c With-profit fund holdings of debt securities The UK with-profits fund holds debt securities as part of its investment portfolio backing policyholder liabilities and unallocated surplus. For 2008, given the expectation that the widening of credit spreads observed in 2008 would not be maintained, the Company considered it appropriate to assume an unchanged level of credit spreads, an unchanged level of default allowance and an unchanged risk discount rate methodology relative to those used at 31 December 2007. For 2009, the approach for with-profit holdings has been refined. For equities and properties the projected earned rate is defined as the risk-free rate plus a long-term risk premium. Under the revised methodology a similar approach is adopted for corporate bonds i.e. the assumed earned rate is defined as the risk-free rate plus an assessment of the long-term spread over gilts, net of expected long-term defaults.
iv Management actions In deriving the time value of financial options and guarantees, management actions in response to emerging investment and fund solvency conditions have been modelled. Management actions encompass, but are not confined to, the following areas: • investment allocation decisions; • levels of reversionary bonuses and credited rates; and • total claim values.
The value attributed to the shareholders’ interest in the estate is derived by increasing final bonus rates (and related shareholder transfers) so as to exhaust the estate over the lifetime of the in-force with-profits business. In those few extreme scenarios where the total assets of the life fund are insufficient to meet policyholder claims in full, the excess cost is fully attributed to shareholders. Similar principles apply, where appropriate, for other with-profit funds of the Group’s Asian operations.
c Accounting presentation i Analysis of profit before tax To the extent applicable, presentation of the EEV profit for the year is consistent with the basis that the Group applies for analysis of IFRS basis profits before shareholder taxes between operating and non-operating results. Operating results reflect the underlying results including longer-term investment returns and, except as explained in note (iv) below, the unwind of discount on the value of in-force business. Operating results include the impact of routine changes of estimates and non-economic assumptions. Non operating results comprise short-term fluctuations in investment returns, the shareholders’ share of actuarial and other gains and losses on defined benefit pension schemes, the mark to market value movements on core borrowings and the effect of changes in economic assumptions and changes in the time value of cost of options and guarantees arising from changes in economic factors. In 2009, during the severe equity market conditions experienced in the first quarter of 2009, coupled with historically high equity volatility, the Group incurred nonrecurrent costs from an exceptional short dated hedge to protect against tail events on the Group IGD capital position in addition to regular operational hedging programmes. These costs have been shown separately within short-term fluctuations in investment returns. Also, in June 2009, the Group completed the disposal of the Taiwan agency business. The effect of this disposal and the results of the Taiwan agency business have been presented separately outside of the operating result.
ii Operating profit For the investment element of the assets covering the net worth of long-term insurance business, investment returns are recognised in operating results at the expected long-term rate of return. These expected returns are calculated by reference to the asset mix of the portfolio. For the purpose of calculating the longer-term investment return to be included in the operating result of the PAC with-profits fund of UK operations, where assets backing the liabilities and unallocated surplus are subject to market volatility, values of assets at the beginning of the reporting period are adjusted to remove the effects of short-term market movements.
For UK annuity business, rebalancing of the asset portfolio backing the liabilities to policyholders may from time to time take place to align it more closely with the internal benchmark of credit quality that management applies. Such rebalancing will result in a change in the projected yield on the asset portfolio and the allowance for default risk. The net effect of these changes is reflected in the result for the year. In general, the effect is booked in operating results. However, in 2008 the element due to the exceptional spread widening in the market since 31 December 2006 was booked in the effect of change in economic assumptions.
iii Effect of changes in operating assumptions Operating profits include the effect of changes to operating assumptions on the value of in force at the end of the period. For presentational purposes, the effect of change is delineated to show the effect on the opening value of in force with the experience variance being determined by reference to the end of period assumptions.
v Pension costs Profit before tax Movements on the shareholders’ share of surpluses (to the extent not restricted by IFRIC 14) and deficits of the Group’s defined benefit pension schemes adjusted for contributions paid in the year are recorded within the income statement. Consistent with the basis of distribution of bonuses and the treatment of the estate described in note 1b(iv) and (v), the shareholders’ share incorporates 10 per cent of the proportion of the financial position attributable to the PAC with-profits fund. The financial position is determined by applying the requirements of IAS 19.
Actuarial and other gains and losses For pension schemes in which the IAS 19 position reflects the difference between the assets and liabilities of the scheme, actuarial and other gains and losses comprise: • the difference between actual and expected return on the scheme assets; • experience gains and losses on scheme liabilities; • the impact of altered economic and other assumptions on the discounted value of scheme liabilities; and • for pension schemes where the IAS 19 position reflects a deficit funding obligation, actuarial and other gains and losses reflect the movement in estimates of deficit funding requirements.
vii Taxation The EEV profit for the year for covered business is in most cases calculated initially at the post-tax level. The post-tax profit is then grossed up for presentation purposes at the effective rate of tax. In general, the effective rate corresponds to the corporation tax rate on shareholder profits of the business concerned.
