Resolution Limited : Final Results

27 March 2012

Resolution Limited (the "Company")

Preliminary results for the year ended 31 December 2011

Good progress towards building a sustainable business

Significant strategic momentum in 2011

Prudent cash levels and resilient capital position maintained

§  Sustainable free surplus generation of £291 million contributed to achievement of £400 million distributable cash target

§  Overall cash generation impacted by investment markets, but £400 million buffer maintained

§  Balance sheet retains low exposure to higher risk European sovereign and corporate debt

§  Robust IGCA surplus of £2.1 billion representing a surplus of 219%

Good progress in the UK, International impacted by weak markets

§  IFRS operating profit before tax of £681 million (2010: £275 million) (including the benefit of £404 million of  one-off
 items from management actions)

§  MCEV operating profit before tax of £517 million (2010: £412 million) (including £140 million of positive one-off
 assumption changes)

§  UK operations made good progress reflecting actions on capital and costs

§  International operations impacted by difficult markets and modelling improvements

§  Lombard affected by tough markets but increased market share in difficult year for sector

§  Full year dividend per share of 19.89 pence, up 10%

Looking forward

§  Further update on cash return no later than 2012 interim results  

§  Base case exit plan to divide underlying business into two separately listed businesses

Mike Biggs, Chairman of Resolution Limited said:

"2011 was an important year for Resolution Limited. It made significant progress driving value from the businesses acquired in its UK Life Project. The Company is committed to returning surplus cash not required by the business to shareholders subject to market conditions and receiving the appropriate regulatory approvals."

Enquiries:

Investors/analysts

Neil Wesley, Resolution Operations LLP                                                                                       +44(0)203 372 2928

Media

Alex Child-Villers, Temple Bar Advisory                                                                                          +44(0)7795 425580

Forward-looking statements

This announcement includes statements that are, or may be deemed to be, "forward-looking statements" with respect to Resolution, its subsidiary undertakings and their outlook, plans and current goals. In some cases, these forward-looking statements can be identified by the use of forward-looking terminology, including the terms "targets", "believes", "estimates", "anticipates", "expects", "intends", "may", "will" or "should" or, in each case, their negative or other variations or comparable terminology. By their nature, forward-looking statements involve risks and uncertainties because they relate to events and depend upon circumstances that may or may not occur in the future. Forward-looking statements are not guarantees of future performance. Resolution's actual performance, results of operations, internal rate of return, financial condition, liquidity, distributions to shareholders and the development of its acquisition, financing and restructuring and consolidation strategies may differ materially from the impression created by the forward-looking statements contained in this announcement. Forward-looking statements in this announcement are current only as of the date of this announcement. Resolution undertakes no obligation to update the forward-looking statement it may make. Nothing in this announcement should be construed as a profit forecast.

There will be a conference call today for wire services at 07.30 (BST) hosted by John Tiner, Chief Executive of Resolution Operations LLP. Dial in telephone number: UK National call 0871 700 0345, UK Standard International +44 (0) 1452 555 566 Passcode: 62400398.

A presentation to analysts will take place at 09.30am (BST) at the London Stock Exchange, 10 Paternoster Square, London EC4M 7LS. Dial in telephone number: 0800 634 5205, UK standard International +44 (0)208 817 9301. An audio cast of the presentation and the presentation slides will be available on Resolution's website, www.resolution.gg.

In accordance with the obligations for issuers of listed debt contained in the Disclosure and Transparency Rules, Friends Life Group plc will issue a separate preliminary results announcement later today.

Website www.resolution.gg

Chairman's statement

Resolution Limited ("Resolution" or "the Company")

Overview

In 2011, Resolution Limited (the "Company") moved from the acquisition phase of its UK Life Project to the integration phase which is primarily focused on delivering value from the acquired businesses. The Company also confirmed that it would not undertake any additional projects until after completion of the UK Life Project.

The Company has sought to articulate a clear strategy for the enlarged Friends Life business to demonstrate to shareholders how it proposes to achieve the overarching goals of the UK Life Project of building a sustainable business and achieving cash returns to shareholders. In market updates on strategy in February, June and November, the Company, among other things:

·      set out its plans to create value in the UK Life Project with a focus on three product areas for new business and with measurable financial targets for costs, cash flow and returns for the enlarged group;

·      announced the results of its work on the cash and capital position of Friends Life and the commencement of a £250 million share buy-back which completed in October 2011;

·      provided a detailed update on Friends Life's business units that focused on the execution of strategy and delivery of the financial targets; and

·      announced a transformational outsourcing agreement, the intention to create an in-house asset manager, and the creation of separate 'Heritage' and 'Go to Market' business units for existing business and new business to increase management accountability.

The Operating Report that follows this statement will provide a more comprehensive summary of these strategic updates.

The full year 2011 results highlight that incremental progress is being made towards achieving the Company's financial targets. The integration of the acquired businesses is substantially on track with the planned full year run-rate savings achieved by the end of 2011. The Group's new business strategy is focused on the three product areas of Protection, Corporate Benefits and Retirement Income in the UK market where the Group has the advantage of scale and where good margins should be achievable. Returns for new business written on the chosen platforms are attractive and close to or ahead of the targets for 2013. Actions taken within the UK businesses resulting in the benefits of capital synergies and the successful merger of funds have had a positive impact on the Group's cash delivery. The Friends Life group continues to make steady progress towards its target operating return on embedded value but much work is still needed to achieve the target.

The net Market Consistent Embedded Value ("MCEV") of the Group as at 31 December 2011 was £5,796 million.

Cash returns to shareholders

At the time of the announcement of the full year 2010 results in March 2011, the Company gave guidance of its intention to increase the 2011 dividend to 18.85 pence per share, up 15% on the 2010 level.

On 7 June 2011, the directors announced that they had reviewed the Company's dividend policy and concluded that the aggregate value of the dividend payable by the Company on all shares in issue should not reduce as a result of the planned £250 million share buy-back in the second half of 2011 also announced that day. This meant that the proposed dividend per share was expected to increase as a result of the £250 million share buy-back. The share buy-back was completed on 26 October 2011. Accordingly, the proposed 2011 final dividend declared by the Board, consistent with the policy of dividends being paid one-third in respect of the interim dividend and two-thirds in respect of the final dividend, is 13.42 pence per share. This takes the dividend for 2011 to 19.89 pence per share.

The Board continues to review whether it is appropriate for the Company to move to a progressive dividend policy.

During the year, the Company generated cash of £393 million, broadly in line with its £400 million Distributable Cash Target. In addition, capital synergies of £281 million were achieved. However, these were more than offset by widening corporate bond spreads and negative equity returns. These economic variances reduced free surplus generated in the year by £352 million.

In keeping with the Company's prudent approach to capital management, it has determined that it would have been inappropriate to release capital over and above its declared dividend policy based on the resultant position at the end of 2011. The Company remains committed to the return of capital to shareholders, when prudent, and will keep the potential to do so under review. The ongoing consideration of capital returns will take into account the performance of markets since the year end and the impact of planned management actions to further optimise capital and address the impact of market volatility. The Company will update the market no later than the 2012 interim results announcement on its intentions with respect to the second stage of the capital return program announced in June 2011. The Operating Report and Business Review that follow this statement comment on the Group's cash and capital position in more detail.

Exit

The February 2011 investor update summarised the exit options that the Company might consider in relation to the UK Life Project. These included: a cash sale, together or in parts; a direct listing as a standalone entity; a merger with another life company; or separation of the UK open business from the back book leading to separate sales or listings.

