Prudential plc is an international financial services company, which aims to help people enhance and protect their own and their dependants’ financial wellbeing by providing them with appropriate savings and protection products.
Products ■ Annuities ■ Corporate Pensions ■ With-profits and Unit-linked Bonds ■ Savings and Investments ■ Protection ■ Equity Release ■ Health Insurance
Institutional Business ■ Segregated fixed interest, pooled pension funds, structured and private finance
Underlying profit increased by 57 per cent in 2004 to £110 million.
Gross fund inflows in Continental Europe grew fourfold to ¤611 million compared to 2003.
Prudential has life insurance and fund management operations across 12 countries in Asia and is Europe’s leading life insurer in Asia in terms of market coverage and number of top five market positions.
Egg’s share of UK credit card market is now over six per cent.
Appleton, Wisconsin Atlanta, Georgia Bismarck, North Dakota Chicago, Illinois Denver, Colorado New York, New York Purchase, New York Roseland, New Jersey Santa Monica, California Tampa, Florida
It pioneered a unit-linked product in Malaysia, Indonesia, the Philippines, Singapore and Taiwan.
Currently, Prudential Corporation Asia has a network of over 130,000 agents serving more than 5.7 million customers around the region.
■ ICICI Bank for life and mutual funds business in India
■ Across the region Prudential Corporation Asia now has a variety of distribution partnerships including relationships with a number of leading banks
Locations China Malaysia Hong Kong The Philippines India Singapore Indonesia Taiwan Japan Thailand Korea Vietnam
Egg’s core UK business made an operating profit of £74 million (2003: £73 million).
MSB operating profit on continuing operations of £182 million, up 46 per cent on 2003.
Achieved Profits Basis Results Operating profit before amortisation of goodwill UK and Europe Insurance Operations 450 359 M&G 136 83 Egg – continuing operations 43 55
UK and Europe Operations 592 408 US Operations – continuing operations 303 194
– discontinued operations 17 22 Asian Operations 400 378 Other Income and Expenditure (including Asia development expenses) (208) (208)
Analysed as: Operating profit from continuing operations 1,124 861 Operating loss from discontinued operations (20) (67)
Amortisation of goodwill (97) (98) Short-term fluctuations in investment returns 679 682 Effect of changes in economic assumptions (100) (540) Profit or loss on the sale or termination of discontinued operations: Profit on business disposals 48 – Egg France closure cost (113) –
Statutory Basis Results Operating profit before amortisation of goodwill 583 357
Operating profit and operating earnings per share include investment returns at the expected long-term rate of return but exclude amortisation of goodwill and exceptional items. The directors believe that operating profit, as adjusted for these items, better reflects underlying performance. Profit on ordinary activities and basic earnings per share include these items together with actual investment returns. This basis of presentation has been adopted consistently throughout these financial statements.
*Earnings per share and dividend per share figures for 2003 have been restated to take account of the Rights Issue in 2004. In addition, the achieved profits and statutory basis shareholders’ funds for 2003 have been adjusted to reflect the implementation of UITF Abstract 38 ‘Accounting for ESOP Trusts’.
After several years of difficult market conditions in the UK and the US, 2004 was a year in which we began to see signs of recovery. In Asia, the economies in which we operate continued to grow, and rising wealth and market liberalisation fuelled interest in savings and investment products.
Across the world we saw a continuation of the growing awareness of the impact that shifting demographics will have on people’s lives, and the central role that insurers can play in helping to address the global savings gap and secure the financial well-being of those who are living longer. Against this backdrop, we continued to pursue opportunities for sustainable, profitable growth in each of our chosen markets, and we ended the year in a stronger position than we have enjoyed for some time.
Shareholders’ funds on an achieved profits basis rose by 27 per cent to £8.6 billion, an increase which reflects the proceeds of our Rights Issue announced in October and the growth in the value of our long-term business.
Egg closed its loss-making French arm during 2004 and is now focused on delivering value from its profitable UK operations. We were disappointed that we were unable to sell Egg during the year but, although we do not see it as a long-term core business, we are determined to ensure that it is managed to protect and build the value of our investment.
Shortly before publication of this Report, we also announced that Jonathan Bloomer will step down at the close of the Annual General Meeting. He will be replaced as Group Chief Executive by Mark Tucker. I would like to thank Jonathan for his significant contribution over the last 10 years, first as Group Finance Director and then as Group Chief Executive. He has brought Prudential through one of the severest markets the insurance sector has experienced and has overseen significant changes in our operations which have contributed to the very good results delivered in 2004. We wish him well for the future.
In 2004, each of our regional businesses delivered double-digit growth in sales and profits. As a result, we achieved record Group insurance annual premium equivalent (APE) sales, and a 23 per cent increase in new business achieved profit compared with 2003*.
We achieved these results by adopting a disciplined approach to investment and growth, allocating capital to those businesses that deliver sustainable high returns. At the same time, we managed our risks by maintaining a diversified portfolio of businesses across our chosen markets, principally in the UK, the US and Asia, including several mature cash generators, as well as attractive newer businesses which require investment.
UNITED KINGDOM The UK insurance market is starting to recover from three years of decline. During this period, we transformed our UK insurance business from a direct-sales operation, selling with-profits products, into a company that sells mainly shareholder-backed products through a range of channels, including independent financial advisers, business to business and partnership agreements with other companies. We also improved our efficiency and broadened our product range. These changes enabled us to take advantage of the upturn in the market in 2004, and resulted in a 40 per cent rise in new business achieved profit year-on-year.
The Rights Issue, announced in October 2004, will allow us to take advantage of these developments in both our business and the marketplace.
In 2005, we expect sales to grow by about 10 per cent from our 2004 base, against an industry expectation of around five per cent market growth. We are aiming for a blended internal rate of return on this business of 14 per cent.
Jackson National Life is an industry leader in distributing products and is able to react quickly to market changes, establishing strong positions in new products and channels. In 2004 it increased new business achieved profit by 18 per cent, to £156 million, with nearly 90 per cent of new sales coming from products developed in the last two years.
We are now Europe’s leading life insurer in Asia in terms of market coverage and number of top five market positions. We have also established a complementary regional funds management business in seven markets and are setting up a fund management operation in Vietnam.
We see very good growth prospects in the region, particularly in India and China, and we are well placed to take advantage of these.
Looking ahead, Egg will continue to develop its UK operation, building its unsecured lending business, while expanding its product range to increase cross-sales to existing customers.
In China, our joint venture with CITIC is one of the country’s leading foreign players, and it achieved new business APE growth of 70 per cent last year. We already operate in three cities, and will launch our fourth operation, in Shanghai, in the second quarter of 2005. We have recently received licences for two further cities, and a licence to write Group Life insurance business. We expect to continue to develop rapidly in China as geographic licensing restrictions ease further.
M&G M&G provides high quality investment management services for Prudential’s customers, and is also a leading UK manager of retail investment funds and institutional fixed income and pooled life and pensions funds. At the end of 2004, it had total funds under management of £126 billion.
In the Business Review and Financial Review, year-on-year comparisons of financial performance are at CER, unless otherwise stated.
INSURANCE United Kingdom and Europe Prudential UK and Europe delivered a strong performance in 2004 increasing its market share in the medium to long-term savings market (excluding collective investments) by 2.3 percentage points to 8.9 per cent (based on data from the Association of British Insurers), reflecting not only its brand franchise and financial strength but also the significant progress made in broadening its distribution channels and product range while maintaining a clear focus on its customers.
Total annual premium equivalent (APE) sales were up 40 per cent on 2003 to £817 million, which included £111 million in relation to a substantial annuity transaction with Royal London which was concluded in December. Excluding Royal London, APE sales grew 21 per cent to £706 million. Growth was driven by increased sales of unit-linked bonds (up 219 per cent), bulk annuities (up 62 per cent), individual annuities (up 24 per cent) and credit life protection products (up 224 per cent).
New business achieved profit margins, averaged across all products, remained stable at 27 per cent, however individual product performance varied. Margins on Business to Business (B2B) corporate pensions fell from 16 per cent to nine per cent principally as a result of higher proportions of less profitable unitlinked products, rather than with-profits products being sold in 2004. In line with our strategy to develop further our shareholderbacked business, we have sold an increasing volume of both unitlinked bonds and protection products. The increased scale of the
GROUP Results Highlights The Group has delivered a good set of results for 2004, as illustrated by the double-digit growth of all the key performance measures shown in the table below. This is the result of strong contributions across all regions.
As a result of healthy sales in the UK, the US and Asia, the Group achieved record insurance sales and new business achieved profit (NBAP) in 2004. This, together with the significant increase in contributions from the in-force insurance business and fund management operations, drove achieved profits basis operating profit up 39 per cent on 2003.
On the modified statutory basis (MSB), operating profit was up 49 per cent on last year. This reflects a combination of solid year-onyear growth in profit in both the insurance and fund management businesses of 40 per cent and 55 per cent respectively.
Changes in exchange rates from year-to-year have an impact on the Group’s results when these are converted into pounds sterling for reporting purposes. In some cases, these exchange rate fluctuations can mask underlying business performance. For example, growth in Asia’s total MSB operating profit was 83 per cent at reported rates, compared to 103 per cent at Constant Exchange Rates (CER). This reflects the close relationship between most Asian currencies and the US dollar and its depreciation against sterling during the year.
Annual premium equivalent (APE) sales 1,846 1,464 26% 1,846 1,557 19%
New business achieved profit (NBAP) 688 561 23% 688 605 14%
*Continuing operations – excluding Jackson Federal Bank (JFB) and Egg’s France business.
In the Business Review and Financial Review, year-on-year comparisons of financial performance are at constant exchange rates (CER), unless otherwise stated.
unit-linked bond business has enabled it to approach a break-even position in terms of NBAP. Margins on annuities and with-profits products remained in excess of 40 per cent. As Prudential UK broadens its product range, the mix of business it expects to write in the future is likely to lead to some reduction in the overall new business profit margin. Prudential UK expects this to be offset by higher new business premiums, a greater proportion of which will be shareholder-backed.
Depolarisation is also expected to have an effect on the UK bank distribution market as some banks move to offer their customers products from a panel of different providers rather than from a single product provider. Prudential UK has already seen significant growth through its partnership agreements with Lloyds TSB and Alliance & Leicester for the distribution of credit life protection products and with Zurich and Pearl for the distribution of individual annuities. The existing reassurance agreement with Zurich will be replaced in the second half of 2005 with a direct offer arrangement under which advisers of Openwork (formerly Zurich Advice Network) will sell Prudential’s range of annuity products to their customers on an exclusive basis following the Openwork operational launch.
Prudential UK has also entered into a five-year partnership agreement with St. James’s Place which becomes effective in May 2005 and will allow SJP Partners to sell exclusively Prudential’s annuity products to their customers. On 1 March 2005, Barclays announced its intention to appoint Prudential UK as one of its nominated product providers as part of the bank’s multi-tie approach to distribution to be launched later this year.
Prudential UK has maintained leading positions in many of its core product areas including annuities, corporate pensions and with-profits bonds. Nearly all of its annuity business is now written through PRIL. From July 2004, this included maturing pensions from the unit-linked and with-profits funds, the latter of which makes up a large proportion of annuity sales. In addition, shareholder capital is used to support the annuity business written on behalf of other insurers (such as the agreements with Zurich and Pearl). Prudential UK is one of the few insurers to write bulk annuity business and, including the Royal London transaction, wrote £158 million APE in 2004, representing a 72 per cent share of the market.
Despite seeing reductions in sales of with-profits bonds across the market, Prudential believes that there is still customer demand for products offering a smoothed investment return; PruFund, a transparent smoothed investment product, was introduced to the market in September. Savers had invested £10 million (APE £1 million) in PruFund by the year end.
UNITED KINGDOM AND EUROPE – RESULTS HIGHLIGHTS Percentage £m unless otherwise stated 2004 2003* change
*Certain investment mandates previously reported as UK Corporate Pensions business are now reported as M&G institutional investment flows. This gives rise to a restatement of 2003 UK APE sales of £32m (from £616m to £584m) and 2003 UK NBAP of £9m (from £166m to £157m).
UK announced in February 2005 that total bonus rates were increased or maintained on all unitised plans showing that with-profits business continues to deliver attractive returns for policyholders when provided by a financially strong and well managed fund such as Prudential.
Throughout the year, Prudential UK has continued to extend its product range. Two risk management products for defined benefit pension schemes will widen the solutions available to pension schemes considering bulk annuity buy-outs. PruHealth, a healthcare product that links health and fitness to the cost of medical insurance plans, was developed in conjunction with Discovery Holdings of South Africa, the market leader in the South African healthcare market and launched in October 2004.
Prudential UK’s performance reflects the continued impact of its brand, track record of investment performance and financial strength, as well as its successful transition from a with-profits and direct sales orientated company into a competitive, cost effective organisation. The successful diversification of its distribution channels, new distribution agreements and broadened product range place Prudential UK in a strong position to continue to gain from developments in the UK market. Prudential UK expects sales in 2005 to grow by about 10 per cent from the base established in 2004. This compares with the industry expectation for UK market growth of around five per cent for 2005.
New business achieved profit of £156 million was up 18 per cent on 2003. This increase reflects a 21 per cent increase in total sales, partially offset by a shift in product mix towards a higher proportion of equity-linked indexed annuity, life and institutional sales and a small impact from economic assumption changes.
In March, JNL launched its first variable universal life product and in May it introduced Fifth Third Perspective, a variable annuity product designed exclusively for customers of Fifth Third Securities. In the eight months since launch, sales of this product accounted for more than 65 per cent of JNL’s total variable annuity sales through Fifth Third Securities in 2004. In October, it added further investment options to its Perspective II variable annuity product as well as two new optional benefits which customers can actively select and pay for.
JNL is a top 10 player (as measured by net flows) in the variable annuity market. Its variable annuity assets grew 36 per cent in 2004 compared to industry growth of 12 per cent and Perspective II was the best selling variable annuity contract in terms of net flows in the US (Source: VARDS). The rate of take up of the fixed account option continued at normal levels, with 29 per cent of the variable premium going into the fixed account, compared with 48 per cent in 2003. JNL offers a range of variable annuity guarantee benefits for which customers pay.
*Continuing operations – excluding Jackson Federal Bank (JFB) which was sold in October 2004.
Institutional APE sales of £85 million were up 98 per cent on 2003. JNL has taken advantage of attractive issuance opportunities as they have arisen during the year, and will continue to do so in 2005.
JNL took a significant step forward in 2004, enhancing its customer servicing and support function through the reorganisation of its customer support centres to provide standardised procedures, increased operational efficiency and improved customer service.
Curian Capital, which provides innovative fee-based separately managed accounts, had net investment flows of £387 million in the year. At the end of 2004, 21 months from launch, it had accumulated over US$1 billion (£550 million) of funds under management. As the business builds scale, we expect operating losses to reduce.
A key factor in JNL’s continuing success is the strength of its relationship-based distribution model, which is heavily dependent upon achieving the highest levels of customer satisfaction. In 2004, JNL received two service awards and was one of only eight companies across all sectors to earn a world-class customer satisfaction award from North America’s Service Quality Measurement Group. It also received the ‘highest customer satisfaction by industry’ award for the financial services industry.
In October 2004, JNL completed the sale of Jackson Federal Bank (JFB) to Union Bank of California for £166 million. JFB’s principal area of business was banking and commercial real estate lending, which no longer aligned with JNL’s strategy.
As part of JNL’s continued focus on developing its life business, in November it announced the purchase, subject to regulatory approval, of Life Insurance Company of Georgia for £137 million.
NBAP of £312 million was up 19 per cent on 2003 reflecting a combination of increased sales and higher product margins. APE increased by 14 per cent on 2003. The NBAP margin was 54 per cent, compared to 52 per cent in 2003 due to effective management of country and product mix.
Total achieved profits basis operating profit* 381 328 16% 381 365 4%
The Asian economies’ consistently high economic growth rates and favourable demographics, together with the trend to allow greater access to foreign financial services players makes these markets very attractive. However, success is not guaranteed; there are many regulatory, cultural, competitive and organisational challenges which favour companies such as Prudential who have a long history and clear commitment to Asia, a track record of delivery and an operating model enabling them to ‘think internationally and act locally’.
This breadth and depth of operations across the region gives Prudential diversity backed up by collective scale that is a real competitive advantage as it can leverage expertise and experience in some countries and apply this elsewhere as appropriate. It is also able to take a longer-term view on the development of the region as a whole. Prudential Corporation Asia’s consistently impressive NBAP margins illustrate not just the overall attractiveness of the Asian markets, but more specifically our success in maximising long-term value creation while effectively managing risk.
During 2004, the strength of Prudential Corporation Asia’s business model was illustrated in a number of ways: ■ when Prudential acquired its life operation in Taiwan in 1999, the first priority was to build distribution scale, and, consequently, agent numbers grew rapidly. In 2003 the focus shifted to broadening the product range and improving profitability by capitalising on being the first life operation in Taiwan to launch regular premium unit-linked insurance products through leveraging successes in markets such as Singapore and Malaysia. During 2004 APE volumes grew significantly by 23 per cent and the proportion of unit-linked sales is 40 per cent, significantly higher than the industry.
■ in India, the ICICI Prudential joint venture continues to grow very strongly with APE up 127 per cent on 2003. With ICICI’s strong local presence and reputation and Prudential’s expertise, it is the leading private sector player, well ahead of its nearest competitors. In 2004, the Indian government announced its intention to increase the cap on foreign ownership from 26 per cent to 49 per cent. While Prudential remains interested in increasing its stake in the joint venture, the relevant legislation has not yet been put before the Indian Parliament.
■ the Hong Kong market has seen some significant changes over the last few years with increasing emphasis on shorter-term single premium products sold through bank channels. Prudential’s innovative bancassurance model, as applied with Standard
■ the Japanese life market remains very challenging and in the third quarter of 2003 we scaled back our operations to focus on higher value distribution channels and more profitable products. While the operation is now somewhat more efficient with lower expense levels and has made some progress with establishing new distribution channels, it will take some time to deliver material new business volumes and become a positive contributor to Prudential Corporation Asia’s overall results.
It is expected that this rapid development will continue as geographic licensing restrictions ease further.
FUND MANAGEMENT M&G M&G is Prudential’s UK and European fund management business and has over £126 billion of funds under management, of which £98 billion relates to Prudential’s long-term business funds. M&G operates in markets where it has a leading position and competitive advantage, including retail fund management, institutional fixed income, pooled life and pension funds, property and private finance. We believe, based on data from the Investment Management Association, M&G ranks as the third largest asset manager in the UK.
Performance-related fees in 2004 were £26 million, including £20 million as a result of several exceptionally profitable realisations by PPM Ventures that are not expected to recur. M&G also received £6 million of performance fees for the management of the Prudential Assurance Company long-term and annuity funds, which continued to beat their strategic and competitor benchmarks during the year.
M&G enjoyed a very strong year in terms of sales, with gross fund inflows up 54 per cent to £5.8 billion. Net fund inflows were up 48 per cent to £2 billion. External funds under management, which represent approximately one quarter of M&G’s total funds under management, rose by 19 per cent during the year to £28.7 billion due to a combination of net fund inflows from both retail and institutional clients and market gains on existing funds.