Notes on the EEV basis supplementary information > continued ix Foreign exchange rates Foreign currency results have been translated as discussed in note 1b(viii), for which the principal exchange rates are as follows: Closing rate at Average Closing rate at Average Opening rate Local currency: £ 31 Dec 2009 for 2009 31 Dec 2008 for 2008 at 1 Jan 2008
Annual Present value premium and of new contribution business Pre-tax newNew business premiums equivalents premiums business
Single Regular note i, 17 note i, 17 note ii, iii (APE) (PVNBP)
New Business Premiums (PVNBP) and are calculated as the ratio of the value of new business profit to APE and PVNBP. APEs are calculated as the aggregate of regular new business amounts and one-tenth of single new business amounts. PVNBPs are calculated as equalling single premiums plus the present value of expected premiums of new regular premium business, allowing for lapses and other assumptions made in determining the EEV new business contribution.
v The increase in new business margin for US operations for 2009 reflects the significant changes to target spread for Fixed Annuity and Fixed Index Annuity business primarily as a result of the exceptional combined benefit of high investment yields on new assets and lower crediting rates, as described in note 16b, and the increasing proportion of variable annuity business, for which margins have benefited from the increased projected separate account return, revised benefits and higher take-up rates on the higher margin guaranteed withdrawal benefits.
Unwind of discount and other expected returns 409 233 569 1,211
ii Effect of change in operating assumptions The charge of £(12) million for Asian operations in 2009 primarily represents a charge of £(78) million for the effect of strengthening persistency assumptions, offset by a credit of £69 million relating to altered projected net of tax cash flows arising from a regulatory reclassification of health and protection products in Hong Kong. The change in persistency assumptions are mainly as a direct consequence of the impact on policyholders’ savings behaviour from adverse economic and market conditions, arising primarily for investment related products, principally in Korea (£(25) million) and Hong Kong (£(12) million), mostly due to premium holidays, and in Indonesia (£(24) million), reflecting recent experience.
iii Experience variances and other items The £(85) million charge for Asian operations in 2009 primarily represents the effects of adverse persistency of £(76) million, as customers have withdrawn from investment related products (for which assumptions have been strengthened, as explained in note ii above). The residual £(9) million charge reflects a combination of adverse expense experience of £(43) million, offset by the favourable mortality and morbidity experience of £52 million, (as explained in notes iv(5) and iv(6) below) and a charge of £(18) million for other items.
The £124 million credit in US operations in 2009 primarily represents £59 million for the amortisation of interest-related realised gains and losses, £40 million for lower than expected levels of expenses and £32 million for favourable mortality experience as detailed in note v(7) below.
Notes 1 The favourable effect of £26 million in 2009 for mortality and morbidity assumption changes primarily arises in Indonesia of £24 million reflecting recent experience. The benefit of £41 million for 2008 mainly relates to Singapore of £34 million and Hong Kong of £15 million, which reflect actual experience across most products, offset by a charge in Malaysia of £(19) million which reflects negative morbidity experience on health and protection products.
2 The charge of £(32) million for strengthened expense assumptions arises principally in Hong Kong of £(23) million with the balance across the regions.
3 The negative effect of the change in persistency assumptions of £(78) million in 2009 arises mostly with investment related products, principally in Korea (£(25) million), Indonesia (£(24) million) and Hong Kong (£(12) million).
4 The effect of other assumption changes for 2009 of £72 million comprises the one-off positive impact of £69 million for altered projected net of tax cash flows arising from a regulatory reclassification of health and protection products in Hong Kong, a credit of £13 million for the effect of altered application of the Group’s EEV methodology and a net charge of £(10) million for other items. The £13 million effect comprises adjustments for asset management margins in Indonesia and Korea of £37 million and a charge of £(24) million to better align the assumed capital requirement with internal management and pricing bases, primarily in China, Indonesia, Philippines and Vietnam, and other minor adjustments with a neutral net effect.
5 The favourable effects of £52 million in 2009 and £34 million in 2008 relating to mortality and morbidity experience variances reflect better than expected experience across the territories.
6 The charge of £(43) million for expense experience variance arises across the territories, principally in Korea (£(10) million) reflecting the lower level of sales in the current year, £(8) million in Taiwan, following the sale of the Agency business during the year and £(16) million for expense overruns for operations which are at a relatively early stage of development, for which actual expenses are in excess of those factored into the product pricing.
The 2008 negative expense experience variance of £(37) million includes a charge of £(11) million arising in Korea, also reflecting lower sales. 7 The charge of £(76) million in 2009 relating to negative persistency experience arises across the region with the largest impacts in Korea
Unwind of discount and other expected returns 344 233 Effect of changes in operating assumptions: Guaranteed Minimum Withdrawal Benefit (GMWB) policyholder behaviour11 156 –
Variable Annuity (VA) fees3 (13) 29 Effect of adjustments for application of EEV methodology for certain reserves and required capital44 – (61)
2 The £33 million credit for mortality for 2009 primarily reflects lower mortality rates for the Life of Georgia business, based upon actual experience since the acquisition of the business in 2005.
4 The effect of the adjustments in 2008 for the application of EEV methodology for certain reserves and required capital of £(61) million are as follows: £m
b The statutory reserves are primarily in respect of guarantees on variable annuity products in excess of the surrender value. c The adjustment in respect of required capital represents a current year refinement to reduce the required capital to align the amount with the required level which has been set as an amount at least equal to 235 per cent of the risk-based capital required by National Association of Insurance Commissioners at the Company Action Level.