It remains the Company's intention to look for exit options involving mergers and acquisitions ("M&A") which would allow shareholders to benefit from the synergies arising from further consolidation. Whilst Resolution Operations LLP ("ROL") is actively investigating such opportunities on behalf of the Company, and has advised the Company that it believes that consolidation of the UK life industry will continue and that attractive transactions may be available, the Company considers it important to have a "self-managed" exit plan which is not reliant on M&A opportunities and could be implemented on a stand-alone basis. Such a self-managed exit plan will also form a benchmark against which M&A exit opportunities can be assessed.

The Company, with ROL, has considered the potential options and concluded that the most attractive self-managed exit plan would involve a division of Friends Life into two separately listed businesses:

·      "OpenCo" - which would consist of the UK Go to Market business units, the overseas businesses, Sesame Bankhall Group, and associated support businesses; and

·      "HeritageCo" - which would consist of the UK Heritage business and associated support businesses including Friends Life Investments, Friends Life's listed debt and the UK pension fund.

Accordingly the Company is now developing detailed implementation plans to ensure that such a division can be achieved by early 2014.

M&A

The Board remains of the view that value can be created from further consolidation in the UK life sector.

ROL continues to explore, on behalf of the Company, M&A transactions which might take place during the course of the UK Life Project, or which might form the basis of M&A transactions to facilitate exit. The types of transactions which ROL might investigate on behalf of the Company are set out in the Operating Report that follows. In considering future M&A transactions during the UK Life Project, the Company will assess how any business to be acquired would be expected to enhance the financial performance, and hence the exit value, of either OpenCo or HeritageCo (or both), and hence how it might increase the expected returns made for shareholders on the UK Life Project overall.

On 20 November 2011, the Company responded to press speculation and confirmed that it investigated a possible acquisition of Phoenix Group Holdings but that talks had terminated.

Relationship with Resolution Operations LLP

On 28 November 2011, the Company announced that it had agreed amendments to its Operating Agreement with ROL and various other arrangements with ROL and its affiliates. The changes enable ROL to pursue other restructuring opportunities in separate investment vehicles, subject to appropriate protections for the Company and its shareholders to minimise the risk of future conflicts.

Shareholders approved the revised terms of our arrangements with ROL and its affiliates on 13 January 2012. The amended Operating Agreement ensures the ongoing commitment of ROL to secure a successful outcome for shareholders from the UK Life Project.

Governance

The Board has carried out a review of its performance and that of its principal committees during 2011, as recommended by the UK Corporate Governance Code, and has concluded that they are operating effectively. More details are set out in the Corporate Governance Report that follows. The Board welcomed the recommendations of Lord Davies's report "Women on Boards" and published a statement on the Company's website during the year. The Board is committed to ensuring that the Group's businesses encourage diversity in general in the development of their management teams.

The Company notes the recent publication of the FSA's consultation paper on amendments to the Listing Rules, Prospectus Rules, Disclosure Rules and Transparency Rules (CP12/2). The consultation paper includes proposals to require certain existing premium listed companies that have appointed an investment adviser to either unwind their investment advisory arrangements or re-designate as a standard listed company. The Company values highly its premium listing, along with the protections that premium listing provides for its shareholders. It will be responding in detail to the FSA's proposals shortly.

Outlook

The current macroeconomic backdrop remains uncertain particularly in Europe and is expected to result in periodic volatility in investment markets. The regulatory environment is experiencing fundamental change as new measures aimed at enhancing financial stability are implemented. However, the Board is encouraged by the progress being made at Friends Life towards the achievement of the 2013 financial targets and is confident that those targets will be achieved.

Returns on the UK Life Project will reflect the level and volatility of investment markets in the period running up to exit.  Subject to these being similar to current levels, the Board expects that the UK Life Project will achieve its targeted mid-teens returns.

The Board would like to acknowledge the efforts of all staff in the enlarged group and thank them for their contribution in what has been a demanding year for the business.

Operating report by Resolution Operations LLP

1.  Introduction

2011 was an important year for the Company. Against a backdrop of significant investment market volatility and a comprehensive regulatory agenda that impacts the UK life sector not least in terms of time commitment and cost, the Company provided three significant investor updates in March, June and November on its UK Life Project. These aimed to provide strategic clarity and set out financial targets for the Friends Life business. Resolution Operations LLP ("ROL") is pleased to report that steady progress is being made towards the delivery of these targets but much work remains to be done.

This Operating Report will provide an update on:

·      strategy, including matters likely to impact progress such as the market environment and the changing regulatory landscape;

·      the UK Life Project including details of updates provided throughout 2011 and the exit;

·      the performance of the business over the year; and

·      the outlook.

The Business Review that follows this report will examine in more detail the progress made against the financial targets and the chosen product areas for new business.

2.   Strategy

The Company confirmed in June 2011 that the original focus of the Company, which was to undertake a number of financial services restructuring opportunities in the UK and Western Europe, would be narrowed to the delivery of the UK Life Project until its completion. ROL continues to advise the Company on its strategic aims for the UK Life Project, namely the creation of a sustainable business, or sustainable businesses, that meet customers' needs while also delivering cash returns to shareholders.

For Friends Life, the Company's strategic aims have translated, in the UK, to a narrowed new business focus on the three product areas of Protection, Corporate Benefits and Retirement Income where the Company believes it has a competitive advantage and scale, and a disciplined focus on the management of the back book. Friends Life expects to deliver value by no longer writing unprofitable business, writing more capital efficient business, leveraging its product solutions and cost-efficient platforms, controlling costs, improving persistency and increasing the retention of vesting amounts in annuities. The focus of the non-UK businesses, which include International and Lombard, is on costs, retention and leveraging their leading positions in higher return specialist markets.

2.1 Market environment

The first half of 2011 was characterised by volatility in investment markets that was driven by uncertainty about the strength and sustainability of global growth, a debt crisis in Europe and geopolitical unrest in North Africa and the Middle East. The global financial environment became even more stressed in the second half of 2011 following increased concerns about the impact of the sovereign debt crisis, the trajectory of global economic growth and the strength of some banking systems. Global financial stress increased with a retrenchment in cross-border bank lending and investors reallocated capital away from "risky" assets. As the price of traded bank equity fell, spreads on corporate bonds widened and cost of sovereign debt increased, wholesale funding pressures rose sharply and exacerbated concerns over global growth and sovereign solvency. The negative feedback loop from these events impacted the environment for life insurance companies and caused a sharp downward correction in the share prices of insurance stocks, reflecting investors' concerns that insurance companies were being negatively impacted by these economic conditions. Since the end of June 2011, the UK life sector, as measured by the FTSE 350 Life Insurance Index, fell almost 25% at its lowest in September 2011 and closed the year down almost 14%. Against this backdrop, the Group's capital position has been relatively resilient to market volatility. However, widening corporate bond spreads have negatively impacted International Financial Reporting Standards ("IFRS") and Market Consistent Embedded Value ("MCEV") total profits but this has been broadly in line with the Group's published sensitivities. The impact on the Group from movements in asset prices is discussed in greater detail in the Business Review that follows.

2.2 Regulatory environment

In 2011, the UK life sector continued to prepare itself for the impact of upcoming regulation in the form of Solvency II, the introduction of auto-enrolment and the Retail Distribution Review ("RDR"), among other regulatory initiatives.

The details of Solvency II, the new capital regime expected to replace the existing capital framework, disappointingly still remain unclear with a risk of further delays in the timing of implementation. The current legislative draft looks less favourable for the UK industry with the treatment of matching premium and contract boundaries, in particular, being more onerous than the last quantitative impact study (QIS5) undertaken by the industry.

The Company continues to expect that auto-enrolment will lead to market growth in corporate pensions.  Friends Life expects that the opportunity from auto-enrolment, together with its corporate pensions offering with its investment in low cost systems, should see it well placed to generate new business from new and existing schemes.

