Legal & General (LGGNY) Risk Analysis

The performance and liquidity of financial and property markets, interest rate movements and inflation impact the value of investments we hold in shareholders’ funds and to meet the obligations from insurance business; the movement in certain investments directly impacts profitability. Interest rate movements and inflation can also change the value of our obligations and although we seek to match assets and liabilities, losses can still arise from adverse markets. Falls in the risk free yield curve can also create a greater degree of inherent volatility to be managed in the Solvency II balance sheet, potentially impacting capital requirements and surplus capital. Falls in investment values can reduce our investment management fee income. We cannot eliminate the downside impacts on our earnings, profitability or surplus capital from investment market volatility and adverse economic conditions, although we seek to position our investment portfolios and wider business plans for a range of plausible economic scenarios and investment market conditions to ensure their resilience across a range of outcomes. This includes setting risk limits on exposures to different asset classes and where hedging instruments exist, we seek to remove interest rate and inflation risk on a financial reporting basis. Our Own Risk & Solvency Assessment (ORSA) is integral to our risk management approach, supporting assessment of the financial impacts of risks associated with investment market volatility and adverse economic scenarios for our Solvency II balance sheet, capital sufficiency, and liquidity requirements. Whilst global and UK economic activity is returning to pre-pandemic levels, there remains significant uncertainty to the impacts of inflation on the sustainability of the recovery, particularly should current inflationary pressures become deep seated or from misjudged central bank monetary policies in response. Financial markets, as well as being impacted by the economic outlook also continue to be susceptible to shocks and re-appraisal of asset values from a range of other factors including geo-political crisis in eastern Europe; a collapse in China’s property sector; and the emergence of further Covid-19 variants that may be resistant to current vaccines. Within the UK, uncertainty persists in certain elements of commercial property markets, and within our construction businesses supply chain and labour shortages are evolving risks.

As a significant investor in financial markets, commercial real estate and housing, we are exposed to climate related transition risks, particularly should abrupt shifts in the political and technological landscape impact the value of those investment assets associated with higher levels of greenhouse gas emissions. Our interests in property assets may also expose us to physical climate change related risks, including flood risks. We are also exposed to the risk of adverse perceptions of the group and climate risk related litigation should our responses not align with environment, social and governance (ESG) rating expectations. We recognise that our scale brings a responsibility to act decisively in positioning our balance sheet to the threats from climate change. We continue to embed the assessment of climate risks in our investment process, including in the management of real assets, and broader risk management framework. At the aggregate level we measure the carbon intensity targets of our investment portfolios, and along with specific investment exclusions for carbon intensive industries, we have set overall reduction targets aligned with a 1.5°C interpretation of the Paris Agreement, including setting near term science based targets to support our long-term emission reduction goals. We also closely monitor the political and regulatory landscape, and as part of our climate strategy we engage with regulators and investee companies in support of climate action. Following COP26, we are still encouraged about the possibility of limiting global temperature rises to 1.5°C. However, this will require societal change on an unprecedented scale over the next decade. We are dependent on the delivery of policy actions, and the climate reduction targets of the firms we invest in. The actions that the world is taking will also to some extent inform the actions that we can take. Climate change and failure to transition to a low carbon economy remains a significant risk that we believe has still to be fully priced in by financial markets, with delays in responding to the threats increasing the risk of sudden late policy action, leading to potentially large and unanticipated shifts in asset valuations for impacted industries.

We have constructed our framework of internal controls to minimise the risk of unanticipated financial loss or damage to our reputation. However, no system of internal control can completely eliminate the risk of error, financial loss, fraudulent actions or reputational damage. We are also inherently exposed to cyber threats including the risks of data theft and fraud. There is also strong stakeholder expectation that our core business services are resilient to operational disruption. Our risk governance model, seeks to ensure that business management are actively engaged in maintaining an appropriate control environment, supported by risk functions led by the Group Chief Risk Officer, with independent assurance from Group Internal Audit. Whilst we seek to maintain a control environment commensurate with our risk profile we recognise that residual risk will always remain across the spectrum of our business operations and we aim to develop response plans so that when adverse events occur, appropriate actions are deployed. Although Covid-19 lockdowns in 2021 had some impact for our business operations, the majority of our business services have operated normally, and we expect to transition in 2022 to a hybrid office:home working environment that will seek to maintain high standards of customer service and internal control. We remain, alert to evolving operational risks and continue to invest in our system capabilities, including those for the management of cyber risks, to ensure that our business processes are resilient. We are also cognisant of the risks as we implement a new global operating model and IT platform for LGIM, and have structured the migration in phases to minimise change risks.

