b Level of encumbered capital In adopting the EEV Principles, Prudential has based encumbered capital on its internal targets for economic capital subject to it being at least the local statutory minimum requirements. Economic capital is assessed using internal models but, when applying the EEV Principles, Prudential does not take credit for the significant diversification benefits that exist within the Group. For withprofits business written in a segregated life fund, as is the case in Asia and the UK, the capital available in the fund is sufficient to meet the encumbered capital requirements. For shareholder-backed business the following capital requirements apply: • Asian operations: the economic capital requirement is substantially higher than local statutory requirements in total. Economic capital requirements vary by territory, but in aggregate, the encumbered capital is broadly equivalent to the amount required under the Insurance Groups Directive (IGD); • US operations: the level of encumbered capital has been set to an amount at least equal to 235 per cent of the risk-based capital required by the National Association of Insurance Commissioners (NAIC) at the Company Action Level (CAL), which is sufficient to meet the economic capital requirement; and
• UK insurance operations: the economic capital requirements for annuity business are fully met by Pillar I requirements being four per cent of mathematical reserves, which are also sufficient to meet Pillar II requirements. For unit-linked and other shareholder-backed business the encumbered capital held reflects the statutory minimum Pillar I requirement, as required by the UK regulatory authorities.
As Prudential’s UK shareholder-backed annuity business is predominantly backed by fixed interest securities, the beta methodology described above is not appropriate. We have therefore used a market consistent embedded value (MCEV) approach to derive an implied risk discount rate which is then applied to the projected cash flows.
In the annuity MCEV calculations, the future cash flows were discounted using the gilt yield curve plus 252 basis points (2007: 84 basis points) for fixed annuities and 120 basis points (2007: 24 basis points) for inflation-linked annuities. The 252 basis points and 120 basis points for 2008 were based on our assessment of the liquidity premium available in the yield on the assets backing the annuity liabilities.
Allowance for risk The risk allowance in the risk discount rate is determined as follows: Market risk Under the Capital Asset Pricing Methodology (CAPM) the discount rate is determined as: Discount rate = risk-free rate + (beta x equity risk premium) Under CAPM, the beta of a portfolio or product measures its relative market risk.
The risk discount rates reflect the market risk inherent in each product group and hence the volatility of product cash flows. They are determined by considering how the profits from each product are affected by changes in expected returns on various asset classes. By converting this into a relative rate of return it is possible to derive a product specific beta. Product level betas are calculated each year. They are combined with the most recent product mix to produce appropriate betas and risk discount rates for each major product grouping.
d Management actions In deriving the time value of financial options and guarantees, management actions in response to emerging investment and fund solvency conditions have been modelled. Management actions encompass, but are not confined to, the following areas: • investment allocation decisions; • levels of reversionary bonuses and credited rates; and • total claim values.
For PSPS the surplus or deficit at the reporting date is allocated between the PAC with-profits fund and shareholder-backed operations by reference to the activities of the members of the scheme during their period of service. At 31 December 2005, the deficit of PSPS was apportioned in the ratio 70/30 between the with-profits fund and shareholder-backed operations following detailed consideration of the sourcing of previous contributions. This ratio was applied to the base deficit position at 1 January 2006 for the purposes of determining the allocation of the movement in that position up to 31 December 2008.
b Principal economic assumptions Deterministic assumptions In most countries, the long-term expected rates of return on investments and risk discount rates are set by reference to period end rates of return on cash or fixed interest securities. 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. Except in respect of the projected returns of holdings of Asian debt and equity securities for those countries where long-term fixed interest markets are less established, the ‘active’ basis of assumption setting has been applied in preparing the results of all the Group’s US and UK long-term business operations.
For countries where long-term fixed interest markets are less established, investment return assumptions and risk discount rates are based on an assessment of longer-term economic conditions. Except for the countries listed above, this basis is appropriate for the Group’s Asian operations. Similarly, the projected returns on holdings of Asian securities in these territories by other Group businesses are set on the same basis.
Risk discount rate: Expected long-term rate of inflation 4.0 2.25 5.0 6.0 0.7 2.75 4.0 2.25 5.0 6.0 0.0 2.75
Risk discount rate: Expected long-term rate of inflation 2.75 5.0 1.75 2.25 3.0 6.0 2.75 5.0 1.75 2.25 3.0 6.0
Notes i The weighted risk discount rates for Asian operations shown above have been determined by weighting each country’s risk discount rates by reference to the EEV basis operating result for new business and the closing value of in-force business. ii For traditional business in Taiwan, the economic scenarios used to calculate the 2008 and 2007 EEV basis results reflect the assumption of a phased progression of the bond yields from the current rates applying to the assets held to the long-term expected rates. For 2008 the projections assume that in the average scenario, the current bond yields at 31 December 2008 of 1.4 per cent trend towards 5.5 per cent at 31 December 2018. This compares to the 2007 results for which the projections assume that in the average scenario, the current bond yields at 31 December 2007 of around 2.5 per cent trend towards 5.5 per cent at 31 December 2013.
Further details are given in note 21. iii The assumptions shown are for US dollar denominated business which comprises the largest proportion of the in-force Hong Kong business. iv The mean equity return assumptions for the most significant equity holdings in the Asian operations were: Hong Kong 6.2 8.1
v For 2008 and 2007, cash rates rather than government bond yields were used in setting the risk discount rates for Malaysia, Singapore, Taiwan and for Hong Kong dollar denominated business.
