For those investment contracts in the US with fixed and guaranteed terms, the Group uses the amortised cost model to measure the liability. On contract inception, the liability is measured at fair value less incremental, directly attributable acquisition costs. Remeasurement at future reporting dates is on an amortised cost basis utilising an effective interest rate methodology whereby the interest rate utilised discounts to the net carrying amount of the financial liability.
The Group has consolidated special purpose entities (SPEs), such as funds holding collateralised debt obligations (CDOs), where evaluation of the substance of the relationship between the SPE and the Group indicates that the Group is deemed to control the SPE under IFRS.
Investment properties Investments in leasehold and freehold properties not for occupation by the Group including from 2009 properties under development for future use as investment properties, are carried at fair value, with changes in fair value included in the income statement. Properties are valued annually either by the Group’s qualified surveyors or by taking into consideration the advice of professional external valuers using the Royal Institution of Chartered Surveyors (RICS) guidelines. The RICS guidelines apply separate assumptions to the value of the land, buildings and tenancy associated with each property. Each property is externally valued at least once every three years. The cost of additions and renovations is capitalised and considered when estimating fair value. Fair value is based on active market prices, adjusted, if necessary, for any difference in the nature, location or condition of the specific property. If this information is not available, the Group uses alternative valuation methods such as discounted cash flow projections or recent prices in less active markets.
The Group utilises the projected unit credit method to calculate the defined benefit obligation. Estimated future cash flows 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.
The plan assets of the Group’s pension schemes exclude several insurance contracts that have been issued by the Group. These assets are excluded from plan assets in determining the pension obligation recognised in the consolidated statement of financial position.
The aggregate of the actuarially determined service costs of the currently employed personnel and the unwind of discount on liabilities at the start of the period, less the expected investment return on scheme assets at the start of the period, is charged to the income statement. Actuarial gains and losses as a result of changes in assumptions or experience variances are also charged or credited to the income statement.
Share-based payments The Group offers share award and option plans for certain key employees and a Save As You Earn (SAYE) plan for all UK and certain overseas employees. The arrangements for distribution to employees of shares held in trust relating to share award plans and for entitlement to dividends depend upon the particular terms of each plan. Shares held in trust relating to these plans are conditionally gifted to employees.
The Company has established trusts to facilitate the delivery of Prudential plc shares under employee incentive plans and savingsrelated share option schemes. None of the trusts that hold shares for employee incentive and savings plans continue to hold these shares once they are issued to employees. The cost to the Company of acquiring these treasury shares held in trusts is shown as a deduction from shareholders’ equity.
Under UK Listing Authority rules, profit before tax is required to be presented. This requirement, coupled with the fact that IFRS does not contemplate tax charges which are attributable to policyholders and unallocated surplus of with-profits funds and unit-linked policies, necessitates the reporting of total tax charges within the presented results. The result before all taxes (i.e. ‘profit before tax’ as shown in the income statement) represents income net of post-tax transfers to unallocated surplus of with-profits funds, before tax attributable to policyholders and unallocated surplus of with-profits funds, unit-linked policies and shareholders. Separately within the income statement, ‘profit before tax attributable to shareholders’ is shown after deduction of taxes attributable to policyholders and unallocated surplus of with-profits funds and unit-linked policies. Tax charges on this measure of profit reflect the tax charges attributable to shareholders. In determining the tax charges attributable to shareholders, the Group has applied a methodology consistent with that previously applied under UK GAAP reflecting the broad principles underlying the tax legislation of life assurance companies.
Property, plant and equipment All property, plant and equipment such as owner occupied property, computer equipment and furniture and fixtures, are carried at depreciated cost. Costs including expenditure directly attributable to the acquisition of the assets are capitalised. Depreciation is calculated and charged on a straight-line basis over an asset’s estimated useful life. The residual values and useful lives are reviewed at each statement of financial position date. If the carrying amount of an asset is greater than its recoverable amount then its carrying value is written down to that recoverable amount.
Leasehold improvements to owner occupied property are depreciated over the shorter of the economic life and the life of the lease. Assets held under finance leases are capitalised at their fair value.
Business acquisitions and disposals 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 costs of acquisition over the fair value of the assets and liabilities of the acquired entity is recorded as goodwill. Should the fair value of the identifiable assets and liabilities of the entity exceed the cost of
acquisition then this amount is recognised immediately in the income statement. Income and expenses of acquired entities are included in the income statement from the date of acquisition. Income and expenses of entities sold during the period are included in the income statement up to the date of disposal. The gain or loss on disposal is calculated as the difference between sale proceeds, net of selling costs, less the net assets of the entity at the date of disposal.
Cash and cash equivalents Cash and cash equivalents consist of cash at bank and in hand, deposits held at call with banks, treasury bills and other short-term highly liquid investments with less than 90 days maturity from the date of acquisition.
Notes on the Group financial statements > A: Background and accounting policies > continued
There are two exceptions to the basis described above for determining operating results based on longer-term investment returns. These are for: • Unit-linked and US variable annuity separate account business.
However, some types of business movements in liabilities do require bifurcation to ensure that at the net level (i.e. after allocated investment return and change for policyholder benefits) the operating result reflects longer-term market returns.
The overall purpose of these adjustments is to ensure that investment returns included in operating results equal longer-term returns but that in any one reporting period movements on liabilities to policyholders caused by investment returns are substantially matched in the presentation of the segmental analysis of profit before tax attributable to policyholders.
The effects of other changes to credit risk provisioning are included in the operating result, as is the net effect of changes to the valuation rate of interest applied to portfolio rebalancing to align more closely with management benchmark.
In accordance with IFRS 8, 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. Further details on the operating segments and their related performance measure are provided in note A4(c) in ‘Segments’.
Improvements to IFRSs (2008) The improvements issued by the IASB in May 2008 include amendments to a number of standards. The only amendment that has impacted the Group’s financial statements is the amendment to IAS 40, ‘Investment property’ (and consequential amendments to IAS 16, ‘Property, Plant and Equipment’) which now states that property that is under construction or development for future use as investment property is within the scope of IAS 40 and so should be measured at fair value where this is reliably measurable. Previously, these properties were within the scope of IAS 16 and were measured at cost.
The fair value adjustment of a gain of £21 million was recorded in the income statement but as the relevant properties were held by the PAC with-profits fund, the gain was absorbed by the liability for unallocated surplus and has no direct effect on the profit or loss attributable to shareholders or shareholders’ equity. There was no deferred tax impact on this fair value adjustment.
Revised IFRS 3, ‘Business Combinations’ and Amendments to IAS 27, ‘Consolidated and Separate Financial Statements’ The revised IFRS 3 and amended IAS 27 are the outcomes of the second phase of the IASB’s and the US Financial Accounting Standards Board’s (FASB) joint business combination project. The more significant changes from the revised IFRS 3 include: • The immediate expensing of acquisition-related costs rather than inclusion in goodwill; and • recognition and measurement at fair value of contingent consideration at acquisition date with subsequent changes to income.
Accounting pronouncements not yet endorsed by the EU The following accounting pronouncements potentially relevant to the Group have been issued but not yet endorsed for use in the EU.
These amendments are effective for Prudential’s 2010 financial statements. The Group is currently assessing the impact of these improvements to its financial statements.
Amendment to IFRS 2 – Group Cash-Settled Share-based Payment Transactions In June 2009, the IASB issued further amendments to IFRS 2 which sets out the accounting requirements for share-based payments. These amendments clarified existing guidance, in particular by specifying that an entity that receives goods or services in a share-based payment arrangement must account for those goods or services no matter which entity in the group settles the transaction and no matter whether the transaction is settled in shares or cash. The Group is still assessing the impact of the standard but it is not expected to have a material impact on the Group’s financial statements.
The standard is not mandatory before 2013 year-ends and is yet to be endorsed by the European Union. The Group is still assessing the full impact of this standard.
Notes on the Group financial statements > B: Summary of results
Other income and expenditure Investment return and other income 22 89
Short-term fluctuations in investment returns on shareholder-backed businessnote vi 36 (1,721)
Loss on sale and results for Taiwan agency businessnote iii (621) 1
ii Effect of changes to assumptions, estimates and bases of determining life assurance liabilities. The results of the Group’s long-term business operations are affected by changes to assumptions, estimates and bases of preparation. These are described in notes D2(h), D3(h) and D4(h).
iv Jackson operating results based on longer-term investment returns. IFRS basis operating profits 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.
Debt securities: Amortisation of interest related realised gains and losses 47 24 Risk margin reserve charge for longer-term credit related losses (see below) (60) (41)
The risk margin reserve (RMR) charge for longer-term credit related losses included in operating profit based on longer-term investment returns for 2009 is based on an average annual RMR of 27 basis points (2008: 23 basis points) on average book values for the year as shown below.
The longer-term rates of return for equity-type investments ranged from 6.7 per cent to 7.9 per cent for 2009 and 6.3 per cent to 8.4 per cent for 2008 depending on the type of investments. These rates are currently based on spreads over 10 year US treasury rates of 400 to 600 basis points.
Market value movements on equity-based derivatives and embedded derivatives are also recorded within operating profits based on longerterm investment returns so as to be consistent with the market related effects on fees and reserve movements for equity-based products. Market value movements on other derivatives are excluded from operating profit, and are included in short-term fluctuations in investment returns.
v UK operations transferred its general insurance business to Churchill in 2002, with general insurance commission representing the commission receivable net of expenses for Prudential-branded general insurance products as part of this arrangement.
Notes on the Group financial statements > B: Summary of results > continued vi Short-term fluctuations in investment returns on shareholder-backed business.
Asian insurance operations The fluctuations for Asian insurance operations in 2009 of a gain of £31 million primarily relate to strong market performance in Taiwan and Japan partially offset by the fall in the Vietnamese bond markets.
Interest related realised gains (losses): Arising in the year 125 (25) Less: amortisation gains and losses arising in current and prior years to operating profit based on longer-term investment returns (59) (28)
Total short-term fluctuations related to debt securities (414) (535) Derivatives (other than equity related): market value movements (net of related change to amortisation of deferred acquisition costs)† 385 (369) Equity type investments: actual less longer-term return (net of related change to amortisation of deferred acquisition costs) (59) (69) Other items (net of related change to amortisation of deferred acquisition costs)‡ 115 (85)
* The charges on debt securities of Jackson incurred in 2009 and 2008 of £631 million and £624 million, respectively comprise the following: Losses on sale of impaired and
Bond deteriorating Recoveries/ 2009 2008 Defaults write downs bonds reversals Total Total £m £m £m £m £m £m
Other bond write downs and defaults of £30 million relate to Piedmont securities. Piedmont is an investment vehicle investing in certain asset-backed and mortgage-backed securities in the US.
† The gain of £385 million (2008: charge of £369 million) value movement is for freestanding derivatives held to manage the fixed annuity and other general account business. Under IAS 39, unless hedge accounting is applied, value movements on derivatives are recognised in the income statement.
Other operations Short-term fluctuations of other operations, in addition to the previously discussed IGD hedge costs, arise from: £m £m
Unrealised value movements on swaps held centrally to manage Group assets and liabilities 28 (38) Unrealised value movements on Prudential Capital’s bond portfolio 66 (190) Unrealised value movements on investments held by other operations 11 (14) Sale of investment in India Mutual fund in May 2008 giving rise to a transfer to operating profit of £47 million for the crystallised gain, and value reduction in the year, prior to sale, of £24 million – (71)
Notes on the Group financial statements > B: Summary of results > continued vii Shareholders’ share of actuarial and other gains and losses on defined benefit pension schemes £m £m
Actuarial gains and losses Actual less expected return on scheme assets 23 (97) Experience gains on scheme liabilities 17 19 (Losses) gains on changes of assumptions for scheme liabilities (147) 71
For diluted earnings per share, the weighted average number of shares in issue is adjusted to assume conversion of all dilutive potential ordinary shares. The Group’s only class of dilutive potential ordinary shares are those share options granted to employees where the exercise price is less than the average market price of the Company’s ordinary shares during the year. No adjustment is made if the impact is anti-dilutive overall.
Shareholders’ share of actuarial and other gains and losses on defined benefit
Based on profit for the year 732 (55) (1) 676 27.0p 27.0p
Before tax Tax Minority minority earnings earnings B1 F5 interests interests per share per share £m £m £m £m Pence Pence
Shareholders’ share of actuarial and other gains and losses on defined benefit pension schemes (13) 3 – (10) (0.4)p (0.4)p
Shares under option at end of year 12 – Number of shares that would have been issued at fair value on assumed option exercise (7) –
Weighted average shares for calculation of diluted earnings per share 2,506 2,472
Parent company: Interim dividend (2009: 6.29p, 2008: 5.99p per share) 159 149
Final dividend for prior period (2009: 12.91p, 2008: 12.30p per share) 322 304
As a result of shares issued in lieu of dividends of £137 million (2008: £157 million), dividends paid in cash, as set out in the consolidated cash flow statement, were £344 million (2008: £297 million).
Parent company dividends relating to reporting period: Interim dividend (2009: 6.29p, 2008: 5.99p per share) 159 149
The movements for Asian and US operations reflect the application of year end exchange rates to the assets and liabilities and average exchange rates to the income statement on translation of these operations into the presentation currency of the Group. The movement unallocated to a segment mainly reflects the translation of currency borrowings and forward contracts which have been designated as a net investment hedge against the currency risk of the net investment in Jackson.
GIC – Medium Term Notes – 337 – – – 34
Notes on the Group financial statements > B: Summary of results > continued
Market translation gross and other 1 Jan 2008 inflows Redemptions movements 31 Dec 2008
ii Investment products referred to in the table for funds under management above are unit trust, mutual funds and similar types of retail fund management arrangements. These are unrelated to insurance products that are classified as ‘investment contracts’ under IFRS 4, as described in the preceding paragraph, although similar IFRS recognition and measurement principles apply to the acquisition costs and fees attaching to this type of business.
iii The tables above include new business for the Taiwan bank distribution operation. New business of the Taiwan Agency business, which was sold in June 2009 (as explained in note I1) is excluded from the tables. Comparative figures have been adjusted accordingly.
iv New business and market gross inflows and redemptions have been translated at the average exchange rate for the year applicable. Funds under management at points in time are translated at the exchange rate applicable at those dates.
Intangible assets attributable to with-profits funds: In respect of acquired subsidiaries for venture fund and other investment purposes 124 – – 124 – – – 124 Deferred acquisition costs and
Notes on the Group financial statements > B: Summary of results > continued 2009 £m
Liabilities Policyholder liabilities and unallocated surplus of with-profits funds: Investment contract liabilities with discretionary
Unallocated surplus of with-profits funds (reflecting application of ‘realistic’ basis provisions for UK
Obligations under funding, securities lending and sale and repurchase agreements 2,108 1,374 – 3,482 – – – 3,482 Net asset value attributable to unit holders of consolidated unit trusts and similar funds 2,534 47 818 3,399 410 – – 3,809
By operating segment D2 D3 D4 tions E2 tions) tions total
Other non-investment and non-cash assetsH3-H6 4,962 1,819 1,416 8,197 135 3,553 (5,608) 6,277
Notes on the Group financial statements > B: Summary of results > continued 2008 £m
Total policyholder liabilities and unallocated surplus of with-profits fundsnote d 115,961 45,361 21,069 182,391 – – – 182,391
Intangible assets attributable to shareholders: Deferred acquisition costs and other intangible assets – – 4,041 8 – – 4,049 5,349
Intangible assets attributable to with-profits funds: In respect of acquired subsidiaries for venture fund and other investment purposes 124 – – – – – 124 174
Deferred acquisition costs and other intangible assets 106 – – – – – 106 126
Other non-investment and non-cash assetsH3-H6 2,017 630 2,711 718 4,393 (5,044) 5,425 6,277
Financial investments: Equity securities and portfolio holdings in unit trusts 29,962 38,620 635 137 – – 69,354 62,122
Properties held for saleH9 – – 3 – – – 3 –
Unit- manage- to a linked ment segment Intra- 31 Dec 31 Dec
Partici- and Non- opera- (central group 2009 2008 pating variable linked tions opera- elimina- Group Group
By business type funds annuity business E2 tions) tions total total
(reflecting application of ‘realistic’ basis provisions for UK regulated with-profits funds)D2fii,H12 10,019 – – – – – 10,019 8,414
Borrowings attributable to with-profits operationsG1,H13 1,284 – – – – – 1,284 1,308
c Debt securities and loans i Information on the credit risks of debt securities
Notes on the Group financial statements > B: Summary of results > continued i UK insurance operations The UK insurance operations’ exposure to asset-backed securities at 31 December 2009 comprises: Shareholder-backed business (2009: 29% AAA, 24% AA) 2,044 1,075
All of the £2,044 million (2008: £1,075 million) exposure of the shareholder-backed business relates to the UK market, primarily to investments held by PRIL. £4,695 million of the £6,451 million (2008: £2,721 million of the £4,977 million) exposure of the with-profits operations relates to exposure to the UK market while the remaining £1,756 million (2008: £2,256 million) relates to exposure to the US market.
ii US insurance operations The US insurance operations’ exposure to asset-backed securities at 31 December 2009 comprises: RMBS*: Sub-prime (2009: 76% AAA, 1% AA) 194 291
CDO funds (2009: 29% AAA, 10% AA),† including £3 million exposure to sub-prime 79 320
iii Asian insurance operations The Asian insurance operations’ exposure to asset-backed securities is primarily held by the with-profits operations. The £378 million (2008: £328 million) asset-backed securities exposure of the Asian with-profits operations comprises: RMBS – all without sub-prime exposure – 46
The £378 million (2008: £328 million) includes £228 million (2008: £259 million) held by investment funds consolidated under IFRS in recognition of the control arrangements for those funds and includes an amount not owned by the Group with a corresponding liability of £61 million (2008: £32 million) on the statement of financial position for net asset value attributable to external unit-holders in respect of these funds, which are non-recourse to the Group. Of the £378 million, 72 per cent (2008: £328 million, 70 per cent) are investment graded by Standard & Poor’s.
CDO funds and other ABS 42 71 iii Loans Information on the credit quality of the portfolio of loans, which almost wholly is for amounts which are neither past due or impaired is shown in notes D2, D3, D4 and E2. Details of allowances for loans, losses and amounts past due are shown in notes G1 and G2. No additional analysis is provided of the element of loans and receivables that were neither past due nor impaired from those of the total portfolio on the grounds of the immateriality of the difference between the neither past due nor impaired element and the total portfolio.
Premiums, surrenders and maturities/deaths represent the amounts impacting policyholder liabilities and may not represent the total cash paid/received (for example, premiums are net of any deductions to cover acquisition costs).