In M&G’s retail businesses, gross fund inflows were a record £2 billion in 2004, up 61 per cent on the previous year. In the UK, M&G maintained its fixed income sales and continued to increase fund flows into equity funds on the back of its strong fund performance. The launch of the M&G Property Fund in March 2004 provided M&G with an additional asset class for the retail market and added a significant boost to sales. The success of M&G’s expansion into Germany, Austria and Italy was evident in 2004 with gross fund inflows growing fourfold to ¤611 million (£433 million), compared with the previous year.
In its institutional businesses, M&G continued to reap the benefits of its position as a leading innovator in fixed income and private finance, with gross fund inflows increasing by 50 per cent to £3.9 billion during 2004. The successful strategy of developing new external business lines with attractive margins, using expertise developed for internal funds, generated increased revenue streams, especially in the area of non-correlated assets such as leveraged loans. M&G’s private finance business closed two more Collateralised Debt Obligations (CDOs) during the year, bringing the total number of CDOs launched since 2001 to six.
Looking forward, we expect M&G to continue to perform strongly building on its current position.
Asia Fund Management Prudential Corporation Asia manages £22.5 billion funds under management, a growth of 24 per cent from 2003, on behalf of the Asian life businesses, funds allocated from elsewhere in the Prudential Group to Asia and retail customers’ funds principally in the form of mutual funds. Collectively it is one of the region’s largest international fund managers and has investment product funds under management of £7.8 billion.
Unsecured lending grew strongly by £1.4 billion during 2004 taking total balances to £6.2 billion as at the end of 2004, up 30 per cent on last year. The successful cross-selling of personal loans into their credit card customer base has been complemented by the MasterCard proposition launched in June, which is proving popular with Egg’s customers and has now achieved almost £140 million in balances. Overall, Egg’s share of the credit card market had increased to six per cent at the end of 2004.
Income arising from the UK of £497 million grew by 18 per cent on 2003, with non-interest income providing the majority of the increase. Margins were under pressure throughout the year from increased competition, especially in the first half, and rising base rates. Despite the rising interest rate and competitive landscape, net interest income increased by nine per cent on 2003. Other income also grew impressively, up 34 per cent to £210 million. Record loan disbursements and good card balance growth, with associated revenue from cross-sales of payment protection insurance, was the main factor.
Net interest income* 287 263 9% Non-interest income* 210 157 34% *Continuing operations – excluding Egg’s France business.
Prudential delivered strong growth in sales during 2004 with total new insurance sales up 40 per cent to £12.1 billion at constant exchange rates (CER). This resulted in record insurance sales of £1.85 billion on the annual premium equivalent (APE) basis, an increase of 26 per cent on 2003. At reported exchange rates, APE was up 19 per cent on 2003.
At 31 December 2004, total insurance and investment funds under management were £187 billion, an increase of 11 per cent from 2003. This marked a record level of funds under management and the increase was primarily due to the combination of changes in the market value of investments and the impact of net insurance and investment sales achieved during the year.
BASIS OF PREPARATION OF RESULTS Prudential is required to account for its long-term insurance business on the modified statutory basis (MSB) of reporting under UK accounting standards. The Group’s primary financial statements are therefore prepared on this basis and broadly reflect the UK solvency-based reporting regime and, for overseas territories, adjusted local or US GAAP. In broad terms, MSB profit for long-term business reflects the aggregate of statutory transfers from with-profits funds and profits on a traditional deferral and matching approach for other long-term business. Although the statutory transfers from with-profits funds are closely aligned with cash flow generation, the pattern of MSB profit over time from shareholder-backed long-term businesses will generally differ from the cash flow pattern. Over time however, aggregate MSB profit will be the same as aggregate cash flow.
Life insurance products are, by their nature, long term and the profit on this business is generated over a significant number of years. MSB profit does not, in Prudential’s opinion, properly reflect the inherent value of these future profit streams.
Accordingly, in common with other listed UK life assurers, Prudential also reports supplementary results for its long-term operations on the achieved profits basis. These results are combined with the statutory basis results of the Group’s other operations, including fund management and banking businesses. Reference to operating profit relates to profit including investment returns at the expected long-term rate of return, but excludes amortisation of goodwill, exceptional items, short-term fluctuations in investment returns and the effect of changes in economic assumptions.
In the directors’ opinion, the achieved profits basis provides a more realistic reflection of the current performance of the Group’s long-term insurance operations than results on the MSB basis, as it reflects the business performance during the accounting period under review, although both bases should be considered in forming a view of the Group’s performance.
There is further discussion on the development of accounting policies and the potential impact on the reported results of the Group on pages 24 to 27 of this Financial Review.
The active basis is applied to UK and US operations, and those countries in Asia where there are well-developed government bond markets (Japan, Korea and US$-denominated business in Hong Kong). Assumptions in other Asian countries continue to be based on an assessment of long-term economic conditions.
In 2004, use of the active basis resulted in a decrease in the risk discount rate applied to the UK insurance operations from 7.4 per cent to 7.2 per cent, and a decrease in the UK investment return assumption for the UK with-profits fund from 6.8 per cent to 6.5 per cent. The decrease primarily reflects decreases in the 15-year gilt yield from 4.8 per cent at the end of 2003 to 4.6 per cent at the end of 2004. The risk margin over the risk free rate was maintained at 2.6 per cent. The expected long-term inflation rate assumption decreased from 3.1 per cent to 2.9 per cent, reflecting the difference between conventional and index-linked gilts. These changes are a function of the active basis rather than a change in Prudential’s long-term view of future returns and levels of price inflation.
In Asia, each country has its own specific discount rate. The weighted average risk discount rate, which is determined by weighting each Asian country’s economic assumptions by reference to the achieved profits basis operating results for new business written in 2004, was 9.6 per cent in 2004, a decrease from 10.4 per cent in 2003. The discount rates used in various country operations range between five per cent to 19 per cent. The weighted risk discount rate declined during 2004 principally due to lower pre-tax expected long-term nominal rates of investment return and lower weighted long-term rate of inflation assumptions due to changes in the geographic mix of business in 2004.
The overall impact on the Group’s achieved profits basis result for 2004 of using these revised economic assumptions compared with those used in 2003, was a reduction in new business achieved profit (NBAP) of around £13 million and a decrease in achieved profits basis shareholders’ funds of £85 million.
Achieved Profits Basis Operating Profit Total achieved profits basis operating profit from continuing operations was £1,124 million, up 39 per cent from 2003 at CER. At reported exchange rates, the result was up 31 per cent. This result reflects a combination of strong growth in the insurance and fund management businesses.
Results from fund management and banking business were £184 million, an increase of 26 per cent at CER on 2003. This was mainly driven by the significant contribution from M&G.
New Business Achieved Profit In 2004, the Group has generated record new business achieved profit (NBAP) from insurance business of £688 million which was 23 per cent above 2003 at CER, driven by strong sales momentum across all markets. At reported exchange rates, NBAP was up 14 per cent. The average Group NBAP margin of 37 per cent was slightly down from 38 per cent in 2003. The overall margin has been broadly maintained over the last two years, reflecting careful management of product mix within each business and across the three regions.
NBAP from the UK and Europe Insurance Operations was £220 million, an increase of 40 per cent on 2003. This reflected increased APE sales and a balanced shift in sales mix. This positive movement arose due to increased sales of more profitable bulk annuities partially offset by reduced sales of high margin with-profits bonds and increased sales of less profitable executive pensions.
Individual and bulk annuity margins remained strong at 43 per cent and 46 per cent respectively, partly as a consequence of nearly all annuity business now being written in Prudential Retirement Income Limited (PRIL), a shareholder-backed business. 88 per cent of
(as reported) exchange rate) Percentage (as reported) (as reported) Percentage £m £m change £m £m change
Insurance business: Fund management business: US broker-dealer and fund management (14) (3) (367)% (14) (3) (367)%
annuities business was written in shareholder-backed funds in 2004, compared with 56 per cent in 2003. Previously, a substantial proportion of annuity business was written in a subsidiary of the with-profits fund.
PRIL was established in September 2000, initially to write bulk annuity business. This was expanded to include external individual annuity business and Prudential-branded internal vestings (annuity business sales arising from maturing in-force pension books) in September 2001 and July 2004 respectively.
JNL’s expense ratio has fallen three basis points from 2002 to stand at 46 basis points at the end of 2004. We believe JNL benefits from its considerable expense advantage relative to its principal competitors enabling it to maintain these attractive margins.
The margin achieved on variable annuity business in 2004 was 37 per cent compared with 36 per cent in 2003. This improvement is a result of pricing changes instituted early in 2004. For fixed annuity business the margin declined by nine per cent over the last two years to 32 per cent at the end of 2004. The reduction in margin is due to a lower fund earned rate as yields have declined, however target spreads have been maintained.
In Asia, NBAP of £312 million was up 19 per cent at CER on 2003, reflecting a combination of increased sales and higher NBAP margin. During 2004, APE sales were up 14 per cent on 2003 and the NBAP margin was 54 per cent, compared with 52 per cent in 2003 at CER. The increase in margin was principally due to a combination of changes in country mix and product mix being offset by the impact of assumption changes.
A charge of £66 million was made reflecting a 40 per cent strengthening of the persistency assumptions on the closed book of personal pensions business sold through the closed direct sales force channel. This assumption change reflects Prudential UK’s experience over the last three years and, post-tax, represents about one per cent of the overall embedded value of the UK business.
The £33 million positive total experience variance includes a £43 million positive spread variance (net of risk margin reserve) primarily reflecting a favourable variance in the fixed annuity portfolio. The assumed spread on new fixed annuity business is 155 basis points grading to 175 basis points over five years.
Non-Insurance Operations M&G M&G’s operating profit was £136 million, an increase of 64 per cent on last year. This included £26 million in performance-related fees (PRF), of which £20 million was generated by PPM Ventures on the exceptionally profitable realisation of several investments during the year.
Underlying profit of £110 million was 57 per cent higher than 2003, achieved as a result of a strong performance across all of M&G’s business lines. Significant growth was delivered in the areas of fixed income, retail and property; attributable to the continued development of new business streams and the recovery in stock markets during 2004. In addition, underlying profit was also boosted by £7 million of one-off provision releases in 2004 that will not recur in future years.
Asia fund management business Profit from Asia fund management operations was £19 million, up 73 per cent from 2003, reflecting a combination of increasing scale and profitability in the retail business, particularly from the joint venture with ICICI in India, and higher management fees from the UK and Asia life businesses.
Egg Egg’s total continuing operating profit in 2004 was £43 million, compared with £55 million in 2003, reflecting an increase in profit
from the UK business offset by a £17 million impairment charge on the underlying assets of Funds Direct.
Following the decision to dispose of its investment in Funds Direct, its investment wrap platform business, Egg provided for a £17 million impairment charge against the full carrying value of the underlying assets of Funds Direct.
Total Achieved Profits Basis – Result Before Tax (Year-on-year comparisons below are based on reported exchange rates.)
The UK component of short-term fluctuations in investment returns of £402 million reflects the difference between an actual investment return delivered for the with-profits life fund of 13.4 per cent and the long-term assumed return of 6.5 per cent.
Short-term investment fluctuations in the US were £207 million. This includes a positive £161 million which represents the difference between actual net bond gains and the five-year average amount included in operating profit, and a positive £24 million in relation to changed expectations of future profitability on in-force variable annuity business, due to the separate account return exceeding the long-term return reported in operating profit. In 2004, actual net bond gains were £48 million, compared with £39 million of bond losses in 2003.
In Asia, short-term investment fluctuations were £48 million, compared with £1 million last year. This mainly reflects the rising equity markets in a number of countries and falling bond yields in Singapore.
In the US, economic assumption changes were negative £53 million and included a reduction in the projected fund earned rate, a reduction in the spread assumption for equity-linked indexed annuities business in force prior to 2002 and an increase in inflation rates.
Asia’s negative economic assumption changes of £28 million primarily reflect a change in Taiwan as a result of an increase in the discount rate and a change in the fund earned rate assumption.
MODIFIED STATUTORY BASIS (MSB) RESULTS MSB Operating Profit Reference to operating profit relates to profit including investment returns at the expected long-term rate of return but excludes amortisation of goodwill, exceptional items and short-term fluctuations in investment returns.
In the UK, MSB operating profit was £305 million in 2004, an increase of 19 per cent on 2003. This included a fourfold increase in PRIL’s profit from £31 million to £124 million. This more than offset the £17 million reduction in the profit from the with-profits fund, which fell due to lower annual and terminal bonus rates announced in February 2004.
EARNINGS PER SHARE Earnings per share, based on achieved profits basis operating profit after tax and related minority interests, but before amortisation of goodwill, were up 11.8 pence to 37.2 pence. The 2003 figure has been restated from 26.4 pence to 25.4 pence to adjust for the bonus element of the Rights Issue. Earnings per share, based on MSB operating profit after tax and related minority interests, but before amortisation of goodwill, were 19.2 pence, compared with a restated 2003 figure of 12.4 pence.
The resulting bonus adjustment factor used for restating earnings and dividends per share using the methodology outlined above is 0.9614.
The directors recommend that the shareholders declare a final dividend for 2004 of 10.65 pence per share. The total dividend for the year, comprising the adjusted interim dividend and the recommended final dividend, amounts to 15.84 pence per share, an increase of 3.0 per cent over the full year 2003 dividend of 15.38 pence per share after adjustment for the bonus element of the Rights Issue.
BALANCE SHEET Explanation of Balance Sheet Structure The Group’s capital on an MSB basis comprises shareholders’ funds £4,281 million; subordinated long-term and perpetual debt of £1,429 million; other senior debt £1,761 million and the Fund for Future Appropriations (FFA) £16.7 billion.
Shareholders’ funds include the £1,021 million of new share capital allotted as a result of the Rights Issue in October 2004.
Subordinated or hybrid debt is debt capital which has some equitylike features and which would rank below other senior debt in the event of a liquidation. These features allow hybrid debt to be treated as capital for Financial Services Authority (FSA) regulatory purposes. All of the Group’s hybrid which qualifies in this way is held at the Group level and is therefore taken as capital into the parent solvency test under the EU Financial Groups Directive (FGD).
Following the implementation of the FGD, it is advantageous to the Group from a regulatory capital standpoint to raise its long-term debt in hybrid form and it is the Group’s policy to take advantage of favourable market conditions as they arise to do so.
RIGHTS ISSUE BONUS ADJUSTMENT Market price cum-rights (Tuesday 19 October 2004) (pence) A 422.00 Rights Issue price (pence) B 308.00
Number of shares pre Rights Issue (million) C 2,023.29 Number of shares issued through Rights Issue (million) D 337.22
(A x C) + (B x D) Theoretical ex-rights price (pence) TERP = 405.71
Asset and Liability Management Prudential manages its assets and liabilities locally, in accordance with local regulatory requirements and reflecting the differing types of liabilities Prudential has in each business. As a result of the diversity of products Prudential offers and the different regulatory environments in which it operates, Prudential employs different methods of asset/liability management on both an in-force and new business basis. Stochastic modelling of assets and liabilities is undertaken in the UK, the US and Asia to assess economic capital requirements for different confidence intervals and time horizons. In addition, reserve adequacy testing under a range of scenarios and dynamic solvency analysis is carried out, including under certain scenarios mandated by the US, the UK and Asian regulators.
RIGHTS ISSUE The strength of Prudential’s businesses and positive developments in a number of its markets represent an opportunity to enhance its market position and generate improved returns for its shareholders. A strong financial position at a Group level will provide increased financial flexibility and allow Prudential to capitalise on these opportunities as they arise.
SHAREHOLDERS’ FUNDS On the achieved profits basis, which recognises the shareholders’ interest in long-term businesses, shareholders’ funds at 31 December 2004 were £8.6 billion, up £1.6 billion from
By the financial year ending 2007, Prudential is targeting an IRR of 14 per cent on the capital required to support new business sold in that year in the UK, including individual product targets of 20 per cent for annuity products, eight per cent for unit-linked bonds, 15 per cent for corporate pensions and 15 per cent for protection products.
Asia In Asia we have target IRRs on new business at a country level of 10 per cent over the country risk discount rate. Risk discount rates vary from five per cent to 19 per cent depending upon the maturity of the market. These target rates of return are average rates and the marginal return on capital on a particular product could be above or below the target.
During 2004, the Group invested £31 million in corporate activities (2003: £58 million receipt, arising from disposal proceeds and exceptional tax receipts).
Together with the proceeds from the Rights Issue of £1,021 million, there was a total increase in cash of £850 million (2003: £4 million).
SHAREHOLDERS’ BORROWINGS AND FINANCIAL FLEXIBILITY As a result of the holding company’s net funds inflow of £850 million and exchange conversion gains of £49 million, net core borrowings at 31 December 2004 were £1,236 million, compared with £2,135 million at 31 December 2003.
After adjusting for holding company cash and short-term investments of £1,561 million, core structural borrowings of shareholderfinanced operations at the end of 2004 totalled £2,797 million, compared with £2,567 million at the end of 2003. This increase reflected the issue of US$250 million (£137 million at transaction rate) Perpetual Subordinated Capital Securities and additional short-term borrowings of £150 million, partially offset by exchange conversion gains of £57 million. Core long-term loans at the end of 2004 included £1,762 million at fixed rates of interest with maturity dates ranging from 2005 to perpetuity. £898 million of the core borrowings were denominated in US dollars, to hedge partially the currency exposure arising from the Group’s investment in Jackson National Life (JNL).
Increase in cash 850 4 *In respect of prior year bonus declarations.
Prudential plc enjoys strong debt ratings from both Standard & Poor’s and Moody’s. Prudential long-term senior debt is rated AA– (negative outlook) and A2 (stable outlook) from Standard & Poor’s and Moody’s respectively, while short-term ratings are A1+ and P-1.
The aim of Prudential’s capital funding programme, which includes the £5,000 million medium-term note programme together with the unlimited commercial paper programme, is to maintain a strong and flexible funding capacity.
In the UK and Asia, Prudential uses derivatives to reduce equity risk, interest rate and currency exposures, and to facilitate efficient investment management. In the US, Jackson National Life (JNL) uses derivatives to reduce interest rate risk, to facilitate efficient portfolio management and to match liabilities under equityindexed policies.
Due to the geographical diversity of Prudential’s businesses, it is subject to the risk of exchange rate fluctuations. Prudential’s international operations in the US, Asia and Europe, which represent a significant proportion of operating profit and shareholders’ funds, generally write policies and invest in assets denominated in local currency. Although this practice limits the effect of exchange rate fluctuations on local operating results, it can lead to significant fluctuations in Prudential’s consolidated financial statements upon conversion of results into pounds sterling. The currency exposure relating to the conversion of reported earnings is not separately managed, as it is not in the economic interests of the Group to do so. The impact of gains or losses on currency conversions is recorded as a component of shareholders’ funds within the consolidated statement of total recognised gains and losses. The impact of exchange rate fluctuations in 2004 is discussed elsewhere in this Financial Review.
