Business Review

EUROPE: UNITED KINGDOM AND OFFSHORE

Strong profit performance in a challenging year

* Restated, as now reporting on an MCEV basis

Positive net client cash flows despite low investor confidence

Skandia UK and Offshore continued to deliver positive net client cash flows for the year with net inflows of £1.7 billion representing 4% of opening funds under management. This comprised strong International net inflows and positive UK net inflows which were lower than 2007. The market downturn contributed to a 17% decrease in funds under management but this compared favourably with the 31% drop in the FTSE 100 in 2008. Investment performance was driven by the diversity of our offering with significant changes in asset mix occurring as investors moved into cash based investments. Foreign currency denominated funds benefited from the weakened sterling.

Investment volatility affects sales

Life assurance sales APE declined in line with the market. The largest relative falls in sales were in the bonds and single premium pensions products and because the 2007 pensions business figure benefited from the lingering benefits of pensions 'A-day' and higher investor confidence at the time. In 2008 the market for single premium bonds was affected by the introduction of an 18% flat rate of CGT confirmed in the March 2008 Budget. Skandia's market share across the entire pensions market remained strong particularly in the core product area of single premium personal pensions. Regular premium business held up better, ending the year 9% up on 2007.

Skandia International performed very well in 2008 due to its geographical diversity, full open-architecture proposition, strong distribution relationships and a focus on high net worth customers. Product and e-business developments greatly enhanced our customer proposition in 2008.

Unit trust performance impacted by volatile markets

Unit trust sales were down 25% on 2007 as a result of one of the lowest ISA seasons on record for the whole industry and again a reflection of the turbulent market conditions. Within this, institutional mutual fund business of £239 million was up by 45% over 2007. Skandia's market share in platform business fell marginally in the year but there were indications that the re-pricing of the platform business in the latter part of the year was starting to have a positive impact on sales. Skandia continue to increase investment solutions on the platform to create wider appeal, especially during periods of market volatility.

New business contribution

VNB fell by 17% to £67 million due to lower new business volumes. The reduction was partially mitigated by a strengthening of the assumptions for the amount of fee income rebated from fund managers, as communicated at the Interim Results aligning Skandia more closely to the market. New business contribution was also positively impacted by the mix of business effects, with a shift towards sales of more profitable portfolio bond charging structures within Skandia International. The new business margin ended the year at 11%, in line with 2007.

Adjusted operating profit (IFRS basis) level with 2007 despite market conditions

An excellent adjusted operating profit (IFRS basis) was generated in the current climate with a decrease of 3% to £167 million for the year, in part reflecting the reduction in funds under management and sales. This was partially offset by changes to the policyholder taxation basis for Skandia UK following the market falls experienced in 2008. Additional integration costs were incurred in 2007, as previously communicated. A favourable variance of £33 million arose following the implementation of PS06/14 - the prudential reserving requirements that permit non-linked insurance business to be valued on a more realistic basis.

Increase in adjusted operating profit (covered business) (MCEV basis)

The adjusted operating profit (MCEV basis), on covered business after tax, increased by 14% to £235 million. This increase includes a positive impact of £56 million from operating assumption changes. This mainly resulted from the recognition of retained unit trust company rebates (referred to above) as Skandia outsources the investment of policyholder funds to unit trust companies. Other operating assumption changes included adjustments to expense assumptions to reflect current maintenance expense experience and modeling improvements. Experience variances were positive in aggregate at £17 million due to impacts on charges and continued positive experience in relation to retained rebates assumptions.

Capital

Current levels of statutory capital for Skandia UK and Skandia International are within or above the target ranges set by management. The businesses are well capitalised with a solvency ratio of 2.6 times the required level.

Continued investment innovation at Skandia

During the year, we continued our track record of innovation in multi-manager investment solutions. The Spectrum range of risk-controlled funds was launched in April 2008 and attracted over £120 million of gross subscriptions by 31 December 2008. In the volatile market, the risk controlled nature of the funds proved very effective from both a return and risk perspective. In June 2008, we launched the Skandia Alternative Investments Fund which has an absolute return focus and has funds under management in excess of £30 million. The high profile Best Ideas fund range continued to attract new sales with funds under management of over £391 million at 31 December 2008. The UK Strategic Best Ideas Fund had funds under management of £80 million at 31 December 2008, and continues to be one of the best selling funds. Amid deteriorating equity markets, the UK Strategic Best Ideas Fund has continued to perform exceptionally well, with the fund being the best performing UK fund in the IMA UK All Companies Sector during 2008 (a universe of over 320 funds).