Notes on the Group financial statements > C: Group risk management
As a provider of financial services, including insurance, the Group’s business is the managed acceptance of risk. The control procedures and systems established within the Group are designed to manage, rather than eliminate, the risk of failure to meet business objectives. They can only provide reasonable and not absolute assurance against material misstatement or loss, and focus on aligning the levels of risk-taking with the achievement of business objectives.
i Earnings volatility: The objectives of the limits are to ensure that (a) the volatility of earnings is consistent with stakeholder expectations, (b) the Group has adequate earnings (and cash flows) to service debt and expected dividends and (c) that earnings (and cash flows) are managed properly across geographies and are consistent with the Group’s funding strategies. The two measures used currently are European Embedded Value (EEV) operating profit based on longer-term investment returns and International Financial Reporting Standards (IFRS) operating profit based on longer-term investment returns. Additionally, EEV and IFRS total profits are also assessed.
ii Capital requirements: The objectives of the limits are to ensure that (a) the Group meets the internal economic capital requirements at all times, (b) the Group achieves its desired target rating to meet its business objectives and (c) supervisory intervention is avoided. The two measures used are EU Insurance Groups Directive (IGD) capital requirements and internal economic capital requirements. In addition we also monitor capital requirements on a local statutory basis.
For businesses that are most sensitive to equity price changes, Prudential uses stochastic modelling and scenario testing to look at the expected future returns on its investments under different scenarios that best reflect the large diversity in returns that equities can produce. This allows Prudential to devise an investment and with-profits policyholder bonus strategy that, on the model assumptions, allows it to optimise returns to its policyholders and shareholders over time, while maintaining appropriate financial strength. Prudential uses this method extensively in connection with its UK with-profits business.
The Group publishes separately within ‘Additional Information’ of its Group Annual Report a section on key risk factors, which discusses inherent risks in the business and trading environment.
Notes on the Group financial statements > C: Group risk management > continued
Approximately 77 per cent of the Group’s IFRS basis shareholders’ equity at 31 December 2009 arose in Prudential’s US and Asian operations (2008: approximately 83 per cent). To mitigate the exposure of the US component there are US$1.55 billion of borrowings held centrally, which are formally designated as net investment hedges at 31 December 2009. Net of the currency position arising from these borrowings some 52 per cent of the Group’s shareholders’ funds are represented by net assets in currencies other than sterling.
ii Credit risk Credit risk is the risk of loss to the Group if another party fails to perform its obligations, or fails to perform them in a timely manner. Credit risk is the Group’s most significant financial risk.
v Non-financial risks – operational, business environment and strategic risk Operational risk is the risk of direct or indirect loss resulting from inadequate or failed internal processes, people, systems or from external events. Business environment risk may arise from exposure to forces in the external environment that could significantly change the fundamentals that drive the business’ overall objectives and strategy. Strategic risk may arise from ineffective, inefficient or inadequate senior management processes for the development and implementation of business strategy in relation to the business environment and the Group’s capabilities.
The Group uses the qualitative and quantitative analysis of operational risk exposures material to the Group to support business decisions, to inform overall levels of capital held and to assess the adequacy of the corporate insurance programme.
In addition, the Group as a whole is subject to the capital adequacy requirements of the Insurance Groups Directive (IGD) as implemented by the FSA. The IGD pertains to groups whose activities are primarily concentrated in the insurance sector. Under this test the surplus capital held in each of the regulated subsidiaries is aggregated with the free assets of non-regulated subsidiaries. From this total Group borrowings are deducted, other than subordinated debt issues which qualify as capital. No credit for the benefit of diversification is allowed for under this approach. The test is passed when this aggregate number is positive: a negative result at any point in time is a notifiable breach of UK regulatory requirements.
At 31 December 2008, Prudential met the requirements of the IGD with £1.5 billion of surplus capital before allowing for the 2008 final dividend. In addition, during 2009, Prudential met the requirements of the FSA under the IGD. The IGD position as at 31 December 2009 will be submitted to the FSA by 30 April 2010 and at the time of preparation of these financial statements the surplus capital under the test was estimated to be around £3.4 billion before allowing for the 2009 final dividend giving a solvency ratio of circa 270 per cent. The main components of the increase in IGD surplus during 2009 are: • net capital generation mainly through operating earnings (in-force releases less investment in new business) of £1.1 billion; • the sale of the Taiwan agency business (increasing IGD surplus by £0.8 billion); • the hybrid debt issues in May and July (increasing IGD surplus by £0.9 billion); • an additional recognition of £0.4 billion in respect of part of the shareholders’ interest in the future transfers from the PAC with-profits fund, recognition of £0.2 billion of future profits in the UK and Hong Kong and other intra-group capital efficiencies of £0.3 billion; • offset by dividend payments, external financing costs and other central costs, credit related impacts in the US, impacts from regulatory changes and foreign exchange movements.
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 withprofits 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.
– non-participating term, whole life, and unit-linked policies, together with accident and health policies.
Deferred income reserves These are required to be established under IAS 18 with amortisation over the expected life of the contract. The majority of the relevant UK contracts are single premium with the initial deferred income reflecting the ‘front-end load’ i.e. the difference between the premium paid and the amount credited to the unit fund. Deferred income is amortised to the income statement in line with service provision. The amortisation profile is either on a straight-line basis or, if more appropriate, a further deferral of income recognition is applied.
b Concentration of risk i Business accepted The Group’s exposure to life assurance risks is well diversified. This is achieved through the geographical spread of the Group’s operations and, within those operations, through a broad mix of product types.
Credit risk remains one of the largest risk exposures. This reflects the relative size of exposure in Jackson and the UK shareholder annuities business. The Group manages concentration of credit risks by setting limits on the maximum exposure to each counterparty based on their credit ratings.
d Sensitivity of EEV basis profit and equity for market and other risks The Group prepares supplementary EEV basis financial statements for half yearly and annual publication. These statements include sensitivity disclosures which are part of the market risk information provided to key management. The 2009 EEV sensitivity disclosures are shown in note 15 of the EEV basis supplementary information in this Annual Report.
e Sensitivity of IFRS basis profit or loss and equity to market and other risks i Overview of risks by business unit The financial 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 profit or loss and equity.
Policyholder liabilities relating to the Group’s life assurance businesses are also sensitive to the effects of other changes in experience, or expected future experience, such as for mortality, other insurance risk and lapse risk.
In addition, the profitability of the Group’s life assurance businesses and, as described in Section E, asset management business, is indirectly affected by the performance of the assets covering policyholder liabilities and related capital.
(including Prudential (Indirect exposure only) subject to smoothing future shareholder Annuities Limited) through declared bonuses transfers
Unit-linked business Net neutral direct exposure Investment performance Persistency risk (Indirect exposure only) through asset management fees
Interest rate risk for assets longevity in excess of liabilities i.e. representing shareholder capital
US insurance operations (see also section D3(i)) All business Currency risk Persistency risk
GIC business and rate credited to events are mitigated policyholders by the use of swaption contracts
These risks are reflected in volatile profit or loss and shareholders’ equity for derivative value movements and impairment losses, and, in addition, for shareholders’
equity for value movements on fixed income securities classified as ‘available for sale’ under IAS 39
Unit-linked business Net neutral direct exposure Investment performance (Indirect exposure only) through asset management fees
For Jackson at the level of operating profit based on longer-term investment returns, the results are sensitive to market conditions to the extent of income earned on spread-based products and equity-based exposure not mitigated by the equity and interest derivative programmes. Further information is given below under the US operations section of market and credit risk.
Jackson’s derivative programme is used to substantially mitigate equity market risk attaching to its equity-based products and interest rate risk associated with its spread-based products. Movements in 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 of fixed annuity and other general account business. Combined with the use of US GAAP measurement (as grandfathered under IFRS 4) for the asset and liabilities for the insurance contract liabilities, which is largely insensitive to current period market movements, the Jackson total profit (i.e. including short-term fluctuations in investment returns) is very sensitive to market movements. In addition to these effects the Jackson IFRS equity is sensitive to the impact of interest rate and credit spread movements on the value of fixed income securities. Movements in unrealised appreciation on these securities are included as movement in equity (i.e. outside the income statement).
At the total IFRS profit level the Asian result is affected by short-term value movements on the asset portfolio for non-linked shareholder-backed business.
The shareholder results of the UK with-profits fund correspond to the shareholders’ share of the cost of bonuses declared on the with-profits business. This currently corresponds to one-ninth of the cost of bonuses declared.
• Prudential Annuities Limited (PAL) PAL’s business is not with-profits, it writes annuity business. However, as PAL is owned by the PAC with-profits sub-fund, changes in the carrying value of PAL’s assets and liabilities are reflected in the liability for unallocated surplus which as described above, do not affect shareholder results.
These differences in carrying value of debt securities, other invested assets, derivatives and insurance liabilities give rise to potentially significant volatility in the IFRS income statement and shareholders’ equity. As with other shareholder-backed business the profit or loss for Jackson is presented in the Group’s segmental analysis of profit as described in note B1, by distinguishing the result for the year between an operating result based on longer-term investment returns and short-term fluctuations in investment returns. In this way the most significant direct effect of market changes that have taken place to the Jackson result are separately identified.
In addition, the total profit for Jackson is affected by the level of impairment losses on the debt securities portfolios, short-term value movements on derivatives held to manage the fixed annuity and other general account business, other temporary value movements on portfolio investments classified as fair value through profit and loss, and those arising on revaluing the embedded derivative components of variable annuity liabilities for the effects of short-term movements in AA corporate bond rate curves and equity volatility levels.
Asian insurance operations For Asian with-profits business the same features apply as described above for UK with-profits business. Similarly, as for other parts of the Group, for unit-linked business the main factor affecting IFRS basis results is investment performance through asset management fees.
By contrast, Group IFRS operating profit is particularly sensitive to longevity outlook that results in changes of assumption for the UK shareholder-backed annuity business.
In Asia adverse persistency experience can impact the IFRS profitability of certain business written in the region. This risk is managed at a business unit level through monthly monitoring of experience and the implementation of management actions as necessary. These actions could include product enhancements, increased management focus on premium collection as well as other customer retention efforts. The potential financial impact of lapses is often mitigated through the specific features of the products, e.g. surrender charges.
Correlation across risk factors • Longevity risk • Expenses • Persistency • Other risks.
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 reflect the actuarially determined best estimate of the likely incidence of these factors on contract duration. Details are shown in sections D2(j), D3(j) and D4(j).
Assets Intangible assets attributable to shareholders: Deferred acquisition costs and other intangible assets – – – – – 127 127 127 134
Investments of long-term business and other operations: Investments accounted for using the equity method – – – – – 4 4 4 –
Liabilities Policyholder liabilities and unallocated surplus of with-profits funds: Contract liabilities
Derivative assets*note G3 910 1,326 Partnerships in investment pools and other† 2,720 2,834 *In the UK, Prudential uses derivatives to reduce equity and credit risk, interest rate and currency exposures, and to facilitate efficient portfolio management. After derivative liabilities of £709 million (2008: £3,401 million), which are also included in the statement of financial position, the overall derivative position was a net asset of £201 million (2008: net liability of £2,075 million).
Assumption changes (shareholder-backed business)note D2h note c – – 447 447
Notes a Net cash flows of negative £4,343 million have increased from negative £3,233 million in 2008, principally as a result of a decrease in premiums following the decision to limit bulk annuity transactions in the period.
b Investment-related items and other movements of £14,118 million across fund types reflected the strong performance of UK equity markets in 2009, as well as the increase in value of debt securities and the reversal of unrealised losses on property investments recorded in 2008. c Assumption changes principally represent the net impact of changes to the deflation reserve, expense assumptions and modelling changes.
As detailed in note D2(i) below, the primary sensitivity of IFRS basis profit or loss and shareholders’ equity relates to non-linked shareholder-backed business which covers ‘PRIL’ and ‘other annuity and long-term business’ in the table above.
d Products and guarantees Prudential’s long-term products in the UK consist of life insurance, pension products and pension annuities.
i With-profits products and PAC with-profits sub-fund Within the statement of financial position of UK insurance operations at 31 December 2009, as shown in note D2(a), there are policyholder liabilities and unallocated surplus of £77.5 billion (2008: £72.1 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-profits business but it also contains some non-profit business (unit-linked, term assurances and annuities). The WPSF’s profits 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.
When target bonus levels change the PAC Board has regard to the overall strength of the long-term fund when determining the length of time over which it will seek to achieve the amended prudent target bonus level.
In normal investment conditions, PAC expects changes in regular bonus rates to be gradual over time, and these are not expected to exceed one per cent per annum over any year. 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.
The rates of final bonus usually vary by type of policy and by reference to the period, usually a year, in which the policy commences or each premium is paid. These rates are determined by reference to the asset shares for the sample policies but subject to the smoothing approach, explained below.
Application of significant judgement The application of the above method for determining bonuses requires the PAC board of directors to apply significant judgement in many respects, including in particular the following: • Determining what constitutes fair treatment of customers: Prudential is required by UK law and regulation to consider the fair treatment of its customers in setting bonus levels. The concept of determining what constitutes fair treatment, while established by statute, is not defined.
Key assumptions As noted above, the overall rate of return on investments and the expectation of future investment returns are the most important influences in bonus rates, subject to the smoothing described below. Prudential determines the assumptions to apply in respect of these factors, including the effects of reasonably likely changes in key assumptions, in the context of the overarching discretionary and smoothing framework that applies to its with-profits business as described above. As such, it is not possible to specifically quantify the effects of each of these assumptions or of reasonably likely changes in these assumptions.
The degree of smoothing is illustrated numerically by comparing in the following table the relatively ‘smoothed’ level of policyholder bonuses declared as part of the surplus for distribution with the more volatile movement in investment return and other items of income and expenditure of the UK component of the PAC with-profits fund for each year presented.
Add back policyholder bonuses for the year (as shown below) 1,827 2,565
Net income of the fund before movement in unallocated surplus 3,922 (1,920)
Surplus for distribution allocated as follows: – 90% policyholders bonus (as shown above) 1,827 2,565
Prudential’s with-profits annuities, which are written in the WPSF, combine the income features of annuity products with the investment smoothing features of with-profits 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 an ‘anticipated bonus’ from the specific range Prudential offers for the particular product. The amount of the annuity payment each year depends upon the relationship between the anticipated bonus rate selected by the policyholder when the product is purchased and the 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 2009, £32.3 billion (2008: £29.4 billion) of investments relate to annuity business of PAL and PRIL. These investments are predominantly in debt securities (including retail price index-linked bonds to match retail price index-linked annuities), loans and deposits and are duration matched with the estimated duration of the liabilities they support.
iv Unit-linked (non-annuity) and other non-profit business Prudential UK insurance operations also have an extensive book of unit-linked policies of varying types and provide a range of other non-profit business such as credit life and protection contracts. These contracts do not contain significant financial guarantees.
Notes on the Group financial statements > D: Life assurance businesses > continued f Process for setting assumptions and determining contract liabilities i Overview The calculation of the contract liabilities involves the setting of assumptions for future experience. This is done following detailed review of the relevant experience including, in particular, mortality, expenses, tax, economic assumptions and where applicable, persistency.
From 1 January 2008, when the previous tariff arrangement terminated, the actual renewal expenses incurred on behalf of SAIF by other Group companies are recharged in full to SAIF.
The provisions have been determined on a basis consistent with the detailed methodology included in regulations contained in the FSA’s rules for the determination of reserves on the FSA’s ‘realistic’ Peak 2 basis. In aggregate, the regime has the effect of placing a value on the liabilities of UK with-profits contracts, which reflects the amounts expected to be paid based on the current value of investments held by the with-profits funds and current circumstances. These contracts are a combination of insurance and investment contracts with discretionary participation features, as defined by IFRS 4.
The cost of guarantees, options and smoothing is very sensitive to the bonus, market value reduction (MVR), and investment policy employed and therefore the stochastic modelling incorporates a range of management actions that would help to protect the fund in adverse investment scenarios. Substantial flexibility has been included in the modelled management actions in order to reflect the discretion that is retained in adverse investment conditions, thereby avoiding the creation of unreasonable minimum capital requirements. The management actions assumed are consistent with the Group’s management policy for with-profits funds and the Group’s disclosures in the publicly available PPFM.
The additional yield received on corporate bonds relative to swaps can be broken into the following constituent parts: • the expected level of future defaults; • the credit risk premium that is required to compensate for the potential volatility in default levels; and • the liquidity premium that is required to compensate for the lower liquidity of corporate bonds relative to swaps.
Given that the normal business model for Prudential’s annuity business is to hold bonds to match long-term liabilities, the valuation rate that is applied to discount the future annuity payments includes a liquidity premium that reflects the residual element of current bond spreads over swap rates after providing for the credit risk.
Historically, until the second half of 2007, when corporate bond spreads widened significantly, the allowance for credit risk was calculated as the long-term expected defaults and a long-term credit risk premium. This long-term credit risk was supplemented by a short-term allowance from 31 December 2007 to allow for the concern that credit ratings applied by the rating agencies may be downgraded and defaults in the short-term might be higher than the long-term assumptions.
iii The long-term credit risk premium, provides compensation against the risk of potential volatility in the level of defaults and is derived by applying the 95th percentile from Moody’s data from 1970 to 2004 to the annuity asset portfolio.
b Asset trading in relation to subordinated financial debt During the second half of 2009, the Group decided to trade out of subordinated financial debt into higher quality assets. This resulted in a gross transaction loss arising from the lower expected yield on the newly purchased assets. The reduction in subordinated financial debt holdings improved the overall credit quality of the corporate bond portfolio and so allowed a release of long-term credit reserves to offset this loss. In addition the allowance for the short-term defaults above has been notionally allocated to the highest yielding assets and so the allowance attaching to the subordinated debt sold has also been released.
In payment 102% – 126% PNMA00 84% – 117% PNFA00 96% – 102% PNMA00 87% – 98% PNFA00
cohort improvement of medium cohort cohort improvement of medium cohort table with a minimum improvement table table with a minimum improvement table annual improvement with a minimum annual annual improvement with a minimum annual of 2.25% up to age 90, improvement of 1.25% of 2.25% up to age 90, improvement of 1.25%
tapering to zero at up to age 90, tapering tapering to zero at up to age 90, tapering age 120 to zero at age 120 age 120 to zero at age 120
In deferment AM92 minus 4 years AF92 minus 4 years AM92 minus 4 years AF92 minus 4 years iv Unit-linked (non-annuity) and other non-profit 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 reflects 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 profile.
h Effect of changes in assumptions used to measure insurance assets and liabilities
Aggregate effect of assumptions changes For UK insurance operations, the effects of assumptions changes for 2009 were as follows: 2009 £m
Notes a Charges and expenses of the with-profits sub-fund have been updated to reflect the experience in 2009. The changes vary by product and the overall impact is a £51 million credit.
