Chairman Paul Manduca note (1) 393 – – – 71 – 464 – – 464 Harvey McGrath note ( 2) 252 – – – 50 – 302 – – 302 Executive directors Rob Devey 600 426 284 710 114 150 1,574 – 1,804 3,378 John Foley 610 586 390 976 156 103 1,845 50 – 1,895 Michael McLintock note (3) 360 904 404 1,308 124 93 1,885 218 3,190 5,293 Nic Nicandrou 630 655 437 1,092 99 158 1,979 – 1,804 3,783 Barry Stowe note (4) 651 613 409 1,022 608 163 2,444 2 2,183 4,629 Tidjane Thiam 1,000 1,000 1,000 2,000 123 250 3,373 – 4,428 7,801 Mike Wells note (5) 663 2,031 871 2,902 55 – 3,620 19 3,008 6,647
Non-executive directors Keki Dadiseth note (6) 120 120 120 Howard Davies 171 171 171 Michael Garrett 111 111 111 Ann Godbehere 181 181 181 Alistair Johnston 111 111 111 Kaikhushru Nargolwala 136 136 136 Kathleen O’Donovan note (7) 28 28 28 Lord Turnbull 161 161 161
¶ ‘The Single Figure’ is based on the methodology outlined on page 124.
2 Harvey McGrath retired from the Board on 2 July 2012. 3 ‘The Single Figure’ for Michael McLintock includes the increase in transfer value of his defi ned benefi t pension. This is outlined on page 130. 4 Barry Stowe’s benefi ts relate primarily to his expatriate status, including costs of £217,567 for housing, £32,104 for children’s education, £69,289 for home leave and a £248,894 Executive Director Location Allowance.
5 Mike Wells’ bonus fi gure excludes a contribution of US$15,000 from a profi t sharing plan which has been made into a 401(k) retirement plan. This is included under employers’ pension contribution.
5 Bridget Macaskill retired from the Board on 30 September 2011. 6 James Ross retired from the Board on 19 May 2011.
Payments and share releases in 2012 to past executive directors Nick Prettejohn The 2009 Directors’ remuneration report provided details of the remuneration arrangements that would apply to Nick Prettejohn after he resigned from the position of Chief Executive UK & Europe. These arrangements were implemented as intended by the Committee.
The performance periods of Nick Prettejohn’s GPSP and UK BUPP awards for 2009 ended on 31 December 2011. Vesting was prorated based on service (ie 9/36ths). Vesting remained dependent on performance achieved over the performance period and shares were released at the same time as for other participants in these plans.
During 2012, Clark Manning received the following payments: AAAAAAAAAAAAA Clark Manning had a prorated 2011 annual bonus opportunity (4/12ths) based on his length of service as Chairman of Jackson during 2011. On this basis, a cash payment of £725,389 was made to him in 2012; AAAAAAAAAAAAA The deferred portion of the bonuses awarded to Clark Manning in respect of performance in 2009 and 2010 were released to Clark Manning in July 2012; AAAAAAAAAAAAA The performance condition attached to the 2009 GPSP award was met in full and 100 per cent of the award was released in 2012; and
AAAAAAAAAAAAA Achievement against the shareholder capital value performance measure attached to the 2009 JNL BUPP award was 11.5 per cent per annum (on a compound basis) so 93.75 per cent of the outstanding portion of this award was released in 2012.
Outstanding 2010 awards made to Clark Manning under the GPSP and BUPP will vest (subject to the achievement of performance conditions) on the same schedule as awards made to other executive directors. These awards will be prorated to refl ect the portion of the performance periods which had elapsed on 31 December 2011 (ie 24/36ths).
Payments and share releases in 2012 to newly appointed executive directors Share awards made to Nic Nicandrou and Rob Devey in connection with their appointment were released, as scheduled, during 2012. Details of these awards were originally set out in the Directors’ remuneration report for 2009. Please see the Other share awards table for details.
Directors’ outstanding long-term incentive awards Share-based long-term incentive awards The section below sets out the outstanding share awards under the Group Performance Share Plan and the awards made under additional long-term plans (Business Unit Performance Plan and JNL Performance Share Plan) for the executive directors with regional responsibilities.
Notes 1 The awards for Barry Stowe and Mike Wells were made in ADRs (1 ADR = 2 Prudential plc shares). The fi gures in the table are represented in terms of
4 At 31 December 2012, the performance period of the 2010 BUPP awards came to an end. Over the performance period the new business profi t, IFRS profi t and cash remittance achieved by the Asia business meant that it is anticipated that 95.2 per cent of the award will vest. This will result in 122,880 shares being released to Barry Stowe under this plan. Since the UK BUPP uses the same TSR performance measure as the GPSP, it is anticipated that 104,089 shares will be released to Rob Devey under this plan. No current executive director participated in the 2010 JNL BUPP. Dividend equivalents will be released on these vested shares.
5 The table above refl ects the maximum number of shares (150 per cent of the original number awarded) which may be released to Mike Wells under the JNL Performance Share Plan. This maximum number of shares may be released if stretch performance targets are achieved. On 31 December 2012, the performance period of the 2009 JNL Performance Share Plan award came to an end. On the basis of the shareholder value being achieved by the Jackson business over the performance period, it is anticipated that 150 per cent of awards will vest, resulting in 218,100 shares being released to Mike Wells under this plan in 2013.
Face value of conditional share awards outstanding at 1 January 2012
See page 128 for a description of the JNL LTIP. Performance over the period from 2008 to 2011 resulted in a payment of £826,975 to Mike Wells during 2012. Performance over the period from 2009 to 2012 will result in a payment of £1,117,509 being paid to Mike Wells in 2013. The awards above were made before Mike Wells became an executive director and it is anticipated that no further awards will be made to him under this Plan.
The sterling face value of Mike Wells’ JNL LTIP awards have been calculated using the average exchange rate for the year in which the grant was made. The dollar face value of conditional share awards outstanding on 1 January 2012 and 31 December 2012 was US$4,200,000 and US$2,800,000 respectively.
Other share awards The table below sets out the share awards that have been made to executive directors under their appointment terms and those deferred from annual incentive plan payments. The number of shares is calculated using the average share price over the three business days commencing on the day of the announcement of the Group’s annual fi nancial results for the relevant year. For the awards from the 2011 annual incentives, made in 2012, the average share price was 776 pence. Please see the table on page 142 for details of shares acquired under the Share Incentive Plan.
Rob Devey Awards under appointment terms 2009 50,575 50,575 – 31 Mar 12 29 Mar 12 639 750 Deferred 2009 annual incentive award 2010 28,737 1,018 29,755 31 Dec 12 552.5 Deferred 2010 annual incentive award 2011 46,694 1,655 48,349 31 Dec 13 721.5 Deferred 2011 annual
Deferred 2009 annual incentive award 2010 39,088 1,386 40,474 31 Dec 12 552.5
Tidjane Thiam Deferred 2008 annual incentive award 2010 69,924 69,924 – 31 Dec 11 15 Mar 12 552.5 780 Deferred 2009 annual incentive award 2010 63,240 2,242 65,482 31 Dec 12 552.5 Deferred 2010 annual incentive award 2011 221,657 7,858 229,515 31 Dec 13 721.5 Deferred 2011 annual
Notes 1 The Deferred Share Awards in 2010, 2011 and 2012 for Barry Stowe and Mike Wells were made in ADRs (1 ADR = 2 Prudential plc shares). The fi gures in the table are represented in terms of Prudential shares.
2 In 2009 and 2010 a scrip dividend equivalent and in 2011 and 2012 a DRIP dividend equivalent were accumulated on these awards. 3 This award attracts dividends in the form of cash rather than shares.
Share incentive plan awards held in Trust at 1 January 2012
Note The table above provides information about shares purchased under the SIP together with Matching shares (awarded on a 1:4 basis) and Dividend shares. The total number of shares will only be released if Nic Nicandrou remains in employment for fi ve years.
Outstanding share options The following table sets out the share options held by the directors in the UK Savings-Related Share Option Scheme (SAYE) as at the end of the period. No other directors held shares in any other option scheme.
John Foley 25 Apr 08 551 865.5 01 Jun 13 29 Nov 13 2,953 – – – – – 2,953 Tidjane Thiam 16 Sep 11 465.8666 865.5 01 Dec 14 29 May 15 965 – – – – – 965 Nic Nicandrou 16 Sep 11 465.8666 865.5 01 Dec 16 31 May 17 3,268 – – – – – 3,268 Rob Devey 16 Sep 11 465.8666 865.5 01 Dec 16 31 May 17 3,268 – – – – – 3,268
Dilution Releases from Prudential’s GPSP and BUPP are satisfi ed using new issue shares rather than by purchasing shares in the open market. Shares relating to options granted under all-employee share plans are also satisfi ed by new issue shares. The combined dilution from all outstanding shares and options at 31 December 2012 was 0.1 per cent of the total share capital at the time. Deferred shares will continue to be satisfi ed by the purchase of shares in the open market.
irecto rs’ rem u n eratio n rep o rt Su p p lem en tary in fo rm atio n
Company TSR performance (unaudited information) As required by the Companies Act, the line chart below compares Prudential’s Total Shareholder Return (TSR) during the fi ve years from 1 January 2008 to 31 December 2012, with that of the peer group against which TSR is measured for the purposes of the Group Performance Share Plan. Our performance is also shown relative to the FTSE 100 since Prudential is a major company within this index. This chart is prepared using the methodology stipulated in the current remuneration regulations: Dec 2007 Dec 2008 Dec 2009 Dec 2010 Dec 2011 Dec 2012
Five highest paid individuals (unaudited information) Of the fi ve individuals with the highest emoluments in 2012, three were directors whose emoluments are disclosed in this report (2011: two; 2010: one). The aggregate of the emoluments of the other two individuals for 2012 (2011: three; 2010: four) were as follows: Base salaries, allowances and benefi ts in kind (note 1) 1 1 –
Pension contributions (note 2) – – – Bonuses paid or receivable 18 23 15 Share-based payments and other
Notes 1 Base salaries, allowances and benefi ts in kind in 2012 were less than £400,000. 2 Pension contributions payable were less than £150,000 in each period.
Financial statements and European Embedded Value (EEV) basis supplementary information 146 Index to Group fi nancial statements 147 Consolidated income statement 148 Consolidated statement of comprehensive income 149 Consolidated statement of changes in equity 151 Consolidated statement of fi nancial position 153 Consolidated statement of cash fl ows 154 Notes on the Group fi nancial statements 315 Balance sheet of the parent company 316 Notes on the parent company fi nancial statements 324 Statement of directors’ responsibilities in respect of the annual report and the fi nancial statements 325 Independent auditor’s report to the members of Prudential plc 326 EEV basis results 331 Notes on the EEV basis results 363 Statement of directors’ responsibilities in respect of the
Section B: Summary of results 176 B1: Segment disclosure – profi t before tax 179 B2: Earnings per share 180 B3: Dividends 181 B4: Exchange translation 182 B5: Group statement of fi nancial position
Section G: Financial assets and liabilities 262 G1: Financial instruments – Designation and fair values 269 G2: Market risk 273 G3: Derivatives and Hedging 274 G4: Derecognition and collateral 274 G5: Impairment of fi nancial assets
Section H: Other information on statement of fi nancial position items 275 H1: Intangible assets attributable to shareholders 279 H2: Intangible assets attributable to with-profi ts funds 280 H3: Reinsurers’ share of insurance contract liabilities 281 H4: Tax assets and liabilities 283 H5: Accrued investment income and other debtors 283 H6: Property, plant and equipment 284 H7: Investment properties 285 H8: Investments in associates and joint ventures 287 H9: Properties held for sale 287 H10: Cash and cash equivalents 287 H11: Shareholders’ equity: share capital, share premium and reserves 289 H12: Insurance contract liabilities and unallocated surplus of with-profi ts funds 289 H13: Borrowings 291 H14: Provisions and contingencies 294 H15: Other liabilities
Section I: Other notes 295 I1: Acquisition of subsidiaries 297 I2: Changes to Group’s holdings 298 I3: Staff and pension plans 308 I4: Share-based payments 311 I5: Key management remuneration 312 I6: Fees payable to auditor 312 I7: Related party transactions 313 I8: Subsidiary undertakings 313 I9: Commitments 314 I10: Cash fl ows 314 I11: Post balance sheet events
Parent company fi nancial statements 315 Balance sheet of the parent company 316 Notes on the parent company fi nancial statements
European Embedded Value (EEV) basis results 326 Operating profi t based on longer-term investment returns 328 Summarised consolidated income statement – EEV basis 328 Earnings per share – EEV basis 328 Dividends per share 329 Movement in shareholders’ equity (excluding non-controlling interests) – EEV basis 330 Net asset value per share – EEV basis 330 Summary statement of fi nancial position – EEV basis 331 Notes on the EEV basis results 363 Statement of directors’ responsibilities in respect of the European
Embedded Value (EEV) basis supplementary information 364 Independent auditor’s report to Prudential plc on the European
Earned premiums, net of reinsurance F2 29,404 25,277 Investment return F2 24,051 9,360 Other income F2 2,021 1,869
Benefi ts and claims (44,831) (31,060) Outward reinsurers’ share of benefi t and claims F1 259 746 Movement in unallocated surplus of with-profi ts funds H12 (1,381) 1,025
Acquisition costs and other expenditure F3 (6,055) (5,120) Finance costs: interest on core structural borrowings of shareholder-fi nanced operations F4 (280) (286)
Profi t before tax attributable to shareholders B1 2,810 1,828 Total tax (charge) attributable to policyholders and shareholders F5 (991) (392) Adjustment to remove tax credit (charge) attributable to policyholders’ returns 378 (17) Tax charge attributable to shareholders’ returns F5 (613) (409)
Attributable to: Equity holders of the Company 2,197 1,415 Non-controlling interests – 4
† This measure is the formal profi t before tax measure under IFRS but it is not the result attributable to shareholders. This is principally because the corporate taxes of the Group include those on the income of consolidated with-profi ts and unit-linked funds that, through adjustments to benefi ts, are borne by policyholders. These amounts are required to be included in the tax charge of the Company under IAS 12. Consequently, the profi t before all taxes measure (which is determined aft er deducting the cost of policyholder benefi ts and movements in the liability for unallocated surplus of the PAC with-profi ts fund aft er adjusting for taxes borne by policyholders) is not representative of pre-tax profi ts attributable to shareholders.
Attributable to: Equity holders of the Company 2,368 1,659 Non-controlling interests – 4
Reserves Profi t for the year – – 2,197 – – 2,197 – 2,197 Other comprehensive income: Exchange movements on foreign operations and net investment hedges, net of related tax – – – (216) – (216) – (216) Unrealised valuation movements, net of related change in amortisation of deferred acquisition costs and related tax – – – – 387 387 – 387
Net increase (decrease) in equity 1 16 1,607 (216) 387 1,795 (38) 1,757
Reserves Profi t for the year – – 1,415 – – 1,415 4 1,419 Other comprehensive income: Exchange movements on foreign operations and net investment hedges, net of related tax – – – (105) – (105) – (105) Unrealised valuation movements, net of related change in amortisation of deferred acquisition costs and related tax – – – – 349 349 – 349
Total comprehensive income for the year – – 1,415 (105) 349 1,659 4 1,663
Reserve movements in respect of share-based payments – – 44 – – 44 – 44 Change in non-controlling interests arising principally from purchase and sale of property partnerships of the PAC with-profi ts fund and other consolidated investment funds – – – – – – (5) (5)
* The Group has adopted updated US GAAP requirements for deferred acquisition costs as an improvement to its accounting policy under IFRS 4 for those operations of the Group which measure insurance assets and liabilities substantially by reference to US GAAP principles. Accordingly, the 2011 comparative results and related notes have been adjusted from those previously published for the retrospective application of the change as if the new accounting policy had always applied, as described in note A5.
Consolidated statement of fi nancial position Assets 31 December Note 2012 £m 2011* £m 2010*† £m
Intangible assets attributable to with-profi ts funds: In respect of acquired subsidiaries for venture fund and other investment purposes H2(a) 178 178 166 Deferred acquisition costs and other intangible assets H2(b) 78 89 110
Other non-investment and non-cash assets: Property, plant and equipment H6 765 748 554 Reinsurers’ share of insurance contract liabilities‡ H3 6,859 1,647 1,344 Deferred tax assets H4 2,314 2,276 2,188 Current tax recoverable H4 254 546 555 Accrued investment income G1,H5 2,798 2,710 2,668 Other debtors G1,H5 1,361 987 903
Investments of long-term business and other operations: Investment properties H7 10,880 10,757 11,247 Associate investments accounted for using the equity method H8 113 70 71 Financial investments§: G1 Loans 11,821 9,714 9,261 Equity securities and portfolio holdings in unit trusts 99,958 87,349 86,635 Debt securities 140,103 124,498 116,352 Other investments 7,900 7,509 5,779 Deposits 12,653 10,708 9,952
† As a result of the adoption of the altered US GAAP requirements as noted above, the 2010 balance sheet has been presented in accordance with IAS 1. The 2010 comparatives for the relevant balance sheet notes which have been aff ected by this change have been retrospectively adjusted accordingly.
Consolidated statement of fi nancial position Equity and liabilities 31 December Note 2012 £m 2011* £m 2010† £m
Other borrowings: Operational borrowings attributable to shareholder-fi nanced operations G1,H13 2,245 3,340 3,004 Borrowings attributable to with-profi ts operations G1,H13 1,033 972 1,522
Total equity and liabilities 310,253 272,745 260,040 * The Group has adopted updated US GAAP requirements for deferred acquisition costs as an improvement to its accounting policy under IFRS 4 for those operations of the Group which measure insurance assets and liabilities substantially by reference to US GAAP principles. Accordingly, the 2011 comparative results and related notes have been adjusted from those previously published for the retrospective application of the change as if the new accounting policy had always applied, as described in note A5.
‡ The increase in reinsurers’ share of insurance contract liabilities and other liabilities from 2011 to 2012 is attributed to amounts due to the reinsurance arrangements attaching to the purchase by Jackson of REALIC in September 2012, as discussed in note I1.
Cash fl ows from fi nancing activities Structural borrowings of the Group: I10
Cash and cash equivalents at end of year H10 6,384 7,257 * The Group has adopted updated US GAAP requirements for deferred acquisition costs as an improvement to its accounting policy under IFRS4, for those operations of the Group which measure insurance assets and liabilities substantially by reference to US GAAP principles. Accordingly, the 2011 comparative results and related notes have been adjusted from those previously published for the retrospective application of the change as if the new accounting policy had always applied, as described in note A5.
Core debt excludes borrowings to support short-term fi xed income securities programmes, non-recourse borrowings of investment subsidiaries of shareholder-fi nanced operations and other borrowings of shareholder-fi nanced operations. Cash fl ows in respect of these borrowings are included within cash fl ows from operating activities.
The Group operates in the UK through its subsidiaries, primarily The Prudential Assurance Company Limited (PAC), Prudential Annuities Limited (PAL), Prudential Retirement Income Limited (PRIL) and M&G Investment Management Limited. Long-term business products written in the UK are principally with-profi ts deposit administration, other conventional and unitised with-profi ts policies and non-participating pension annuities in the course of payment. Long-term business written in the UK also includes unit-linked products.
The consolidated fi nancial statements consolidate the Group and the Group’s interest in associates and jointly-controlled entities. The parent company fi nancial statements present information about the Company as a separate entity and not about the Group.
The consolidated fi nancial statements have been prepared and approved by the directors in accordance with International Financial Reporting Standards (IFRS) as issued by the International Accounting Standards Board (IASB) and as endorsed by the European Union (EU) as required by EU law (IAS regulation EC 1606/2032). The Company has elected to prepare its parent company fi nancial statements in accordance with UK Generally Accepted Accounting Practice (GAAP). These are presented on pages 315 to 323. A reconciliation to IFRS has also been provided for shareholders’ equity and profi t for the year of the parent company.
The Group has applied all IFRS standards and interpretations adopted by the EU that are effective for fi nancial years commencing on or before 1 January 2012. The Group has applied the same accounting policies in preparing the 2012 results as for 2011 except for the adoption of altered US GAAP reporting requirements for Group IFRS reporting, which is described in note A5.
A3: Accounting policies 1 Critical accounting policies Prudential’s discussion and analysis of its fi nancial condition and results of operations are based upon Prudential’s consolidated fi nancial statements, which have been prepared in accordance with IFRS as issued by the IASB and as endorsed by the EU. EU-endorsed IFRS may differ from IFRS as issued by the IASB if, at any point in time, new or amended IFRSs have not been endorsed by the EU. As at 31 December 2012, there were no unendorsed standards effective for the two years ended 31 December 2012 affecting the consolidated fi nancial information of Prudential and there were no differences between IFRSs endorsed by the EU and IFRSs issued by the IASB in terms of their application to Prudential. Accordingly, Prudential’s fi nancial information for the two years ended 31 December 2012 is prepared in accordance with IFRS as issued by the IASB. Prudential adopts mandatory requirements of new or altered EU-adopted IFRS standards when required, and may consider earlier adoption where permitted and appropriate in the circumstances.