US 10-year treasury bond rate at end of period 2.3 4.1 Pre-tax expected long-term nominal rate of return for US equities 6.3 8.1 Expected long-term rate of inflation 1.5 2.4
ii Credit risk treatment The projected cash flows incorporate the expected long-term spread between the earned rate and the rate credited to policyholders. The projected earned rates reflect book value yields which are adjusted over time to reflect projected reinvestment rates. The expected spread incorporates a Risk Margin Reserve (RMR) allowance of 25 basis points for longer-term defaults as described in note 4b.
The results for Jackson reflect the application of the low discount rates shown above. In the event that US 10-year treasury rates increase, the altered embedded value results would reflect a lower contribution from fixed annuity business and a partially offsetting increase for variable annuity business as the projected earned rate, as well as the discount rate, would increase for this type of business.
The book value yields, net of RMR allowance, are in excess of the risk discount rate. To correct for the anomalous effect that would otherwise occur no credit has been taken for the cost of capital benefit that this feature would give rise to for fixed annuity business.
Fixed annuities 6.4 to 6.7 5.4 to 5.6 Inflation-linked annuities 5.7 to 5.8 5.0 to 5.2
Pre-tax expected long-term nominal rates of investment return: UK equities 7.7 8.55 Overseas equities 6.3 to10.25 8.1 to 10.2
– other business 5.2 6.25 Expected long-term rate of inflation 3.0 3.2
Post-tax expected long-term nominal rate of return for the PAC with-profits fund: Pension business (where no tax applies) 6.6 7.85 Life business 5.8 6.9
ii The risk discount rates for new business and business in force for UK insurance operations other than shareholder-backed annuities reflect weighted rates based on the type of business.
iii The pre-tax rates of return for shareholder-backed annuity business are based on the gross redemption yield on the backing assets net of a best estimate allowance for future defaults.
iv Credit spread treatment For with-profits business, the embedded value reflects the discounted value of future shareholder transfers. These transfers are directly affected by the level of projected rates of return on investments, including debt securities. Given the current exceptional fixed interest market conditions, and the Company’s expectation that the widening of credit spreads observed in 2008 will not be maintained, the Company considers that it is most appropriate to assume an unchanged level of credit spreads, an unchanged level of longer-term default allowance and an unchanged risk discount rate methodology relative to those used at 31 December 2007.
For UK annuity business, different dynamics apply both in terms of the nature of the business and the EEV methodology applied. For this type of business the assets are generally held to maturity to match long duration liabilities. It is therefore appropriate under EEV methodology to include a liquidity premium in the economic basis used. The appropriate EEV risk discount rate is set in order to equate the EEV with a ‘market consistent embedded value’ including liquidity premium. The liquidity premium is derived from the yield on the assets held after deducting an appropriate allowance for credit risk. For Prudential Retirement Income Limited (PRIL), which has approximately 90 per cent of UK shareholder-backed annuity business, the allowance for credit risk at 31 December 2008 is made up of: a 16 bps for fixed annuities and 13 bps for inflation-linked annuities in respect of long-term expected defaults; this is derived by applying Moody’s data from 1970 onwards uplifted by between 100 per cent (B) and 200 per cent (AAA) according to credit rating, to the asset portfolios. b 11 bps for fixed annuities and 9 bps for inflation-linked annuities in respect of long-term credit risk premium for the potential volatility in default levels; this is derived by applying the 95th worst percentile from Moody’s data from 1970 onwards, to the asset portfolios.
c 56 bps for fixed annuities and 48 bps for inflation-linked annuities in respect of additional short-term credit risk, reflecting the extreme market conditions at 31 December 2008; this is derived as 25 per cent of the increase in credit spreads over swaps that has occurred since 31 December 2006 based on a set of externally published indices weighted to reflect the asset mix.
The Pillar I allowance of 80 bps per annum is financially equivalent to 185 bps for the years 2009 to 2011 and 45 bps thereafter for the life of the book. The overall allowance for credit risk is prudent by comparison with historic rates of default and would be sufficient to withstand a wide range of extreme credit events over the expected lifetime of the annuity business.
The risk discount rate for new business profits reflects the assets allocated to back new business and an allowance for credit risk based on point of sale market conditions, consistent with how the business was priced. The allowance for credit risk at the point of sale is determined using the same methodology for in-force business. In both cases, the allowance for credit risk included in setting the discount rate reflects the three constituent elements of long-term expected defaults, long-term credit risk premiums, and additional short-term credit risk.
Asian operations The same asset return models as used in the UK, appropriately calibrated, have been used for the Asian operations as described for UK insurance operations below. The principal asset classes are government and corporate bonds. Equity holdings are much lower than in the UK whilst property holdings do not represent a significant investment asset.
The mean stochastic returns are consistent with the mean deterministic returns for each country. The expected volatility of equity returns for 2008 ranges from 18 per cent to 30 per cent (2007: 18 per cent to 25 per cent), and the volatility of government bond yields ranges from 1.4 per cent to 2.4 per cent (2007: 1.3 per cent to 2.5 per cent).
UK insurance operations • Interest rates are projected using a two-factor model calibrated to actual market data; • The risk premium on equity assets is assumed to follow a log-normal distribution; • The corporate bond return is calculated as the return on a zero-coupon bond plus a spread. The spread process is a mean reverting stochastic process; and • Property returns are modelled in a similar fashion to corporate bonds, namely as the return on a riskless bond, plus a risk premium, plus a process representative of the change in residual values and the change in value of the call option on rents.
d Expense assumptions Expense levels, including those of service companies that support the Group’s long-term business operations, are based on internal expense analysis investigations and are appropriately allocated to acquisition of new business and renewal of in-force business. Exceptional expenses are identified and reported separately.
