For with-profits business the only change of note is an altered basis of recognising liabilities and unallocated surplus for SAIF. This is to comply with actuarial guidance GN 45, which requires that for a closed fund where the fund will be distributed fully that the working capital is shown as zero, with the future enhancements to asset shares being increased by the free capital. Without the adjustment the unallocated surplus would have been approximately £700 million. Shareholder results and equity are not altered by this change.
At 31 December 2005, the EEV basis value of the in-force business of the UK insurance operations, after taking account of the cost of encumbered capital and the cost of the time value of financial options and guarantees, was £4,274 million. This value has been determined after applying the principles of valuation described in note D1 and the following key assumptions. %
Interest rates (including consequential changes for assumed investment returns for all asset classes, market values of debt securities, and all risk discount rates): Equity/property yields – 1% rise 297
D2: UK insurance operations continued (h) Sensitivity of IFRS basis profit or loss and equity to changes that have a material effect
The primary sensitivities that have a material effect on the IFRS basis results of the UK insurance operations relate to asset-liability matching and mortality experience for shareholder-backed annuity business. Further details are described below.
The main factors that influence the determination of bonus rates are the return on the investments of the fund, the effect of inflation, taxation, the expenses of the fund chargeable to policyholders and the degree to which investment returns are smoothed. Mortality and other insurance risk represent a relatively small component of the factors.
The level of unallocated surplus is particularly sensitive to the level of investment returns on the portion of the life fund assets that represent the surplus. The effects for 2005 and 2004 are demonstrated in note D5.
Unit-linked and other business represents a comparatively small proportion of the in-force business of the UK insurance operations.
The actual amounts payable will vary with future investment performance of SAIF and the WPSF. To ascribe particular amounts payable to these contracts in future years does not provide appropriate information.
D2: UK insurance operations continued The Group uses cash flow projections of expected benefit payments as part of the determination of the value of in-force business when preparing EEV basis results. The maturity profile of the cash flows used for 2005 for that purpose for insurance contracts, as defined by
Expected maturity: D3: US operations (a) Summary balance sheet at 31 December 2005
assets and and other and fund operations liabilities* business* Total management total £m £m £m £m £m
Operational borrowings attributable to shareholder-financed operations – 1,085 1,085 – 1,085
Other non-insurance liabilities – 5,398 5,398 120 5,518 *Assets and liabilities attaching to variable annuity business that are not held in the separate account are shown within those of other business.
D3: US operations continued Summary policyholder liabilities (net of reinsurance) and reserves at 31 December 2005
The policyholder liabilities, net of reinsurers’ share of £520 million reflect balances in respect of the following: £m
In 2005, interest-sensitive fixed annuities accounted for 36 per cent (2004: 41 per cent) of policy and contract liabilities of JNL. Interestsensitive 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.
Approximately 29 per cent (2004: 22 per cent) of the interest-sensitive fixed annuities JNL wrote in 2005 provide for a market value adjustment, that could be positive or negative, on surrenders in the surrender period of the policy. This formula-based adjustment approximates the change in value that assets supporting the product would realise as interest rates move up or down. The minimum guaranteed rate is not affected by this adjustment.
JNL hedges the equity return risk on fixed index products using futures and options linked to the relevant index. The cost of these hedges is taken into account in setting index participation rates and caps. JNL bears the investment and surrender risk on these products.
At 31 December 2005, immediate annuities accounted for 2 per cent (2004: 2 per cent) of JNL’s policy and contract liabilities. 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.
At 31 December 2005, VAs accounted for 32 per cent (2004: 26 per cent) of JNL’s policy and contract liabilities. VAs are deferred annuities that have the same tax advantages and payout options as interest-sensitive and fixed index annuities.
(2004: 26 per cent) of VA funds were in fixed accounts.
D3: US operations continued JNL issues VA contracts where it contractually guarantees to the contract holder either a) return of no less than total deposits made to the contract adjusted for any partial withdrawals, b) total deposits made to the contract adjusted for any partial withdrawals plus a minimum return, or c) the highest contract value on a specified anniversary date adjusted for any withdrawals following the contract anniversary.
These guarantees include benefits that are payable in the event of death (guaranteed minimum death benefit (GMDB)), annuitisation
JNL’s institutional products consist of GICs, funding agreements (including agreements issued in conjunction with JNL’s participation in the US Federal Home Loan Bank programme) and medium-term note funding agreements. At 31 December 2005, institutional products accounted for 14 per cent of JNL’s policyholder reserves (2004: 15 per cent). Under a traditional GIC, the policyholder makes a lump sum deposit. The interest rate paid is fixed and established when the contract is issued. If deposited funds are withdrawn earlier than the specified term of the contract, an adjustment is made that approximates a market value adjustment.
JNL enters into financial derivative transactions, including swaps, forwards, put-swaptions, futures and options to reduce and manage business risks. These transactions manage the risk of a change in the value, yield, price, cash flows, or quantity of, or a degree of exposure with respect to assets, liabilities or future cash flows, which JNL has acquired or incurred.
JNL generally uses free-standing derivative instruments for hedging purposes. Additionally, certain liabilities, primarily trust instruments supported by funding agreements, fixed index annuities and GMWB and reinsurance GMIB features of variable annuities, issued by
JNL contain embedded derivatives as defined by IAS 39, ‘Financial Instruments: Recognition and Measurement’. JNL does not account for such derivatives as either fair value or cash flow hedges as might be permitted if specific hedge documentation requirements of IAS 39 were followed. Financial derivatives, including derivatives embedded in certain host liabilities that have been separated for accounting and financial reporting purposes are carried at fair value.
Value movements on the derivatives are reported within the income statement. Under the Group’s accounting policies supplementary analysis of the profit before taxes attributable to shareholders is provided as shown in note B1. In preparing this analysis value movements on JNL derivative contracts, other than for certain equity-based product management activities, are included within short-term fluctuations in investment returns and excluded from operating results based on longer-term investment returns. Value movements on derivative instruments used for certain equity-based product management activities are included within operating results based on longer-term investment returns as the value movements broadly offset the economic impact of changed levels of benefit payments and reserves as equity markets fluctuate. The types of derivative used by JNL and their purpose are as follows: ■ Interest rate swaps agreements generally involve the exchange of fixed and floating payments over the life of the agreement without an exchange of the underlying principal amount. These agreements are used for hedging purposes; ■ forwards consist of interest spreadlock agreements, in which JNL locks in the forward interest rate differential between a swap and the corresponding US Treasury security. The forwards are held for investment purposes; ■ put-swaption contracts provide the purchaser with the right, but not the obligation, to require the writer to pay the present value of a long-duration interest rate swap at future exercise dates. JNL purchases and writes put-swaptions with maturities up to 10 years.
■ cross-currency swaps, which embody spot and forward currency swaps and additionally, in some cases, interest rate swaps and equity index swaps, are entered into for the purpose of hedging JNL’s foreign currency denominated funding agreements supporting trust instrument obligations.
As noted above, JNL is exposed to equity risk through the options embedded in JNL’s fixed indexed liabilities and guarantees included in certain VA benefits including GMDB and GMWB. This risk is managed using a comprehensive equity hedging programme to minimise the risk of a significant economic impact as a result of increases or decreases in equity market levels while taking advantage of naturally offsetting exposures in JNL’s operations. JNL purchases external futures and options that hedge the risks inherent in these products, while also considering the impact of rising and falling separate account fees. As a result of this hedging programme, if the equity markets were to increase by 10 per cent, JNL’s free-standing derivatives would decrease in value by approximately £22 million net of related changes to amortisation of deferred acquisition costs. This would be substantially offset by the positive impact of increased separate account fees and reserve decreases of approximately £14 million, net of related changes to amortisation of deferred acquisition costs, resulting in a net loss of approximately £8 million.
For risk management purposes, the US general account portfolio is divided substantially into assets that support the interest-sensitive life and fixed annuity business, the institutional business and the fixed index business. Prudential hedges the equity return risk on fixed index products by purchasing futures and options on the relevant index.
For statutory reporting in the US, debt securities are classified into six quality categories specified by the Securities Valuation Office of the
The following table shows the quality of publicly traded and SEC Rule 144A traded debt securities held by the US operations as at 31 December 2005: Carrying value £m % of total
Of the residential mortgage-backed securities, 86.9 per cent were rated AAA or the equivalent by a nationally recognised statistical ratings organisation (including Standard & Poor’s, Moody’s and Fitch) and 99.9 per cent were rated NAIC 1.
Of the commercial mortgage-backed securities, 100 per cent were rated by a nationally recognised statistical ratings organisation
(including Standard & Poor’s, Moody’s and Fitch) and 98.5 per cent were rated investment grade.