The critical accounting policies in respect of the items discussed below are critical for those that relate to the Group’s shareholder-fi nanced business. In particular this applies for Jackson which is the largest shareholder-backed business in the Group. The policies are not critical in respect of the Group’s with-profi ts business. This distinction refl ects the basis of recognition of profi t and accounting treatment of unallocated surplus of with-profi ts funds as a liability, as described elsewhere in these fi nancial statements.
Insurance contract accounting With the exception of certain contracts described in note D1, the contracts issued by the Group’s life assurance business are classifi ed as insurance contracts and investment contracts with discretionary participating features. As permitted by IFRS 4, ‘Insurance Contracts’, assets and liabilities of these contracts are accounted for under previously applied GAAP. Accordingly, except as described below, the modifi ed statutory basis (MSB) of reporting as set out in the revised Statement of Recommended Practice (SORP) issued by the Association of British Insurers (ABI) in 2003 has been applied.
AAAAAAAAAAAAAAAAAAA With-profi ts funds With-profi ts funds are those in which the policyholder has a contractual right to receive at the discretion of the insurer, additional benefi ts based on factors such as the performance of a pool of assets held within the fund as a supplement to any guaranteed benefi ts.
AAAAAAAAAAAAAAAAAAA UK regulated with-profi ts funds For Group IFRS reporting, UK regulated with-profi ts funds are accounted for by the voluntary application of the UK accounting standard FRS 27, ‘Life Assurance’. Under this standard, for such funds, policyholder liabilities are measured on a ‘realistic basis’ as discussed in section 2(a) of this note.
AAAAAAAAAAAAAAAAAAA Unallocated surplus of with-profi ts funds Unallocated surplus represents the excess of assets over policyholder liabilities for the Group’s with-profi ts funds that have yet to be appropriated between policyholders and shareholders. The Group has elected to account for unallocated surplus wholly as a liability with no allocation to equity. This treatment refl ects the fact that shareholders’ participation in the cost of bonuses arises only on distribution. The unallocated surplus is shown separately in the statement of fi nancial position.
Additional details on the Group’s accounting policies for insurance assets and liabilities are shown in section 2 below.
For derivative instruments of Jackson, the Group has considered whether it is appropriate to undertake the necessary operational changes to qualify for hedge accounting so as to achieve matching of value movements in hedging instruments and hedged items in the performance statements. In reaching the decision a number of factors were particularly relevant. These were: AAAAAAAAAAAAAAAAAAA IAS 39 hedging criteria have been designed primarily in the context of hedging and hedging instruments that are assessable as fi nancial instruments that are either stand-alone or separable from host contracts, rather than, for example, duration characteristics of insurance contracts; AAAAAAAAAAAAAAAAAAA The high hurdle levels under IAS 39 of ensuring hedge effectiveness at the level of individual hedge transactions; AAAAAAAAAAAAAAAAAAA The diffi culties in applying the macro hedge provisions under IAS 39 (which are more suited to banking arrangements) to Jackson’s derivative book; AAAAAAAAAAAAAAAAAAA The complexity of asset and liability matching of US life insurers such as those with Jackson’s product range; and fi nally AAAAAAAAAAAAAAAAAAA Whether it is possible or desirable, without an unacceptable level of costs and constraint on commercial activity, to achieve the accounting hedge effectiveness required under IAS 39.
Under IAS 39, unless carried at amortised cost (subject to impairment provisions where appropriate) under the held-to-maturity category, debt securities are also carried at fair value. The Group has chosen not to classify any fi nancial assets as held-to-maturity. Debt securities of Jackson are designated as available-for-sale with value movements, unless impaired, being recorded as movements within other comprehensive income. Impairments are recorded in the income statement.
2 Other signifi cant accounting policies a Long-term business contracts Income statement treatment
Policy fees charged on linked and unitised with-profi ts policies for mortality, asset management and policy administration are recognised as revenue when related services are provided.
Acquisition costs are deferred and amortised as described in note A4.
The WPBR is primarily based on the retrospective calculation of accumulated asset shares but is adjusted to refl ect future policyholder benefi ts and other outgoings. Asset shares broadly refl ect the policyholders’ share of the with-profi ts fund assets attributable to their policies.
The realistic basis liabilities representing the Peak 2 basis realistic liabilities for with-profi ts business included in the FSA regulatory returns include the element for the shareholders’ share of the future bonuses. For accounting purposes under FRS 27, this latter item is reversed because, consistent with the current basis of fi nancial reporting, shareholder transfers are recognised only on declaration.
Unallocated surplus The unallocated surplus represents the excess of assets over policyholder liabilities for the Group’s with-profi ts funds. As allowed under IFRS 4, the Group has opted to continue to record unallocated surplus of with-profi ts funds wholly as a liability. The annual excess (shortfall) of income over expenditure of the with-profi ts funds, after declaration and attribution of the cost of bonuses to policyholders and shareholders, is transferred to (from) the unallocated surplus each year through a charge (credit) to the income statement. The balance retained in the unallocated surplus represents cumulative income arising on the with-profi ts business that has not been allocated to policyholders or shareholders. The balance of the unallocated surplus is determined after full provision for deferred tax on unrealised appreciation on investments.
Asia operations Except for the operations in India, Japan, Taiwan and, until 2012, Vietnam, the future policyholder benefi t provisions for Asian businesses are determined in accordance with methods prescribed by local GAAP adjusted to comply, where necessary, with UK GAAP. Refi nements to the local reserving methodology are generally treated as change in estimates, dependent on the nature of the change.
Although the basis of valuation of Prudential’s overseas operations is in accordance with the requirements of the Companies Act 2006 and ABI SORP, the valuation of policyholder benefi t provisions for these businesses may differ from that determined on a UK MSB for UK operations with the same features. These differences are permitted under IFRS 4.
Liability adequacy The Group performs liability adequacy testing on its insurance provisions to ensure that the carrying amounts of provisions (less related DAC) and, where relevant, present value of acquired in-force business is suffi cient to cover current estimates of future cash fl ows. Any defi ciency is immediately charged to the income statement.
The treatment of any gains or losses arising on the purchase of reinsurance contracts is dependent on the underlying accounting basis of the entity concerned amongst other things.
Under IAS 39, subject to specifi c criteria, fi nancial instruments are required to be accounted for under one of the following categories: fi nancial investments at fair value through profi t and loss, fi nancial investments held on an available-for-sale basis, fi nancial investments held-to-maturity or loans and receivables. These IAS 39 classifi cations have been changed by IFRS 9 ‘Financial Investments: Classifi cation and Measurement’ which is not required to be adopted until 2015 and is still subject to EU endorsement. In addition, the International Accounting Standards Board (IASB) continues to consult on future possible changes to IFRS 9. This standard has not been adopted by the Group in 2012. The Group holds fi nancial investments on the following bases: i Financial assets and liabilities at fair value through profi t and loss – this comprises assets and liabilities designated by management as fair value through profi t and loss on inception and derivatives that are held for trading. These investments are measured at fair value with all changes thereon being recognised in investment return in the income statement; ii Financial investments on an available-for-sale basis – this comprises assets that are designated by management and/or do not fall into any of the other categories. Available-for-sale fi nancial assets are initially recognised at fair value plus attributable transaction costs. For available-for-sale debt securities, the difference between their cost and par value is amortised to the income statement using the effective interest rate. The effective interest rate is the rate that exactly discounts estimated future cash receipts through the expected life of the fi nancial instrument or, when appropriate, a shorter period to the net carrying amount of the fi nancial asset.
Available-for-sale fi nancial assets are subsequently measured at fair value. Interest income is recognised on an effective interest basis in the income statement. Except for foreign exchange gains and losses on debt securities, not in functional currency, which are included in the income statement, unrealised gains and losses are recognised in other comprehensive income. Upon disposal or impairment, accumulated unrealised gains and losses are transferred from other comprehensive income to the income statement as realised gains or losses; and
159Notes on the Group fi nancial statements Prudential plc Annual Report 2012 F
: B ack gro u n d an d acco u n tin g p o licies iii Loans and receivables – except for those designated as at fair value through profi t and loss or available-for-sale, these instruments comprise non-quoted investments that have fi xed or determinable payments. These investments include loans collateralised by mortgages, deposits, loans to policyholders and other unsecured loans and receivables. These investments are initially recognised at fair value plus transaction costs. Subsequently, these investments are carried at amortised cost using the effective interest method.
The Group uses the trade date method to account for regular purchases and sales of fi nancial assets.
The Group uses current bid prices to value its investments with quoted prices. Actively traded investments without quoted prices are valued using prices provided by third parties. If there is no active established market for an investment, the Group applies an appropriate valuation technique such as a discounted cash fl ow technique. Additional details are provided in note G1.
Derivative fi nancial instruments are used to reduce or manage investment, interest rate and currency exposures, to facilitate effi cient portfolio management and for investment purposes.
The Group may designate certain derivatives as hedges. For hedges of net investments in foreign operations, the effective portion of any change in fair value of derivatives or other fi nancial instruments designated as net investment hedges is recognised in other comprehensive income. The ineffective portion of changes in the fair value of the hedging instrument is recorded in the income statement. The gain or loss on the hedging instrument is recognised directly in other comprehensive income while the foreign operation is held.
The Group does not regularly seek to apply fair value or cash fl ow hedging treatment under IAS 39. The exceptions, where hedge accounting has been applied in 2012 and 2011, are summarised in note G3.
The primary areas of the Group’s continuing operations where derivative instruments are held are the UK with-profi ts funds and annuity business, and Jackson.
The Group is party to various securities lending agreements under which securities are loaned to third parties on a short-term basis. The loaned securities are not derecognised; rather, they continue to be recognised within the appropriate investment classifi cation. The Group’s policy is that collateral in excess of 100 per cent of the fair value of securities loaned is required from all securities’ borrowers and typically consists of cash, debt securities, equity securities or letters of credit.
In cases where the Group takes possession of the collateral under its securities lending programme, the collateral, and corresponding obligation to return such collateral, are recognised in the consolidated statement of fi nancial position.
The Group’s policy is to derecognise fi nancial assets when it is deemed that substantially all the risks and rewards of ownership have been transferred.
The Group derecognises fi nancial liabilities only when the obligation specifi ed in the contract is discharged, cancelled or has expired.
The Group holds investments in internally and externally managed open-ended investment companies (OEICs) and unit trusts. These are consolidated where the Group’s percentage ownership level is (i) 50 per cent or greater, and (ii) where the Group’s ownership of internally managed funds declines marginally below 50 per cent and the decline in ownership is expected to be temporary.
Where the Group exercises signifi cant infl uence or has the power to exercise signifi cant infl uence over an entity, generally through ownership of 20 per cent or more of the entity’s voting rights, but does not control the entity, then this is considered to be an investment in an associate. With the exception of those referred to below, the Group’s investments in associates are recorded at the Group’s share of the associates’ net assets including any goodwill and intangibles arising upon initial acquisition. The carrying value of investments in associates is adjusted each year for the Group’s share of the entities’ profi t or loss. This does not apply to investments in associates held by the Group’s insurance or investment funds including the venture capital business or mutual funds and unit trusts, which as permitted by IAS 28, ‘Investments in Associates’, are carried at fair value through profi t and loss.
The Group’s investments in joint ventures are recognised using proportional consolidation whereby the Group’s share of an entity’s individual balances are combined line-by-line with similar items into the Group fi nancial statements. Other interests in entities, where signifi cant infl uence is not exercised, are carried as investments at fair value through profi t and loss.
The Group utilises the projected unit credit method to calculate the defi ned benefi t obligation. This method sees each period of service as giving rise to an additional unit of benefi t entitlement and measures each unit separately to build up the fi nal obligation. Estimated future cash fl ows are then discounted at a high-quality corporate bond rate, adjusted to allow for the difference in duration between the bond index and the pension liabilities where appropriate, to determine its present value. These calculations are performed by independent actuaries.
Contributions to the Group’s defi ned contribution schemes are expensed when due.
Current tax expense is charged or credited to operations based upon amounts estimated to be payable or recoverable as a result of taxable operations for the current year. To the extent that losses of an individual UK company are not offset in any one year, they can be carried back for one year or carried forward indefi nitely to be offset against profi ts arising from the same company.
Deferred taxes are provided under the liability method for all relevant temporary differences. IAS 12, ‘Income Taxes’ does not require all temporary differences to be provided for, in particular, the Group does not provide for deferred tax on undistributed earnings of subsidiaries where the Group is able to control the timing of the distribution and the temporary difference created is not expected to reverse in the foreseeable future. Deferred tax assets are only recognised when it is more likely than not, that future taxable profi ts will be available against which these losses can be utilised.
Business acquisitions are accounted for by applying the purchase method of accounting, which adjusts the net assets of the acquired company to fair value at the date of purchase. The excess of the acquisition consideration over the fair value of the assets and liabilities of the acquired entity is recorded as goodwill. Expenses related to acquiring new subsidiaries are expensed in the period in which they are incurred. Income and expenses of acquired entities are included in the income statement from the date of acquisition.
Goodwill arising on acquisitions of subsidiaries and businesses is capitalised and carried on the Group statement of fi nancial position as an intangible asset at initial value less any accumulated impairment losses. Goodwill impairment testing is conducted annually and when there is an indication of impairment. For the purposes of impairment testing, goodwill is allocated to cash generating units.
Under IFRS 8, ‘Operating Segments’, the Group determines and presents operating segments based on the information that is internally provided to the Group Executive Committee which is the Group’s chief operating decision maker.
The operating segments identifi ed by the Group refl ect the Group’s organisational structure, which is by both geography (Asia, US and UK) and by product line (insurance operations and asset management).
Asset management comprises both internal and third-party asset management services, inclusive of portfolio and mutual fund management, where the Group acts as an advisor, and broker-dealer activities. The nature of the products and the managing of the business differ from the risks inherent in the insurance operations segments, and the regulatory environment of the asset management industry differs from that of the insurance operations segments.
Asset management operations AAAAAAAAAAAAAAAA M&G (including Prudential Capital) AAAAAAAAAAAAAAAA Eastspring Investments AAAAAAAAAAAAAAAA US broker-dealer and asset management (including Curian)
The Group’s operating segments are also its reportable segments with the exception of Prudential Capital (PruCap) which has been incorporated into the M&G operating segment for the purposes of segment reporting.
The performance measure of operating segments utilised by the Company is IFRS operating profi t attributable to shareholders based on longer-term investment returns, as described below. This measure excludes the recurrent items of short-term fl uctuations in investment returns and the shareholders’ share of actuarial and other gains and losses on defi ned benefi t pension schemes. In addition for 2012 this measure excluded a gain arising upon the dilution of the Group’s holding in PPM South Africa and the amortisation of the acquisition accounting adjustments arising on the purchase of REALIC as described further in note I1. Operating earnings per share is based on operating profi t based on longer-term investment returns, after tax and non-controlling interests. Further details on the determination of the performance measure of operating profi t based on longer-term investment returns is provided below.
d Operating profi t based on longer-term investment returns The Group provides supplementary analysis of profi t before tax attributable to shareholders that distinguishes operating profi t based on longer-term investment returns from other constituent elements of the total profi t.
163Notes on the Group fi nancial statements Prudential plc Annual Report 2012 F
In the case of other shareholder-fi nanced business, the measurement of operating profi t based on longer-term investment returns refl ects the particular features of long-term insurance business where assets and liabilities are held for the long term and for which the accounting basis for insurance liabilities under current IFRS is not generally conducive to demonstrating trends in underlying performance of life businesses exclusive of the effects of short-term fl uctuations in market conditions. In determining the profi t on this basis, the following key elements are applied to the results of the Group’s shareholder-fi nanced operations as refl ected in the segment results shown in note B1.
At 31 December 2012, the level of unamortised interest-related realised gains and losses related to previously sold bonds for the Group was a net gain of £498 million (31 December 2011: £462 million).
For equity-type securities, the longer-term rates of return are estimates of the long-term trend investment return for income and capital having regard to past performance, current trends and future expectations. Equity-type securities held for shareholder-fi nanced operations other than the UK annuity business, unit-linked and US variable annuity are of signifi cance for the US and Asia insurance operations. Different rates apply to different categories of equity-type securities.
As at 31 December 2012, the equity-type securities for US insurance non-separate account operations amounted to £1,004 million (31 December 2011: £902 million). For these operations, the longer-term rates of return for income and capital applied in 2012 refl ects the combination of risk free rates and appropriate risk premium are as follows: Equity-type securities such as common and preferred stock and portfolio holdings in mutual funds 5.5% to 6.2% 5.9% to 7.5% Other equity-type securities such as investments in limited partnerships and private equity funds 7.5% to 8.2% 7.9% to 9.5%
For Asia insurance operations, investments in equity securities held for non-linked shareholder-fi nanced operations amounted to £659 million as at 31 December 2012 (31 December 2011: £590 million). The rates of return applied in the years 2012 and 2011 ranged from 1.0 per cent to 13.8 per cent, with the rates applied varying by territory. The investment amounts for 2011 of £590 million included the Group’s investment in China Life Insurance Company of Taiwan (China Life (Taiwan)) of £88 million which was sold in 2012, as described in note B1.
The longer-term rates of return discussed above for equity-type securities are determined after consideration by the Group’s in-house economists of long-term expected real government bond returns, equity risk premium and long-term infl ation. These rates are broadly stable from period to period but may be different between countries refl ecting, for example, differing expectations of infl ation in each territory. The assumptions are for returns expected to apply in equilibrium conditions. The assumed rates of return do not refl ect any cyclical variability in economic performance and are not set by reference to prevailing asset valuations.
A3: Accounting policies continued ii US variable and fi xed index annuity business The following value movements for Jackson’s variable and fi xed index annuity business are excluded from operating profi t based on longer-term investment returns: AAAAAAAAAAAAAAAA Fair value movements for equity-based derivatives; AAAAAAAAAAAAAAAA Fair value movements for embedded derivatives for Guaranteed Minimum Withdrawal Benefi t (GMWB) ‘not for life’ and fi xed index annuity business, and Guaranteed Minimum Income Benefi t (GMIB) reinsurance (see note); AAAAAAAAAAAAAAAA Movements in accounts carrying value of Guaranteed Minimum Death Benefi t (GMDB) and GMWB ‘for life’ liabilities, for which, under the ‘grandfathered’ US GAAP applied under IFRS for Jackson’s insurance assets and liabilities, the measurement basis gives rise to a muted impact of current period market movements; AAAAAAAAAAAAAAAA Fee assessments and claim payments, in respect of guarantee liabilities; and AAAAAAAAAAAAAAAA Related changes to amortisation of deferred acquisition costs for each of the above items.
Note: US operations – embedded derivatives for variable annuity guarantee features
iv Other liabilities to policyholders and embedded derivatives for product guarantees Under IFRS, the degree to which the carrying values of liabilities to policyholders are sensitive to current market conditions varies between territories depending upon the nature of the ‘grandfathered’ measurement basis. In general, in those instances where the liabilities are particularly sensitive to routine changes in market conditions, the accounting basis is such that the impact of market movements on the assets and liabilities is broadly equivalent in the income statement, and operating profi t based on longer-term investments returns is not distorted. In these circumstances, there is no need for the movement in the liability to be bifurcated between the elements that relate to longer-term market conditions and short-term effects.
However, some types of business movements in liabilities do require bifurcation to ensure that at the net level (ie after allocated investment return and change for policyholder benefi ts) the operating result refl ects longer-term market returns.
Examples where such bifurcation is necessary are: Asia i Hong Kong For certain non-participating business, the economic features are more akin to asset management products with policyholder liabilities refl ecting asset shares over the contract term. For these products, the charge for policyholder benefi ts in the operating results should refl ect the asset share feature rather than volatile movements that would otherwise be refl ected if the local regulatory basis (which is applied for IFRS balance sheet purposes) was used.
For other Hong Kong non-participating business, longer-term interest rates are used to determine the movement in policyholder liabilities for determining operating results. Similar principles apply for other Asia operations; ii Japan Guaranteed Minimum Death Benefi t (GMDB) product features For unhedged GMDB liabilities accounted for under IFRS using ‘grandfathered’ US GAAP, such as in the Japanese business, the change in carrying value is determined under FASB ASC subtopic 944-80, Financial Services – Insurance – Separate Accounts (formerly SOP 03-1), which partially refl ects changes in market conditions. Under the Company’s segmental basis of reporting the operating profi t refl ects the change in liability based on longer-term market conditions with the difference between the charge to the operating result and the movement refl ected in the total result included in short-term fl uctuations in investment returns;
The operating result based on longer-term investment returns refl ects the impact of value movements on policyholder liabilities for annuity business in PRIL and the PAC non-profi t sub-fund after adjustments to allocate the following elements of the movement to the category of ‘short-term fl uctuations in investment returns’ in the Group’s supplementary analysis of profi t: AAAAAAAAAAAAAAAAAAA The impact on credit risk provisioning of actual upgrades and downgrades during the period; AAAAAAAAAAAAAAAAAAA Credit experience compared to assumptions; and AAAAAAAAAAAAAAAAAAA Short-term value movements on assets backing the capital of the business.