Corporate expenditure for Group Head Office, to the extent not allocated to the PAC with-profits fund, Asia development and Regional Head Office expenses are charged to EEV basis results as incurred. No adjustment is made to the embedded value of covered business.
e Inter-company arrangements The EEV results for covered business incorporate the effect of the reinsurance arrangement of non-profit immediate pension annuity liabilities of SAIF to PRIL. In addition, the analysis of free surplus and value of in-force business takes account of the impact of contingent loan arrangements between Group companies.
b Operating profit Investment returns, including investment gains, in respect of long-term insurance business are recognised in operating results at the expected long-term rate of return. For the purpose of calculating the longer-term investment return to be included in the operating results of UK operations, where equity holdings are a significant proportion of investment portfolios, values of assets at the beginning of the reporting period are adjusted to remove the effects of short-term market volatility.
For UK annuity business, rebalancing of the asset portfolio backing the liabilities to policyholders may from time to time take place to align it more closely with the internal benchmark of credit quality that management applies. Such rebalancing will result in a change in the risk adjusted yield on the assets used to determine the valuation interest rate for calculating the carrying value of policyholder liabilities. Operating profit includes the effect of rebalancing the portfolio calibrated to investment conditions at 31 December 2006 i.e. prior to the exceptional spread widening in 2007 and 2008. Non-operating profit incorporates the effect of rebalancing calibrated by reference to changes to credit spreads since 31 December 2006.
d Effect of changes in economic assumptions and time value of cost of options and guarantees Movements in the value of in-force business caused by changes in economic assumptions and the time value of cost of options and guarantees resulting from changes in economic factors are recorded in non-operating results.
e Results for asset management operations The results of the Group’s asset management operations include the profits from management of internal and external funds. For EEV basis reporting, Group shareholders’ other income is adjusted to deduct the expected margin for the year on management of covered business. The deduction is on a basis consistent with that used for projecting the results for covered business. Group operating profit accordingly includes the variance between actual and expected profit in respect of covered business.
f Capital held centrally for Asian operations Previously, for the purpose of presentation of the Group’s operating results, the return on capital held centrally to back the economic capital requirements for the Taiwan life business has been allocated to the operating result for Asian operations with a consequent reduction in Group shareholders’ other income for EEV basis reporting. In the 2008 results this approach has no longer been applied. The presentation of the 2007 comparative results has been adjusted accordingly, as explained in note 6(ii)(b).
The exchange movements in 2008 and 2007 recorded within the movements in shareholders’ equity (and for 2008, in note 16) for long-term business and other operations comprise amounts in respect of: Long-term business operations: Asian operations 1,170 80 US operations 1,264 (53)
Other operations (primarily reflecting US$ denominated holding company borrowings and hedge positions) (424) 37
5 Premiums, operating profit and margins from new business Annual premium and Present value of new a Premiums and contributionsnote i contribution equivalents business premiums Single Regular (APE) (PVNBP)
Total mature life and pensions 512 531 137 140 188 193 1,025 1,023
Notes i The tables shown above are provided as an indicative volume measure of transactions undertaken in the reporting period that have the potential to generate profits for shareholders. The amounts shown are not, and not intended to be, reflective of premium income recorded in the IFRS income statement.
Annual Present value premium and of new contribution business Pre-tax newNew business premiums equivalent premiums business
Notes i The results for Asian operations include those of the Taiwanese life operations for which the Company agreed to transfer its agency business to
iii To align with the treatment in the 2008 results, the tables for UK insurance operations above for 2007 reflect the inclusion of the Group’s UK health insurance joint venture operation, PruHealth, with an APE of £13 million and PVNBP of £107 million.
In general, as described in note 2a, the use of point of sale or end of period economic assumptions is not significant in determining the new business contribution for different types of business and across financial reporting periods. However, to obtain proper measurement of the new business contribution for business which is interest rate sensitive, it is appropriate to use point of sale economic assumptions, consistent with how the business was priced. In practice, the only area within the Group where this has a material effect, particularly in light of the dislocation of markets in 2008, is for UK shareholder-backed annuity and lifetime mortgage business. The 2008 results for shareholder-backed annuity and lifetime mortgage business have been prepared on the basis of point of sale rather than end of period economic assumptions which previously applied for EEV reporting. New business profits would have been £111 million lower if end of year economic assumptions had been applied. The reduction is reflected in non-operating profit. The £111 million primarily reflects the level of credit spread widening since the point of sale. For 2007, the effect of the use of point of sale market conditions would not have been material.
Unwind of discount and other expected returnsnote i 434 340 Changes in operating assumptionsnote ii a 135 54 Experience variances and other itemsnote ii b (1) 5
Spread experience variancenote iiia 54 99 Amortisation of interest-related realised gains and losses 28 37 Changes in operating assumptionsnote iii b (17) (24)
Unwind of discount and other expected returnsnote i 569 592 Effect of change in UK corporate tax ratenote iv a – 67 Annuity business:note iv b
The effect of changes in operating assumptions represent the following: £m £m
2 The favourable overall net effect of £26 million for expense assumption changes in 2008 mainly relates to a reduction in investment management expenses. The credit of £51 million for 2007 mainly relates to Singapore (£37 million) and Korea (£21 million) both due to increases in investment margins.
4 The effect of change in corporate tax rates represents the effect of incorporating the benefit arising from the reduction in the corporate tax rate in Indonesia for 2008 and in China, Malaysia and Singapore for 2007.