D3: US operations continued (d) Process for setting assumptions and determining liabilities
Under US GAAP, investment contracts (as defined for US GAAP purposes) are accounted for by applying in the first instance a retrospective deposit method to determine the liability for policyholder benefits. This is then augmented by potentially three additional amounts. These amounts are for: ■ Any amounts that have been assessed to compensate the insurer for services to be performed over future periods (i.e. deferred income); ■ any amounts previously assessed against policyholders that are refundable on termination of the contract; and
VA contracts written by JNL may, as described above, provide for GMDB, GMIB and GMWB features. 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.
(2004: 8.4 per cent) and assumptions for lapse, mortality and expense that are the same as those used in amortisation of capitalised acquisition costs.
For traditional life insurance contracts, provisions for future policy benefits are determined under US GAAP standard FAS 60, ‘Accounting and Reporting by Insurance Enterprises’ using the net level premium method and assumptions as of the issue date as to mortality, interest, policy lapses and expenses plus provisions for adverse deviation.
The principal reinsurance ceded by JNL outside the Group is on term life insurance, direct and assumed accident and health business and certain annuity guarantees. In 2005, the premiums for such ceded business amounted to £78 million. Net commissions received on ceded business and claims incurred ceded to external reinsurers totalled £13 million and £54 million, respectively, during 2005. There were no deferred gains or losses on reinsurance contracts in either 2005 or 2004. The reinsurance asset for business ceded outside the Group was £520 million.
The operating profit based on longer-term investment returns of £362 million for US operations for 2005 has been determined after taking account of material changes of assumptions during the year. Several assumptions were modified in 2005 to conform to more recent experience. The most significant changes included a DAC write-down of £21 million for Single Premium Deferred Annuities partial withdrawal changes and a Universal Life SOP 03-1, ‘Accounting and Reporting by Insurance Enterprises for Certain Non-traditional Long
Duration Contracts and Separate Accounts’ reserve increase of £13 million due to increasing the mortality assumption. Several smaller changes relating to Single Premium Whole Life surrenders and annuity mortality and annuitisation rates, resulted in a £19 million benefit on adjusting amortisation of deferred acquisition costs. Combined with other minor modifications, the resulting net impact of all changes during the year was a decrease to pre-tax profits of £7 million.
At 31 December 2005, the EEV basis value of in-force business of the US operations, after taking account of the cost of encumbered capital, and the cost of the time value of financial options and guarantees was £1,251 million. This value has been determined after applying the principles of valuation described in section (d) of this note. The key assumptions in these projections are the risk discount rates, which are 8.0 per cent for VA business and 5.2 per cent for other business, and the expected long-term spread between the earned rate and the rate credited to policyholders for single premium deferred annuity business of 1.75 per cent.
Mortality and morbidity – 5% decrease in base rates (i.e. increased longevity): Life 83
Consistent with the Group’s accounting policies the profits of the Group’s US operations are translated at average exchange rates and shareholders’ equity at the closing rate for the reporting period. For 2005, the rates were US$1.82 and US$1.72 to £1 sterling respectively.
A 10 per cent increase in these rates would reduce reported profit before tax attributable to shareholders and shareholders’ equity attributable to US insurance operations by £48 million and £270 million respectively.
For term business, acquisition costs are deferred and amortised in line with expected premiums. For annuity business, acquisition costs are deferred and amortised in line with expected gross profits on the relevant contracts. For interest-sensitive business, the key assumption is the expected long-term spread between the earned rate and the rate credited to policyholders, which is based on an annual spread analysis. In addition, expected gross profits depend on mortality assumptions, assumed unit costs and terminations other than deaths (including the related charges) all of which are based on a combination of actual experience of the JNL companies, industry experience and future expectations. A detailed analysis of actual experience is measured by the internally developed mortality studies.
■ Variations in fees and other income, offset by variations in market value adjustment payments and, where necessary, strengthening of liabilities.
Notwithstanding the market risk exposure described in section D3(c), except in the circumstances of interest rate scenarios where the guarantee rates included in contract terms are higher than crediting rates that can be supported from assets held to cover liabilities, the accounting measurement of liabilities of JNL products is not generally sensitive to interest rate risk. This position derives from the nature of the products and the US GAAP basis of measurement described in sections D3(b) and D3(d).
The Group uses cash flow projections of expected benefit payments as part of the determination of the value of in-force business when preparing EEV basis results. The maturity profile of the cash flows used for that purpose for 2005 is as follows: Fixed annuity and other business
Unit-linked With-profit assets and business liabilities Other Total £m £m £m £m
Investments of long-term business, banking and other operations: Financial investments: Loans and receivables 382 – 723 1,105
Equity securities and portfolio holdings in unit trusts 2,444 1,889 626 4,959
Policyholder liabilities and unallocated surplus of with-profits funds: Investment contract liabilities with discretionary participation features 80 – – 80
Investment contract liabilities without discretionary participation features 22 – – 22
At 31 December 2005 the policyholder liabilities (net of reinsurance) and unallocated surplus for Asian operations of £10.9 billion (2004: £7.9 billion) comprised the following: £m
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.
Maturity values are guaranteed for non-participating products and on the guaranteed portion of participating products. Declared annual bonuses are also guaranteed once vested. Future bonus rates and cash dividends are not guaranteed in participating products.
Surrender values are guaranteed for non-participating products and on the guaranteed portion of participating products. The surrender value of declared reversionary bonuses are also guaranteed once vested.
Market value adjustments and surrender penalties are used where the law permits such adjustments in cash values.
It is common in Asia for regulations or market driven demand and competition to provide some form of capital value protection and minimum crediting interest rate guarantees. This would be reflected within the guaranteed maturity and surrender values.
Participating product guarantees are predominantly supported by the segregated life fund and its estate.
The most significant book of non-participating business in the Group’s Asian operations is Taiwan’s whole of life contracts. For these contracts there are floor levels of policyholder benefits that accrue at rates set at inception which are set by reference to minimum terms established by local regulation also at the time of inception. These rates do not vary subsequently with market conditions.
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.
The other area of note in respect of guarantees is the Japan business where pricing rates are higher than current bond yields. Lapse risk is a feature in that policyholders could potentially surrender their policies on guaranteed terms if interest rates significantly increased leaving the potential for losses if bond values had depreciated significantly. However, the business is matched to a relatively short realistic liability duration.
procedure, premium deficiency reserve calculations are performed each year to establish whether the carrying values of the liabilities are insufficient.
For Asian operations in countries where local GAAP is not well established and in which the business written is primarily non-participating and linked business, US GAAP is used as the most appropriate reporting basis. Of the more significant Asia 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.
For the Singapore life business, under the basis applied previously, 2004 liabilities of non-participating business were determined on a net premium basis using prescribed interest rates such that a very high degree of prudence resulted. This basis has been replaced under the
The second item reflects the application of liability adequacy testing for the Taiwan life business which has resulted in a write-off of deferred acquisition costs of £21 million in 2005. The assumptions for future investment returns for Taiwan are described in section (d) above. The loss reflects the reduction in 2005 in the expected yields over the trending period to the assumed long-term rate of 5.5 per cent for Taiwanese government bonds.
(g) Amount, timing and uncertainty of future cash flows from insurance contracts
At 31 December 2005, the EEV basis value of in-force business of the Group’s Asian operations, after taking account of the cost of encumbered capital, and the cost of the time value of financial options and guarantees was £1,226 million. The most significant businesses in Asia are in Hong Kong, Malaysia, Singapore and Taiwan. These businesses account for 77 per cent of the total value of business in force for Prudential’s Asian operations. These EEV basis in-force values for the Asian operations have been determined after applying the principles of valuation described in section D1 and the following key assumptions for the four most significant businesses.
Risk discount Expected rate (in-force long-term rate Government business) of inflation bond yield *Hong Kong business is predominantly US dollar denominated.
The most significant equity holdings in Asian operations are in Hong Kong, Singapore and Malaysia. The arithmetic average equity return assumptions for these three territories at 31 December 2005 were 8.6 per cent, 9.3 per cent and 12.8 per cent respectively
Interest rates (including consequential changes for assumed investment returns for all assets classes, market values of debt securities, and all risk discount rates): Equity/Property yields – 1% rise 136
Mortality and morbidity – 5% decrease in base rates (i.e. increased longevity) 69
In addition to these disclosures, for Asian operations as a whole it should be noted that the cash flows of the Taiwan life business are particularly sensitive to projected rates of investment return.
Consistent with the Group’s accounting policies, the profits of the Group’s Asian operations are translated at average exchange rates and shareholders’ equity at the closing rate for the reporting period. For 2005, the rates for the most significant operations are given in note I9.