The FGD requires a continuous parent company solvency test which requires the aggregating of surplus capital held in the regulated subsidiaries, from which group borrowings are deducted, other than those subordinated debt issues which qualify as capital. 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. Additionally, the FSA has indicated that it will require public disclosure of the FGD solvency position from 31 December 2005, for which the detailed rules on disclosure have yet to be published. In practice, whether Prudential is classified as a financial conglomerate or insurance group, there is very little difference in application of the rules. This is because the FSA has decided to make the test mandatory from 31 December 2006 to all insurance groups, and requires public disclosure of the group solvency position from 31 December 2005.
The European Union is continuing to develop a new prudential framework for insurance companies, ‘the Solvency II project’. The main aim of this framework is to ensure the financial stability of the insurance industry and protect policyholders through establishing solvency requirements better matched to the true risks of the business. Like Basel 2, the new approach is expected to be based on the concept of three pillars – minimum capital requirements, supervisory review of firms’ assessments of risk and enhanced disclosure requirements. In particular, companies will be encouraged to improve their risk management processes, including making use of internal economic capital models to enable a better understanding of the business. The emphasis on transparency and comparability would help ensure a level playing field.
Solvency II is being lead by the European Commission’s (EC) Internal Market Director-General. The EC have directed the Committee of European Insurance and Occupational Pensions Supervisors (CEIOPS) to provide input on many technical aspects of the framework. To this end, the EC and CEIOPS have jointly issued Calls for Advice in order to incorporate broader feedback from industry.
The expected outcome of the CEIOPS working groups is a draft directive for the EC. Final agreement on the terms of the new Directive is not expected before 2007 followed by implementation in 2009.
FINANCIAL STRENGTH OF INSURANCE OPERATIONS United Kingdom A common measure of financial strength in the United Kingdom for long-term insurance business is the free asset ratio. The free asset ratio is the ratio of assets less liabilities to liabilities, and is expressed as a percentage of liabilities. On a comparable basis with 2003, the free asset (or previous regulatory Form 9) ratio of the Prudential Assurance Company (PAC) long-term fund was approximately 14.8 per cent at the end of 2004, compared with 10.5 per cent at 31 December 2003.
The valuation has been prepared, in our opinion, on a conservative basis in accordance with the current FSA valuation rules, and without the use of implicit items. No allowance has been taken for the present value of future profits and the PAC long-term fund has not entered into any financial reinsurance contracts. Certain reinsurance treaties with a value of approximately £49 million, which were transferred from Scottish Amicable Life when that Company’s business transferred into the PAC long-term fund at the end of 2002, were converted into a contingent loan during 2004.
The fund is very strong with an inherited estate measured on an essentially deterministic valuation basis of more than £6.5 billion compared with approximately £6 billion at the end of 2003. On a realistic basis, with liabilities recorded on a market consistent basis, the free assets of the With-Profits Sub-Fund are valued at around £5 billion before a deduction for the risk capital margin. Additional information on the effects of the realistic basis on the PAC longterm fund is shown on pages 103, 104 and 107.
The table below shows the change in the investment mix of Prudential’s main with-profits fund.
With-profits contracts are long-term contracts with relatively low guaranteed amounts, the nature of which permits Prudential to invest primarily in equities and property. However, over the period from 1999 to mid-2001 the fund reduced its exposure to equities. There was also a reweighting within equities out of the
UK and into overseas equities. This change in asset mix reflected Prudential’s view that equity valuations were high and that other assets, particularly corporate bonds, were relatively attractive. The change within equities improved the fund’s diversification and reduced expected fund volatility. The change in asset mix in recent years has had a substantial beneficial impact on investment returns. The broad asset mix will continue to be reviewed as the economic environment and market valuations change.
The investment return on the Prudential main with-profits fund was 13.4 per cent in the year to 31 December 2004 compared with the rise in the FTSE All Share (Total Return) Index of 12.8 per cent over the same period. Over the last 10 years the with-profits fund has consistently generated positive fund returns with three, five and 10 year compound returns of 6.7 per cent per annum, 3.8 per cent per annum and 10.3 per cent per annum respectively. These returns demonstrate the benefits of the fund’s strategic asset allocation and long-term outperformance. During 2004 there was no change to the strategic asset allocation of the fund. There has been no significant reduction in the level of the fund’s equity holdings during the year or subsequently.
United States The capital adequacy position of Jackson National Life (JNL) remains strong, with a strong risk-based capital ratio of 4.3 times the National Association of Insurance Commissioners (NAIC) Company Action Level Risk Based Capital. JNL’s financial strength is rated AA by Standard & Poor’s (negative outlook) and A1 by Moody’s.
JNL’s invested asset mix on a US regulatory basis (including JNL of New York but excluding policy loans and reverse repo leverage) in the table below.
Private equities and real estate 3 4 3 Equities, cash and other assets 2 2 1
REDRESS OF MORTGAGE ENDOWMENT PRODUCTS Prudential Assurance’s main long-term business with-profits fund paid compensation of £16 million in 2004 in respect of mortgage endowment product mis-selling claims and held provisions of £61 million at 31 December 2004 to cover further claims. These provisions have no impact on policyholders’ asset shares. As a result, policyholders’ bonuses and the shareholders’ share of these bonuses are unaffected, resulting in no impact on the Group’s profit before tax.
INHERITED ESTATE The long-term fund contains the amount that the Company 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 With-Profits Sub-Fund is equal to the policyholders’ accumulated asset shares plus any additional payments that may be required for smoothing or to meet guarantees. The balance of the assets of the With-Profits Sub-Fund is called the ‘inherited estate’ and represents the major part of the working capital of Prudential’s long-term fund which enables the Company to support with-profits business by: ■ providing the benefits associated with smoothing and guarantees; ■ providing investment flexibility for the fund’s assets; ■ meeting the regulatory capital requirements, which demonstrate solvency; and
In 1998, Prudential stated that deducting personal pension misselling costs from the inherited estate of the With-Profits Sub-Fund would not impact the Company’s bonus or investment policy. The
Company 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, to ensure that policyholders were not disadvantaged.
The maximum amount of capital support available under the terms of the assurance will reduce over time as claims are paid on the policies covered by it.
The bonus and investment policy for each type of with-profits policy is the same irrespective of whether the assurance applies. Hence removal of the assurance for new business has had no impact on policyholder returns and this is expected to continue for the foreseeable future.
DEFINED BENEFIT PENSION SCHEMES The Group operates three defined benefit schemes in the UK, of which the principal scheme is the Prudential Staff Pension Scheme (PSPS). The level of surplus or deficit of assets over liabilities for defined benefit schemes is currently measured in three ways, namely the triennial actuarial valuation, SSAP 24 and FRS 17 bases.
Defined benefit schemes are generally required to be subject to full actuarial valuation every three years to assess the appropriate level of funding for schemes having regard 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 2002 and this valuation demonstrated the Scheme to be 110 per cent funded, with an excess of actuarially determined assets over liabilities of 10 per cent, representing a fund surplus of £376 million. As a result, no change in employers’ contributions from the current 12.5 per cent of salaries was required.
In the meantime, companies are required to publish details of pension scheme surpluses and deficits on the FRS 17 basis by way of disclosure.
Surpluses and deficits on the Group’s defined benefit schemes are apportioned to the Prudential Assurance Company (PAC) life fund and shareholders’ funds depending on an estimation of the activity of the personnel involved. Such apportionment is necessary to properly reflect the economic interests in and exposures to the schemes’ financial position. The aforementioned volatility can be illustrated by considering the movements in the surplus and deficit over the last three years. For the PAC life fund the estimated interest, net of tax, in the pension schemes’ FRS 17 basis financial position has changed from a surplus at 31 December 2001 of £392 million to a deficit at 31 December 2002 of £380 million, a deficit at 31 December 2003 of £411 million and a deficit at 31 December 2004 of £444 million. For the shareholders’ fund the estimated interest, net of tax in the pension schemes’ FRS 17 basis financial position, has changed from a surplus at 31 December 2001 of £101 million to a deficit at 31 December 2002 of £85 million, a deficit at 31 December 2003 of £101 million, and a deficit at 31 December 2004 of £109 million. The large reduction in 2002 reflects the steep fall in equity markets in that year. The modest changes in 2003 and 2004 reflect the negative impact of increased inflation assumptions, that are implicit within the yields on index-linked gilts, being offset by the positive value movements in scheme assets arising from the strong recovery in equity markets.
All the insurance operations of the Group prepare a financial condition report which is reported on to the Board, who receive regular reports from the Group Finance Director on the financial position of the Group.
PRODUCTS AND DRIVERS OF INSURANCE OPERATIONS’ PROFIT United Kingdom and Europe In common with other UK long-term insurance companies, Prudential’s products are structured as either with-profits (or participating) products, or non-participating products including annuities in payment and unit-linked products. Depending upon the structure, the level of shareholders’ interest in the value of policies and the related profit or loss varies.
With-profits policies are supported by a with-profits fund and can be single premium (for example, Prudence Bond) or regular premium (for example, certain corporate pension products). Prudential’s primary with-profits fund is part of Prudential Assurance Company’s (PAC) long-term fund. The return to shareholders on virtually all with-profits products is in the form of a statutory transfer to PAC shareholders’ funds which is analogous to a dividend from PAC’s long-term fund and is dependent upon the bonuses credited or declared on policies in that year. Prudential’s with-profits policyholders currently receive 90 per cent of the distribution from the main with-profits fund as bonus additions to their policies and shareholders receive 10 per cent as a statutory transfer.
United States Jackson National Life’s (JNL) principal retail savings products are sold as single premium fixed, variable or equity-linked indexed deferred annuities.
Variable annuities are tax advantaged deferred annuities where the rate of return depends upon the performance of the underlying portfolio, similar in principle to UK unit-linked products. They are used for retirement planning and to provide income in retirement.
The policyholder’s premiums are held apart from other assets, in a separate account, which is analogous to a unit-linked fund. The policyholder can allocate the premiums between a variety of variable sub-accounts with a choice of fund managers and/or to guaranteed fixed-rate options. The value of the portion of the separate account allocated to variable sub-accounts fluctuates with the underlying investment. Variable annuity policies provide for early surrender charges.
These include the guaranteed minimum death benefit, which guarantees on death the policyholder receives a minimum value regardless of past market performance. These guaranteed death benefits might be expressed as the return of original premium, the highest past anniversary value of the policy, or as the original premium accumulated at a fixed rate of interest. In addition there are two other types of guarantee, guaranteed minimum withdrawal benefits (GMWB) and guaranteed minimum income benefits (GMIB). GMWB provides a guaranteed return of the principal invested by allowing for periodic withdrawals which are limited to a maximum percentage of the initial premium. GMIB provides for a minimum level of benefits upon annuitisation regardless of the value of the investments under the contract at the time of annuitisation. This is fully reinsured.
JNL earns fee income on the underlying investment, earns profits from the spread between what it earns on investments in fixed rate accounts and the interest credited, and fee income for certain additional performance guarantees in the contract.
Prudential’s business in Asia is focused on regular premium products that provide both savings and protection benefits. In 2004, the new business achieved profit mix was 47 per cent unit-linked, 26 per cent non-linked and 27 per cent Accident and Health (A&H) products.
Unit-linked products combine savings with protection and the cash value of the policy depends on the value of the underlying unitised funds. Participating products provide savings with 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 insurer. Non-participating products offer savings with protection where the benefits are guaranteed or determined by a set of defined market related parameters. A&H products provide mortality or morbidity benefits and include health, disablement, critical illness and accident covers. A&H
Unit-linked products tend to have higher profits on the achieved profits basis of reporting than traditional non-linked products as expenses and charges are better matched and solvency capital requirements are lower. At the end of 2004 Prudential Corporation Asia offered unit-linked products in 10 of the 12 countries in Asia in which it operates.
In addition to the life products described above, Prudential offers mutual fund investment products in India, Taiwan, Japan, Singapore, Malaysia, Hong Kong and Korea, allowing customers to participate in debt, equity and money market investments. The Company earns a fee based on assets under management.
The Accounting Standards Board (ASB) published FRS 27 ‘Life Assurance’ in December 2004. The implementation of FRS 27 is governed by a Memorandum of Understanding (MoU) agreed between the UK’s leading life assurance companies, the Association of British Insurers and the ASB. Under the terms of the MoU, certain unaudited narrative and numerical disclosures are required to be published in the companies’ annual reports.
International Financial Reporting Standards Background The European Union (EU) requires that all listed European groups prepare their 2005 financial statements in accordance with EU approved International Financial Reporting Standards (IFRS). The IFRS basis of reporting will replace the current modified statutory basis (MSB) of reporting. In common with other major groups, Prudential has a well-developed programme to implement the necessary changes.
It should be emphasised that the IFRS changes to profit recognition for these contracts are merely of timing. Cash flow in any particular period from these contracts, as they mature and regulatory basis surpluses emerge, will of course be unaffected, as is the aggregate profit for the contracts over their life.
For UK unit-linked contracts to be accounted for under IAS 39 the main effects will be for the elimination of certain actuarial liabilities, restriction on the deferral of acquisition costs to incremental costs, principally external commission, and the amortisation profile of deferred acquisition costs and front end fees.
The impact of the changes on the result in any given period depends upon the level of deferred acquisition costs under previous (UK GAAP) and revised (IFRS) basis. In general under IFRS, one would expect that with a growing book of unit-linked business, emergence of profit will be delayed.
For derivative instruments of JNL, we have carefully considered at length whether it is appropriate to undertake the necessary operational changes to enable hedge accounting so as to achieve matching of value movements in hedging instruments and hedged items in the performance statements. In reaching our decisions a number of factors were particularly relevant. These are: ■ IAS 39 hedging criteria has been designed primarily in the context of hedging and hedged instruments that are assessable as financial instruments that are either stand-alone or separable from host contracts, rather than, for example, duration characteristics of insurance contracts; ■ the high hurdle levels under IAS 39 of ensuring hedge effectiveness at the level of individual hedge transactions for specific transactions; ■ the difficulties in applying the macro hedge provisions under IAS 39 (which are more suited to banking arrangements) to JNL’s derivative book; ■ the complexity of asset and liability matching of US life insurers such as those with JNL’s product range; and finally
We intend under IFRS to continue to analyse the total pre shareholder tax results between an operating profit based on longer-term investment returns, short-term fluctuations in investment returns, and exceptional items. Movements in the value of JNL’s derivative book will be included within short-term fluctuations in investment returns.
Banking operations The introduction of IFRS will not significantly affect Egg’s underlying business or the cash flows. However, it does represent a significant change to its accounting and reporting. Wholesale assets will be classified as AFS and held at fair value with unrealised gains and losses reflected in equity rather than the income statement. Liabilities will be measured at amortised cost with no effect compared to UK GAAP except where set-up fees had been previously expensed but will under IFRS, be capitalised and amortised.
The impact of other IFRS changes to the accounting for retail products such as adjustments for effective interest rate calculations, dormant accounts, and bad debts is dependent on a range of factors but, based on current indications, is expected to be relatively neutral overall.
Other IFRS changes Two other areas will involve significant change on the adoption of IFRS, namely goodwill and pension cost accounting. For goodwill, subject to regular impairment testing, amortisation charges will no longer be necessary. For pension cost accounting, the latest version of IAS 19 is similar to the requirements of FRS 17. Details of the FRS 17 effect are shown in note 17 to the financial statements.
Reported shareholders’ funds will also be affected by the requirement under IFRS not to accrue dividend declarations made after the reporting period date.
■ deferred tax effects of these and the other IFRS adjustments described above.
The main impact of the property, consolidation and grossing up changes is almost wholly confined to altering the line by line consolidation rather than shareholder results. The line items affected include carrying values of certain properties and related finance lease obligations, category of investment classification for newly consolidated investment funds, and goodwill and nonrecourse borrowings on the face of the balance sheet for newly consolidated venture fund investments.
Adoption date We expect that the first time adoption date for conversion to IFRS will be 1 January 2004. However, as the Group is also listed in the US, we also have to comply with the requirements of the Securities Exchange Commission (SEC). These requirements have yet to be finalised but we anticipate that the SEC will confirm that comparative results will be required for only one rather than the usual two years. Should this not be the case, the adoption date will be 1 January 2003. The main practical effect of this uncertainty on IFRS financial statements is as to the start point for the discontinuance of amortisation of goodwill.
Basis of adoption of IAS 32, IAS 39 and IFRS 4 It is the Group’s intention to formally adopt IAS 32 (on disclosures on financial instruments), IAS 39 and IFRS 4, as permitted under IFRS, prospectively from 1 January 2005. The results for the half year 2005 will include a cumulative transitional adjustment for the impact on shareholders’ funds for the adoption of these standards. The most significant element of the adjustment will be for the mark to market value of JNL’s fixed income securities and derivative book.
However, in common with many other banks, 2004 results on an IAS 39 measurement basis will not be provided for Egg. This is because the lack of availability of hedge accounting for 2004 under IAS 39 makes results on this basis unrepresentative of the basis going forward, where as described above, macro hedge accounting will be applied.
Achieved Profits Basis Reporting Prudential’s results are prepared on two bases of accounting, the supplementary achieved profits basis and the modified statutory basis (MSB) prepared under the Companies Act. Over the life of any given product, the total profit recognised will be the same under either the MSB or the achieved profits basis. However, the two methods recognise the emergence of that profit differently, with profit emerging earlier under the achieved profits basis than under MSB. This section explains how the two bases operate and why they are used.
Prudential’s primary financial statements are prepared in accordance with the MSB of reporting of long-term business, in full compliance with the revised Statement of Recommended Practice issued by the Association of British Insurers (ABI) in November 2003. In broad terms, MSB profit for long-term business reflects the aggregate of statutory transfers from with-profits funds and profit on a traditional deferral and matching approach for other long-term business.
However, the products sold by the life insurance industry are by their nature long term, as it commits to service the products for many years into the future. In many cases policies require customers to continue to pay further premiums in the future. The profit on these insurance sales is generated over a significant number of years and MSB profit does not, in Prudential’s opinion, properly reflect the inherent value of these future profit streams.
Therefore, since 1997 Prudential and other major UK-quoted financial groups have adopted the achieved profits basis as a supplementary accounting measure in order to give a better reflection of the value attaching to long-term insurance business. Achieved profits basis financial statements are prepared under guidance issued by the ABI in December 2001.
The achieved profits method not only provides a good indicator of the value being added by today’s management in a given accounting period but it also demonstrates whether shareholder capital is being deployed to best effect. Indeed insurance companies in many countries use comparable bases of accounting for management purposes. Prudential believes that the achieved profits basis provides useful information for shareholders. In contrast, for many types of contract, the MSB result does not reflect the long-term benefit that will arise in the future from current management initiatives and capital expenditure in the year under review, as it focuses instead on the amounts accruing to shareholders in the current year only from business already in force.
The achieved profits basis is a value based method of reporting in that it reflects the change in value of the business over the accounting period. This value is called the shareholders’ funds on an achieved profits basis which, at a given point in time, is the value of future cash flows expected to arise from the current book of long-term insurance business plus the net worth of the Company. In determining these expected cash earnings, Prudential makes full allowance for the risks attached to their emergence and associated cost of capital and takes into account recent experience in assessing likely future persistency, mortality and expenses.