The spread assumption for Jackson is determined on a longer-term basis net of a provision for defaults, with impairment losses in excess of the provision for defaults taken through short-term fluctuations in investment returns.
b Changes in operating assumptions The effect of changes in operating assumptions for US operations is as follows: £m
Interest Maintenance Reserve (IMR)note 3 (10) Variable Annuity Statutory Reservesnote 4 (68) Required Capitalnote 5 17 Surplus note borrowingsnote 6 –
3 The IMR is a statutory liability in respect of realised gains on the sale of bonds which, on a regulatory basis, are amortised to income over time in line with the duration of the bonds sold. The 2008 results reflect this reserve as an explicit liability, consistent with the regulatory basis which, after the effects of discounting results in a charge to embedded value of £(10) million.
4 The statutory reserves are primarily in respect of guarantees on variable annuity products in excess of the surrender value. The impact of including these amounts as explicit liabilities, consistent with the regulatory basis, after the effects of discounting, results in a charge to embedded value of £(68) million.
5 The adjustment in respect of required capital represents a current year refinement to reduce the required capital to align the amount with the required level which has been set as an amount at least equal to 235 per cent of the risk-based capital required by National Association of Insurance Commissioners at the Company Action Level, which is sufficient to meet the economic capital requirement. The decrease results in an associated benefit from a reduction in the cost of capital of £17 million.
7 The adjustments in respect of the IMR, variable annuity reserves, surplus note borrowings and required capital detailed in 3 to 6 above also resulted in a post-tax net reallocation from free surplus and required capital of £(110) million and £(137) million respectively to the value of in-force of £207 million, as detailed in note 17a.
The comparative results for 2007 of £67 million reflect the effects of the change to reduce the UK corporate tax rate from 30 per cent to 28 per cent in projecting the tax cash flows attaching to in-force business.
The charge of £(81) million for 2007 includes £(13) million in respect of annual licence fee payments, £(36) million of costs associated with product and distribution development, £(14) million for expense over-runs in respect of a tariff agreement with SAIF and £(19) million for other items which includes a credit of £1 million for a positive persistency experience.
The 2007 comparative result has been reduced by £4 million in respect of the separate disclosure of UK general insurance commission. Total operating profit from UK insurance operations is unaffected by this adjustment.
The short-term fluctuations in investment returns for US operations primarily reflect the impact of impairment losses on debt securities and the effects on the value of variable annuity business of adverse movements in US equity markets. The fluctuations for US operations comprise the following items: £m £m
Realised impairment losses: Actual losses on fixed income securities (466) (78) Less: Risk margin charge included in operating profit 54 48
Sale of investment in India mutual fund in May 2008 giving rise to a transfer to operating profit of £47 million for the crystallised gain, and value reduction in the period, prior to sale, of £24 million (71)
Unrealised value movements on swaps held centrally to manage Group assets and liabilities (38) Unrealised value movements, net of hedge effects, on Prudential Capital’s bond portfolio (190) Unrealised value movements on a centrally held investment (14)
Core borrowings of the Group are marked to market value under EEV. The figures in the table above reflect the movement in the difference between market and IFRS carrying values. As the liabilities are generally held to maturity or for the long term, no deferred tax asset or liability has been established on the difference (compared to IFRS) in carrying value. Accordingly, no deferred tax charge is recorded in the results in respect of the 2008 credit of £656 million (2007: £223 million).
11 Shareholders’ share of actuarial and other gains and losses on defined benefit pension schemes
The loss of £(15) million (2007: loss of £(5) million) included within the (loss) profit before tax reflects the shareholders’ share of actuarial and other gains and losses on the Group’s defined benefit pension schemes and can be analysed as follows: PSPS (5) – M&G pension scheme (9) 5 Scottish Amicable pension scheme 2 (10) Taiwan (3) –
ii The credit for the effect of changes in economic assumptions for 2008 for US operations of £267 million primarily arises as a result of the impact of a change in the risk discount rate of £454 million, partially offset by the impact of a decrease in the variable annuity separate account return of £(230) million, both movements reflecting the 180 bps reduction in the 10-year Treasury rate as shown in note 3b.
12 Effect of changes in economic assumptions and time value of cost of options and guarantees continued
Notes a For shareholder-backed annuity business (i.e. held in PRIL and the PAC non-profit sub-fund) the impact of the change in risk discount rate of £(394) million includes £(400) million in respect of strengthening credit risk assumptions (excluding the strengthening required in respect of the £2.8 billion rebalancing of the asset portfolios). The impact of the change in portfolio yields of £83 million includes a profit of £231 million in respect of the rebalancing, calculated by reference to changes in credit spreads since 31 December 2006.
The tax (credit) charge comprises: Tax charge on operating profit from continuing operations based on longer-term investment returns Long-term business:note i
Total tax charge on operating profit from continuing operations based on longer-term investment returns 765 692
Tax (credit) charge on items not included in operating profit Tax (credit) charge on short-term fluctuations in investment returns (1,411) 22 Tax (credit) charge on shareholders’ share of actuarial and other gains and losses on defined benefit pension schemes (3) 0 Tax (credit) charge on effect of changes in economic assumptions and time value of cost of options and guarantees (122) 213
Tax (credit) charge on (loss) profit on ordinary activities from continuing operations (including tax on actual investment returns)note iv (771) 927
Total EPS from continuing operations: Total (loss) profit before tax (2,106) 3,670
Shareholders’ funds before capital charge 4,357 3,689 Capital chargenote v (18) (84) EEV basis shareholders’ funds 4,339 3,605
Notes i A charge is deducted from the annual result and embedded value for the cost of capital supporting the Group’s long-term business operations.
ii Under IFRS, goodwill is not amortised but is subject to impairment testing. Goodwill attaching to venture fund investment subsidiaries of the PAC with-profits fund that are consolidated under IFRS is not included in the table above as the goodwill attaching to these companies is not relevant to the analysis of shareholders’ funds.