Where there is no obligation to transfer assets, shares are classifi ed as equity. The difference between the proceeds received on issue of the shares, net of share issue costs, and the nominal value of the shares issued, is credited to share premium. Where the Company purchases shares for the purposes of employee incentive plans, the consideration paid, net of issue costs, is deducted from retained earnings. Upon issue or sale any consideration received is credited to retained earnings net of related costs.
The Group’s consolidated fi nancial statements are presented in pounds sterling, the Group’s presentation currency. Accordingly, the results and fi nancial position of foreign subsidiaries must be translated into the presentation currency of the Group from their functional currencies, ie the currency of the primary economic environment in which the entity operates. All assets and liabilities of foreign subsidiaries are converted at year end exchange rates whilst all income and expenses are converted at average exchange rates where this is a reasonable approximation of the rates prevailing on transaction dates. The impact of these currency translations is recorded as a separate component in the statement of comprehensive income.
In determining the measurement of the Group’s assets and liabilities estimates and judgements are required. The critical aspects are described below.
Investments Determining the fair value of fi nancial investments when the markets are not active The Group holds certain fi nancial investments for which the markets are not active. These can include fi nancial investments which are not quoted on active markets and fi nancial investments for which markets are no longer active as a result of market conditions eg market illiquidity. When the markets are not active, there is generally no or limited observable market data to account for fi nancial investments at fair value. The determination of whether an active market exists for a fi nancial investment requires management’s judgement.
If the market for a fi nancial investment of the Group is not active, the fair value is determined by using valuation techniques. The Group establishes fair value for these fi nancial investments by using quotations from independent third parties, such as brokers or pricing services or by using internally developed pricing models. Priority is given to publicly available prices from independent sources when available, but overall the source of pricing and/or the valuation technique is chosen with the objective of arriving at a fair value measurement which refl ects the price at which an orderly transaction would take place between market participants on the measurement date. The valuation techniques include the use of recent arm’s length transactions, reference to other instruments that are substantially the same, discounted cash fl ow analysis, option adjusted spread models and, if applicable, enterprise valuation and may include a number of assumptions relating to variables such as credit risk and interest rates. Changes in assumptions relating to these variables could positively or negatively impact the reported fair value of these fi nancial investments.
At 31 December 2012, £6,660 million (2011: £4,565 million) of the fi nancial investments (net of derivative liabilities) valued at fair value were classifi ed as level 3. Of these £861 million (2011: £800 million) are held to back shareholder non-linked business and so changes to these valuations will directly impact shareholders’ equity. Further details of the level 3 investments and the classifi cation of fi nancial instruments are given in note G1.
The majority of Jackson’s debt securities portfolio are accounted for on available-for-sale basis. The consideration of evidence of impairment requires management’s judgement. In making this determination the factors considered include, for example: AAAAAAAAAAAAAAAA Whether the decline of the fi nancial investment’s fair value is substantial; a substantial decline in fair value might be indicative of a credit loss event that would lead to a measurable decrease in the estimated future cash fl ows; AAAAAAAAAAAAAAAA The impact of the duration of the security on the calculation of the revised estimated cash fl ows; the duration of a security to maturity helps to inform whether assessments of estimated future cash fl ows that are higher than market value are reasonable; AAAAAAAAAAAAAAAA The duration and extent to which the amortised cost exceeds fair value; this factor provides an indication of how the contractual cash fl ows and effective interest rate of a fi nancial asset compares with the implicit market estimate of cash fl ows and the risk attaching to a ‘fair value’ measurement. The length of time for which that level of difference has been in place may also provide further evidence as to whether the market assessment implies an impairment loss has arisen; and
If a loss event that will have a detrimental effect on cash fl ows is identifi ed an impairment loss in the income statement is recognised. The loss recognised is determined as the difference between the book cost and the fair value of the relevant impaired securities. This loss comprises the effect of the expected loss of contractual cash fl ows and any additional market-price-driven temporary reductions in values.
167Notes on the Group fi nancial statements Prudential plc Annual Report 2012 F
Except for certain loans of the UK insurance operations and Jackson National Life, which are accounted for on a fair value through profi t and loss basis, and as described below, fi nancial assets classifi ed as loans and receivables under IAS 39 are carried at amortised cost using the effective interest rate method. The loans and receivables include loans collateralised by mortgages, deposits and loans to policyholders. In estimating future cash fl ows, the Group looks at the expected cash fl ows of the assets and applies historical loss experience of assets with similar credit risks that has been adjusted for conditions in the historical loss experience which no longer exist or for conditions that are expected to arise. The estimated future cash fl ows are discounted using the fi nancial asset’s original or variable effective interest rate and exclude credit losses that have not yet been incurred.
IFRS 4 permits the continued usage of previously applied GAAP for insurance contracts and investment contracts with discretionary participating features. Except for UK regulated with-profi ts funds, as described subsequently in section A3(2)(a), this basis has been applied by the Group.
Contracts, other than those of with-profi ts funds, are written by shareholder-backed operations of the Group. The signifi cant shareholder-backed product groupings and the factors that may signifi cantly affect IFRS results due to experience against assumptions or changes of assumptions vary signifi cantly between business units. For some types of business the effect of changes in assumptions may be signifi cant, whilst for others, due to the nature of the product, assumption setting may be of less signifi cance. The nature of the products and the signifi cance of assumptions are discussed in notes D2, D3 and D4.
UK insurance operations From the perspective of shareholder results the key sensitivity for UK insurance operations are the assumptions for allowance for credit risk and mortality for UK annuity business.
Fixed annuity contracts, which are investment contracts under US GAAP terminology, are accounted for by applying in the fi rst instance a retrospective deposit method to determine the liability for policyholder benefi ts. This is then augmented by potentially three additional amounts, namely deferred income, any amounts previously assessed against policyholders that are refundable on termination of the contract, and any premium defi ciency, ie any probable future loss on the contract. These types of contracts contain considerable interest rate guarantee features. Notwithstanding the accompanying market risk exposure, except in the circumstances of interest rate scenarios where the guarantee rates included in contract terms are higher than crediting rates that can be supported from assets held to cover liabilities, the accounting measurement of Jackson’s fi xed annuity products is not generally sensitive to interest rate risk. This position derives from the nature of the products and the US GAAP basis of measurement.
For traditional life insurance contracts, provisions for future policy benefi ts are determined using assumptions as of the issue date as to mortality, interest, policy lapses and expenses plus provisions for adverse deviation.
The deferral and amortisation of acquisition costs is of most relevance to the Group’s results for Jackson and Asia operations. The DAC for Jackson and some Asia operations is determined with reference to US GAAP principles.
Jackson Under IFRS 4, the Group applies ‘grandfathered’ US GAAP for measuring the insurance assets and liabilities of Jackson. In the case of Jackson term business, acquisition costs are deferred and amortised in line with expected profi ts. For interest-sensitive business, the key assumption is the long-term spread between the earned rate on investments and the rate credited to policyholders, which is based on an annual spread analysis. In addition, expected gross profi ts depend on mortality assumptions, assumed unit costs and terminations other than deaths (including the related charges), all of which are based on a combination of Jackson’s actual industry experience and future expectations. A detailed analysis of actual mortality, lapse and expenses experience is performed using internally developed experience studies.
For US variable annuity business the key assumption is the investment return from the separate accounts, which for 2012 and 2011 was 8.4 per cent per annum (after deduction of external fund management fees) determined using a mean reversion methodology. Under the mean reversion methodology, projected returns over the next fi ve years are fl exed (subject to capping) so that, combined with the actual rates of return for the current and the previous two years the 8.4 per cent rate is maintained. The projected rates of return are capped at no more than 15 per cent for each of the next fi ve years. Further details are explained in note D3(e). These returns affect the level of future expected profi ts through their effects on the fee income with consequential impact on the amortisation of DAC.
The level of acquisition costs carried in the statement of fi nancial position is also sensitive to unrealised valuation movements on debt securities held to back the liabilities and solvency capital. Further details are explained in notes D3(e) and H1.
In applying this overarching basis, the Group has chosen to apply US GAAP for measuring the insurance assets and liabilities of Jackson. In addition, for the Group’s operations in India, Japan, Taiwan and, until 2012, Vietnam*, where the local GAAP basis would not be appropriate as the start point for deriving MSB insurance asset and liabilities, the measurement has been determined substantially by reference to US GAAP requirements.
For 2012, the Group had the option to either continue with its current basis of measurement or improve its accounting policy under IFRS 4 to acknowledge the issuance of the Update. Prudential has chosen to improve its accounting policy in 2012 to apply the US GAAP update, on a retrospective basis, to the results of Jackson and the affected Asia operations.
Profi t before tax (being tax attributable to shareholders’ and policyholders’ returns) 3,335 (147) 3,188 1,926 (115) 1,811
(Less) Add tax (charge) credit attributable to policyholders’ returns (378) – (378) 17 – 17
Total comprehensive income for the year 2,418 (50) 2,368 1,706 (43) 1,663
(b) The effect of the change in accounting policy for deferred acquisition costs on the Group’s supplementary analysis of profi t is shown in the table below: Segment disclosure – profi t before tax
Total 2,659 (126) 2,533 2,070 (43) 2,027 Short-term fl uctuations in investment returns on
Gain on dilution of Group’s holdings 42 – 42 – – – Amortisation of acquisition accounting adjustments arising on the purchase of REALIC (19) – (19) – – –
Basic EPS from operating profi t based on longer-term investment returns after tax and non-controlling interests 80.2p (3.4)p 76.8p 63.9p (1.1)p 62.8p
Basic EPS based on total profi t after tax and non-controlling interests 90.4p (3.9)p 86.5p 58.8p (3.0)p 55.8p
A5: New accounting pronouncements continued c Accounting pronouncements endorsed by the EU but not yet eff ective The following accounting pronouncements potentially relevant to the Group have been issued and endorsed for use in the EU but are not mandatory for adoption for the 31 December 2012 year end.
Adoption of the revised IAS 19 standard will have no impact on shareholders’ equity.
The standards are effective from annual periods beginning on or after 1 January 2013. The standards are expected to have a minor impact on the Group’s assessment of its interests in investment funds (including OEICs and unit trusts) and is likely to increase the number of funds consolidated. The Group is currently determining those additional funds that will require consolidation under the requirements of IFRS 10 and the effect of retrospective adjustment to comparative results. The principal effect will be to ‘gross up’ the consolidated balance sheet for: (i) The difference between the net value of the newly consolidated assets and liabilities and the previous carrying value for the Group’s interest; and
(ii) The equal and opposite liability or minority interest for the external parties’ interests in the funds.
175Notes on the Group fi nancial statements Prudential plc Annual Report 2012 F
IFRS 13, ‘Fair value measurement’ In May 2011, the IASB issued IFRS 13, ‘Fair value measurement’ standard which creates a uniform framework to explain how to measure fair value and aims to enhance fair value disclosures, but it does not change when to measure fair value or require additional fair value measurements. The standard requires additional disclosure on the fair value of non-fi nancial assets and liabilities and enhanced disclosures of recurring level 3 fair value measurements.
d Accounting pronouncements not yet endorsed by the EU The following accounting pronouncement potentially relevant to the Group has been issued but not yet endorsed for use in the EU.
Operating result before gain on sale of stake in China Life of Taiwan 869 709 Gain on sale of stake in China Life of Taiwan 51 –
Total Asia insurance operations after development expenses 913 704 Eastspring Investments 75 80
US operations Jackson (US insurance operations) notes (i),(ii),(iii) 964 651 Broker-dealer and asset management 39 24
Other income and expenditure Investment return and other income 13 22 Interest payable on core structural borrowings (280) (286) Corporate expenditure (231) (219)
Profi t before tax attributable to shareholders 2,810 1,828 * The 2011 comparative results have been adjusted from those previously published for the retrospective application of the change in accounting policy described in note A5.
177Notes on the Group fi nancial statements Prudential plc Annual Report 2012 F
(ii) Eff ect of changes to assumptions, estimates and bases of determining life assurance liabilities The results of the Group’s long-term business operations are aff ected by changes to assumptions, estimates and bases of preparation. These are described in notes D2(g), D3(g) and D4(g). (iii) Jackson operating results based on longer-term investment returns IFRS basis operating profi ts for US operations include the following amounts (net of related change in amortisation of deferred acquisition costs, where applicable) so as to derive longer-term investment returns. 2012 £m 2011 £m
Debt securities: Amortisation of interest-related realised gains and losses 72 67 Risk margin reserve charge for longer-term credit-related losses (see note (iv) below) (66) (56)
(iv) The risk margin reserve (RMR) charge for longer-term credit-related losses included in operating profi t based on longer-term investment returns of Jackson for 2012 is based on an average annual RMR of 26 basis points (2011: 25 basis points) on average book values of US$47.6 billion (2011: US$44.4 billion) as shown below: Moody’s rating category (or equivalent under NAIC ratings of MBS)
Insurance operations: Other operations: Economic hedge value movement (32) – Other 114 (120)
General overview of defaults The Group did not experience any defaults on its shareholder-backed debt securities portfolio in 2012 or 2011.
Asia insurance operations The positive short-term fl uctuations of £76 million in 2012 refl ects unrealised gains on bond assets following a fall in yields in the period. These gains more than off set the impact of falling interest rates in Hong Kong and the transfer to operating profi t of previously booked unrealised gains on the sale of the Group’s stake in China Life of Taiwan. The realised gain on the sale of the Group’s stake in China Life of Taiwan of £51 million is included in the Group’s operating profi t based on longer-term investment returns as disclosed above.
The fl uctuations of £(92) million in 2011 in part refl ected equity market falls in Taiwan and negative unrealised value movement on the Group’s stake in China Life of Taiwan.
US insurance operations The short-term fl uctuations in investment returns for US insurance operations comprise the following items: 2012 £m 2011* £m
Notes (a) The charges on the debt securities of Jackson comprise the following: Residential mortgage-backed securities: Prime (including agency) (4) (25)
(b) The gain of £135 million (2011: gain of £554 million) is principally for the value movement of non-equity free-standing derivatives held to manage interest rate exposures, and for the GMIB reinsurance asset that is considered to be a derivative under IAS 39.
(c) The amount of £(302) million (2011: £(788) million) relates to the net equity hedge accounting eff ect of the equity-based derivatives and associated guarantee liabilities of Jackson’s variable and fi xed index annuity business. The details of the value movements excluded from operating profi t based on longer-term investment returns are as described in note C. The principal movements are for (i) value for free-standing and GMWB ‘not for life’ embedded derivatives, (ii) accounting values for GMDB and GMWB ‘for life’ guarantees, (iii) fee assessments and claim payments in respect of guarantee liabilities and (iv) related changes to DAC amortisation. In 2012, the charge of (£302) million principally refl ects fair value movements on free-standing futures contracts and short-dated options. The movements included within the net equity hedge result include the eff ect of lower interest rates for which the movement was particularly signifi cant in 2011. The value movements on derivatives held to manage this and any other interest rate exposure are included in the £135 million (2011: £554 million) described above in note (b).
179Notes on the Group fi nancial statements Prudential plc Annual Report 2012 F
Economic hedge value movement This item represents the costs on short-dated hedge contracts taken out in the fi rst half of 2012 to provide downside protection against severe equity market falls through a period of particular uncertainty with respect to the Eurozone. The hedge contracts were terminated in the second half of 2012.
Other operations Short-term fl uctuations in investment returns for Other operations in 2012 of £114 million primarily represent unrealised fair value movements on
(ix) Shareholders’ share of actuarial and other gains and losses on defi ned benefi t pension schemes
Actuarial gains and losses Actual less expected return on scheme assets 11 9 Experience gains on scheme liabilities 15 19 (Losses) gains on changes of assumptions for scheme liabilities (40) 12
The actuarial gains and losses shown in the table above relate to the Prudential Staff Pension Scheme (PSPS), and the Scottish Amicable and M&G schemes. The amounts did not include actuarial gains and losses for the Prudential Staff Pension Scheme, for which the Group has not recognised a substantial portion of its interest in the scheme’s underlying surplus.
For the 2011 comparatives, the shareholders’ share of actuarial and other gains and losses on defi ned benefi t pension schemes comprises the aggregate eff ect of actual less expected returns on scheme assets, experience gains and losses, the eff ect of changes in assumptions and altered provisions for defi cit funding, where relevant. For 2012, these items also apply. However, the shareholders’ share of actuarial and other gains and losses on defi ned benefi t pension schemes also includes £49 million for the eff ect of partial recognition of surplus of the main Prudential Staff Pension Scheme. This credit arose from an altered funding arrangement following the 5 April 2011 triennial valuation. Further details on the Group’s defi ned benefi t pension schemes are shown in note I3.
Basic earnings per share is calculated by dividing the earnings attributable to ordinary shareholders by the weighted average number of ordinary shares outstanding during the year, excluding those held in employee share trusts and consolidated unit trusts and open ended investment companies (OEICs), which are treated as cancelled.
Based on operating profi t based on longer-term investment returns 2,533 (582) – 1,951 76.8p 76.7p
Shareholders’ share of actuarial and other gains and losses on defi ned benefi t pension schemes B1 50 (12) – 38 1.5p 1.5p
Based on operating profi t based on longer-term investment returns 2,027 (433) (4) 1,590 62.8p 62.7p
Number of shares A reconciliation of the weighted average number of ordinary shares used for calculating basic and diluted earnings per share is set out as below: 2012 millions 2011 millions
Weighted average shares for calculation of diluted earnings per share 2,544 2,538
The 2012 fi nal dividend of 20.79 pence per ordinary share will be paid on 23 May 2013 in sterling to shareholders on the principal register and the Irish branch register at 6.00pm BST on Tuesday, 2 April 2013 (Record Date), and in Hong Kong dollars to shareholders on the Hong Kong branch register at 4.30pm Hong Kong time on the Record Date (HK Shareholders). Holders of US American Depositary Receipts (US Shareholders) will be paid their dividends in US dollars on or about 3 June 2013. The fi nal dividend will be paid on or about 30 May 2013 in Singapore dollars to shareholders with shares standing to the credit of their securities accounts with The Central Depository (Pte.) Limited (CDP) at 5.00pm Singapore time on the Record Date (SG Shareholders). The dividend payable to the HK Shareholders will be translated using the exchange rate quoted by the WM Company at the close of business on 12 March 2013. The exchange rate at which the dividend payable to the SG Shareholders will be translated into SG$, will be determined by CDP. The dividend will distribute an estimated £532 million of shareholders’ funds.
Exchange movement recognised in other comprehensive income 2012 £m 2011* £m
To explain more comprehensively the assets, liabilities and capital of the Group’s businesses, it is appropriate to provide analyses of the Group’s statement of fi nancial position by operating segment and type of business.
a Group statement of fi nancial position by operating segment i Position at 31 December 2012 2012 £m
Properties held for sale H9 98 – – 98 – – – 98 Cash and cash equivalents H10 2,638 513 1,668 4,819 1,083 482 – 6,384
183Notes on the Group fi nancial statements Prudential plc Annual Report 2012 F
: Su m m ary o f resu lts 2012 £m
Total policyholder liabilities and unallocated surplus of with-profi ts funds 144,438 92,261 34,664 271,363 – – – 271,363
Operational borrowings attributable to shareholder-fi nanced operations 127 26 7 160 1 2,084 – 2,245
Other non-insurance liabilities: Obligations under funding, securities lending and sale and repurchase agreements 1,461 920 55 2,436 – – – 2,436 Net asset value attributable to unit holders of consolidated unit trusts and similar funds 2,307 25 1,851 4,183 162 – – 4,345 Deferred tax liabilities 1,185 2,168 588 3,941 13 16 – 3,970 Current tax liabilities 237 – 49 286 8 151 – 445 Accruals and deferred income 429 – 110 539 266 28 – 833 Other creditors 2,766 611 1,601 4,978 3,771 145 (6,113) 2,781 Provisions 291 20 66 377 149 75 – 601 Derivative liabilities 1,007 645 837 2,489 150 190 – 2,829 Other liabilities 210 2,554 640 3,404 37 13 – 3,454
B5: Group statement of fi nancial position continued i Position at 31 December 2011 2011* £m
Assets Intangible assets attributable to shareholders: Goodwill – – 235 235 1,230 – – 1,465 Deferred acquisition costs and other intangible assets 113 3,115 977 4,205 16 13 – 4,234
Intangible assets attributable to with-profi ts funds: In respect of acquired subsidiaries for venture fund and other investment purposes 178 – – 178 – – – 178 Deferred acquisition costs and other intangible assets 6 – 83 89 – – – 89
Deferred tax assets 231 1,392 115 1,738 129 409 – 2,276 Other non-investment and non-cash assets H3,H6 4,771 1,542 1,024 7,337 1,000 4,532 (6,231) 6,638 Investments of long-term business and other operations: Investment properties 10,712 35 10 10,757 – – – 10,757 Investments accounted for using the equity method 70 – – 70 – – – 70
185Notes on the Group fi nancial statements Prudential plc Annual Report 2012 F
Equity and liabilities Equity Shareholders’ equity H11 2,581 3,761 2,306 8,648 1,783 (1,867) – 8,564 Non-controlling interests 33 – 5 38 5 – – 43
Total policyholder liabilities and unallocated surplus of with-profi ts funds 136,189 69,189 30,912 236,290 – – – 236,290
Other non-insurance liabilities: Obligations under funding, securities lending and sale and repurchase agreements H4, H14, H15 1,945 1,169 – 3,114 – – – 3,114 Net asset value attributable to unit holders of consolidated unit trusts and similar funds 2,043 18 1,101 3,162 678 – – 3,840 Deferred tax liabilities 1,349 1,818 506 3,673 5 251 – 3,929 Current tax liabilities 553 – 116 669 106 155 – 930 Accruals and deferred income 321 – 103 424 290 22 – 736 Other creditors 2,829 548 660 4,037 4,493 245 (6,231) 2,544 Provisions 266 13 47 326 133 70 – 529 Derivative liabilities 1,298 887 480 2,665 182 207 – 3,054 Other liabilities 209 379 590 1,178 31 40 – 1,249 * The 2011 comparative results have been adjusted from those previously published for the retrospective application of the change in accounting policy described in note A5.