RDR is expected to significantly impact the distribution environment. Friends Life believes that its strategic decision to stop selling single premium bonds, strong nil-commission offering in corporate pensions, good relationships with employee benefit consultants, and the opportunity to sell products in the workplace position it well for the introduction of RDR. Protection is outside the scope of the RDR regime and Friends Life's strong relationships with intermediaries and growing track record in tied distribution leaves it well placed in this product segment.

3.   UK Life Project

Since the launch of its UK Life Project, the Company has acquired three businesses at a price of approximately 66.9% of net MCEV. It brought these three businesses together under the Friends Life brand, which was launched in March 2011. In 2011, the Company moved firmly into the integration and value delivery phases of its UK Life Project. In order to provide greater detail on its strategic intent for the enlarged group, the Company provided the market with three updates on its plans to extract value from the businesses acquired. This report will briefly summarise the strategic updates provided over the course of 2011.

February - Delivering value

In February, the Company presented the results of the strategic review undertaken of the businesses acquired - namely, the Friends Provident business (November 2009), the AXA UK Life Business (September 2010) and Bupa Health Assurance business (January 2011). The Company indentified that the focus of its new business efforts would be on the product areas of Protection, Corporate Benefits and Retirement Income. In light of its detailed review of integration plans, the Company was also able to announce an increase in its expected cost synergies target from the acquired businesses from the £75 million of annualised cost synergies (before tax) announced on signing of the AXA transaction to £112 million per annum.

In addition, the Company identified clear financial targets that it expects its underlying businesses to meet by the end of 2013 and committed to regularly updating the market on progress in meeting them. These targets included new business strain reduction, new business internal rates of return ("IRR"), sustainable distributable cash and operating return on embedded value. The Company also highlighted that a number of options exist for it to exit the UK Life Project. The options outlined included: a cash sale, together or in parts of the Friends Life business; a direct listing of Friends Life as a standalone entity; separation of the UK open business from the UK back book leading to separate sales or listings; or merger with another life company.

One of the key strategic elements the Company identified in February as the subject of future market update was the cash and capital framework of the enlarged group where work was underway to deliver capital synergies by merging smaller acquired life companies; and evaluate the potential to transfer cash to the Group from the re-attributed inherited estate that forms part of the AXA UK Life Business.

March to June - Cash and capital update

The update in June outlined the key elements of the work completed and in progress on the cash and capital position of Friends Life. The Company announced its policy of returning excess cash released from Friends Life to shareholders to the extent that it was not expected to be required for further M&A opportunities in the short to medium term. The Company targeted a return of £500 million of excess cash to shareholders over the course of the second half of 2011 and the first half of 2012. It started this return of cash in 2011 with a £250 million on-market share buy-back which commenced immediately following the update. The Company also announced that it had planned management actions which were intended to deliver a further £235 million of capital synergies in Friends Life before the end of 2011 which would be required, along with necessary regulatory approval, before any return of the targeted further £250 million in 2012.

The Company reiterated Friends Life's Distributable Cash Target ("DCT") of £400 million per annum and noted that over time Friends Life is expected to be in a position where the DCT is met from sustainable sources (comprising surplus emerging from the in-force business plus required capital released through run-off less new business strain and associated required capital for new business).

As part of the Group's wider cash and capital management work in 2011, the Company repaid a £400 million acquisition finance facility and issued £500 million of lower tier 2 debt in the public markets. The facility was drawn down in September 2010 to part fund the AXA UK Life Business acquisition and repaid in April 2011.

July to November - Value delivery

Having provided a framework for cash and capital and clearly identified the 2013 target financial metrics for Friends Life, the Company announced with its interim results in August 2011 the split of the UK life business between the UK legacy in-force portfolios (the "Heritage" business unit) and the UK new business in the chosen product areas (the "Go to Market" business unit).

The purpose of the update on the UK Life Project in November was to reveal the creation of a sustainable business at Friends Life and showcase the management team at Friends Life. At the Company's presentation, management of Friends Life demonstrated the clear accountability for the Heritage and Go to Market business units in the UK. The update provided details on the market context for these business units and the strategy that each of the business units would execute in order to achieve the 2013 financial targets.

The Company also announced details of a significant outsourcing agreement with Diligenta that would deliver new synergies in the coming years and de-risk the achievement of the previously announced cost savings. The other key strategic initiative announced was the creation of an in-house asset manager, Friends Life Investments ("FLI"), in order to re-capture fees currently being paid to external asset managers by bringing in-house the externally managed assets of the Group. While the initial focus of FLI is the management of fixed income assets backing annuities and shareholder funds, FLI is also exploring the potential to manage other fixed income portfolios within the Group.

Summary

In 2011 the Company clearly identified the strategic direction for the acquired businesses, provided measurable financial targets that it expected Friends Life to achieve by 2013, articulated its cash and capital position and policy, commenced returning excess cash to shareholders, announced a major outsourcing agreement and creation of an in-house asset manager, and showcased the Friends Life UK business and management team. In summary, it was a busy year with much achieved in terms of shaping a sustainable business at Friends Life.

3.1 Path to achieving financial targets

As noted above, the Company set out targets for the Friends Life businesses in February 2011, particularly in relation to the financial performance of UK new business. These targets are challenging; but the financial performance of the UK new business has improved in line with our expectations during 2011.

For its UK Protection business, Friends Life has targeted reducing cash new business strain to £30 million per annum, increasing gross value of new business ("VNB") to £80 million per annum and achieving a new business IRR of 20% per annum. During 2011, Friends Life wrote £92 million of new protection annual premium equivalent ("APE"), of which £22 million was on the target platform. Business written on the target platform is already achieving the targeted financial metrics. The £22 million of new APE written on the target platform resulted in £22 million gross VNB and achieved a 20% IRR with cash new business strain of only £8 million. This gives considerable confidence that as the proportion of new protection business written on the target platform increases towards 100% through 2012 (reflecting the switch of all new independent financial adviser business to this platform in the fourth quarter of 2011 and the switch of new controlled business to the target platform during 2012), Friends Life will achieve its financial targets in relation to this key product area.

For its Corporate Benefits business, Friends Life has targeted reducing cash new business strain to £75 million per annum, gross VNB of £25 million per annum and a new business IRR in double figures by 2013. In 2011, Friends Life wrote £440 million of new corporate pensions APE, of which £356 million was on the target New Generation Pensions ("NGP") platform. Cash new business strain reduced from a 2010 baseline figure of £80 million to £51 million in 2011. Incremental improvement through the year was significant, with cash new business strain reduced to only £16 million in the second half of the year. Similarly, gross VNB increased from £5 million in the first half of 2011, to £10 million in the second half of the year, with the new business IRR achieved for the full year on the NGP platform being 9.4%. Only a modest improvement would be required from the performance achieved in the second half of 2011 in order to achieve our 2013 targets. If the impact of auto-enrolment is as positive to this product as some forecasts indicate it could be, there is potential for this business line to materially outperform the 2013 targets.

Finally, for its Retirement Income business Friends Life has targeted increasing retention rates on vesting pension funds to 50% and increasing gross VNB to £50 million per annum. Friends Life has made significant investments in capability in this area during 2011, however no changes to the original product propositions came on line during the year and retention rates were broadly unchanged from those achieved in 2010. Notwithstanding this, the retirement income business delivered gross VNB of £32 million in 2011 providing confidence that the £50 million per annum VNB target will be delivered, and potentially exceeded, in the years ahead.