As indicated above, achieved profits basis results are prepared by first of all making assumptions about all relevant factors including
The total profit that emerges over the lifetime of an individual contract as calculated using the achieved profits basis is the same as that calculated under the modified statutory basis. However, since the achieved profits basis reflects discounted future cash flows under this methodology the profit emergence is advanced, thus more closely aligning the timing of the recognition of benefits with the efforts and risks of current management actions, particularly with regard to business sold during the year.
The different timing of profit recognition under the two bases is demonstrated in the next chart, which shows the cumulative level of profit recognition for the yearly profit shown in the previous chart. It illustrates that under the achieved profits basis profit emerges earlier, but the eventual total profit is the same under both bases.
ILLUSTRATION MODIFIED STATUTORY BASIS AND ACHIEVED PROFITS BASIS CUMULATIVE PROFIT PROFILES FOR A TYPICAL WITH-PROFITS PRODUCT
European Embedded Value Reporting In May 2004 the CFO Forum, representing the Chief Financial Officers of 19 European insurers, published the European Embedded Value (EEV) Principles which are designed to improve the transparency and consistency of embedded value reporting.
For Prudential, EEV reporting represents an evolution from the current achieved profits basis used for supplementary reporting and we welcome the improved clarity and consistency of information that it will provide to investors. We reiterate our view that embedded value information provides investors with a more realistic reflection of the current performance of life insurance business. In summary, the principal changes from current achieved profits reporting are in respect of three areas: ■ inclusion of an explicit allowance for the impact of options and guarantees. This will typically require stochastic calculations, under which a large number of simulations are performed that provide a representation of the future behaviour of financial markets; ■ more active allowance for the combined impact of risk profile, encumbered capital and explicit valuation of options and guarantees in the selection of discount rates. This will ensure that the risks to the emergence of shareholder cash flows are properly accounted for; and
■ enhanced disclosure that will enable informed investors to more fully understand the key risks within the business together with management’s approach to them, and the basis of preparation of results.
INITIATIVES Promoting Healthy Lifestyles PruHealth, our private medical insurance joint venture that provides financial incentives for people to lead healthier lifestyles, was launched in 2004 in the UK. The more effort people make to improve their general levels of fitness, control their weight, stop smoking and maintain sensible levels of alcohol intake, the lower their premiums will be. The PruHealth model is based on similar schemes which have been established in South Africa and, more recently, in the US. In all these markets, there have been significant changes in people’s attitude and behaviour. For example, in Illinois, 79 per cent of policyholders took up a new fitness programme or changed their eating plan within 12 months of becoming a policyholder; this compares with a 32 per cent average among all policyholders.
Investing in our Communities In 2004 we invested £4.5 million in a wide range of projects around our business, supporting, for example, educational, welfare and environmental initiatives. This total includes the significant contribution made by many of our people around the Group through volunteering, often linked with professional skills development. It also includes direct donations to charitable organisations of £2.7 million. A detailed breakdown of Prudential’s investment in the community and our policy on not donating to political parties can be viewed on page 54.
Our focus on acting responsibly and with integrity is not new. It is a philosophy that we have striven to incorporate within the way we work throughout our history. Responsible corporate behaviour is essential in maintaining successful relationships with, among others, our customers, our people and the communities around our business. Understanding our stakeholders’ needs today can also help us innovate in a way that creates both commercial and social future value.
MANAGEMENT AND POLICY ABI Guidelines The Association of British Insurers (ABI) has set out guidelines for companies to report on how they incorporate corporate responsibility issues into the management of business. We seek to follow the guidelines.
Prudential’s Group Finance Director, Philip Broadley, has responsibility on the Board for social, environmental and ethical risk management and the Board discusses Prudential’s performance on this at least once a year. The Board also reviews and approves our corporate responsibility report and strategy.
The Corporate Responsibility Policy Group (CRPG) is a specialist Groupwide committee reporting to the Group Finance Director and is responsible for making recommendations on business conduct and social and environmental policy. The CRPG submits a report on corporate responsibility activity across the business to the Board.
Our Corporate Responsibility (CR) unit also defines strategy, provides training on, co-ordinates and profiles our approach to social, environmental and ethical issues and works closely with individual business units to advise on and guide the development of CR activity.
Socially Responsible Investment During 2004, Prudential plc along with 143 institutional investors pledged its support to the Carbon Disclosure Project. This aims to encourage the disclosure of greenhouse gas emissions and to facilitate its integration into general investment analysis.
Employee Work Life Balance One means of attracting and retaining talented, motivated and committed people is to help them achieve an appropriate work life balance. Jackson National Life provides a subsidised child development centre for the children of employees. A unique aspect of the centre is that the subsidy is based on family income, with a greater discount for those on lower incomes. The centre was officially accredited by the National Association for the Education of Young Children in 2004.
A detailed report on our performance is given in our on-line CR report at www.prudential.co.uk/cr and a hard copy of this is also available from our Corporate Responsibility unit.
1. SIR DAVID CLEMENTI MA FCA MBA Chairman. Aged 56. Chairman since December 2002. In July 2003 he was appointed by the Secretary of State for Constitutional Affairs to carry out a review of the regulation of legal services in England and Wales, which was completed in December 2004. In February 2003 he joined the Financial Reporting Council. He is also a non-executive director of Rio Tinto plc, which he joined on 28 January 2003. From September 1997 to August 2002 he was Deputy Governor of the Bank of England. During this time he served as a member of the Monetary Policy Committee and as a non-executive director of the Financial Services Authority. From 1975 to 1997 he worked for the Kleinwort Benson Group, latterly as Chief Executive.
2. JONATHAN BLOOMER FCA Group Chief Executive. Aged 50. Appointed as a director in January 1995 and as Group Chief Executive in March 2000. He was previously Deputy Group Chief Executive and Group Finance Director. He is a non-executive director of Egg plc. He is also Chairman of the Practitioner Panel of the Financial Services Authority and a Board Member of the Association of British Insurers. In addition, he is a member of the Finance Committee of the NSPCC.
5. MICHAEL McLINTOCK Executive director. Aged 43. Appointed in September 2000. He is also Chief Executive of M&G, a position he held at the time of M&G’s acquisition by Prudential in March 1999.
8. KEKI DADISETH FCA Independent non-executive director. Aged 59. Appointed with effect from 1 April 2005. He is Director, Home and Personal Care, responsible for the HPC business of Unilever worldwide, and has been a main board director of Unilever PLC and Unilever N.V. since 2000. He joined Hindustan Lever Ltd in India in 1973, became Vice President of the Hindustan Lever Management Committee in 1987 progressing to Chairman in 1996. He is a Trustee of the Ratan Tata Trust, a director of The Indian Hotels Company Limited, ‘The Taj Group’, a member of the International Advisory Board of DaimlerChrysler Group and a director of the Indian School of Business (a venture between industry and the Business Schools at Wharton, Kellogg and LBS).
9. MICHAEL GARRETT Independent non-executive director. Aged 62. Appointed in September 2004. He is an Executive Vice President of Nestlé S.A., and member of the Executive Board. He has worked for Nestlé since 1961, becoming Head of Japan in 1990 and director with responsibility for the Far East in 1993. He is a member of the Advisory Committee for an APEC (Asia-Pacific Economic Cooperation) Food System. He is a director of a number of listed Nestlé companies in Asia, Africa and the Middle East. He has been a member of the Supervisory Board of Cereal Partners Worldwide (a joint venture between Nestlé and General Mills) since 1993.
12. KATHLEEN O’DONOVAN Independent non-executive director. Aged 47. Appointed in May 2003. She is a non-executive director of EMI Group plc, Great Portland Estates PLC and the Court of the Bank of England. She is also Chairman of the Audit Committee of the Bank of England and of the Audit Committee of the EMI Group plc, and Chairman of the Invensys Pension Fund. She was previously Finance Director at BTR and Invensys. Prior to that she was a partner at Ernst & Young.
13. JAMES ROSS Independent non-executive director. Aged 66. Appointed in May 2004. He holds non-executive directorships with McGraw Hill and Datacard in the United States and Schneider Electric in France. He is also Chairman of the Leadership Foundation for Higher Education. He was previously Deputy Chairman of National Grid Transco plc, and prior to that Chairman of National Grid Group plc and Littlewoods plc. He was also Chief Executive of Cable and Wireless plc and Chairman and Chief Executive of BP America Inc., and a Managing Director of the British Petroleum Company plc.
The directors are committed to high standards of corporate governance and support the Combined Code on Corporate Governance appended to the Listing Rules of the Financial Services Authority (the Code). The Board has adopted Group standards which set out the behaviours expected of staff in their dealings with shareholders, customers, fellow employees, suppliers and other stakeholders of the Group. The Company has complied throughout the financial year ended 31 December 2004 with all the Code provisions set out in Section 1 of the Code.
The Board is accountable for ensuring that an effective system for succession planning and management development is in place. This is delivered through an established review process that is applied across all the businesses and covers both director and senior management succession and development. The Board reviews the outcomes of the review annually and actions arising from the review are implemented as part of the management development agenda.
All directors have direct access to the services of the Company Secretary who advises them on all corporate governance matters, on Board procedures, and on compliance with applicable rules and regulations. In order to ensure good information flows, full Board and Committee papers are provided to the directors by the Company Secretary approximately one week before each Board or Committee meeting. The Company Secretary also supports the Chairman in providing tailored induction programmes for new directors and on-going training for all directors.
Audit Committee Report At Prudential, the Audit Committee is a key element of our governance framework. This report sets out its responsibilities and the work the Committee has done to meet its objectives.
Role of the Committee The Audit Committee’s principal oversight responsibilities cover: ■ internal control and risk management; ■ internal audit; ■ external audit (including auditor independence); and
Sandy Stewart resigned from the Committee on 6 May 2004, and James Ross was appointed on 6 May 2004.
The Board has designated the Chairman of the Committee as its audit committee financial expert for Sarbanes-Oxley Act purposes; he also has recent and relevant financial experience for the purposes of the Code.
The Committee received detailed presentations during the year from senior management designed to keep members up to date and aware of the impacts on the business of changes to accounting standards and practices including International Financial Reporting Standards and European Embedded Value.
The Chairman holds preparatory meetings with the Group Chief Internal Auditor, the external auditor and the Group Finance Director before each Committee meeting. A detailed forward agenda has been developed which ensures all matters that the Committee is responsible for are addressed at the appropriate time of the year. The principal business of the Committee’s meetings includes: ■ full year results and press release (including accounting policies and key judgemental areas), external auditor’s full year memorandum, Turnbull compliance statement, internal audit effectiveness, effectiveness of the Group Risk Framework; ■ annual report and accounts, external audit opinion and final management letter, effectiveness of the external audit process, external auditor’s qualifications, expertise and resources; ■ external auditor’s interim management letter, Group Finance report on accounting policies (including judgemental areas), half year compliance and risk report, Audit Committee effectiveness, Audit Committee terms of reference; ■ half year results and press release, external auditor’s plans and audit strategy, half year key risk report; ■ US filings and related external audit opinion, annual security report on anti-money laundering, Group policies for compliance with relevant regulations, half year compliance report; ■ Group Security annual report, European Embedded Value, International Accounting Standards; and
During the year, the Committee’s standing agenda items also included reports from Group Internal Audit, Group Compliance and Group Security, as well as reports on progress of the SarbanesOxley Section 404 project from management and the external auditor. The Committee also received presentations from some of the business unit chief executives.
The Audit Committee Chairman reported to the Board on matters of particular significance after each Committee meeting. The minutes of Committee meetings were circulated to all Board members.
The Committee recognises the need to meet without the presence of executive management. Such sessions were held twice, in March and July 2004, with the external and internal auditors.
managing business risks. The Committee also received the minutes of the Disclosure Committee and the Group Operational Risk Committee and noted their activities. Further information on these Committees appears on pages 39 and 40.
Internal audit The Audit Committee regards its relationship with internal audit as a particularly important one. Group Internal Audit plays an important role in supporting the Committee to fulfil its responsibilities under the Code and the Sarbanes-Oxley Act. Each of the Group’s business units has its own internal audit function whose resources, plans and work are overseen by Group Internal Audit. The Group Chief Internal Auditor reports functionally to the Committee and administratively to the Group Finance Director.
For the year ended December 2004, fees for audit services of £5.6 million for 2004 were approved. All non-audit services were approved by the Committee in accordance with the Group’s Auditor Independence Policy prior to work commencing and, at regular intervals in 2004, the Audit Committee reviewed the nonaudit services being provided to the Group by its external auditor.
During the year, fees for non-audit services of £4.1 million were put forward to the Audit Committee for approval. Fees for nonaudit services amounted to 42 per cent of total fees paid to KPMG Audit Plc. These primarily related to Sarbanes-Oxley Section 404 assistance, the Rights Issue due diligence work, and International Financial Reporting Standards and other regulatory changes. A more detailed analysis is set out in note 19 to the accounts.
Confidential reporting At each meeting, the Committee received and reviewed a report on calls to the confidential reporting lines and other confidential communications received and investigated since the preceding meeting, and actions taken in response to these calls. The Committee also considered whether any internal control implications arose from communications received. No internal control implications were raised from calls to the confidential reporting lines.
The Committee is satisfied, based on the findings of these reviews and the improvements made in response to them, that it had been operating as an effective Audit Committee, meeting all applicable legal and regulatory requirements. Further reviews of the effectiveness of the Audit Committee will be undertaken annually.
Remuneration Committee Report Roberto Mendoza (Chairman) Bart Becht (until 31 August 2004) Michael Garrett (from 1 September 2004) Bridget Macaskill Kathleen O’Donovan James Ross (from 6 May 2004) Rob Rowley Sandy Stewart (until 6 May 2004)
The Nomination Committee, which is comprised of a majority of independent non-executive directors, meets as required to consider candidates for appointment to the Board and to make recommendations to the Board in respect of those candidates. The Committee, in consultation with the Board, evaluates the balance of skills, knowledge and experience on the Board and makes recommendations regarding appointments based on merit and against objective criteria and the requirements of the Group’s business. In appropriate cases, search consultants are used to identify suitable candidates.
During 2004 the Committee held five meetings resulting in the appointment by the Board of three new independent nonexecutive directors. James Ross was appointed with effect from the conclusion of the Annual General Meeting on 6 May 2004, Michael Garrett was appointed to the Board on 1 September 2004 and Keki Dadiseth was appointed to the Board with effect from 1 April 2005. Biographical details of all these directors are set out on page 33.
ATTENDANCE AT BOARD AND COMMITTEE MEETINGS The number of full Board and Committee meetings attended by each director during 2004 was as follows: Full Audit Remuneration Nomination Board Committee Committee Committee meetings* meetings** meetings*** meetings
Notes *During 2004 there were eight scheduled Board meetings and six additional Board meetings.
3. Unable to attend one scheduled Board, Remuneration and Nomination Committee meeting due to injury.
4. Declared a conflict of interest on the subject under discussion at two Board meetings.
INDEPENDENT PROFESSIONAL ADVICE The Board has approved a procedure whereby directors have the right in furtherance of their duties to seek independent professional advice at the Company’s expense.
Independent professional advice was sought by Roberto Mendoza during 2004 regarding a potential conflict of interest arising from his position as Chairman of Egg plc.
DIRECTORS’ INDEPENDENCE, DEVELOPMENT AND RE-ELECTION Throughout the year all the non-executive directors were considered by the Board to be independent in character and judgement. No non-executive director: ■ has been an employee of the Group within the last five years; ■ has, or has had within the last three years, a material business relationship with the Group; ■ receives remuneration from the Group other than a director’s fee; ■ has close family ties with any of the Group’s advisers, directors or senior employees; ■ represents a significant shareholder; or
A cross-directorship exists with Roberto Mendoza and Jonathan Bloomer who both sit on the Board of Egg plc, the Company’s 79 per cent owned subsidiary which has its own listing on the London Stock Exchange. Under the Company’s Relationship Agreement with Egg established prior to its flotation in 2000 the Company has agreed with Egg that, absent specific events, the number of Company related directors represents less than half the total number of directors in office. The Company has the right, while it continues to own more than 10 per cent of the voting shares, to nominate one director and also, while it continues to own more than 15 per cent of the voting shares, to appoint the Chairman of the Board. Jonathan Bloomer was accordingly appointed as the Company’s nominated director and Roberto Mendoza was appointed as the Chairman of the Board of Egg.
Consequently, Roberto Mendoza discloses his interest as Chairman of Egg and if a conflict of interest arises he will withdraw from any decision-making by the Board of Prudential plc in respect of matters regarding Egg. The Board does not consider that this relationship in any way affects his status as an independent director of the Company.
SARBANES-OXLEY ACT 2002 The Sarbanes-Oxley Act 2002 (the Act) was passed by the US Congress in July 2002 to establish new or enhanced standards for corporate accountability in the US. As a result of the listing of its securities on the New York Stock Exchange, the Company must comply with the relevant provisions of the Act.
In discharging these objectives, the Committee helps to support the Group Chief Executive’s and Group Finance Director’s certifications of the effectiveness of disclosure procedures and controls required by Section 302 of the Act.
Company law requires the directors to prepare financial statements for each financial year which give a true and fair view of the state of affairs of the Company and of the Group and of the results for the period and which comply with the Companies Act 1985. In preparing those statements, the directors ensure that suitable accounting policies are selected and applied consistently, that reasonable and prudent judgements and estimates are made and that applicable accounting standards are followed. They also ensure that appropriate accounting records are maintained which disclose with reasonable accuracy at any time the financial position of the Group and enable them to prepare the financial statements and that reasonable steps are taken to safeguard the assets of the Group and to prevent and detect fraud and other irregularities.
INTERNAL CONTROL AND RISK MANAGEMENT The Board has responsibility for the Group’s system of internal control and for reviewing its effectiveness. The Board has conducted a review of the effectiveness of the Group’s system of internal control.
The control procedures and systems the Group has established are designed to manage, rather than eliminate, the risk of failure to meet business objectives and can only provide reasonable and not absolute assurance against material misstatement or loss. The system of internal control includes financial, operational and compliance controls and risk management.
The Group Risk Framework, adopted in 1999, requires that all of the Group’s businesses and functions establish processes for identifying, evaluating and managing the key risks faced by the Group. The Group risk categorisation model breaks risk down into risk classes, risk categories and risk components. The seven risk classes cover business environment risk, strategic risk, credit risk, regulatory compliance risk, investment risk, underwriting risk and operational risk, and are intended to encompass all risks faced by
Group Asset Liability Committee The Group Asset Liability Committee is chaired by the Group Finance Director and its membership includes business unit and Group management involved in the operation of the asset liability, credit and insurance risks framework. The Group Asset Liability Committee is the senior management forum responsible for oversight of asset-liability mismatch, solvency, market, credit and insurance risks across the Group. The Group Asset Liability Committee reports to the Group Chief Executive.