5 The effect of other changes in assumptions in 2009 of £(75) million primarily represents the negative impact of changes in persistency assumptions of £(53) million, reflecting an increase in the assumed utilisation of the partial withdrawal option on Variable and Fixed Annuity business of £(29) million and £(24) million for the effect of other altered lapse rates, in line with experience.
6 The spread assumption for Jackson is determined on a longer-term basis, net of provision for defaults. The charge of £(3) million for spread experience variance in 2009 is better assessed in the context of both spread and amortisation of interest-related realised gains and losses. Amortisation of interest-related gains and losses reflects the same treatment applied to the supplementary analysis of IFRS profit. When bonds that are neither impaired nor deteriorating are sold and reinvested there will be a consequent change in the investment yield. To reflect better the longer-term returns on operating profits the realised gain or loss is amortised into the result over the period when the bonds would have otherwise matured. The net effect on the EEV results of these two items is a credit of £56 million for 2009 and £82 million for 2008.
During 2007 and 2008, exceptional credit spread widening took place. Accordingly in 2008, to better reflect performance reporting, the effect of asset rebalancing reflected in the operating result was determined by reference to investment conditions at 31 December 2006. The excess effect of asset rebalancing was included in non-operating results, as described in note 6.
The short-term fluctuations in investment returns in Asia for 2009 of £437 million reflect the effect of strong equity market performance in particular for participating business and unit-linked business where the in-force value benefits from increases in shareholder transfers and from the capitalisation of increased projected fees due to the higher asset base at the end of the year.
ii US operations The fluctuations for US operations comprise the following items: £m £m
Actual less long-term return on equity based investments and other items2 (144) (148) Investment return related gain (loss) due primarily to changed expectation of profits on in-force variable annuity business in future periods based on current period equity returns, net of related hedging activity for equity related products33 110 (733)
With-profits1 430 (2,083) Shareholder-backed annuity2 (40) (213) Unit-linked and other3 55 (111)
3 The credit of £55 million relates primarily to unit-linked business representing the increase in capitalised value of future fees arising from the positive movements in market values experienced during the year.
Sale of investment in India mutual fund in May 2008 giving rise to a transfer to operating profit of £47m for the crystallised gain, and value reduction in the year, prior to sale, of £24m – (71)
Change in of cost of Change in of cost of economic options and economic options and assumptions guarantees Total assumptions guarantees Total
The effect of changes in economic assumptions in Asia for 2008 of a credit of £157 million reflects the impact of the reduction in risk discount rates across most territories.
6 Effect of changes in economic assumptions and time value of cost of options and guarantees
Notes on the EEV basis supplementary information > continued ii The charge of £(528) million for the effect of changes in economic assumptions for US operations for 2009 reflects the following: £m £m
Fixed annuity and other general account business (410) 385 Variable Annuity (VA) business 183 (118)
For fixed annuity and other general account business the effect of changes to the risk-free rate, which is defined as the 10-year treasury rate, is reflected in the risk discount rate. This discount rate is in turn applied to projected cash flows which principally reflect projected spread, which is largely insensitive to changes in the risk-free rate. For 2009, the effect of these changes resulted in an overall charge for fixed annuity and other general account business of £(410) million, reflecting the increase in the risk-free rate of 1.6 per cent (as shown in note 16b). For 2008, the effect of the change in economic assumptions on this business was a credit of £385 million, which reflects the decrease in the risk-free rate of 1.8 per cent.
The additional allowance to be applied in future reporting periods will be altered, as necessary, for future credit conditions and as the business in force alters over time. Accordingly, a simple formulaic approach for the future allowance is not possible and does not apply. However, as a guide the current allowance can be summarised as broadly reflecting that 50 per cent of the increase in credit spread since 31 December 2006 can be attributed to credit risk and 50 per cent to liquidity premium, and that management actions can be used to absorb some 50 basis points of credit losses without adversely impacting value.
iii The effect of changes in economic assumptions of a charge of £(270) million for UK insurance operations comprises the effect of: Shareholder- With- Shareholder- Withbacked profits backed profits annuity and other annuity and other business business business business note 1 note 2 Total note 1 note 2 Total
Total long-term business operations 6,375 9,047 15,422 5,520 9,113 14,633 7 Shareholders’ funds – segmental analysis
Notes i With the exception of the share of the Prudential Staff Pension Scheme (PSPS) deficit attributable to the PAC with-profits fund, which is included in
Free surplus is the market value of the net worth in excess of the capital required to support the covered business. Where appropriate, adjustments are made to the regulatory basis net worth from the local regulatory basis so as to include backing assets movements at fair value rather than cost so as to comply with the EEV principles. Prudential has based required capital on its internal targets for economic capital subject to it being at least the local statutory minimum requirements, as described in note 1b(ii).
Long-term business and asset management operationsnote i note 13 note ii commission
Changes in non-operating itemsnote iii (239) 41 (198) Profit on sale and results for Taiwan agency business 987 – 987
ii For the purposes of this analysis, free surplus for asset management operations and the UK general insurance commission is taken to be IFRS basis shareholders’ funds as shown in note 7.