iii With the exception of the share of pension scheme deficit attributable to the PAC with-profits fund, which is included in ‘Other operations’ net liabilities, and the borrowings as described in note iv, the amounts shown for the items in the table above that are referenced to this note have been determined on the statutory IFRS basis. The overall pension scheme deficit, net of tax, attributable to shareholders relating to the Prudential Staff Pension and Scottish Amicable Pension Schemes is determined as shown below: £m £m
iv Net core structural borrowings of shareholder-financed operations comprise: Mark to EEV basis Mark to EEV basis IFRS market value at market IFRS market value at market basis adjustment value basis adjustment value £m £m £m £m £m £m
Holding company* cash and short-term investments 1,165 – 1,165 1,456 – 1,456 Core structural borrowings – central funds(note) (2,785) 802 (1,983) (2,367) 38 (2,329)
Perpetual subordinated capital securities (Innovative Tier 1) (513) (679) Subordinated debt (Lower Tier 2) (737) (817) Senior debt (733) (833)
vi The proportion of surplus allocated to shareholders from the UK with-profits business has been based on the present level of 10 per cent. Future bonus rates have been set at levels which would fully utilise the assets of the with-profits fund over the lifetime of the business in force.
Short-term fluctuations in investment returns9 (1,063) (1,344) (2,407) (4,814) (313) (5,127) Mark to market value movements on core borrowings10 37 37 619 656 Shareholders’ share of actuarial and other gains and losses on defined benefit pension schemes11 (3) (3) (12) (15) Effect of changes in economic assumptions and time value of cost of options and guarantees12 (26) 278 (833) (581) – (581)
Profit (loss) for the year 18 (253) (1,571) (1,806) 468 (1,338)
Net increase (decrease) in shareholders’ equity 1,538 734 (1,578) 694 (338) 356 Shareholders’ equity at 1 January 2008 effect of adoption of principles of IFRIC 14 for accounting for pension schemes – – – – (179) (179)
Shareholders’ equity at 31 December 2008note iii,15 5,264 4,339 4,919 14,522 434 14,956
Asian US insurance business Other GroupEEV basis shareholders’ equity operations operations operations operations operations total at 31 December 2008 £m £m £m £m £m £m
Analysed as: Statutory IFRS basis shareholders’ equity 1,258 2,690 1,364 5,312 750 6,062 Additional retained profit on an EEV basis 2,468 915 5,133 8,516 22 8,538
Comprising: Value of in-force business before deduction of cost of capital and of guarantees 3,245 1,612 5,641 10,498
17 Reconciliation of net worth and value of in-force business a Summary by business unit 2008 £m
Shareholders’ equity at 1 January 2008note vi 1,468 2,870 4,338 9,490 13,828 New business contributionnote ii, iii (825) 472 (353) 1,290 937 Existing business – transfer to net worth 1,413 (416) 997 (997) – Expected return on existing business 53 130 183 718 901 Changes in operating assumptions and experience variances: Adjustments in respect of certain statutory reserves, required capital and surplus note borrowingsnote viii (187) (137) (324) 284 (40)
Effect of establishment and increase in allowance for short-term credit risk under the statutory (Pillar l) reporting* (770) 41 (729) 705 (24)
Shareholders’ equity at 31 December 2008note vi 447 4,117 4,564 9,958 14,522
17 Reconciliation of net worth and value of in-force business continued a Summary by business unit continued 2008 £m
Changes in non-operating assumptions and experience variances and minority interests (606) (606) (28) (634)
Existing business – transfer to net worth 575 (105) 470 (470) – Expected return on existing business 24 29 53 360 413 Changes in operating assumptions and experience variances: Adjustment in respect of certain statutory reservesnote viii (77) – (77) 77 – Effect of establishment and increase in allowance for short-term credit risk under statutory (Pillar l) reporting* (770) 41 (729) 705 (24)
*This adjustment reflects the reserve for short-term credit risk that was established for Pillar l reporting subsequent to the EEV full year 2007 basis results announced in March 2008 and the movement in 2008.
2008 2007ii The movements arising from new business contribution are as follows: £m £m
iii New business capital usage Annual New business premium capital usage Free equivalent per £100m surplus (APE) APE note 5a £m £m £m
(2007: £349 million) in respect of asset management business falling within the scope of covered business as follows: £m £m
Adjustment for net of tax asset management projected profits of covered business (35) Other adjustments 39 viii The charge of £40 million to total EEV represents the cost of capital relating to the reallocation of certain items from net worth to the value of in-force business for US and UK operations. These adjustments related to the following items: 2008 £m Value of Total
US operations: Interest Maintenance Reserve (IMR) and certain statutory reserves relating to variable annuity businessnote 1 (404) – (404) 353 (51)
1 These reserves represent additional prudent reserves recognised for local regulatory purposes and comprise reductions in free surplus of £(45) million in respect of the Interest Maintenance Reserve (IMR) and £(359) million relating to certain statutory reserves for variable annuity business. The value of in-force business reflects an increase of £38 million in respect of the IMR and £315 million in respect of the reallocation of other statutory reserves. The IMR is a statutory liability in respect of realised gains on the sale of bonds which, on a regulatory basis, are amortised to income over time, in line with the duration of the bonds sold. The statutory reserves are in respect of guarantees on variable annuity products in excess of the surrender value. Previously for EEV basis reporting, the IMR and these certain statutory variable annuity reserves were immediately released from the value of in-force business and treated as elements of free surplus. Their reallocation to the value of in-force business reflects the reinstatement of these amounts as explicit liabilities, consistent with the regulatory basis.