B5: Group statement of fi nancial position continued ii Group statement of fi nancial position – additional analysis by business type 2012 £m 2011* £m
Assets Intangible assets attributable to shareholders: Goodwill – – 239 1,230 – – 1,469 1,465 Deferred acquisition costs and other intangible assets – – 4,235 14 18 – 4,267 4,234
187Notes on the Group fi nancial statements Prudential plc Annual Report 2012 F
Equity and liabilities Equity Shareholders’ equity – – 9,905 1,937 (1,483) – 10,359 8,564 Non-controlling interests 1 – 4 – – – 5 43
Borrowings attributable to with-profi ts operations 1,033 – – – – – 1,033 972
B5: Group statement of fi nancial position continued b Reconciliation of movement in policyholder liabilities and unallocated surplus of with-profi ts funds A reconciliation of the total policyholder liabilities and unallocated surplus of with-profi ts funds of the Group from the beginning of the year to the end of the year is as follows: Insurance operations £m
Net fl ows (4,454) 9,597 2,421 7,564 Shareholders' transfers post-tax (205) – (31) (236) Investment-related items and other movements 13,006 4,241 2,178 19,425 Foreign exchange translation differences (98) (3,678) (816) (4,592) Acquisition of REALIC I1 – 12,912 – 12,912
* Averages have been based on opening and closing balances and adjusted for acquisitions and disposals in the period and exclude unallocated surplus of with-profi ts funds.
The items above represent the amount attributable to changes in policyholder liabilities and unallocated surplus of with-profi ts funds as a result of each of the components listed. The policyholder liabilities shown include investment contracts without discretionary participation features (as defi ned in IFRS 4) and their full movement in the year. The items above are shown gross of reinsurance.
189Notes on the Group fi nancial statements Prudential plc Annual Report 2012 F
S&P – AAA 9,200 187 785 10,172 1,046 11,218 12,593 S&P – AA+ to AA- 9,623 6,343 5,523 21,489 106 21,595 17,038 S&P – A+ to A- 23,000 7,728 3,282 34,010 206 34,216 31,161 S&P – BBB+ to BBB- 17,720 10,230 1,906 29,856 235 30,091 25,860 S&P – Other 3,043 1,173 3,132 7,348 37 7,385 6,346
Moody’s – Aaa 8,446 55 1,389 9,890 135 10,025 9,615 Moody’s – Aa1 to Aa3 1,420 18 271 1,709 36 1,745 806 Moody’s – A1 to A3 927 21 169 1,117 – 1,117 1,352 Moody’s – Baa1 to Baa3 1,385 56 375 1,816 12 1,828 1,228 Moody’s – Other 307 13 112 432 – 432 318
B5: Group statement of fi nancial position continued ii Group’s exposure to holdings in asset-backed securities The Group’s exposure to holdings in asset-backed securities (ABS), which comprise residential mortgage-backed securities (RMBS), commercial mortgage-backed securities (CMBS), collateralised debt obligations (CDO) funds and other asset-backed securities, at 31 December 2012 is as follows: Shareholder-backed operations: UK insurance operations (2012: 34% AAA, 17% AA) note (i) 1,408 1,358 US insurance operations D3 5,626 5,380 Asia insurance operations note (ii) 144 176 Asset management operations note (iii) 566 594
(2011: £454 million, 75 per cent) are investment grade. (iii) Asset management operations Asset management operations’ exposure to asset-backed securities is held by Prudential Capital with no sub-prime exposure. Of the £566 million, 77 per cent (2011: £595 million, 77 per cent) are graded AAA.
iii Group sovereign debt exposure The exposures held by the shareholder-backed business and with-profi ts funds in sovereign debts and bank debt securities at 31 December 2012 are given within the Risk and capital management section of the Business review under Credit risk.
191Notes on the Group fi nancial statements Prudential plc Annual Report 2012 F
Insurance contracts Insurance contracts are permitted to be accounted for under previously applied GAAP. The Group has chosen to adopt this approach. However, as an improvement to accounting policy, permitted by IFRS 4, the Group has applied the measurement principles for with-profi ts contracts of UK regulated entities and disclosures of the UK Standard FRS 27 from 1 January 2005. An explanation of the provisions under FRS 27 is provided in note D2.
Under the previously applied GAAP, UK GAAP, the assets and liabilities of contracts are reported in accordance with the Modifi ed Statutory Basis (MSB) of reporting as set out in the ABI SORP.
The insurance contracts of the Group’s shareholder-backed business fall broadly into the following categories: AAAAAAAAAAAAAAAA UK insurance operations – bulk and individual annuity business, and other categories of non participating UK business; AAAAAAAAAAAAAAAA Jackson – fi xed and variable annuity business and life insurance; and
AAAAAAAAAAAAAAAA Prudential Corporation Asia – non-participating term, whole life, and unit-linked policies, together with accident and health policies.
AAAAAAAAAAAAAAAA Prudential Corporation Asia – minor amounts for a number of small categories of business.
As part of the risk management framework, the Group regularly monitors concentration of risk using a variety of risk monitoring tools, including scenario testing and sensitivity analysis of the Group’s capital and profi tability metrics involving IGD, Group economic capital, EEV and IFRS, to help identify concentrations of risks by risk types, products and business units, as well as the benefi ts of diversifi cation of risks.
d Sensitivity of EEV shareholders’ basis profi t and equity to market and other risks The Group prepares supplementary EEV basis fi nancial statements for half-yearly and annual publication. These statements include sensitivity disclosures which are part of the market risk information provided to key management.
e Sensitivity of IFRS basis profi t or loss and shareholders’ equity to market and other risks i Overview of risks by business unit The fi nancial and insurance assets and liabilities attaching to the Group’s life assurance business are, to varying degrees, subject to market and insurance risk and other changes of experience assumptions that may have a material effect on IFRS basis profi t or loss and shareholders’ equity.
Market risk is the risk that the fair value or future cash fl ows of a fi nancial instrument or, in the case of liabilities of insurance contracts, their carrying value, will fl uctuate because of changes in market prices. Market risk comprises three types of risk, namely: AAAAAAAAAAAAAAAAA Currency risk: due to changes in foreign exchange rates; AAAAAAAAAAAAAAAAA Interest rate risk: due to changes in market interest rates; and AAAAAAAAAAAAAAAAA Other price risk: due to fl uctuations in market prices (other than those arising from interest rate risk or currency risk).
Three key points are to be noted, namely: AAAAAAAAAAAAAAAAA The Group’s with-profi ts and unit-linked funds absorb most market risk attaching to the funds’ investments. Except for second order effects, for example, on asset management fees and shareholders’ share of cost of bonuses for with-profi ts business, shareholder results are not directly affected by market value movements on the assets of these funds; AAAAAAAAAAAAAAAAA The Group’s shareholder results are most sensitive to market risks for assets of the shareholder-backed business; and AAAAAAAAAAAAAAAAA The main exposures of the Group’s IFRS basis results to market risk for its life assurance operations on investments of the shareholder-backed business are for debt securities.
The most signifi cant items for which the IFRS shareholders’ profi t or loss and shareholders’ equity for the Group’s life assurance business is sensitive to these variables are shown in the following tables. The distinction between direct and indirect exposure is not intended to indicate the relative size of the sensitivity.
SAIF sub-fund Net neutral direct exposure (Indirect exposure only) Asset management fees earned by M&G
Unit-linked business Net neutral direct exposure (Indirect exposure only) Investment performance through asset management fees
195Notes on the Group fi nancial statements Prudential plc Annual Report 2012 F
With-profi ts business Net neutral direct exposure (Indirect exposure only) Investment performance subject to smoothing through declared bonuses
Detailed analyses of sensitivity of IFRS basis profi t or loss and shareholders’ equity to key market and other risks are provided in notes D2(h), D3(h), D4(h) and E4. The sensitivity analyses provided show the effect on profi t or loss and shareholders’ equity to changes in the relevant risk variables, all of which are reasonably possible at the relevant balance sheet date. Other features to note are as follows.
UK The IFRS operating profi t based on longer-term investment returns for UK insurance operations has high potential sensitivity for changes to longevity assumptions affecting the carrying value of liabilities to policyholders for UK shareholder-backed annuity business. At the total IFRS profi t level, the result is particularly sensitive to temporary value movements on assets backing US and Asia policyholder liabilities (which in general are measured on a basis that is insensitive to current market movements) and shareholder equity.
Jackson’s derivative programme is used to manage interest rate risk associated with a broad range of products and equity market risk attaching to its equity-based products. Movements in equity markets, interest rates and credit spreads materially affect the carrying value of derivatives which are used to manage the liabilities to policyholders and backing investment assets. Combined with the use of US GAAP measurement (as ‘grandfathered’ under IFRS 4) for the insurance contracts assets and liabilities which is largely insensitive to current period market movements, the Jackson total profi t (ie including short-term fl uctuations in investment returns) is very sensitive to market movements. In addition to these effects the Jackson shareholders’ equity is sensitive to the impact of interest rate and credit spread movements on the value of fi xed income securities. Movements in unrealised appreciation on these securities are included as movement in shareholders’ equity (ie outside the income statement). See D3(h) for details of the hedging.
Asia For Asia operations, the operating profi t based on longer-term investment returns is mainly affected by the impact of market levels on unit-linked business persistency, and other insurance risks.
Impact of diversifi cation on risk exposure The Group enjoys signifi cant diversifi cation benefi ts. This arises because not all risk scenarios will happen at the same time and across all geographic regions. Relevant correlation factors include: Correlation across geographic regions AAAAAAAAAAAAAAAAA Financial risk factors AAAAAAAAAAAAAAAAA Non-fi nancial risk factors
f Duration of liabilities Under the terms of the Group’s contracts, as for life assurance contracts generally, the contractual maturity date is the earlier of the end of the contract term, death, other insurable events or surrender. The Group has therefore chosen to provide details of liability duration that refl ect the actuarially determined best estimate of the likely incidence of these factors on contract duration. Details are shown in sections D2(i), D3(i) and D4(i).
D2: UK insurance operations a Summary statement of fi nancial position In order to show the statement of fi nancial position by reference to the differing degrees of policyholder and shareholder economic interest of the different types of fund and business, the analysis below is structured to show separately assets and liabilities of the Scottish Amicable Insurance Fund (SAIF), the PAC with-profi ts sub-fund (WPSF), unit-linked assets and liabilities and annuity (principally PRIL) and other long-term business.
Assets Intangible assets attributable to shareholders: Deferred acquisition costs and other intangible assets – – – 105 105 105 113
Deferred tax assets 1 113 – 69 69 183 231 Other non-investment and non-cash assets 369 2,440 385 2,230 2,615 5,424 4,771 Investments of long-term business and other operations: Investment propertiesnote (iv) 500 8,159 622 1,571 2,193 10,852 10,712 Associate investments accounted for using the equity method – – – 72 72 72 70 Financial investments: Loansnote (v) 116 1,993 – 1,264 1,264 3,373 3,115 Equity securities and portfolio holdings in unit trusts 2,070 19,875 14,071 11 14,082 36,027 36,722 Debt securities 3,864 46,643 6,310 27,045 33,355 83,862 77,953 Other investmentsnote (vi) 283 3,958 10 325 335 4,576 4,568 Deposits 910 8,395 822 1,004 1,826 11,131 9,287
Liabilities Policyholder liabilities and unallocated surplus of with-profi ts funds: Contract liabilities (including amounts in respect of contracts classifi ed as investment contracts under
IFRS 4) 7,878 76,529 22,197 27,308 49,505 133,912 127,024 Unallocated surplus of with-profi ts funds (refl ecting application of ‘realistic’ basis provisions for UK
regulated with-profi ts funds) – 10,526 – – – 10,526 9,165
Operational borrowings attributable to shareholder-fi nanced operations – – 1 126 127 127 103
Notes (i) For the purposes of this table and subsequent explanation, references to the WPSF also include, for convenience, the amounts attaching to the Defi ned
Included in the PAC with-profi ts fund is £13.3 billion (2011: £12.6 billion) of non-profi ts annuities liabilities. (ii) Excluding policyholder liabilities of the Hong Kong branch of PAC. (iii) SAIF is a separate sub-fund within the PAC long-term business fund.
199Notes on the Group fi nancial statements Prudential plc Annual Report 2012 F
(iv) Investment properties At 31 December 2012, the Group’s UK insurance operations had £10,852 million (2011: £10,712 million) of investment properties. The following table shows the property portfolio by type of investment. The properties are shown at market value below in accordance with the policies described in note A3.
Total UK insurance operations loans 3,373 3,115 * The mortgage loans are collateralised by properties. By carrying value, 86 per cent of the £1,259 million held for shareholder-backed business relates to lifetime (equity release) mortgage business which has an average loan to property value of 29 per cent.
† Other loans held by the PAC with-profi ts fund are all commercial loans and comprise mainly syndicated loans. (vi) Other investments comprise: Derivative assets* 1,349 1,461 Partnerships in investment pools and other† 3,227 3,107 * Aft er including derivative liabilities of £1,007 million (2011: £1,298 million), which are also included in the statement of fi nancial position, the overall derivative position was a net asset of £342 million (2011: £163 million).
† Partnerships in investment pools and other comprise mainly investments held by the PAC with-profi ts fund. These investments are primarily investments in limited partnerships and additionally, investments in property funds.
D2: UK insurance operations continued b Reconciliation of movement in policyholder liabilities and unallocated surplus of with-profi ts funds A reconciliation of the total policyholder liabilities and unallocated surplus of with-profi ts funds of UK insurance operations from the beginning of the year to the end of the year is as follows: Other shareholder-backed funds and subsidiaries
Shareholders’ transfers post tax (216) – – (216) Switches (237) 237 – – Investment-related items and other movementsnote (b) 3,338 25 2,499 5,862 Foreign exchange translation differences (94) – – (94)
Notes (a) Net outfl ows decreased from £5,080 million in 2011 to £4,454 million in 2012. An improvement in the net outfl ows of the with-profi ts business, following increased sales of with-profi ts bonds in the year, has been greater than the increase in outfl ows in the unit-linked business. The levels of infl ows/outfl ows for unit-linked business is driven by the activity of corporate pension schemes with transfers in or out from only one or two schemes infl uencing the level of fl ows in the year. The net fl ows of negative £1,261 million in unit-linked business was a result of lower single premiums in and higher transfers out of this business in 2012.
: L ife assu ran ce b u sin ess c Information on credit risk of debt securities The following table summarises by rating the securities held by UK insurance operations as at 31 December 2012 and 2011: UK insurance operations 31 Dec 2011 £m
S&P – AAA 441 4,716 582 3,023 438 9,200 9,928 S&P – AA+ to AA- 527 4,908 829 3,041 318 9,623 8,647 S&P – A+ to A- 1,031 12,345 1,805 6,934 885 23,000 21,474 S&P – BBB+ to BBB- 911 10,614 1,340 4,210 645 17,720 15,746 S&P – Other 224 2,358 115 307 39 3,043 3,175
Moody’s – Aaa 241 3,780 1,239 2,557 629 8,446 7,945 Moody’s – Aa1 to Aa3 41 538 106 622 113 1,420 651 Moody’s – A1 to A3 32 505 26 321 43 927 1,008 Moody’s – Baa1 to Baa3 54 818 113 370 30 1,385 1,030 Moody’s – Other 15 224 30 30 8 307 242
Where no external ratings are available, internal ratings produced by the Group’s asset management operation, which are prepared on the Company’s assessment of a comparable basis to external ratings, are used where possible. The £8,264 million total debt securities held at 31 December 2012 (2011: £7,615 million) which are not externally rated are either internally rated or unrated. These are analysed as follows: Internal ratings or unrated: AAA to A- 3,150 2,726 BBB to B- 3,752 3,773 Below B- or unrated 1,362 1,116
During 2011 Standard & Poor’s withdrew its ratings of debt securities issued by a number of sovereigns. Where these are no longer available Moody’s ratings have been used. This primarily impacts the UK and Asia insurance operations.
As detailed in note D2(h) below, the primary sensitivity of IFRS basis profi t or loss and shareholders’ equity relates to non-linked shareholder-backed business which is represented by ‘PRIL’ and ‘other annuity and long-term business’ in the table above.
i With-profi ts products and PAC with-profi ts sub-fund Within the statement of fi nancial position of UK insurance operations at 31 December 2012, as shown in note D2(a), there are policyholder liabilities and unallocated surplus of £87.1 billion (2011: £81.6 billion) that relate to the WPSF. These amounts include the liabilities and capital of Prudential Annuities Limited, a wholly-owned subsidiary of the fund. The WPSF mainly contains with-profi ts business but it also contains some non-profi t business (unit-linked, term assurances and annuities). The WPSF’s profi ts are apportioned 90 per cent to its policyholders and 10 per cent to shareholders as surplus for distribution is determined via the annual actuarial valuation.
The WPSF held a provision of £47 million at 31 December 2012 (2011: £90 million) to honour guarantees on a small amount of guaranteed annuity products. SAIF’s exposure to guaranteed annuities is described below.
With-profi ts products provide returns to policyholders through bonuses that are ‘smoothed’. There are two types of bonuses: ‘annual’ and ‘fi nal’. Annual bonuses are declared once a year, and once credited, are guaranteed in accordance with the terms of the particular product. Unlike annual bonuses, fi nal bonuses are guaranteed only until the next bonus declaration. The main factors that infl uence the determination of bonus rates are the return on the investments of the with-profi ts fund, infl ation, taxation, the expenses of the fund chargeable to policyholders and the degree to which investment returns are smoothed. The overall rate of return earned on investments and the expectation of future investment returns are the most important infl uences on bonus rates.
A high proportion of the assets backing the with-profi ts business are invested in equities and real estate. If the fi nancial strength of the with-profi ts business is affected, then a higher proportion of fi xed interest or similar assets might be held by the fund.
Further details on the determination of the two types of the bonuses: ‘regular’ and ‘fi nal’, the application of signifi cant judgement, key assumptions and the degree of smoothing of investment returns in determining the bonus rates are provided below.
For regular bonuses, the bonus rates are determined for each type of policy primarily by targeting the bonus level at a prudent proportion of the long-term expected future investment return on underlying assets. The expected future investment return is reduced as appropriate for each type of policy to allow for items such as expenses, charges, tax and shareholders’ transfers. However, the rates declared may differ by product type, or by the date of payment of the premium, or date of issue of the policy, or if the accumulated annual bonuses are particularly high or low, relative to a prudent proportion of the achieved investment return.
In normal investment conditions, PAC expects changes in regular bonus rates to be gradual over time. However, the PAC Directors retain the discretion whether or not to declare a regular bonus each year, and there is no limit on the amount by which regular bonus rates can change.
In general, the same fi nal bonus scale applies to maturity, death and surrender claims except that: AAAAAAAAAAAAAAAAA The total surrender value may be impacted by the application of a Market Value Reduction for accumulating with-profi ts policies and is the surrender bases for conventional with-profi ts business; and
AAAAAAAAAAAAAAAAA For the SAIF and Scottish Amicable, the fi nal bonus rates applicable on surrender may be adjusted to refl ect expected future bonus rates.