Credit risk In total, for 2008, the effect of changes to the allowance for credit risk and the effect of portfolio rebalancing gave rise to a charge of £23 million. For shareholder-backed annuity and lifetime mortgage business, the operating profit based on longer-term investment returns included a charge of £413 million for the additional credit risk allowance for the annuity portfolio as a whole. Partially offsetting this was £390 million for the impact of £2.8 billion of portfolio rebalancing to more closely align management benchmark. The credit reflecting the additional yield expected after allowing for additional credit risk arising from the rebalancing.
Notes on the Group financial statements > D: Life assurance businesses > continued
Aggregate effect of assumptions changes For UK insurance operations, the effects of assumptions changes for 2008 were as follows: 2008 £m
Notes a The £421 million credit for modelling of management actions relates primarily to enhancements for actions in the event of solvency distress scenarios. b Net of additional credit risk allowance attaching to effect of portfolio balancing described above. c In 2008, no changes to mortality assumptions were made or necessary.
ii Shareholder-backed annuity business Profits from shareholder-backed annuity business are most sensitive to: • The extent to which the duration of the assets held closely matches the expected duration of the liabilities under the contracts. Assuming close matching, the impact of short-term asset value movements as a result of interest rate movements will broadly offset changes in the value of liabilities caused by movements in valuation rates of interest; • actual versus expected default rates on assets held; • the difference between long-term rates of return on corporate bonds and risk-free rates; • the variance between actual and expected mortality experience; • the extent to which expected future mortality experience gives rise to changes in the measurement of liabilities; and • changes in renewal expense levels.
Profits from unit-linked and similar contracts primarily arise from the excess of charges to policyholders, for management of assets under the Company’s stewardship, over expenses incurred. The former is most sensitive to the net accretion of funds under management as a function of new business and lapse and timing of death. The accounting impact of the latter is dependent upon the amortisation of acquisition costs in line with the emergence of margins (for insurance contracts) and amortisation in line with service provision (for the investment management component of investment contracts). By virtue of the design features of most of the contracts which provide low levels of mortality cover, the profits are relatively insensitive to changes in mortality experience.
A decrease A decrease An increase An increase A decrease A decrease An increase An increase of 2% of 1% of 1% of 2% of 2% of 1% of 1% of 2%
In addition the shareholder-backed portfolio of UK non-linked insurance operations covering liabilities and shareholders’ equity includes equity securities and investment property. Excluding any second order effects on the measurement of the liabilities for future cash flows to the policyholder, a fall in their value would have given rise to the following effects on pre-tax profit, profit after tax, and shareholders’ equity.
A decrease A decrease A decrease A decrease A decrease of 20% of 10% of 40% of 20% of 10%
Net sensitivity of profit after tax and shareholders’ equity (210) (105) (366) (183) (92)
Fair value (as included in statement of financial position) 15,414 6,577
Included within the movement in gross unrealised losses for the debt securities of Jackson of £1,925 million (2008: £1,997 million) as shown above was a value reduction of £72 million (2008: £105 million) relating to the sub-prime and Alt-A securities as referred to in section B6.
ii Statement of financial position Variable annuity Fixed US insurance operations separate account annuity, GIC
Investments of long-term business and other operations: Financial investments: Equity securities and portfolio holdings in unit trusts 20,639 345 20,984 15,142
Contract liabilities (including amounts in respect of contracts classified as investment contracts under IFRS 4) 20,639 27,672 48,311 45,361
The loans of the Group’s US insurance operations of £4,319 million (2008: £5,121 million) comprise mortgage loans of £3,774 million (2008: £4,534 million), policy loans of £530 million (2008: £587 million) and other loans of £15 million (2008: £nil). All of the mortgage loans are commercial mortgage loans which are collateralised by properties. The property types are mainly industrial, multi-family residential, suburban office, retail and hotel. The breakdown by property type is as follows: Multi-family residential 18 21
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 (2008: £7.5 million). The portfolio has a current estimated average loan to value of 74 per cent (2008: 73 per cent) which provides significant cushion to withstand substantial declines in value.
The policy loans are fully secured by individual life insurance policies or annuity policies. These loans are accounted for at amortised cost, less any impairment.
Derivative assetsnote G3* 519 675 Partnerships in investment pools and other† 436 581 *In the US, Prudential uses derivatives to reduce interest rate risk, to facilitate efficient portfolio management to match liabilities under annuity policies, and for certain equity-based product management activities. After taking account of the derivative liability of £461 million (2008: £863 million), which is also included in the statement of financial position, the derivative position for US operations is a net asset of £58 million (2008: net liability of £188 million).
† Partnerships in investment pools and other comprise primarily investments in limited partnerships. These include interest in the PPM America Private Equity Fund and diversified investments in 159 (2008: 157) other partnerships by independent money managers that generally invest in various equities and fixed income loans and securities.
b Reconciliation of movement in policyholder liabilities A reconciliation of the total policyholder liabilities of US insurance operations from the beginning of the year to the end of the year is as follows: Variable annuity separate Fixed annuity, US insurance account GIC and other operations liabilities business Total £m £m £m
Net cash flowsnote b 3,586 1,603 5,189 Transfers from general to separate account 984 (984) – Investment-related items and other movementsnote c 3,368 (382) 2,986 Foreign exchange translation differencesnote a (1,837) (3,388) (5,225)
Notes a Movements in the year have been translated at an average rate of 1.57 (full year 2008: 1.85). The closing balance has been translated at closing rate of 1.61 (full year 2008: 1.44). Differences upon retranslation are included in foreign exchange translation differences of £5,225 million. b Net cash flows for the year were £5,189 million compared with £2,312 million in 2008, driven largely by increased new business volumes for the variable annuity business.
c Positive investment-related items and other movements in variable annuity separate account liabilities were impacted by the recovery of
US equity markets during 2009. Negative movements in fixed annuity, GIC and other business of £382 million primarily represents a reduction in the liabilities for variable annuity guarantees following improvements in equity markets and increases in interest rates offset by interest credited to policyholder accounts.
Corporate security and commercial loans: Publicly traded and SEC Rule 144A traded 13,338 13,198
In the table above, with the exception of residential mortgage-backed securities for 2009, S&P ratings have been used where available. For securities where S&P ratings are not immediately available, those produced by Moody’s and then Fitch have been used as an alternative.
During 2009, the National Association of Insurance Commissioners (NAIC) in the US revised the regulatory ratings process for more than 20,000 residential mortgage-backed securities. The table above includes these securities, where held by Jackson, using the regulatory rating levels established by an external third party (PIMCO).
In 2008, due to inactive and illiquid markets, beginning at the end of the third quarter of 2008 the external prices obtained for certain asset-backed securities were deemed not to reflect fair value in the dislocated market conditions at that time. For the valuations at 31 December 2008, Jackson had therefore utilised internal valuation models, provided by PPM America, as best estimate of fair values of all non-agency Residential Mortgage-backed Securities (RMBS) and Asset-backed Securities (ABS) and certain Commercial Mortgage-backed Securities (CMBS).
During 2009, improvements were observed in the level of liquidity for these sectors of structured securities and this increased liquidity in the markets for certain tranches of non-agency RMBS and ABS resulted in Jackson being able to rely on external prices for the securities as the most appropriate measure of fair value.
CDO funds (31 Dec 2009: 29% AAA, 10% AA)*, including £3 million exposure to sub-prime 79 320
Jackson defines its exposure to sub-prime mortgages as investments in residential mortgage-backed securities in which the underlying borrowers have a US Fair Isaac Credit Organisation (FICO) credit score of 680 or lower.
The following table shows the fair value of the debt securities in a gross unrealised loss position for various percentages of book value at 31 December: Fair Unrealised Fair Unrealised Fair value of securities as a percentage of book value value loss value loss
Included within the table above are amounts relating to sub-prime and Alt–A securities of: Fair Unrealised Fair Unrealised Fair value of securities as a percentage of book value value loss value loss
i Fixed annuities Interest-sensitive annuities At 31 December 2009, interest-sensitive fixed annuities accounted for 24 per cent (2008: 29 per cent) of policy and contract liabilities of Jackson. Interest-sensitive fixed annuities are primarily deferred annuity products that are used for retirement planning and for providing income in retirement. They permit tax-deferred accumulation of funds and flexible payout options.
Approximately 61 per cent (2008: 34 per cent) of the interest-sensitive fixed annuities Jackson wrote in 2009 provide for a market value adjustment, that could be positive or negative, on surrenders in the surrender period of the policy. This formula-based adjustment approximates the change in value that assets supporting the product would realise as interest rates move up or down. The minimum guaranteed rate is not affected by this adjustment.
Jackson hedges the equity return risk on fixed indexed products using futures and options linked to the relevant index. The cost of these hedges is taken into account in setting the index participation rates or caps. Jackson bears the investment and surrender risk on these products.
iii Life insurance Jackson’s life insurance products accounted for nine per cent (2008: 10 per cent) of Jackson’s policy and contract liabilities at 31 December 2009. The products offered include variable universal life insurance, term life insurance and interest-sensitive life insurance.
iv 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 2009, institutional products accounted for six per cent of policy and contract liabilities (2008: 12 per cent). Under a traditional GIC, the policyholder makes a lump sum deposit. The interest rate paid is fixed and established when the contract is issued. If deposited funds are withdrawn earlier than the specified 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 specified periodic deposits. Jackson agrees to pay a rate of interest, which may be fixed but which is usually a floating short-term interest rate linked to an external index. The average term of the funding arrangements is one to two years. Funding agreements terminable by the policyholder with less than 90 days’ notice account for less than one per cent (2008: one per cent) of total policyholder reserves.
Value movements on the derivatives are reported within the income statement. In preparing Jackson’s segment profit as shown in note B1, value movements on Jackson’s derivative contracts, other than for certain equity-based product management activities, are included within short-term fluctuations in investment returns and excluded from operating results based on longer-term investment returns (defined as segment profit). Value movements on derivative instruments used for certain equity-based product management activities, based on a static long-term volatility assumption and, for embedded liabilities, average Corporate AA interest rates, are included within operating results based on longer-term investment returns, as the value movements broadly offset the economic impact of changed levels of benefit payments and reserves as equity markets fluctuate, (subject to some limitations for GMDB where US GAAP does not fully reflect the economic features being hedged). Any differences in value movements on these derivatives between the static long-term volatility assumption and implied volatility or average Corporate AA interest rates and ending Corporate AA interest rates are reflected as components of short-term fluctuations. The types of derivatives used by Jackson and their purpose are as follows: D F
• interest rate swaps generally involve the exchange of fixed and floating payments over the period for which Jackson holds the instrument without an exchange of the underlying principal amount. These agreements are used for hedging purposes; • put-swaption contracts provide the purchaser with the right, but not the obligation, to require the writer to pay the present value of a long-duration interest rate swap at future exercise dates. Jackson purchases and writes put-swaptions with maturities up to 10 years. On a net basis, put-swaptions hedge against significant upward movements in interest rates; • equity index futures contracts and equity index call and put options are used to hedge Jackson’s obligations associated with its issuance of fixed indexed immediate and deferred annuities and certain VA guarantees. These annuities and guarantees contain embedded options which are fair valued for financial reporting purposes; • total return swaps in which Jackson receives equity returns or returns based on reference pools of assets in exchange for short-term floating rate payments based on notional amounts, are held for both hedging and investment purposes; • cross-currency swaps, which embody spot and forward currency swaps and additionally, in some cases, interest rate swaps and equity index swaps, are entered into for the purpose of hedging Jackson’s foreign currency denominated funding agreements supporting trust instrument obligations; • spread cap options are used as a macro-economic hedge against declining interest rates. Jackson receives quarterly settlements based on the spread between the two-year and the 10 year constant maturity swap rates in excess of a specified spread; and
Capitalised acquisition costs and deferred income for these contracts are amortised over the life of the book of contracts. The present value of the estimated gross profits is generally computed using the rate of interest that accrues to policyholder balances (sometimes referred to as the contract rate). Estimated gross profits include estimates of the following elements, each of which will be determined based on the best estimate of amounts of the following individual elements over the life of the book of contracts without provision for adverse deviation for: • amounts expected to be assessed for mortality less benefit claims in excess of related policyholder balances; • amounts expected to be assessed for contract administration less costs incurred for contract administration; • amounts expected to be earned from the investment of policyholder balances less interest credited to policyholder balances; • amounts expected to be assessed against policyholder balances upon termination of contracts (sometimes referred to as surrender charges); and • other expected assessments and credits.
g Reinsurance The principal reinsurance ceded by Jackson outside the Group is on term life insurance, direct and assumed accident and health business and GMIB variable annuity guarantees. In 2009, the premiums for such ceded business amounted to £82 million (2008: £68 million). Net commissions received on ceded business and claims incurred ceded to external reinsurers totalled £12 million and £66 million respectively, during 2009 (2008: £10 million and £49 million respectively). There were no deferred gains or losses on reinsurance contracts in either 2009 or 2008. The reinsurance asset for business ceded outside the Group was £667 million (2008: £800 million).
The mean reversion methodology is applied with the objective of adjusting the amortisation of deferred acquisition costs that would otherwise be highly volatile for the fact that the expected level of future gross profits fluctuates for altered variable annuity asset values arising from changes in equity market levels at the end of each reporting period.
The mean reversion methodology achieves this objective by dynamic adjustment to the level of expectations of short-term future investment returns. Under the methodology the projected returns for the next five years are, for the purposes of determining the amortisation profile, set so that normally combined with the actual returns for the current and preceding two years the average rate of return is 8.4 per cent. The mean reversion methodology does, however, include a cap of 15 per cent per annum on the projected return for each of the next five years. Projected returns after the next five years are set at 8.4 per cent. For 2008 following the fall in equity markets in that year, this capping effect applied to restrict the projected returns below the rate of approximately 20 per cent per annum level that would have otherwise applied to the first five years. Although equity markets rose during the year, the return in 2008 was such that the cap remains in place at 31 December 2009, albeit at a lower level.
The DAC amortisation reflected in the 2008 results, after incorporating the mean reversion, increased by some £140 million, of which £40 million arises due to the capping feature. In 2009, following improvements in equity markets, no such DAC acceleration arose during the period and DAC amortisation fell accordingly.
Statement of changes in equity – ‘shadow DAC adjustments’ Consequent upon the positive unrealised valuation movement in 2009 of £2,669 million (2008: negative £2,104 million) there is a debit of £1,069 million (2008: £831 million credit) for altered ‘shadow’ amortisation booked within other comprehensive income. These adjustments reflect movement from period to period, in the changes to the pattern of reported gross profits that would have happened if the assets had been sold, crystallising the gain or loss, and the proceeds reinvested at the yields currently available in the market. At 31 December 2009 the cumulative ‘shadow DAC balance’ was negative £10 million (2008: positive £1,192 million).
Profit (loss) before tax attributable to shareholders note i (44) 59 54 (72)
ii Other sensitivities The principal determinants of variations in operating profit based on longer-term returns are: • growth in the size of assets under management covering the liabilities for the contracts in force; • variations in fees and other income, offset by variations in market value adjustment payments and, where necessary, strengthening of liabilities; • incidence of guarantees and the effectiveness of the related hedge programme; • spread returns for the difference between investment returns and rates credited to policyholders; For the purpose of determining longer-term returns, adjustment is necessary for the normalisation of investment returns to remove the effects of short-term volatility in investment returns.
At 31 December 2009 based on the hedges in place at that time, it is estimated that an immediate decrease in the equity markets of 10 per cent would result in an accounting benefit, net of related DAC amortisation, before tax of up to £60 million, excluding the impact on future separate account fees. After related deferred tax there would have been an estimated increase in shareholders’ equity at 31 December 2009 of up to £40 million. An immediate decrease in the equity markets of 20 per cent is estimated to result in an accounting benefit, net of related DAC amortisation, before tax of up to £110 million, excluding the impact on future separate account fees. After related deferred tax there would have been an estimated increase in shareholders’ equity at 31 December 2009 of up to £80 million. An immediate increase in the equity markets of 10 and 20 per cent is estimated to result in an approximately equal and opposite estimated effect on profit and shareholders’ equity as that disclosed above for a decrease.
At 31 December 2008, based on the hedges in place at that time, it was estimated that an immediate decrease in the equity markets at 10 per cent would result in an accounting charge, net of related DAC amortisation, before tax of up to £20 million, excluding the impact on future separate account fees. After related deferred tax, it was estimated that there would have been a decrease in shareholders’ equity of up to £15 million. An immediate decrease in the equity markets of 20 and 40 per cent was estimated to result in an accounting charge, net of related DAC amortisation, before tax of up to £40 million and £90 million respectively excluding the impact of future separate account fees. After related deferred tax there would have been an estimated reduction in shareholders’ equity at 31 December 2008 of up to £30 million and £60 million respectively. The difference in the effects of a decrease in the equity markets at 31 December 2009 as compared to 2008 was due to a high number of GMDB and GMWB guarantees being ‘in the money’ at 31 December 2008. As a result, the adverse effects on provisions for policyholder liabilities from a decreasing equity market at 31 December 2008 more than offset the benefits from the hedging instruments held at that time.
In addition, Jackson is also exposed to equity risk from its holding of equity securities, partnerships in investment pools and other financial derivatives. A range of reasonably possible movements in the value of equity securities, partnerships in investment pools and other financial derivatives have been applied to Jackson’s holdings at 31 December 2009 and 31 December 2008. The table below shows the sensitivity to a 10 and 20 per cent (2008: 10, 20 and 40 per cent) fall in value and the impact that this would have on pre-tax profit, net of related changes in amortisation of DAC, profit after tax and shareholders’ equity.