Correspondingly the profit emergence reflects bonus declaration and is relatively insensitive to period by period fluctuations in insurance risk or interest rate movements.
As for the UK insurance operations, the profits and shareholders’ equity related to the Group’s Asian operations is primarily driven by charges related to invested funds. For the Group’s Asian operations substantially all of the contracts are classified as insurance contracts under IFRS 4, i.e. containing significant insurance risk. The sensitivity of profits and equity to changes in insurance risk is minor, and to interest rate risk, not material.
The principal other non-participating business of Asian operations is the traditional whole life business written in Taiwan.
The adequacy of the insurance contract liabilities is tested by reference to best estimates of expected investment returns on policy cash flows and reinvested income. The assumed earned rates are used to discount the future cash flows. The assumed earned rates consist of a long-term best estimate determined by consideration of long-term market conditions, and rates assumed to be earned in the trending in period. As previously noted in section (d), for 2005, it has been projected that rates of return for Taiwanese bond yields will trend from the current levels of some 2 per cent to 5.5 per cent by 31 December 2012.
D4: Asian operations continued The liability adequacy test results are sensitive to the attainment of the trended rates during the trending period. Based on the current asset mix, margins in other contracts that are used in the assessment of the liability adequacy tests, and currently assumed future rates of return, if interest rates were to remain at current levels in 2006 the premium reserve, net of deferred acquisition costs, would be broadly sufficient. If interest rates were to remain at current levels in 2007 then some level of write-off of deferred acquisition costs may be necessary. However, the amount of the charge, currently estimated at £50-70 million is sensitive for the previously mentioned variables.
The adequacy of the liability is also sensitive to the level of the projected long-term rate. The current long-term assumption of 5.5 per cent has been determined on a prudent best estimate basis by reference to detailed assessments of the financial dynamics of the Taiwanese economy. In the event that the rate applied was reduced or increased the carrying value of the liabilities would be affected.
In broad terms, if the assumed long-term rate applied was to fall by 0.25 per cent from 5.5 per cent to 5.25 per cent the impact on IFRS
The Group uses cash flow projections of expected benefit payments as part of the determination of the value of in-force business when preparing EEV basis results. The maturity profile of the cash flows, taking account of expected future premiums and investment returns, is as follows: Asia total
D5: Capital position statement for life assurance businesses (a) Summary statement
Total PAC subsidiaries Asian life Total life other WPSF with-profits and funds assurance assurance subsidiaries
Part of IAS 19 basis deficit attributable to WPSF not recognised for regulatory
Other UK subsidiaries Total life and Asian life assurance SAIF WPSF (i) funds (ii) JNL operations operations
and non- equity of Total PAC profit funds Asian life Total life other
Unallocated surplus of with-profits funds (note v): Reflecting previous GAAP basis of measuring liabilities for with-profit contracts for UK
Reflecting FSA realistic basis of measuring liabilities for with-profit contracts for UK
SAIF WPSF and funds JNL operations operations £m £m £m £m £m £m
Notes (i) WPSF unallocated surplus includes amounts related to the Hong Kong branch. Policyholder liabilities of the Hong Kong branch are included in the amounts of Asian operations.
(v) Other adjustments to shareholders’ equity and unallocated surplus include amounts for the value of non-participating business for UK regulated with-profits funds, deferred tax, admissibility and other items measured differently on the regulatory basis. For Jackson National Life the principal reconciling item is deferred tax related to deferred acquisition costs of £568 million (2004: £535 million).
(vi) Insurance business accounted for as financial instruments under IAS 39.
Each of the Group’s long-term business operations is capitalised to a sufficiently strong level for its individual circumstances. Details by the Group’s major operations are shown below.
As noted in section D2(d)(ii), the Company has discretion in its management actions in the case of adverse investment conditions.
When target bonus levels change, the PAC board has regard to the overall financial strength of the long-term fund when determining the length of time over which it will seek to achieve the amended product target bonus level.
D5: Capital position statement for life assurance businesses continued Other UK subsidiaries
The available capital of £759 million (2004: £548 million) reflects the excess of regulatory basis assets over liabilities, before deduction of the capital resources requirement of £580 million (2004: £462 million).
The capital resources requirement for these companies broadly reflects a formula, which for active funds equates to a percentage of regulatory reserves plus a percentage of death strains.
The regulatory framework for JNL is governed by the requirements of the US NAIC approved risk-based capital standards. Under the requirements life insurance companies report on a formula-based capital standard that they calculate by applying factors to various asset, premium and reserve items. The formula takes into account the risk characteristics of a company, including asset risk, insurance risk, interest rate risk and business risk.
The available capital of JNL shown above of £2,257 million (2004: £1,796 million) reflects US regulatory basis assets less liabilities excluding asset valuation reserves but inclusive of provision for interest (the interest maintenance reserve). The asset valuation reserve is designed to provide for future credit-related losses on debt securities and losses on equity investments. The interest maintenance reserve is designed by state regulators to defer recognition of non-credit related realised capital gains and losses.
JNL’s risk-based capital ratio is significantly in excess of regulatory requirements.
The available capital shown above of £570 million (2004: £621 million) represents the excess of local regulatory basis assets over liabilities before deduction of required capital of £149 million (2004: £177 million). These amounts have been determined applying the local regulations in each of the operations.
At the country level, Prudential’s businesses in Asia are subject to comprehensive and supervisory schemes in the jurisdictions in which they operate. The Hong Kong business branch of PAC and its capital requirements are subsumed within those of the PAC long-term fund.
Mathematical reserves for traditional business are determined on a net premium basis using prescribed mortality and interest rates.
Mathematical reserves for traditional business are determined on a modified net premium basis using prescribed mortality and interest rates (no higher than 4 per cent).
D5: Capital position statement for life assurance businesses continued (iv) Group capital requirements
In addition to the requirements at individual company level, FSA requirements under the FCD apply additional prudential requirements for the Group as a whole. Discussion of the Group’s estimated FCD position at 31 December 2005 is provided in the operating and financial review section of the Group’s 2005 Annual Report.
Total available capital for the Group’s life assurance operations has changed during 2005 as follows: £m
Notes (i) WPSF The increase in available capital arises from: £m
For PAC and all other UK long-term insurers, long-term business assets and liabilities must, by law, be maintained in funds separate from those for the assets and liabilities attributable to non-life insurance business or to shareholders. Only the ‘established surplus’ – the excess of assets over liabilities in the long-term fund determined through a formal valuation – may be transferred so as to be available for other purposes. Distributions from the with-profit sub-fund to shareholders reflect the shareholders’ one-ninth share of the cost of declared policyholders’ bonuses.
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.
JNL can pay dividends on its capital stock only out of earned surplus unless prior regulatory approval is obtained. Furthermore, dividends which exceed the greater of 10 per cent of JNL’s statutory surplus or statutory net gain from operations for the prior year require prior regulatory approval.
Available capital of the non-insurance business units is transferable to the life assurance businesses after taking account of an appropriate level of operating capital, based on local regulatory solvency targets, over and above basis liabilities. The economic capital model described in section D1 (concentration of risks) takes into account restrictions on mobility of capital across the Group with capital transfers to and from business units triggered at a solvency level consistent with these targets. The model takes into account restrictions on the availability to the Group of the estate of the various with-profits funds throughout the Group.
D5: Capital position statement for life assurance businesses continued (e) Sensitivity of liabilities and total capital to changed market conditions and capital management policies
Prudential manages its assets, liabilities, and capital locally, in accordance with local regulatory requirements and reflecting the different types of liabilities Prudential has in each business. As a result of the diversity of products offered by Prudential and the different regulatory requirements in which it operates, Prudential employs differing methods of asset/liability and capital management, depending on the business concerned.
For example, for businesses that are most sensitive to interest rate changes, such as immediate annuity business, Prudential uses cash flow analysis to create a portfolio of debt securities whose value changes in line with the value of liabilities when interest rates change.
This type of analysis helps protect profits from changing interest rates. This type of analysis is used in the UK for annuity business and by JNL for its interest-sensitive and fixed index annuities and stable value products.
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.
Bonuses declared in respect of the Group’s with-profits business are included in the change in long-term business provisions or, where the policy is no longer in force, in claims incurred.
Due to the quality and diversity of the assets in SAIF 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.
E1: Income statement for banking operations Profit (loss) included in the Group consolidated income statement in respect to banking operations is as follows: Note £m £m
Discontinued operations above relate to Egg France, Funds Direct and Jackson Federal Bank (in 2004) and have been treated as discontinued operations in the Group’s consolidated income statement. For further information on discontinued operations, see note F6.