Furthermore, in accordance with industry-wide regulatory requirements, the PAC Board has appointed: AAAAAAAAAAAAAAAAA An Actuarial Function Holder who provides the PAC Board with all actuarial advice; AAAAAAAAAAAAAAAAA A With-Profi ts Actuary whose specifi c duty is to advise the PAC Board on the reasonableness and proportionality of the manner in which its discretion has been exercised in applying the PPFM and the manner in which any confl icting interests have been addressed; and
(including charge for provision for asset shares and excluding policyholder bonuses) (8,981) (5,080) Earned premiums, net of reinsurance 4,558 3,404 Other income 39 17 Acquisition costs and other expenditure (740) (696) Tax charge (292) (63)
Net income of the fund before movement in unallocated surplus 2,934 1,676 Movement in unallocated surplus (863) 485
Surplus for distribution allocated as follows: 90% policyholders’ bonus (as shown above) 1,865 1,945 10% shareholders’ transfers 206 216 ii Annuity business Prudential’s conventional annuities include level, fi xed-increase and infl ation-linked annuities, the link being to the Retail Prices Index (RPI) in the majority of cases. They are mainly written within the subsidiaries PAL, PRIL, the PAC non-profi t sub-fund and the PAC with-profi ts sub-fund, but there are some annuity liabilities in Prudential Pensions Limited and SAIF.
Prudential’s with-profi ts annuities, which are written in the WPSF, combine the income features of annuity products with the investment smoothing features of with-profi ts products and enable policyholders to obtain exposure to investment return on the WPSF’s equity shares, property and other investment categories over time. Policyholders select a ‘required smoothed return’ bonus from the specifi c range Prudential offers for the particular product. The amount of the annuity payment each year depends upon the relationship between the required smoothed return bonus rate selected by the policyholder when the product is purchased and the smoothed return bonus rates Prudential subsequently declares each year during the term of the product. If the total bonus rates fall below the anticipated rate, then the annuity income falls.
At 31 December 2012, £41.7 billion (2011: £38.3 billion) of investments relate to non-profi t annuity business of the PAC WPSF (including PAL) and the annuity business of PRIL. These investments are predominantly in debt securities (including retail price index-linked bonds to match retail price index-linked annuities), loans, deposits and property, and are duration matched with the estimated duration of the liabilities they support.
Provision is made for the risks attaching to some SAIF unitised with-profi ts policies that have (Market Value Reduction) MVR-free dates and for those SAIF products which have a guaranteed minimum benefi t on death or maturity of premiums accumulated at 4 per cent per annum.
iv Unit-linked (non-annuity) and other non-profi t business Prudential UK insurance operations also have an extensive book of unit-linked policies of varying types and provide a range of other non-profi t business such as credit life and protection contracts. These contracts do not contain signifi cant fi nancial guarantees.
For with-profi ts business written in the WPSF or SAIF, a market consistent valuation is performed (as described in section (ii) below). Additional assumptions required are for persistency and the management actions under which the fund is managed. Assumptions used for a market-consistent valuation typically do not contain margins, whereas those used for the valuation of other classes of business do.
The actual renewal expenses incurred on behalf of SAIF by other Group companies are recharged in full to SAIF. The assumptions for asset management expenses are based on the charges specifi ed in agreements with the Group’s asset management operations, plus a margin for adverse deviation for non-profi t business.
Tax assumptions are set equal to current rates of taxation. For non-profi t business excluding unit-linked business, the valuation interest rates used to discount the liabilities are based on the yields as at the valuation date on the assets backing the technical provisions. For fi xed interest securities the gross redemption yield is used, except for the PAL (including the business recaptured by PAC WPSF in 2011) and PRIL annuity business, where the internal rate of return of the assets backing the liabilities is used. Properties are valued using the rental yield, and for equities it is the greater of the dividend yield and the average of the dividend yield and the earnings yield. An adjustment is made to the yield on non risk-free fi xed interest securities and property to refl ect credit risk. To calculate the non-unit reserves for linked business, assumptions have been set for the gross unit growth rate and the rate of infl ation of maintenance expenses, as well as for the valuation interest rate as described above.
ii WPSF and SAIF The policyholder liabilities reported for the WPSF are primarily for two broad types of business. These are accumulating and conventional with-profi ts contracts. The policyholder liabilities of the WPSF are accounted for under FRS 27.
The FSA’s Peak 2 calculation under the realistic regime requirement is explained further in note A3(2)(a) under the UK regulated with-profi ts section.
The additional yield received on corporate bonds relative to swaps can be broken into the following constituent parts: (a) The expected level of future defaults; (b) The credit risk premium that is required to compensate for the potential volatility in default levels; (c) The liquidity premium that is required to compensate for the lower liquidity of corporate bonds relative to swaps; and (d) The mark to market risk premium that is required to compensate for the potential volatility in corporate bond spreads (and hence market values) at the time of sale.
The sum of (c) and (d) is often referred to as ‘liquidity premium’. The allowance for credit risk comprises (i) an amount for long-term best estimate defaults, and (ii) additional provisions for credit risk premium, downgrade resilience and short-term defaults. The weighted components of the bond spread over swap rates for shareholder-backed fi xed and linked annuity business for
Notes (i) Bond spread over swap rates refl ect market observed data.
(ii) Long-term expected defaults are derived by applying Moody’s data from 1970 to 2009 and the defi nition of the credit rating used is the second highest credit rating published by Moody’s, Standard & Poor’s and Fitch. (iii) Additional provisions comprise credit risk premium, which is derived from Moody’s data from 1970 to 2009, an allowance for a one-notch downgrade of the portfolio subject to credit risk and an additional allowance for short-term defaults.
207Notes on the Group fi nancial statements Prudential plc Annual Report 2012 F
Total allowance for credit risk at 31 December 2012 65 42
For periods prior to full year 2011, favourable credit experience was retained in short-term allowances for credit risk on both the Pillar 1 and IFRS bases. From full year 2011 onwards, the methodology applied is to continue to retain such surplus experience in the IFRS credit provisions but not for Pillar 1.
The mortality assumptions are set in light of recent population and internal experience. The assumptions used are percentages of standard actuarial mortality tables with an allowance for future mortality improvements. Where annuities have been sold on an enhanced basis to impaired lives an additional age adjustment is made. The percentages of the standard table used are selected according to the source of business.
The tables and range of percentages used are set out in the following tables: Non-profi t annuities within the WPSF (including PAL) PRIL
In deferment 93% – 99% PCMA00 with future improvements in line with Prudential’s own calibration of the CMI 2011 mortality model, with a long-term improvement rate of 2.25%.
AM92 minus 4 years 86% – 96% PCFA00 with future improvements in line with Prudential’s own calibration of the CMI 2009 mortality model, with a long-term improvement rate of 1.25%.
In deferment 92% – 98% PCMA00 with future improvements in line with Prudential’s own calibration of the CMI 2009 mortality model, with a long-term improvement rate of 2.25%.
AM92 minus 4 years 88% – 100% PCFA00 with future improvements in line with Prudential’s own calibration of the CMI 2009 mortality model, with a long-term improvement rate of 1.25%.
: L ife assu ran ce b u sin ess iv Unit-linked (non-annuity) and other non-profi t business The majority of other long-term business written in the UK insurance operations is unit-linked business or other business with similar features. For these contracts, the attaching liability refl ects the unit value obligation and provision for expenses and mortality risk. The latter component is determined by applying mortality assumptions on a basis that is appropriate for the policyholder profi le.
For those contracts where the level of insurance risk is insignifi cant, the assets and liabilities arising under the contracts are distinguished between those that relate to the fi nancial instrument liability and acquisition costs and deferred income that relate to the component of the contract that relates to investment management. Acquisition costs and deferred income are recognised consistent with the level of service provision in line with the requirements of IAS 18.
f Reinsurance The Group’s UK insurance business cedes only minor amounts of business outside the Group. During 2012, reinsurance premiums for externally ceded business were £135 million (2011: £132 million) and reinsurance recoverable assets were £608 million (2011: £589 million) in aggregate. The gains and losses recognised in profi t and loss for the 2012 and 2011 contracts were immaterial.
There has been no change of approach in the setting of assumption levels. However, changes in the portfolio have given rise to altered levels of credit risk allowance as set out in note D2 (e)(iii).
In 2012, for the shareholder-backed business, the net effect of assumption changes, other than the allowance for credit risk described above was a charge to shareholder results of £17 million. This comprises the aggregate effect of strengthening of mortality assumptions for the annuity business, offsetting releases of margins and altered expenses and other assumptions.
For the with-profi ts sub-fund, the aggregate effect of assumption changes in 2012 was a net charge to unallocated surplus of £90 million, relating to changes in mortality and offsetting releases of margins, expense, persistency and economic assumptions.
In 2011, for the shareholder-backed business, the aggregate effect of assumption changes other than the allowance for credit risk described above, was a net charge to the shareholder results of £9 million, comprising a number of individually small assumption changes.
For the with-profi ts sub-fund, the aggregate effect of assumption changes in 2011 was a net charge to unallocated surplus of £59 million, relating to changes in mortality, expense, persistency and economic assumptions.
h Exposure and sensitivity of IFRS basis profi t or loss and shareholders’ equity to market and other risks i With-profi ts business SAIF
Shareholders have no interest in the profi ts of the ring-fenced fund of SAIF but are entitled to the asset management fees paid on the assets of the fund.
Mortality and other insurance risk are relatively minor factors in the determination of the bonus rates. Adverse persistency experience can affect the level of profi tability from with-profi ts but in any given one year, the shareholders’ share of cost of bonus may only be marginally affected. However, altered persistency trends may affect future expected shareholder transfers.
ii Shareholder-backed annuity business The principal items affecting the IFRS results of the UK shareholder-backed annuity business are mortality experience and assumptions, and credit risk. The assets covering the liabilities are principally debt securities and other investments that are held to match the expected duration and payment characteristics of the policyholder liabilities. These liabilities are valued for IFRS reporting purposes by applying discount rates that refl ect the market rates of return attaching to the covering assets.
Asset/liability duration matching is reviewed regularly. Except to the extent of any asset/liability duration mismatch and exposure to credit risk, the sensitivity of the Group’s results to market risk for movements in the carrying value of the liabilities and covering assets is broadly neutral on a net basis.
The main market risk sensitivity for the UK shareholder-backed annuity business arises from interest rate risk on the debt securities which substantially represent shareholders’ equity. This shareholders’ equity comprises the net assets held within the long-term fund of the company that cover regulatory basis liabilities that are not recognised for IFRS reporting purposes, for example, contingency reserves and shareholder capital held outside the long-term fund.
A decrease in assumed mortality rates of 1 per cent would decrease gross profi ts by approximately £74 million (2011: £64 million). A decrease in credit default assumptions of fi ve basis points would increase gross profi ts by £157 million (2011: £137 million). A decrease in renewal expenses (excluding asset management expenses) of 5 per cent would increase gross profi ts by £25 million (2011: £25 million). The effect on profi ts would be approximately symmetrical for changes in assumptions that are directionally opposite to those explained above.
: L ife assu ran ce b u sin ess iv Shareholder exposure to interest rate risk and other market risk By virtue of the fund structure, product features and basis of accounting, the policyholder liabilities of the UK insurance operations are, except for pension annuity business, not generally exposed to interest rate risk. At 31 December 2012, pension annuity liabilities accounted for 98 per cent (2011: 98 per cent) of UK shareholder-backed business liabilities. For pension annuity business, liabilities are exposed to interest rate risk. However, the net exposure to the PAC WPSF (for PAL) and shareholders (for annuity liabilities of PRIL and the non-profi t sub-fund) is very substantially ameliorated by virtue of the close matching of assets with appropriate duration. The level of matching from period to period can vary depending on management actions and economic factors so it is possible for a degree of mis-matching profi ts or losses to arise.
The estimated sensitivity of the UK non-linked shareholder-backed business (principally pension annuities business) to a movement in interest rates is as follows: A decrease of 2%
A 10 or 20 per cent increase in their value would have an approximately equal and opposite effect on profi t and shareholders’ equity to the sensitivities shown above. The market risk sensitivities shown above refl ect the impact of temporary market movements and therefore, the primary effect of such movements would, in the Group’s segmental analysis of profi ts, be included within the short-term fl uctuations in investment returns.
In the equity risk sensitivity analysis shown above, the Group has considered the impact of an instantaneous 20 per cent fall in equity markets. If equity markets were to fall by more than 20 per cent, the Group believes that this would not be an instantaneous fall, but rather, this would be expected to occur over a period of time during which the Group would be able to put in place mitigating management actions.
D2: UK insurance operations continued i Duration of liabilities With the exception of most unitised with-profi ts bonds and other whole of life contracts the majority of the contracts of the UK insurance operations have a contract term. However, in effect, the maturity term of contracts refl ects the earlier of death, maturity, or lapsation. In addition, with-profi ts contract liabilities as noted in note D2(e) include projected future bonuses based on current investment values. The actual amounts payable will vary with future investment performance of SAIF and the WPSF.
The tables above show the carrying value of the policyholder liabilities. The tables in the accompanying notes below show the maturity profi le of the cash fl ows for insurance contracts, as defi ned by IFRS, ie those containing signifi cant insurance risk, and investment contracts, which do not.
Expected maturity: 0 to 5 years 47 32 41 29 25 27 34 28 31 35 5 to 10 years 24 26 25 24 22 22 25 22 24 24 10 to 15 years 13 19 16 18 18 18 18 18 18 17 15 to 20 years 8 14 10 12 13 13 11 12 11 11 20 to 25 years 5 7 6 8 10 9 7 9 7 7 over 25 years 3 2 2 9 12 11 5 11 9 6
Notes (i) The cash fl ow projections of expected benefi t payments used in the maturity profi le table above are from value of in-force business and exclude the value of future new business, including future vesting of internal pension contracts.
213Notes on the Group fi nancial statements Prudential plc Annual Report 2012 F
D3: US insurance operations a Summary results and statement of fi nancial position i Results and movements in shareholders’ equity 2012 £m 2011* £m
Operating profi t based on longer-term investment returns 964 651 Short-term fl uctuations in investment returns (90) (167) Amortisation of acquisition accounting adjustments arising on the purchase of REALIC I1 (19) –
Profi t for the year 621 357 2012 £m 2011* £m
Profi t for the year (as above) 621 357 Items recognised in other comprehensive income: Exchange movements (181) 35 Unrealised valuation movements on securities classifi ed as available-for-sale: Unrealised holding gains arising during the year 930 912 Deduct net gains included in the income statement (68) (101)
Total comprehensive income for the year 827 741 Dividends, interest payments to central companies and other movements (245) (330)
Net increase in equity 582 411 Shareholders’ equity at beginning of year: As previously reported 4,271 3,815 Effect of change in accounting policy for deferred acquisition costs* (510) (465) After effect of change 3,761 3,350
Shareholders’ equity at end of year 4,343 3,761 * The 2011 comparative results have been adjusted from those previously published for the retrospective application of the change in accounting policy described in note A5.
In 2012, there was a movement in the statement of fi nancial position value for debt securities classifi ed as available-for-sale from a net unrealised gain of £2,057 million to a net unrealised gain of £2,807 million. The gross unrealised gain in the statement of fi nancial position increased from £2,303 million at 31 December 2011 to £2,985 million at 31 December 2012, while the gross unrealised loss decreased from £246 million at 31 December 2011 to £178 million at 31 December 2012.
Refl ected as part of movement in consolidated statement of comprehensive income
Assets fair valued at below book value Book value* 4,551 2,455 Unrealised (loss) gain (178) 59 9 (246)
Fair value (as included in statement of fi nancial position) 4,373 2,209
Fair value (as included in statement of fi nancial position) 28,452 24,807
Fair value (as included in statement of fi nancial position)‡ 32,825 27,016 * Book value represents cost/amortised cost of the debt securities.
: L ife assu ran ce b u sin ess ii Statement of fi nancial position
Assets Intangible assets attributable to shareholders: Deferred acquisition costs and other intangibles – 3,222 3,222 3,115
Properties held for sale – – – 3 Cash and cash equivalents – 513 513 271
Liabilities Policyholder: Contract liabilities (including amounts in respect of contracts classifi ed as investment contracts under IFRS 4)note (iv) 49,298 42,963 92,261 69,189
Core structural borrowings of shareholder-fi nanced operations – 153 153 160 Operational borrowings attributable to shareholder-fi nanced operations – 26 26 127 Deferred tax liabilities – 2,168 2,168 1,818 Other non-insurance liabilitiesnote (vi) – 4,775 4,775 3,014 * The 2011 comparative results have been adjusted from those previously published for the retrospective application of the change in accounting policy described in note A5.
† The statement of fi nancial position at 31 December 2012 includes the assets and liabilities of the acquired REALIC business. Details of the acquisition are described in note I1.
Notes (i) Assets and liabilities attaching to variable annuity business that are not held in the separate account are shown within other business. (ii) Loans The loans of the Group’s US insurance operations comprise: Total US insurance operations loans 6,235 4,110 * All of the mortgage loans are commercial mortgage loans which are collateralised by properties. The property types are industrial, multi-family residential, suburban offi ce, retail and hotel. The breakdown by property type is as follows: Industrial 29 28 Multi-family residential 25 23 Offi ce 19 19 Retail 17 19 Hotels 10 11
The US insurance operations’ commercial mortgage loan portfolio does not include any single-family residential mortgage loans and is therefore, not exposed to the risk of defaults associated with residential sub-prime mortgage loans. The average loan size is £6.3 million (2011: £6.6 million). The portfolio has a current estimated average loan to value of 65 per cent (2011: 68 per cent) which provides signifi cant cushion to withstand substantial declines in value.
At 31 December 2012, Jackson had mortgage loans with a carrying value of £78 million where the contractual terms of the agreements had been restructured. In addition to the regular impairment review aff orded all loans in the portfolio, restructured loans are also reviewed for impairment. An impairment will be recorded if the expected cash fl ows under the newly restructured terms discounted at the original yield (the pre-structured interest rate) are below the carrying value of the loan.
† The policy loans are fully secured by individual life insurance policies or annuity policies. The increase in 2012 refl ects the purchase of REALIC as explained in note I1. The policy loans from the purchase of REALIC amounted to £1,842 million at 31 December 2012, and are accounted for at fair value through profi t and loss as described above. All other policy loans are accounted for at amortised cost, less any impairment.
Aft er taking account of the derivative liabilities of £645 million (2011: £887 million), which are also included in Other non-insurance liabilities, the derivative position for US operations is a net asset of £901 million (2011: £790 million).
In addition to the policyholder liabilities above, Jackson has entered into a programme of funding arrangements under contracts which, in substance, are almost identical to GICs. The liabilities under these funding arrangements totalled £825 million (2011: £1,070 million) and are included in ‘Other non-insurance liabilities’ in the statement of fi nancial position above.
(v) Equity securities and portfolio holdings in unit trusts includes investments in mutual funds, the majority of which are equity based. (vi) Reinsurance balances relating to REALIC Included within Other non-investment and non-cash assets of £6,792 million (2011: £1,542 million) were balances of £6,076 million (2011: £907 million)
for reinsurers’ share of insurance contract liabilities. Of the £6,076 million as at 31 December 2012, £5,234 million related to the reinsurance ceded by the newly acquired REALIC business. REALIC holds collateral for certain of these reinsurance arrangements with a corresponding funds withheld liability. As of 31 December 2012, the funds withheld liability of £2,021 million was recorded within Other non-insurance liabilities.
Net fl owsnote (b) 6,978 846 7,824 Transfers from general to separate account 957 (957) – Investment-related items and other movements (1,735) 1,871 136 Foreign exchange translation differencesnote (a) 430 276 706
Net fl owsnote (b) 7,808 1,789 9,597 Transfers from general to separate account 1,577 (1,577) – Investment-related items and other movementsnote (c) 4,014 227 4,241 Foreign exchange translation differencesnote (a) (1,998) (1,680) (3,678)
* Averages have been based on opening and closing balances, and adjusted for acquisitions and disposals in the period.
Notes (a) Movements in the year have been translated at an average rate of US$1.58/£1.00 (2011: US$1.60/£1.00). The closing balances have been translated at closing rate of US$1.63/£1.00 (2011: US$1.55/£1.00). Diff erences upon retranslation are included in foreign exchange translation diff erences. (b) Net fl ows for the year were £9,597 million compared with £7,824 million in 2011 driven largely by increased new business volumes. (c) Positive investment-related items and other movements in variable annuity separate account liabilities of £4,014 million for 2012 refl ects the increase in the
(d) The acquisition of REALIC refl ects the liabilities, before reduction for reinsurances ceded, acquired at the date of acquisition.
D3: US insurance operations continued c Information on credit risks of debt securities
Total debt securities 32,993 27,022 * The Securities Valuation Offi ce of the National Association of Insurance Commissioners (NAIC) classifi es debt securities into six quality categories ranging from Class 1 (the highest) to Class 6 (the lowest). Performing securities are designated as Classes 1 to 5 and securities in or near default are designated Class 6.