Pre-tax profit, net of related changes in amortisation of DAC (117) (58) (255) (141) (98)
A 2% A 1% A 1% A 2% A 2% A 1% A 1% A 2% decrease decrease increase increase decrease decrease increase increase
Related effect on amortisation of DAC 364 162 (156) (328) 498 215 (193) (395)
Direct effect on carrying value of debt securities 2,183 1,179 (1,179) (2,183) 2,476 1,238 (1,238) (2,476)
Related effect on amortisation of DAC (764) (413) 413 764 (619) (310) 310 619
j Duration of liabilities The table below shows the carrying value of policyholder liabilities. Separately, the Group uses cash flow projections of expected benefit payments as part of the determination of the value of in-force business when preparing EEV basis results. The table below also shows the maturity profile of the cash flows used for that purpose for 2009 and 2008: Fixed Fixed annuity annuity and other and other business business
(including (including GICs and GICs and similar Variable similar Variable contracts) annuity Total contracts) annuity Total
Intangible assets attributable to with-profit funds: Deferred acquisition costs and other intangible assets 97 – – 97 113
Asian insurance operations With-profits Unit-linked business assets and note i liabilities Other Total Total £m £m £m £m £m
Liabilities Policyholder liabilities and unallocated surplus of with-profits funds: Contract liabilities (including amounts in respect of contracts classifies as investment contract
iii Further segmental analysis: No goodwill attributable to any individual country included in the Asia total of £80 million (2008: £111 million) exceeds 10 per cent of the Group goodwill attributable to shareholders of £1,310 million (2008: £1,341 million). Included within ‘Other non-investment and non-cash assets’ of £880 million (2008: £1,416 million), was ‘Property, plant and equipment’ of £94 million (2008: £144 million). No individual country in Asia held property, plant and equipment at the end of the year which exceeds 10 per cent of the Group total of £367 million (2008: £635 million).
Summary policyholder liabilities (net of reinsurance) and unallocated surplus At 31 December 2009, the policyholder liabilities (net of reinsurance of £18 million (2008: £24 million)) and unallocated surplus for Asian operations of £21.9 billion (2008: £21.0 billion) comprised the following: Hong Kong 5,762 5,100
With-profits assets and operations business liabilities Other Total £m £m £m £m
Change in reserving basis in Malaysianote iii – (9) (54) (63) Change in other reserving basis – – (4) (4) Shareholders’ transfers post tax (20) – – (20) Investment-related items and other movementsnote iv 1,431 2,661 150 4,242 Foreign exchange translation differencesnote i (853) (612) (604) (2,069) Disposal of Taiwan agency businessnote v – (724) (2,784) (3,508)
ii The increase in policyholder liabilities due to new business premium for the with-profits business fell by £345 million to £46 million. This is predominantly driven by a fall in sales of single premium with-profits policies in Hong Kong following the withdrawal of the PruSaver product in 2009.
The increase in policyholder liabilities due to new business premium for Asia unit-linked business was lower by £609 million in 2009, in line with decreases in single premium sales during the year.
iii The change in reserving basis in Malaysia of £63 million reflects the change made following the adoption of a risk based capital (RBC) approach to the local regulatory reporting in that country.
v The disposal of Taiwan agency business reflects the liabilities transferred at the date of disposal.
Of the £517 million (2008: £555 million) debt securities for other business which are not rated in the table above, £225 million (2008: £231 million) are in respect of government bonds and £265 million (2008: £221 million) are in respect of corporate bonds rated as investment grade by local external ratings agencies, and £22 million (2008: £nil) structured deposits issued by banks which are themselves rated but where the specific deposits have not been.
In general terms, the Asian participating products provide savings and protection where the basic sum assured can be enhanced by a profit share (or bonus) from the underlying fund as determined at the discretion of the insurers. The Asian operations’ non-participating term, whole life and endowment products offer savings and/or protection where the benefits are guaranteed or determined by a set of defined market-related parameters. Unit-linked products combine savings with protection, the cash value of the policy depends on the value of the underlying unitised funds. Health and Protection (H&P) policies provide mortality or morbidity benefits and include health, disability, critical illness and accident coverage. H&P products are commonly offered as supplements to main life policies but can be sold separately.
• Surrender values Surrender values are guaranteed for non-participating products and on the guaranteed portion of participating products. The surrender value of declared reversionary bonuses are also guaranteed once vested. Market value adjustments and surrender penalties are used where the law permits such adjustments in cash values.
e Exposure to market risk The Asian operations sell with-profits and unit-linked policies and, although the with-profits business generally has a lower terminal bonus element than in the UK, the investment portfolio still contains a proportion of equities and, to a lesser extent, property. Nonparticipating business is largely backed by debt securities or deposits. The exposure to market risk of the Group arising from its Asian operations is therefore at modest levels. This arises from the fact that the Asian operations have a balanced portfolio of with-profits, unit-linked and other types of business.
For Asian operations in countries where local GAAP is not well established and in which the business written is primarily nonparticipating and linked business, US GAAP is used as the most appropriate reporting basis. This basis is applied in Japan and Vietnam and, materially for 2008 but less so for 2009 following the sale of the agency business, in Taiwan. The future policyholder benefit 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 benefit provisions vary by operation depending on the circumstances attaching to each block of business.
g Reinsurance The Asian businesses cede only minor amounts of business outside the Group with immaterial effects on reported profit. During 2009, reinsurance premiums for externally ceded business were £119 million (2008: £76 million) and the reinsurance assets were £18 million (2008: £24 million) in aggregate.
h Effect of changes in bases, estimates and assumptions used to measure insurance assets and liabilities a Exceptional credit of £63 million regarding the liability measurement for Malaysia long-term business For the Malaysia life business, under the basis applied previously, 2008 IFRS basis liabilities were determined on the local regulatory basis using prescribed interest rates such that a high degree of prudence resulted.
As of 1 January 2009, the local regulatory basis has been replaced by the Malaysian authority’s risk-based capital (RBC) framework. In the light of this development, the Company has remeasured the liabilities by reference to the method applied under the new RBC framework, which is more realistic than the previous approach, but with an overlay constraint to the method such that negative reserves derived at an individual policyholder level are not included. This change has resulted in a one-off release from liabilities at 1 January 2009 of £63 million.
b Changes in key assumptions Excluding the change in Malaysia as explained above, the result for Asian operations was increased in 2009 by the effect of a number of other individually small assumptions changes of, in aggregate, £4 million. For 2008 the result for Asian operations was reduced by the effect of a number of individually small assumptions charges of, in aggregate, £21 million.
c Deferral and amortisation of acquisition costs Under IFRS, the basis of accounting for insurance assets and liabilities reflects ‘grandfathered’ GAAP under the Modified Statutory Basis (MSB). In general, this requires the deferral and amortisation of acquisition costs in line with the emergence of margins. In 2008, the basis of deferral and amortisation was adjusted for a number of territories to better reflect the MSB requirement as follows: For the India life operation, reflecting the initial development stage of the business, acquisition costs had previously not been deferred. In 2008, £19 million of deferred acquisition costs, net of amortisation in the year, were established.
For Singapore, refinements were made with a £21 million benefit in 2008 (of which £7 million related to the 1 January 2008 position) where the local risk based capital approach does not provide an appropriate basis of implicit allowance for acquisition costs for certain products and in Hong Kong, adjustments were made with a net overall effect of a credit to profit of £10 million in 2008.
i Sensitivity of IFRS basis profit and equity to market and other risks Currency translation Consistent with the Group’s accounting policies, the profits of the Asian insurance operations are translated at average exchange rates and shareholders’ equity at the closing rate for the reporting period. For 2009, the rates for the most significant operations are given in note B4.
A 10 per cent increase or decrease in these rates would have reduced or increased profit before tax attributable to shareholders, profit for the year and shareholders’ equity, excluding goodwill, attributable to Asian operations respectively as follows: A 10% increase in A 10% decrease in exchange rates exchange rates
Notes on the Group financial statements > D: Life assurance businesses > continued iii Other business a Interest rate risk for Taiwan For 2008 the principal other business of Asian operations that was most sensitive to movements in interest rates was the whole of life business written in Taiwan. In June 2009 the Company completed the sale of its agency distribution business and associated liabilities and its agency force in Taiwan to China Life Insurance Company Ltd. as explained in note I1. For 2009 the assets and liabilities of the element of Taiwan business retained by the Company are relatively less sensitive to variances in interest rates, with a reasonably possible decrease in interest rates of 0.5 per cent leading to an increase in IFRS pre-tax profits of £24 million. After adjusting these results for deferred tax the reasonably possible effect on shareholders’ equity is £19 million. A 0.5 per cent increase in interest rates is estimated to have an approximately equal and opposite effect on profit and shareholders’ equity.
b Interest rate risk for other business excluding Taiwan Asian operations offer a range of insurance and investment products, predominately with-profits and non-participating term, whole life endowment and unit-linked. Excluding with-profit and unit-linked business along with Taiwan, the results of the Asian business are sensitive to the vagaries of routine movements in interest rates.
Note i One per cent sensitivity has been used in all territories (except Japan (0.5 per cent)) (2008: Japan 0.5 per cent, Vietnam 1.5 per cent).
The pre-tax impacts, if they arose, would mostly be recorded within the category short-term fluctuations in investments returns in the Group’s supplementary analysis of profit before tax.
The estimated sensitivity to a 10 and 20 per cent (2008: 10, 20 and 40 per cent) change in equity and property prices for shareholderbacked Asian other business, which would be reflected in the short-term fluctuation component of the Group’s segmental analysis of profit before tax, at 31 December 2009 and 2008 would be as follows: A decrease A decrease A decrease A decrease A decrease of 20% of 10% of 40% of 20% of 10%
The disclosure of the effect of a 40 per cent fall for the 2008 year-end was included because of the exceptional market conditions at that time. These conditions have now abated and the disclosure is no longer appropriate.
In the equity risk sensitivity analysis given above the Group has, for 2009, 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.
d Insurance risk Many of the territories in Asia are exposed to mortality/morbidity risk and provision is made within IFRS policyholder liabilities on a prudent regulatory basis to cover the potential exposure. If these prudent assumptions were strengthened by five per cent (estimated at one in ten year shock) then it is estimated that post tax IFRS profit would be impacted by approximately £9 million (with a corresponding change to IFRS shareholders’ equity). Mortality/morbidity has a symmetrical effect on portfolio and so a weakening of mortality/morbidity assumptions would have an approximately equal and opposite similar impact.
Group shareholders’ equity Held outside long-term funds: Held in long-term fundsnote iii – – – 1,114 – – 1,114 – – 1,114
Shareholders’ share of realistic liabilities – (3,001) (3,001) – – – (3,001) Deferred acquisition costs of non-participating business not recognised for regulatory reporting
Jackson surplus notesnote iv – – – – 154 – 154 Investment and policyholder liabilities valuation differences between
Jacksonnote viii – – – – 2,221 – 2,221 Adjustment from IAS 19 basis pension deficit attributable to WPSF to pension liability for regulatory
IFRS basis and regulatory basis – (1,294) (1,294) – – – (1,294) Other adjustments to restate these amounts to a regulatory basis
Notes on the Group financial statements > D: Life assurance businesses > continued 2008 £m
Total subsidi- life life M&G other PAC with- aries and assurance assurance (including subsidi-
Group shareholders’ equity Held outside long-term funds: Held in long-term fundsnote iii – – – 920 – – 920 – – 920
Shareholders’ share of realistic liabilities – (2,028) (2,028) – – – (2,028)
Adjustment from IAS 19 basis pension deficit attributable to WPSF to pension liability for regulatory
Total available capital resources of life assurance businesses on local regulatory bases – 5,362 5,362 1,053 2,758 1,410 10,583
Investment contracts without discretionary participation features (principally unit-linked and similar contracts in the UK
and GIC liabilities of Jackson)note vi – – – 11,584 2,885 32 14,501
Total policyholder liabilities shown in the consolidated statement of financial position 10,018 63,836 73,854 33,853 45,361 20,909 173,977
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 with segregated assets and liabilities.
iv For regulatory purposes the Jackson surplus notes are accounted for as capital. v Other adjustments to shareholders’ equity and unallocated surplus include amounts for the value of non-participating business for UK regulated with-profits funds, deferred tax, admissibility and other items measured differently on the regulatory basis. For Jackson the principal reconciling item is deferred tax related to the differences between IFRS and regulatory basis as shown in the table above and other methodology differences.
i UK insurance operations The FSA rules which govern the Prudential regulation of insurance form part of the Prudential Sourcebook for Insurers, the General Prudential Sourcebook and Interim Prudential Sourcebook for Insurers. Overall, the net requirements of the General Prudential Sourcebook are intended to align the capital adequacy requirements for insurance business more closely with those of banking and investment firms and building societies, for example, by addressing tiers of capital, rather than looking at net admissible assets. An insurer must hold capital resources equal at least to the Minimum Capital Requirement (MCR).
The two separate peaks are: i The requirement comprised by the mathematical reserves plus the ‘Long-Term Insurance Capital Requirement’ (LTICR), together known as the ‘regulatory peak’; and ii a calculation of the ‘realistic’ present value of the insurer’s expected future contractual liabilities together with projected ‘fair’ discretionary bonuses to policyholders, plus a risk capital margin, together known as the ‘realistic peak’.
As noted in section D2(f)(ii), PAC has discretion in its management actions in the case of adverse investment conditions. Management actions encompass, but are not confined to, investment allocation decisions, levels of reversionary bonuses, crediting rates and total claim values. To illustrate the flexibility of management actions, rates of regular bonus are determined for each type of policy primarily by targeting them at a prudent proportion of the long-term expected future investment return on the 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 date of payment of the premiums or date of issue of the policy, if the accumulated annual bonuses are particularly high or low relative to a prudent proportion of the achieved investment return.
As regards smoothing of maturity and death benefits, in normal circumstances PAC does not expect most pay-out values on policies of the same duration to change by more than 10 per cent up or down from one year to the next, although some larger changes may occur to balance pay-out values between different policies. Greater flexibility may be required in certain circumstances, for example, following a significant rise or fall in market values (either sudden or over a period of years) and in such situations the PAC board may decide to vary the standard bonus smoothing limits to protect the overall interests of policyholders.
For surrender benefits, any substantial fall in the market value of the assets of the with-profits sub-fund would lead to changes in the application of MVRs for accumulating with-profits policies, firstly to increase the size of MVRs already being applied and, secondly, to extend the range of policies for which an MVR is applied.
The capital resources requirement for these companies broadly reflects a formula which, for active funds, equates to a percentage of regulatory reserves plus a percentage of death strains. Death strains represent the payments made to policyholders upon death in excess of amounts explicitly allocated to fund the provisions for policyholders claims and maturities.
Jackson’s risk-based capital ratio is significantly in excess of regulatory requirements. Effective for 2008 reporting, the local regulator granted Jackson three permitted practices. One permitted practice allowed Jackson to carry 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 local regulator also granted a permitted practice to allow Jackson to recognise book to tax differences that will reverse within the next three years (instead of one year as required by the NAIC) in determining the admissible tax asset (subject to a limitation of 15 per cent of capital and surplus versus the 10 per cent limitation imposed by the NAIC guidance). Finally, the local regulator granted a permitted practice to allow Jackson to use an average interest rate in calculating certain regulatory capital requirements. In 2009 the permitted practice with respect to the interest rate swaps was renewed until 1 October 2010, while the other two expired on 1 October 2009. The total effect of these permitted practices was to increase statutory surplus by £117 million and £588 million at 31 December 2009 and 2008 respectively, and reduce authorised control level required capital by £57 million at 31 December 2008.
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 In Singapore a risk-based regulatory framework applies rather than one based on a net premium approach.
Indonesia Policy reserves for traditional business are determined on a modified net premium basis. The valuation interest rates are capped at nine per cent for local currency products and five per cent for foreign currency products.
For linked business the value of units is held together with a non-unit reserve calculated in accordance with standard actuarial methodology. Solvency capital is determined using risk-based capital approach. Insurance companies in Indonesia are expected to maintain the level of net assets above 120 per cent of solvency capital. Due to the 2008 financial crisis, the local regulator provided relief in solvency capital and the measure continues until further notice.
With regard to solvency, the adjusted solvency capital assets of the Company must exceed 200 per cent of the risk related capital requirement value at risk. It is thus a risk-based capital approach.
Malaysia A new risk-based capital framework was adopted from 1 January 2009 to replace the previous framework that used a net premium approach.
For participating business, a gross premium reserve on the guaranteed and non-guaranteed benefits determined using best estimate assumptions is held. The amount held is subject to a minimum of a gross premium reserve on the guaranteed benefits, determined using best estimate assumptions along with provisions of risk margin for adverse deviations (PRADs) discounted at the risk-free rate.
The risk-free rate is derived from a yield curve of zero-coupon spot yields of Malaysian Government Securities.
iv Group capital requirements In addition to the requirements at individual company level, FSA requirements under the IGD apply additional prudential requirements for the Group as a whole. Discussion of the Group’s estimated IGD position at 31 December 2009, together with market risk sensitivity disclosure provided to key management, is provided in the business review section of the Group’s 2009 Annual Report and in section C.
Changes in management policy – 26 – (101) (75) Changes in regulatory requirements – – 128 178 306 New business and other factors 1,052 505 (398) (360) 799
Detail on the movement for 2008 is as follows: 2008 £m
The increase in 2009 reflects primarily the positive investment returns earned on the opening available capital and £18 million positive effect of changes in assumptions on a regulatory basis compared to the £65 million effect of change in assumptions on the IFRS basis as shown in note D2 (i).
iii Other UK life assurance subsidiaries and funds The effect from the changes in assumptions of valuation interest rates on insurance liabilities is broadly matched by the corresponding effect on assets leaving no significant impact on the available capital.
e Sensitivity of liabilities and total capital to changed market conditions and capital management policies Prudential manages its assets, liabilities and capital locally, in accordance with local regulatory requirements and reflecting the different types of liabilities Prudential has in each business. As a result of the diversity of products offered by Prudential and the different regulatory requirements in which it operates, Prudential employs differing methods of asset/liability and capital management, depending on the business concerned.
Stochastic modelling of assets and liabilities is undertaken in the UK, Jackson and Asia to assess the economic capital requirements under different confidence intervals and time horizons. In addition, reserve adequacy testing under a range of scenarios and dynamic solvency testing is carried out, including under certain scenarios mandated by the UK, US and Asian regulators.
A stochastic approach models the inter-relationship between asset and liability movements, taking into account asset correlation, management actions and policyholder behaviour under a large number of alternative economic scenarios. These scenarios are projected forward over a period of time, typically 25 years or longer, and the liabilities and solvency position of the fund are calculated in each scenario in each future year. The fund’s policy on management actions, including bonus and investment policy, continue to be set in order that they are consistent with the available capital and the targeted risk of default.
Shareholders’ share of actuarial gains and losses on defined benefit pension schemes (14) – – (14) (10)
‡Short-term fluctuations for M&G are primarily in respect of unrealised value movements on Prudential Capital’s bond portfolio.
b M&G operating profit based on longer-term investment returns: Asset management fee income 457 455
Total M&G operating profit based on longer-term investment returns 238 286
The difference between the fees and other income shown above in respect of asset management operations, and the revenue figure for M&G shown in the main table primarily relates to income and investment gains (losses) earned by Prudential Capital and by investment funds controlled by the asset management operations which are consolidated under IFRS.