4 These reserves represent additional prudent reserves recognised for local regulatory purposes.
Free Required Value Total surplus capital Net of in-force long-term note ii note iii worth business business Groupnote i £m £m £m £m £m
Net cash flows to parent companynote viii (166) 0 (166) (132) (298)
Net movement (1,021) 1,247 226 468 694 Balance at 1 January 2008 1,468 2,870 4,338 9,490 13,828
ii Free surplus is the market value of the net worth in excess of the capital required to support the covered business. Where appropriate adjustments are made to the regulatory basis net worth from the local regulatory basis so as to include backing assets movements at fair value rather than cost so as to comply with the EEV principles.
iv The increase in UKIO credit provisions reflects the allowances explained in note 3. v Other investment movements and effect of changes in economic assumptions represent: Free Required Value Total surplus capital Net of in-force long-term note ii note iii worth business business £m £m £m £m £m
vi Investment movements primarily reflect temporary market movements on the portfolio of investments held by the Group’s shareholder-backed operations together with the shareholders’ 10 per cent interest in the value movements on the assets in the with-profits funds.
viii Net cash flows to or from parent company reflect the flows for long-term business operations as included in the holding company cash flow at transaction rate.
Notes continued ix Other items represent: Free Required Value Total surplus capital Net of in-force long-term note ii note iii worth business business £m £m £m £m £m
Mark to market value movements on Jackson assets backing surplus and required capital (148) – (148) – (148)
x The effect of other items on total embedded value of £472 million primarily relate to the impact on free surplus of an intra-group capital adjustment in respect of UK insurance operations of £320 million, an adjustment for funds loaned to the parent company of £133 million from Singapore and an adjustment of £50 million to reflect the cash flows to parent company at year end rates of exchange, consistent with the closing embedded value. Also included is a net overall charge of £(40) million for the reallocation of certain statutory reserves for UK insurance and US operations, an adjustment to required capital and the reallocation of surplus note borrowings for US operations. The effect of these adjustments is a decrease in free surplus of £(187) million, a reduction in required capital of £(137) million and an increase in the value of in-force business of £284 million.
The discounted value of in-force business and required capital at 31 December 2008 can be reconciled to the analysis of free surplus crystallisation as follows: £m
Required capital17 4,117 Value of in-force (VIF) 17 9,958 Add: cost of time value of guarantees16 474 Other items (181)
Cash flows are projected on a certainty equivalent basis and are discounted at the appropriate risk discount rate. The modelled cash flows use the same methodology underpinning the Group’s embedded value methodology reporting and so is subject to the same assumptions and sensitivities.
US operations 4,374 2,415 1,167 460 180 152 UK insurance operations 4,621 2,297 975 600 389 360
Embedded Interest rates value of long-term 1% 1% operations increase decrease 2008 £m £m £m
Embedded Interest rates value of long-term 1% 1% operations increase decrease 2007 £m £m £m
Asian operations *Taiwan sensitivity to starting bond rate (i.e. the starting bond rate for the progression to the assumed long-term rate): increase decrease
19 Sensitivity of results to alternative assumptions continued b Sensitivity analysis – non-economic assumptions The tables below show the sensitivity of the embedded value as at 31 December 2008 (31 December 2007) and the new business contribution after the effect of encumbered capital for 2008 and 2007 to: • 10 per cent proportionate decrease in maintenance expenses (a 10 per cent sensitivity on a base assumption of £10 per annum would represent an expense assumption of £9 per annum); • 10 per cent proportionate decrease in lapse rates (a 10 per cent sensitivity on a base assumption of five per cent would represent a lapse rate of 4.5 per cent per annum); and
To provide consistency with the basis applied for IFRS reporting, the EEV basis results reflect adoption of the principles of IFRIC 14 for accounting for pension schemes. The impact of the adoption is as follows: Previous Effect of Revised As Effect of After basis adoption basis published adoption change
Short-term fluctuations in investment returns (5,127) (5,127) 174 174 Mark to market value movements on core
Shareholders’ share of actuarial and other gains and losses on defined benefit pension schemes 17 (32) (15) 116 (121) (5) Effect of changes in economic assumptions and time value of cost of options and guarantees (581) (581) 748 748
21 Intended sale of legacy agency book and agency force in Taiwan to China Life Insurance of Taiwan
On 20 February 2009, the Company announced that it had entered into an agreement to sell the assets and liabilities of its agency distribution business and its agency force in Taiwan to China Life Insurance Company Ltd of Taiwan for the nominal sum of NT$1. In addition, Prudential will invest £45 million to purchase a 9.95 per cent stake in China Life through a share placement. The business being transferred represents 94 per cent of Prudential’s in-force liabilities in Taiwan and includes Prudential’s legacy interest rate guaranteed products. The transfer is subject to regulatory approval.
After taking account of EEV shareholders’ funds at 31 December 2008 of the business and restructuring and other costs the Group’s EEV shareholders’ equity is expected to increase by approximately £90 million.
Short-term fluctuations in investment returns (163) Effect of changes in economic assumptions and time value of cost of options and guarantees (185) Shareholders’ share of actuarial and other gains and losses on defined benefit pension schemes (3)
Statement of directors’ responsibilities in respect of the European Embedded Value (EEV) basis supplementary information
Respective responsibilities of directors and auditor As described in the statement of directors’ responsibilities on page 357, the directors’ responsibilities include preparing the supplementary information on the EEV basis in accordance with the EEV Principles. Our responsibilities, as independent auditor, in relation to the supplementary information are established in the UK by the Auditing Practices Board, by our profession’s ethical guidance and the terms of our engagement.
Under the terms of engagement we are required to report to the Company our opinion as to whether the supplementary information has been properly prepared in accordance with the EEV Principles using the methodology and assumptions set out on pages 322 to 330. We also report if we have not received all the information and explanations we require for this audit.