† The amounts within Other which are not rated by S&P, Moody’s nor Fitch, nor are MBS securities using the revised regulatory ratings, have the following NAIC classifi cations: For some mortgage-backed securities within Jackson, the table above includes these securities using the regulatory ratings detail issued by the NAIC. These regulatory ratings levels were established by external third parties (PIMCO for residential mortgage-backed securities and BlackRock Solutions for commercial mortgage-backed securities) based on Jackson’s carrying value.
219Notes on the Group fi nancial statements Prudential plc Annual Report 2012 F
iii Asset-backed securities funds exposures Included within the debt securities of Jackson at 31 December 2012, are exposures to asset-backed securities as follows: RMBS: Sub-prime (2012: 15% AAA, 6% AA) 261 207 Alt-A (2012: 4% AAA, 1% AA) 323 310 Prime including agency (2012: 0% AAA, 75% AA) 1,816 2,074 CMBS (2012: 40% AAA, 24% AA) 2,639 2,169 CDO funds (2012: 0% AAA, 27% AA)*, including £nil exposure to sub-prime 44 44 Other ABS (2012: 24% AAA, 15% AA), including £nil exposure to sub-prime 543 576 * Including Group’s economic interest in Piedmont and other consolidated CDO funds.
iv Debt securities classifi ed as available-for-sale in an unrealised loss position The following table shows the fair value of those securities that are in a gross unrealised loss position for various percentages of book value at 31 December: Fair value Unrealised loss Fair value Unrealised loss * The unrealised losses as at 31 December 2012 include £77 million (2011: £183 million) relating to mortgage-backed and other debt securities. The unrealised losses in the portfolio by reference to the length of time of three years or more as at 31 December 2012 are £36 million (2011: £105 million) in the investment grade and £31 million (2011: £61 million) in non-investment grade.
The policyholder of an interest-sensitive fi xed annuity pays Jackson a premium, which is credited to the policyholder’s account. Periodically, interest is credited to the policyholder’s account and in some cases administrative charges are deducted from the policyholder’s account. Jackson makes benefi t payments at a future date as specifi ed in the policy based on the value of the policyholder’s account at that date.
Fixed indexed annuities (FIA) accounted for 8 per cent (2011: 9 per cent) of Jackson’s policy and contract liabilities at 31 December 2012. Fixed indexed annuities vary in structure, but generally are deferred annuities that enable policyholders to obtain a portion of an equity-linked return (based on participation rates and caps) but provide a guaranteed minimum return. These guaranteed minimum rates are generally set between 1.0 per cent and 3.0 per cent. Jackson had fi xed indexed annuities allocated to indexed funds totalling £5.6 billion (US$9.2 billion) (2011: £5.0 billion (US$7.8 billion)) in account value with minimum guaranteed rates on indexed accounts ranging from 1.0 per cent to 3.0 per cent and a 1.82 per cent average guaranteed rate (2011: 1.0 per cent to 3.0 per cent and a 1.76 per cent average guarantee rate). Jackson also offers fi xed interest accounts on some fi xed indexed annuity products. Fixed interest accounts of fi xed indexed annuities totalled £1.5 billion (US$2.3 billion) (2011: £1.4 billion (US$2.1 billion)) in account value with minimum guaranteed rates ranging from 1.0 per cent to 3.0 per cent and a 2.53 per cent average guaranteed rate (2011: 1.0 per cent to 3.0 per cent and a 2.50 per cent average guarantee rate).
ii Variable annuities At 31 December 2012, VAs accounted for 60 per cent (2011: 63 per cent) of Jackson’s policy and contract liabilities. VAs are deferred annuities that have the same tax advantages and payout options as interest-sensitive and fi xed indexed annuities.
The primary differences between VAs and interest-sensitive or fi xed indexed annuities are investment risk and return. If a policyholder chooses a VA, the rate of return depends upon the performance of the selected fund portfolio. Policyholders may allocate their investment to either the fi xed or a selection of variable accounts. Investment risk on the variable account is borne by the policyholder, while investment risk on the fi xed account is borne by Jackson through guaranteed minimum fi xed rates of return. At 31 December 2012, approximately 8 per cent (2011: approximately 10 per cent) of VA funds were in fi xed accounts. Jackson had fi xed interest rate accounts in variable annuities totalling £4.3 billion (US$7.0 billion) (2011: £4.3 billion (US$6.7 billion)) in account value with minimum guaranteed rates ranging from 1.0 per cent to 3.0 per cent and a 1.89 per cent average guaranteed rate (2011: 1.0 per cent to 3.0 per cent and a 1.99 per cent average guarantee rate).
iii Aggregate distribution of account values The table below shows the distribution of account values for fi xed annuities (interest sensitive and fi xed indexed) and variable annuities within the range of minimum guaranteed interest rates as described in notes i and ii above as at 31 December 2012 and 2011: Account value
Minimum guaranteed interest rate 2012 £m 2011 £m iv Life insurance Jackson’s life insurance products accounted for 15 per cent (2011: 7 per cent) of Jackson’s policy and contract liabilities at 31 December 2012. The increase from 2011 was a result of the acquisition of REALIC. Jackson discontinued new sales of life insurance products effective 1 August 2012. The life products included term life, universal life and variable universal life. Term life provides protection for a defi ned period and a benefi t that is payable to a designated benefi ciary upon death of the insured. Universal life provides permanent individual life insurance for the life of the insured and includes a savings element. Variable universal life is a type of life insurance policy that combines death benefi t protection with the ability for the policyholder account to be invested in separate account funds.
D3: US insurance operations continued v Institutional products Jackson’s institutional products consist of GICs, funding agreements (including agreements issued in conjunction with Jackson’s participation in the US Federal Home Loan Bank programme) and medium-term note funding agreements. At 31 December 2012, institutional products accounted for 3 per cent of policy and contract liabilities (2011: 4 per cent). Under a traditional GIC, the policyholder makes a lump sum deposit. The interest rate paid is fi xed and established when the contract is issued. If deposited funds are withdrawn earlier than the specifi ed term of the contract, an adjustment is made that approximates a market value adjustment.
Under a funding agreement, the policyholder either makes a lump sum deposit or makes specifi ed periodic deposits. Jackson agrees to pay a rate of interest, which may be fi xed but which is usually a fl oating short-term interest rate linked to an external index. The average term of the funding arrangements is one to two years. In 2012 and 2011, there were no funding agreements terminable by the policyholder with less than 90 days’ notice.
e Process for setting assumptions and determining contract liabilities Under the MSB of reporting applied under IFRS 4 for insurance contracts, providing the requirements of the Companies Act, UK GAAP standards and the ABI SORP are met, it is permissible to refl ect the previously applied UK GAAP basis. Accordingly, and consistent with the basis explained in note A3, in the case of Jackson the carrying values of insurance assets and liabilities are consolidated into the Group accounts based on US GAAP. Under US GAAP, investment contracts (as defi ned for US GAAP purposes) are accounted for by applying, in the fi rst instance, a retrospective deposit method to determine the liability for policyholder benefi ts. This is then augmented by potentially three additional amounts. These amounts are for: AAAAAAAAAAAAAAAA Any amounts that have been assessed to compensate the insurer for services to be performed over future periods (ie deferred income); AAAAAAAAAAAAAAAA Any amounts previously assessed against policyholders that are refundable on termination of the contract; and AAAAAAAAAAAAAAAA Any probable future loss on the contract (ie premium defi ciency).
In accordance with US GAAP, the ‘grandfathered’ basis for IFRS, which specifi es how certain guarantee features should be accounted for, the GMDB and the ‘for life’ portion of GMWB liabilities are not fair valued but are instead determined each period end by estimating the expected value of benefi ts in excess of the projected account balance and recognising the excess ratably over the life of the contract based on total expected assessments. At 31 December 2012, these liabilities were valued using a series of deterministic investment performance scenarios, a mean investment return of 8.4 per cent (2011: 8.4 per cent) and assumptions for lapse, mortality and expense that are the same as those used in amortising the capitalised acquisition costs.
The direct GMIB liability is determined by estimating the expected value of the annuitisation benefi ts in excess of the projected account balance at the date of annuitisation and recognising the excess ratably over the accumulation period based on total expected assessments.
223Notes on the Group fi nancial statements Prudential plc Annual Report 2012 F
Jackson regularly evaluates, estimates used and adjusts the additional GMDB, GMIB and GMWB ‘for life’ liability balances, with a related charge or credit to benefi t expense, if actual experience or other evidence suggests that earlier assumptions should be revised.
Volatility assumptions are based on a weighting of available market data on implied volatility for durations up to ten years, at which point the projected volatility is held constant. Non-performance risk is incorporated into the calculation through the use of discount interest rates sourced from a AA corporate credit curve. Other risk margins, particularly for market illiquidity and policyholder behaviour, are also incorporated into the model through the use of explicitly conservative assumptions. On a periodic basis, Jackson rationalises the resulting fair values based on comparisons to other models and market movements.
With the exception of the GMDB, GMIB, GMWB and GMAB features of VA contracts, the fi nancial guarantee features of Jackson’s contracts are in most circumstances not explicitly valued, but the impact of any interest guarantees would be refl ected as they are earned in the current account value (ie the US GAAP liability).
For traditional life insurance contracts, provisions for future policy benefi ts are determined under US GAAP using the net level premium method and assumptions as of the issue date as to mortality, interest, policy lapses and expenses plus provisions for adverse deviation.
Certain institutional products representing obligations issued in currencies other than US dollars have been hedged for changes in exchange rates using cross-currency swaps. The fair value of derivatives embedded in funding agreements, as well as foreign currency transaction gains and losses, are included in the carrying value of the trust instruments supported by funding agreements recorded in other non-insurance liabilities.
Deferred acquisition costs Under IFRS 4, the Group applies ‘grandfathered’ US GAAP for measuring the insurance assets and liabilities of Jackson. In the case of Jackson term business, acquisition costs are deferred and amortised in line with expected premiums. For annuity and interest-sensitive life business, acquisition costs are deferred and amortised in line with a combination of historical and future expected gross profi ts on the relevant contracts. For fi xed and indexed annuity and interest-sensitive life business, the key assumption is the long-term spread between the earned rate on investments and the rate credited to policyholders, which is based on an annual spread analysis. Expected gross profi ts also depend on mortality assumptions, assumed unit costs and terminations other than deaths (including the related charges), all of which are based on a combination of actual experience of Jackson, industry experience and future expectations. A detailed analysis of actual mortality, lapse and expense experience is performed using internally developed experience studies.
As with fi xed and indexed annuity and interest-sensitive life business, acquisition costs for Jackson’s variable annuity products are amortised in line with the emergence of profi ts. The measurement of the amortisation, in part, refl ects current period fees (including those for guaranteed minimum death, income, or withdrawal benefi ts) earned on assets covering liabilities to policyholders, and the historical and expected level of future gross profi ts which depends on the assumed level of future fees, as well as components related to mortality, lapse and expense.
As explained in note A5, the Company has adopted the US Financial Accounting Standards Board requirements in the Emerging Issues Task Force (EITF) Update No. 2010-26 on ‘Accounting for Costs Associated with Acquiring or Renewing Insurance Contracts’ from 1 January 2012 into Prudential’s Group IFRS reporting for the results of Jackson and those Asia operations whose IFRS insurance assets and liabilities are measured principally by reference to US GAAP principles. Under the Update, insurers are required to capitalise only those incremental costs directly relating to successfully acquiring a contract from 1 January 2012. For Group IFRS reporting, the Company has chosen to apply this new basis retrospectively for the results of these operations.
On application of the new policy for Jackson, the deferred costs balance for business in force at 31 December 2011, was retrospectively reduced from £3,880 million to £3,095 million.
Under the mean reversion technique applied by Jackson, the projected level of return for each of the next fi ve years is adjusted from period to period, so that in combination with the actual rates of return for the preceding two years and the current year, the 8.4 per cent annual return is realised on average over the entire eight year period. Projected returns after the mean reversion period revert back to the 8.4 per cent assumption.
However, to ensure that the methodology does not over anticipate a reversion to trend following adverse markets, the mean reversion technique has a cap and fl oor feature whereby the projected returns in each of the next fi ve years can be no more than 15 per cent per annum and no less than 0 per cent per annum (both gross of asset management fees) in each year. The capping feature was relevant in late 2008, 2009 and 2010 due to the very sharp market falls in 2008. Notwithstanding this capping feature, the mean reversion technique gave rise to a benefi t in 2008 of £110 million. This benefi t was effectively ‘paid back’ under the mean reversion technique through charges for accelerated amortisation in 2011, as discussed below.
At 31 December 2012, the projected rate of return for the next fi ve years is materially the same as the long-term assumption of 8.4 per cent, and so the mean reversion technique had little effect at that date.
Furthermore, in those periods where the cap or fl oor is relevant, the mean reversion technique provides no further dampening and additional volatility may result.
In 2011, the DAC amortisation charge to operating profi t included £190 million of accelerated amortisation. This amount refl ected the combined effect of: (a) The separate account performance in the year of negative 4 per cent, net of all fees as it compared with the assumed level for the year; and
The reduction in assumed future rates refl ected, in large part, the elimination from the calculation in 2011 of the 2008 negative returns. Setting aside other complications and the growth in the book, the 2011 accelerated amortisation can be broadly equated as ‘paying back’ the benefi t experienced in 2008.
In 2012, the DAC amortisation charge to operating profi t of £356 million was determined after taking credit for decelerated amortisation of £56 million. This amount primarily refl ects the separate account performance of 11 per cent, net of all fees, over the assumed level for the year.
The application of the mean reversion formula has the effect of dampening the impact of equity market movements on DAC amortisation while the mean reversion assumption lies within the corridor. It would take a very signifi cant movement in equity markets in 2013 (outside the range of negative 20 per cent to positive 50 per cent) for the mean reversion assumption to move outside the corridor.
225Notes on the Group fi nancial statements Prudential plc Annual Report 2012 F
D3: US insurance operations continued i Sensitivity to equity risk Variable annuity contract related
Combination net deposits plus minimum return, highest specifi ed anniversary account value minus withdrawals post-anniversary * Amounts shown for GMWB comprise sums for the ‘not for life’ portion (where the guaranteed withdrawal base less the account value equals to the net amount at risk (NAR)), and a ‘for life’ portion (where the NAR has been estimated as the present value of future expected benefi t payment remaining aft er the amount of the ‘not for life’ guaranteed benefi ts is zero).
227Notes on the Group fi nancial statements Prudential plc Annual Report 2012 F
As a result of this hedging programme, if the equity markets were to increase further in the future, the net effect on Jackson’s free-standing derivatives would decrease in value. However, over time, this movement would be broadly offset by increased separate account fees and reserve decreases, net of the related changes to amortisation of deferred acquisition costs. Due to the nature of the free-standing and embedded derivatives, this hedge, while highly effective on an economic basis, may not completely mute in the fi nancial reporting the immediate impact of equity market movements as the free-standing derivatives reset immediately, while the hedged liabilities reset more slowly and fees are recognised prospectively. The opposite impact would be observed if the equity markets were to decrease.
At 31 December 2012, the estimated sensitivity of Jackson’s profi t for VA business, and shareholders’ equity to immediate increases and decreases in equity markets is shown below. The sensitivities are shown net of related changes in DAC amortisation.
Pre-tax profi t, net of related changes in amortisation of DAC (excluding impact on future separate account fees) 326 120 (86) (215) 373 196 (242) (539)
Net sensitivity of profi t after tax and shareholders’ equity 212 78 (56) (140) 243 127 (157) (350)
In addition to the exposure explained above, Jackson is also exposed to equity risk from its holding of equity securities, partnerships in investment pools and other fi nancial derivatives.
Net sensitivity of profi t after tax and shareholders’ equity (93) (47) (84) (41)
Debt securities and related derivatives are marked to fair value. Value movements on derivatives, again net of related changes to amortisation of DAC and deferred tax, are recorded within profi t and loss. Fair value movements on debt securities, net of related changes to amortisation of DAC and deferred tax, are recorded within other comprehensive income. The estimated sensitivity of these items and policyholder liabilities to a 1 per cent and 2 per cent decrease (subject to a fl oor of zero) and increase in interest rates at 31 December 2012 and 2011 is as follows: 2012 £m 2011* £m
Total net effect on shareholders’ equity 1,530 928 (963) (1,773) 1,441 782 (740) (1,302)
: L ife assu ran ce b u sin ess iii Currency translation risk Consistent with the Group’s accounting policies, the profi ts of the Group’s US operations are translated at average exchange rates and shareholders’ equity at the closing rate for the reporting period. For 2012, the rates were US$1.58 (2011: US$1.60) and US$1.63 (2011: US$1.55) to £1.00 sterling, respectively. A 10 per cent increase or decrease in these rates would reduce or increase profi t before tax attributable to shareholders, profi t for the year and shareholders’ equity attributable to US insurance operations respectively as follows: A 10% increase in US$: £ exchange rates
Profi t before tax attributable to shareholders note (78) (44) 95 53 Profi t for the year (56) (32) 69 39 Shareholders’ equity attributable to US insurance operations (395) (342) 483 418 * The 2011 comparative results have been adjusted from those previously published for the retrospective application of the change in accounting policy described in note A5.
iv Other sensitivities As noted in section D1, total profi t is very sensitive to market risk on the assets covering liabilities other than variable annuity business segregated in the separate accounts.
For term business, acquisition costs are deferred and amortised in line with expected premiums. For annuity and interest sensitive life business, acquisition costs are deferred and amortised in line with expected gross profi ts on the relevant contracts. For interest-sensitive business, the key assumption is the expected long-term spread between the earned rate and the rate credited to policyholders, which is based on an annual spread analysis. In addition, expected gross profi ts depend on mortality assumptions, assumed unit costs and terminations other than deaths (including the related charges), all of which are based on a combination of actual experience of Jackson, industry experience and future expectations. A detailed analysis of actual experience is measured by internally developed expense, mortality and persistency studies.
Except to the extent of mortality experience, which primarily affects profi ts through variations in claim payments and GMDB reserves, the profi ts of Jackson are relatively insensitive to changes in insurance risk.
D4: Asia insurance operations a Summary statement of fi nancial position 2012 £m 2011* £m 31 December
Assets Intangible assets attributable to shareholders: Goodwill – – 239 239 235 Deferred acquisition costs and other intangible assets – – 908 908 977
Deferred tax assets – – 83 83 115 Other non-investment and non-cash assets 324 123 670 1,117 1,024 Investments of long-term business and other operations: Investment properties – – 4 4 10 Financial investments: Loansnote (iii) 600 – 414 1,014 1,233 Equity securities and portfolio holdings in unit trusts 3,160 10,491 659 14,310 11,997 Debt securities 11,495 3,194 6,713 21,402 17,681 Other investments 504 47 406 957 470 Deposits 165 574 488 1,227 1,165
Equity and liabilities Equity Shareholders’ equity – – 2,529 2,529 2,306 Non-controlling interests – – 4 4 5
Liabilities Policyholder liabilities and unallocated surplus of with-profi ts funds: Contract liabilities (including amounts in respect of contracts classifi ed as investment contracts under IFRS 4) 13,388 14,028 7,185 34,601 30,862 Unallocated surplus of with-profi ts fundsnote (ii) 63 – – 63 50
Operational borrowings attributable to shareholder-fi nanced operations – – 7 7 141
233Notes on the Group fi nancial statements Prudential plc Annual Report 2012 F
Net fl ows note (b) 339 770 1,069 2,178 Shareholders’ transfers post tax (30) – – (30) Investment-related items and other movements 1,274 (1,154) 245 365 Foreign exchange translation differencesnote (a) 36 (325) (52) (341)
Net fl ows note (b) 439 923 1,059 2,421 Shareholders’ transfers post tax (31) – – (31) Investment-related items and other movementsnote (d) 639 1,451 88 2,178 Foreign exchange translation differencesnote (a) (239) (361) (216) (816)
Comprising: Policyholder liabilities 13,388 14,028 7,185 34,601 Unallocated surplus of with-profi ts funds 63 – – 63
Notes (a) Movements in the year have been translated at the average exchange rates for the year ended 31 December 2012. The closing balance has been translated at the closing spot rates as at 31 December 2012. Diff erences upon retranslation are included in foreign exchange translation diff erences. (b) Net fl ows have increased by £243 million to £2,421 million in 2012, compared with £2,178 million in 2011, refl ecting increased fl ows from new business and growth in the in-force books.
(c) In 2012 the rate of surrenders for shareholder-backed business (expressed as a percentage of opening liabilities) was 10.6 per cent (2011: 9.8 per cent).
