance was strong in difficult market conditions reflecting the resilience of Phoenix Life in the first half of the year and the realisation of value from management actions. We have delivered growth in embedded value from management actions of £116 million and are therefore well on track to meet our 2010 target of £145 million incremental embedded value.

MCEV operating earnings/(loss)	Half year ended 30 June 2010 £m	Half year ended 30 June 2009 pro forma £m
Life MCEV operating earnings/(loss)1	304	(22)
Management services operating profit/(loss)	7	(7)
Ignis Asset Management operating profit	22	16
Corporate costs	(33)	(18)
Group MCEV operating earnings/(loss) before tax	300	(31)
Tax (charge)/credit on operating earnings/loss	(84)	9
Group MCEV operating earnings/(loss) after tax2	216	(22)

1 Life MCEV operating earnings are derived on an after tax basis. For presentational purposes Life MCEV operating earnings before tax have been calculated by grossing up the after tax Life MCEV operating earnings. Life MCEV operating earnings before tax of £304 million (half year ended 30 June 2009: pro forma operating loss of £22 million) are therefore calculated as £219 million operating earnings (pro forma half year ended 30 June 2009: £16 million operating loss) grossed up for tax at 28 percent (half year ended 30 June 2009:
28 percent)
2 The Group has moved to calculating the expected contribution on existing business using longer term expectations of investment returns. The pro forma ‘Group MCEV operating earnings/(loss) after tax’ would have been positive £37 million for the half year ended 30 June 2009 if it had been calculated using longer term rates of return

*The Phoenix Group Market Consistent Embedded Value methodology (referred to herein and in the supplementary information as MCEV) is in accordance with the MCEV principles and guidance published by the CFO Forum in October 2009, except that:

– risk-free rates have been defined as the annually compounded UK government nominal spot curve plus 10 basis points rather than as a swap rate curve

– no allowance for the costs of non-hedgeable risk has been made because, in the opinion of the Directors, the Group operates a robust outsourcer model in terms of operational risk, does not write new business, is focused entirely on the back book, and has succeeded in closing out significant legacy risks. The theoretical value of the costs of residual non-hedgeable risk is £201 million (31 December 2009: £234 million)

– the value of the asset management and management service companies are calculated on an IFRS net assets basis.

Covered business includes all long-term insurance business written by the Group, but excludes the asset management and management service companies.

Life MCEV operating earnings/(loss) after tax

Other than vesting annuities, the Group’s life division is closed to new business. The principal underlying components of the life MCEV operating earnings are therefore the expected existing business contribution together with non-economic experience variances and assumption changes.

Life MCEV operating earnings/(loss) after tax	Half year ended 30 June 2010 £m	Half year ended 30 June 2009 pro forma £m
Expected existing business contribution	150	47
New business value	11	11
Non-economic experience variances and assumption changes
Experience variances	74	(83)
Assumption changes	(12)	(6)
Other operating variances	(4)	15
Total non-economic experience variances and assumption changes	58	(74)
Life MCEV operating earnings/(loss) after tax	219	(16)

Expected existing business contribution

The Group uses long-term investment returns in calculating the expected existing business contribution. In 2009 the expected contribution was calculated using a 1 year risk-free rate plus the Group’s long-term expectations of excess investment returns on equities, properties and bonds. From 2010, the Group considers that an average return over the remaining term of our in-force business is more appropriate than using a short-term rate and is more consistent with the Group’s expectation of longer term rates of return. Therefore, the Group has moved to calculating the expected contribution on existing business using a long-term risk-free rate (15 year gilt rate plus 10 basis points) plus long-term expectations of excess investment returns.

This change in assumption only affects the analysis of movement and does not impact the total calculated embedded value. The pro forma expected existing business contribution at 30 June 2009 would have been £106 million if it had been calculated using expectations of longer term rates of return but economic variances within the analysis of Group MCEV earnings would have been reduced by the same amount.

The expected contribution of existing business for the half year ended 30 June 2010 of £150 million after tax is
£44 million higher than the comparative period on a consistent basis (half year ended 30 June 2009 pro forma:
£106 million using a longer-term rate of return) largely due to the increase in the long-term risk-free rate and the higher opening MCEV.