E3: Risk management overview Egg offers banking and credit card products and intermediated services. Through its normal operations, Egg is exposed to a number of risks, the most significant of which are credit, operational, liquidity, market and currency risk. The overall responsibility for risk management and the risk appetite of Egg is set by the Egg Board and responsibility for managing these risks resides with the Egg Executive Committee.
Loans and advances to banks 636 50 – 5 27 718
Securities purchased under agreement to resell – 319 – – – 319
Loans and advances to customers 1 3,464 39 1,438 2,700 7,642
E5: Losses on loans and advances The following table details the movements in the allowance for losses on loans and advances to customers held by Egg in 2005 and 2004.
Transition adjustment to reflect adoption of IAS 39 at 1 January 2005 5 –
Financial assets and liabilities not held at fair value through profit and loss and the weighted average effective interest rate for those balances is provided below: £m
E6: Market risk continued See note G2 for further information on interest rate risk.
North America 26 450 *This includes £9,104 million (2004: £8,700 million) of off-balance sheet items, which mainly relate to unutilised credit limits on credit cards.
Egg has 3.1 million customers that are defined as ‘marketable’ based on their activity levels, with the majority of these acquired into its credit card product. These customers are typically aged between 25 and 45, are ABC1 in terms of their social demographics (according to the definition set by the Central Statistical Office of the UK based on occupation) and earn above average salaries. Full use is made of software technology and external bureaus in credit scoring both new and top-up lending applications. The counterparty credit quality is monitored through the analysis of qualitative and quantitative information. There are limits for exposure to individual countries, sectors and corporate and financial institutions.
Additionally, it is unlikely that, should all these customers utilise their credit or borrowing limits, that all of them would default on their debt entirely.
In its capacity as fund manager to fellow Prudential plc subsidiaries, M&G earns fees for investment management and related services.
Total charges include £12,745 million (2004: £9,528 million) of non-cash expenses mainly relating to changes in technical reserves and pension actuarial and other gains and losses. The majority of this amount is borne by the long-term business segment.
Realised losses on available-for-sale securities, previously recognised directly in equity (22)
Income from consolidated venture investments of the PAC with-profits funds 1,158 1,349
(ii) Interest income is calculated on the effective interest rate method for all financial assets that are not at fair value through profit and loss.
F4: Finance costs: interest on core structural borrowings of shareholder-financed operations Finance costs consist of interest on core debt of the parent company and related finance subsidiaries and JNL surplus notes of £175 million
Deferred tax arising from: Origination and reversal of temporary differences 870 374
In 2005, a deferred tax credit of £93 million has been taken directly to reserves. When this amount is taken with the deferred tax expense shown above, the result is an increase of £784 million in the Group’s net deferred tax liability.
In 2005, there is no tax relating to discontinued operations (2004: £14 million credit) (see note F6).
The total tax expense is attributable to shareholders and policyholders as summarised in the income statement.
Taxation charge: Expected tax rate 35% (note ii) 100% 70% 31% (note ii) 100% 62%
Variance from expected tax charge 112 – 112 21 – 21
Profit before tax comprises profit attributable to shareholders and pre-tax profit attributable to policyholders of linked and with-profits funds and unallocated surplus of with-profits funds.
Profit before tax attributable to shareholders: Operating profit based on longer-term investment returns 400 348 175 34 957
Expected tax rate (note i): Operating profit based on longer-term investment returns 30% 35% 26% 30% 31%
Expected tax charge based on expected tax rates: Operating profit based on longer-term investment returns (120) (122) (46) (10) (298)
Variance from expected tax charge (note ii): Operating profit based on longer-term investment returns 3 (1) (17) 127 112
IAS 39 and IFRS 4 had been applied to the Group’s long-term business operations. The reconciliation of the effective tax rate for 2004 relates to the statutory IFRS basis results.
UK long-term insurance business Other operations JNL operations operations Total 2004 £m £m £m £m £m
Profit before tax attributable to shareholders 325 357 154 14 850
Expected tax charge based on expected tax rates (98) (125) (35) (3) (261)
Jackson Federal Bank, Egg France and Funds Direct are included within banking operations in the segment analysis whilst Life Assurance
Holding Corporation Limited is included within long-term business of UK insurance operations.
G1: Financial instruments – designation and fair values The Group formally adopted IAS 39 on 1 January 2005. On application of IAS 39, all financial assets are designated as either fair value through profit and loss, available-for-sale, or as loans and receivables and financial liabilities are designated as either fair value through profit and loss or amortised cost or for investment contracts with discretionary participation features accounted for under IFRS 4 as described in note A4.
Borrowings attributable to with-profits funds (note H13) 559 1,339 – 1,898 1,929
Net asset value attributable to unit holders of consolidated unit trust and
Notes (i) See note G3 for details of the derivative assets included. The balance also contains the PAC with-profit fund’s participation in various investment funds and limited liability property partnerships.
The estimated fair value of derivative financial instruments reflects the estimated amount the Group would receive or pay in an arm’s length transaction. This amount is mainly determined using quotations from independent third parties.
Refer to section A4 for the determination of fair value for investment contracts without fixed and guaranteed terms (notably UK unit-linked policies). For investment contracts in the US with fixed and guaranteed terms the fair value is determined based on the present value of future cash flows discounted at current interest rates.
At 31 December 2005, UK insurance operations held investments with a fair value of £3,729 million (of which £3,466 million were held in the PAC with-profits fund) which were measured in full or in part using valuation techniques. The majority of these assets are private debt securities such as private placements, project finance, asset securitisations and local authority securities. The securities are mainly long-dated and not regularly traded and are valued internally using market standard practices. These practices mainly use matrix pricing, which is based on assessing credit quality of the underlying borrower to derive a suitable discount rate relative to government securities.
The total amount of the change in fair value estimated using valuation techniques, including valuation techniques based on assumptions not wholly supported by observable market prices or rates, recognised in the profit and loss account in 2005 was £93 million.
The US operations of Prudential had two groups of assets which were valued using valuation techniques – derivatives and securities held by the Piedmont trust entity, an 80 per cent JNL held static trust formed as a result of a securitisation of asset-backed securities in 2003.
As at 31 December 2005, the fair value of the Piedmont and derivative assets valued using valuation techniques were £700 million and £518 million, respectively.
The majority of the factors entering into the valuation of the derivatives are readily observable in the market and, therefore, are not subject to interpretation in the model. The most significant non-observable factor is the level of implied volatility assumed in the valuation.
Management has obtained broker bids on these securities that represent the value at which the Group could sell the investments, if forced.
The interest income on financial assets not at fair value through profit and loss was £2,662 million for the year ended 31 December 2005.
The interest expense on financial liabilities not at fair value through profit and loss was £893 million for the year ended 31 December 2005.
The following table shows an analysis of the classes of financial assets and liabilities with direct exposure to interest rate risk. Each applicable class of the Group’s financial assets or liabilities are analysed between those exposed to fair value interest rate risk, cash flow interest rate risk and those with no direct interest rate risk exposure: Not directly
Fair value Cash flow exposed to interest interest interest rate risk rate risk rate risk Total 2005 £m £m £m £m
The following table sets out the Group’s commitments to lend funds at a fixed rate: Weighted average interest
Of the above commitments £104 million related to US operations, £32 million related to the banking operations and £31 million related to
For further information on effective interest rates specific to the banking operations, please refer to section E6.
Banking customer accounts 5,830 – – – – – – 5,830
Durations of long-term business contracts, including investment contracts, are included in section D.
The financial assets, of which 86 per cent are held by the PAC with-profits fund, allow the PAC with-profits fund to obtain exposure to foreign equity markets.
The financial liabilities, of which 22 per cent are held by the PAC with-profits fund, mainly relate to foreign currency borrowings.
The exchange risks inherent in these exposures are mitigated through the use of derivatives, mainly forward currency contracts (see G3 below).
The amount of exchange gains recognised in the income statement in 2005 except for those arising on financial instruments measured at fair value through profit and loss is £152 million (2004: £27 million). Of this amount, £134 million (2004: £31 million) is offset by value movements on cross-currency swaps and £12 million (2004: exchange loss of £2 million) relates to investments of the PAC with-profits fund.
The Group enters into a variety of exchange traded and over-the-counter derivative financial instruments, including futures, options, forward currency contracts and swaps such as interest rate swaps, cross-currency swaps, swaptions and credit default swaps.
The total fair value balances of derivative assets and liabilities as at 31 December 2005 were as follows: UK insurance Banking Other operations US operations operations Total 2005 £m £m £m £m £m
The notional amount of the derivatives, distinguishing between UK insurance, US, banking and other operations were as follows as at 31 December 2005: UK insurance operations US Banking operations
FTSE swap – – – – 49 49 *In addition, the other operations, including the Group Treasury function and the Asian operations, have cross-currency swap assets and liabilities with notional amounts of £2,761 million and £2,692 million, respectively, forward currency contracts assets and liabilities with notional amounts of £501 million and £167 million, respectively and interest rate swaps of £1,310 million and £1,310 million, respectively.