D4: Asia insurance operations continued c Information on credit risks of debt securities The following table summarises the credit quality of the debt securities of the Asia insurance operations as at 31 December 2012 by rating agency ratings: With-profi ts business
S&P – AAA 675 19 91 785 1,423 S&P – AA+ to AA- 2,960 466 2,097 5,523 3,843 S&P – A+ to A- 2,059 279 944 3,282 3,055 S&P – BBB+ to BBB- 1,377 112 417 1,906 1,451 S&P – Other 1,443 815 874 3,132 2,137
Whole of life contracts with fl oor levels of policyholder benefi ts that accrue at rates set at inception, and do not vary subsequently with market conditions, are written in the Korean life operations, though this is not of a signifi cant extent as Korea has a much higher proportion of linked and health business. The Korean business has non-linked liabilities and linked liabilities at 31 December 2012 of £505 million and £1,628 million respectively (2011: £447 million and £1,407 million respectively).
For some countries in Asia where local GAAP is not well established, and in which the business written is primarily non-participating and linked business, US GAAP is used as the most appropriate reporting basis. This basis is applied in India, Japan, Taiwan and until 2012, Vietnam. Under this basis, the future policyholder benefi t provisions for non-linked business are determined using the net level premium method, with an allowance for surrenders, maintenance and claims expenses. Rates of interest used in establishing the policyholder benefi t provisions vary by operation depending on the circumstances attaching to each block of business. In Vietnam, the Company improved its estimation basis for liabilities in 2012 from one determined substantially by reference to US GAAP requirements. After making this change, the estimation basis for Vietnam is aligned substantially with that used in Singapore, Malaysia and some other Asia operations.
f Reinsurance The Asia businesses cede only minor amounts of business outside the Group with immaterial effects on reported profi t. During 2012, reinsurance premiums for externally ceded business were £178 million (2011: £226 million) and the reinsurance assets were £175 million (2011: £151 million) in aggregate.
D4: Asia insurance operations continued h Exposure and sensitivity of IFRS basis profi t and shareholders’ equity to market and other risks The Asia operations sell with-profi ts and unit-linked policies and, although the with-profi ts business generally has a lower terminal bonus element than in the UK, the investment portfolio still contains a proportion of equities. Non-participating business is largely backed by debt securities or deposits. The exposure to market risk of the Group arising from its Asia operations is therefore at modest levels. This arises from the fact that the Asia operations have a balanced portfolio of with-profi ts, unit-linked and other types of business.
For the purposes of analysing sensitivity to variations in interest rates, reference has been made to the movements in the 10-year government bond rates of the territories. At 31 December 2012, 10-year government bond rates vary from territory to territory and range from 0.60 per cent to 9.50 per cent (2011: 0.99 per cent to 12.88 per cent).
The pre-tax impacts, if they arose, would mostly be recorded within the category short-term fl uctuations in investments returns in the Group’s segmental analysis of profi t before tax.
Equity price risk The non-linked shareholder business has limited exposure to equity and property investment (£663 million at 31 December 2012). Generally, changes in equity and property investment values are not directly offset by movements in policyholder liabilities.
The estimated sensitivity to a 10 per cent and 20 per cent change in equity and property prices for shareholder-backed Asia other business, which would be refl ected in the short-term fl uctuation component of the Group’s segmental analysis of profi t before tax, at 31 December 2012 and 2011 would be as follows: Decrease of 20%
Net effect on profi t and shareholders’ equity (103) (52) (96) (48)
Insurance risk Many of the territories in Asia are exposed to mortality/morbidity risk and provision is made within policyholder liabilities on a prudent regulatory basis to cover the potential exposure. If these prudent assumptions were strengthened by 5 per cent then it is estimated that post tax profi t would be decreased by approximately £30 million (2011: £27 million). Mortality and morbidity has a symmetrical effect on the portfolio and any weakening of these assumptions would have a similar equal and opposite impact.
A 10 per cent increase or decrease in these rates would have reduced or increased profi t before tax attributable to shareholders, profi t for the year and shareholders’ equity, excluding goodwill, attributable to Asia operations respectively as follows: A 10% increase in local currency to £ exchange rates
The primary purpose of this section is to meet the disclosure requirements of FRS 27, the UK GAAP Standard on Life Assurance. Prudential, together with other major UK life assurers, undertook to the UK Accounting Standards Board in 2004 to adopt this standard for Group IFRS reporting. Under the disclosure requirements of FRS 27 the capital position statement and related footnotes are prepared by reference to local regulation.
a Summary statement The Group’s estimated capital position for life assurance businesses with reconciliations to shareholders’ equity is shown below. As noted above, available capital for each fund or group of companies has been determined by reference to local regulation at 31 December 2012 and 2011.
Shareholders’ share of realistic liabilities – (2,469) (2,469) – – – (2,469)
Deferred acquisition costs of non-participating business not recognised for regulatory reporting purposes and goodwill – (6) (6) (103) (3,199) (893) (4,201)
Adjustment from IAS 19 basis pension defi cit attributable to WPSF to pension liability for regulatory purposes – (107) (107) – – – (107)
239Notes on the Group fi nancial statements Prudential plc Annual Report 2012 F
With-profi ts liabilities of UK regulated with-profi ts funds: Insurance contracts 7,217 29,353 36,570 – – 6,696 43,266 Investment contracts (with
Other liabilities: Insurance contracts: With-profi ts liabilities of non-UK regulated funds – – – – – 6,597 6,597 Unit-linked, including variable annuity – 29 29 6,086 49,298 14,028 69,441 Other life assurance business 309 14,013 14,322 27,259 40,894 7,058 89,533
Investment contracts without discretionary participation features (principally unit-linked and similar contracts in the UK and GIC liabilities of Jackson)note (vi) – 22 22 16,160 2,069 127 18,378
Total policyholder liabilities shown in the consolidated statement of fi nancial position 7,878 76,529 84,407 49,505 92,261 34,601 260,774
D5: Capital position statement for life assurance businesses continued 2011* £m
Group shareholders’ equity Held outside long-term funds: Total – – – 930 3,761 2,306 6,997 1,382 (1,437) 6,942 Held in long-term fundsnote (iii) – – – 1,622 – – 1,622 – – 1,622
Unallocated surplus of with-profi ts funds note (v) – 9,165 9,165 – – 50 9,215
Jackson surplus notes note (iv) – – – – 160 – 160 Investment and policyholder liabilities valuation differences between IFRS and regulatory basis for Jackson note (vii) – – – – 1,002 – 1,002
: L ife assu ran ce b u sin ess 2011 £m
With-profi ts liabilities of UK regulated with-profi ts funds: Insurance contractsnote (viii) 7,934 30,077 38,011 – – 6,777 44,788 Investment contracts (with
Total policyholder liabilities shown in the consolidated statement of fi nancial position 8,555 72,421 80,976 46,048 69,189 30,862 227,075
(ii) Excluding PAC shareholders’ equity that is included in ‘parent company and shareholders’ equity of other subsidiaries and funds’. (iii) The term shareholders’ equity held in long-term funds refers to the excess of assets over liabilities attributable to shareholders of funds which are required by law to be maintained, ring-fenced with segregated assets and liabilities.
Under FSA rules, insurers with with-profi ts liabilities of more than £500 million must hold capital equal to the higher of the MCR and the Enhanced Capital Requirement (ECR). The ECR is intended to provide a more risk responsive and ‘realistic’ measure of a with-profi t insurer’s capital requirements, whereas the MCR is, broadly speaking, equivalent to the previous required minimum margin under the Interim Prudential Sourcebook and satisfi es the minimum EU Standards.
Available capital of the WPSF and SAIF of £7.0 billion (2011: £6.1 billion) represents the excess of assets over liabilities on the FSA realistic basis. Unlike the previously discussed FRS 27 basis, realistic liabilities on the regulatory basis include the shareholders’ share of future bonuses. These amounts are shown before deduction of the risk capital margin (RCM), which is estimated to be £1.5 billion at 31 December 2012 (2011: £2.0 billion).
The available capital of £2,370 million (2011: £1,937 million) refl ects the excess of regulatory basis assets over liabilities of the subsidiaries and funds, before deduction of the capital resources requirement of £1,376 million (2011: £1,194 million).
The available capital of Jackson shown above of £2,899 million (2011: £2,527 million) refl ects US regulatory basis assets less liabilities, including asset valuation reserves. The asset valuation reserve is designed to provide for future credit-related losses on debt securities and losses on equity investments. Available capital includes a reduction for the effect of the interest maintenance reserve, which is designed by state regulators to defer recognition of non-credit related realised capital gains and losses and to recognise them rateably in the future.
Jackson’s risk-based capital ratio is signifi cantly in excess of regulatory requirements. At 31 December 2012, Jackson had a permitted practice in effect as granted by the local regulator allowing Jackson to carry certain interest rate swaps at book value, as if statutory hedge accounting were in place, instead of at fair value, as would have been otherwise required. Jackson was also required to demonstrate the effectiveness of its interest rate swap programme pursuant to the Michigan Insurance Code. The total effect of this permitted practice net of tax was to decrease statutory surplus by £357 million at 31 December 2012.
The businesses in Asia are subject to local capital requirements in the jurisdictions in which they operate. The Hong Kong business branch of PAC and its capital requirements are subsumed within those of the PAC long-term fund. For the other material Asian operations, the details of the basis of determining regulatory capital and regulatory capital requirements are as follows: Singapore
A risk-based regulatory framework applies in Singapore. For participating business, a gross premium reserve, determined using prudent best estimate assumptions and which makes allowance for future bonus, is held. The amount held is subject to a minimum of the higher of the assets attributed to participating business and a gross premium reserve calculated on specifi ed assumptions, but without allowance for future bonus, that include prescribed provisions for adverse deviations (PADs).
For non-participating business, gross premium reserves are held. For linked business the value of units is held together with a non-unit reserve calculated in accordance with standard actuarial methodology; Indonesia
Mathematical reserves for traditional business are determined on a net premium basis using prescribed mortality and interest rates. Interest rates refl ect the original pricing assumptions.
A risk-based capital framework applies in Malaysia. For participating business, a gross premium reserve on the guaranteed and non-guaranteed benefi ts determined using best estimate assumptions is held. The amount held is subject to a minimum of a gross premium reserve on the guaranteed benefi ts, determined using best estimate assumptions along with provisions of risk margin for adverse deviations discounted at the risk-free rate.
For non-participating business, gross premium reserves determined using best estimate assumptions along with provisions of risk margin for adverse deviations discounted at the risk-free rate are held. For linked business, the value of units is held together with a non-unit reserve calculated in accordance with standard actuarial methodology.
Mathematical reserves are calculated using a modifi ed net premium approach, set using assumptions agreed with the regulator. The capital requirement is determined as 4 per cent of reserves plus a specifi ed percentage of 0.1 per cent of sums at risk for policies with original term less than or equal to fi ve years or 0.3 per cent of sums at risk for policies with original term of more than fi ve years. An additional capital requirement of Vietnamese Dong 200 billion is also required for companies transacting unit-linked business; and
Available capital at 31 December 2011 6,139 1,937 2,527 1,493 12,096 Changes in assumptions (136) (145) – 30 (251) Changes in management policy 500 – – (24) 476 Changes in regulatory requirements – – – 27 27 New business and other factorsnote (v) 497 578 372 95 1,542
The increase of £115 million in 2011 refl ected an underlying increase of £134 million (applying the relevant 2011 year end exchange rates) and £19 million of exchange translation loss.
d Transferability of available capital For PAC and all other UK long-term insurers, long-term business assets and liabilities must, by law, be maintained in funds separate from those for the assets and liabilities attributable to non-life insurance business or to shareholders. Only the ‘established surplus’, the excess of assets over liabilities in the long-term fund determined through a formal valuation, may be transferred so as to be available for other purposes. Distributions from the with-profi ts sub-fund to shareholders refl ect the shareholders’ one-ninth share of the cost of declared policyholders’ bonuses.
For Jackson, capital retention is maintained at a level consistent with an appropriate rating by Standard & Poor’s. Currently Jackson is rated AA. Jackson can pay dividends on its capital stock only out of earned surplus, unless prior regulatory approval is obtained. Furthermore, dividends which exceed the greater of statutory net gain from operations for the prior year, or 10 per cent of Jackson’s statutory surplus, require prior regulatory approval.
For Asian subsidiaries, the amounts retained within the companies are at levels that provide an appropriate level of capital strength in excess of the local regulatory minimum. For ring-fenced with-profi ts funds, the excess of assets over liabilities is retained with distribution tied to the shareholders’ share of bonuses through declaration of actuarially determined surplus. The Singapore and Malaysian businesses may, in general, remit dividends to the UK, provided the statutory insurance fund meets the capital adequacy standard required under local statutory regulations.
The Group’s asset management operations are based in the UK, Asia and the US where they operate different models and under different brands tailored to their markets.
Other operations cover unallocated corporate activities and includes the head offi ce functions.
a The profi t included in the income statement in respect of asset management operations for the year is as follows: M&G US Eastspring
Notes (i) Under IFRS, disclosure details of segment revenue are required. The segment revenue of the Group’s asset management operations are required to include two items that are for amounts which, refl ecting their commercial nature, are also wholly refl ected as charges within the income statement. Aft er allowing for these charges, there is no eff ect on profi t from these two items which are: (a) Investment funds which are managed on behalf of third parties and are consolidated under IFRS in recognition of the control arrangements for the funds. The gains and losses of these funds are non-recourse to M&G and the Group; and
(b) NPH broker-dealer fees which represent commissions received, that are then paid on to the writing brokers on sales of investment products. The presentation in the table above shows the amounts attributable to these two items so that the underlying revenue and charges can be seen. (ii) Short-term fl uctuations in investment returns for M&G are primarily in respect of unrealised fair value movements on Prudential Capital’s bond portfolio. (iii) Included within Eastspring Investments revenue and charges are £42 million of commissions (2011: £44 million).
Asset management fee income 728 662 Other income 6 4 Staff costs (289) (270) Other costs (147) (134)
Operating profi t from asset management operations 320 301 Operating profi t from Prudential Capital 51 56
The difference between the fees and other income shown above in respect of asset management operations, and the revenue fi gure for M&G shown (excluding consolidated investment funds) in the main table primarily relates to the total revenue of Prudential Capital (including short-term fl uctuations) of £218 million (2011: £96 million) and commissions which have been netted off in arriving at the fee income of £728 million (2011: £662 million) in the table above. The difference in the presentation of commission is aligned with how management reviews the business.
249Notes on the Group fi nancial statements Prudential plc Annual Report 2012 F
Equity and liabilities Equity Shareholders’ equity 1,545 124 268 1,937 1,783 Non-controlling interests – – – – 5
Liabilities Core structural borrowing of shareholder-fi nanced operations 275 – – 275 250 Intra-group debt represented by operational borrowings at
Notes (i) Loans The M&G loans relate to loans and receivables managed by Prudential Capital. These assets are generally secured but most have no external credit ratings.
Internal ratings prepared by the Group’s asset management operations as part of the risk management process are: Loans and receivables internal ratings: BBB+ to BBB- 836 1,000 BB+ to BB- 339 89 B+ to B- 24 38
M&G: AAA to A- by Standard & Poor’s or Aaa rated by Moody’s 1,493 1,547 Other 346 287
(iii) The M&G statement of fi nancial position includes the assets and liabilities in respect of Prudential Capital. (iv) Intra-group debt represented by operational borrowings at Group level Operational borrowings for M&G are in respect of Prudential Capital’s short-term fi xed income security programme and comprise: Commercial paper 1,535 2,706 Medium-Term Notes 549 250
Total intra-group debt represented by operational borrowings at Group level 2,084 2,956
ii Sensitivities to other fi nancial risks for asset management operations The principal sensitivities to other fi nancial risk of asset management operations are credit risk on the bridging loan portfolio as described in note E2 of the Prudential Capital operation and the indirect effect of changes to market values of funds under management. Due to the nature of the asset management operations there is limited direct sensitivity to movements in interest rates. Total debt securities held at 31 December 2012 by asset management operations were £1,846 million (2011: £1,842 million), the majority of which are held by the Prudential Capital operation. Debt securities held by M&G and Prudential Capital are in general variable rate bonds and so market value is limited in sensitivity to interest rate movements and consequently any change in interest rates would not have a material impact on profi t or shareholders’ equity. The Group’s asset management operations do not hold signifi cant investments in property or equities.
Gross premiums earned 7,020 14,660 8,230 – – – 29,910 29,910 Outward reinsurance premiums (135) (193) (178) – – – (506) (506)
Total revenue, net of reinsurance 21,593 20,658 11,317 1,223 731 282 55,804 (328) 55,476
Outward reinsurers’ share of benefi ts and claims note (iv) 159 (8) 108 – – – 259 – 259 Movement in unallocated surplus of with-profi ts funds note (iii) (863) – (518) – – – (1,381) – (1,381)
Acquisition costs and other operating expenditure F3 (1,478) (1,079) (1,965) (686) (692) (207) (6,107) 52 (6,055)
Profi t (loss) before tax (being tax attributable to shareholders’ and policyholders’ returns) note (i) 1,158 855 1,067 521 39 75 3,715 (527) 3,188
Short-term fl uctuations in investment returns on shareholder-backed business 136 (90) 76 93 – – 215 (11) 204
Shareholders’ share of actuarial and other gains and losses on defi ned benefi t pension schemes (14) – – 15 – – 1 49 50
Gain on dilution of Group holdings – – – 42 – – 42 – 42 Amortisation of acquisition accounting adjustments arising on purchase of REALIC – (19) – – – – (19) – (19)
Profi t (loss) from continuing operations before tax attributable to shareholders 858 855 989 521 39 75 3,337 (527) 2,810
253Notes on the Group fi nancial statements Prudential plc Annual Report 2012 F
Total revenue, net of reinsurance 13,344 13,963 7,590 1,051 654 292 36,894 (388) 36,506
Outward reinsurers’ share of benefi ts and claims note (iv) 290 280 176 – – – 746 – 746 Movement in unallocated surplus of with-profi ts funds note (iii) 485 – 540 – – – 1,025 – 1,025
Benefi ts and claims and movements in unallocated surplus of with-profi ts funds, net of reinsurance (11,273) (12,651) (5,365) – – – (29,289) – (29,289)
Total charges, net of reinsurance (12,512) (13,479) (6,927) (719) (630) (212) (34,479) (216) (34,695)
Short-term fl uctuations in investment returns on shareholder-backed business 159 (167) (92) (29) – – (129) (91) (220)
Profi t (loss) from continuing operations before tax attributable to shareholders 900 484 612 332 24 80 2,432 (604) 1,828 * The 2011 comparative results have been adjusted from those previously published for the retrospective application of the change in accounting policy described in note A5.
Notes (i) This measure is the formal profi t (loss) before tax measure under IFRS but is not the result attributable to shareholders. (ii) Investment return principally comprises: – Interest and dividends; – Realised and unrealised gains and losses on securities and derivatives classifi ed as fair value through profi t and loss under IAS 39; and – Realised gains and losses, including impairment losses, on securities classifi ed as available-for-sale under IAS 39.
(ii) Interest income includes £13 million (2011: £8 million) accrued in respect of impaired securities. (iii) Fee income includes £35 million (2011: £13 million) relating to fi nancial instruments that are not held at fair value through profi t and loss. These fees primarily related to prepayment fees, late fees and syndication fees.
Revenue from external customers: Insurance operations 8,205 14,465 7,098 – 29,768 Asset management 274 725 972 (333) 1,638 Unallocated corporate – – 19 – 19 Intragroup revenue eliminated on consolidation (84) (77) (172) 333 –
Revenue from external customers: Insurance operations 7,307 12,516 5,740 – 25,563 Asset management 290 653 923 (323) 1,543 Unallocated corporate – – 40 – 40 Intragroup revenue eliminated on consolidation (93) (68) (162) 323 –
Revenue from external customers is made up of the following: Earned premiums, net of reinsurance 29,404 25,277 Fee income from investment contract business and asset management (presented as ‘Other income’) 2,021 1,869
In their capacity as fund managers to fellow Prudential Group subsidiaries, M&G, Eastspring Investments and US asset management businesses generate fees for investment management and related services. These services are charged at appropriate arm’s length prices, typically priced as a percentage of funds under management. Intragroup fees included within asset management revenue were earned by the following asset management segment: Intragroup revenue generated by: M&G 172 162 Eastspring Investments 84 93 US broker-dealer and asset management (including Curian) 77 68
Acquisition costs incurred for insurance policies (2,649) (2,264) Acquisition costs deferred less amortisation of acquisition costs for insurance policies 480 520 Administration costs and other expenditure (3,728) (3,524) Movements in amounts attributable to external unit holders (158) 148
257Notes on the Group fi nancial statements Prudential plc Annual Report 2012 F
(v) Movements in amounts attributable to external unit holders are in respect of those OEIC and unit trusts which are required to be consolidated and comprises a charge of £(195) million (2011: a credit of £28 million) for UK insurance operations and a credit of £37 million (2011: £120 million) for Asia insurance operations.