This represents short-term fluctuations in investment returns, the shareholders’ share of actuarial and other gains and losses on defined benefit pension schemes and the effect of changes in economic assumptions for long-term business operations.
v Exchange movements, timing differences and other items represent: Asset management and UK general
In July 2009, the Company issued US$750 million perpetual subordinated capital securities. In accordance with the EEV Principles, core borrowings are carried at market value. As the liabilities are generally held to maturity or for the long-term, no deferred tax asset or liability has been established on the market value adjustment above.
Asian US insurance business Other Group operations operations operations operations operations Total
Operating profit (based on longer-term investment returns) Long-term business: Asia development expenses (6) – – (6) – (6) UK general insurance commission – – – – 51 51
Asian asset management operations – – – – 55 55 US broker-dealer and asset management – – – – 4 4 Other income and expenditure – – – – (433) (433)
Operating profit based on longer-term investment returns 1,099 1,233 850 3,182 (92) 3,090 Short-term fluctuations in investment returns5 437 (401) 445 481 (130) 351 Mark to market value movements on core borrowings9 – (21) – (21) (774) (795) Shareholders’ share of actuarial and other gains and losses on defined benefit pension schemes – – (52) (52) (32) (84) Effect of changes in economic assumptions and time value of cost of options and guarantees6 (174) (518) (218) (910) – (910) Profit on sale and results for Taiwan agency business18 148 – – 148 (57) 91
Profit (loss) from continuing operations before tax (including actual investment returns) 1,510 293 1,025 2,828 (1,085) 1,743
Discontinued operations (net of tax)4 – – – – (14) (14) Minority interests – – – – (3) (3)
Exchange movements on foreign operations and net investment hedgesnote i (435) (483) – (918) 157 (761)
Movement in own shares held in respect of share-based payment plans – – – – 3 3 Movement in Prudential plc shares purchased by unit trusts consolidated under IFRS – – – – (3) (3) New share capital subscribed – – – – 141 141 Mark to market value movements on Jackson assets backing surplus and required capital (net of related tax of £72m)13 – 133 – 133 – 133
Net increase (decrease) in shareholders’ equity 517 (217) 520 820 (503) 317 Shareholders’ equity at 1 January 2009note iii, 7 5,264 4,339 4,919 14,522 434 14,956
Notes i Profits are translated at average exchange rates, consistent with the method applied for statutory IFRS basis results. The amounts recorded above for exchange rate movements reflect the difference between 2009 and 2008 exchange rates as applied to shareholders’ funds at 1 January 2009 and the difference between 31 December 2009 and average 2009 rates for profits.
ii Investment in operations reflects increases in share capital. This includes certain non-cash items. iii For the purposes of the table above, goodwill related to Asia long-term operations (as shown in note 7) is included in Other operations. iv Other transfers (from) to long-term business operations to Other operations in 2009 represent: Total UK long-term
Tax credit on profit on sale and results for Taiwan agency business – (16)
Total tax credit on items not included in operating profit (385) (1,529)
Tax charge (credit) on profit (loss) on ordinary activities from continuing operations
Notes i The profit for the year for covered business is in most cases calculated initially at the post-tax level. The post-tax profit for covered business is then grossed up for presentation purposes at the effective rates of tax applicable to the countries and periods concerned. In the UK, the effective rate is the UK corporation tax rate of 28 per cent which took effect from 1 April 2008. For Jackson, the US federal tax rate of 35 per cent is applied to gross up movements on the value of in-force business. Effects on statutory tax for the period affect the overall tax rate. For Asia, similar principles apply subject to the availability of taxable profits.
ii Including tax relief on Asia development expenses and restructuring costs borne by UK insurance operations.
Total EPS: Profit (loss) from continuing operations before tax 1,743 (2,106)
New business contributionnotes ii, iii (675) 451 (224) 1,355 1,131 Existing business – transfer to net worth 1,551 (434) 1,117 (1,117) – Expected return on existing business 106 100 206 856 1,062 Changes in operating assumptions and experience variances 175 50 225 (136) 89 Profit on sale and results for Taiwan agency business 987 (1,232) (245) 393 148 Increase in capital requirements for US operations arising from impairments and credit downgrades (168) 168 – – – Changes in non-operating assumptions and experience variances and minority interests (71) 42 (29) (158) (187)
Existing business – transfer to net worth 377 5 382 (382) –
Changes in non-operating assumptions and experience variances and minority interests 101 (26) 75 206 281
Profit after tax and minority interests from long-term business 1,207 (1,094) 113 1,176 1,289
13 Reconciliation of net worth and value of in-force businessnote i
Notes on the EEV basis supplementary information > continued 2009 £m
Value of Free in-force Total surplus Required Total net business long-term note 8 capital worth note iv business
Changes in operating assumptions and experience variances 115 (12) 103 58 161
Increase in capital requirements for US operations arising from impairments and credit downgrades (168) 168 – – –
Profit after tax and minority interests from long-term business 268 163 431 (208) 223
Existing business – transfer to net worth 468 (80) 388 (388) –
Changes in non-operating assumptions and experience variances and minority interests (95) 57 (38) 164 126
Total net worth (224) (334) Value of in-force business 1,355 1,189
Free surplus Post-tax new contribution Free surplus Post-tax new contribution invested business per £1m free invested business per £1m free in new contribution surplus in new contribution surplus business note ii invested business note ii invested iv The value of in-force business includes the value of future margins from current in-force business less the cost of holding encumbered capital and represents: Value of Value of in-force in-force business business before before deduction deduction of cost Cost of Net of cost Cost of Net of capital time value of of capital time value of and of Cost value of in-force and of Cost value of in-force guarantees of capital guarantees business guarantees of capital guarantees business
UK insurance v The amounts shown in respect of free surplus and the value of in-force business for UK and Asian operations for intragroup dividends and investment in operations include the impact of contingent loan funding.