Internal Control Framework As a provider of financial services, including insurance, the Group’s business is the managed acceptance of risk. The system of internal control is an essential and integral part of the risk management process. As part of the annual preparation of its business plan, all of the Group’s businesses and functions are required to carry out a review of risks. This involves an assessment of the impact and likelihood of key risks and of the effectiveness of the controls in place to manage them. The assessment is reviewed regularly throughout the year. In addition, business units review opportunities and risks to business objectives regularly with the Group Chief Executive and Group Finance Director.
Businesses are required to confirm annually that they have undertaken risk management during the year as required by the Group Risk Framework and that they have reviewed the effectiveness of the system of internal control. The results of this review were reported to and reviewed by the Group Audit Committee, and it was confirmed that the processes described above and required by the Group Risk Framework were in place throughout the period covered by this report, and complied with Internal Control: Guidance on the Combined Code (the Turnbull guidance). Business unit internal audit teams execute risk based audit plans throughout the Group, from which all significant issues are reported to the Group Audit Committee.
INTRODUCTION What this report covers This report to shareholders: ■ sets out our remuneration policy for executive directors for 2004; ■ explains the policy under which our executive and non-executive directors were remunerated for the year ended 31 December 2004; ■ sets out tables of information showing details of the remuneration and share interests of all the directors for the year ended 31 December 2004; and
THE REMUNERATION COMMITTEE Role of the Remuneration Committee The Board believes that a properly constituted and effective Remuneration Committee is key to ensuring that executive directors’ remuneration is aligned with shareholders’ interests and enhances the competitiveness of the Company. The terms of reference of the Remuneration Committee are available on the Company’s website and a copy may be obtained from the Company Secretary, Group Secretarial Department. The Board has delegated to the Remuneration Committee the setting of the remuneration policy and individual remuneration packages for the Chairman and the executive directors. The fees of non-executive directors are a matter for the Board itself. The Chairman and the Group Chief Executive attend Remuneration Committee meetings to provide background and context on matters relating to the remuneration of the other executive directors, but do not attend when their own remuneration is discussed. No director has any involvement in determining his or her own remuneration. The Remuneration Committee meets on at least three occasions each year and more frequently if necessary.
Perrin to provide consultancy and market data and Freshfields Bruckhaus Deringer to advise on legal matters. Towers Perrin also provided the Company with consultancy advice and salary survey information and Freshfields Bruckhaus Deringer provided other legal advice.
Key Principles of the Remuneration Policy The principles developed by the Remuneration Committee reflect the relative importance of those elements that are performancerelated and those which are fixed and are as follows: ■ a high proportion of total remuneration will be delivered through performance-related reward; ■ a significant element of performance-related reward will be provided in the form of shares; ■ the total remuneration package for each director will be set in relation to the relevant employment market; ■ performance measures will include both absolute financial measures and comparative measures as appropriate to provide a clear alignment between the creation of shareholder value and reward; and
Elements of the Remuneration Package The remuneration package for the Company’s executive directors comprises the following elements: ■ a basic salary; ■ an annual incentive; ■ long-term incentives, paid in cash or shares depending on the plan; and
Basic salary The Remuneration Committee normally reviews executive directors’ salaries each year on an individual basis having regard to business results, individual accountabilities and performance, and market conditions.
*The annual incentive for these executive directors is further aligned with the interests of shareholders in that any part of the annual incentive award made for performance above target is made in Prudential shares. Receipt of these shares is deferred and the shares are normally only released after three years providing the director is still in employment. During the deferral period, dividends accumulate for the benefit of award holders.
This important performance-related element of the total reward package for executive directors rewards the achievement of TSR relative to other companies that were in the FTSE 100 at the beginning of each three-year performance period. The performance measure was chosen when the RSP was introduced as it reflected a combination of market practice, an assessment of Prudential’s main competitors and the focus of UK investors at that time.
In 2004, for Jonathan Bloomer the conditional and maximum RSP award was equivalent to 200 per cent of his basic salary at the time the award was granted. For Philip Broadley, Clark Manning, Mark Norbom and Mark Wood, these awards were equivalent to 160 per cent of basic salary and for Michael McLintock this award was equivalent to 80 per cent of basic salary.
Michael McLintock To reflect his role as Chief Executive of M&G, Michael McLintock participates in the M&G Chief Executive Long Term Incentive Plan that provides a cash reward through phantom M&G share awards and options, whose value depends on the profit and fund performance of M&G over the performance period. The change in the phantom share price equals the change in M&G profit, modified up or down by the investment performance of M&G, over the performance period. For 2004 the face value of the share award was £225,000. Provided the phantom share options have value, they may be exercised in part or in full during annual exercise periods after three to seven years from the start of the performance period. For 2004 the phantom option award had a face value of £367,800.
CHAIRMAN’S LETTER OF APPOINTMENT AND BENEFITS The Chairman is paid annual fees and the contractual notice periods are 12 months from either party. The Chairman participates in a medical insurance scheme, has life assurance cover and has the use of a car and driver. He is entitled to a supplement to his fees, intended for pension purposes. He is not a member of any Group pension scheme providing retirement benefits.
DIRECTORS’ SERVICE CONTRACTS AND LETTERS OF APPOINTMENT Executive directors have contracts that terminate on their normal retirement date, which is the date of their 60th birthday. The normal notice of termination that the Company is required to give executive directors is 12 months, although for newly appointed directors there may be an initial contractual period of up to two years before the 12 months’ notice period applies. The service contracts for all current executive directors contain a 12 months’ notice period from the Company. When considering termination of service contracts, the Remuneration Committee will have regard to the specific circumstances of each case, including a director’s obligation to mitigate his loss.
2. The commencement and expiry dates of Michael Garrett’s and James Ross’s initial terms are subject to resolutions for their election being passed at the Annual General Meeting in May 2005.
BENEFITS AND PROTECTIONS Executive directors receive certain benefits, principally participation in medical insurance schemes, the provision of a cash allowance for a car (except for Clark Manning and Mark Norbom), and, in some cases the use of a car and driver and security arrangements. Mark Norbom also receives expatriate allowances. No benefits are pensionable. The executive directors’ pension arrangements and life assurance provisions are set out in the Pensions and Life Assurance section on pages 51 to 52.
NON-EXECUTIVE DIRECTORS’ REMUNERATION Non-executive directors are not eligible to participate in annual incentive plans, long-term incentive plans or pension arrangements. Their fees are determined by the Board and reflect their individual responsibilities including membership of the Audit and Remuneration Committees as appropriate. The Board reviews the fees annually but the last change was made in 2003.
Roberto Mendoza, as Chairman of Egg, receives a fee of £75,000 per annum and Sandy Stewart, as Chairman of the Scottish Amicable (supervisory) Board, received a fee of £30,000 per annum until 1 December 2004, when the fee was increased to £32,500 per annum.
PERFORMANCE GRAPH The line graph below represents the comparative Total Shareholder Return (TSR) of the Company during the five years from 1 January
The interests of directors in shares of the Company include shares awarded under the Share Participation Plan, the deferred annual incentive awards that are detailed in the table on Other Share Awards on page 50, shares held for Michael McLintock in an M&G allemployee trust established prior to the acquisition of M&G in 1999 which were released to him during the year, and Mark Norbom’s interests in the shares awarded on appointment that are detailed in the table on Other Share Awards on page 50. In addition, interests include rights granted to Jonathan Bloomer under the 1997, 1998 and 1999 Restricted Share Plan that are detailed in the table on the Restricted Share Plan on page 49 where he has yet to exercise his right to receive shares. Awards that remain conditional under the Restricted Share Plan are excluded.
The interests of directors in shares of the Company shown below include changes between 31 December 2004 and 1 March 2005. All interests are beneficial.
Sir David Clementi 10,742 16,615 16,615 *Or date of appointment if later.
Ann Burdus (until 31 December 2003) – – 53 Michael Garrett (from 1 September 2004) 17 17 –
3. Clark Manning’s bonus figure excludes a contribution of £6,712 from a profit sharing plan that has been made into a 401k retirement plan which is included in the table on pension contributions on page 52.
4. In 2004 a deferred share award valued at £244,000 from his 2003 annual bonus was made to Michael McLintock. This is included in the 2003 total and further details are shown in the section on Other Share Awards on page 50.
7. In 2004 Mark Norbom was also paid £80,358 in dividend equivalents from the awards detailed in the section on Other Share Awards on page 50. In addition he was compensated for the loss of a portion of his 2003 bonus award and his 2003 long-term incentive award from his previous employer with a total cash sum of £152,410. These amounts are included in the column headed Other payments.
8. Mark Norbom’s benefits include those that reflect his expatriate status, which include costs of £149,085 related to housing. He was also paid £29,513 in respect of relocation expenses, not included in the benefits figure.
EXECUTIVE DIRECTORS – NON-EXECUTIVE DIRECTOR EARNINGS Executive directors who are released to serve as non-executive directors of other external companies retain the earnings resulting from such duties. In 2004, Michael McLintock earned £43,468 from an external company. No other executive director served with an external company, other than with educational bodies.
DIRECTORS’ OUTSTANDING LONG-TERM INCENTIVE AWARDS The section below sets out the outstanding awards under the Restricted Share Plan and the additional long-term plans for the executive directors who run specific businesses.
Restricted Share Plan The table below shows all outstanding awards under the Restricted Share Plan.
2. In respect of awards made in 2002 under the Restricted Share Plan, the Company's TSR was ranked at 89th percentile at the end of the three-year performance period on 31 December 2004. As Prudential’s position was lower than 60th percentile, the 2002 awards lapsed and rights will not be granted over any of the shares conditionally awarded to executive directors.
Rights not yet exercised that were granted under the Restricted Share Plan prior to 31 December 2003 are shown in the following table: Adjustment Market
Face value of Face value of conditional conditional awards Conditionally Payments awards Date of outstanding at awarded made outstanding at end of
Year of 1 Jan 2004 in 2004 in 2004 31 Dec 2004 performance
Mark Wood Business cash LTIP 2001 450 Nil – 31 Dec 03
Notes Clark Manning’s 2000 and 2001 cash long-term incentive plans had four-year performance periods respectively with payouts in both cases depending on Jackson National Life’s US GAAP net income in the final year. For the 2000 award the results led to a payment only from the phantom share award of US$176,000 while the 2001 award led to a payment of US$675,900 for the share element and US$151,800 for the option element. The face values of the awards for Clark Manning are converted at the average exchange rate for 2004 which was US$1.8326 = £1 (2003: US$1.6351= £1). Upon joining the Board, Clark Manning also participated in the 2002 JNL Chief Executive Long-Term Incentive Plan which has a performance period of three years. The performance conditions are the same as described in the Business-Specific Long-Term Incentive Plans section on page 43. The compound growth rate of the JNL appraisal value was below the threshold for a payment to be made in respect of the award.
The table also includes the share awards that have been deferred from annual incentive plan payouts. The values of the deferred share awards are included in the bonus and total figures in the Directors’ Remuneration table on page 47. The number of shares is calculated using the average share price over the three business days commencing on the day of the announcement of the Group’s annual financial results for the relevant year. For the 2003 awards the average share price was 492 pence.
Conditional Adjustment Conditional Date of original price at Year of share awards Conditionally Scrip for Rights Shares share awards end of Shares date of date of initial outstanding awarded dividends Issue on released in outstanding at restricted released Date of award vesting grant at 1 Jan 2004 in 2004 accumulated 11 Nov 2004 2004 31 Dec 2004 period in 2004 release (pence) (pence)
Notes 1. The value of the 2003 deferred share award from the annual incentive plan is included in the Total emoluments 2003 figure in the Directors’ Remuneration table on page 47.
3. In order to secure the appointment of Mark Norbom, he has been awarded rights to Prudential plc shares, which vest as set out in the table. These awards will normally vest dependent on continuing employment at the date of vesting except for the element compensating for the loss of supplemental pension rights which vests on his leaving Prudential providing this is after 20 February 2013. If there is a change of control of Prudential or a sale of all or part of the Asian business he may become entitled to retain any unvested awards in accordance with the vesting schedules above. The equivalent of dividend distributions will be made from these awards during the restricted period and the cash dividend equivalents paid in 2004 from these awards are included in the Directors’ Remuneration table on page 47.
DIRECTORS’ SHARE OPTIONS The Restricted Share Plan replaced the Executive Share Option Scheme (ESOS) in 1995 as the Group’s primary long-term incentive plan. Options under ESOS are set out below together with options under the Savings-Related Share Option Scheme (SAYE). The SavingsRelated Share Option Scheme is open to all UK and certain overseas employees. Options under this scheme up to Inland Revenue limits are granted at a 20 per cent discount and cannot normally be exercised until a minimum of three years has elapsed. No payment has been made for the grant of any options. The price to be paid for exercise of these options is shown in the table below. No variations to any outstanding options have been made.
4. The highest and lowest share prices during 2004 were 512 pence and 386 pence respectively.
UK Inland Revenue Approved Pension Schemes Executive directors employed in the UK are eligible to participate in Inland Revenue approved pension schemes on the same basis as other employees who joined at that time, providing benefits based on basic salary up to the Inland Revenue earnings cap.
Other Supplementary Arrangements Sir David Clementi is provided with a salary supplement, part of which is a contribution to a personal pension, and life assurance of four times his annual fees.
Jonathan Bloomer, Philip Broadley, Michael McLintock and Mark Wood are entitled to supplements based on the portion of their basic salary not covered for pension benefits under a UK Inland Revenue approved scheme. These supplements are paid directly to them or to a Funded Unapproved Retirement Benefit Scheme (FURBS) established in their name. They are provided with life assurance cover related to salary over the Inland Revenue earnings cap. The cover is broadly equivalent to the death in service benefits provided under the relevant UK Inland Revenue approved pension scheme.
Mark Norbom is provided with a salary supplement for pension purposes, and life assurance provision of four times his basic salary.
Age at service at 31 Dec 2004 20031 20032 B A during 2004 arrangements4
Mark Norbom 46 – – – – – – – 146
Notes 1. As required by the London Stock Exchange Listing rules.
PRINCIPAL ACTIVITY AND BUSINESS REVIEW Prudential plc is the Group holding company and the principal activity of its subsidiary undertakings is the provision of financial services in the UK, the US and Asia. Particulars of principal subsidiary undertakings are given in note 31 on page 89. The Group’s businesses and likely future developments are reviewed in the Chairman’s Statement on page 2, the Group Chief Executive’s Review on pages 3 and 4, the Business Review on pages 5 to 11 and the Financial Review on pages 12 to 29, which contain details of the development of the businesses of the Group during the financial year and of the Group’s position at the end of it. No important events affecting the Group have occurred since the end of the financial year.
DIVIDENDS The directors recommend that the shareholders declare a final dividend for 2004 of 10.65 pence per share payable on 25 May 2005 to shareholders on the register of members at the close of business on 18 March 2005. After adjusting for the bonus element of the Rights Issue in 2004, the interim dividend for 2004 was 5.19 pence per share (actual amount paid in 2004 was 5.40 pence). The total dividend for the year, including the adjusted interim dividend and the recommended final dividend, amounts to 15.84 pence per share compared with 15.38 pence per share as adjusted for 2003. The total cost of dividends for 2004 was £362 million.
EMPLOYEES The following information is given principally in respect of employees of the Group in the United Kingdom. The policy towards employees overseas is the same but the practical application of the policy varies according to local requirements.
Equal Opportunity Prudential recognises, respects and values difference and diversity. Its equal opportunities policy is to be fair, responsible and caring in all aspects of the business. The Group seeks to ensure all employees and applicants to its businesses are given equal opportunity in all aspects of employment to ensure that the Group’s businesses attract, retain and promote the best available talent. All the businesses work to embed these principles in all aspects of their management practices and to ensure that this is evident to employees in their day-to-day work.
Employee Involvement The Group has effective communication channels through which employees’ views can be sought on issues which concern them. Throughout the Group there is close consultation between management and other employees on appropriate matters of concern, with a view to keeping employees informed about the progress of the Group’s business and the economic factors affecting it. Communication with employees is achieved in a number of ways, including one-to-one staff briefings and through the Group’s intranet site. Prudential’s European Employee Forum provides an opportunity for elected employee representatives to consult with senior management on strategic European business issues. M&G’s Staff Consultative Committee promotes communication and consultation throughout M&G and is the forum for dialogue on a range of issues of interest to its staff.
During 2004 all Prudential UK based operations began a process of reviewing their staff consultative arrangements with a view to improving their effectiveness, consulting trade unions and staff as relevant. This review was given impetus by the impending UK legislation on Information and Consultation. Some changes were implemented in 2004 and plans to consult on and change other arrangements in 2005 were developed.
In 2004 employees were again invited to participate in the Prudential Savings-Related Share Option Scheme. The Scheme has now been operating for 21 years and 63 per cent of UK staff currently participate. The Prudential International Savings-Related Share Option Scheme (ISSOS) for employees has been operating since 2000 in Hong Kong, Malaysia and Singapore; since 2001 in Taiwan and India; and since 2003 in Korea. On average 27 per cent of employees in those countries covered by the ISSOS currently participate. In addition, since 2002 Prudential has operated the International Savings-Related Share Option Scheme for NonEmployees (ISSOSNE) for its agents in Hong Kong. Currently 13 per cent of agents participate.
Following shareholder agreement in 2000 to authorise the Board to introduce a Share Incentive Plan, The Prudential UK Share Incentive Plan (SIP) was introduced in 2004 for employees of Prudential UK Services Limited and The Prudential Assurance Company Limited. This SIP enables employees to buy Prudential shares on a tax efficient basis. For every four Partnership Shares bought, an additional Matching Share is granted. Currently 12 per cent of eligible staff participate.
AUDITOR A resolution for the re-appointment of KPMG Audit Plc as auditor of the Company until the end of the 2006 Annual General Meeting will be put to the Annual General Meeting on 5 May 2005.
Operating profit (based on long-term investment returns) before amortisation of goodwill Balance on the general business technical account (analysed on page 56) 0 0
– discontinued operations 17 22 Asian Operations (net of development expenses of £15m (£27m)) 111 58
US broker-dealer and fund management (14) (3) Asia fund management 19 13 Egg – continuing operations 43 55
Statutory basis profit on ordinary activities before tax (analysed on page 58) 650 350
Minority interests 10 2 Statutory basis profit for the financial year after minority interests: Operating profit after tax and related minority interests before amortisation of goodwill 408 257 Items excluded from operating profit after tax before amortisation of goodwill 20 (49)
Total statutory basis profit for the financial year after minority interests 428 208
Based on operating profit after tax and related minority interests before amortisation of goodwill* 19.2p 12.4p Based on total statutory profit for the financial year after minority interests – basic* 20.1p 10.0p
Gross premiums written 11 – – Change in the gross provision for unearned premiums – 155 Change in the provision for unearned premiums, reinsurers’ share – (155)
Allocated investment return transferred from the non-technical account 11 6 7
The whole of the general business technical account relates to operations in run-off (see note 11).