(vi) The total amounts for acquisition costs and other expenditure shown above includes Corporate expenditure shown in note B1 (Segment disclosure – income statement). The charge for Corporate expenditure comprises: Group Head Offi ce (168) (168) Asia Regional Head Offi ce: Gross costs (99) (86) Recharges to Asia operations 36 35
F4: Finance costs – Interest on core structural borrowings of shareholder-fi nanced operations
Finance costs of £280 million (2011: £286 million) comprise £251 million (2011: £258 million) interest on core debt of the parent company, £13 million (2011: £13 million) on US insurance operations’ surplus notes and £16 million (2011: £15 million) on PruCap’s bank loan.
F5: Tax a Total tax charge by nature of expense An analysis of the total tax benefi t (expense) of continuing operations recognised in the income statement by nature of benefi t (expense) is as follows: 2012 £m 2011* £m
Current tax expense: Corporation tax (950) (775) Adjustments in respect of prior years 143 33
The current tax charge of £807 million includes £18 million (2011: charge of £16 million) in respect of the tax charge for Hong Kong. The Hong Kong current tax charge is calculated as 16.5 per cent for all periods on either (i) 5 per cent of the net insurance premium or (ii) the estimated assessable profi ts, depending on the nature of the business written.
Until the end of 2012 for the Group’s UK life insurance companies, shareholders’ profi ts were calculated using regulatory surplus as a starting point, with appropriate deferred tax adjustments for IFRS. Beginning in 2013, under new UK life tax rules, shareholders’ profi ts will be calculated using accounting profi t or loss as a starting point.
The total tax charge comprises tax attributable to policyholders and unallocated surplus of with-profi ts funds, unit-linked policies and shareholders as shown below.
The principal reason for the increase in the tax charge attributable to policyholders’ returns is an increase in deferred tax on unrealised gains and losses on investments.
The total deferred tax (charge)/credit arises as follows: 2012 £m 2011* £m
In 2012, a deferred tax charge of £198 million (2011: charge of £187 million) has been taken through other comprehensive income. Other movements in deferred tax totalling a £378 million credit mainly arises as a result of bringing a deferred tax asset in respect of the acquired REALIC business on to the balance sheet. When these amounts are taken with the deferred tax charge shown above there is no signifi cant change in the Group’s net deferred tax liability (2011: decrease of £0.1 billion).
259Notes on the Group fi nancial statements Prudential plc Annual Report 2012 F
Profi t before tax 3,188 1,811 Tax (charge) credit attributable to policyholders’ returns (378) 17
Profi t for the year 2,197 1,419 * The 2011 comparative results have been adjusted from those previously published for the retrospective application of the change in accounting policy described in note A5.
ii Overview For the purposes of explaining the relationship between tax expense and accounting profi t, it is appropriate to consider the sources of profi t and tax by reference to those that are attributable to shareholders and policyholders, as follows: 2012 £m 2011* £m
Profi t (loss) before tax 2,810 378 3,188 1,828 (17) 1,811 Taxation charge: Variance from expected tax charge note v(ii) 150 – 150 110 – 110 Actual tax (charge) credit (613) (378) (991) (409) 17 (392)
† For the column entitled ‘Attributable to policyholders’, the profi t (loss) before tax represents income, before tax attributable to policyholders and unallocated surplus of with-profi ts funds and unit-linked policies. This income has been determined aft er deduction of charges for policyholder benefi ts and movements on unallocated surplus which are determined net of tax. Hence, the pre-tax results attributable to policyholders is the inverse of the tax charge attributable to policyholders.
F5: Tax continued iii Reconciliation of eff ective tax rate The total tax charge is attributable to shareholders and policyholders as summarised in the income statement.
Operating profi t (loss) based on longer-term investment returns 913 964 736 (80) 2,533
Profi t before tax attributable to shareholders 989 855 858 108 2,810
Tax at the expected tax rate 227 300 210 26 763 Effects of: Adjustment to tax charge in relation to prior years (11) 10 (26) (10) (37) Movements in provisions for open tax matters – (3) – 32 29 Income not taxable or taxable at concessionary rates (87) – – (2) (89) Deductions not allowable for tax purposes 30 – – 3 33 Different local basis of tax on overseas profi ts – (68) – – (68) Impact of changes in local statutory tax rates – – (39) 9 (30) Deferred tax adjustments (6) – 8 (1) 1 Irrecoverable withholding taxes – – – 14 14 Other 5 (5) 8 (11) (3)
* The expected tax rates shown in the table above (rounded to the nearest whole percentage) refl ect the corporation tax rates generally applied to taxable profi ts of the relevant country jurisdictions. For Asia operations the expected tax rates refl ect the corporation tax rates weighted by reference to the source of profi ts of operations contributing to the aggregate business result. The expected tax rate for Other operations refl ects the mix of business between UK and overseas non-insurance operations, which are taxed at a variety of rates. The rates will fl uctuate from year to year dependent on the mix of profi ts.
Operating profi t (loss) based on longer-term investment returns 704 651 723 (51) 2,027
Profi t (loss) before tax attributable to shareholders 612 484 900 (168) 1,828
Analysed into: Tax on operating profi t based on longer-term investment returns 122 185 190 (64) 433 Tax on non-operating profi t 2 (58) 39 (7) (24)
Actual tax rate: Operating profi t based on longer-term investment returns 17% 28% 26% 125% 21%
† The 2011 comparative results have been adjusted from those previously published for the retrospective application of the change in accounting policy described in note A5.
† Other taxes paid includes property taxes, withholding taxes, customs duties, stamp duties, employer payroll taxes and irrecoverable indirect taxes. ‡ Taxes collected are other taxes that Prudential remits to tax authorities which it is obliged to collect from employees, customers and third parties which includes sales/VAT/GST taxes, employee and annuitant payroll taxes.
: F in an cial assets an d liab ilities 2011 £m
Financial assets Cash and cash equivalents – – 7,257 7,257 7,257 Deposits – – 10,708 10,708 10,708 Equity securities and portfolio holdings in unit trusts 87,349 – – 87,349 87,349 Debt securities note (i) 97,482 27,016 – 124,498 124,498 Loans note (ii) 279 – 9,435 9,714 9,828 Other investments note (iii) 7,509 – – 7,509 7,509 Accrued investment income – – 2,710 2,710 2,710 Other debtors – – 987 987 987 2011 £m
For investment contracts in the US with fi xed and guaranteed terms the fair value is determined based on the present value of future cash fl ows discounted at current interest rates.
The fair value of other fi nancial liabilities is determined using discounted cash fl ows of the amounts expected to be paid.
The classifi cation criteria and its application to Prudential can be summarised as follows: Level 1 – quoted prices (unadjusted) in active markets for identical assets and liabilities Level 1 includes fi nancial instruments where there is clear evidence that the valuation is based on a quoted publicly traded price in an active market (eg exchange listed equities, mutual funds with quoted prices and exchange traded derivatives).
Pricing services, where available, are used to obtain the third-party broker quotes. Where pricing services providers are used, a single valuation is obtained and applied.
265Notes on the Group fi nancial statements Prudential plc Annual Report 2012 F
Generally, no adjustment is made to the prices obtained from independent third parties. Adjustment is made in only limited circumstances, where it is determined that the third-party valuations obtained do not refl ect fair value (eg either because the value is stale and/or the values are extremely diverse in range). These are usually securities which are distressed or that could be subject to a debt restructure or where reliable market prices are no longer available due to an inactive market or market dislocation. In these instances, prices are derived using internal valuation techniques including those as described above in this note with the objective of arriving at a fair value measurement which refl ects the price at which an orderly transaction would take place between market participants on the measurement date. The techniques used require a number of assumptions relating to variables such as credit risk and interest rates. Examples of such variables include an average credit spread based on the corporate bond universe and the relevant duration of the asset being valued. Prudential measures the input assumptions based on the best available information at the measurement dates. Securities valued in such manner are classifi ed as Level 3 where these signifi cant inputs are not based on observable market data.
Of the total Level 2 debt securities of £105,839 million at 31 December 2012 (31 December 2011: £94,378 million), £8,248 million are valued internally (31 December 2011: £6,847 million). The majority of such securities are valued using matrix pricing, which is based on assessing the credit quality of the underlying borrower to derive a suitable discount rate relative to government securities of a comparable duration. Under matrix pricing, the debt securities are priced taking the credit spreads on comparable quoted public debt securities and applying these to the equivalent debt instruments factoring in a specifi ed liquidity premium. The majority of the parameters used in this valuation technique are readily observable in the market and, therefore, are not subject to interpretation.
Level 3 – Signifi cant inputs for the asset or liability that are not based on observable market data (unobservable inputs) Level 3 includes investments which are internally valued or subject to a signifi cant number of unobservable assumptions (eg private equity funds and certain derivatives which are bespoke or long-dated).
Of these amounts, £3,916 million (2011: £3,732 million) was held by the Group’s participating funds and therefore shareholders’ profi t and equity are not impacted by movements in the valuation of these fi nancial instruments. At 31 December 2012, the £3,916 million (2011: £3,732 million) represented 4.3 per cent (2011: 4.3 per cent) of the total fair valued fi nancial instruments, net of derivative liabilities of the participating funds.
Included within the £2,703 million Level 3 fair valued fi nancial investments, net of derivative liabilities at 31 December 2012 (2011: £800 million) held to support non-linked shareholder-backed business were loans of £1,842 million, attaching to the purchase of REALIC in 2012 held to back the liabilities for funds withheld under reinsurance arrangement. The funds withheld liability, which was also accounted for on a fair value basis and classifi ed as Level 3, amounted to £2,021 million at 31 December 2012. This liability is included within Other fi nancial liabilities held at fair value in the table below.
If the value of all Level 3 investments backing non-linked shareholder-backed business valued internally was varied downwards by 10 per cent, the change in valuation would be £2 million (2011: £4 million), which would reduce shareholders’ equity by this amount before tax. Of this amount, a £1 million increase (2011: £1 million decrease) would pass through the income statement substantially as part of short-term fl uctuations in investment returns outside of operating profi t and a £3 million decrease (2011: £3 million decrease) would be included as part of other comprehensive income, being unrealised movements on assets classifi ed as available-for-sale.
Total fi nancial investments, net of derivative liabilities 77,522 5,857 41 83,420 Percentage of total 93% 7% 0% 100%
Non-linked shareholder-backed Loans – 226 1,842* 2,068 Equity securities and portfolio holdings in unit trusts 937 7 49 993 Debt securities 13,721 54,630 246 68,597 Other investments (including derivative assets) 31 2,306 761 3,098 Derivative liabilities (16) (1,484) (195) (1,695)
Total fi nancial investments, net of derivative liabilities 14,673 55,685 2,703 73,061 Percentage of total 20% 76% 4% 100%
Group total analysis, including other fi nancial liabilities held at fair value
Other fi nancial liabilities held at fair value – (259) (2,021)* (2,280)
* The Level 3 loans and other fi nancial liabilities held by the non-linked shareholder-backed business include amounts of £1,842 million and £(2,021) million, respectively relating to the reinsurance arrangements attaching to the purchase of REALIC as described in note I1.
267Notes on the Group fi nancial statements Prudential plc Annual Report 2012 F
Total fi nancial investments, net of derivative liabilities 37,337 45,292 3,732 86,361 Percentage of total 43% 53% 4% 100%
Total fi nancial investments, net of derivative liabilities 63,838 4,984 33 68,855 Percentage of total 93% 7% 0% 100%
Other fi nancial liabilities held at fair value – (281) – (281)
Reconciliation of movements in Level 3 fi nancial instruments measured at fair value The following tables reconcile the value of Level 3 fi nancial instruments at 1 January 2012 to that presented at 31 December 2012 and at 1 January 2011 to that presented at 31 December 2011.
At 31 Dec portfolio holdings in unit trusts 375 49 44 – 255 (98) – – 6 (63) 568
Total fi nancial investments, net of derivative liabilities 4,565 331 (62) 1,858 997 (830) (85) 84 24 (222) 6,660
Debt securities 1,117 46 5 – 274 (490) (21) – 51 (73) 909 Other investments (including
Total fi nancial investments, net of derivative liabilities 4,573 303 (46) – 1,027 (1,185) (21) – 51 (137) 4,565
Of the total gains and losses in the income statement of £357 million (2011: £225 million), £126 million (2011: £99 million) relates to fi nancial instruments still held at the end of the year, which can be analysed as follows: Equity securities 27 49 Debt securities 51 20 Other investments 48 176 Derivative liabilities – (68) Net asset value attributable to unit holders of consolidated unit trusts and similar funds – (78)
Transfers between Level 1 and Level 2 During 2012, the transfers between levels within the Group’s portfolio were primarily transfers from Level 1 to Level 2 of £600 million (2011: £335 million) and transfers from Level 2 to Level 1 of £227 million (2011: nil). These transfers which relate to equity securities and debt securities arose to refl ect the change in the observability of the inputs used in valuing these securities.
Financial liabilities Core structural borrowings of shareholder-fi nanced operations 3,362 249 – 3,611 Operational borrowings attributable to shareholder-fi nanced operations 3,114 213 13 3,340 Borrowings attributable to with-profi ts funds 120 743 109 972 Obligations under funding, securities lending and sale and repurchase agreements 580 2,534 – 3,114 Investment contracts without discretionary participation features 1,011 903 15,053 16,967 Derivative liabilities 1,426 615 1,013 3,054 Other liabilities 158 142 949 1,249
Liquidity analysis i Contractual maturities of fi nancial liabilities The following table sets out the contractual maturities for applicable classes of fi nancial liabilities, excluding derivative liabilities and investment contracts that are separately presented. The fi nancial liabilities are included in the column relating to the contractual maturities at the undiscounted cash fl ows (including contractual interest payments) due to be paid assuming conditions are consistent with those of year end.
Aft er 15 years to 20 years Over 20 years No stated maturity Total
Financial liabilities Core structural borrowings of shareholder-fi nanced operations H13 3,611 245 624 606 840 1,243 737 1,834 6,129 Operational borrowings attributable to shareholder-fi nanced operations H13 3,340 2,971 394 – – – – – 3,365 Borrowings attributable to with-profi ts funds H13 972 199 418 158 100 5 97 139 1,116 Obligations under funding, securities lending and sale and repurchase agreements 3,114 3,114 – – – – – – 3,114 Other liabilities 1,249 842 106 5 – – – 296 1,249 Net asset value attributable to unit holders of consolidated unit-trusts and similar funds 3,840 3,840 – – – – – – 3,840 Other creditors 2,544 2,268 20 27 36 45 148 – 2,544
271Notes on the Group fi nancial statements Prudential plc Annual Report 2012 F
: F in an cial assets an d liab ilities ii Maturity analysis of derivatives The following table provides a maturity analysis of derivative assets and liabilities: 2012 £m
Aft er 3 years to 5 years Aft er 5 years Total 2011 £m
The net derivative positions as shown in the table above comprise the following derivative assets and liabilities: Derivative assets 3,862 3,655 Derivative liabilities (2,829) (3,054)
Most investment contracts have options to surrender early, albeit these are often subject to surrender or other penalties. It is therefore the case that most contracts could be said to have a contractual maturity of less than one year, but in reality the additional charges and term of the contracts means these are unlikely to be exercised in practice and the more useful information is to present information on expected payment.
The maturity profi le above excludes certain corporate unit-linked business with gross policyholder liabilities of £12 billion (2011: £11 billion) which has no stated maturity but which is repayable on demand.
This table has been prepared on an undiscounted basis and accordingly the amounts shown for life assurance investment contracts differ from those disclosed on the statement of fi nancial position. Durations of long-term business contracts, covering insurance and investment contracts, on a discounted basis are included in section D.
For the reasons above, an analysis of the Group’s assets by contractual maturity is not considered necessary to evaluate the nature and extent of the Group’s liquidity risk.
Market and other fi nancial risks The Group’s maximum exposure to credit risk of fi nancial instruments before any allowance for collateral or allocation of losses to policyholders is represented by the carrying value of fi nancial instruments on the balance sheet that have exposures to credit risk. These assets comprise cash and cash equivalents, deposits, debt securities, loans and derivative assets, and other debtors, the carrying value of which are disclosed at the start of this note and note G3 for derivative assets. The collateral in place in relation to derivatives is described in G4. Notes D2a(iv), D3a(ii)(ii) and D4a(iii), describe the security for these loans held by the Group, as disclosed at the start of this note.
Of the total loans and receivables held, £25 million (2011: £39 million) are past their due date but have not been impaired. Of the total past due but not impaired, £18 million is less than one year past their due date (2011: £3 million). The Group expects full recovery of these loans and receivables.
Further details of collateral and pledges are provided in note G4.
Currency risk As at 31 December 2012, the Group held 19 per cent (2011: 21 per cent) and 7 per cent (2011: 9 per cent) of its fi nancial assets and fi nancial liabilities respectively, in currencies, mainly US dollar and Euro, other than the functional currency of the relevant business unit.
Financial liabilities, of which 28 per cent (2011: 28 per cent) are held by the PAC with-profi ts fund, mainly relate to foreign currency borrowings.
The amount of exchange loss recognised in the income statement in 2012, except for those arising on fi nancial instruments measured at fair value through profi t and loss, is £213 million (2011: £1 million gain). This constitutes £1 million loss (2011: £11 million loss) on Medium Term Notes (MTN) liabilities and £212 million of net loss (2011: £12 million net gain), mainly arising on investments of the PAC with-profi ts fund. The gains/losses on MTN liabilities are fully offset by value movements on cross-currency swaps, which are measured at fair value through profi t and loss.
Derivatives The Group enters into a variety of exchange traded and over-the-counter derivative fi nancial instruments, including futures, options, forward currency contracts and swaps such as interest rate swaps, cross-currency swaps, swaptions and credit default swaps.
The above derivative assets are included in ‘other investments’ in the primary statements. These derivatives are used for effi cient portfolio management to obtain cost effective and effi cient exposure to various markets in accordance with the Group’s investment strategies and to manage exposure to interest rate, currency, credit and other business risks. See also note D3 for use of derivatives by the Group’s US operations.
Fair value hedges The Group has chosen to designate as a fair value hedge certain fi xed to fl oating rate swaps which hedge the fair value exposure to interest rate movements of certain of the Group’s operational borrowings.
The fair value of the derivatives designated as fair value hedges above at 31 December 2012, was an asset of less than £1 million (2011: asset of £3 million). Movements in the fair value of the hedging instruments of a net loss of £3 million (2011: net loss of £2 million) and the hedged items of a net gain of £3 million (2011: net gain of £2 million) are recorded in the income statement in respect of the fair value hedges above.
Cash fl ow hedges The Group has no cash fl ow hedges in place.
Securities lending and reverse repurchase agreements The Group has entered into securities lending (including repurchase agreements) whereby blocks of securities are loaned to third parties, primarily major brokerage fi rms. The amounts above the fair value of the loaned securities required to be held as collateral by the agreements depend on the quality of the collateral, calculated on a daily basis. The loaned securities are not removed from the Group’s consolidated statement of fi nancial position, rather they are retained within the appropriate investment classifi cation. Collateral typically consists of cash, debt securities, equity securities and letters of credit. At 31 December 2012, the Group had lent £3,015 million (2011: £7,843 million) of securities of which £2,047 million (2011: £5,820 million) was lent by the PAC with-profi ts fund and held collateral under such agreements of £3,137 million (2011: £8,160 million) of which £2,138 million (2011: £6,108 million) was held by the PAC with-profi ts fund.
At 31 December 2012, the Group had entered into reverse repurchase transactions under which it purchased securities and had taken on the obligation to resell the securities for the purchase price of £943 million (2011: £1,607 million), together with accrued interest.
During the year ended 31 December 2012, impairment losses of £50 million (2011: £126 million) were recognised for available-forsale securities and loans and receivables analysed as shown in the attached table.
Impairment losses recognised on available-for-sale securities amounted to £37 million (2011: £62 million). Of this amount, 22 per cent (2011: 34 per cent) has been recorded on structured asset-backed securities, primarily due to reduced cash fl ow expectations on such securities that are collateralised by diversifi ed pools of primarily below investment grade securities. Of the losses related to the impairment of fi xed maturity securities, the top fi ve individual corporate issuers made up 74 per cent (2011: 75 per cent), refl ecting a deteriorating business outlook of the companies concerned. The impairment losses have been recorded in ‘investment return’ in the income statement.
The effect of those reasonably likely changes in the key assumptions that underpin the assessment of whether impairment has taken place depends on the factors described in note A4. A key indicator of whether such impairment may arise in future, and the potential amounts at risk, is the profi le of gross unrealised losses for fi xed maturity securities accounted for on an available-for-sale basis by reference to the time periods by which the securities have been held continuously in an unrealised loss position and by reference to the maturity date of the securities concerned.
For 2012, the amount of gross unrealised losses for fi xed maturity securities classifi ed as available-for-sale under IFRS in an unrealised loss position was £178 million (2011: £246 million). Notes B1 and D3 provide further details on the impairment charges and unrealised losses of Jackson’s available-for-sale securities.
275Notes on the Group fi nancial statements Prudential plc Annual Report 2012 F