Egg has also made general use of credit default swaps to manage credit risk without changing the underlying product or investment portfolios.
For the purpose of reducing currency risk, Egg uses forward exchange contracts and currency swaps.
The Group has a US$1 billion fair value hedge in place which hedges the interest exposure on the US$1 billion, 6.5 per cent perpetual subordinated capital securities.
In addition, Jackson has entered into a collar fair value hedge, which has been hedge accounted for from 1 March 2005. This common stock equity collar transaction was entered into to protect the Company’s unrealised gain of US$5.9 million on an equity investment.
In December 2005, the Group entered into a series of forward currency transactions which together form a US$2 billion net investment hedge of the currency exposure of the net investments in the US operations.
G4: Derecognition, securitisation and collateral Securities lending and reverse repurchase agreements
(of which £8,657 million was held by the PAC with-profits fund).
During the year ended 31 December 2005, an amount of £278 million for impairment losses was recognised, mainly for loans and advances to customers in Egg and available-for-sale securities held by JNL.
Impairment losses in the year recognised in the profit and loss (120) (5)
Shareholders (principally in respect of M&G and Asian businesses) 1,341 1,461 *Under IFRS 1, the carrying value of goodwill of £1,504 million under UK GAAP is the deemed cost under IFRS on the date of transition, 1 January 2004. An additional £309 million relates to newly consolidated venture investment subsidiaries of the PAC with-profits fund.
The additions of £151 million (2004: £537 million) relate to additions to the PAC with-profits fund venture holdings in which the Group has a controlling interest. All goodwill additions relate to the UK and the long-term business segments. Additional details on the acquisitions are provided in note I6.
Goodwill disposals in 2004 relate to the sale of Jackson Federal Bank (£38 million) and sales of a PAC with-profits fund venture subsidiary
During 2005, the acquired goodwill of the Japanese life company was tested for impairment and a charge of £120 million has been separately disclosed in the consolidated income statement. The charge reflects the slower than expected development of the Japanese life business.
Goodwill does not generate cash flows independently of other groups of assets and thus is assigned to cash generating units (CGUs) for the purposes of impairment testing. These CGUs are based upon how management monitors the business and represent the lowest level to which goodwill can be allocated on a reasonable basis. An allocation of the Group’s goodwill to CGUs is shown below: £m £m
The discounted cash flow valuation has been based on a three-year plan prepared by M&G, and approved by the directors of Prudential plc, and cash flow projections for later years.
The fair value of each entity is calculated by PPM Capital in accordance with the International Private Equity and Venture Capital Valuation
All amounts relating to financial instruments ranking higher in a liquidation than those controlled by PPM Capital are then deducted from the enterprise value and a marketability discount applied to the result to give a fair value attributable to the instruments controlled by
The carrying value of other intangible assets is attributable to: PAC with-profits fund 35 798
UK regulated with-profits funds. The transition adjustment also removes deferred acquisition costs on with-profits investment contracts without discretionary participation features of UK regulated with-profits funds. Costs associated with the investment management element of other life assurance contracts classified as financial instruments and investment management contracts under IFRS 4 and fund management contracts are remeasured under the provisions of IAS 18. In addition, the transition adjustment includes adjustments to JNL
H2: Other intangible assets continued Deferred acquisition costs related to investment management contracts
The present value of future profits of acquired investment management contracts relates to unit-linked contracts acquired as part of the
Transition adjustment on application of IAS 32, IAS 39 and IFRS 4 (18) 12
Note (i) Movement on reinsurers’ share of insurance contract liabilities £m
Balance at 31 December 2005 1,203 *Comprising long-term business provision plus technical provisions for linked liabilities which all relate to contracts classified as insurance under IFRS 4.
Of the £231 million (2004: £159 million) current tax recoverable, the majority is expected to be settled in one year or less.
H6: Property, plant and equipment Property, plant and equipment comprise Group occupied properties, development property and tangible assets. A reconciliation of the carrying amount of these items from the beginning of the year to the end of the year is as follows: Group occupied Development Tangible property property assets Total £m £m £m £m
All additions arising on acquisitions relate to acquisitions of venture investment subsidiaries of the PAC with-profits fund.
H7: Investment properties Investment properties principally relate to the PAC with-profits fund and are carried at fair value. A reconciliation of the carrying amount of investment properties at the beginning and end of the year is set out below: £m £m
That did not generate rental income during the year 7 1
H7: Investment properties continued Investment properties of £4,463 million (2004: £5,095 million) are held under finance leases. A reconciliation between the total of future minimum lease payments at the balance sheet date, and their present value is shown below: £m £m
The Group’s policy is to rent investment properties to tenants through operating leases. Minimum future rentals to be received on non-cancellable operating leases are receivable in the following periods: £m £m
Limited that was sold in August 2004 and realised a profit on sale of £7 million before tax. This has been further disclosed in the discontinued operations note (see note F6).
(IfOnline), a company whose principal activity is mortgage intermediation. Until its sale in September 2004, the Group also accounted for its share in Hazell Carr Pensions Consulting plc (Hazell Carr) as an equity accounted associate.
In September 2004, the Company sold its 25 per cent share of Hazell Carr for £5 million. The profit on sale before tax of £2 million is included in investment income in the consolidated income statement.
The Group’s share of the assets, liabilities, revenues and profit and loss of associates accounted for using the equity method at 31 December 2005 and 2004 is as follows: £m £m
The Group’s associates that are carried at fair value through profit and loss comprise investments in OEICs, unit trusts, funds holding collateralised debt obligations, property unit trusts, and venture capital investments of the PAC with-profits fund managed by PPM Capital, where the Group has significant influence. These investments are incorporated both in the UK and overseas, and some have year ends which are non-coterminous with that of the Group. In these instances, the investments are recorded at fair value at 31 December 2005 based on valuations or pricing information at that specific date. The aggregate fair value of associates carried at fair value through profit and loss where there are published price quotations is approximately £2 billion at 31 December 2005.
The aggregate assets of these associates are approximately £9 billion. Aggregate liabilities, excluding liabilities to unit holders and shareholders for unit trusts and OEICs, are approximately £3 billion. Fund revenues, with revenue arising in unit trusts and OEICs deemed to constitute the investment return for these vehicles, was approximately £2 billion and net profit in the year, excluding unit trusts or OEICs where all investment returns accrue to unit holders or shareholders respectively, was approximately £0.1 billion.
However, in 2005 the Group sold a 6 per cent holding resulting in a new interest of 49 per cent. Hence, the Group now accounts for this investment as a joint venture, as there is a contractual agreement to share control.
Services Limited and Prudential ICICI Asset Management Company Limited. Although these two investments have a reporting period of 31 March, 12 months of financial information up to 31 December is recorded. Accordingly, the information is deemed to cover the same period as that of the Group.
H11: Shareholders’ equity: share capital, share premium and reserves The authorised share capital of the Company is £170 million (divided into 3,000,000,000 ordinary shares of 5 pence each and 2,000,000,000 sterling preference shares of 1 pence each) and US$20 million (divided into 2,000,000,000 US dollar preference shares of 1 cent each)
A summary of the ordinary shares in issue is set out below: £m £m
Issued shares of 5p each fully paid: At the beginning of the year 2,009,176,830 100 553
Shares issued under Rights Issue, net of expenses 339,011,347 17 1,004
H11: Shareholders’ equity: share capital, share premium and reserves continued Amounts recorded in share capital represent the nominal value of the shares issued. The difference between the proceeds received on issue of shares, net of issue costs and the nominal value of shares issued is credited to the share premium account.
In October 2004, the Company announced a one for six Rights Issue at 308 pence per new share. The Rights Issue raised £1,044 million and issue expenses were £23 million.
The Group has consolidated a number of authorised investment funds where it is deemed to control these funds under IFRS. Certain of these funds hold shares in Prudential plc. The total number of shares held by these funds at 31 December 2005 was 5 million (2004: 5.9 million)
Policyholder liabilities at 31 December 2004 as reported under UK GAAP
Unallocated surplus of with-profits funds reflecting previous UK GAAP basis provisioning 16,686
Total at 31 December 2004 as reported under UK GAAP 129,101 16,686
Effect of changes on implementation of IFRS (note A5) (39) (537)
Notes (i) 2004 technical provisions in respect of non-linked business as reported under UK GAAP include £826 million of claims outstanding.
(ii) Transitional adjustments include adoption of FRS 27 and reallocation of £22.7 billion and £9.8 billion to investment contracts with and without discretionary participation features, respectively.