Delivery against the VNB targets is critical to delivering Friends Life 10% per annum operating ROEV target, however it will not alone be sufficient. Short term interest rates remain at historically low levels, depressing the return achieved on net worth and making the achievement of the 10% operating ROEV target more challenging than it would be in more "normal" conditions. In the absence of an increase in short term interest rates and a sustained increase in equity markets, Friends Life will need to outperform against the 2013 VNB targets and the Company will need to undertake further work to optimise the Group's balance sheet in order to achieve a 10% operating ROEV.

In his statement, the Chairman comments on the Company's decision to adopt a base case self-managed exit plan involving separate listings for OpenCo and HeritageCo, and this is commented on further below. As the shape of these businesses evolves and is finalised, the Friends Life operating ROEV target will be broken down into separate targets for each business.

3.2 Cash and capital

Despite the volatile economic environment and fall in market returns during the year, Friends Life contributed £393 million of cash, broadly in line with the DCT of £400 million per annum. This amount comprises £291 million met from sustainable free surplus generation, with the balance of £102 million coming from other actions and working capital.

The £102 million included the £100 million of lower tier 2 debt raised by Friends Life in excess of the £400 million received to repay the acquisition finance facility. It also included the benefit of £281 million of capital synergies delivered against £235 million expected as a result of planned management actions. The benefits were offset by the impact of economic variances, in particular, by falling equity markets and widening corporate bond spreads, which reduced MCEV profits before tax by £600 million. Of this £600 million reduction, £352 million had a direct impact on free surplus effectively representing a reduction in the cash generated within the businesses during the year.

As a result of the actions taken to optimise Friends Life's capital position, including the delivered capital synergies, capital requirements on a Pillar 1 basis have reduced significantly. However, during the year, widening corporate bond spreads and the assessment of the overall level of economic risk, particularly in Europe, have significantly increased capital requirements on a Pillar 2 basis. Accordingly, Friends Life now needs to focus its capital management activities on both the Pillar 1 and Pillar 2 capital positions, as it is on the cusp of both bases biting.

The cash generation of the underlying business and the delivery of capital synergies were in line with the Company's expectations. However in light of the weak investment markets in the year and the increased volatility from the Pillar 2 basis now biting, the Company has determined that it would have been inappropriate to release capital over and above its declared dividend policy based on the position at the end of 2011. The Company will keep the potential to do so under review, taking account of the performance and stability of markets since the year end and the impact of planned management actions to further optimise capital and address the impact of market volatility.  The Company will update the market no later than the 2012 interim results announcement on its intentions with respect to the second stage of the capital return program announced in June 2011.

Friends Life retains a strong Insurance Group Capital Adequacy position of £2,139 million, representing a surplus of 219% and continues to hold a cash buffer of £400 million after meeting its 2012 dividend and debt repayment and servicing costs.

3.3 Exit

As the Chairman has explained in his statement, the Company, advised by ROL, has concluded that in the absence of value accretive exit M&A opportunities, it needs to be ready to implement a self-managed exit plan. ROL has recommended, and the Company has approved, a base case exit plan which involves a division of Friends Life into two separately listed businesses:

·      "OpenCo" - which would consist of the UK Go to Market business units, the International businesses, Sesame Bankhall Group, and associated support businesses; and

·      "HeritageCo" - which would consist of the UK Heritage business and associated support businesses including FLI, Friends Life's listed debt and the UK pension fund.

The precise division of assets and liabilities between OpenCo and HeritageCo has not been finalised yet, and will be influenced to some extent by the final form of the Solvency II regime. We expect that OpenCo will be a high operating ROEV business with relatively modest cash generation (at least in the early years), whilst HeritageCo will be highly cash generative, but lower ROEV. We also expect that the embedded value of OpenCo will be in the range of £2 billion to £3 billion at exit.

The following gives an illustrative example of the financial metrics which OpenCo and HeritageCo might be capable of exhibiting based on Friends Life's 31 December 2011 MCEV of approximately £6 billion and assuming that, after allowing for any dis-synergies arising from separating into two separate businesses, Friends Life hits its cash generation and ROEV targets in 2013.

The implementation of the Company's ongoing capital optimisation programme is expected to ensure that, by the end of 2013, the two UK business units (Go to Market and Heritage) will be divided into two separate life companies, capable of being exited independently. Friends Life has been re-aligning the majority of its resources to reflect the split between the UK Go to Market and Heritage businesses since the announcement of the creation of the Heritage business unit in August 2011. Together with ROL, it is now putting in place a programme to re-align the majority of the remaining shared service and group functions to either OpenCo or HeritageCo over the next 18 months.

Detailed planning work has commenced to ensure that the Company is able to implement this plan by early 2014. As part of this planning, consideration is being paid to the interests of current and future holders of Friends Life's listed debt instruments including ensuring each business retains only an appropriate level of gearing in the context of its gross embedded value and its cash generation capability. In the case of HeritageCo, this includes having regard to the current in-force portfolio run off, in order to maintain an appropriate level of gearing in the absence of further closed fund transactions.

We believe that the separation of OpenCo and HeritageCo will create two businesses which will be attractive to different groups of investors, both debt and equity, and will be able to adopt different strategies following exit from the Company:

·      OpenCo will be a fit for purpose life company playing in key markets in which it has competitive advantage; and

·      HeritageCo will adopt a UK closed life fund consolidation strategy following exit.

The value that could be created from implementation of the self-managed exit plan will form a benchmark against which exit M&A opportunities can be assessed. Following completion of legal separation of the UK Go to Market and Heritage businesses at the end of 2013, we expect that the Company will be in a position to implement the self-managed exit plan and provide OpenCo and HeritageCo with separate listings in the second or third quarters of 2014. ROL therefore currently anticipates that the Company will have completed the UK Life Project by no later than the end of 2014.

3.4 M&A

Whilst the Company and ROL's main priority for the remainder of the UK Life Project will be to deliver the targeted financial performance for the UK life business and to prepare to implement a self-managed exit during 2014, we do not rule out the possibility of further M&A.

Such transactions could include:

·      the acquisition of small bolt-on businesses which would enhance or accelerate the development of the UK Go to Market business unit; and

·      further acquisitions of UK closed life funds at attractive prices to enhance HeritageCo.

As the Company has noted previously, it does not expect to undertake further transactions during the remainder of the period of the UK Life Project which would dilute the returns (either as a result of the price paid, or the impact on project duration) which it currently expects to be able to realise from the businesses already acquired. Nor would the Company expect to undertake transactions which required a material capital raise from existing shareholders unless the proposed impact on project returns was exceptionally strong (in which case we would expect to bring such transactions to shareholders for approval).

4.   Business performance

The Business Review that follows this report will set out in detail the results under both IFRS and MCEV bases. The 2011 results are not directly comparable to the 2010 results as they include Friends Provident business and the AXA UK Life Business for 12 months, the Bupa Health Assurance business for 11 months and the Winterthur Life UK Limited business for 2 months.

The IFRS based operating profit before tax was £681 million and included £404 million of reserving changes and one-off items that included capital synergies, the impact of the outsourcing agreement with Diligenta and the impact of expense, persistency, morbidity and mortality experience in the year.

The MCEV operating profit before tax was £517 million and includes £140 million of operating assumption changes. These operating assumption changes relate primarily to the impact of the outsourcing agreement with Diligenta which allowed the expense benefit to be recognised in the MCEV operating profit.

The key highlights of the full year results include:

·      steady progress with the integration of the acquired businesses with £45 million of run-rate savings achieved;

·      sustainable free surplus of £291 million contributed to distributable cash target;

·      management actions including delivery of capital synergies and the impact of the Diligenta outsourcing agreement have contributed positively to operating profit;

·      steady progress is being made towards the achievement of the 2013 financial targets.