Skandia supports changes in the UK distribution landscape

The FSA published its paper on the Retail Distribution Review on 25 November 2008 moving the Review from the consultation phase into the implementation stage. The paper focused on the clarity of the service (distribution channels), remuneration, professional standards and prudential requirements. Skandia has already started to support its distribution channel through offering assistance in preparing our businesses for the change and assisting advisers in obtaining the necessary qualifications. The intention of the FSA is to consult with the industry on implementing the proposed changes over a period running through to 31 December 2012.

On 3 November 2008 Skandia UK announced that it is ending its membership of the Association of British Insurers (ABI) as evidence that its proposition is clearly differentiated from old style life and pensions companies, finding little alignment of interests with the broader ABI membership.

Skandia UK announced a new pricing structure in September 2008 removing the initial charge on platform sales. This move not only made Skandia's proposition very competitively priced but it also made the charging structure simple and transparent. The price changes have been positively received by financial advisers.

Skandia continues to receive awards for its service and investment innovation

In recognition of its leading customer service Skandia achieved a five star rating in the industry Financial Adviser Awards for the eleventh year running and became the first company to win the Outstanding Achievement Award for Pensions and Investments. Skandia has now won more than 30 five star awards in the 18 year history of the Financial Adviser Awards.

Skandia won the MultiManager of the Year award at the annual Investment Life & Pension Moneyfacts Awards in September 2008 and was also Commended in the Best Unit Trust/OEIC Provider category. These awards recognise the outstanding achievements of providers who manage to stand out from the crowd by offering high calibre products and delivering first class service.

Principal risks and uncertainties

The principal risks to Skandia UK arise from operational experience, along with market risk as Skandia UK derives income from fees which are charged as a percentage of funds under management. The broader financial risks are limited. Skandia UK does not offer material investment guarantees. Although we offer protection business, and so have exposure to mortality and morbidity risk, the majority of the risk is transferred to reinsurance counterparties. Credit risk exposures are small; the main exposures are the risk of default on the investment of company assets. Skandia UK has exposure to risk arising from operating experience in respect of factors including persistency and management expenses. These risks are managed within the operational functions who have primary responsibility for the identification, mitigation and monitoring of risks. Risks exceeding pre-determined thresholds are escalated and reported to management and to the Group CRO, along with details of the mitigating management action. Recent falls in investment markets have adversely impacted fund related revenues and new business volumes. The profitability and capital position of Skandia UK remains strong.

Outlook

Details of the changes to be introduced as part of the FSA's Retail Distribution Review are still under discussion. Meanwhile, Skandia is already preparing its response, with the aim of optimising its position in the new model of financial services and the distribution landscape that is likely to emerge. It will be particularly important to secure significant funds under management to ensure scale in the platform market that this review will stimulate. To secure assets on Skandia UK's platform we are running an aggressive campaign which began in 2008 with the removal of the initial margin on platform products to make our charges highly competitive.

Our offshore business is geographically diversified with sales in Europe, the Middle East, the Far East, Africa and Latin America, as well as in the UK. Skandia International is a high growth business with high potential for further growth in 2009 and beyond. Investment in the operating infrastructure to drive efficiencies and continued excellence in customer services will create further market, product and distribution opportunities. Whilst 2009 will be a challenging year, Skandia International remains confident about long-term future growth prospects owing to a growing customer base, robust regulatory and compliance infrastructure and a strong offshore brand.

EUROPE: NORDIC

Strong year with excellent sales performance and strengthened relations with distributors

* Restated, as now reporting on an MCEV basis

Strong net client cash flows

Net client cash flows for the year were an exceptional SEK7.0 billion, representing 6% of opening funds under management. The positive performance was largely driven by strong net inflows in the life business benefiting from an excellent sales performance and reduced outflows. However, volatile equity markets negatively impacted asset growth during the year, with funds under management at 31 December 2008 down 21% to SEK91.9 billion.