We planned and performed our audit so as to obtain all the information and explanations which we considered necessary in order to provide us with sufficient evidence to give reasonable assurance that the supplementary information is free from material misstatement, whether caused by fraud or other irregularity or error. In forming our opinion, we also evaluated the overall adequacy of the presentation of the supplementary information.
A number of factors (risk factors) affect Prudential’s operating results and financial condition and, accordingly, the trading price of its shares. The risk factors mentioned below should not be regarded as a complete and comprehensive statement of all potential risks and uncertainties. The information given is as of the date of this report, is not updated, and any forward-looking statements are made subject to the reservations specified under ‘Forward-Looking Statements’(page 367).
Prudential’s businesses are inherently subject to market fluctuations and general economic conditions. Uncertain or negative trends in international economic and investment climates which have adversely affected Prudential’s business and profitability could be repeated, or prolonged, or could worsen. The adverse effects of such trends, including the unprecedented market dislocation across asset classes and geographical markets witnessed since mid-2008, have been and would be felt principally through the following: • Reduced investment returns could impair its ability to write significant volumes of new business as a result of market volatility, which would have a negative impact on Prudential’s assets under management and profit; • higher credit defaults and wider credit and liquidity spreads resulting in realised and unrealised credit losses, as recently experienced when illiquidity and credit spreads reached all-time highs; • Prudential in the normal course of business enters into a variety of transactions, including derivative transactions, with counterparties. Failure of any of these counterparties to discharge their obligations, or where adequate collateral is not in place, could have an adverse impact on Prudential’s results; and
Increased illiquidity also adds to uncertainty over the accessibility of financial resources and may reduce capital resources as valuations decline.
In the United States, fluctuations in interest rates can affect results from Jackson National Life Insurance Company (Jackson), which has a significant spread-based business and where the majority of investments are in fixed-income securities. The spread is the difference between the rate of return Jackson is able to earn on the assets backing the policyholders’ liabilities and the amounts that are credited to policyholders in the form of benefit increases, subject to minimum crediting rates. During 2008, the US financial services industry faced an unprecedented array of challenges: the S&P 500 index fell by 38.5 per cent, government interest rates fell to historic lows, and global markets experienced a significant increase in volatility. In addition, credit markets seized and global credit spreads widened to historic levels.
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 United States and Asia, which represent a significant proportion of operating profit and shareholders’ funds, generally write policies and invest in assets denominated in local currency. Although this practice limits the effect of exchange rate fluctuations on local operating results, it can lead to significant fluctuations in Prudential’s consolidated financial statements upon translation of results into 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 shareholders’ funds). The impact of gains or losses on currency translations is recorded as a component within the statement of changes in equity.
The Group's accounts are prepared in accordance with current international financial reporting standards (IFRS) applicable to the insurance industry. The International Accounting Standards Board (IASB) introduced a framework that it described as Phase I that permitted insurers to continue to use the statutory basis of accounting that existed in their jurisdictions prior to January 2005. The IASB has published proposals in its Phase II discussion paper that would introduce significant changes to the statutory reporting of insurance entities that prepare accounts according to IFRS. It is uncertain in what form the proposals in the discussion paper will be taken forward into a definitive IFRS and when such changes might take effect.
European Embedded Value (EEV) basis results are published as supplementary information. The EEV basis is a value based reporting method for Prudential's long-term business which is used by market analysts and which underpins a significant part of the key performance indicators used by the Company's management for both internal and external reporting purposes. In June 2008, in an effort to improve still further the consistency and transparency of embedded value reporting, the Chief Financial Officers’ (CFO) Forum published the initial Market Consistent Embedded Value (MCEV) Principles. The CFO Forum announced on 19 December 2008, that it would be reviewing the Principles given the current turbulent markets. They acknowledged that the MCEV principles were designed during a period of relatively stable market conditions and their application could, in turbulent markets, lead to misleading results.The review may lead to changes to the published MCEV Principles or the issuance of guidance. On completion of this review, Prudential will consider its approach to them. If Prudential adopts the new Principles, this will result in a restatement of reported EEV results and change the reporting basis of future results.
Prudential is, and in the future may be, subject to legal and regulatory actions in the ordinary course of its business, both in the United Kingdom and internationally. This could be a review of business sold in the past under previously acceptable market practices at the time such as the requirement in the United Kingdom to provide redress to certain past purchasers of pension and mortgage endowment policies, changes to the tax regime affecting products and regulatory reviews on products sold and industry practices, including in the latter case businesses it has closed.
In the United States, federal and state regulators have focused on, and continue to devote substantial attention to, the mutual fund, fixed index and variable annuity and insurance product industries. This includes new regulations in respect of the suitability of broker-dealers’ sales of certain products. 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.
Prudential’s businesses are conducted in highly competitive environments with developing demographic trends and Prudential’s continued profitability depends on its management’s ability to respond to these pressures and trends. The markets for financial services in the United Kingdom, United States and Asia are highly competitive, with several factors affecting Prudential’s ability to sell its products and its continued profitability, including price and yields offered, financial strength and ratings, range of product lines and product quality, brand strength and name recognition, investment management performance, historical bonus levels, developing demographic trends and customer appetite for certain savings products. In some of its markets Prudential faces competitors that are larger, have greater financial resources or a greater market share, offer a broader range of products or have higher bonus rates or claims-paying ratios. Further, heightened competition for talented and skilled employees with local experience, particularly in Asia, may limit the Group’s potential to grow its business as quickly as planned.
Within the United Kingdom, Prudential’s principal competitors in the life insurance market include many of the major retail financial services companies including, in particular, Aviva, Legal & General, Lloyds Banking Group and Standard Life.