vi For Asian operations, the effect of changes in operating assumptions and experience variances in 2009 includes the impact of changes in the assumed capital requirement to better align with internal management and pricing bases. This primarily arises in China, Indonesia, Philippines and Vietnam, with a consequent reduction in free surplus and increase in required capital of £73 million.
Add back: deduction for cost of time value of guarantees13 260 474
Long-term expected defaults – 5 bps increase – – (9) (9) Liquidity premium – 10 bps increase – – 18 18
b Sensitivity analysis – non-economic assumptions The tables below show the sensitivity of the embedded value as at 31 December 2009 (31 December 2008) and the new business contribution after the effect of encumbered capital for 2009 and 2008 to: • 10 per cent proportionate decrease in maintenance expenses (a 10 per cent sensitivity on a base assumption of £10 per annum would represent an expense assumption of £9 per annum); • 10 per cent proportionate decrease in lapse rates (a 10 per cent sensitivity on a base assumption of five per cent would represent a lapse rate of 4.5 per cent per annum); and
Asian operations (excluding Total sold Taiwan UK long-term agency US insurance business business) operations operations operations
Change representing effect on: Embedded value of long-term operations at 31 December 2008
Change representing effect on: 15 Sensitivity of results to alternative assumptions continued
a Best estimate assumptions Best estimate assumptions are used for the cash flow projections, where best estimate is defined as the mean of the distribution of future possible outcomes. The assumptions are reviewed actively and changes are made when evidence exists that material changes in future experience are reasonably certain.
Expected returns on equity and property asset classes in respect of each territory are derived by adding a risk premium, based on the long-term view of Prudential’s economists, to the risk-free rate. In Asia, equity risk premiums range from 3.0 per cent to 8.35 per cent (2008: 3.0 per cent to 7.0 per cent). In the US and the UK, the equity risk premium is 4.0 per cent (2008: 4.0 per cent).
Malaysia Philippines Singapore Taiwan Thailand Vietnam Malaysia Philippines Singapore Taiwan Thailand Vietnam Asian operations note iii note iv note iii note iv note iii note iii
Risk discount rate: Expected long-term rate of inflation 2.75 5.0 1.75 2.25 3.0 6.0 2.75 5.0 1.75 2.25 3.0 6.0 16 Assumptions
iv In 2009, the Group reconsidered the application of the Group’s methodology for certain less established operations, with a consequent change in the risk discount rates used for Indonesia and Korea and a change in the assumed capital requirement to better align with internal management and pricing bases, primarily in China, Indonesia, Philippines and Vietnam. The change in the risk discount rate for Indonesia from 2008 to 2009 reflects a more granular assessment of the risks when determining the beta.
US 10-year treasury bond rate at end of period 3.9 2.3
First six months of 2009 2.75 2.0 3.5 Second six months of 2009 2.25 2.0 2.5 *Including the proportion of variable annuity business invested in the general account. †For new tranches of business in 2009, the expected spread is assumed to grade back to the long-term assumption over the next 10 years.
The increases in the spread assumptions are due primarily to the exceptional combined benefit of high investment yields with a net annualised yield on new assets of 6.4 per cent during 2009 and lower crediting rates. These revised assumptions include a provision that crediting rates and spreads will normalise in the future. Thus, the assumption for new business spreads shown above for fixed annuities and the proportion of variable annuity business invested in the general account is set at the higher new level for the first five years before reducing over the following 10 years. As before, the valuation of new business takes into account an assumed associated risk of increased lapse under certain interest rate scenarios.
iii Credit risk treatment The projected cash flows incorporate the expected long-term spread between the earned rate and the rate credited to policyholders. The projected earned rates reflect book value yields which are adjusted over time to reflect projected reinvestment rates. Positive net cash flows are assumed to be reinvested in a mix of corporate bonds, commercial mortgages and limited partnerships. The yield on those assets is assumed to grade from the current level to a yield that allows for a long-term assumed credit spread of 1.25 per cent over 10 years. The expected spread for 2009 has been determined after allowing for a Risk Margin Reserve (RMR) allowance of 28 basis points for longer-term defaults as described in note 1b(iii). The RMR of 28 bps represents the allowance, as at 31 December 2009, applied in the cash flow projections of the value of the in-force business.