(iii) These Surplus Notes are unsecured and subordinated to all present and future indebtedness, policy claims and other creditor claims of the US operations.
(iv) Maturity analysis The following table sets out the maturity analysis of the Group’s core structural borrowings: £m £m
(iv) The borrowings in respect of banking operations comprise deposits by banks of £2,452 million (2004: £2,352 million) and unsubordinated debt securities issued by Egg of £1,404 million (2004: £1,807 million). The deposits by banks mainly relate to securitisation of credit card receivables. See also note G4.
Other borrowings (predominantly external funding of consolidated investment vehicles) 810 870
Provision in respect of defined benefit pension schemes (note I1): Deficits, gross of deferred tax, based on scheme assets held, including investments in Prudential insurance policies: Attributable to PAC with-profits fund (ie absorbed by the liability for unallocated surplus) 329 525
Provision after elimination of investments in Prudential insurance policies and matching policyholder liability from Group balance sheet 796 825
Of the other provisions balance, £74 million (2004: £53 million) is expected to be settled within one year. Employer contributions expected to be paid into Group defined benefit pension schemes within one year are shown in note I1.
The legal provisions of £11 million (2004: £13 million) relate predominantly to JNL. JNL has been named in civil proceedings, which appear to be substantially similar to other class action litigation brought against many life insurers in the US, alleging misconduct in the sale of insurance products. During 2005, an additional provision of £4 million was made, £1 million was reversed, £3 million was paid and there was a £2 million exchange gain. As at 1 January 2004, the provision amounted to £10 million. During 2004, an additional provision of £8 million was made, £1 million was reversed, £3 million was paid and there was a £1 million exchange gain.
Restructuring provisions of £41 million (2004: £66 million) comprise £30 million (2004: £49 million) relating to restructuring activity of
As at 1 January 2004, the provision for these restructurings was £80 million. During 2004, £20 million costs were paid, £12 million was released to the profit and loss account and an additional provision of £1 million was made. During 2005, costs of £9 million were paid, £11 million of costs were released and an additional £1 million was provided. At 31 December 2005, the remaining £30 million all relates to property charges.
In 2004, Egg announced its withdrawal from the French market. £113 million was charged in 2004 to cover the costs of the exit of which £25 million related to redundancy costs and £88 million related to other associated costs up to the completion of the closure. During 2004, £96 million of the provision had been utilised with a further £12 million utilised in 2005 and a £4 million release to the income statement.
Other provisions of £124 million (2004: £102 million) include provisions of £94 million (2004: £77 million) relating to staff benefit schemes.
In addition to the legal proceedings relating to JNL mentioned above, 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.
Financial Advisers and other intermediaries to not join, to transfer from or to opt out of their occupational pension schemes in favour of private pension products introduced under the UK Income and Corporation Taxes Act 1988. The UK insurance regulator (previously the
The FSA regularly updates the actuarial assumptions to be used in calculating the provision, including interest rates and mortality assumptions.
The pension mis-selling provision represents the discounted value of future expected payments, including benefit payments and all internal and external legal and administrative costs of adjudicating, processing and settling those claims. To the extent that amounts have not been paid, the provision increases each year reflecting the shorter period of discount.
H14: Provisions and contingencies continued In 1998, Prudential stated that deducting mis-selling costs from the inherited estate would not impact its bonus or investment policy and it gave an assurance that if this unlikely event were to occur, it would make available support to the fund from shareholder resources for as long as the situation continued, so as to ensure that policyholders were not disadvantaged. The assurance was designed to protect both existing policyholders at the date it was announced, and policyholders who subsequently purchased policies while the pension mis-selling review was continuing.
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.
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 SAIF. At 31 December 2005, provisions of £6 million
(2004: £7 million) in SAL and £50 million (2004: £47 million) in SAIF were held 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, in the year ended 31 December 2005 Prudential Assurance’s main with-profits fund paid compensation of £24 million
(2004: £16 million) in respect of mortgage endowment products mis-selling claims and at 31 December 2005 held a provision of £63 million
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.
The inherited estate represents the major part of the working capital of Prudential Assurance’s long-term fund. This enables the Company to support with-profits business by providing the benefits associated with smoothing and guarantees, by providing 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. The size of the inherited estate fluctuates from year to year depending on the investment return and the extent to which it has been required to meet smoothing costs, guarantees and other events.
The Company believes that it would be beneficial if there were greater clarity as to the status of the inherited estate. In due course, and only after discussion with the FSA, the Company may therefore take steps to achieve that clarity, whether through guidance from the
H14: Provisions and contingencies continued Support for long-term business funds by shareholders’ funds
SAIF, was established within Prudential Assurance’s long-term business fund. This sub-fund contains all the with-profits business and all other pension business that was transferred. No new business has been or will be written in the sub-fund and the sub-fund is managed to ensure that all the invested assets are distributed to SAIF policyholders over the lifetime of SAIF policies. With the exception of certain amounts in respect of the unitised with-profits life business, all future earnings arising in SAIF are retained for SAIF policyholders. Any excess (deficiency) of revenue over expense within SAIF during a period is offset by a transfer to (from) the SAIF unallocated surplus.
Shareholders have no interest in the profits of SAIF but are entitled to the investment management fees paid on this business. With the exception of certain guaranteed annuity products mentioned earlier in this note, and certain products which include a minimum guaranteed rate of accumulation, the majority of SAIF with-profits policies do not guarantee minimum rates of return to policyholders.
(2004: £10 million). Similar assessments for the UK businesses were not significant. The directors believe that the reserve is adequate for all anticipated payments for known insolvencies.
The commitments were entered into in the normal course of business to hedge obligations associated with the issuance of equity indexlinked immediate and deferred annuities and fall due for payment over the next two years.
relating to defined contribution schemes. Of the defined contribution scheme costs £13 million (2004: £12 million) related to overseas defined contribution schemes.
contributions for ongoing service of current employees will approximately double to some £35 million to £40 million per annum based on current levels of active members of the scheme. In addition, deficit funding amounts designed to eliminate the actuarial deficit over a 10-year period will be made of some £35 million per annum. These amounts compare to current total contributions in 2005 of £19 million.
Finally, a revised allocation of the deficit between the PAC with-profits fund and shareholder-backed operations has been applied in 2005. Previously the deficit of the PSPS had been attributed between the PAC with-profits fund and shareholders in the ratio of 80/20.
I1: Staff and pension plans continued The Group also operates two smaller defined benefit schemes for UK employees in respect of Scottish Amicable and M&G activities. For all three schemes the projected unit method was used for the most recent full actuarial valuations. There is also a small defined benefit scheme in Taiwan.
Amicable Staff Pension Scheme, which are both final salary schemes, follow similar principles, but have different target allocations, reflecting the particular requirements of the schemes.
The calculations are based on current actuarially calculated mortality estimates with a specific allowance made for future improvements in mortality, which is broadly in line with that adopted for the 92 series of mortality tables prepared by the Continuous Mortality Investigation
The actuarial assumptions used in determining benefit obligations and the net periodic benefit costs for the years ended 31 December were as follows: Discount rate 4.8 5.3
Rate of increase of pensions in payment for inflation: Expected returns on plan assets 6.1 6.8 *The rates of 2.5 per cent shown are those for PSPS. Assumed rates of increase of pensions in payment for inflation for all other schemes remains at 2.8 per cent in 2005.
The Group liability in respect of defined benefit pension schemes is as follows: £m £m
Economic position: Deficits, gross of deferred tax, based on scheme assets held, including investments in Prudential insurance policies: Attributable to the PAC with-profits fund (ie absorbed by the liability for unallocated surplus) (329) (525)
Add back: investments in Prudential insurance policies (eliminated on consolidation against insurance liabilities) (253) (125)
Charge to gains and losses operating results Actuarial Charge for (based on gains (losses) revised longer-term attributable estimate of Contributions investment to PSPS deficit paid by
At beginning returns) shareholders allocation shareholder At end of year (note i) (note ii) (note ii) operations of year 2005 £m £m £m £m £m £m
Current service cost (65) (69) Finance income (expense): Interest on pension scheme liabilities (257) (245) Expected return on pension scheme assets 279 277
Charge to operating results, based on longer-term investment returns, attributable to shareholders (21) (16)
Total actuarial and other gains (losses) 171 (43) Less: amount attributable to PAC with-profits fund (139) 36
Charge for actuarial and other gains and losses attributable to shareholders, excluded from operating results based on longer-term investment returns, but included in profit before tax attributable to shareholders (31) (7)
Since shareholder profits in respect of the PAC with-profits funds are a function of the actuarially determined surplus for distribution, the overall income statement result is not directly affected by the level of pension cost or other expenses attributable to the fund.