5.   Outlook

Despite a difficult external environment, the Company has made steady progress against its strategic priorities and financial targets. The Company's priorities in 2012 remain the development of a sustainable underlying business. As the Company advances towards an exit from its UK Life Project, work will continue towards delivering the best return for shareholders. ROL remains confident that the Company will achieve its financial and strategic targets.

Business Review

Introduction

Transformational year

2011 represented a transformational year for the Group as it transitioned from the acquisition phase of the UK Life Project towards the delivery of a focused and integrated life business.

The acquisition of Bupa Health Assurance Limited (since renamed Friends Life BHA Limited) ("BHA") in January 2011 brought with it a well regarded and efficient protection platform as well as a range of market leading Individual and Group Protection products. In addition, the second phase of the acquisition of the AXA UK Life Business was formally completed with the acquisition of Winterthur Life UK Limited ("WLUK") and disposal of the Guaranteed over Fifty ("GOF") and Trustee Investment Plan ("TIP") portfolios in November 2011.

In March 2011, the acquired businesses were rebranded as Friends Life. In August, the Group announced the restructuring, for management purposes, of the UK business into distinct 'Heritage' and 'Go to Market' businesses: Corporate Benefits, Protection and Retirement Income.

In November, the Group set out its intention to develop in-house asset management capabilities with the creation of Friends Life Investments ("FLI") to manage its significant portfolio of fixed income assets. It also announced a transformational 15 year outsourcing partnership with IT and customer service specialist, Diligenta. This outsourcing partnership has allowed the Group to increase its cost savings target from £112 million to £143 million (30% of UK 2010 baseline costs). On 1 March 2012, the new outsourcing partnership commenced with most of the Group's remaining UK Heritage service operations transferring across to Diligenta.

In December, the Group completed various Part VII transfers combining a number of smaller life companies into Friends Life Limited ("FLL"), restructuring the acquired businesses to maximise capital synergies and to continue the restructuring that supports the future direction of the business.

Business performance

The UK operating result has shown significant improvement with good progress towards strategic objectives reflecting both the improved trading performance, as the businesses integrate, and a number of one-off items including the Diligenta outsourcing arrangement. For MCEV, these benefits were partly offset by the adverse net impact of revised persistency and morbidity assumptions of £73 million, in line with guidance given with the Interim Management Statement in November.

The Corporate Benefits and Protection businesses have demonstrated improvements in the value of new business ("VNB"), internal rate of return ("IRR") and new business strain ("NBS") with the focus on strategic products' platforms and expense reductions driving the overall development of these results and offsetting the impact of adverse pensions persistency. The Retirement Income business continues to exceed its targeted IRR although the VNB was reduced by adverse market conditions in the second half of the year. The performance of the UK Heritage business reflects the challenging market conditions, adverse persistency and provisions established in respect of the Retail Distribution Review ("RDR") partially offset by the positive impact of mortality and morbidity experience.

The good progress in the UK business was offset by a poor performance in the International business; despite a 6% increase in sales volumes, VNB and IRR reduced due to an increase in the proportion of the existing lower margin 'Premier' products in Asia and a lower proportion of higher margin German business sales. The continued review of the in-force portfolio, which commenced in the first half of 2011, highlighted further issues and the business's performance was also impacted adversely by the effect of economic markets through an increased cost of guarantees in respect of certain Overseas Life Assurance Business ("OLAB") products. The International management team has been strengthened, a strategic review is well advanced and the business is focused on improving profitability, driving through reductions in new business strain and is working to meet its cash generation target.

Lombard continued to perform well, but again results reflect the economic downturn in Europe, with some adverse impact on persistency as well as sales. Notwithstanding these difficult conditions, Lombard has outperformed its peers.

The following table shows the IRR performance of the key business lines compared with the targets set for 2013.

(i) 2010 full year baseline includes an estimate of 12 months BHA and AXA UK Life Business results.

(ii)  Target IRRs for the Go to Market businesses are set out in the relevant sections of the UK operating review.

(iii)            The 2011 Lombard IRR (and therefore the blended group IRR) now takes account of the Luxembourg regulatory regime in which DAC is an allowable asset.

Market environment

As well as affecting the operational performance, the difficult economic environment in the year has negatively impacted IFRS and MCEV total profits, and cash generation. On an IFRS basis, income on shareholder assets and the value of annual management charges ("AMCs") have fallen, and reserves for certain guarantees have increased, reducing the operating result. In addition, on an MCEV basis, the future value of in-force ("VIF") business has fallen, principally reflecting the reduced equity returns and widening of credit spreads giving rise to significant, but primarily unrealised, economic experience losses. This has had a corresponding impact on free surplus generation.

Capital strength

The Group's robust capital position has been maintained during 2011 with a Friends Life Group plc ("FLG") IGCA surplus as at 31 December 2011 of £2.1 billion (31 December 2010: £2.3 billion). The movement in the year principally reflects:

·  the surplus generated offset by economic impacts, primarily credit spreads;

·  the impact of the BHA transaction; and

·  dividends paid to Resolution Holdings (Guernsey) Limited ("RHG").

Significant capital synergies were delivered in the year, but much of this benefit has been eroded by widening credit spreads. The Group changed its capital policy in the year from 160% to 150% of Group Capital Resource Requirements (excluding WPICC), reflecting reduced integration risk. The reduction in Pillar 1 capital requirements and increases in Pillar 2 from market movements mean that the Group is now on the cusp of both Pillars biting and accordingly capital management actions in 2012 are focused on the management of both bases.

The Group's balance sheet remains strong and the shareholder exposure to the higher risk government debts of Spain, Portugal, Italy, Ireland and Greece remains low at £6 million (31 December 2010: £7 million).

Dividends and return of capital

In accordance with previous commitments the final dividend is recommended to increase to 13.42 pence per share, resulting in a full year dividend of 19.89 pence per share. The full year dividend is an increase of 10% from 2010, reflecting the benefit of the £250 million share buy-back during the year.

The Group's available shareholder cash ("ASC") at 31 December 2011 was £853 million, including £350 million of dividends proposed by FLL in respect of 2011. FLG's contribution to its distributable cash target ("DCT") of £400 million per annum was £393 million, including £100 million of proceeds from its external LT2 debt issue that has been retained in the life companies. FLG generated sustainable free surplus of £291 million and one-off capital synergies of £281 million.

Whilst the overall cash generation of the business was in line with the Company's expectations, the weak investment markets in the year and resulting negative economic experience variances have offset the value of the capital synergies achieved. Accordingly, the Company has concluded that it would have been imprudent to make a further return of capital over and above the declared dividend policy based on the resultant 2011 position. The Company will update the market no later than the interim 2012 results announcement on its intentions with respect to the second stage of the capital return programme announced in June 2011.

The key performance indicators for the Group and an analysis of the IFRS and MCEV results are set out below followed by detailed segmental commentary, cash and capital information and an explanation of the principal risks and uncertainties for the Group and its approach to managing these.

Key performance indicators

The Group's results for 2011 include the post-acquisition results of the acquired businesses and are therefore not currently directly comparable from period to period where acquisitions have taken place in the year under review. The 2010 results included Friends Provident for 12 months and the AXA UK Life Business (including GOF and TIP but excluding WLUK) for four months while the 2011 results include Friends Provident and the AXA UK Life Business for 12 months, BHA for 11 months, GOF and TIP for 10 months and WLUK for two months.

The Group uses the following key performance indicators.

KPI: IFRS based operating profit before tax

2011:£681 million

2010:£275 million

IFRS based operating profit before tax of £681 million (31 December 2010: £275 million) benefited from the increased scale of the UK business as well as the actions taken to release negative reserves, the Diligenta outsourcing transaction and other favourable assumption changes. These were offset by the adverse impact on operating profit of poor market conditions (reflected through reduced AMCs, higher cost of guarantees and reduced long-term investment return) and the inclusion of a full year's financing costs.