Sales performance continued to improve

Nordic delivered excellent growth in sales during 2008 with life sales on an APE basis up 30% mainly due to strong sales in Sweden. The broker sales channel accounted for the majority of this increase as a result of strengthened relationships supported by the new investment portfolio product and faster introduction of new funds to the market. A focus on the selling of unit-linked products has continued throughout the internal sales force, which together with several sales initiatives contributed to the improved sales. The very strong upward trend in new sales continued throughout 2008 and so far there have been no negative effects on sales performance from the volatile markets.

Mutual fund sales were down 8% on 2007, mainly due to lower inflows to fund deposits within our bank offering, partially offset by growth through other channels. This growth was mainly through deposits in fixed income and money market funds and through a hedge fund launched in the third quarter.

VNB grew strongly in 2008

VNB of SEK397 million for the year was up 27% on 2007, in line with the excellent life sales. In addition to strong volume growth, the APE margin benefited from the introduction of currency spreads and tighter cost controls. These largely offset the business mix impact in Sweden, particularly from the removal of Kapitalpension product tax advantages as well as the strengthened retention assumptions in 2008 and the negative economic changes in 2007. The life new business margin ended the year at 15% just below the margin in 2007. In the medium term, the new business margin is expected to improve to reach the high teens.

Strong underlying adjusted operating profits despite market turbulence

Adjusted operating profit (IFRS basis) increased 23% over 2007 despite the equity market downturn. This was largely due to excellent cost control and SkandiaBanken continuing to benefit from an improved interest margin.

The adjusted operating profit (MCEV basis) was up 109% on 2007 mainly due to strong VNB growth and the positive effect from assumption changes. In 2007 there was a negative effect of SEK526 million relating to strengthened retention assumptions and lower fund charges on 'tick-the-box' collective agreements and tendered corporate business. In 2008 the effect from operating assumption changes was SEK391 million which was mainly attributable to the introduction of currency spreads and increased assumption for the take-up rate for unit-linked contracts on retirement, partly offset by strengthened retention assumptions. Experience variances in 2008 of SEK142 million were driven by a higher level of fee income than assumed, tax and profits not valued within the value of in-force (e.g. Healthcare Business) partly offset by a negative retention effect mainly caused by premium reductions due to a Swedish legislative change relating to the level of tax deductible pension savings contributions.

Continued growth in banking business benefiting from market conditions with improved interest margin

SkandiaBanken is completely funded by deposits and therefore has a unique liquidity position enabling it to benefit from the current market situation with an improved interest margin and increased business volumes. SkandiaBanken has sufficient surplus liquidity and management continue to ensure that the liquidity position remains strong. The capital ratio as at 31 December 2008 was 14.1% (Basel II, pillar one). SkandiaBanken's lending portfolio has been built on sound lending practices and is comprised of 95% mortgages which have excellent credit worthiness with the remaining 5% comprised of unsecured loans. The average loan-to-value in the portfolio at the end of the year was approximately 40% to 45%. As a consequence, the bank has only been marginally affected by the market turbulence. The credit loss ratio (credit losses as a percentage of the opening lending balance) remains low at only 0.13%. The net interest margin was 1.67% in 2008 compared to 1.32% in 2007. We are confident SkandiaBanken's conservative lending policy means it is well positioned to respond to any adverse market developments.

Both deposit and loan books at SkandiaBanken increased in 2008. Excluding the divested car finance business, lending increased to SEK43.8 billion, up 9% since 2007. The increase related mainly to successful mortgage campaigns during the year in Sweden together with a highly competitive floating interest rate which led to increased lending volumes. As a consequence of the turbulent market conditions, customers have been switching funds from ordinary saving accounts with variable interest rates to saving accounts with fixed interest rates. Deposits of SEK52.0 billion were up 3% since 2007 and the number of customers increased 7% over 2007. SkandiaBanken's operating profit for 2008 was SEK283 million, 48% higher than 2007.

Capital

Skandia Nordic's capital position is stable with sufficient surplus equity exceeding both external requirements and internal buffers. The businesses are well capitalised with a surplus 9.9 times the required level.

Other

During the year we announced that Skandia and Livfösäkringsaktiebolaget Skandia (publ) (Skandia Liv) are reviewing the potential benefits to both the Group and to Skandia Liv policyholders of demutualising Skandia Liv. The review is at a very preliminary stage and a conclusion is not likely before late 2009.