CONSOLIDATED PROFIT AND LOSS ACCOUNT YEAR ENDED 31 DECEMBER 2004 56 PRUDENTIAL PLC ANNUAL REPORT 2004
Gross premiums written 6 16,355 13,781 Outwards reinsurance premiums (256) (290)
Change in the provision for claims: Gross amount (27) (29) Reinsurers’ share 2 (3)
Change in provisions for linked liabilities, net of reinsurance (4,322) (4,728)
Balance on the long-term business technical account before tax 8 629 479
Unrealised gains (losses) on investments 8 (10) Allocated investment return transferred from the long-term business technical account 215 77 Investment expenses and charges 16 (213) (189) Allocated investment return transferred to the general business technical account (6) (7) Other income: UK fund management result 136 83 Asia fund management result 19 13 US broker-dealer and fund management result (14) (3) Profit on the sale of discontinued operations 34 48 –
Other charges: UK banking business result – continuing operations 11 43 55
Amortisation of goodwill 21 (97) (98) Egg France closure cost 11 (113) –
Total recognised gains (losses) relating to the financial year 267 (45)
*The figures for these lines have been restated (see note 4).
Reinsurers’ share of technical provisions Long-term business provision 612 499 Claims outstanding 99 151 Technical provisions for linked liabilities 307 274
Debtors Debtors arising out of direct insurance operations: Debtors arising out of reinsurance operations 20 19 Other debtors: Tax recoverable 159 158
Cash at bank and in hand 35 1,415 1,221 Present value of acquired in-force long-term business 27 86 108
Prepayments and accrued income Accrued interest and rent 1,195 1,131 Deferred acquisition costs 2,908 2,952 Other prepayments and accrued income 250 138
CONSOLIDATED BALANCE SHEET 31 DECEMBER 2004 60 PRUDENTIAL PLC ANNUAL REPORT 2004
Profit and loss account 2,646 2,625 Cost of shares held in trusts for employee incentive plans* 28 (42) (38)
Total liabilities* 174,540 161,709 *The 2003 figures for these lines have been restated (see note 4).
Fixed assets Investments: Shares in subsidiary undertakings 29 5,629 4,000 Loans to subsidiary undertakings 29 2,129 2,526
Current assets Debtors: Amounts owed by subsidiary undertakings 1,085 1,072 Other debtors 38 32
The financial statements on pages 56 to 95 were approved by the Board of directors on 1 March 2005.
BALANCE SHEET OF THE COMPANY 31 DECEMBER 2004 62 PRUDENTIAL PLC ANNUAL REPORT 2004
The net cash inflow was invested as follows: Portfolio investments Purchases: Ordinary shares 36 1 Fixed income securities 2,204 962
Long-term business products written in the UK and Asia are principally with-profits deposit administration, other conventional and unitised with-profits policies and non-participating pension annuities in the course of payment. Long-term business also includes linked business written in the UK and Asia. The principal products written by Jackson National Life in the US are interest sensitive deferred annuities and whole-life policies, variable annuities, guaranteed investment contracts, equity linked indexed deferred annuities and term life insurance.
3. SIGNIFICANT ACCOUNTING POLICIES CONTINUED Deferred acquisition costs Costs of acquiring new business, principally commissions, marketing and advertising costs and certain other costs associated with policy issuance and underwriting that are not reimbursed by policy charges are specifically identified and capitalised as deferred acquisition costs (DAC), which are included as an asset in the balance sheet. The DAC asset is amortised against margins in future revenues on the related insurance policies, to the extent that the amounts are recoverable out of the margins. Recoverability of the unamortised DAC asset is assessed at the time of policy issue, and reviewed if profit margins have declined.
For the business of Jackson National Life the determination of the expected emergence of margins, against which the amortisation profile of the DAC asset is established, is dependent on certain key assumptions. For single premium deferred annuity business, the key assumption is the expected long-term spread between the earned rate and the rate credited to policyholders. For variable annuity business, the key assumption is the expected long-term level of equity market returns which, for 2004 and 2003, was 8.4% per annum implemented using a mean reversion methodology. These returns affect the level of future expected profits through their effects on fee income and the required level of provision for guaranteed minimum death benefit claims.
Long-term business provision UK Insurance Operations Prudential’s long-term business written in the UK comprises predominantly life insurance policies under which the policyholders are entitled to participate in the profits of the long-term business supporting these policies. This business is also written in parts of Asia. Such policies are called ‘with-profits’ policies. Prudential maintains with-profits funds within the Group’s long-term business funds, which segregate the assets and liabilities and accumulate the profit and loss activity related to that with-profits business. The amounts accumulated in these with-profits funds are available to provide for future policyholder benefit provisions and for bonuses to be distributed to with-profits policyholders. The bonuses, both annual and final, reflect the right of the with-profits policyholders to participate in the financial performance of the with-profits funds. Shareholders’ profits with respect to bonuses declared on with-profits business correspond to the shareholders’ share of the cost of bonuses as declared by the Board of directors. The shareholders’ share currently represents one-ninth of the cost of bonuses declared for with-profits policies.
Annual bonuses are declared and credited each year to all with-profits policies. The annual bonuses increase policy benefits and, once credited, become guaranteed. Annual bonuses are charged to the profit and loss account as a change in the long-term business provision in the year declared. Final bonuses are declared each year and accrued for all policies scheduled to mature and death benefits expected to be paid during the next financial year. Final bonuses are not guaranteed and are only paid on policies that result from claims through the death of the policyholder or maturity of the policy within the period of declaration or by concession on surrender. No policyholder benefit provisions are recorded for future annual or final bonus declarations.
For PAC business, the provision has been taken as the lower of: ■ the accumulated fund or the value at the bid price of the notional number of units allocated to policyholders, in both cases excluding final bonus; and
For the purpose of calculating the liability using the bonus reserve method, the assumed interest rates range from 2.5% to 5.0% at 31 December 2004 and from 3.0% to 5.0% at 31 December 2003, while future reversionary bonuses are assumed to fall immediately from current levels to zero. There have been no significant changes of assumption for accumulating with-profits business.
Jackson National Life The future policyholder benefit provisions for Jackson National Life’s conventional protection-type policies are determined using the net level premium method under US GAAP principles and assumptions as of the issue date as to mortality, interest, policy lapsation and expenses plus provisions for adverse deviations. Rates of interest used in establishing the policyholder benefit provisions range from 4.0% to 8.0%. Mortality assumptions range from 50% to 90% of the 1975-1980 Basic Select and Ultimate tables, depending on underwriting classification and policy duration. For investment-type products sold by Jackson National Life, the policyholder benefit provision included within technical provisions in the consolidated balance sheet is the policyholder account balance.
Asian Operations The future policyholder benefit provisions for Asian businesses are determined in accordance with methods prescribed by local GAAP adjusted to comply, where necessary, with UK GAAP. For the Hong Kong business, which is a branch of PAC, and the Singapore and Malaysian operations the valuation principles and sensitivities to changes of assumptions of conventional with-profits and other protectiontype policies are similar to those described above for equivalent products written by the UK operations. For Hong Kong business the interest rate has reduced to 3.4% at 31 December 2004 from 3.6% at 31 December 2003 for traditional business and to between 2.5% and 2.9% at 31 December 2004 from 3.25% at 31 December 2003 for accumulating with-profits assurances. For Singapore and Malaysia there have been no significant changes of assumption. Interest rates of 3.5% to 4.0% in Singapore and 4.0% in Malaysia at both 31 December 2004 and 31 December 2003 have been used in accordance with local regulations.
In the case of Jackson National Life, US GAAP results are adjusted to comply with UK GAAP in respect of the valuation basis for fixed income securities and certain financial derivative instruments. Further details are shown in note 12.
Investment Returns Investment returns comprise investment income, realised gains and losses and changes in unrealised gains and losses, except for changes in unrealised gains and losses on debt securities held by Jackson National Life. Subject to provisions for permanent diminutions in value, debt securities held by Jackson National Life are carried at amortised cost.
Realised investment gains and losses represent the difference between the net sale proceeds and the cost of acquisition. Unrealised investment gains and losses represent the difference between the carrying value at the previous year-end (or purchase value during the year) and the carrying value at the current year-end.
The balance on the long-term business technical account is net of the total tax attributable to the long-term business. In order to present the profit on long-term insurance activities in the non-technical account on a pre-tax basis, a tax credit attributable to the shareholders’ portion of the tax provision for long-term business, calculated at the effective tax rate (where appropriate on a long-term basis) of the underlying business, is added. This shareholder tax add-back is then included in the tax expense on the profit on ordinary activities within the non-technical account. Further details are provided in note 20.
In December 2003, Urgent Issues Task Force Abstract 38 ‘Accounting for Employee Share Ownership Trusts’ (UITF 38) was issued. The main effect of UITF 38 is that the Company must present the cost of acquiring the shares held in such trusts as a deduction in determining shareholders’ funds. The Company has adopted the provisions of UITF 38 in its 2004 results. Further details are provided in note 4.
Land and Buildings Investments in tenant and Group occupied leasehold and freehold (directly owned) properties are carried at estimated fair value, with changes in estimated fair value included in investment returns. Properties are valued annually either by the Group’s qualified surveyors or 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.
In accordance with SSAP 19, ‘Investment properties’, no depreciation is provided on investment properties (other than Group occupied) as the directors consider that these properties are held for investment purposes.
The Group’s investments in joint ventures are also recorded at the Group’s share of net assets. Other participating interests, where significant influence is not exercised, are carried as investments on the consolidated balance sheet at fair value.
Other Financial Investments Other financial investments include equity securities, debt and other fixed income securities, mortgages and other loans, loans to policyholders (excluding unpaid interest) and deposits with credit institutions.
3. SIGNIFICANT ACCOUNTING POLICIES CONTINUED Equity securities and debt and other fixed income securities Equity securities are carried at fair value. Debt and other fixed income securities are carried at fair value, except for those held by Jackson National Life, which, subject to provision for permanent diminutions in value, are carried at amortised cost. Fair value is based on quoted market prices for listed securities, and on quotations provided by external fund managers, brokers, independent pricing services or values as determined by the directors for unlisted securities. Changes in fair value are recognised in investment returns during the year of the change. Debt and other fixed income securities held by Jackson National Life are carried at amortised cost as permitted by paragraph 24 of Schedule 9A to the Companies Act 1985. The amortised cost basis of valuation is appropriate under the provisions of the ABI SORP for Jackson National Life’s redeemable fixed income securities as they are held as part of a portfolio of such securities intended to be held to maturity. Further details of the valuation basis for fixed income securities of Jackson National Life are explained in note 12.
Mortgages and other loans Loans collateralised by mortgages and other unsecured loans are carried at unpaid principal balances, net of unamortised discounts and premiums and an allowance for loan losses, except for loans held by UK insurance operations which are carried at fair value. The allowance for loan losses is maintained at a level considered adequate to absorb losses inherent in the mortgage loan portfolio.
Tangible Assets Tangible assets, principally computer equipment, software development expenditure, and furniture and fixtures, are capitalised and depreciated on a straight-line basis over their estimated useful lives, generally three to ten years. Leasehold improvements are depreciated over the life of the lease. Assets held under finance leases are capitalised at their fair value.
3. SIGNIFICANT ACCOUNTING POLICIES CONTINUED Banking Business Assets and Liabilities Banking business assets consist primarily of certificates of deposit and short-term deposits with credit institutions carried at fair value and mortgage loans carried at recoverable amount, being outstanding principal balances, net of allowances for loan losses. Loan provisions are recorded for the overall loan portfolio to cover bad debts which have not been separately identified but which are known from experience to be present in the portfolio. For loans in default, specific loan provisions are recorded. General provisions are raised in respect of losses, which although not specifically identified, are known from experience to be present in any such portfolios. The level of general provision is determined by the application of a number of basis points to the aspects of the portfolio which are not currently identified as delinquent but which experience suggests contains lending which will ultimately lead to losses. The number of basis points applied to the portfolios are regularly assessed against recent experience and adjusted if appropriate. Changes in loan provisions during the year are included in the consolidated profit and loss account.
Liabilities relating to the Group’s banking business consist primarily of customer short-term or demand deposits, including interest accrued on the deposits.
With effect from 1 January 1998, goodwill arising from acquisitions is reflected as an asset on the consolidated balance sheet and is amortised through the consolidated profit and loss account on a straight-line basis over its estimated useful life, not exceeding 20 years. Prior to 1 January 1998, goodwill relating to acquisitions was charged directly to shareholders’ funds. As permitted under the transitional arrangements of FRS 10, ‘Goodwill and intangible assets’, amounts previously charged to shareholders’ funds have not been reinstated as assets. Upon disposal of a business acquired prior to 1 January 1998 to which goodwill relates, the original goodwill balance is charged to the consolidated profit and loss account in determining the gain or loss on the sale.
Share Premium The difference between the proceeds received on issue of shares, net of issue costs, and the nominal value of the shares issued is credited to the share premium account.
Foreign Currency Translation The profit and loss accounts of foreign subsidiaries are translated at average exchange rates for the year. Assets and liabilities of foreign subsidiaries are translated at year-end exchange rates. 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 as a component of shareholders’ funds within the statement of total recognised gains and losses.
Other assets and liabilities denominated in foreign currencies are also converted at year-end exchange rates with the related foreign currency exchange gains or losses reflected in the profit and loss account for the year.
5. SUPPLEMENTAL EARNINGS INFORMATION The Group uses operating profit based on long-term investment returns before amortisation of goodwill as a supplemental measure of its results. For the purposes of measuring operating profit, investment returns on shareholder financed business are based on expected long-term rates of return. The expected long-term rates of return are intended to reflect historical real rates of return and, where appropriate, current inflation expectations adjusted for consensus economic and investment forecasts. The significant operations that require adjustment for the difference between actual and long-term investment returns are Jackson National Life and certain businesses in Asia.
For the Group’s continuing operations with investment portfolios that are both attributable to shareholders and subject to short-term volatility, and the UK general business that was sold in 2002, a comparison of actual and long-term gains is as follows: 1993 to 1993 to 1993 to 1993 to £m £m £m £m £m £m £m
For the purposes of determining the long-term investment returns of Jackson National Life, from 2001 realised gains and losses arising on debt securities (including losses arising on the recognition of permanent diminutions in value) have been averaged over five years for inclusion in operating profit. For equity-related investments of Jackson National Life, a long-term rate of return of 8.0% has been assumed and this rate has been applied to the monthly average carrying value of such investments after excluding the estimated effect of short-term market movements.
5. SUPPLEMENTAL EARNINGS INFORMATION CONTINUED The Group’s supplemental measure of its results and reconciliation of operating profit based on long-term investment returns before amortisation of goodwill to profit on ordinary activities, including the related basic earnings per share amounts, are as follows: Before Basic tax Tax Minority earnings
Amortisation of goodwill (98) (98) (4.7)p Short-term fluctuations in investment returns: *The 2003 earnings per share figures have been restated to take account of the Rights Issue in 2004.
Weighted average shares for basic earnings per share 2,129 2,076 Shares under option at end of year (note 28) 13 16 Number of shares that would have been issued at fair value on assumed option exercise (10) (14)
The analysis of gross premiums written is based on the territory of the operating unit assuming the risk. A similar analysis by territory of risk would not be materially different.
7. SEGMENTAL INFORMATION – INSURANCE AND INVESTMENT PRODUCTS NEW BUSINESS Insurance Products and Investment Products
7. SEGMENTAL INFORMATION – INSURANCE AND INVESTMENT PRODUCTS NEW BUSINESS CONTINUED Insurance Products – New Business Premiums
Annual Single Regular Premium Equivalents £m £m £m £m £m £m
Department of Work and Pensions rebate business 89 103 – – 9 10
GIC – Medium Term Notes 672 303 – – 67 30
1 Jan 2004 inflows Redemptions movements 31 Dec 2004 £m £m £m £m £m 8. SEGMENTAL INFORMATION – PROFIT ON ORDINARY ACTIVITIES BEFORE TAX
Other Income and Expenditure: Unrealised gains (losses) on investments 8 (10) 8 (10) Allocations from technical accounts 209 70 209 70 Short-term fluctuations in investment returns (229) (91) (229) (91)
Operating profit before amortisation of goodwill 629 479 (46) (122) 583 357
Analysed as: Items excluded from operating profit before amortisation of goodwill: Short-term fluctuations in investment returns (note 5) 229 91 229 91 Profit or loss on the sale or termination of discontinued operations: Profit on business disposals (note 34) 48 – 48 – Egg France closure cost (note 11) (113) – (113) –
(closed to new business and wholly attributable but not allocated to policyholders)† 1,836 1,404 Other funds* 14,850 11,253
Comprising: UK and Europe Operations* 111,846 102,565 Jackson National Life 24,682 23,854 Asian Operations 8,241 6,687 *The 2003 figures for these lines have been restated (see note 4).
10. SEGMENTAL INFORMATION – SHAREHOLDERS' FUNDS Core Core structural structural borrowings of Restated borrowings of
UK and Europe Operations: Long-term business operations 889 889 612 612
Other Operations: *The 2003 figures for these lines have been restated (see note 4). † Total goodwill comprises amounts included in: £m £m
The Group sold its UK home and motor insurance business in 2002 and, as part of the sale arrangements, the insurance liabilities of this business at the end of 2001 were fully reinsured. This business is now in run-off, as is the Group's UK commercial business that was closed to new business in 1992.
Liabilities Customer accounts 6,607 6,452 Debt securities issued (note 32) 1,807 1,423 Securities sold under agreements to repurchase (note 32) 131 829 Deposits by banks 2,352 1,610 Other banking business liabilities 320 473
Total banking business liabilities 11,217 10,787 Debenture loans (note 32) 451 451 Other liabilities including tax 22 23
Profit and loss account Operating profit: Broker-dealer and fund management 11 (37) (26) (14)
Realised investment gains (losses), net of related change to amortisation of acquisition costs (note (ii)) (US GAAP as published also includes the change in the fair value of hedging instruments) 143 (65) 78 (78)
Short-term fluctuations in investment returns 291 291 159 Gain on sale of Jackson Federal Bank 66 66 10 76 41 Income from discontinued operations 32 32 32 17
Movement in shareholders’ funds Net income (as shown above) 630 (169) 461 5 (1) 465
Shareholders’ funds at beginning of year 4,402 (405) 3,997 127 45 4,169
12. US OPERATIONS – ADDITIONAL DETAIL ON BASIS OF PRESENTATION OF RESULTS CONTINUED (i) The Valuation Basis of Debt Securities – Reversal of FAS 115 Effects Under US GAAP, debt securities classified as ‘available for sale’ under Financial Accounting Standard (FAS) 115 are carried in the balance sheet at fair value with movements on unrealised appreciation accounted for directly within shareholders’ reserves as ‘Other Comprehensive Income’. By contrast, consistent with the ABI SORP, for Group reporting purposes, all fixed income securities are carried at amortised cost subject to provision for permanent diminution in value. This accounting treatment is appropriate as the securities are held as part of a portfolio of such securities intended to be held to maturity. Movements in unrealised appreciation arising from changes in the fair value of these securities do not feature as a part of the Group’s UK GAAP accounting.
(iii) Minority Interests The UK GAAP results are determined after adjustment for minority interests. For UK reporting purposes the segmental result of Jackson National Life reflects its proportionate interests in the results of two investment funds that are consolidated as quasi-subsidiaries.