KPI: IFRS (loss)/profit after tax

2011:£(31) million

2010:£820 million

IFRS loss after tax of £(31) million (31 December 2010: £820 million profit) reflects investment market losses as well as the impact of one-off costs relating to separation and integration spend, the Diligenta outsourcing transaction, and other project activity. Amortisation and impairment includes the one-off impact of adoption of negative reserves and a full year charge for the AXA UK Life Business. The result benefits from the gains recognised on the acquisition of BHA and WLUK whilst the prior year result reflects the much larger gain on the acquisition of the AXA UK Life Business.

KPI: MCEV operating profit before tax

2011:£517 million

2010:£412 million

Segment results comprise covered and non-covered business.

MCEV(i) operating profit before tax of £517 million (31 December 2010: £412 million) reflects the increased scale of the UK operations, with improved VNB in the AXA UK Life Business, the benefit of future expense savings (secured in part through the Diligenta outsourcing transaction) partially offset by the adverse net impact of persistency and morbidity assumption changes (in line with previous guidance).

(i)  The MCEV basis is in compliance with the European Insurance CFO Forum MCEV Principles ("MCEV Principles") (Copyright© Stichting CFO Forum Foundation 2008), issued in June 2008, and re-issued in amended form in October 2009.

KPI: MCEV (loss)/profit after tax

2011:£(295) million

2010:£460 million

MCEV loss after tax of £(295) million (31 December 2010: £460 million profit) reflects adverse economic variances driven by the fall in investment markets in the period. The result also reflects the impact of non-recurring project costs including £124 million for the Diligenta outsourcing transaction.

KPI: Group embedded value on an MCEV basis

2011:£5,796 million

2010:£6,515 million

Group embedded value on an MCEV basis of £5,796 million (31 December 2010: £6,515 million) principally reflects the payment of the cash dividend to shareholders of £226 million, the return of capital of £250 million through the share buy-back programme and the loss for the year.

FLG operating ROEV(i) of 6.5% (31 December 2010: 8.3%) reflects the inclusion of the AXA UK Life Business for a full year but is showing progress through the Group's targeted reduction in new business strain and achievement of synergies. The increase in full year 2011 ROEV from the annualised half year ROEV of 4.5% reflects the progress made to date in migrating UK business to target platforms and securing future cost savings in part through completion of the Diligenta outsourcing transaction.

(i)  FLG operating ROEV is calculated as the annualised MCEV operating return, after tax and financing, divided by the start of period net embedded value, and is adjusted to allow for the timing of significant capital movements such as dividends and acquisitions.

KPI: Asset quality - corporate debt and asset backed securities

2011:£8.6 billion

2010:£8.2 billion

The Group has maintained high asset quality, with 97% of shareholder-related corporate debt and asset-backed securities at investment grade or above (2010: 95%). The Group has no significant shareholder exposure to sovereign debt or corporate bonds of higher risk European economies.

KPI: Available shareholder cash

Group available shareholder cash of £853 million decreased by £214 million from 31 December 2010 (£1,067 million) reflecting the return of £476 million of cash to shareholders; £226 million through dividends and £250 million through the share buy-back programme. The life companies contributed £415 million to ASC underpinned by sustainable free surplus generation of £291 million. Full year free surplus generation was impacted by a number of one-off items including delivery of one-off capital synergies of £281 million (against a target of £235 million) and adverse economic experience of £352 million. Working capital increased in the year driven by the retention of free surplus to fund future integration activity (including the Diligenta outsourcing) and increased funding retained in the life companies in response to recent adverse economic conditions.

KPI: IGCA

Estimated FLG IGCA surplus capital of £2.1 billion (31 December 2010: £2.3 billion) reflects the £350 million dividend paid to RHG and the acquisition of BHA, partially offset by surplus emergence in the year.

The estimated IGCA at the end of February increased to £2.2 billion, with the impact of positive investment performance partially offset by separation and integration spend.

IFRS results

IFRS profit

The Group's IFRS results are set out below, including a reconciliation from IFRS based operating profit to the IFRS result after tax. The Group uses the operating profit measure as the Board considers that this better represents the underlying performance of the business and the way in which it is managed.

These results include the results of the acquired Friends Provident business, AXA UK Life Business, BHA and WLUK from the deemed dates of their acquisitions, which were 4 November 2009, 3 September 2010, 31 January 2011 and 7 November 2011 respectively. The results of the GOF and TIP portfolios are included for the period from 3 September 2010 until their disposal on 1 November 2011.

IFRS based operating profit for 2011 was £681 million comprising the operating profit of the life businesses of £750 million, £28 million of corporate costs for FLG and £41 million of corporate costs for the Resolution holding companies. This result includes £404 million of principal reserving changes and one-off items which comprised:

·  £221 million one-off benefit in respect of PS06/14;

·  £71 million release of expense reserves, including the benefit of the savings secured through the Diligenta outsourcing; and

·  a further £124 million of positive UK assumption changes offset by £12 million adverse changes in International.

Excluding the impact of these items and the equivalent one-off changes in 2010 leads to an underlying IFRS based operating profit of £277 million for 2011 compared to £288 million for 2010. The increase in the size of the Group and the improvements to new business strain (reflecting cost reductions and transition to target platforms) have been offset by the adverse impact of market conditions on operating profit (resulting in lower annual management charges for UK business, higher cost of guarantees for certain International business and lower long-term investment return assumptions), the ongoing negative impact of the adoption of PS06/14 and the poor performance in International. Further details on the operating performance of the Group are included in the relevant business unit operating sections.

Non-operating items

Investment market performance has been volatile throughout 2011 and deteriorated in the second half of the year. As a result negative short-term fluctuations in investment return amounted to £261 million, principally relating to variances against the expected return on assets backing the non-profit funds. The major movements comprise:

·  adverse variances as a result of mismatches between  the assets backing the Friends Life annuity portfolios and the related liabilities. These variances are a consequence of the Group's asset/liability matching approach which is typically undertaken on a realistic basis. As policyholder liabilities are reported in the results according to their treatment on a regulatory basis the differing approaches create a mismatch;

·  credit default assumptions have been strengthened following the worsening of economic conditions during the second half of 2011 as evidenced by the significant widening of corporate bond spreads; and

·  negative shareholder fluctuations of £46 million represent the difference between actual and expected investment returns, due to the Group's higher holding in cash combined with lower than expected rates of return.

Acquisition accounting adjustments, totalling £759 million, represent the amortisation and impairment of the intangible assets recognised on the acquisitions. These charges comprise £675 million of amortisation and impairment of acquired in-force business, and £84 million of amortisation of other intangible assets. The amortisation of acquired in-force business includes a one-off charge of £201 million (£130 million for the AXA UK Life Business, £71 million for BHA) reflecting the accelerated run-off of in-force surplus following the recognition of negative reserves in these businesses.

Non-recurring items include gains on acquisitions of £116 million. The completion of the BHA and WLUK acquisitions has resulted in gains of £68 million and £48 million respectively, offset by acquisition costs of £3 million.

The disposal of the GOF and TIP portfolios did not have a significant impact on the Group results.

Other non-recurring costs of £293 million include £84 million of costs relating to the 15 year outsourcing arrangement with Diligenta; and £209 million of other non-recurring costs. These comprise:

·  separation and integration programme costs of £128 million;

·  finance transformation costs of £55 million including Solvency II;

·  capital optimisation project costs of £19 million; and

·  other costs of £7 million.

The Diligenta impact of £84 million in 2011 reflects the reserving required for transition and service improvement costs in relation to in-force insurance contract business. In accordance with IFRS, no reserves have been established for the investment contracts business. Total implementation costs for both in-force insurance and investment business are expected to be £250 million with the remainder incurred over 2012 to 2014.