UK insurance operationsnote iv 31 Dec 2009 % 31 Dec 2008 %
Pre-tax expected long-term nominal rate of return for shareholder-backed annuity business:note iii
Pre-tax expected long-term nominal rates of investment return: UK equities 8.4 7.7
Post-tax expected long-term nominal rate of return for the PAC with-profits fund: Pension business (where no tax applies) 6.9 6.6
For UK shareholder-backed annuity business, different dynamics apply both in terms of the nature of the business and the EEV methodology applied. For this type of business the assets are generally held to maturity to match long duration liabilities. It is therefore appropriate under EEV methodology to include a liquidity premium in the economic basis used. The appropriate EEV risk discount rate is set in order to equate the EEV with a ‘market consistent embedded value’ including liquidity premium. The liquidity premium in the ‘market consistent embedded value’ is derived from the yield on the assets held after deducting an appropriate allowance for credit risk. The risk discount rate in EEV reflects the excess of the total allowance for credit risk over the best estimate default assumptions. For Prudential Retirement Income Limited (PRIL), which has approximately 90 per cent of UK shareholder-backed annuity business, the allowance for credit risk at 31 December 2009 is made up of: a 20 bps for fixed annuities and 15 bps for inflation-linked annuities in respect of long-term expected defaults. This is derived by applying Moody’s data from 1970 to 2004 uplifted by between 100 per cent (B) and 200 per cent (AAA) according to credit rating, to the asset portfolios.
Notes on the EEV basis supplementary information > continued b 13 bps for fixed annuities and 10 bps for inflation-linked annuities in respect of long-term credit risk premium for the potential volatility in default levels. This is derived by applying the 95th worst percentile from Moody’s data from 1970 to 2004, to the asset portfolios.
Credit risk allowance Long-term expected defaults 19 15 Long-term credit risk premium 13 11 Short-term allowance for credit risk 39 54
• The stochastic cost of guarantees is primarily only of significance for the Hong Kong, Korea, Malaysia and Singapore operations. • The mean stochastic returns are consistent with the mean deterministic returns for each country. The expected volatility of equity returns for 2009 ranges from 18 per cent to 35 per cent (2008: 18 per cent to 30 per cent), and the volatility of government bond yields ranges from 1.3 per cent to 2.4 per cent (2008: 1.4 per cent to 2.4 per cent).
US operations (Jackson) • Interest rates are projected using a log-normal generator calibrated to the market yield curve at the valuation date; • Corporate bond returns are based on Treasury securities plus a spread that has been calibrated to current market conditions and varies by credit quality; and • Variable annuity equity and bond returns have been stochastically generated using a log-normal model with parameters determined by reference to historical data. The volatility of equity fund returns for both 2009 and 2008 ranges from 18.6 per cent to 28.1 per cent, depending on risk class, and the standard deviation of bond returns ranges from 1.4 per cent to 1.6 per cent (2008: 1.5 per cent to 1.6 per cent).
UK insurance operations • Interest rates are projected using a two-factor model calibrated to the initial market yield curve; • The risk premium on equity assets is assumed to follow a log-normal distribution; • The corporate bond return is calculated as the return on a zero-coupon bond plus a spread. The spread process is a mean reverting stochastic process; and • Property returns are modelled in a similar fashion to corporate bonds, namely as the return on a riskless bond, plus a risk premium, plus a process representative of the change in residual values and the change in value of the call option on rents.
d Expense assumptions Expense levels, including those of service companies that support the Group’s long-term business operations, are based on internal expense analysis investigations and are appropriately allocated to acquisition of new business and renewal of in-force business. Exceptional expenses are identified and reported separately. It is Prudential’s policy not to take credit for future cost reduction programmes until the savings have been delivered.
Expenditure of the Regional Head Office that is not allocated to the covered business or asset management operations is charged as incurred. These costs are primarily for corporate related activities. Development expenses are also charged as incurred.
Corporate expenditure for Group Head Office, to the extent not allocated to the PAC with-profits fund, is charged to EEV basis results as incurred.
Annual premium and Present value of new contribution equivalents business premiums
Guaranteed Investment Contracts – 857 – – – 86 – 857 GIC – Medium Term Notes – 337 – – – 34 – 337
iii The 2008 comparatives shown in the table are translated at average exchange rates for the year.
Estimate as announced on 20 February 2009 90 Plus: effect of completion and other adjustments 1
b 2008 comparative results The results for 2008 of £(248) million comprise the total result for the sold business i.e. including operating profit, short-term fluctuations in investment returns and the effect of changes in economic assumptions and the time value of cost of options and guarantees.
a Acquisition of UOB Life Assurance Limited On 6 January 2010 the Group announced the acquisition from United Overseas Bank Limited (UOB) of its 100 per cent interest in UOB Life Assurance Limited in Singapore for total cash consideration of SGD428 million (£192 million) subject to a post-completion adjustment to reflect the net asset value as at the completion date. This acquisition accompanied the announcement of a long-term strategic partnership with UOB. Through this partnership Prudential’s life insurance products will be distributed through UOB Group’s 414 bank branches across Singapore, Indonesia and Thailand.