New business value

New business profits generated from vesting annuities during the 2010 half year were flat at £11 million after tax (half year ended 30 June 2009 pro forma: £11 million). New business value represents the value of vesting pension policies not reflected in the opening MCEV. These arise from pension policies which have no attaching annuity guarantees.

The new business margin is 5 percent after tax (half year ended 30 June 2009 pro forma: 5 percent) and represents the ratio of the net of tax new business value to the amount received as new single premiums.

Non-economic experience variances and assumption changes

The life divisions’ non-economic experience variances and assumption changes increased the MCEV by £58 million after tax for the half year ending 30 June 2010, the main driver being experience variances. Positive experience variances largely related to a benefit of £37 million from converting intra-group debt into listed Eurobonds, which removes the burden of UK withholding tax, and other tax optimisation benefits. There were also benefits realised from back book management including data cleansing projects. Unfavourable experience variances for the half year ended 30 June 2009 were driven by higher cost of capital charges following increases in capital resource requirements and changes to capital policy in 2009.

Management services

The operating profit for management services comprises income from the life companies in accordance with the respective management service agreements less fees related to the outsourcing of services and other operating costs.

Ignis Asset Management

Ignis recorded an operating profit before tax of £22 million for the half year ended 30 June 2010, an increase of 38 percent on the pro forma comparative period.

Ignis Asset Management operating profit	Half year ended 30 June 2010 £m	Half year ended 30 June 2009 pro forma £m
Retail revenue	8	7
Institutional and international revenue1	7	9
Life fund revenue2	48	38
Other income	1	1
Total revenues3	64	55
Staff costs	(27)	(24)
Other operating expenses	(15)	(15)
Total expenses3	(42)	(39)
Ignis Asset Management operating profit before tax	22	16

1 Includes performance fees of £nil (half year ended 30 June 2009 pro forma: £3 million)
2 Includes performance fees of £10 million (half year ended 30 June 2009 pro forma: £nil)
3 Revenues and expenses are stated net of rebates from collective investment schemes

Ignis has delivered significantly higher operating profits with the business benefiting from a combination of improved bond and real estate markets, third party net inflows of £0.8 billion and performance fees from the life companies.

Assets under management development	Life companies £bn	Third party £bn	Group pension schemes £bn	Total £bn
Opening assets under management at 31 December 2009	60.1	4.1	2.7	66.9
Inflows	–	1.3	–	1.3
Outflows	(2.7)	(0.5)	(0.9)	(4.1)
Market movements	1.8	(0.2)	0.1	1.7
Transfer from third party asset manager	2.8	–	–	2.8
Closing assets under management at 30 June 2010	62.0	4.7	1.9	68.6

Internal funds under management increased by £1.9 billion (3 percent) to £62 billion in the first half of the year as
a transfer from a third party manager of £2.8 billion and positive market movements of £1.8 billion outweighed the run-off of the closed life business of £2.7 billion.

Ignis has continued with its programme of bringing in-house externally managed life company assets that were previously overseen by Ignis. In addition to the above mentioned transfer, £3.3 billion of assets previously managed by third parties and transferred to Ignis in 2009 are now being managed by Ignis on an active basis having formerly been passively managed.

Third-party net inflows were £0.8 billion in the period mainly reflecting strong sales of retail products and liquidity funds.

Corporate costs

The Group’s business structure includes a Corporate Office that provides a coordination and oversight function. Corporate office costs and project spend amounted to £16 million before tax (half year ended 30 June 2009: £6 million). The increase in corporate office costs in 2010 reflects the additional ongoing costs associated with our Premium Listing on the LSE. The balance of the charge in both periods relates primarily to the pension schemes.

Group MCEV earnings

Group MCEV earnings are reconciled to the Group MCEV operating earnings, as follows:

	Half year ended 30 June 2010 £m	Half year ended 30 June 2009 pro forma £m	Adjustment to move to a longer term rate of return1	Half year ended 30 June 2009 on a consistent basis £m
Group MCEV operating earnings/(loss) after tax	216	(22)	59	37
Economic variances on covered business	106	(35)	(82)	(117)
Economic variances on non-covered business	(14)	(46)	–	(46)
Non-recurring items	(22)	(62)	–	(62)
Finance costs attributable to owners	(81)	(125)	–	(125)
Tax (charge)/credit on non-operating earnings/loss	(13)	14	23	37
Group MCEV earnings/(loss) after tax	192	(276)	–	(276)

1 The Group has moved to calculating the expected contribution on existing business using longer term expectations of investment returns. The pro forma ‘Group MCEV operating earnings/(loss) after tax’, ‘Economic variances on covered business’ and ‘Tax (charge)/credit on non-operating earnings/loss’ would have been positive £37 million, negative £117 million and positive £37 million respectively for the half year ended 30 June 2009 if the expected contribution had been calculated using longer term rates of return

Economic variances on covered business

Positive economic variances in the period of £106 million before tax reflect improvements in the property market, movements in risk-free rates and strong returns on investments in hedge funds offset by declines in the value of equities.