Assets Intangible assets: Deferred acquisition costs 8 – – 8 6
The M&G loans of £1,413 million (2008: £1,763 million) relate to loans and receivables managed by Prudential Capital. These assets are generally secured but have no external credit ratings. Internal ratings prepared by the Group’s asset management operations as part of the risk management process, are £92 million A+ to A- (2008: £nil), £835 million BBB+ to BBB- (2008: £1,100 million), £330 million BB+ to BB- (2008: £663 million) and £156 million B+ to B- (2008: £nil).
ii Debt securities Of the total debt securities of £1,164 million in 2009 (2008: £991 million) £1,149 relates to M&G (2008: £975 million), of which £1,072 million were rated AAA to A– by Standard and Poor’s or Aaa rated by Moody’s (2008: £959 million).
Operational borrowings for M&G are in respect of Prudential Capital’s short-term fixed income security programme and comprise £2,031 million (2008: £1,269 million) of commercial paper and £7 million (2008: £9 million) of medium-term notes.
Asset management operations in the UK, Hong Kong, Singapore, Malaysia, Vietnam and China are subject to regulatory requirements based on fixed operating expenses and other operating considerations. The movement in the year of the surplus regulatory capital position of these operations, combined with the movement in the IFRS basis shareholders’ funds for other asset management operations, is as follows: Asset management operations
The movement in the year reflects changes in regulatory requirements whilst gains are driven by profits generated during the year. Distributions consist of dividends paid up to the parent company.
i Currency translation Consistent with the Group’s accounting policies, the profits of the Asia and PPM America asset management operations are translated at average exchange rates and shareholders’ equity at the closing rate for the reporting period. For 2009, the rates for the most significant operations are given in note B4.
Other operations consist of unallocated corporate activities relating to Group Head Office and the Asia regional head office, with net income and expenditure for the year of negative £395 million (2008: negative £260 million) as detailed in note B1. An analysis of the assets and liabilities of other operations is shown in note B6.
Earned premiums, net of reinsurance 5,635 9,115 5,226 – – – 19,976 – 19,976
Total revenue, net of reinsurance 23,177 14,167 9,693 799 500 217 48,553 (454) 48,099
Total charges, net of reinsurance (21,708) (13,681) (9,805) (505) (496) (162) (46,357) (178) (46,535)
Earned premiums, net of reinsurance 7,567 5,965 5,257 – – – 18,789 – 18,789
Movement in unallocated surplus of with-profits funds 4,769 – 1,046 – – – 5,815 – 5,815
This is represented in the segmental analysis of profit from continuing operations before tax attributable to shareholders in note B1 as follows: Year ended 31 December 2008 £m
Shareholders’ share of actuarial and other gains and losses on defined
Notes i The measure is the formal profit (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 classified as fair value through profit and loss under IAS 39; and – Realised gains and losses, including impairment losses, on securities classified as available-for-sale under IAS 39.
iii Total revenue for 2008 was negative £10,267 million whilst charges were a credit of £8,193 million. These abnormal effects arose from the basis of preparation whereby revenue includes investment appreciation, which was negative in 2008, and charges reflect the allocation, where appropriate, of investment return to policyholder benefits.
Realised and unrealised gains and losses on securities at fair value through profit and loss 18,175 (34,157)
Realised and unrealised gains and losses on derivatives at fair value through profit and loss 1,164 (5,261)
Realised gains and losses on available-for-sale securities, previously recognised in other comprehensive income (420) (487)
Fee income from investment contract business and asset management notes iii,iv 1,234 1,109
Income from venture investments of the PAC with-profits funds – 37
These fees primarily related to prepayment fees, late fees and syndication fees. iv The following table provides additional segmental analysis of revenue from external customers: 2009 £m
Revenue from external customers: Unallocated corporate – – 61 – 61 Intragroup revenue eliminated on consolidation (73) (45) (172) 290 –
Revenue from external customers is made up of the following: £m £m
Earned premiums, net of reinsurance 19,976 18,789 Fee income from investment contract business and asset management (included within ‘Other income’) 1,234 1,109
In their capacity as fund managers to fellow Prudential Group subsidiaries, M&G, the US and the Asian asset management businesses earn fees for investment management and related services. Intragroup fees included within asset management revenue were £271 million (2008: £280 million) earned £134 million (2008: £162 million) by M&G, £67 million (2008: £45 million) by the US asset management segment and £70 million (2008: £73 million) by the Asian asset management segment. In 2009, the remaining £11 million (2008: £10 million) of intragroup revenue was recognised by UK insurance operations. These services are charged at appropriate arm’s length prices, typically priced as a percentage of funds under management.
Total acquisition costs and other operating expenditure notes iv,v 4,572 2,459
Notes i Acquisition costs in 2009 comprise amounts related to insurance contracts of £871 million (2008: £1,048 million), and investment contracts and asset management contracts of £162 million (2008: £137 million). These costs include amortisation of £290 million (2008: £520 million) and £15 million (2008: £15 million) respectively.
Group of a charge of £615 million (2008: a credit of £963 million). iv The total depreciation and amortisation expense is £377 million (2008: £618 million). Of this amount, £305 million (2008: £535 million) relates to amortisation of deferred acquisition costs of insurance contracts and asset management contracts, which is primarily borne by the insurance operations. The segmental analysis of total depreciation and amortisation expense is as follows: £m £m
Asset management operations: M&G – 34 US – – Asia – –
Write down or reversal of a previous write down of a deferred tax asset – (3)
The total deferred tax (charge) credit arises as follows: Unrealised gains and losses on investments (35) 1,521
In 2009, a deferred tax charge of £546 million (2008: credit of £561 million) has been taken through other comprehensive income. Other movements in deferred tax totalling a £69 million credit is mainly comprised of foreign exchange movements. When these amounts are taken with the deferred tax charge shown above the result is an increase of £0.8 billion in the Group’s net deferred tax liability (2008: decrease of £2.1 billion).
i Summary of pre-tax profit (loss) and tax (charge) credit The income statement includes the following items: Profit (loss) before tax 1,564 (2,074)
Tax attributable to shareholders’ profits (losses): Tax (charge) credit (873) 1,683
ii Overview For the purposes of explaining the relationship between tax expense and accounting profit, it is appropriate to consider the sources of profit and tax by reference to those that are attributable to shareholders and policyholders, as follows: Attributable to Attributable to Attributable to Attributable to shareholders policyholders* Total shareholders policyholders* Total
Taxation charge: Variance from expected tax charge note v(ii) 178 – 178 (129) – (129)
Profit (loss) before tax comprises profit attributable to shareholders and pre-tax profit attributable to policyholders of linked and with-profits funds and unallocated surplus of with-profits funds.
In meeting the reconciliation requirements set out in paragraph 81(c) of IAS 12, the presentation shown in this disclosure note seeks to ensure that the explanation of the relationship between tax expense and accounting profit draw properly the distinction between the elements of the profit and tax charge that are attributable to policyholders and shareholders as explained below in notes (iv) and (v) respectively. Due to the nature of the basis of taxation of UK life and pension business (as described in note (iii) below), and the significance of the results of the business to the Group, it is inappropriate to seek to explain the effective tax rate on profit before tax by the traditional approach that would apply for other industries.
The shareholder elements are the components of the profit and tax charge that are of most direct relevance to investors, and it is this aspect that the IAS 12 reconciliation requirement is seeking to explain for companies that do not need to account for both with-profits and unit-linked funds, where tax is borne by the Company on the policyholders’ behalf and which is not contemplated by the IFRS requirement.
For unit-linked business, pre-tax profits also reflect the aggregate of profits attributable to policyholders and shareholders. The pretax profits attributable to policyholders represent fees earned that are used to pay tax borne by the Company on policyholders’ behalf. The net of tax profit attributable to policyholders for unit-linked business is thus zero.
v Reconciliation of tax charge on profit (loss) attributable to shareholders 2009 £m
Profit (loss) before tax attributable to shareholders: Operating profit based on longer-term
Short-term fluctuations in investment returns 7 186 (30) 61 224 Shareholders’ share of actuarial and other gains and losses on defined benefit pension schemes – – 13 8 21 Loss on sale and results for Taiwan agency business 18 – – – 18
Notes i Expected tax rates for profit (loss) attributable to shareholders: • The expected tax rates shown in the table above reflect the corporate tax rates generally applied to taxable profits of the relevant country jurisdictions. • For Asian operations the expected tax rates reflect the corporate tax rates weighted by reference to the source of profits of operations contributing to the aggregate business result. • The expected tax rate for Other operations reflects the mix of business between UK and overseas operations, which are taxed at a variety of rates.
The rates will fluctuate from year to year dependent on the mix of profits. ii For 2009, the principal variances arise from differences between the standard corporation tax rate and actual rates due to a number of factors, including: a For Asian long-term operations, profits in certain countries which are not taxable partly offset by the inability to fully recognise deferred tax assets on losses being carried forward; b For Jackson, the ability to fully recognise deferred tax assets on losses brought forward which we were previously unable to recognise together with income subject to a lower level of taxation and the benefit of a deduction from taxable income of a proportion of dividends received attributable to the variable annuity business; c For UK insurance operations, adjustments in respect of the prior year tax charge and different tax bases of UK life business; d For Other operations, the ability to now recognise a deferred tax asset on various tax losses which we were previously unable to recognise offset by adjustments in respect of the prior year tax charge; and e The actual tax rate in relation to Asia excluding the result for the sold Taiwan agency business would have been 13 per cent for the period.
Shareholders’ share of actuarial and other gains and losses on defined benefit pension schemes (2) – – (11) (13)
Expected tax credit (charge) based on expected tax rates: Operating profit based on longer-term
Shareholders’ share of actuarial and other gains and losses on defined benefit pension schemes 1 – – 3 4
Results for sold Taiwan agency business (4) – – – (4)
Notes i Expected tax rates for profit attributable to shareholders: The tax rate of 23 per cent reflects the mix of business between UK and overseas operations, which are taxed at a variety of rates. The rate will fluctuate from year to year dependent on the mix of profits between jurisdictions.
HMRC at an amount below that previously provided and the different tax bases of UK life business; and d For Other operations, the settlement of issues with HMRC at amounts below those previously provided and a reduction in amounts previously provided on outstanding issues with HMRC which has been partially offset by the inability to recognise a deferred tax asset on various tax losses. iii Operating profit based on longer-term investment returns is net of attributable restructuring costs and development expenses.
Value movements on derivative hedging programme for general account business 340 (311)
Interest/dividend income and value movements on other financial instruments for which fair value movements are booked in the income statement 1,567 1,478
The returns as shown in the table above, are delineated between those returns allocated to policyholders and those allocated to shareholders. In making this distinction, returns allocated to policyholders are those from investments in which shareholders have no direct economic interest, namely: • Unit-linked business in the UK, Asia and SAIF in the UK, for which the investment return is wholly attributable to policyholders; • Separate account business of US operations, the investment return of which is also wholly attributable to policyholders; and • With-profits business (excluding SAIF) in the UK and Asia (in which the shareholders’ economic interest, and the basis of recognising
Investment returns for unit-linked and similar products have reciprocal impact on benefits and claims, with a decrease in market returns on the attached pool of assets affecting policyholder benefits on these products. Similarly for with-profits funds there is a close correlation between increases or decreases in investment returns and the level of combined charge for policyholder benefits and movement on unallocated surplus that arises from such returns.
Shareholder returns For shareholder-backed non-participating business of the UK (comprising PRIL and other non-linked non-participating business) and of the Asian operations, the investment return is not directly attributable to policyholders and therefore does impact shareholders’ profit directly. However, it should be noted that for UK shareholder-backed annuity business, principally PRIL, where the durations of asset and liability cash flows are closely matched, the discount rate applied to measure liabilities to policyholders (under ‘grandfathered’ UK GAAP and under IFRS 4) reflects movements in asset yields (after allowances for the future defaults) of the backing portfolios. Therefore, the net impact on the shareholders’ profits of the investment return of the assets backing liabilities of the UK shareholder-backed annuity business is after taking into account the consequential effect on the movement in policyholder liabilities.
Changes in shareholder investment returns for US operations reflect primarily movements in the investment income, movements in the value of the derivative instruments held to manage the general account assets and liability portfolio, and realised gains and losses. However, separately reflecting Jackson’s types of business an allocation is made to policyholders through the application of crediting rates. The shareholder investment return for US operations also includes the fair value movement of the derivatives and the movement on the related liabilities of the variable annuity guarantees under Jackson’s dynamic hedging programme.
Benefits and claims and movements in unallocated surplus of with-profits funds net of reinsurance can be further analysed as follows: 2009 £m
Movement in unallocated surplus of with-profits funds 1,046 – 4,769 5,815
The Group designates all financial assets as either fair value through profit and loss, available-for-sale, or as loans and receivables. Financial liabilities are designated as either fair value through profit and loss, amortised cost, or as investment contracts with discretionary participating features accounted for under IFRS 4 as described in note A4.
Equity securities and portfolio holdings in unit trusts 69,354 – – 69,354 69,354
Operational borrowings attributable to shareholder-financed operationsH13 – 1,977 – 1,977 1,977
Net asset value attributable to unit holders of consolidated unit trust and similar funds 3,843 – – 3,843 3,843
(2008: £363 million) were included in borrowings. ii Loans and receivables are reported net of allowance for loan losses of £44 million (2008: £27 million). iii See note G3 for details of the derivative assets included. The balance also contains the PAC with-profits fund’s participation in various investment funds and limited liability property partnerships.
v For financial liabilities designated as fair value through profit and loss there was no impact on profit from movements in credit risk during 2009
At 31 December 2008 illiquid market conditions resulted in inactive markets for certain of the Group’s financial instruments namely certain asset-backed securities held by Jackson. As a result, there was generally limited observable market information for these instruments. Fair value estimates for financial instruments deemed to be in an illiquid market are based on judgements regarding current economic conditions, liquidity discounts, currency, credit and interest rate risks, loss experience and other factors. These fair values are estimates and involve considerable uncertainty and variability as a result of the inputs selected and may differ significantly from the values that would have been used had the ready market existed, and the differences could be material. At 31 December 2008 Jackson utilised internal valuation models as best estimate of fair values of all non-agency Residential Mortgage-Backed Securities (RMBS) and Asset-Backed Securities (ABS) and certain Commercial Mortgage-Backed Securities (CMBS). The use of internal models for these securities (which are accounted for on an available-for-sale basis) resulted in a fair value that was higher than those provided from pricing services and brokers of £760 million on a total amortised cost of £3.5 billion. During 2009, improvements were observed in the level of liquidity for these sectors of structured securities with the result that Jackson was able to rely on external prices for these securities as the most appropriate measure of fair value. At 31 December 2009, nearly all of the non-agency RMBS, ABS and certain CMBS which at 31 December 2008 were valued using internal models due to the dislocated market conditions in 2008 were valued using external prices.
The estimated fair value of derivative financial instruments reflects the estimated amount the Group would receive or pay in an arm’s length transaction. This amount is determined using quoted prices if exchange listed, quotations from independent third-parties or valued internally using standard market practices. In accordance with the Group’s risk management framework, all internally generated valuations are subject to assessment against external counterparties’ valuations.
UK unit-linked policies). For investment contracts in the US with fixed and guaranteed terms the fair value is determined based on the present value of future cash flows discounted at current interest rates.
The classification 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 principally includes exchange listed equities, mutual funds with quoted prices, exchange traded derivatives such as futures and options, and national government bonds unless there is evidence that trading in a given instrument is so infrequent that the market could not possibly be considered active. It also includes other financial instruments (including net assets attributable to unit holders of consolidated unit trusts and similar funds) where there is clear evidence that the year end valuation is based on a traded price in an active market.
In addition level 2 includes debt securities that are valued internally using standard market practices. Of the total level 2 debt securities of £83,301 million at 31 December 2009, £6,426 million are valued internally. The majority of such securities use matrix pricing, which is based on assessing the credit quality of the underlying borrower to derive a suitable discount rate relative to government securities. Under matrix pricing, the debt securities are priced taking the credit spreads of comparable quoted public debt securities and applying these to the equivalent debt instruments factoring a specified 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.
At 31 December 2009 the Group held £5,190 million, three per cent of the fair valued financial instruments, within level 3. Of this amount £3,510 million was held by the Group’s participating funds and therefore shareholders’ profit and equity are not impacted by movements in the valuation of these financial instruments. Total level 3 assets represented 3.7 per cent of the total assets of the participating funds at 31 December 2009. Total level 3 liabilities were £348 million out of total participating fund liabilities of
Of the £1,684 million level 3 items, net of derivative liabilities which support non-linked shareholder-backed business (3.6 per cent of the total assets net of derivative liabilities backing this business), £1,653 million are externally valued and £31 million are internally valued. Internal valuations, which represent only 0.04 per cent of the total assets net of derivative liabilities supporting non-linked shareholder-backed business, are inherently more subjective than external valuations.
If the value of all level 3 investments backing non-linked shareholder-backed business was varied by 10 per cent, the change in valuation would be £3 million, which would reduce shareholders’ equity by this amount before tax. Of this amount a £5 million increase would pass through the income statement substantially as part of short-term fluctuations outside of operating profit offset by a £8 million decrease included as part of other comprehensive income, being unrealised movements on assets classified as available-for-sale.
With-profits Equity securities and portfolio holdings in unit trusts 28,688 799 475 29,962
Total financial investments, net of derivative liabilities 35,776 40,545 3,833 80,154 Borrowing attributable to the with-profits fund held at fair value – (105) – (105) Investment contract without discretionary participation features held at fair value – – – – Net asset value attributable to unit holders of consolidated unit trusts
Unit-linked and variable annuity Equity securities and portfolio holdings in unit trusts 38,616 4 – 38,620
Other investments (including derivative assets) 30 80 – 110 Derivative liabilities – – – –
Total financial investments, net of derivative liabilities 6,475 38,845 1,684 47,004 Investment contract without discretionary participation features held at fair value – (1,598) – (1,598) Net asset value attributable to unit holders of consolidated unit trusts
Total financial investments, net of derivative liabilities 31,864 3,816 33 35,713
Borrowing attributable to with-profits fund held at fair value – – – –
Investment contracts without discretionary participation features held at fair value – (1,307) – (1,307)
Group total Equity securities and portfolio holdings in unit trusts 60,269 1,026 827 62,122
Total financial investments, net of derivative liabilities 76,615 73,434 8,766 158,815
Borrowing attributable to with-profits fund held at fair value – (158) – (158)
Investment contract without discretionary participation held at fair value – (11,616) – (11,616)
Total gains and losses recorded in other comprehensive income includes unrealised gains and losses on debt securities held as available-for-sale within Jackson and foreign exchange movements arising from the retranslation of the Group’s overseas subsidiaries and branches.