(iv) Presentation of Investment Returns within the UK Basis Performance Statements Profit (loss) on ordinary activities before tax With the exception of the elimination of FAS 133 effects, as explained in note (ii), and revaluation gains on certain equity-based securities that are recorded within Other Comprehensive Income under US GAAP, the total profit (loss) under UK GAAP is the same as under US GAAP.
Average rate for 2004 applied to profit and loss account 1.83 Year end rate 2004 applied to shareholders’ funds 1.92 13. INVESTMENT INCOME Long-term business Non-technical technical account account £m £m £m £m
Shareholder financed business: Non-participating business 24 23 Linked business 19 17
Financed by with-profits funds: With-profits business 19 25 Non-participating business† 1 1
Shareholder financed business: Non-participating business 60 54 Linked business 19 18 *The Scottish Amicable Insurance Fund is closed to new business. The assets and liabilities of the fund are wholly attributable to the policyholders of the fund. † Annuity business written by Prudential Annuities Limited, a subsidiary of the with-profits fund of The Prudential Assurance Company Limited (PAC), and by a separate fund of the PAC with-profits fund, which comprises non-participating and linked business purchased from the Scottish Amicable Life Assurance Society.
15. NET OPERATING EXPENSES Long-term business General business technical account technical account £m £m £m £m
Acquisition costs 1,508 1,188 – – Change in deferred acquisition costs (78) (3) – – Administrative expenses 530 633 1 3 Amortisation of present value of acquired in-force business (note 27) 25 26 – –
Net operating expenses in the consolidated profit and loss account also include corporate expenditure of £83m (£67m) in the non-technical account.
16. INVESTMENT EXPENSES AND CHARGES Long-term business Non-technical technical account account £m £m £m £m
This Scheme has assets held in separate trustee administered funds and was last subject to a full triennial actuarial valuation as at 5 April 2002 by P N Thornton, a qualified actuary and a partner in the firm of Watson Wyatt Partners. The principal actuarial assumptions adopted were investment return 6.6% per annum, pensionable earnings growth 4.5% per annum, increases to pensions in payment 2.5% per annum and dividend growth 3.5% per annum.
The market value of Scheme assets as at that date was £4,034m and the actuarial value of the assets was sufficient to cover 110% of the benefits that had accrued to members, allowing for expected future increases in earnings. As a result of the actuarial valuation, the employers’ contribution rate has continued at the minimum rate prescribed under the Scheme rules, which is 12.5% of salaries.
(a) Profit and loss charge attributable to shareholders This comprises: £m £m £m
Operating charge (all current service cost) (66) (62) (65) Finance income (expense): Interest on pension scheme liabilities (243) (222) (212) Expected return on pension scheme assets 276 261 300
Total profit and loss account charge (33) (23) 23 less: amount attributable to PAC with-profits fund* 19 11 (24)
*Since shareholder profits in respect of the PAC with-profits fund are a function of the actuarially determined surplus for distribution, the overall profit and loss account result is not directly affected by the level of pension cost or other expenses.
(b) Actuarial losses attributable to shareholders This comprises losses charged to the statement of total recognised gains and losses, after adjusting for amounts attributable to the PAC with-profits fund: £m £m £m
Actual less expected return on pension scheme assets (3% (8%) ((26)%) of pension scheme assets) 115 311 (932) Experience losses on scheme liabilities (0% (0%) (1%) of the present value of scheme liabilities) (18) (3) (38) Changes in assumptions underlying the present value of scheme liabilities (142) (372) (219)
Total actuarial losses (1% (1%) (29%) of the present value of the scheme liabilities) (45) (64) (1,189) less: amounts attributable to the PAC with-profits fund 37 41 914
Pre-tax impact on the statement of total recognised gains and losses attributable to shareholders (8) (23) (275) Related deferred tax 2 7 82
The apportionment of the deficit between the estimated amounts attributable to the PAC with-profits fund and shareholders' operations reflects the activities of the retired and active members of the schemes.
SSAP 24 basis FRS 17 basis SSAP 24 basis FRS 17 basis
Pension scheme liability attributable to shareholders and PAC with-profits fund (net of related deferred tax) Nil* (553) Nil* (512)
Total audit services 5.6 4.9 Further assurance services associated with: Implementation of Sarbanes-Oxley requirements 1.8 0.2 Prospectuses for equity and debt issues 0.5 – Implementation of regulatory requirements 0.4 – Tax compliance 0.2 0.3 Comfort and attestation letters 0.2 0.2
Other services: Acquisitions and disposals due diligence 0.5 – Other services 0.5 1.2
(b) By category of tax expense (benefit) £m £m £m £m
Long-term business operations: UK and Europe 85 78 Jackson National Life 72 58 Asian Operations 38 14
Tax on profit on ordinary activities (including tax on actual investment returns) 232 144
(b) By fund Scottish Amicable Insurance Fund 125 87 PAC with-profits fund* 1,448 1,225 Jackson National Life (85) (172) Other long-term business operations 88 50 Other operations (54) (36)
(c) Reconciliation of movement in deferred tax Deferred tax liability at beginning of year 1,154 696 Exchange movements 20 28 Deferred tax charged to profit and loss account for the year 348 430
Balance at beginning of year 1,504 1,604 Charge to profit and loss account: Writedown in respect of Funds Direct included in Egg result (2) – Writedown in respect of Zebank included in Egg France closure cost (3) – Goodwill of Jackson Federal Bank taken into account on profit on sale of £41m (35) –
Current value: Leasehold with a term of over 50 years 4,497 4,153 Leasehold with a term of less than 50 years 220 188
Interests in joint ventures mainly reflect long-term insurance business operations with the Bank of China in Hong Kong and ICICI in India. Group operating profit included losses of £6m (losses of £5m) incurred by these operations. In August 2004, the Company sold its 15% interest in Life Assurance Holding Corporation Limited and realised a profit on sale of £7m before tax.
The market value of debt securities and other fixed income securities carried at amortised cost was £20,426m (£21,202m). All debt securities carried at amortised cost are held by long-term business operations.
Cost: Balance at beginning of year 450 460 Exchange movement (12) (17)
Balance at beginning of year 108 133 Exchange movement (5) (7) Amortisation: Pre-tax (25) (26)
Number of 2004 2004 Issued shares of 5 pence each fully paid shares £m £m
In October 2004, the Company announced a 1 for 6 Rights Issue at 308 pence per new share. The Rights Issue raised £1,044m and issue expenses were £23m.
The Company has established trusts to facilitate the delivery of shares under employee incentive plans and savings-related share option schemes. In 2004 the Company purchased 1.0m shares in respect of employee incentive plans at a cost of £4m. At 31 December 2004, 10.6m Prudential plc shares with a market value of £48m were held in such trusts. This was also the maximum number held at any time during the year. Of this total, 5.4m shares were held by trusts under employee incentive plans. The cost of acquiring Prudential plc shares held in these trusts of £42m (£38m) has been shown as a deduction from shareholders' funds.
In addition, 5.2m 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 at a weighted average exercise price of 277 pence.
The Prudential Assurance Company Limited Insurance England and Wales Prudential Annuities Limited* Insurance England and Wales Prudential Retirement Income Limited* Insurance Scotland M&G Investment Management Limited* Investment management England and Wales Egg Banking plc* Banking England and Wales Jackson National Life Insurance Company* Insurance US Prudential Assurance Company Singapore (Pte) Limited* Insurance Singapore PCA Life Assurance Company Limited* Insurance Taiwan *Owned by a subsidiary undertaking of the Company.
Capital Securities^† (note (ii)) 512 547 512 547 US$250m 6.75% Perpetual Subordinated
Jackson National Life: Currency translation net asset on swap transactions (13) (20) (13) (20)
Other borrowings of shareholders’ funds: Bank loans and overdrafts 17 16 17 16 Obligations under finance leases 2 3 2 3 Commercial paper 2005^ (note (iv)) 1,057 1,041 1,057 1,041 Medium Term Notes (note (iv)) 9 10 9 10 Currency translation net liability on swap transactions (note (iv)) 13 23 13 23 Non-recourse borrowings of investment subsidiaries managed by PPM America (note (v)) 128 153 55 61 183 214
^ Borrowings issued by the holding company. The interests of the holders of the Subordinated Notes and the Subordinated Capital Securities are subordinate to the entitlements of other creditors of the holding company. † Net of issue costs.
Reconciliation to cash flow statement disclosures (note 35): Recorded in the consolidated balance sheet on page 61 as: Subordinated liabilities 1,429 1,336 Debenture loans 1,761 1,781
(ii) Interest on the US$1,000m 6.5% borrowings has been swapped into floating rate payments at 3 month US$Libor plus 0.80%.
(iv) These borrowings support a short-term fixed income securities reinvestment programme.
(vi) The interests of the holders of the Notes issued by Egg plc as structured debt capital are subordinate to the entitlements of other creditors of that operation. At 31 December 2004, Egg had also issued unsubordinated debt securities totalling £1,807m (£1,423m) and sold securities under agreements to repurchase totalling £131m (£829m) as part of its trading activities.
(vii) The interests of the holders of the Bonds issued by Scottish Amicable Finance plc, a subsidiary of the Scottish Amicable Insurance Fund of The Prudential Assurance Company Limited, are subordinate to the entitlements of the policyholders of that fund.
The Group is involved in other litigation and regulatory issues arising in the ordinary course of business. Whilst the outcome of such matters cannot be predicted with certainty, the directors believe that the ultimate outcome of such litigation will not have a material adverse effect on the Group’s financial condition, results of operations or cash flows.
33. CONTINGENCIES AND RELATED OBLIGATIONS CONTINUED Pension Mis-selling Review continued The bonus and investment policy for each type of with-profits policy is the same irrespective of whether or not the assurance applies. Hence removal of the assurance for new business has had no impact on policyholder returns and this is expected to continue for the foreseeable future.
Free Standing Additional Voluntary Contribution Business Review In February 2000, the FSA ordered a review of Free Standing Additional Voluntary Contribution business, which constitutes sales of personal pensions to members of company pension schemes. Individuals who purchased these pensions instead of the Additional Voluntary Contributions (AVC) scheme connected to their company’s pension scheme may have been in a better financial position investing their money, and any matching contributions from their employers, in their company’s AVC scheme. The FSA’s review was to ensure that any employees disadvantaged due to not being properly informed of the benefits foregone from not investing in their AVC scheme were compensated.
The review required companies to identify relevant investors and to contact them with an offer to review their individual case. The Group met the deadline set by the FSA to issue offers to all cases by 31 December 2002. As a result of the review, the Group held a provision of £2m at 31 December 2004.
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) and transferred into the Scottish Amicable Insurance Fund (SAIF). Provisions of £7m in SAL and £47m in SAIF were held at 31 December 2004 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. In addition, Prudential Assurance’s main with-profits fund paid compensation of £16m in respect of mortgage endowment products mis-selling claims and held a provision of £61m at 31 December 2004 to cover further claims. This provision has no impact on the Group’s profit before tax.
33. CONTINGENCIES AND RELATED OBLIGATIONS CONTINUED Other Matters Prudential Assurance’s inherited estate The assets of the main with-profits fund within the long-term fund of Prudential Assurance comprise the amounts that the Company 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 with-profits fund 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 with-profits fund is called the ‘inherited estate’ and has accumulated over many years from various sources.
Support of long-term business funds by shareholders’ funds As a proprietary insurance company, the Group is liable to meet its obligations to policyholders even if the assets of the long-term funds are insufficient to do so. The assets, represented by the Fund for Future Appropriations, in excess of amounts expected to be paid for future terminal bonuses and related shareholder transfers (the excess assets) in the long-term funds could be materially depleted over time, by, for example, a significant or sustained equity market downturn, costs of significant fundamental strategic change, or a material increase in the pension mis-selling provision. In the unlikely circumstance that the depletion of the excess assets within the long-term fund was such that the Group’s ability to satisfy policyholders’ reasonable expectations was adversely affected, it might become necessary to restrict the annual distribution to shareholders or to contribute shareholders’ funds to the long-term funds to provide financial support.
Should the assets of SAIF be inadequate to meet the guaranteed benefit obligations to the policyholders of SAIF, the Prudential Assurance long-term fund would be liable to cover any such deficiency. At 31 December 2004, the excess of SAIF assets over guaranteed benefits was £1,836m. Due to the quality and diversity of the assets in SAIF, the excess of assets stated above and the ability of SAIF to revise guaranteed benefits in the event of an asset shortfall, the directors believe that the probability of either the Prudential Assurance long-term fund or the Group’s shareholders’ funds having to contribute to SAIF is remote.
Reconciliation of Operating Profit to Net Cash Inflow from Operations £m £m
Portfolio investments net of financing at end of year (2,084) (1,998)
Reconciliation of Cash Shareholders’ funds (as above) 431 410 Long-term business operations 984 811
Reconciliation of Borrowings Shareholders’ funds (as above) 4,399 4,185 Long-term business operations 274 260
The directors are responsible for keeping proper accounting records which disclose with reasonable accuracy at any time the financial position of the Company and the Group and to enable them to ensure that the financial statements comply with the Companies Act 1985. They have general responsibility for taking such steps as are reasonably available to safeguard the assets of the Group and to prevent and detect fraud and other irregularities.
We have audited the financial statements on pages 56 to 95. We have also audited the information on pages 47 to 52 in the directors’ remuneration report that is required to be audited.
We report to you our opinion as to whether the financial statements give a true and fair view and whether the financial statements and the part of the directors’ remuneration report to be audited have been properly prepared in accordance with the Companies Act 1985. We also report to you if, in our opinion, the directors’ report is not consistent with the financial statements, if the Company has not kept proper accounting records, if we have not received all the information and explanations we require for our audit, or if information specified by law regarding directors’ remuneration and transactions with the Group is not disclosed.
OPINION In our opinion: ■ the financial statements give a true and fair view of the state of affairs of the Company and the Group as at 31 December 2004 and of the profit of the Group for the year then ended; and
Shareholders’ investment return and other income 44 29 3 51 64 Interest payable on core structural borrowings (154) (143) (130) (118) (131)
Achieved profits basis capital and reserves 8,596 7,005 7,160 8,109 8,725
Statutory basis capital and reserves 1,470 1,296 1,305 1,187 1,227 Additional achieved profits basis retained profit 3,162 2,812 2,472 3,268 3,984
Achieved profits basis capital and reserves 4,632 4,108 3,777 4,455 5,211
US Operations Long-term business: New business: Gross investment product inflows 418 159 – – – Operating profit (including long-term investment returns): Broker-dealer and fund management (14) (3) 14 16 7
Statutory basis capital and reserves 2,362 2,329 2,449 2,498 2,333 Additional achieved profits basis retained profit 234 161 283 319 423
Achieved profits basis capital and reserves 2,596 2,490 2,732 2,817 2,756
Asian Operations Long-term business: New business: Operating profit before development expenses 126 85 82 44 39
Achieved profits basis capital and reserves 1,738 1,419 1,407 1,089 793
The information provided in this section of the Financial Review reflects the requirements of Annex 1 of the MoU.
In summary, the requirements address the following areas: ■ for large UK with-profits life assurance businesses falling within the scope of the Financial Services Authority’s realistic capital regime, memorandum disclosure of liabilities to policyholders determined in accordance with that basis, together with disclosure of the excess of realistic assets over realistic liabilities, is required; ■ an abridged statement of capital held within life assurance businesses with supporting disclosures; and
2. TECHNICAL PROVISIONS AND RESERVES Summary of Modified Statutory Basis Technical Provisions (Net of Reinsurance) and Reserves at 31 December 2004 £m
Technical provisions: Prudential Assurance Company (PAC) With-Profits Sub-Fund (WPSF)1 49,263 Prudential Annuities Limited2 13,623 Scottish Amicable Insurance Fund (SAIF)3 11,732
Total technical provisions of the PAC WPSF and SAIF4 74,618 Fund for Future Appropriations5: WPSF 14,465 SAIF3 1,836
Total technical provisions and reserves of the PAC WPSF and SAIF 90,919 Shareholder-backed business
2. Wholly-owned subsidiary of the PAC WPSF that writes annuity business.
4. Excluding technical provisions of the Hong Kong branch of PAC.
7. Including technical provisions of the Hong Kong branch of PAC.
These products are written primarily in: ■ one of three separate sub-funds of the PAC long-term fund, namely the With-Profits Sub-Fund, the Scottish Amicable Insurance Fund, and the non-profit sub-fund; ■ Prudential Annuities Limited, which is owned by the PAC With-Profits Sub-Fund; ■ Prudential Retirement Income Limited, a shareholder owned subsidiary; or
3(a) With-Profits Products and PAC With-Profits Sub-Fund Within the balance sheet of UK and Europe Insurance Operations there are technical provisions of £49.3bn and a Fund for Future Appropriations of £14.5bn that relate to the With-Profits SubFund (WPSF). 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% to its policyholders and 10% to shareholders as surplus for distribution is determined via the annual actuarial valuation.
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.
When determining policy payouts, including final bonuses, Prudential considers policyholders’ reasonable expectations, the need to smooth claim values and payments from year-to-year and competitive considerations, together with ‘asset shares’ for specimen policies. Asset shares broadly reflect the value of premiums paid plus the investment return on the assets notionally attributed to the policy, less the other items to be charged such as expenses and the cost of the life insurance cover.
However, it is defined within the regulatory framework which also now contains an explicit requirement to treat customers fairly.
The technical provisions reported under the modified statutory basis of accounting for the WPSF are primarily for two broad types of business. These are accumulating with-profits and conventional with-profits (and other protection type policies). 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 regulatory reporting reserves. Details of the process for setting assumptions and determination of liabilities, together with the particularly sensitive assumptions are set out in note 3 to the financial statements.
The WPSF held a provision of £49m at 31 December 2004 to honour guarantees on a small amount of guaranteed annuity products. SAIF’s exposure to guaranteed annuities is described below.
Beyond the generic guarantees described above there are very few explicit options or guarantees such as of minimum investment returns, surrender values or annuity at retirement and any granted have generally been at very low levels.
Valuation of the generic with-profits and other explicit guarantees of the WPSF and SAIF is required by the FSA’s new realistic capital regime, which applies from 31 December 2004, as also described below.
3(b) Annuity Business Prudential’s conventional annuities include level, fixed-increase and Retail Prices Index (RPI) annuities. They are mainly written within the subsidiaries Prudential Annuities Limited and Prudential Retirement Income Limited, but there are some annuity liabilities in the WPSF and SAIF.
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.
The long-term business provision for these companies is based on the FSA regulatory solvency basis. The valuation is then modified for MSB reporting purposes to remove certain of the margins for prudence within the assumptions and contingency reserves, both of which are required under the solvency basis applied for regulatory purposes, but not for financial accounting.
The fund is solely for the benefit of policyholders of SAIF. Shareholders have no interest in the profits of this fund although 102 PRUDENTIAL PLC ANNUAL REPORT 2004
3(d) Unit-Linked and Other Non-Profit Business Prudential UK and Europe Insurance Operations also have an extensive book of unit-linked policies of varying types and provides a range of other non-profit business such as stakeholder, credit life and non-life long-term contracts. These contracts do not contain significant financial guarantees.