AIG will receive total consideration of US$35.5 billion, comprising US$25.0 billion in cash and US$10.5 billion in New Prudential shares and other securities. The cash component of the consideration will be financed through an underwritten rights issue, raising US$20.0 billion (net of fees and expenses) and through issuance of US$5.0 billion senior notes (net of fees and expenses). These issues have been agreed to be underwritten by certain banks. The terms of the rights issue will be set at the time of publication of Prudential and New Prudential prospectuses.
19 Post balance sheet events 18 Sale of legacy agency book and agency force in Taiwan to China Life Insurance of Taiwan continued
Respective responsibilities of directors and auditor As explained more fully in the statement of directors’ responsibilities set out on page 341, the directors have accepted responsibility for the preparation of the supplementary information on the EEV basis in accordance with the EEV Principles.
Scope of the audit of the supplementary information An audit involves obtaining evidence about the amounts and disclosures in the supplementary information to give reasonable assurance that the supplementary information is free from material misstatement, whether caused by fraud or error. This includes an assessment of: whether the accounting policies are appropriate to the Group’s circumstances and have been consistently applied and adequately disclosed; the reasonableness of significant accounting estimates made by the directors; and the overall presentation of the supplementary information.
Opinion on supplementary information In our opinion, the EEV basis supplementary information for the year ended 31 December 2009 has been properly prepared in accordance with the EEV Principles using the methodology and assumptions set out on pages 308 to 312 and 333 to 337 respectively.
344 Risk factors 348 Shareholder information 350 How to contact us
A number of factors (risk factors) affect Prudential’s operating results and financial condition and, accordingly, the trading price of its shares. The risk factors mentioned below should not be regarded as a complete and comprehensive statement of all potential risks and uncertainties. The information given is as of the date of this report, is not updated, and any forward-looking statements are made subject to the reservations specified under ‘Forward-Looking Statements’ (page 351).
Prudential’s businesses are inherently subject to market fluctuations and general economic conditions. Uncertain or negative trends in international economic and investment climates which have adversely affected Prudential’s business and profitability could be repeated, or prolonged, or could worsen. The adverse effects of such trends, including the unprecedented market dislocation across asset classes and geographical markets witnessed in 2008 and in the first half of 2009, have been and would be felt principally through the following: • investment impairments or reduced investment returns, as a result of market volatility, could impair Prudential’s ability to write significant volumes of new business as a result of market volatility, which would have a negative impact on its assets under management and profit; • higher credit defaults and wider credit and liquidity spreads resulting in realised and unrealised credit losses, as experienced during 2008 and 2009, when illiquidity and credit spreads reached all-time highs; • Prudential in the normal course of business enters into a variety of transactions with counterparties, including derivative transactions. Failure of any of these counterparties to discharge their obligations, or where adequate collateral is not in place, could have an adverse impact on Prudential’s results; and
Due to the geographical diversity of its businesses, Prudential is subject to the risk of exchange rate fluctuations. Prudential’s international operations in the US and Asia, which represent a significant proportion of operating profit and shareholders’ funds, generally write policies and invest in assets denominated in local currency. Although this practice limits the effect of exchange rate fluctuations on local operating results, it can lead to significant fluctuations in Prudential’s consolidated financial statements upon translation of results into sterling. The currency exposure relating to the translation of reported earnings is not separately managed.
Current EU directives, including the EU Insurance Groups Directive (‘IGD’) require European financial services groups to demonstrate net aggregate surplus capital in excess of solvency requirements at the Group level in respect of shareholder-owned entities. The test is a continuous requirement, so that Prudential needs to maintain a somewhat higher amount of regulatory capital at the Group level than otherwise necessary in respect of some of its individual businesses to accommodate, for example, short-term movements in global foreign exchange rates, interest rates, deterioration in credit quality and equity markets. The EU is also developing a new solvency framework for insurance companies, referred to as ‘Solvency II’. The new approach will be based on the concept of three pillars – minimum capital requirements, supervisory review of firms’ assessment of risk, and enhanced disclosure requirements – and will cover valuations, the treatment of insurance groups, the definition of capital and the overall level of capital requirements. A key aspect of Solvency II is that the assessment of risks and capital requirements will be aligned more closely with economic capital methodologies, and may allow the Group to make use of its internal economic capital models, if approved by the FSA. The Solvency II Directive was formally approved by a meeting of the EU’s Economic and Financial Affairs Council on 10 November 2009. The European Commission has already initiated the process of developing the detailed rules that will complement the high-level Principles of the Directive, referred to as ‘implementing measures’, which are subject to a consultation process and are not expected to be finalised until late 2011. There is a significant uncertainty regarding the final outcome of this process. As a result there is a risk that the effect of the measures finally adopted could be adverse for the Group, including a potentially significant increase in the capital required to support the UK annuity business. In addition, the application of Solvency II to international groups is still unclear and there is a risk of inconsistent application, which may place Prudential at a competitive disadvantage to other European and non-European financial services groups.
In Asia, regulatory regimes are developing at different speeds, driven by a combination of global factors and local considerations. There is a risk that new requirements are introduced that are retrospectively applied to sales made prior to their introduction.