Interest payable on the FLG STICS of £31 million is included as a £26 million deduction to corporate long-term investment return in the operating profit analysis, and £5 million adverse investment fluctuation. As the STICS are accounted for as equity in IFRS (with interest being recorded as a reserve movement), £31 million is added back to the non operating result to reflect the requirements of IFRS.

A shareholder tax credit of £457 million is recognised in the period and is significantly higher than the loss before tax of £488 million would imply. The principal differences between the implied and actual shareholder tax credit relate to:

·  £69 million one-off shareholder tax credit triggered by the change in pricing basis on certain unit-linked funds to reflect the fact these funds were contracting;

·  £60 million shareholder tax credit relating to the reduction in the rate of UK corporation tax;

·  £68 million and £48 million gains on the acquisitions of BHA and WLUK respectively, which are not taxable (the tax impact of this is £31 million); and

·  £190 million shareholder credit for tax reliefs, expenses and exemptions predominantly in relation to the life insurance companies in the Group which are taxed on the "I minus E" basis, an element of which is matched by liabilities which are accounted for within policyholder liabilities and form part of the loss before tax.

The tax credit includes £194 million credit in respect of the amortisation and impairment of AVIF and other acquired intangibles in the year.

The £23 million return on F&C Commercial Property Trust in 2010 reflects the market return attributable to third parties for the period up to April 2010. This was the date at which FLG ceased to consolidate the results of this company, as holdings had been reduced to below the level requiring consolidation, hence there is no impact on the 2011 results.

Summary IFRS balance sheet

(i)  Adjusted to exclude 2,661,384 Resolution Limited shares held by subsidiaries at 31 December 2011 (31 December 2010: 8,579,292).

At 31 December 2011, IFRS total equity was £5,995 million (31 December 2010: £6,549 million), with equity attributable to equity holders of the parent of £5,672 million (31 December 2010: £6,227 million). IFRS net assets per share attributable to shareholders were £4.13 (31 December 2010: £4.31) based on shares in issue at the balance sheet date, excluding the Company's shares held by subsidiaries.

The Company's issued share capital has decreased reflecting the shares repurchased and cancelled under the share buy-back programme, changes in the shares held by subsidiaries and the impact of shares issued to satisfy the scrip element of the 2010 final dividend (14 million shares) and 2011 interim dividend (3 million shares). The return of capital to shareholders through the share buy-back programme commenced on 8 June 2011, was completed on 26 October 2011 and resulted in a reduction in issued share capital of 93 million shares with a total value of £250 million. There has been a reduction in the number and value of shares in the Company held by the life companies (£7 million compared to £20 million at 31 December 2010). In accordance with IFRS requirements, these shares have been excluded from the equity attributable to equity holders of the parent.

Financial assets are predominantly invested in listed shares, other variable yield securities and corporate bonds and asset backed securities. Asset quality has been maintained with 96.9% of shareholder-related corporate bonds and asset backed securities held at investment grade or above.

As part of the financing for the acquisition of the AXA UK Life Business, a £400 million short-term funding arrangement was put in place. This was repaid in April 2011 following the successful raising of £500 million external LT2 subordinated debt by FLG.

At 31 December 2011, the ratio of debt to IFRS equity attributable to equity holders of the parent, gross of debt, was 17.4% (31 December 2010: 16.3%), with the movement primarily reflecting the decrease in equity following the return of capital to shareholders.

MCEV results

MCEV profit

MCEV is an alternative accounting basis to IFRS for life assurance companies. MCEV reporting is designed to recognise profit as it is earned over the lifetime of each policy and reflects the future cash flows that are expected to arise from sales in the year, together with the effect of updating the previous year's assumptions on existing business for the actual experience. The total profit recognised under both MCEV and IFRS will be the same over the life of each policy, it is the timing of the recognition of that profit which differs.

The results and financial position of the Group's life and pensions business ("covered business") are presented on the MCEV basis with all other businesses included on an IFRS basis.

Group MCEV profit

(i)  2011 results comprise 12 months results for Friends Provident and the AXA UK Life Business, 11 months for BHA, ten months for GOF and TIP and two months for WLUK.

(ii)  2010 results include 12 months results for Friends Provident and four months for the AXA UK Life Business (including GOF and TIP but excluding WLUK).

Overall MCEV operating profit before tax for 2011 was £517 million compared to £412 million in 2010. Excluding the impact of one-off assumption changes for both periods gives an underlying operating profit of £377 million in 2011 and £435 million in 2010. Consistent with IFRS, the MCEV operating result has been negatively impacted by the poor performance in International and by adverse market performance with a reduction in certain longer term rates of return and a significant fall in Lombard results reflecting the challenging market conditions.

The VNB has increased from 2010 reflecting the benefit of the inclusion of a full year of sales for the AXA UK Life Business (with improvements in VNB driven primarily by cost savings), the acquisition of BHA, the impact of the Diligenta transaction (reflecting the contractualised reduction in future maintenance expenses for the new business written in 2011) offset by reduced sales and profitability in Lombard, resulting from the impact of adverse economic conditions.

The expected return on existing business has increased following the acquisition of the AXA UK Life Business (including WLUK) and BHA. However, the longer term rates of return applied to equities and properties have fallen since 2010. The longer term return for government bonds used to determine 2011 MCEV operating profit is based on the one-year risk free rate at 31 December 2010 of 1.14%, which is materially below the longer term rate that could be derived from the 10 year swap rate at 31 December 2010 of 3.70%. The use of the one year rate results in a lower expected return, and hence a lower MCEV operating profit, than that which would have been obtained had a longer term risk free rate been applied. It is estimated that applying the 10 year swap rate of 3.70% to government bonds would have increased operating profit by £49 million for the period. The Group is reviewing the appropriateness of the rate applied in its MCEV operating profit and may, subject to any changes in industry practice, adopt a higher rate, based on the 10 year swap rate, as this is more closely aligned with the underlying characteristics of the Group's business. Any change in rate will have no impact on overall embedded value, as any increase in operating profit is offset by a decrease in economic variances.

Operating experience variances and other operating variances were £22 million adverse in the year. This reflects the adverse impact of persistency in the UK and Lombard, the negative impact of modelling changes in the International business (primarily in respect of more accurate modelling of guarantees on paid-up policies) offset by positive mortality and morbidity experience and the benefit of the change in Group capital policy to hold a minimum of 150% (previously 160%) of Group Capital Resource Requirements (excluding WPICC). Further details of this change are included in the cash and capital section.

Operating assumption changes amount to £140 million benefit in the year, comprising £185 million benefit of the Diligenta outsourcing and positive mortality changes of £30 million offset by £73 million net adverse impact of the favourable morbidity and adverse persistency assumption changes including the establishment of a provision for the expected impact of the Retail Distribution Review, and £2 million of other adverse changes. This corresponds to the guidance given in the Group's Interim Management Statement in November 2011 which anticipated an adverse impact of £40 to £70 million for operating assumption changes at 31 December 2011 in respect of persistency and morbidity.

Further details on the operating performance of the Group are included in the relevant business unit operating sections.

Non-operating items

Economic variances combine the impact of changes to economic assumptions with the investment return variances over the year. Total economic variances in 2011 had a £600 million adverse impact on results (2010: £229 million favourable). The main contribution to the adverse variance is a £419 million impact arising from the reduction in the value of future profits from annual management charges on unit-linked business (UK: £241 million, International and Lombard: £178 million). The volatile macroeconomic conditions have also resulted in corporate bond spreads widening in the second half of the year with credit default and illiquidity premium assumptions changed to take account of these conditions. These changes have resulted in a £239 million impact on the UK annuity business.