Prudential’s short-term debt is rated as P-1 by Moody’s, A-1 by Standard & Poor’s and F1+ by Fitch.
Prudential Assurance Company’s (PAC’s) financial strength is rated Aa1 (rating under review for possible downgrade) by Moody’s, AA+ (negative outlook) by Standard & Poor’s and AA+ (stable outlook) by Fitch.
Operational risks are present in all of Prudential’s businesses, 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 in the United Kingdom a significant part of its back office and customer-facing functions as well as a number of 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 incorporate controls which are designed to manage and mitigate the operational risks associated with its activities. For example, any weakness in the administration systems or actuarial reserving processes could have an 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 2008, or which have subsequently caused, or are expected to cause, a significant negative impact on its results of operations.
Adverse experience against the assumptions used in pricing products and reporting business results could significantly affect Prudential’s results of operations. Prudential needs to make assumptions about a number of factors in determining the pricing of its products and for reporting the results of its long-term business operations. For example, the assumption that Prudential makes about future expected levels of mortality is particularly relevant for its United Kingdom 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. Prudential conducts rigorous research into longevity risk, using data from its substantial annuitant portfolio. As part of its pension annuity pricing and reserving policy, Prudential United Kingdom assumes that current rates of mortality continuously improve over time at levels based on adjusted data from the Continuous Mortality Investigations (CMI) medium cohort table projections (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.
A further example is the assumption that Prudential makes about future expected levels of the rates of early termination of products by its customers (persistency). This is particularly relevant to its lines of business other than its United Kingdom annuity business. Prudential’s persistency assumptions reflect recent past experience for each relevant line of business. Any expected deterioration in future persistency is also reflected in the assumption. If actual levels of future persistency are significantly different from those assumed, Prudential’s results of operations could be adversely affected.
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 equity, debt and commercial paper. Certain of the subsidiaries are regulated and therefore have 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 thirdparties. These arrangements involve certain risks that Prudential does not face with respect to its consolidated subsidiaries.
Prudential’s Articles of Association contain an exclusive jurisdiction provision. Under Prudential's Articles of Association, certain legal proceedings may only be brought in the courts of England and Wales. This applies to legal proceedings between a shareholder (in its capacity as such) against Prudential and/or its directors and/or its professional service providers. It also applies to legal proceedings between Prudential and its directors and/or Prudential and Prudential's professional service providers that arise in connection with legal proceedings between the shareholder and such professional service provider. This provision could make it difficult for US and other non-UK shareholders to enforce their shareholder rights.
% of total Number of number of % of total shareholder shareholder number of Size of shareholding accounts accounts Number of shares shares
Evergreen scrip dividend scheme The Company will be offering an evergreen scrip dividend scheme in respect of the final dividend for the year ending 31 December 2008. The number of new shares each participating shareholder will be entitled to, is calculated by dividing the total cash dividend due at the record date (14 April 2009) by the scrip reference price.
The scrip reference price is calculated as the average of the middle market quotations for the Company’s shares as derived from the Daily Official List of the London Stock Exchange for the five business days commencing on 8 April 2009.
Once signed up to the evergreen scrip, shareholders will automatically receive shares for all future scrip dividends. This election can be cancelled at any time by the shareholder. Further details of the scrip dividend scheme are available on our website plc/investors
Electronic communications Shareholders are encouraged to elect to receive shareholder documents electronically by registering with Shareview at This will save on printing and distribution costs, creating environmental benefits. When you register, you will be sent an email notification to say when shareholder documents are available on our website and you will be provided with a link to that information. When registering, you will need your shareholder reference number which can be found on your share certificate or proxy form. Please contact Equiniti if you require any assistance or further information.
Share dealing services The Company’s Registrars, Equiniti, offer a postal dealing facility for buying and selling Prudential plc ordinary shares. Please see the Equiniti address above or telephone 0871 384 2248. They also offer a telephone and internet dealing service, Shareview, which provides a simple and convenient way of selling Prudential plc shares. For telephone sales call 0871 384 2020 between 8.30am and 4.30pm, Monday to Friday, and for internet sales log on to
Jackson National Life 1 Corporate Way Lansing Michigan 48951 United States www.jackson.com
Registered office Laurence Pountney Hill London EC4R 0HH Registered number 1397169 www.prudential .co.uk
Forward-Looking Statement This report may contain certain ‘forward-looking statements’ with respect to certain of Prudential’s plans and its current goals and expectations relating to its future financial condition, performance, results, strategy and objectives. Statements containing the words ‘believes’, ‘intends’, ‘expects’, ‘plans’, ‘seeks’ and ‘anticipates’, and words of similar meaning, are forward-looking. By their nature, all forward-looking statements involve risk and uncertainty because they relate to future events and circumstances which are beyond Prudential’s control including among other things, UK domestic and global economic and business conditions, market related risks such as fluctuations in interest rates and exchange rates, and the performance of financial markets generally; the policies and actions of regulatory authorities, the impact of competition, inflation, and deflation; experience in particular with regard to mortality and morbidity trends, lapse rates and policy renewal rates; the timing, impact and other uncertainties of future acquisitions or combinations within relevant industries; and the impact of changes in capital, solvency or accounting standards, and tax and other legislation and regulations in the jurisdictions in which Prudential and its affiliates operate. This may for example result in changes to assumptions used for determining results of operations or re-estimations of reserves for future policy benefits. As a result, Prudential’s actual future financial condition, performance and results may differ materially from the plans, goals, and expectations set forth in Prudential’s forward-looking statements. Prudential undertakes no obligation to update the forward-looking statements contained in this report or any other forward-looking statements it may make.