Cash generation

As outlined in our 2009 Annual Report and Accounts, the Group’s cash flows are generated from the interest earned on capital, the release of excess capital as the life funds run down, policyholder charges and management fees earned on assets under management. The Group’s closed life funds provide predictable fund maturity and liability profiles, creating stable long-term cash flows for distribution to owners and for repayment of outstanding debt. Although investment returns are less predictable some of this risk is borne by policyholders.

Holding Companies' cash flows

The statement of cash flows prepared in accordance with IFRS combines cash flows relating to policyholders and cash flows relating to owners, but the practical management of cash within the Group maintains a distinction between the two, as well as taking into account regulatory and other restrictions on availability and transferability of capital. For this reason, the following analysis of cash flows focuses on the Holding Companies' cash flows* for the half year ended 30 June 2010, which reflect cash flows relating only to owners and which are, therefore, more representative of the cash that could potentially be distributed to the Group’s owners, or used for the repayment of debt. This cash flow reflects the cash paid by the operating subsidiaries to the Group’s Holding Companies, as well as the uses of the cash receipts.

Holding Companies' cash inflows from the operating subsidiaries for the half year ended 30 June 2010 were £335 million (pro forma half year ended 30 June 2009: £252 million). We are on track to deliver annual recurring cash flows from our operating subsidiaries at the top of our stated £400 million to £500 million range as well as accelerated cash flows of £225 million from management actions which are expected to complete mainly in the second half of 2010. Accelerated cash flows will be achieved through outsourcer and cost management, tax optimisation and fund restructurings.

*The cash flow analysis was previously presented for the UK Holding Companies under Phoenix Group Holdings, being Phoenix Life Holdings Limited, Phoenix Group Holdings (No. 2) Limited, Impala Holdings Limited, Pearl Group Holdings (No. 1) Limited, PGH (LCA) Limited, PGH (LCB) Limited, PGH (LC1) Limited, PGH (LC2) Limited and Pearl Life Holdings Limited. For 2010 Phoenix Group Holdings is included in the cash flow analysis, which now refers to Holding Companies, and prior periods have been restated to reflect this.

1 Restated to include the cash flows of Phoenix Group Holdings
2 Amounts received by Holding Companies in respect of Group relief are included within cash receipts from the relevant subsidiaries
3 Certain contributions are made directly by the service companies to the pension schemes
4 Closing balance at 30 June 2010 includes required prudential cash buffer of £150 million

Cash receipts

£326 million of cash was remitted by Phoenix Life from the emergence of surplus and regulatory capital releases including £30 million of cash generated through management actions from the resolution of legacy tax issues.
Cash is typically distributed from the life companies twice a year following the full actuarial valuations at
31 December and 30 June. The half year 2010 cash flows include the receipts from the life companies following the
31 December 2009 valuation.

The table below analyses the movement in free surplus of the life companies.

1 Free surplus at 1 January 2010 funded the 2010 half year cash release
2 Excluding management services IFRS operating profit of £7 million for the half year ended 30 June 2010
3 Represents minor differences between IFRS valuation of assets and liabilities and valuation for capital purposes
4 Cash release in the second half of 2010 to be determined post 2010 capital policy review

The life companies’ free surplus is the excess of the net worth over the required capital reflected in the MCEV and represents excess capital over capital policies.

Pension scheme contributions

The triennial valuation for the PGL Pension Scheme is nearing completion and the Group aims to agree additional contributions to the scheme with the scheme trustees in the second half of the year. It is expected that £37 million of the additional contributions will be recovered from the Phoenix Life with-profits funds in line with the indemnity provided in 2005. The triennial valuation for the Pearl Group Staff Pension Scheme is complete and no changes to the funding levels are expected.

Pension scheme contributions under existing agreements are mainly paid in the second half of the year and remain in line with the 2010 target of £33 million. Expected annual pension scheme contributions including the new funding arrangement will be confirmed in the second half of the year.

In line with many other employers who operate defined benefit schemes the Group has recently decided to undertake a formal review of the benefits of both the Pearl Group Staff Pension Scheme and the PGL Pension Scheme. This review, which we expect to complete shortly, will consider ways of mitigating the financial risk and volatility associated with funding these schemes going forward.

Other operating expenses

Other operating expenses include corporate staff costs and other corporate expenses.

Debt interest

The Holding Companies are targeting debt servicing cash outflows for 2010 of £102 million in recurring interest on bank debt and £27 million in recurring coupons on the Tier 1 Notes post the restructuring of the Notes which included a reduction in face value of 15 percent. A £33 million coupon, based on the value of the Notes prior to restructuring, was paid by the Holding Companies in April 2010, with the remaining 2009 deferred coupon to be paid by the end of 2010. £6 million of the 2010 coupon paid has been disclosed as a non-recurring outflow for the half year ended 30 June 2010 to reflect the subsequent 15 percent reduction in the face value of the Notes and the purchase of notes from Royal London with a face value (pre discount) of £19 million.

Debt prepayment

A £22 million voluntary debt prepayment was made in respect of one of the Group's main credit facilities in the first half of 2010. Scheduled repayments of the Group's main facilities commences in 2011.

IT and other business transformation costs

The Group’s Holding Companies incurred IT and other business transformation costs of £25 million in the first half of 2010, including costs associated with the Group’s transformation programme with its outsourcers. Business transformation costs are expected to reduce going forward as the investment programmes complete.

The Group is investing in transforming its actuarial IT systems to meet the requirements of Solvency II, provide greater operational efficiencies and further enhance the quality and speed of financial reporting. The majority of payments for this project will be made by the operating businesses.

Transaction and restructuring costs

Transaction and restructuring costs include cash payments related to the Premium Listing and consent fees paid to the lending banks for various internal restructurings and corporate activity.

Target cash flows

The Group is targeting the generation of the following aggregate Holding Companies' cash inflows for the period from 2010 to 2014:

1 No management actions assumed beyond 2011
2 Includes emergence of surplus of Ignis Asset Management and Management Services

The resilience of these forecast cash flows is demonstrated by the following stress testing:

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

One off shocks would be expected to lead to a deferral of cash emergence rather than a permanent diminution.