Economic variances on non-covered business

Negative economic variances on non-covered business of £14 million before tax largely relate to negative returns on interest rate swaps held in the holding companies. The half year ended 30 June 2009 was impacted by market value movements on the listed Tier 1 Notes issued by the Group’s subsidiary Pearl Group Holdings (No. 1) Limited and Phoenix Group Holdings warrants, which reduced pro forma MCEV earnings by £52 million before tax and which had a nil impact in the 2010 half year.

Non-recurring items

Overall non-recurring items reduced embedded value by £22 million before tax and primarily include:

• Costs associated with the Phoenix Life site rationalisation and associated staff reductions and the Group’s transformation programme with its outsourcers of £11 million (half year ended 30 June 2009 pro forma: £8 million)
• Premium Listing and other restructuring costs of £28 million (half year ended 30 June 2009 pro forma: £37 million of restructuring costs)
• Regulatory change and systems transformation costs of £8 million after tax (half year ended 30 June 2009 pro forma: £nil)
• A gain of £19 million after tax following the near finalisation of revised asset shares in the Phoenix & London Assurance with-profit fund as a result of a guaranteed annuity option compromise scheme last year which reduced longevity risk for the Group whilst providing policyholder benefit enhancements. This outweighs the overall charge of £12 million after tax recognised in the second half of 2009 which was based on estimated asset shares.

Finance costs attributable to owners

	Half year ended 30 June 2010 £m	Half year ended 30 June 2009 pro forma £m
Debt finance costs1	48	117
Tier 1 coupon	33	–
Other finance costs	–	8
Finance costs attributable to owners	81	125

1 Finance costs in respect of the Impala and Pearl facility agreements (and associated swap interest) and the Royal London Payments in Kind (PIK) notes and facility

As part of their acquisition by Phoenix Group Holdings, the Pearl businesses restructured the Pearl and Impala facilities and Royal London PIK notes and facility resulting in an overall reduction in external debt of £575 million. In addition, the remainder of the £2.9 billion of this external debt was also restructured and the terms amended.

Debt finance costs reduced by 59 percent on the pro forma comparative period as a result of the above restructuring and lower interest rates.

On 22 April 2010, the holders of the Tier 1 Notes agreed to a number of amendments to the Notes, including a 15 percent reduction in the face value of the Notes. Following these amendments, the Group settled in full the 2010 coupon on the Notes on 26 April 2010. Future coupon payments will be £27 million reflecting the 15 percent reduction in the face value of the Notes and the purchase of Notes from Royal London with a face value (pre discount) of £19 million.

Tax on non-operating earnings

Tax on non-operating earnings includes a charge of £33 million relating to economic variances and non-recurring items related to covered business (half year ended 30 June 2009 pro forma: a credit of £15 million).

Group MCEV

The Group MCEV increased by £135 million over the half year to £1,962 million at 30 June 2010 as shown below.

Movement in Group MCEV	Half year ended 30 June 2010 £m	Half year ended 30 June 2009 pro forma £m
Group MCEV at 1 January	1,827	1,044
Group MCEV earnings/(loss) after tax	192	(276)
Other comprehensive income
Actuarial (losses)/gains of defined benefit pension scheme	(45)	15
Exchange differences on translating foreign operations	–	(70)
	(45)	(55)
Capital and dividend flows	(12)	-
Group MCEV at 30 June	1,962	713

Exchange differences on translating foreign operations have not occured in the period as Phoenix Group Holdings changed its functional currency to Sterling in the second half of 2009.

Capital and dividend flows mainly comprise external dividend payments of £20 million net of a release of warrant liabilities of £7 million on conversion of warrants to ‘B’ ordinary shares.