As highlighted earlier in this note, at 31 December 2008 Jackson had utilised internal valuations for certain structured securities given the illiquidity of the market at that time. These assets have therefore been classified as level 3 given the unobservable nature of the assumptions within the internal valuation models used. During the first half of 2009 improvements were observed in the level of liquidity for these structured securities such that external prices based on observable inputs from pricing services or brokers were used to value nearly all of the structured securities at 31 December 2009. There is therefore a transfer of £2,072 million from level 3 to level 2 during 2009 in respect of these securities. The remaining transfers in or out of level 3 represent sundry individual asset reclassifications, none of which are materially significant as highlighted in the table opposite.
Unit-linked and variable annuity Equity securities and portfolio holdings in unit trusts – – – – – – – – –
Net asset value attributable to unit holders of consolidated unit trusts and similar funds – – – (1) – – (1) – (2)
Net asset value attributable to unit holders of consolidated unit trusts and similar funds (446) 26 6 48 – – (1) – (367)
Interest rate risk The following table shows an analysis of the classes of financial assets and liabilities and their direct exposure to interest rate risk. Each applicable class of the Group’s financial assets or liabilities is analysed between those exposed to fair value interest rate risk, cash flow interest rate risk and those with no direct interest rate risk exposure: 2009 £m
Financial liabilities Core structural borrowings of shareholder-financed operations 3,394 – – 3,394 Operational borrowings attributable to shareholder-financed operations 2,128 620 3 2,751 Borrowings attributable to with-profits funds 804 312 168 1,284 Obligations under funding, securities lending and sale and repurchase agreements 611 2,871 – 3,482 Investment contracts without discretionary participation features 1,098 867 13,840 15,805
Notes on the Group financial statements > G: Financial assets and liabilities > continued 2008 £m
Financial liabilities Core structural borrowings of shareholder-financed operations 2,958 – – 2,958
Liquidity analysis i) Contractual maturities of financial liabilities The following table sets out the contractual maturities for applicable classes of financial liabilities, excluding derivative liabilities and investment contracts and that are separately presented. The financial liabilities are included in the column relating to the contractual maturities at the undiscounted cash flows (including contractual interest payments) due to be paid assuming conditions are consistent with those of year end.
Obligations under funding, securities lending and sale and repurchase agreements 3,482 3,482 – – – – – – 3,482
Net asset value attributable to unit holders of consolidated unit-trusts and similar funds 3,809 3,809 – – – – – – 3,809
Net asset value attributable to unit holders of consolidated unit-trusts and similar funds 3,843 3,843 – – – – – – 3,843 ii) Maturity analysis of derivatives The following table provides a maturity analysis of derivative assets and liabilities: 2009 £m
Total After 1 After 3 carrying 1 year year to years to After value or less 3 years 5 years 5 years Total 2008 £m
Total After 1 After 5 After 10 After 15 undis1 year year to years to years to years to Over counted Carrying or less 5 years 10 years 15 years 20 years 20 years value value 2008 £bn
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 financial position. Durations of long-term business contracts, covering insurance and investment contracts, on a discounted basis are included in section D.
The vast majority of the Group’s financial assets are held to back the Group’s policyholder liabilities. Although asset/liability matching is an important component of managing policyholder liabilities (both those classified as insurance and those classified as investments), this profile is mainly relevant for managing market risk rather than liquidity risk. Within each business unit this asset/liability matching is performed on a portfolio by portfolio basis.
In terms of liquidity risk a large proportion of the policyholder liabilities contain discretionary surrender values or surrender charges, meaning that many of the Group’s liabilities are expected to be held for the long term. Much of the Group’s investment portfolios is in marketable securities, which can therefore be converted quickly to liquid assets.
Credit risk The Group’s maximum exposure to credit risk before any allowance for collateral or allocation of losses to policyholders is represented by the carrying value of financial 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, 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 D2, D3 and D4, describe the security for these loans held by the Group, as disclosed at the start of this note.
There was no collateral held against loans that are past due and impaired or that are past due but not impaired at 31 December 2009 (2008: £nil).
In addition, during the year the Group took possession of £15 million (2008: £66 million) of other collateral held as security, which mainly consists of assets that could be readily convertible into cash.
The financial assets, of which 74 per cent (2008: 77 per cent) are held by the PAC with-profits fund, allow the PAC with-profits fund to obtain exposure to foreign equity markets.
The amount of exchange losses recognised in the income statement in 2009, except for those arising on financial instruments measured at fair value through profit and loss, is £201 million (2008: £638 million gains). This constitutes £41 million losses (2008: £32 million gains) on Medium Term Notes (MTN) liabilities and £160 million of net losses (2008: £606 million net gains), mainly arising on investments of the PAC with-profits fund. The gains/losses on MTN liabilities are fully offset by value movements on cross-currency swaps, which are measured at fair value through profit and loss.
The total fair value balances of derivative assets and liabilities as at 31 December 2009 were as follows: 2009 £m
The above derivative assets are included in ‘other investments’ in the primary statements.
The notional amount of the derivatives, distinguishing between UK insurance and US operations, was as follows: 2009 £m
UK insurance operations US insurance operations Notional amount on which Notional amount on which future payments are based future payments are based
Inflation swaps 2,337 2,205 – – Credit default swaps 90 12 – – Single stock options – – – – Credit derivatives – – – 189 Put options – – 9,072 –
Total return swaps 479 514 – 313 *In addition, the other operations, including the Group Treasury function and the Asian operations, have cross-currency swap assets and liabilities with notional amounts of £819 million (2008: £1,503 million) and £122 million (2008: £605 million) respectively, forward currency contracts assets and liabilities with notional amounts of £570 million (2008: £1,419 million) and £958 million (2008: £2,310 million) respectively, interest rate swaps assets and liabilities of £793 million (2008: £1,407 million) and of £522 million (2008: £2,316 million), respectively, and cliquet options assets of £7 million (2008: £1,525 million).
Fair value hedges The Group uses interest rate derivatives to hedge the interest exposures on its US$300 million, 6.5 per cent perpetual subordinated capital securities. In addition, the Group similarly used interest rate derivatives to hedge the exposure on its US$1 billion, 6.5 per cent perpetual subordinated capital securities until this hedge was cancelled in March 2009. Where the hedge relationship is de-designated and re-designated, the fair value adjustment to the hedged item up to the point of de-designation continues to be reported as part of the basis of the hedged item and is amortised to the income statement based on a recalculated effective interest rate over the residual period to the first break clause date of the perpetual subordinated capital securities.
The Group has chosen to designate as a fair value hedge certain fixed to floating 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 2009, were an asset of £7 million and liability of £1 million (2008: asset of £17 million and liability of £nil). Movements in the fair value of the hedging instruments of a net loss of £11 million (2008: net loss of £4 million) and the hedged items of a net gain of £11 million (2008: net gain of £7 million) are recorded in the income statement in respect of the fair value hedges above.
Net investment hedges The Group entered into a series of rolling one to three-month period forward currency transactions which together formed a net investment hedge of the currency exposure of the net investments in the US operations. The programme ceased in August 2009. At 31 December 2008 US$600 million of the forward currency contracts were designated as a partial net investment hedge of the currency exposure of the net investments in the US operations. The fair value of the forward currency contracts at 31 December 2008 was a liability of £56 million, of which a liability of £17 million was designated as a net investment hedge of the currency exposure of the net investments in the US operations.
Securities lending and reverse repurchase agreements The Group has entered into securities lending (including repurchase agreements) whereby blocks of securities are loaned to thirdparties, primarily major brokerage firms. 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 financial position, rather they are retained within the appropriate investment classification. Collateral typically consists of cash, debt securities, equity securities and letters of credit. At 31 December 2009, the Group had lent £10,446 million (2008: £12,617 million) of which £7,910 million (2008: £9,701 million) was lent by the PAC with-profits fund of securities and held collateral under such agreements of £10,669 million (2008: £13,497 million) of which £8,086 million (2008: £9,924 million) was held by the PAC with-profits fund.
In accordance with the Group’s accounting policy set out in note A4, impairment reviews were performed for available-for-sale securities and loans and receivables. In addition, impairment reviews were undertaken for the reinsurers’ share of insurance contract liabilities.
The impairment losses have been recorded in ‘investment return’ in the income statement. In 2009, the Group realised gross losses on sales of available-for-sale securities of £134 million (2008: 184 million) with 60 per cent
Notes on the Group financial statements > H: Other information on statement of financial position items
Assessment of whether goodwill may be impaired With the exception of M&G, the goodwill attributable to shareholders in the statement of financial position mainly relates to acquired life businesses. The Company routinely compares the aggregate of net asset value and acquired goodwill on an IFRS basis of acquired life business with the value of the business as determined using the EEV methodology, as described in note D1. Any excess of IFRS over EEV carrying value is then compared with EEV basis value of current and projected future new business to determine whether there is any indication that the goodwill in the IFRS statement of financial position may be impaired. The assumptions underpinning the Group’s EEV basis of reporting are included in the EEV basis supplementary information in this Annual Report.
Goodwill is tested for impairment by comparing the CGUs carrying amount, including any goodwill, with its recoverable amount.
The value in use is particularly sensitive to a number of key assumptions as follows: i The set of economic, market and business assumptions used to derive the five-year plan. The direct and secondary effects of recent developments, e.g. the fall in global equity markets, are considered by management in arriving at the expectations for the financial projections for the plan.
ii The assumed growth rate on forecast cash flows beyond the terminal year of the plan. A growth rate of 2.5 per cent (2008: 2.5 per cent) has been used to extrapolate beyond the plan period representing management’s best estimate view of the long-term growth rate of the business after considering the future and past growth rates and external sources of data.
Japanese life company The aggregate goodwill impairment of £120 million at 31 December 2009 and 2008 relates to the goodwill held in relation to the Japanese life operation which was impaired in 2005.
Deferred acquisition costs related to investment management contracts, including life assurance contracts classified as financial instruments and investment management contracts under IFRS 4 107 108
Deferred acquisition costs related to insurance contracts attributable to shareholders The movement in deferred acquisition costs relating to insurance contracts attributable to shareholders is as follows: Deferred acquisition costs at 1 January 5,097 2,644
Present value of acquired in-force business of long-term business contracts attributable to shareholders The present value of acquired in-force business (PVAIF) relating to investment contracts without discretionary participation features represents the contractual right to benefit from providing these investment management services in the future. The fair value is measured as the present value of the future profits of the asset management component of these contracts. These contracts are accounted for under the provisions of IAS 18. The remainder of the PVAIF balance relates to insurance contracts and is accounted for under UK GAAP as permitted by IFRS 4.
Amortisation is charged to the ‘acquisition costs and other operating expenditure’ line in the income statement over the period of provision of asset management services as those profits emerge.
a Goodwill in respect of acquired investment subsidiaries for venture fund and other investment purposes
This impairment charge is recorded under ‘acquisition costs and other operating expenditure’ but are also taken account of in determining the charge/credit in the income statement for the transfer to the liability for unallocated surplus of with-profits funds. Accordingly, the charge does not affect shareholders’ profits or equity.
b Deferred acquisition costs and other intangible assets Other intangible assets in the Group consolidated statement of financial position attributable to with-profits funds consist of: Deferred acquisition costs related to insurance contracts attributable to the PAC with-profits fund 9 13
Distribution rights attributable to with-profits funds of the Asian insurance operations 97 113
The movement on reinsurers’ share of insurance contract liabilities is as follows: Movement in the year 24 243
Assets Of the £636 million (2008: £657 million) current tax recoverable, the majority is expected to be recovered in one year or less.
The deferred tax asset at 31 December 2009 and 2008 arises in the following parts of the Group: UK insurance operations: PAC with-profits fund (including PAL) 141 272
The taxation regimes applicable across the Group apply separate rules to trading and capital profits and losses. The distinction between temporary differences that arise from items of either a trading or capital nature may affect the recognition of deferred tax assets. Accordingly, for the 2009 results and statement of financial position at 31 December 2009, the possible tax benefit of approximately £257 million (2008: £211 million), which may arise from capital losses valued at approximately £1.2 billion (2008: £1 billion), is sufficiently uncertain that it has not been recognised. In addition, a potential deferred tax asset of £607 million (2008: £678 million), which may arise from tax losses and other potential temporary differences totalling £2.1 billion (2008: £2.2 billion) is sufficiently uncertain that it has not been recognised. Forecasts as to when the tax losses and other temporary differences are likely to be utilised indicate that they may not be utilised in the short term.
Year ended 31 December 2008 Opening net book amount 151 655 206 1,012
Disposals (including amounts disposed of with the Taiwan agency business) (99) – (15) (114) Reclassify as investment property* – (131) – (131)
Investment properties principally relate to the PAC with-profits fund and are carried at fair value. A reconciliation of the carrying amount of investment properties at the beginning and end of the year is set out below: Reclassification of development property* 131 –
The income statement includes the following items in respect of investment properties: Rental income from investment properties 754 726
That did not generate rental income during the year – 1
Investment properties of £3,177 million (2008: £3,559 million) are held under finance leases. A reconciliation between the total of future minimum lease payments at the statement of financial position date, and their present value is shown below: Future minimum lease payments at 31 December 1,683 963
There have been no changes recognised in the other comprehensive income of associates that would also be recognised in the other comprehensive income by the Group. Exchange translation and other movements for 2009 mainly relate to the investment in IFonline mentioned above.
The aggregate assets of these associates are approximately £9 billion (2008: £8 billion). Aggregate liabilities, excluding liabilities to unit holders and shareholders for unit trusts and OEICs, are approximately £2 billion (2008: £2 billion). Fund revenues, with revenue arising in unit trusts and OEICs deemed to constitute the investment return for these vehicles, were approximately £0.8 billion (2008: £0.8 billion) and net loss in the year, excluding unit trusts and OEICs where all investment returns accrue to unit holders or shareholders respectively, was approximately £0.2 billion (2008: profit of £0.3 billion).
Investments in joint ventures Joint ventures represent activities over which the Group exercises joint control through contractual agreement with one or more parties. The Group’s significant joint ventures, which are accounted for using proportionate consolidation, comprise various joint ventures relating to property investments where the Group has a 50 per cent interest as well as the following interests: Investment % held Principal activity Country ICICI Prudential Life Insurance Company Limited 26 Life assurance India
The investments noted in the table above have the same accounting year end as the Group, except for ICICI Prudential Life Insurance Company Limited and Prudential ICICI Asset Management Company Limited. Although these investments have reporting periods ending 31 March, 12 months of financial information up to 31 December is recorded. Accordingly, the information covers the same period as that of the Group.
Investment properties are classified as held for sale when contracts have been exchanged but the sale has not been completed at the period end. At 31 December 2009 the value of assets held for sale was £3 million (2008: nil).
Transfer to retained earnings in respect of shares issued in lieu of cash dividends – – (156) At end of the year 2,496,947,688 125 1,840
Issued shares of 5p each fully paid: At the beginning of the year 2,496,947,688 125 1,840 Shares issued under share option schemes 605,721 – 3 Shares issued in lieu of cash dividends 34,674,062 2 136 Transfer to retained earnings in respect of shares issued in lieu of cash dividends – – (136) At end of the year 2,532,227,471 127 1,843
At 31 December 2009, there were options outstanding under Save As You Earn schemes to subscribe for 12,230,833 (2008: 6,825,343) shares at prices ranging from 266 pence to 572 pence (2008: 266 pence to 617 pence) and exercisable by the year 2016 (2008: 2015). In addition, there are 17,292 (2008: 967,652) conditional options outstanding under the RSP and 6,644,203 (2008: 4,906,234) under the GPSP exercisable at nil cost within a 10-year period.
Of the total shares held in trust, 0.5 million (2008: 0.4 million) shares were held by a qualifying employee share ownership trust. These shares are expected to be fully distributed in the future on maturity of savings-related share option schemes.
Parent company Subordinated debt: ¤20m Medium-Term Subordinated Notes 2023 note ii 18 18 19
US$1,000m 6.5% Perpetual Subordinated Capital Securities note iii 619 619 696
US$750m 11.75% Perpetual Subordinated Capital Securities note ix 456 456 –
viii Management analyses the net core structural borrowings position as follows: £m £m
Total core structural borrowings (as above) 3,394 2,958 Less: Holding company cash and short-term investments (recorded within the consolidated statement of financial position) (1,486) (1,165)
Exchange differences (9) 12 At 31 December 206 155 Comprising: Legal provisions 15 23
Of the other provisions balance of £206 million (2008: £155 million), £148 million (2008: £90 million) is expected to be settled within one year. Employer contributions expected to be paid into defined benefit pension schemes within one year are shown in note I2.
During 2009, £1 million of unused provision was released, and £3 million was paid.
Pension mis-selling review In 1988, the UK government introduced new pensions legislation intended to encourage more individuals to make their own arrangements for their pensions. During the period from April 1988 to June 1994, many individuals were advised by insurance companies, Independent Financial Advisers and other intermediaries to not join, to transfer from or to opt out of their occupational pension schemes in favour of private pension products introduced under the UK Income and Corporation Taxes Act 1988. The UK insurance regulator (previously the Personal Investment Authority, now the FSA), subsequently determined that many individuals were incorrectly advised and would have been better off not purchasing the private pension products sold to them. Industry participants are responsible for compensating the persons to whom private pensions were mis-sold. As a result, the FSA required that all UK life insurance companies review their potential cases of pension mis-selling and pay compensation to policyholders where necessary and, as a consequence, record a provision for the estimated costs. The Group met the requirement of the FSA to issue offers to all cases by
In 1998, Prudential stated that deducting mis-selling costs from the inherited estate would not impact its bonus or investment policy and it gave an assurance that if this unlikely event were to occur, it would make available support to the fund from shareholder resources for as long as the situation continued, so as to ensure that policyholders were not disadvantaged. The assurance was designed to protect both existing policyholders at the date it was announced, and policyholders who subsequently purchased policies while the pension misselling review was continuing.
The Group is exposed to mortgage endowment products in respect of policies issued by Scottish Amicable Life plc (SAL) and policies issued by Scottish Amicable Life Assurance Society (SALAS) which were transferred into SAIF. At 31 December 2009, provisions of £4 million (2008: £5 million) in SAL and £35 million (2008: £40 million) in SAIF were held within policyholder liabilities to cover potential compensation in respect of mortgage endowment product mis-selling claims. As SAIF is a separate sub-fund of the Prudential Assurance long-term business fund, this provision has no impact on shareholders.