Prudential is, and may be in the future, subject to legal actions and disputes in the ordinary course of its insurance, investment management and other business operations. These legal actions and disputes may relate to aspects of Prudential’s businesses and operations that are specific to Prudential, or that are common to companies that operate in Prudential’s markets. Legal actions and disputes may arise under contracts, regulations (including tax) or from a course of conduct taken by Prudential, and may be class actions. Although Prudential believes that it has adequately provided in all material aspects for the costs of litigation and regulatory matters, no assurance can be provided that such provisions are sufficient. Given the large or indeterminate amounts of damages sometimes sought, and the inherent unpredictability of litigation and disputes, it is possible that an adverse outcome could, from time to time, have an adverse effect on Prudential’s results of operation or cash flows.
The markets for financial services in the UK, US and Asia are highly competitive, with several factors affecting Prudential’s ability to sell its products and continued profitability, including price and yields offered, financial strength and ratings, range of product lines and product quality, brand strength and name recognition, investment management performance, historical bonus levels, developing demographic trends and customer appetite for certain savings products. In some of its markets, Prudential faces competitors that are larger, have greater financial resources or a greater market share, offer a broader range of products or have higher bonus rates or claims-paying ratios. Further, heightened competition for talented and skilled employees with local experience, particularly in Asia, may limit Prudential Group’s potential to grow its business as quickly as planned.
In Asia, the Prudential Group’s principal regional competitors are international financial companies, including Allianz, AXA, ING, AIA and Manulife. In a number of markets, local companies have a very significant market presence.
Downgrades in Prudential’s financial strength and credit ratings could significantly impact its competitive position and hurt its relationships with creditors or trading counterparties.
Prudential’s long-term senior debt is rated as A2 (negative outlook) by Moody’s, A+ (negative outlook) by Standard & Poor’s and A+ (negative outlook) by Fitch.
Prudential Assurance Company Limited (‘Prudential Assurance’) long-term fund is rated Aa2 (negative outlook) by Moody’s, AA (negative outlook) by Standard & Poor’s and AA+ (negative outlook) by Fitch.
Notwithstanding anything in this risk factor, this risk factor should not be taken as implying that Prudential or any member of the Group will be unable to comply with its obligations as a company with securities admitted to the Official List or as a supervised firm regulated by the FSA.
A further example is the assumption that Prudential makes about future expected levels of the rates of early termination of products by its customers (persistency). This is particularly relevant to its lines of business other than its UK annuity business. Prudential’s persistency assumptions reflect recent past experience for each relevant line of business. Any expected deterioration in future persistency is also reflected in the assumption. If actual levels of future persistency are significantly lower than assumed (that is, policy termination rates are significantly higher than assumed), Prudential’s results of operations could be adversely affected.
Dividend mandates Shareholders may find it convenient to have their dividends paid directly to their bank or building society account. If you wish to take advantage of this facility, please call Equiniti and request a 'Cash Dividend Mandate' form. Alternatively, you may download a form from www.prudential.co.uk/prudential-plc/investors/ shareholder_services/forms
Scrip dividend alternative The Company will be offering a scrip dividend alternative in respect of the final dividend for the year ending 31 December 2009.
Once signed up to the evergreen scrip shareholders will automatically receive shares for all future scrip dividends; this election can be cancelled at any time by the shareholder. Further details of the scrip dividend scheme and the timetable for each payment are available on the Company website at www.prudential.co.uk/prudential-plc/investors
Share dealing services The Company's Registrars, Equiniti, offer a postal dealing facility for buying and selling Prudential plc ordinary shares; please see the Equiniti address above or telephone 0871 384 2248. They also offer a telephone and internet dealing service, Shareview, which provides a simple and convenient way of selling Prudential plc shares. For telephone sales call 0871 384 2020 between 8.30am and 4.30pm, Monday to Friday, and for internet sales log on to www.shareview.co.uk/dealing
ShareGift Shareholders who only have a small number of shares whose value makes it uneconomic to sell them may wish to consider donating them to ShareGift (Registered Charity 1052686). The relevant share transfer form may be obtained from our website www.prudential.co.uk/prudential-plc/investors/ shareholder_services/forms or from Equiniti. Further information about ShareGift may be obtained on +44 (0)20 7930 3737 or from www.ShareGift.org. There are no implications for capital gains tax purposes (no gain or loss) on gifts of shares to charity and it is also possible to obtain income tax relief.
Irish branch register The Company operates a branch register for Irish shareholders. All enquiries regarding Irish branch register accounts should be directed to Capita Registrars (Ireland), Unit 5, Manor Street Business Park, Manor Street, Dublin 7. Telephone: + 353 1 810 2400
Jackson National Life Insurance Company 1 Corporate Way Lansing Michigan 48951 USA
Registered office: Laurence Pountney Hill London EC4R 0HH Registered number 1397169 www.prudential.co.uk
This Annual Report is printed on paper made from 50 per cent recycled post-consumer waste. The paper is Forest Stewardship Council (FSC) accredited. This Annual Report can be recycled.
Registered office Laurence Pountney Hill London EC4R 0HH Registered number 1397169 www.prudential.co.uk