I1: Staff and pension plans continued Estimated pension scheme deficits attributable to PAC with-profits fund
Less: M&G scheme plan assets used to acquire Prudential insurance policy* (112) 112 0 0
Less: actuarial gains on investments of scheme assets in Prudential insurance policies (16) (3)
None of the scheme assets included shares in Prudential plc or property occupied by the Prudential Group.
Fair value of plan assets, end of year (IAS 19 basis) 4,622 4,092
Present value of the benefit obligation, end of year (5,418) (4,917)
The Group operates various defined contribution pension schemes including schemes in JNL, Egg and Asia. As noted earlier, the cost of the Group’s contributions to these schemes in 2005 was £23 million (2004: £18 million).
The Prudential UK Share Incentive Plan (SIP) is also designed to foster share ownership amongst staff in designated UK businesses.
It enables employees to buy shares on a tax efficient basis. For every four partnership shares bought, an additional matching share is granted, purchased in the open market. Participants have voting rights and are entitled to dividend payments which are reinvested in the SIP. Partnership shares may be withdrawn from the scheme at any time while matching shares may only be withdrawn five years after their award date.
JNL operates a performance-related share award which, subject to the prior approval of the Jackson National Life Remuneration Committee, may grant share awards to eligible employees in the form of a contingent right to receive shares or a conditional allocation of shares.
These share awards have vesting periods of four years and are at nil cost to the employee. The employee does not have any beneficial ownership of the shares and, accordingly, does not have any right to dividends or voting rights attaching to the shares. Only issued shares purchased from the open market are used for the performance share award and there is no limit on the value of shares which may be granted to a participant in any year or over the life of the plan, which is usually no longer than 10 years.
deferred share award is awarded to board members in respect of any overall annual incentive award above 50 per cent of salary, and will represent the element of the bonus above 50 per cent of salary. The award is restricted for three years before it can be released, subject to close periods, to the participant who must not be under a period of notice at the time and must still be in employment of Prudential. The shares are held in the employee share trust and, shares equivalent to dividends otherwise payable will accumulate up to the release date.
The Share Participation Plan was designed to encourage share ownership amongst senior executives and to provide rewards based upon various performance factors of the Group. Each year, participants were offered the choice of a cash award, a matching share award if cash or shares to the value of the cash award were lodged, or a combination of 50 per cent of each. Share awards vested after five years for executive directors of Prudential plc and three years (formerly five years) for all other eligible employees and were transferred to the participants at no additional cost. Ordinary shares for share awards were purchased in the open market by a trust, which held them during the vesting period for the benefit of qualifying employees. At 31 December 2005, all outstanding shares in this plan have been paid for by employees and are registered in the names of the participants. No new shares have been granted in this scheme since 1999.
I2: Share-based payments continued Movements in share options outstanding under the Group’s share-based compensation plans relating to Prudential plc shares during 2005 and 2004 were as follows: Weighted Weighted average average
Weighted average Weighted Weighted remaining average average Number contractual exercise Number exercise outstanding life prices exercisable prices Range of exercise prices (millions) (years) £ (millions) £
I2: Share-based payments continued The following table provides a summary of the range of exercise prices for Prudential plc options (including conditional options)
The expected volatility is measured at the standard deviation of expected share price returns based on statistical analysis of daily share prices over a period up to the grant date equal to the expected life of options. Risk-free interest rates are UK gilt rates with projections for three, five and seven year terms to match corresponding vesting periods. Dividend yield is determined as the average yield over the year of grant and expected dividends are not incorporated into the measurement of fair value. Additionally, for the RSP, volatility and correlation of the comparator group with the Group are required. These assumptions are based on the TSR of the comparators over a period up to the grant date equal to the performance period. For grants in 2005, an average comparator volatility of 31 per cent and an average correllation of comparators of 33 per cent were used.
In 2005 and 2004, the Group maintained three main share award and share option plans relating to Egg plc shares, which are described below. As a result of the offer by Prudential to acquire the minority shareholding in Egg (note I8), executive share options are exercisable for six months from 19 December 2005, although this period may be shortened should Prudential become entitled to make a compulsory acquisition of the remaining Egg shares. Also as a result of the offer, awards under the RSP were assessed against the performance conditions. None of the awards met the performance conditions and they have therefore lapsed in February 2006 following consideration of the performance measurement results by the Remuneration Committee.
Egg made awards of shares at no cost to eligible employees selected by the Remuneration Committee under the plan. All Egg’s directors and employees, including employees of its subsidiaries, were eligible to participate, subject to the discretion of the Remuneration
Egg also operated a sharesave scheme, which was an Inland Revenue approved all-employee Save as You Earn scheme. Under this scheme, employees entered into either three or five year contracts, at the end of which time they will be entitled to exercise their options and purchase shares at an exercise price fixed at a 20 per cent discount to the share price at the date of grant. Employees have six months after the contract matures in which to exercise the options. These options will continue in force until their normal maturity dates.
Prior to the implementation of the RSP schemes, Egg granted options to employees under Inland Revenue approved and unapproved share option schemes.
Outstanding and exercisable at the end of year 0.5 0.7 1.15 1.16 0.3 0.4 1.20 1.20
Number Weighted average Number Weighted average (millions) exercise price £ (millions) exercise price £
Egg share option scheme awards made prior to 7 November 2002. Number Weighted average (millions) exercise price £
Outstanding and exercisable at the end of year 9.3 11.5 1.42 1.42
The weighted average share price of Egg plc during the year ended 31 December 2005 was 106 pence compared to 134 pence for the year ended 31 December 2004.
I2: Share-based payments continued The exercise prices and the weighted average remaining contractual life of the number of options outstanding at the year end are as follows: Weighted Weighted average average
Number remaining Number remaining Exercise of options contractual Exercise of options contractual price £ (millions) life (years) price £ (millions) life (years)
The fair value of the Egg RSP scheme at the date of grant was calculated using a Present Economic Value (binomial) model. The fair values of the sharesave schemes at the date of grant were determined using a Black-Scholes model.
Risk-free interest rate (%) (note i) – 4.14 4.15 – 4.70 4.76
Notes (i) The risk-free interest rate reflects yields available on government bonds of similar terms at the date of grant.
(iii) Analysis of the share price volatility of the FTSE 100 has been used as a reasonable proxy for the share price volatility of the comparator group of the RSP, this comparator group being the constituents of the FTSE 350 index.
Carrying value at 31 December of liabilities arising from share-based payment transactions 10 3
Total key management remuneration amounts to £13,688,000 (2004: £11,274,000). This comprises salaries and short-term benefits of £8,087,000 (2004: £7,639,000), post-employment benefits of £1,032,000 (2004: £1,058,000), termination benefits of £1,600,000
‘Share-Based Payments’ (see note I2) and £1,127,000 (2004: £762,000) of deferred share awards.
Total key management remuneration includes total directors’ emoluments of £9,214,000 as shown in the remuneration report on pages 46 to 57, and additional amounts in respect of pensions, share-based payments and termination benefits. Further information on directors’
The Audit Committee regularly monitors the non-audit services provided to the Group by its auditors and has developed a formal Auditor
Independence Policy which sets out the types of services that the auditors may provide, consistent with the guidance in Sir Robert Smith’s report ‘Audit Committees – Combined Code Guidance’ and with the provisions of the US Sarbanes-Oxley Act. The Audit Committee annually reviews the auditors’ objectivity and independence. More information on these issues is given in the corporate governance report on page 40.
The principal subsidiary undertakings of the Company at 31 December 2005, all wholly owned except Egg Banking plc and PCA Life
statutory surplus for the prior year. As JNL paid dividends in 2005, in order to fund the purchase of the Life Insurance Company of
PAC and JNL are the two principal insurance subsidiaries of the Group, which together comprise approximately 77 per cent (2004: 77 per cent)
On 18 May 2005, the Group purchased, in exchange for £142 million in cash, 100 per cent of the share capital of Life Insurance Company of Georgia, a life insurance company domiciled in the US, from ING Groep N.V. (ING). The results of Life Insurance Company of Georgia’s operations have been included in the consolidated financial statements commencing 18 May 2005, and contributed £4 million to the consolidated net profit. The preliminary purchase price is subject to post-closing adjustments and has been allocated to the assets acquired and liabilities assumed using management’s best estimate of fair value as of the acquisition date. JNL is in negotiations with ING over certain post-closing purchase price adjustments. During 2006, any unresolved differences will be submitted to an arbitrator for resolution. If the final purchase price is reduced as a result of the arbitrator’s review, the opening balance sheet will be reassessed accordingly, with any excess adjustment over the amounts presented in the balance sheet recognised as a gain.