Legislation and government fiscal policy influence our product design, the period of retention of products and required reserves for future liabilities. Regulation defines the overall framework for the design, marketing, taxation and distribution of our products, and the prudential capital that we hold. Significant changes in legislation or regulation may increase our cost base, reduce our future revenues and impact profitability or require us to hold more capital. The prominence of the risk increases where change is implemented without prior engagement with the sector. The nature of long-term business can also result in some changes in regulation, and the reinterpretation of regulation over time, having a retrospective effect on inforce books of business, impacting future cash generation. We are supportive of regulation in the markets in which we operate where it ensures trust and confidence and can be a positive force on business. We seek to actively participate with government and regulatory bodies to assist in the evaluation of change so as to develop outcomes that meet the needs of all stakeholders. Internally, we evaluate change as part of our formal risk assessment processes, with material matters being considered at the Group Risk Committee and the Group Board. Our internal control framework seeks to ensure on-going compliance with relevant legislation and regulation. Residual risk remains, however, that controls may fail or that historic financial services industry accepted practices may be reappraised by regulators, resulting in sanctions against the group. Regulatory driven change remains a significant risk factor across our businesses. Areas of future change include HM Treasury’s consultation on Solvency II and the Future Regulatory Framework post Brexit; and the UK’s financial conduct regulators proposal for a new Consumer Duty will place obligations to evidence the delivery of good customer outcomes. Regulatory focus also continues on operational resilience, the management of third parties and the transition risks presented to the financial service sector from climate change. We are also monitoring potential for changes in UK fiscal policy arising from the need to fund government borrowing in response to Covid-19; and the likelihood of a global move towards a higher tax environment. We also continue to prepare in readiness for IFRS 17, which will introduce a new suite of financial reporting metrics. Within our property construction businesses, the Building Safety Bill and the Environment Act 2021 will also introduce new operating requirements

The Group aims to recruit, develop and retain high quality individuals. We are inherently exposed to the risk that key personnel or teams of expertise may leave the Group, with an adverse effect on the Group’s businesses. As we increasingly focus on the digitalisation of our businesses, we are also competing for data and digital skill sets with other business sectors as well as our peers. We seek to ensure that key personnel dependencies do not arise, through employee training and development programmes, remuneration strategies and succession planning. Our processes include the active identification and development of talent within our workforce, and by highlighting our values and social purpose, promoting Legal & General as a great place to work. We also engage our people on new ways of working under our hybrid home:office model and are investing in technology and upgrading our buildings to support a range of working styles. Competition for talent across the full range of capabilities and qualifications is intense and demands that the Group offers competitive compensation arrangements as well as opportunities for development and an attractive work environment. People with skills in areas such as technology and digital are particularly sought after across many business sectors, including those in which we operate. We also recognise the risks posed by the outlook for inflation in salary expectations across the wider employment market. Marketwide approaches to hybrid working are still evolving, and although we believe we are taking the right steps, there remains a risk that our model does not align with the expectations of those we seek to attract or retain.

There is already strong competition in our markets, and although we have had considerable past success at building scale to offer low cost products, we recognise that markets remain attractive to new entrants. It is possible that alternative digitally enabled financial services providers emerge with lower cost business models or innovative service propositions and disrupt the current competitive landscape. We are also cognisant of competitors who may have lower return on capital requirements or be unconstrained by Solvency II. We continuously monitor the factors that may impact the markets in which we operate, including evolving domestic and international capital standards, and are maintaining our focus on developing our digital platforms. We have a number of direct investments in strategically important market segments to enhance delivery of our core businesses including workplace benefits, insurtech, mortgages, health and care and equity funding. LGIM continue to invest in technology to achieve the resilience and agility critical to future success. The need to adjust to living with Covid-19 has seen the acceleration of a number of trends, including greater consumer engagement in digital business models and on-line servicing tools. It has also seen businesses like ours transform working practices, and we expect to continue to invest in automation, using robotics to improve business efficiency. Our businesses are well positioned for changes in the competitive landscape that may arise from the roll out of defined benefit ‘superfund’ consolidation schemes, pension dashboards and ‘collective’ pension scheme arrangements. We also continue to be supportive of the opportunity for reform of the Solvency II capital regime post Brexit.