Other matters Inherited estate of the PAC long-term fund The assets of the with-profits sub-fund (WPSF) within the long-term fund of The Prudential Assurance Company Limited (PAC) comprise the amounts that it expects to pay out to meet its obligations to existing policyholders and an additional amount used as working capital. The amount payable over time to policyholders from the WPSF is equal to the policyholders’ accumulated asset shares plus any additional payments that may be required by way of smoothing or to meet guarantees. The balance of the assets of the WPSF is called the ‘inherited estate’ and has accumulated over many years from various sources.
In 1997, the business of SALAS, a mutual society, was transferred to PAC. In effecting the transfer, a separate sub-fund, SAIF, was established within PAC’s long-term business fund. This sub-fund contains all the with-profits business and all other pension business that was transferred. No new business has been or will be written in the sub-fund and the sub-fund is managed to ensure that all the invested assets are distributed to SAIF policyholders over the lifetime of SAIF policies. With the exception of certain amounts in respect of the unitised with-profits life business, all future earnings arising in SAIF are retained for SAIF policyholders. Any excess (deficiency) of revenue over expense within SAIF during a period is offset by a transfer to (from) the SAIF unallocated surplus. Shareholders have no interest in the profits of SAIF but are entitled to the asset management fees paid on this business. With the exception of certain guaranteed annuity products mentioned earlier in this note, and certain products which include a minimum guaranteed rate of accumulation, the majority of SAIF with-profits policies do not guarantee minimum rates of return to policyholders.
On 20 February 2009, the Company announced that it had entered into an agreement to sell the assets and liabilities of its agency distribution business and its agency force in Taiwan to China Life Insurance Company Ltd of Taiwan for the nominal sum of NT$1 subject to regulatory approval. In addition, the Company would invest £45 million to purchase a 9.99 per cent stake in China Life through a share placement. The business transferred represented 94 per cent of Prudential’s in-force liabilities in Taiwan and included Prudential’s legacy interest rate guaranteed products with IFRS basis gross assets at 31 December 2008 of £4.5 billion. After taking account of IFRS shareholders’ equity of the business at 31 December 2008, provisions for restructuring costs, and other costs the Group’s IFRS shareholders’ equity at 31 December 2008 was expected to decrease by approximately £595 million.
The sale was completed, following regulatory approval, on 19 June 2009. The trading results shown below are for the period 1 January to 19 June 2009.
The carrying value of the IFRS equity of the business, as applied in the calculation of the loss on sale, reflects the application of ‘grandfathered’ US GAAP under IFRS 4 of insurance assets and liabilities. US GAAP does not, and is not designed to, include the cost of holding economic capital to support the legacy interest rate guaranteed products as recognised under the Company’s supplementary reporting basis under European Embedded Value principles. The IFRS loss on sale reflects this missing element of the economic value. The effects on the IFRS income statement and equity attributable to shareholders is shown below.
Net asset value attributable to equity holders of the Company and provision for restructuring costs (551) –
Loss on sale of the Taiwan agency business, gross and net of tax (as shown in income statement) (559) –
Trading results before tax (including short-term fluctuations in investment returns) (62) 1
The loss on disposal of £559 million includes cumulative foreign exchange gains of £9 million recycled through the profit and loss account as required by IAS 21. The impact on shareholders’ funds of the disposal (including trading losses up to the date of disposal) is £607 million. The difference of £12 million from the estimate of £595 million reflects a number of minor adjustments.
Notes on the Group financial statements > I: Other notes > continued
In order to facilitate comparisons of the Group’s retained businesses, the presentation of the segmental analysis of IFRS loss before shareholder tax (as shown in note B1) has been adjusted to show separately the result for the sold Taiwan agency business, as explained below.
I1: Sale of legacy agency book and agency force in Taiwan to China Life Insurance Company of Taiwan continued
b Pension plans i Defined benefit plans 1 Summary The Group business operations operate a number of pension schemes. The specific features of these plans vary in accordance with the regulations of the country in which the employees are located, although they are, in general, funded wholly by the Group and based either on a cash balance formula or on years of service and salary earned in the last year or years of employment. The largest defined benefit scheme is the principal UK scheme, namely the Prudential Staff Pension Scheme (PSPS); 86 per cent (2008: 87 per cent) of the underlying scheme liabilities of the Group defined benefit schemes are accounted for within PSPS.
Defined benefit schemes in the UK are generally required to be subject to full actuarial valuation every three years in order to assess the appropriate level of funding for schemes in relation to their commitments. These valuations include assessments of the likely rate of return on the assets held within the separate trustee administered funds. PSPS was last actuarially valued as at 5 April 2008. This valuation demonstrated the scheme to be 106 per cent funded by reference to the Scheme Solvency Target that forms the basis of the scheme’s statutory funding objective. Accordingly, the total contributions to be made by the Group into the scheme were reduced from the previous arrangement of £70-£75 million per annum to £50 million per annum effective from 1 July 2009. As the scheme was in a surplus position at the valuation date, no formal deficit funding plan was required. However, recognising that there had been significant deterioration in the value of the scheme assets from 5 April 2008 to the date of the finalisation of the valuation, contributions to the scheme for additional funding of £25 million per annum, as well as the £25 million per annum employer’s contributions for ongoing service of current employees, was agreed with the Trustees subject to a reassessment when the next valuation is completed. The additional funding is akin to deficit funding. Deficit funding for PSPS is apportioned in the ratio of 70/30 between the PAC life fund and shareholder-backed operations following detailed consideration in 2005 of the sourcing of previous contributions. Employer contributions for ongoing service of current employees are apportioned in the ratio relevant to current activity. In 2009 total contributions for the year including expenses and augmentations were £67 million at 31 December (2008: £79 million).
The valuation of the Scottish Amicable Pension Scheme as at 31 March 2008 demonstrated the scheme to be 91 per cent funded, with a shortfall of actuarially determined liabilities of nine per cent, representing a deficit of £38 million. Based on this valuation, deficit funding amounts designed to eliminate the actuarial deficit over a seven year period were made from July 2009 of £7.3 million per annum. The IAS 19 deficit of the Scottish Amicable Pension Scheme at 31 December 2009 of £139 million (2008: £44 million) has been allocated 50 per cent to the PAC with-profits fund and 50 per cent to the PAC shareholders fund.
Subsequent to the year end, the valuation of the M&G Pension Scheme as at 31 December 2008 was finalised in January 2010. The valuation demonstrated the scheme to be 76 per cent funded, with a shortfall of actuarially determined assets to liabilities of £51 million. Based on this valuation, deficit funding amounts designed to eliminate the actuarial deficit over a five year period were made from January 2010 of £14.1 million per annum for the first two years and £9.3 million per annum for the subsequent three years. The IAS 19 deficit of the M&G Pension Scheme on an economic basis at 31 December 2009 was £36 million (2008: £23 million) and is wholly attributable to shareholders.
The asset and liabilities of PSPS are unaffected by the impact of the application of IFRIC 14. PSPS is managed on an economic basis for the longer-term benefit of its current and deferred pensioners and active members. The surplus in PSPS is available to absorb future adverse asset value movements and, if required, strengthening in mortality assumptions.
On the economic basis (including investments of the M&G scheme in Prudential policies as assets), for 2009, a £32 million (2008: £26 million) pre-tax shareholder charge to operating results based on longer-term returns arises. In addition, outside the operating result but included in total profits is a pre-tax shareholder loss of £74 million (2008: £14 million) for shareholders’ share of actuarial and other gains and losses.
In addition, also on the economic basis, the PAC with-profits sub-fund was charged £16 million (2008: charge of £10 million) for its share of the pension charge of PSPS and Scottish Amicable and charged with £81 million (2008: £7 million) for its share of net actuarial and other losses on the scheme assets and liabilities. As shareholder profits for the PAC with-profits sub-fund reflects the surplus for distribution, these amounts are effectively absorbed by an increased credit in the income statement for the transfer to the liability for unallocated surplus.
At 31 December 2009, after the effect of the application of IFRIC 14, the total share of the liability for deficit funding on PSPS and the deficit on the smaller Scottish Amicable Scheme attributable to the PAC with-profits fund amounted to a liability of £110 million (2008: £60 million) net of related tax relief.
The Trustee sets the general investment policy and specifies any restrictions on types of investment and the degrees of divergence permitted from the benchmark, but delegates the responsibility for selection and realisation of specific investments to the Investment Managers. In carrying out this responsibility, the Investment Managers are required by the Pensions Act 1995 to have regard to the need for diversification and suitability of investments. Subject to a number of restrictions contained within the relevant asset management agreements, the Investment Managers are authorised to invest in any class of investment asset. However, the Investment Managers will not invest in any new class of investment asset without prior consultation with the Trustee.
3 Assumptions The actuarial assumptions used in determining benefit obligations and the net periodic benefit costs for the years ended 31 December were as follows: Discount rate* 5.8 6.1
Rate of increase of pensions in payment for inflation: Expected returns on plan assets 4.5 6.2 *The discount rate of 5.8 per cent has been determined by reference to an ‘AA’ corporate bond index adjusted, where applicable, to allow for the difference in duration between the index and the pension liabilities.
The tables used for PSPS immediate annuities in payment at 31 December 2009 were: Male: 108.6 per cent PNMA 00 with medium cohort improvements subject to a floor of 1.75 per cent up to the age of 90, decreasing linearly to zero by age of 120; and Female: 103.4 per cent PNFA 00 with 75 per cent medium cohort improvements subject to a floor of 1.00 per cent up to the age of 90 and decreasing linearly to zero by age of 120.
The tables used for PSPS immediate annuities in payment at 31 December 2008 were: Male: 100 per cent PMA 92 with CMIR17 improvements to the valuation date and medium cohort improvements subject to a floor of 1.75 per cent up to the age of 90, decreasing linearly to zero by age of 120; and Female: 100 per cent PFA92 with CMIR17 improvements to the valuation date and 75 per cent medium cohort improvements subject to a floor of one per cent up to the age of 90 and decreasing linearly to zero by age of 120.
The assumed life expectancies on retirement at age 60, based on the mortality table used was: 2009 years 2008 years
4 Summary financial position The Group liability in respect of defined benefit pension schemes is as follows: Economic position: Deficit, gross of deferred tax, based on scheme assets held, including investments in Prudential insurance policies: Attributable to the PAC with-profits fund (i.e. absorbed by the liability for unallocated surplus) (122) (67)
5 Group economic financial position The following tables illustrate the movement on the financial position of the Group’s defined benefit pension schemes on an economic basis. The underlying position reflects the assets (including investments in Prudential policies that are offset against liabilities to policyholders on the Group consolidation) and the liabilities of the schemes. At 31 December 2009, the investments in Prudential policies comprise £101 million (£2008: £103 million) for PSPS and £187 million (2008: £157 million) for the M&G scheme.
Separately, the economic financial position also includes the effect of the application of IFRIC 14, whereby for PSPS, where there are constraints in the trust deed to prevent the company access, the surplus is not recognised and a liability to additional funding (as described earlier) is established.
Less: amount attributable to PAC with-profits fund (483) 33 207 (42) – (285)
Shareholders’ share: Gross of tax surplus (deficit) (243) 6 56 – – (181)
With the effect of IFRIC 14 Surplus (deficit) (149) (48) (155) 85 17 (250) Less: amount attributable to PAC with-profits fund 67 16 81 (42) – 122
Surplus (based on other Results (deficit) (deficit) in longer-term gains of sold in scheme scheme at investment and Taiwan at 31 Dec 1 January returns) losses agency Contributions 2008 2008 note b note c business paid Exchange note a
Shareholders’ share: Gross of tax surplus (deficit) 109 (2) 12 (1) 47 (4) 161
a On the ‘economic basis’, after including the underlying assets represented by the investments in Prudential insurance policies as scheme assets, the underlying statements of financial position of the schemes at 31 December were: Other Other schemes schemes
Effect of the application of IFRIC 14 for pension schemes: Derecognition of PSPS surplus (513) – (513) (728) – (728)
ii The resulting scheme deficit arising from the excess of liabilities over assets at 31 December 2009 of £250 million (2008: £149 million) comprised a deficit of £122 million (2008: deficit of £67 million) attributable to the PAC with-profits fund and deficit of £128 million (2008: deficit of £82 million) attributable to shareholder operations.
The movements in the deficit on the ‘economic basis’ between scheme assets and liabilities were: Current service cost (11) (19)
Total (charge) credit without the effect of IFRIC 14 (71) 46
The net charge to operating profit (gross of the share attributable to the PAC with-profits fund) of £48 million (2008: £36 million) is made up of a charge of £29 million (2008: £29 million) relating to PSPS and a charge of £19 million (2008: £7 million) for other schemes. This net charge represents: Underlying IAS 19 charge for other pension schemes (19) (7)
Consistent with the derecognition of the Company’s interest in the underlying IAS 19 surplus of PSPS, the actuarial gains and losses do not include those of PSPS. In addition, as a result of applying IFRIC 14, the Group has recognised a provision for deficit funding in respect of PSPS. The change in 2009 in relation to this provision recognised above as other gains and losses on defined benefit pension schemes was £48 million (2008: £13 million).
Service cost – current charge only (11) (11) Interest cost (35) (35) Expected return on plan assets 18 9 27 27
Notes on the Group financial statements > I: Other notes > continued 2008 £m
Provision fair value in Prudential basis: present value basis: for deficit of plan insurance total of benefit net funding assets policies assets obligations obligations
Fair value of plan assets, beginning of year 401 172 573 573
7 IAS 19 basis financial position as consolidated The IAS 19 basis pensions deficit can be summarised as follows: Fair value of plan assets, end of year 5,224 5,057 5,150 4,988 4,622
Present value of funded benefit obligation (4,951) (4,493) (4,826) (5,023) (5,228)
Present value of unfunded obligations (M&G scheme)* (223) (180) (189) (187) (190)
Set up obligation for deficit funding for PSPS (75) (65) (102) (143) –
Deficit recognised in the statement of financial position (437) (306) (355) (380) (796)
* The M&G pension scheme assets are invested in Prudential insurance policies. For IFRS accounting purposes, the M&G scheme is in effect unfunded. Please see above for more details.
Less: actuarial gains on investments of scheme assets in Prudential insurance policies 8 79
* Consistent with the derecognition of the Company’s interest in the underlying IAS 19 surplus of PSPS, the effect on the net periodic pension cost for PSPS was to replace the usual IAS 19 pension charges and credits with the cash cost of contribution for ongoing services of active members and also not to report the actuarial gains and losses.
The long-term expected rate of return has been taken to be the weighted average (by market value) of the long-term expected rates of return on each major asset class shown below: Scheme assets (IAS 19 basis before effect of IFRIC 14)
The actual return on scheme assets was a gain of £348 million (2008: loss of £20 million) on an IAS 19 basis.
Percentage of scheme liabilities at 31 December 1.47% 3.10% 0.28% (0.35)% (0.02)%
Discount rate Increase by 0.2% from 5.8% to 6.0% Decrease in scheme liabilities by: PSPS 3.2%
Rate of inflation Decrease by 0.2% from 3.7% to 3.5% Decrease in scheme liabilities by: with consequent reduction in PSPS 0.9%
Discount rate Increase by 0.2% from 6.1% to 6.3% Decrease in scheme liabilities by: PSPS 3.1%
The Group maintains 10 main share award and share option plans relating to Prudential plc shares, which are described below. The Group Performance Share Plan (GPSP) is the incentive plan in which all executive directors and other senior executives within the Group can participate. This scheme was established as a replacement for the Restricted Share Plan (RSP) under which no further awards could be made after March 2006. Awards are granted either in the form of a nil cost option, conditional right over shares, or such other form that shall confer to the participant an equivalent economic benefit, with a vesting period of three years. The performance measure for the awards is that Prudential’s Total Shareholder Return (TSR) outperforms an index comprising of peer companies. Vesting of the awards between each performance point is on a straight line sliding scale basis. Participants are entitled to the value of reinvested dividends that would have accrued on the shares that vest. Shares are currently purchased in the open market by a trust for the benefit of qualifying employees. Beginning 2010, newly issued shares will be used in settling the awards that vest and are released.
The RSP was, until March 2006, the Group’s long-term incentive plan for executive directors and other senior executives designed to provide rewards linked to shareholder return. Each year participants were granted a conditional option to receive a number of shares. There was a deferment period of three years at the end of which the award vested to an extent that depended on the performance of the Group’s shares including notional reinvested dividends and on the Group’s underlying financial performance. After vesting, the option may be exercised at zero cost at any time, subject to closed period rules, in the balance of a 10-year period. Shares are purchased in the open market by a trust for the benefit of qualifying employees.
Movements in share awards outstanding under the Group’s share-based compensation plans relating to Prudential plc shares at 31 December 2009 and 2008 were as follows: Number of Number of awards awards
The following table provides a summary of the range of exercise prices for Prudential plc options (including conditional options) outstanding at 31 December 2009.
The following table provides a summary of the range of exercise prices for Prudential plc options (including conditional options) outstanding at 31 December 2008.
Intrinsic value of above liabilities for which rights had vested at 31 December 7 4
The share-based payments charge is the sum of £5,270,000 (2008: £4,624,000), which is determined in accordance with IFRS 2, ‘Share-Based Payments’ (see note I3) and £2,102,000 (2008: £1,563,000) of deferred share awards.
In addition, there were fees incurred of £0.2 million (2008: £0.2 million) for the audit of pension schemes. The Audit Committee regularly monitors the non-audit services provided to the Group by its auditor and has developed a formal
Transactions between the Company and its subsidiaries are eliminated on consolidation. In addition, the Company has transactions and outstanding balances with certain unit trusts, OEICs, collateralised debt obligations and similar entities which are not consolidated and where a Group company acts as manager. These entities are regarded as related parties for the purposes of IAS 24. The balances are included in the Group’s statement of financial position sheet at fair value or amortised cost in accordance with their IAS 39 classifications. The transactions are included in the income statement and include amounts paid on issue of shares or units, amounts received on cancellation of shares or units and paid in respect of the periodic charge and administration fee. Further details of the aggregate assets, liabilities, revenues, profits or losses and reporting dates of entities considered to be associates under IFRS are disclosed in note H8.
In 2009 and 2008, other transactions with directors were not deemed to be significant both by virtue of their size and in the context of the directors’ financial positions. As indicated above, all of these transactions are on terms broadly equivalent to those that prevail in arm’s length transactions.
Prudential Assurance Company Singapore (Pte) Limited* Insurance Singapore * Owned by a subsidiary undertaking of the Company.