Other positive economic variances total £58 million and include the offsetting impacts of economic conditions on the time value of options and guarantees ("TVOG"), £52 million adverse, the change in market value of Group debt, £97 million favourable and £13 million of other minor, positive variances.

Costs of £3 million have been incurred relating to the acquisition of BHA and WLUK (31 December 2010: cost of acquisitions totalled £28 million).

Non-recurring costs total £345 million (31 December 2010: £61 million) and include £124 million of one-off costs relating to the outsourcing agreement with Diligenta, £209 million of non-recurring costs consistent with IFRS (as explained above) and £12 million specific to MCEV. The £12 million MCEV-specific costs relate primarily to the difference between the actual tax relief expected to be received on UK pensions business of 6.5% and the approach applied in MCEV where a notional tax gross up of 26.5% is applied to the net of tax figure, resulting in a higher cost, gross of notional tax, under MCEV than under IFRS.

Other non-recurring items and non-operating variances of £66 million include a benefit of £23 million from the capital optimisation project and £35 million benefit from the impact on the UK business of the Budget in April 2011.This includes the impact on the value of in-force business of changing the corporation tax rate from 27% to 26% with effect from 1 April 2011 and changing the ultimate corporation tax rate effective from 1 April 2014 from 24% to 23%. A further £8 million of non-operating profit was generated through activities including a restructuring within Lombard.

MCEV balance sheet

(i)  Includes IFA distribution and management services businesses including the pension asset of FPPS.

(ii)  Adjusted to exclude 2,661,384 Resolution Limited shares held by subsidiaries at 31 December 2011 (31 December 2010: 8,579,292).

At 31 December 2011, net Group MCEV was £5,796 million (31 December 2010: £6,515 million) giving MCEV per share of £4.22 based on shares in issue at the balance sheet date, adjusted to exclude shares held by subsidiaries. MCEV per share at 31 December 2010 was £4.51 on a comparable basis.

At the end of the period the ratio of debt to gross Group MCEV (excluding internal debt) was 19.3% (31 December 2010: 18.7%), primarily reflecting the reduction in MCEV arising from the return of capital to shareholders. The ratio of debt to gross FLG MCEV was 16.3% (31 December 2010: 16.6%).

The Resolution holding companies' net worth, including internal and external debt, decreased by £154 million reflecting the payment of cash dividends of £226 million, the return of capital to shareholders of £250 million and corporate costs, offset in part by the receipt of a £350 million dividend from FLG.

The annualised FLG operating ROEV, after tax, for the year to 31 December 2011 is 6.5%. This represents steady progress when compared to the annualised 4.5% achieved at 30 June 2011 and 2010 baseline of 5.5%. The baseline operating ROEV includes the estimated full year impact of the AXA UK Life Business and BHA and assumes nil impact of operating variances and assumption changes. The operating ROEV at 31 December 2011 principally reflects the improvements made to the contribution of new business in the second half of the year as well as the benefit of year end assumption changes including the Diligenta outsourcing transaction. Low expected rates of return, particularly on shareholder assets, continue to provide a challenging environment in which to deliver improving returns.

UK operating review

In August 2011, the Group announced the creation of distinct 'Go to Market' and 'Heritage' UK business units, reflecting the Group's desire to improve the focus on both the profitable products and markets, and the existing in-force customer base The Go to Market businesses are Corporate Benefits, Protection, and Retirement Income. They represent scale markets where good margins are generally available and where the Group has strong market positions enabling access to those margins. The Heritage business manages products not being marketed actively and the dedicated Heritage management team is focused on retention, cash and capital. The Heritage business unit forms the bulk of the UK business by assets and in-force value.

UK AUM

£88 billion

UK VIF

£2.9 billion

Key financial metrics for the UK businesses are shown below, further details are included in the financial results section:

Profitability of new business

The Group's new business strategy focuses on products and distribution channels in the UK market where the Group has a strong market position and the potential to access attractive returns. This strategy drives the focus of the Group's UK Go to Market business units whilst steps have been taken to exit or scale back sales in product lines where Friends Life will not be able to generate satisfactory returns (mainly individual pensions and investment bonds). The creation of a UK Heritage business unit will allow more active management of the products no longer actively marketed.

The activities undertaken to reduce costs through synergies and outsourcing as well as the transition of new business to the selected target platforms have significantly improved the contribution from new business. The contribution from UK new business was £59 million in the year and is significantly higher than the £11 million 2010 baseline.

A number of critical steps have now been taken as part of the drive to improve profitability to meet the Group's 2013 targets. The recognition of negative reserves in the acquired AXA UK Life Business and BHA protection books has significantly reduced new business cash strain. In addition, the focus on new business profitability across Friends Life has served to reduce cash strain down to £169 million in the year, representing a £134 million reduction on the £303 million 2010 baseline and demonstrates the significant progress made toward the target set out in early 2011 to reduce UK cash strain by £200 million.

A significant proportion of the Go to Market Protection and Corporate Benefits new business is now written on their respective target platforms. The profitability of the selected platforms is already close to or above the target 2013 returns with the target Corporate Benefits platform delivering 9.4% IRR (target: 10%) and the target Individual Protection platform delivering 20.0% IRR (target: 20%). The UK blended new business IRR has improved throughout the year with a progression from 5.9% in the 2010 full year baseline improving to 7.7% at the end of 2011. As a result, Friends Life remains confident of meeting the targeted product metrics by the end of 2013. The relevant sections below contain detailed commentary on the results for each component business within the UK operating segment.

Cost savings

Separation and Integration

The separation and integration programme is progressing well with the BHA acquisition absorbed without interruption in January 2011. The BHA separation was completed at the end of January 2012 with the exit from Bupa transitional service arrangements ("TSAs").

The joint separation plans and operational service provision between AXA and Friends Life continues to work well, with 59% of transitional service arrangements exited by the end of 2011. Further arrangements have been exited early in 2012 and the separation from AXA IT infrastructure, the most significant component of the Friends Life and AXA separation agenda, is well advanced.

There have been five site closures announced to date, being Coventry, Manchester Spring Gardens, Basingstoke, Preston and London Crosswall (the former offices of BHA, where employees moved across to Friends Life's One New Change offices at the end of January 2012).

The integration projects remain on plan with £45 million run-rate savings achieved by the end of 2011 with cumulative costs of £67 million incurred to date (£58 million in 2011). This progress represents an acceleration of synergy delivery primarily across Customer Services and IT, and has been delivered through closing legacy products to new business as well as the initial impacts of announced site exits. Cumulative separation project costs of £72 million (£57 million incurred in 2011) are also in line with plan at this stage of the project.

Diligenta

The Diligenta transaction complements the current outsourcing arrangements already in place with Capita. The service start date of this transformational transaction was 1 March 2012 when the remaining UK Heritage IT and Customer Services functions were outsourced thereby materially de-risking the future expense levels of the UK business together with significantly enhancing the level of synergies available. This certainty of future cost levels for a significant proportion of the business has been recognised in the operating results.

·  IFRS based operating profit has benefited by £71 million in 2011 reflecting the release of maintenance expense reserves. Implementation costs of £84 million (which exclude costs relating to investment contracts in accordance with IFRS) have been reserved for and are presented within non-recurring costs. This results in a small net loss included in IFRS profit before tax of £13 million.

·  In MCEV the recognition of the contractualised future expense savings has resulted in an uplift of £185 million in the MCEV operating result. In addition the certainty over lower ongoing maintenance expense levels has positively benefited VNB by £15 million taking the total benefit in MCEV operating profit to £200 million. Implementation costs of £124 million have been recognised as non-recurring costs in the 2011 result, reflecting the element attributable to the in