3(e) Impact of FSA Realistic Capital Regime on the PAC With-Profits Fund The amounts shown in the consolidated balance sheet for technical provisions and Fund for Future Appropriations for with-profits business of the PAC with-profits fund i.e. the WPSF and SAIF have been determined in accordance with the modified statutory basis of accounting. With the exception of minor accounting adjustments, the technical provisions reflect the UK regulatory basis of reporting that has applied for many years, and which effectively constitutes the Peak 1 basis under the new FSA regime.
The FPRL must include a market consistent valuation of costs of guarantees, options and smoothing, less any related charges, and this amount must be determined using either a stochastic approach, hedging costs or a series of deterministic projections with attributed probabilities. Under the Peak 1 basis there is an allowance on a deterministic basis for the intrinsic value of these costs.
■ replacement of modified statutory basis liabilities for with-profits business with adjusted realistic basis liabilities.
■ the estimated shareholders’ share of future bonuses contained within that estimated regulatory basis liability; plus
4. US OPERATIONS 4(a) Products and Guarantees Jackson National Life (JNL) provides long-term savings and retirement products to retail and institutional customers throughout the US. JNL offers individual fixed annuities, equityindexed annuities, immediate annuities, variable annuities, life insurance and institutional products.
Fixed annuities Interest sensitive annuities In 2004, interest sensitive fixed annuities accounted for 41% of policyholder reserves of JNL. 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.
The policyholder of an interest sensitive fixed annuity pays JNL a premium, which is credited to the policyholder’s account. Periodically, interest is credited to the policyholder’s account and in some cases administrative charges are deducted from the policyholder’s account. JNL makes benefit payments at a future date as specified in the policy based on the value of the policyholder’s account at that date.
The policy provides that at JNL’s discretion it may reset the interest rate, subject to a guaranteed minimum. The minimum guarantee varies from 1.5% to 5.5% depending on the date of issue, with 73% of the fund at 3% or less at 31 December 2004. The average guarantee rate is 3.3%.
JNL hedges the equity return risk on equity indexed products by purchasing futures and options on the relevant index. The cost of these hedges is taken into account in setting index participation rates. JNL bears the investment and surrender risk on these products.
Immediate annuities At 31 December 2004, immediate annuities accounted for 2% of JNL’s policyholder reserves. Immediate annuities guarantee a series of payments beginning within a year of purchase and continuing over either a fixed period of years and/or the life of the policyholder. If the term is for the life of the policyholder, then JNL’s primary risk is mortality risk. The implicit interest rate on these products is based on the market conditions that exist at the time the policy is issued and is guaranteed for the term of the annuity.
JNL issues variable annuity 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 contract anniversary. These guarantees include benefits that are payable in the event of death (guaranteed minimum death benefit (GMDB)), annuitisation (guaranteed minimum income benefit (GMIB)), or at specified dates during the accumulation period (guaranteed minimum withdrawal benefit (GMWB)).
Institutional products JNL’s institutional products consist of guaranteed investment contracts (GICs), funding agreements, and medium term note funding agreements. At 31 December 2004 institutional products accounted for 15% of JNL’s policyholder reserves.
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. JNL agree 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 2% of JNL total policyholder reserves.
Medium term note funding agreements are generally issued to support trust instruments issued on non-US exchanges or to qualified investors (as defined by SEC rule 144A). Through the funding agreements, JNL agrees to pay a rate of interest, which may be fixed or floating, to the holders of the trust instruments.
Profit recognition is determined by amortisation of capitalised acquisition costs over the life of the book of contracts at a constant rate based on estimated gross profit amounts expected to be realised over this period. In determining these estimated gross profits assumptions are made as to lapse and mortality rates, expenses, investment returns and policy crediting rates.
Variable annuity contracts written by JNL may, as described above, provide for GMDB, GMIB and GMWB. In general terms liabilities for these benefits are accounted for under US GAAP by using estimates of future benefits and fees under best estimate persistency assumptions.
Singapore 2,967 Hong Kong 1,717 Taiwan 1,451 Japan 666 Malaysia 507 Other countries 548
This amount covers a range of with-profits, unit-linked and nonparticipating contracts.
5(b) Products The life insurance products offered by Prudential Corporation Asia include a range of with-profits and non-participating term, whole life, endowment and unit-linked policies. Prudential Corporation Asia also offers health, disability, critical illness and accident coverage to supplement its core life products.
The terms and conditions of the contracts written in Prudential Corporation Asia’s operations, and in particular the product’s options and guarantees, vary from territory to territory depending upon local market circumstances.
Product guarantees in Asia can be broadly classified into four main categories, namely: Premium Rate; Cash Value and Interest Guarantees; Policy Renewability; and Convertibility Options.
Under these contracts the cost of premiums are also fixed at inception based on a number of assumptions at that time, including long-term interest rates, mortality assumptions and expenses. The guaranteed maturity and surrender values reflect the pricing basis.
As explained below the method for determining liabilities for UK GAAP purposes for some Asian operations is based on US GAAP principles and this method applies to these contracts with cash value and interest rate guarantees. Following standard US GAAP procedure, premium deficiency reserve calculations are performed each year to establish whether the carrying values of the liabilities are insufficient.
The main variable that determines the amounts payable under the contracts is the duration of the contracts, which is determined by death or surrender.
5(d) Process for Setting Assumption and Determining MSB Liabilities The future policyholder benefit provisions for Asian businesses in the Group’s modified statutory basis accounts are determined in accordance with methods prescribed by local GAAP adjusted to comply, where necessary, with UK GAAP.
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. Of the more significant Asian operations this basis is applied in Taiwan, Japan and Vietnam. The future policyholder benefit provisions for non-linked business are determined under FAS 60 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. Additional details are shown in note 3 to the financial statements.
Available capital of the WPSF and SAIF of £6.0bn represents the excess of assets over liabilities on the regulatory realistic basis. Unlike the previously discussed FRS 27 basis, realistic liabilities on the regulatory basis include the shareholders’ share of future bonuses.
The regulatory basis version of realistic available capital of £6.0bn is shown before deduction of the risk capital margin (RCM) which is estimated to be £1.8bn at 31 December 2004.
PRUDENTIAL PLC ANNUAL REPORT 2004 107 6. CAPITAL POSITION STATEMENT 6(a) Reconciliation of Group Modified Statutory Basis Shareholders' Funds at 31 December 2004 to Available Capital on Local Regulatory Bases in the Group’s Life Assurance Businesses £bn
Total available capital on local regulatory bases to meet local regulatory requirements 8.9 *In determining available capital for the PAC WPSF, realistic liabilities reflect the regulatory Peak 2 basis inclusive of shareholders’ share of future bonuses. In addition to the WPSF and SAIF, the PAC long-term fund includes the PAC Non-Participating Sub-Fund (NPSF). The available capital of the NPSF is subsumed within the Peak 1 basis available capital of the aggregate PAC long-term fund.
For non-participating business, gross premium reserves are held. For linked business the value of units is held together with a nonunit reserve calculated in accordance with standard actuarial methodology.
The capital requirement is determined as 4% of reserves plus a specified percentage of sums at risk. There is an overriding minimum capital requirement of RM100m.
Group capital requirements In addition to the requirements at individual company level, FSA requirements under the Insurance Groups Directive for 2004 and Financial Groups Directive apply additional prudential requirements for the Group as a whole, as discussed on page 20.
Accordingly, the excess of assets over liabilities of the PAC long-term fund is retained within that company. The retention of the capital enables the company to support with-profits and other business of the fund by, for example, providing the benefits associated with smoothing and guarantees. It also provides investment flexibility for the fund’s assets, by meeting the regulatory capital requirements that demonstrate solvency, and by absorbing the costs of significant events or fundamental changes in its long-term business without affecting the bonus and investment policies.
For Asian subsidiaries, the amounts retained within the companies are at levels which provide an appropriate level of capital strength in excess of the local regulatory minimum. For ring-fenced withprofits funds, the excess of assets over liabilities is retained with distribution tied to the shareholders’ share of bonuses through declaration of actuarially determined surplus. The Group’s Singapore and Malaysian businesses may remit dividends to the Group, in general, provided the statutory insurance fund meets the capital adequacy standard required under local statutory regulations.
Stochastic modelling of assets and liabilities is undertaken in the UK, the US 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, the US and Asian regulators.
For businesses that are most sensitive to equity price changes, Prudential uses stochastic modelling and scenario testing to look at the future returns on its investments under different scenarios and 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 methodology extensively in connection with its UK with-profits business.
6(e) Intra-Group Arrangements in Respect of SAIF Should the assets of SAIF be inadequate to meet the guaranteed benefit obligations to the policyholders of SAIF, the PAC long-term fund would be liable to cover any such deficiency. At 31 December 2004, the excess of SAIF assets over guaranteed benefits, accounted for as the SAIF FFA on the modified statutory basis, was £1.8bn. Due to the quality and diversity of the assets in SAIF, the excess of assets stated above, and the ability of SAIF to revise guaranteed benefits in the event of an asset shortfall, the directors believe that the probability of either the PAC long-term fund, or the Group’s shareholders’ funds under its obligation to maintenance of the capital position of long-term funds generally, having to contribute to SAIF is remote.
For some non unit-linked investment products, in particular those written in some of the Group’s Asian operations, it may not be possible to hold assets which will provide cash flows to exactly match those relating to policyholder liabilities. This is particularly true in those countries where bond markets are not developed and in certain markets such as Taiwan, Korea and Japan where regulated surrender values are set with reference to the interest rate environment prevailing at the time of policy issue. This is due to the duration and uncertainty of the liability cash flows and the lack of sufficient assets of a suitable duration. This results in a residual asset/liability mismatch risk which can be managed but not eliminated.
Prudential is subject to the risk of exchange rate fluctuations owing to the geographical diversity of its businesses. Due to the geographical diversity of Prudential’s businesses, it is subject to the risk of exchange rate fluctuations. Prudential’s international operations in the US, Asia and Europe, which represent a significant proportion of operating profit and shareholders’ funds, generally write policies and invest in assets denominated in local currency. Although this practice limits the effect of exchange rate fluctuations on local operating results, it can lead to significant fluctuations in Prudential’s consolidated financial statements upon translation of results into pounds sterling. The currency exposure relating to the translation of reported earnings is not separately managed. Consequently, this could impact on the Group’s gearing ratios (defined as debt over debt plus shareholder funds). The impact of gains or losses on currency translations is recorded as a component of shareholders’ funds within the consolidated statement of total recognised gains and losses.
Similar changes in regulation in other jurisdictions could also have an impact elsewhere in the Group.
The EU Insurance Groups Directive, which was implemented in the UK in 2001, together with the Financial Group’s Directive (FGD), which became effective from 1 January 2005, require European financial services groups to demonstrate net aggregate surplus capital in excess of solvency requirements at the Group level in respect of shareholder-owned entities. The EU is also currently reviewing future solvency requirements (the Solvency II review). The implementation of these directives leads to Prudential being required to maintain a somewhat higher amount of capital at the Group level than necessary in respect of some of its businesses. The FGD parent company solvency requirements have to be complied with continuously starting 1 January 2005, with the result that Prudential needs to maintain an appropriate amount of capital at the parent company level to accommodate, for example, short-term movements in global foreign exchange rates, interest rates, deterioration in the credit quality of the Group’s bond portfolios and equity markets. In addition, changes in the local regulatory regimes of designated territories could affect the calculation of the Group’s solvency position.
In the US, federal and state regulators have focused on, and continue to devote substantial attention to, the mutual fund, variable annuity and insurance product industries including the broker-dealer system. As a result of publicity relating to widespread perceptions of industry abuses, there have been numerous regulatory inquiries and proposals for legislative and regulatory reforms.
Although Prudential believes it has adequately reserved in all material aspects for the costs of litigation and regulatory matters, no assurance can be provided that such reserves are sufficient. It is possible that Prudential’s future performance could be affected by an unfavourable outcome in these matters.
Prudential’s businesses are conducted in highly competitive environments and Prudential’s continued profitability depends on its management’s ability to respond to these pressures. The markets for the UK, the US and Asian financial services are highly competitive, with several factors affecting Prudential’s ability to sell its products, including price and yields offered, financial strength and ratings, range of product lines and product quality, brand strength and name recognition, investment management performance and historical bonus levels. In some of its markets Prudential faces competitors that are larger, have greater financial resources or a greater market share, offer a broader range of products or have higher bonus rates or claims-paying ratios.
Within the UK, Prudential’s principal competitors in the life market include many of the major stock and mutual retail financial services companies including, in particular, Aviva, Legal & General, HBOS and Standard Life.
Jackson National Life’s competitors in the US include major stock and mutual insurance companies, mutual fund organisations, banks and other financial services companies. Jackson National Life’s principal life insurance company competitors in the US include AIG, Allstate Financial, Allianz Life of North America, AXA Financial Inc, Hartford Life Inc., ING, John Hancock, Lincoln National Corporation and Met Life.
Within Asia, the Group’s main regional competitors are international financial companies, including AIG, Allianz, ING and Manulife.
are affected by its debt credit ratings, which are in place to measure Prudential’s ability to meet its contractual obligations.
Prudential’s long-term senior debt is rated as A2 (stable outlook) by Moody’s and AA– (negative outlook) by Standard & Poor’s.
Adverse experience in the operational risks inherent in Prudential’s business could have a negative impact on its results of operations. Operational risks are present in all of Prudential’s business, including the risk of direct or indirect loss resulting from inadequate or failed internal and external processes, systems and human error or from external events. Prudential’s business is dependent on processing a large number of complex transactions across numerous and diverse products, and is subject to a number of different legal and regulatory regimes. In addition, Prudential outsources several operations, including certain UK processing and IT functions. In turn, Prudential is reliant upon the operational processing performance of its outsourcing partners.
Further, because of the long-term nature of much of Prudential’s business, accurate records have to be maintained for significant periods. Prudential’s systems and processes are designed to ensure that the operational risks associated with its activities are appropriately controlled, but any weakness in the systems could have a negative impact on its results of operations during the effective period. Prudential has not experienced or identified any operational risks in its systems or processes during 2004 or subsequently which have caused, or are expected to cause, a significant negative impact on its results of operations.
For example, the assumption that Prudential makes about future expected levels of mortality is particularly relevant for its UK annuity business. In exchange for a premium equal to the capital value of their accumulated pension fund, pension annuity policyholders receive a guaranteed payment, usually monthly, for as long as they are alive. As part of its pension annuity pricing and reserving policy, Prudential assumes that current rates of mortality continuously improve over time. Annuity mortality assumptions were revised in 2003 to assume future improvements in mortality for males and females at levels projected on the Continuous Mortality Investigations (CMI) medium cohort table as published by the Institute and Faculty of Actuaries. If mortality improvement rates significantly exceed the improvement assumed, Prudential’s results of operations could be adversely affected.
As a holding company, Prudential is dependent upon its subsidiaries to cover operating expenses and dividend payments. Prudential’s insurance and investment management operations are generally conducted through direct and indirect subsidiaries. As a holding company, Prudential’s principal sources of funds are dividends from subsidiaries, shareholder backed funds, the shareholder transfer from Prudential’s long-term funds and any amounts that may be raised through the issuance of debt and commercial paper.
Certain of the subsidiaries have regulatory restrictions that can limit the payment of dividends, which in some circumstances could limit the Group’s ability to pay dividends to shareholders.
Prudential operates in a number of markets through joint ventures and other arrangements with third parties. These arrangements involve certain risks that Prudential does not face with respect to its consolidated subsidiaries. Prudential operates, and in certain markets is required by local regulation to operate, through joint ventures. Prudential’s ability to exercise management control over its joint venture operations and its investment in them depends on the terms of the joint venture agreements, in particular, the allocation of control among, and continued co-operation between, the joint venture participants. Prudential may also face financial or other exposure in the event that any of its joint venture partners fails to meet its obligations under the joint venture or encounters financial difficulty. In addition, a significant proportion of the Group’s product distribution is carried out through arrangements with third parties not controlled by Prudential and is dependent upon continuation of these relationships. A temporary or permanent disruption to these distribution arrangements could affect Prudential’s results of operations.
Other Income and Expenditure Investment return and other income 44 29 Interest payable on core structural borrowings (154) (143) Corporate expenditure: Group Head Office (54) (43) Asia Regional Head Office (29) (24)
Profit on ordinary activities before tax (including actual investment returns) 1,521 838
Profit for the financial year before minority interests 1,036 483 Minority interests 10 2
Retained profit for the financial year 684 165 † Operating profit and operating earnings per share include investment returns at the expected long-term rate of return but exclude amortisation of goodwill and exceptional items. The directors believe that operating profit, as adjusted for these items, better reflects underlying performance. Profit on ordinary activities and basic earnings per share include these items together with actual investment returns. This basis of presentation has been adopted consistently throughout this achieved profits basis supplementary information.
YEAR ENDED 31 DECEMBER 2004 114 PRUDENTIAL PLC ANNUAL REPORT 2004
Based on operating profit after tax and related minority interests before amortisation of goodwill of £791m (£527m) 5 37.2p 25.4p
Consideration paid for own shares* (4) (3) Movement in cost of own shares* – 1
Net increase (decrease) in shareholders’ capital and reserves* 14 1,591 (155)
Shareholders’ capital and reserves, at beginning of year: As originally reported 7,043 7,196 Prior year adjustment on implementation of UITF 38 (38) (36)
Shareholders’ capital and reserves at end of year 14 8,596 7,005 *The 2003 figures for these lines have been restated as a result of the implementation of UITF Abstract 38 ‘Accounting for ESOP Trusts’.
RECONCILIATION OF MOVEMENT IN SHAREHOLDERS’ CAPITAL AND RESERVES – ACHIEVED PROFITS BASIS
Share capital 119 100 Share premium 1,558 553 Statutory basis retained profit* 2,604 2,587 Additional achieved profits basis retained profit 4,315 3,765
Shareholders’ capital and reserves* 13 8,596 7,005 *The 2003 figures for these lines have been restated as a result of the implementation of UITF Abstract 38 ‘Accounting for ESOP Trusts’.
1. BASIS OF PREPARATION OF RESULTS The achieved profits basis results include the results of the Group’s long-term business operations on the achieved profits basis. These results are combined with the statutory basis results of the Group’s other operations including banking and fund management business. The achieved profits basis results for long-term business for 2004 and 2003 have been prepared in accordance with the guidance issued by the Association of British Insurers (ABI) in December 2001 ‘Supplementary Reporting for Long-Term Insurance Business (the Achieved Profits Method)’. The information is supplementary to the financial statements on pages 56 to 95.
3. ECONOMIC ASSUMPTIONS Under the ABI guidance, for most countries, long-term expected rates of return on investments and risk discount rates are set by reference to period end rates of return on fixed interest securities. This ‘active’ basis of assumption setting has been applied in preparing the results of all the Group’s UK, US and European long-term business operations. For the Group’s Asian operations, the active basis is appropriate for business written in Japan, Korea and US dollar denominated business written in Hong Kong.
(applying the rates listed above to the investments held by the fund) 6.5% 6.8% Expected long-term rate of inflation 2.9% 3.1%
Risk margin included within the risk discount rate 2.6% 2.6% Risk discount rate(i) 7.2% 7.4%