As announced on 3 October 2008, a ruling has been passed in respect of the arbitration proceedings between Skandia AB and Skandia Liv. The arbitration board did not accept Skandia Liv's claim to any part of the purchase price paid, but ruled that Skandia AB is obliged to pay Skandia Liv a total sum of SEK580 million (£47 million) plus interest by way of compensation in relation to fees under the asset management agreement which Skandia Liv deemed to be higher than prevailing market rates. Old Mutual had already set aside SEK500 million (£41 million) to cover the arbitration within our pre-acquisition balance sheet. Skandia AB will also have to compensate Skandia Liv for future payments to DnB NOR that are higher than prevailing market rates until the contract with DnB NOR expires in 2013. A new provision of SEK426 million has therefore been set up.

Principal risks and uncertainties

Nordic's main risks relate to strategic and operational risks as well as market risks. The market risks mainly relate to asset based income which reduces when the value of the unit-linked funds declines. Having a diversified product range and a wide range of investment options address some of the market risks. Risks arising from operating experience (e.g. persistency and management expenses) are managed through the risk framework which includes a three lines of defence model and risks exceeding pre-defined risk tolerance levels are escalated to the Group Chief Risk Officer. Political and regulatory changes which could have an impact on the businesses are continuously monitored and managed.

Outlook

The continuing financial crisis will make 2009 a challenging year. In addition, there will be more legislative changes that will impact on our business.
Our corporate clients have been affected by the economic downturn and the effects of that will start to be seen during 2009. The private client market is now already under pressure and customer behaviour will be impacted. This could lead to lower customer activity during the year however we continue to focus on developing innovative financial product solutions to address customer needs in the current economic climate.

We continue to benefit from a combination of a broad product mix, a range of insurance, banking and investment business, market-leading expertise and a proven business model. As such, we are well positioned to handle the challenges ahead as demonstrated by the delivery of excellent 2008 results despite the market turbulence.

EUROPE: EUROPE AND LATIN AMERICA (ELAM)

Continuous innovation and customer focus in response to difficult market conditions

* Restated, as now reporting on an MCEV basis

Strongly positive net client cash flow during market volatility

Net client cash flows at ELAM were robust considering the market volatility, especially in the highly unstable fourth quarter of 2008. With the market in some of our operating countries, such as France and Italy, showing substantial outflows during the fourth quarter, our own performance compares strongly. Strong persistency, driven by pro-active retention campaigns and the ability for clients to switch to more conservative portfolios, provided support to strong net client cash flows.
Funds under management ended the year 15% below 2007 on a like-for-like basis (net of Pallayne divested during 2008). This included negative market movements on portfolio values of 27% of opening funds under management, reflecting the fall in financial markets across the globe throughout 2008. In comparison, the majority of European equity indices fell between 30% and 50% in 2008. Funds under management were partially supported by the effective asset mix of the portfolio which incorporates non-equity asset classes and reflects the investment appetite of customers that shifted further during 2008 towards guaranteed funds and other less risky asset classes.

Life sales impacted by constrained sales environment

Life sales on an APE basis were down throughout the year but especially in the fourth quarter due to negative investor sentiment. This effect was stronger in single premium business where investors typically have access to a wider range of investment opportunities and seem to have been taking a "wait-and-see" approach to investing under the current conditions. Regular premium business has been relatively more stable, reflecting the smaller premium sizes and habitual nature of saving on a regular premium basis. Nevertheless, regular premium sales have also been under pressure during the year, and the market volatility had a dampening effect on the traditional European seasonal ramp-up in sales in the final quarter, with the fourth quarter falling short of prior year levels.

Focused activity to support mutual fund sales

Given the market volatility and our core differentiator of this business line being international equities, mutual fund sales provided a solid contribution, although down 20% compared with 2007 on a like-for-like basis. We continued our efforts to deliver innovative products and quality service. During 2008, much focus was placed on improving the productivity of financial planners in Latin America. Increased training, new product offers and planning tools assisted financial planners in generating sales in the current conditions.

Value of new business and profit margins down

VNB of €13 million was down 77% over 2007, mainly as a result of lower sales in 2008 in light of the market crisis. In addition, VNB was negatively affected by changes in operating assumptions, where in particular the changed regulation on policyholder profit participation reduced the German VNB. The APE margin deteriorated to 6% from 20% in 2007. This was attributed to lower APE sales, which for the more recently established businesses was aggravated by a relatively fixed expense base leading to acquisition expense over-runs. In addition, the strong sales of high margin business in Poland in 2007 was not sustained in 2008.