Notes on the Group financial statements > I: Other notes > continued ii Dividend restrictions and minimum capital requirements Certain Group subsidiaries are subject to restrictions on the amount of funds they may transfer in the form of cash dividends or otherwise to the parent company. UK insurance companies are required to maintain solvency margins which must be supported by capital reserves and other resources, including unrealised gains on investments. Jackson can pay dividends on its capital stock only out of earned surplus unless prior regulatory approval is obtained. Furthermore, without the prior regulatory approval, dividends cannot be distributed if all dividends made within the preceding 12 months exceed the greater of Jackson’s statutory net gain from operations or 10 per cent of Jackson’s statutory surplus for the prior year. In 2010, the maximum amount of dividends that can be paid by Jackson without prior regulatory approval is US$454 million (£281 million) (in 2009: US$290 million (£202 million)). The Group’s Asian subsidiaries, mainly the Singapore and Malaysia businesses, may remit dividends to the Group, in general, provided the statutory insurance fund meets the capital adequacy standard required under local statutory regulations.
The Group capital position statement for life assurance businesses is set out in note D5, showing the available capital reflecting the excess of regulatory basis over liabilities for each fund or group of companies determined by reference to the local regulation of the subsidiaries. In addition, disclosure is also provided in note D5 of the local capital requirement of each of the fund or group of companies.
Future minimum lease payments for non-cancellable operating leases fall due during the following periods: Not later than 1 year 63 86
Minimum lease rental payments for the year ended 31 December 2009 of £105 million (2008: £84 million) are included in the consolidated income statement.
The charge of £14 million, which is net of nil tax, reflects completion adjustments for a previously disposed business.
Within the analysis of the items for 2008 that reconcile from the total loss of £2,074 million to the net cash flow from operating activities of £1,144 million reclassification adjustments in respect of two items have been made. These adjustments are to: a increase the ‘change in operating assets and liabilities’ attributable to ‘investments’, and decrease the amount attributable to ‘other non-investment and non-cash assets’, by £831 million, for shadow DAC movements accounted for in Other Comprehensive Income, and b increase the deduction for the ‘interest income and expense and dividend income included in the result before tax’ and ‘interest receipts’ by £2,938 million for foreign exchange losses, arising principally with the PAC with-profits fund, that were previously netted within the amounts for these lines.
i 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 SGD 428 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’s 414 bank branches across Singapore, Indonesia and Thailand.
The Group continues to complete its compilation of the acquisition balance sheet and further details will be provided in the Group’s 2010 half year results announcement.
This decision does not effect the Group’s asset management operations in Japan, which ranks among the largest foreign asset managers.
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.
The rights issue and the Scheme will be subject to shareholder approval at a General Meeting. The Transaction is also subject to certain regulatory and anti-trust approvals including various regulatory approvals required on a change of control of Prudential as a result of the Scheme.
Less liabilities: amounts falling due within one year Debenture loans 6 – (249)
The financial statements of the parent company on pages 292 to 301 were approved by the Board of directors on 8 March 2010 and signed on its behalf.
Prudential plc (the Company) is a parent holding company. The Company together with its subsidiaries (collectively, the Group) is an international financial services group with its principal operations in the UK, the US and Asia. The Group operates in the UK through its subsidiaries, primarily The Prudential Assurance Company Limited, Prudential Annuities Limited, Prudential Retirement Income Limited and M&G Investment Management Limited. In the US, the Group’s principal subsidiary is Jackson National Life Insurance Company. In Asia, the Group’s main operations are in Hong Kong, Indonesia, Malaysia and Singapore. The Company is responsible for the financing of each of its subsidiaries.
The amendments to FRS 8 ‘Related Party Transactions’ became effective for the Company in 2009. The amendments made were to align the definition of related party with that in UK law and IAS 24 ‘Related Party Disclosures’. The main effect of this amendment is that there is no longer an exemption from disclosure of related party transactions in the Company’s financial statements on the basis that these financial statements are presented with the consolidated financial statements. The Company is required under the amendment to disclose any transactions with subsidiaries which are not wholly-owned. The Company did not have any disclosable transactions under this amendment.
Additionally, in 2009, the Company adopted the following new accounting pronouncements. Their adoption had no material impact on the financial statements of the Company: • Amendment on FRS 26 financial instruments – Eligible Hedged Items • Amendments to UITF Abstract 42 and FRS 26 – Embedded Derivatives • Amendments to FRS 20 ‘Share-based Payment – Vesting Conditions and Cancellations’ • Improvements to Financial Reporting Standards (2008)
Loans to subsidiary undertakings Loans to subsidiary undertakings are shown at cost, less provisions.
3 Significant accounting policies 2 Basis of preparation 1 Nature of operations
Foreign currency translation Foreign currency borrowings that have been used to finance or provide a hedge against Group equity investments in overseas subsidiaries are translated at year end exchange rates. The impact of these currency translations is recorded within the profit and loss account for the year.
The assets and liabilities of the defined benefit pension schemes of the Prudential Group are subject to a full triennial actuarial valuation using the projected unit method. Estimated future cash flows 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.
Under the principles of UITF 44, where the Company, as the parent company, grants options or awards of its equity instruments to employees of its subsidiary undertakings, and such share-based payments are accounted for as equity-settled in the Group financial statements, the Company records an increase in the investment in the subsidiary undertakings for the value of the share options and awards granted with a corresponding credit entry recognised directly in equity. The value of the share options and awards granted is based upon the fair value of the options and awards at the grant date, the vesting period and the vesting conditions.
The transfer of investment in subsidiary undertaking relates to the sale of shares in a central finance subsidiary to another such company. The consideration was the assignment of loans to a further central finance subsidiary with a value of £889 million and cash of £132 million.
Other borrowings: Medium-Term Notes 2010note ix – – 7 9 7 9
Floating Rate Notes 2010note x – – 200 200 200 200
Recorded in the balance sheet as: Subordinated liabilitiesnote xi 2,687 1,983
Notes i The £249 million 5.5 per cent borrowings were repaid on maturity in May 2009.
iii The ¤20 million borrowings were issued at 20-year Euro Constant Maturity Swap (capped at 6.5 per cent). These have been swapped into borrowings of £14 million with interest payable at three month £LIBOR plus 1.2 per cent. iv The interest rate on the £400 million 11.375 per cent borrowings will change to three month £LIBOR plus 11.348 per cent on 29 May 2019. v Interest on the US$1,000 million 6.5 per cent borrowings was swapped into floating rate payments at three month US$LIBOR plus 0.80 per cent.
ix These borrowings support a short-term fixed income securities programme. x The Company originally issued £200 million Floating Rate Notes in October 2008 which matured in April 2009. New £200 million Notes were issued in April 2009, which matured in October 2009, and again in October 2009 which will mature in April 2010. All Notes have been wholly subscribed to by a Group subsidiary and accordingly have been eliminated on consolidation in the Group financial statements.
The Company has a US$300 million fair value hedge in place which hedges the interest rate exposure on the US$300 million 6.5 per cent perpetual subordinated capital securities. In addition, the Company had a US$1,000 million fair value hedge which hedged the interest rate exposure on the US$1,000 million 6.5 per cent perpetual subordinated capital securities until this hedge was cancelled in March 2009. The derivative financial instruments were valued internally using standard market practices. In accordance with the Company’s risk management framework, all internally generated valuations are subject to independent assessment against external counterparties’ valuations.
The assets and liabilities of PSPS were: 31 Dec 2009 31 Dec 2008 31 Dec 2007 31 Dec 2006 31 Dec 2005
After deducting deferred tax, the amounts reflected in the balance sheet of the Company are 37 36 117 34 (80)
Underlying scheme assets and liabilities of PSPS The change in the present value of the underlying scheme liabilities and the change in the fair value of the underlying assets of PSPS are as follows: Present value of scheme liabilities, at 1 January 4,075 4,361
Pension (charge) credit and actuarial (losses) gains of PSPS The pension charge recognised in the Company’s profit and loss account is as follows: Pension (charge) credit
The pension charge attributable to the Company is net of the apportionment to the PAC with-profits fund and is related to the surplus recognised on the balance sheet of the Company. In 2008, an amount of £9 million was applied to extinguish the curtailment credit attributable to the Company from the unrecognised portion of the pension surplus at 31 December 2008. There was no such amount applied against the pension charge in 2009.
The total actual return on scheme assets for PSPS was a gain of £298 million (2008: £40 million). The experience gains on scheme liabilities in 2008 of £127 million related mainly to the ‘true-up’ reflecting improvements in data consequent upon the ongoing triennial valuation of PSPS.
Shares issued under share option schemes 605,721 – 3 Shares issued in lieu of cash dividends 34,674,062 2 136 Transfer to retained profit in respect of shares issued in lieu of cash dividends – – (136)
At 31 December 2009, there were options subsisting under share option schemes to subscribe for 12,230,833 (2008: 6,825,343) shares at prices ranging from 266 pence to 572 pence (2008: 266 pence to 617 pence) and exercisable by the year 2016 (2008: 2015). In addition, there were 17,292 (2008: 967,652) conditional options outstanding under the Restricted Share Plan and exercisable at nil cost by the year 2015. No further options have been issued under this Plan since it was replaced by the Group Performance Share Plan in March 2006. There were 6,644,203 (2008: 4,906,234) conditional options outstanding under the Group Performance Share Plan and exercisable at nil cost within a 10 year period. Further information on the Group’s employee share options is given in note I3 ‘Share-based payments’ of the notes on the financial statements of the Group.
The profit after tax of the Company for the year was £913 million (2008: £486 million). After dividends of £481 million (2008: £453 million), actuarial losses net of tax in respect of the pension scheme of £2 million (2008: £103 million), share-based payment reserve movement of £10 million (2008: £9 million) and a transfer from the share premium account of £136 million (2008: £156 million) in respect of shares issued in lieu of cash dividends, retained profit at 31 December 2009 amounted to £1,856 million (2008: £1,280 million).
A reconciliation of the movement in shareholders’ funds of the Company for the years ended 31 December 2009 and 2008 is given below: Profit for the year 913 486
b Information on transactions of the directors with the Group is given in note I6 ‘Related party transactions’ of the notes on the financial statements of the Group.
c The Company employs no staff. d Fees payable to the Company’s auditor for the audit of the Company’s annual accounts were £0.1 million (2008: £0.1 million).
In addition, the Company paid fees for other services of £0.2 million (2008: £0.2 million). e In certain instances the Company has guaranteed that its subsidiaries will meet their obligations when they fall due for payment.
Statement of directors’ responsibilities in respect of the Annual Report and the financial statements
This report is made solely to the Company’s members, as a body, in accordance with Chapter 3 of Part 16 of the Companies Act 2006. Our audit work has been undertaken so that we might state to the Company’s members those matters we are required to state to them in an auditors’ report and for no other purpose. To the fullest extent permitted by law, we do not accept or assume responsibility to anyone other than the Company and the Company’s members, as a body, for our audit work, for this report, or for the opinions we have formed.
Under the Listing Rules we are required to review: • the directors’ statement, set out on page 93, in relation to going concern; and
G Bainbridge (Senior Statutory Auditor) for and on behalf of KPMG Audit Plc, Statutory Auditor Chartered Accountants London
Other income and expenditure Investment return and other income 22 89 Interest payable on core structural borrowings (209) (172) Corporate expenditure: Group Head Office (146) (130) Asia Regional Head Office (57) (41)
Analysed as profits (losses) from: Business in force 3 1,601 1,636
Long-term business 3,208 2,836 Asset management 297 345 Other results (415) (316)
ii The US broker-dealer and asset management result includes losses for Curian of £6 million (2008: £3 million). iii The value of future profits or losses from asset management and service companies that support the Group’s covered businesses are included in the profits for new business and the in-force value of the Group’s long-term business. The results of the Group’s asset management operations include the profits from management of internal and external funds. For EEV basis reporting, Group shareholders’ other income is adjusted to deduct the expected margin for the year on management of covered business. The deduction is on a basis consistent with that used for projecting the results for covered business. Group operating profit accordingly includes the variance between actual and expected profit in respect of covered business.
v In June 2009, the Group completed the previously announced sale of its Taiwan agency business. In order to facilitate comparisons of the results of the Group’s retained businesses the effect of disposal and the results of the Taiwan agency business are shown separately. The presentation of the comparative results for full year 2008 has been adjusted accordingly as explained in note 18.
Mark to market value movements on core borrowings 9 (795) 656
Shareholders’ share of actuarial and other gains and losses on defined benefit pension schemes (84) (14)
Profit on sale and results for Taiwan agency business 18 91 (248)
Profit (loss) from continuing operations before tax (including actual investment returns) 1,743 (2,106)
From operating profit based on longer-term investment returns, after related tax and minority interests of £2,221m (2008: £2,103m) 12 88.8p 85.1p
Dividends relating to reporting year: Dividends declared and paid in reporting year: Current year interim dividend 6.29p 5.99p
Items taken directly to equity: Exchange movements on foreign operations and net investment hedges: Exchange movements arising during the year (761) 2,010
Treasury shares: 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) (25)
Net asset value per share (in pence) Based on EEV basis shareholders’ equity of £15,273m (2008: £14,956m) 603p 599p
*Return on embedded value is based on EEV operating profit after tax and minority interests as a percentage of opening EEV basis shareholders’ equity.
Policyholder liabilities (net of reinsurers’ share) and unallocated surplus of with-profits funds (195,230) (181,151)
The supplementary information on pages 304 to 340 was approved by the Board of directors on 8 March 2010 and signed on its behalf.
In determining the new business contribution for UK immediate annuity and lifetime mortgage business, which is interest rate sensitive, it is appropriate to use assumptions reflecting point of sale market conditions, consistent with how the business is priced. For other business within the Group, end of period economic assumptions are used.
Valuation movements on investments With the exception of debt securities held by Jackson, investment gains and losses during the period (to the extent that changes in capital values do not directly match changes in liabilities) are included directly in the profit for the period and shareholders’ equity as they arise.
Value of in-force business The embedded value results are prepared incorporating best estimate assumptions about all relevant factors including levels of future investment returns, expenses, persistency and mortality. These assumptions are used to project future cash flows. The present value of the future cash flows is then calculated using a discount rate which reflects both the time value of money and the non-diversifiable risks associated with the cash flows that are not otherwise allowed for.
Cost of capital A charge is deducted from the embedded value for the cost of capital supporting the Group’s long-term business. This capital is referred to as encumbered capital. The cost is the difference between the nominal value of the capital and the discounted value of the projected releases of this capital allowing for investment earnings (net of tax) on the capital.
Where encumbered capital is held within a with-profits long-term fund, the value placed on surplus assets in the fund is already discounted to reflect its release over time and no further adjustment is necessary in respect of encumbered capital.
Fixed annuities provide that, at Jackson’s discretion, it may reset the interest rate credited to policyholders’ accounts, subject to a guaranteed minimum. The guaranteed minimum return varies from 1.5 per cent to 5.5 per cent (2008: 1.5 per cent to 5.5 per cent), depending on the particular product, jurisdiction where issued, and date of issue. At 31 December 2009, 82 per cent (2008: 83 per cent) of the account values on fixed annuities relates to policies with guarantees of 3 per cent or less. The average guarantee rate is 3.0 per cent (2008: 3.0 per cent).
Jackson issues VA contracts where it contractually guarantees to the contract holder either a) return of no less than total deposits made to the contract adjusted for any partial withdrawals, b) total deposits made to the contract adjusted for any partial withdrawals plus a minimum return, or c) the highest contract value on a specified anniversary date adjusted for any withdrawals following the specified contract anniversary. These guarantees include benefits that are payable at specified dates during the accumulation period (Guaranteed Minimum Withdrawal Benefit (GMWB)) and minimum accumulation, death and income benefits. Jackson hedges these risks using equity options and futures contracts.
These guarantees generally protect the policyholder’s value in the event of poor equity market performance. Jackson also issues fixed index annuities that enable policyholders to obtain a portion of an equity-linked return while providing a guaranteed minimum return. The guaranteed minimum returns would be of a similar nature to those described above for fixed annuities.
With-profits products provide returns to policyholders through bonuses that are smoothed. There are two types of bonuses: annual and final. Annual bonuses are declared once a year and, once credited, are guaranteed in accordance with the terms of the particular product. Unlike annual bonuses, final bonuses are guaranteed only until the next bonus declaration. The with-profits fund held a provision on the Pillar I Peak 2 basis of £31 million (2008: £42 million) at 31 December 2009 to honour guarantees on a small amount of guaranteed annuity option products.
ii Level of encumbered capital In adopting the EEV Principles, Prudential has based encumbered capital on its internal targets for economic capital subject to it being at least the local statutory minimum requirements. Economic capital is assessed using internal models but, when applying the EEV Principles, Prudential does not take credit for the significant diversification benefits that exist within the Group. For with-profits business written in a segregated life fund, as is the case in Asia and the UK, the capital available in the fund is sufficient to meet the encumbered capital requirements. For shareholder-backed business the following capital requirements apply: • Asian operations: the level of encumbered capital has been set at the higher of local statutory requirements and the economic capital requirement; • US operations: the level of encumbered capital has been set to an amount at least equal to 235 per cent of the risk-based capital required by the National Association of Insurance Commissioners (NAIC) at the Company Action Level (CAL); and
The risk margin represents the aggregate of the allowance for market risk, additional allowance for credit risk where appropriate, and allowance for non-diversifiable non-market risk. No allowance is required for non-market risks where these are assumed to be fully diversifiable. The majority of non-market and non-credit risks are considered to be diversifiable.
Market risk allowance The allowance for market risk represents the multiple of beta x equity risk premium. Except for UK shareholder-backed annuity business (as explained below) such an approach has been used for all of the Group’s businesses.
Asian operations For Asian operations, the allowance for credit risk incorporated in the projected rates of return and the market risk allowance are sufficient. Accordingly no additional allowance for credit risk is required.
For 2009 the risk discount rate incorporates an additional allowance for credit risk premium and short-term defaults. The allowance for 2009 is 150 basis points for spread-based business and 30 basis points for variable annuity business to reflect the fact that a proportion of the variable annuity business is allocated to the general account.
UK business a Shareholder-backed annuity business For Prudential’s UK shareholder-backed annuity business, Prudential has used a market consistent embedded value (MCEV) approach to derive an implied risk discount rate which is then applied to the projected best estimate cash flows.
b With-profit fund PAL annuity business For UK annuity business written by PAL for 2008 the allowance for credit risk was for best estimate defaults. For 2009, the basis for determining the appropriate aggregate allowance for credit risk has been aligned with that of UK shareholder-backed annuity business so as also to include provision for short-term defaults. The allowance for credit risk in PAL is taken into account in determining the projected cash flows to the with-profits fund, which are in turn discounted at the risk discount rate applicable to all of the projected cash flows of the fund.