Adjusted operating profit (IFRS basis) impacted by wider market environment

ELAM generates a significant element of its revenues from funds under management and these fees were lower in line with reduced levels of funds under management. This negative impact was partially offset by the growth of the in-force book of business during the year. Furthermore the revised policyholder participation regulations implemented in Germany during 2008 both widened the definition of revenues to be shared with policyholders and increased the level of participation. This had a €20 million impact on the IFRS adjusted operating profit for the year. This calculation is net of acquisition expenses and these were lower, in line with new sales levels, and so policyholder participation levels were relatively high. To protect the bottom line, ELAM maintained its expense base at 2007 levels, identifying efficiencies to offset growth in sales force and inflationary impacts.

Adjusted operating profit (MCEV basis) suffered from weak new business contribution and negative experience variances

MCEV adjusted operating profit was €5 million for 2008, 62% lower than 2007. This was largely due to lower VNB and poorer experience variances which included divisional restructuring costs. The operating assumption changes had a negative impact on the adjusted operating profit, but not to the same magnitude as for 2007. Changes have been made to persistency rates and expense levels, both of which have been strengthened.

Capital

ELAM's businesses continue to measure and monitor their capital resources on an ongoing basis to ensure compliance with the minimum capital requirements of the regulators in each territory in which we operate. Internally we manage our businesses to maintain a buffer of at least 25% in excess of the local requirements. Due to the decrease in funds under management levels, solvency requirements across our markets reduced, while our capital employed increased and therefore solvency coverage increased significantly over the year.

Market recognition of customer focus and innovation

We continued to focus strongly on our customers, delivering a number of new products and service innovations throughout the year. Examples include annuity features in Germany, a second Easy Plan product in Switzerland, various distributor products in Italy and France, dollar cost averaging and rebalancing features in Europe and new investment alternatives in Latin America. We also improved service to our customers and distributors through differentiated service offers to top distributors, pro-active service and retention campaigns, and improved distributor tools.

These innovations have been well received by the market, as can be judged from the various product and service awards won during the year, as well as from feedback on internal and external surveys undertaken.

Business restructure

From January 2009 we have restructured the business in continental Europe to reflect our principal customer segments in order to leverage capabilities and operational efficiencies across geographies. The transition to two main business structures will take place throughout 2009.

'Affluent' targets the affluent segment and currently comprises the businesses in France, Italy and Spain. 'Mass Retail' meets the savings needs of this significant part of the population and comprises the businesses in Germany, Austria, Switzerland, Poland and Eastern Europe. This foundation for efficiency in Central Europe and the integration of the Southern European businesses will allow us to take advantage of further efficiency opportunities in the future in the Mass Retail and Affluent businesses.

Principal risks and uncertainties

ELAM's business model carries limited guarantee and liability risk. Strategic and operational risk is reviewed regularly and managed through our risk framework. Our ongoing focus to build and diversify distribution aims to reduce concentration risk. The existing concentration levels remain within a reasonable range and we expect that future planned activities will assist us to manage this risk further.

ELAM's business mix, which includes regular and single premium, retail and institutional business, provides mitigating support to impacts on business results in the current volatile market conditions. However, uncertainty about the future extent and length of a global recession remains and market trends remain difficult to predict. ELAM's geographic diversity reduces the economic, market, political and legal/regulatory risks that would typically exist in single-market businesses. The transition to our new business line structure carries some change risk. A strong change management programme has been defined to reduce impacts to new and existing business.

Outlook

The global financial crisis and recessionary pressures are expected to be the main influence on the market in 2009. We expect new business to be constrained during the year as investor confidence remains suppressed.

Guaranteed products are likely to remain important to investors in 2009, temporarily slowing the growth of the unit-linked segment compared with traditional life. Products such as our traditional life fund in France and our rebalancing features will help us win sales in the current climate.

Regular premium business, which has been relatively unaffected by the market crisis, is expected to help our sales development in 2009 as the averaging effect of regular premium inflows should support our sales propositions.

Our strong performance in net client cash flows and client asset values has supported our market share. We believe that we will be able to capitalise on this further once confidence returns and markets return to more stable growth patterns.