A fair value adjustment of £1 million was made, representing the value of in-force business on acquisition. As indicated above, this amount may be adjusted depending upon the outcome of arbitration proceedings. There is currently no goodwill recorded on acquisition.
These acquisitions are considered individually immaterial and therefore all 2005 information relating to ventures acquisitions has been presented in aggregate throughout the note. Due to the nature of venture investments, it is not practicable to provide certain information for acquisitions occurring in 2005 and 2004, including the pro forma Group revenue and consolidated net profit information as if the acquisitions had occurred at the beginning of the year, and the carrying amounts, in accordance with IFRS, of each class of the acquirees assets, liabilities, and contingent liabilities immediately before acquisition.
The results of the aggregated ventures acquisitions in 2005 have been included in the consolidated financial statements of the Group commencing on the respective dates of acquisition and contributed £0.1 million to earnings within the income statement, which is also reflected as part of the change in unallocated surplus of the with-profits fund.
Aggregate goodwill of £151 million has been recognised for the excess of the cost over the Group’s interest in the net fair value of the entities’ assets, liabilities, and contingent liabilities acquired in 2005.
There are no intangible assets that were not recognised separately from goodwill for these companies because the fair value of the intangible asset could not be reliably measured.
Acquisitions in 2004 relate to the PAC with-profits fund venture capital holdings. There were five such acquisitions during 2004: ■ Acquired 39 per cent of the voting equity interests of Pharmacia Diagnostics (Pharmacia), a Swedish healthcare company, in April 2004; ■ acquired 45 per cent of the voting equity interests of TMF Group (TMF), a Dutch business administration company, in September 2004; ■ acquired 75 per cent of the voting equity interests of Muller & Weygandt GmbH (M&W), a German healthcare company, in October 2004; ■ acquired 73 per cent of the voting equity interests of Sterigenics International, Inc. (Sterigenic), a US based healthcare company, in June 2004; and
■ acquired 100 per cent of the voting equity interests of Edotech (Edotech), a UK business services company, in March 2004.
The results of the aggregated acquisitions in 2004 have been included in the consolidated financial statements of the Group commencing on the respective dates of acquisition and contributed £16 million to earnings within the income statement which is also reflected as part of the change in the liability for unallocated surplus ie profit before tax attributable to shareholders is not affected. This aggregate amount of £16 million does not include earnings from Edotech for the period since the date of acquisition. Disclosure of this amount is impracticable as Edotech is an acquisition by a consolidated PPM Capital venture subsidiary.
The table below identifies the net assets acquired and reconciles this amount to the consideration paid for the aggregated acquisitions in 2004: Fair value on acquisition £m
Aggregate goodwill of £537 million has been recognised for the excess of the cost over the Group’s interest in the net fair value of the entities’ assets, liabilities, and contingent liabilities acquired in 2004.
and Global Brands Co. Inc., all venture subsidiaries of the PAC with-profits fund, were disposed of for cash consideration of £284 million.
The Group disposed of its interest in Jackson Federal Bank on 27 October 2004 to Union Bank of California (see note F6).
Goodwill of £62 million was the primary asset that was disposed of. Cash and cash equivalents disposed of were insignificant.
Minimum lease rental payments for the year ended 31 December 2005 of £55 million (2004: £50 million) are included in the consolidated income statement.
The Group has provided, from time to time, certain guarantees and commitments to third parties including funding the purchase or development of land and buildings and other related matters. At 31 December 2005, the aggregate amount of contractual obligations to purchase and develop investment properties amounted to £199 million (2004: £42 million). The vast majority of these commitments have been made by the PAC with-profits fund.
I8: Post-balance sheet events In December 2005, the Company announced its intention to acquire the minority interests in Egg representing approximately 21.7 per cent of the existing issued share capital of Egg. Under the terms of the offer, Egg shareholders would receive 0.2237 new ordinary shares in the
Company for each Egg share. In January 2006, the Company announced that it had received acceptances in respect of 80.3 per cent of the shares that it did not already own and that it would extend the offer until further notice. In February 2006, the Board of Egg announced the delisting of Egg shares. Full acceptance of the offer would result in the issue of 41 million new ordinary shares in the Company representing 1.7 per cent of its issued ordinary share capital as enlarged by this acquisition.
I9: Foreign exchange translation Foreign currency profit and losses have been translated at average exchange rates for the year. Foreign currency assets and liabilities have been translated at year end rates of exchange.
The principal exchange rates applied are: Closing Closing Opening rate at Average rate at Average rate at
I10: Cash flows Structural borrowings of shareholder-financed operations comprise core debt of the parent company and related finance subsidiaries,
JNL surplus notes and Egg debenture loans. Core debt excludes borrowings to support short-term fixed income securities reinvestment programmes and non-recourse borrowings of investment subsidiaries of shareholder-financed operations. Cash flows in respect of these borrowings are included within operating cash flows.
Structural borrowings of with-profits operations relate solely to the £100 million 8.5 per cent undated subordinated guaranteed bonds which contribute to the solvency base of SAIF. Cash flows on other borrowings of with-profits funds, which principally relate to venture investment subsidiaries, are categorised as operating.
Cash flows relating to discontinued operations, as detailed in note F6, are outflows of £5 million and inflows of £174 million for 2005 and 2004 respectively. All of these relate to cash flows from operating activities.
Shareholders’ funds* 2,457 2,694 *The 2004 figures for these lines have been restated for the implementation of FRS 17, ‘Retirement Benefits’ and FRS 21, ‘Events after the Balance Sheet Date’ (see note 3).
M&G Group Limited and Egg plc. In the US, the Group’s principal subsidiary is Jackson National Life Insurance Company. In Asia, the
Group’s main operations are in Hong Kong, Malaysia, Singapore and Taiwan.
The Company arranges the financing of each of its subsidiaries (except Egg, which is responsible for its own financing) primarily by raising external finance either at the Company level (including through finance subsidiaries whose obligations the Company guarantees) or at the operating company level.
Practice (UK GAAP), including Financial Reporting Standards (FRS) and Statements of Standard Accounting Practice (SSAP).
The Company has implemented the following UK GAAP accounting standards in preparing its results for the year ended 31 December 2005. All of these standards closely reflect the requirements of International Financial Reporting Standards (IFRS) and form part of the implementation of IFRS in the UK.
The main effect of the adoption of FRS 17 in 2005 is the recognition of a surplus or deficit in respect of the defined benefit pension schemes on the balance sheet. The Company is assuming a portion of the pension deficit of the Group’s largest pension scheme, the
FRS 23, ‘The Effects of Changes in Foreign Exchange Rates’, FRS 24, ‘Financial Reporting in Hyperinflationary Economies’,
FRS 25, ‘Financial Instruments: Disclosures and Presentation’ and FRS 26, ‘Financial Instruments: Measurement’
The main impacts of the adoption of these standards are described below: FRS 23, ‘The Effects of Changes in Foreign Exchange Rates’
The main requirements of this standard relate to fair value adjustments on acquisitions treated as assets of acquired foreign operations and the recycling of cumulative translation adjustment from 1 January 2004 on disposal of foreign operations. This standard applies prospectively to acquisitions and disposals occurring after the effective date of 1 January 2005. There is no impact on the balance sheet and profit and loss account in the year upon the adoption of this standard.
3. Significant accounting policies continued FRS 25, ‘Financial Instruments: Disclosures and Presentation’
FRS 25 is based on the text of IAS 32, ‘Financial Instruments: Disclosures and Presentation’ as at 31 March 2004, incorporating the revised version of IAS 32 issued by the International Accounting Standards Board (IASB) in December 2003 and includes amendments made by
The significant adjustments for the Company resulting from FRS 26 arise primarily in respect of the valuation of derivative financial instruments and borrowings. Previously, derivative financial instruments held by the Company, depending on their nature and purpose, were either accounted for at fair value or treated as a hedge and accounted for on an accrual or deferral basis. Under FRS 26, derivative financial instruments are carried at fair value with value movements being recorded in the profit and loss account. Hedge accounting, whereby value movements on derivatives and hedged items are recorded together in the profit and loss account, is permissible only if certain criteria are met regarding the establishment of documentation and continued measurement of hedge effectiveness. In addition to the valuation of derivative financial instruments, FRS 26 has also resulted in a change in terms of the application of the effective interest rate method to amortise borrowings.
The effects of the changes in accounting policies on opening shareholders’ funds and profit and loss account are as follows: Profit and Shareholders’ loss account funds £m £m 31 December 2004 as previously published 848 2,525
Effect of adoption of FRS 26: Fair valuation of derivatives (12) (12)
Shares in subsidiary undertakings in the balance sheet of the Company are shown at the lower of cost and estimated realisable value.
Derivative financial instruments are used to reduce or manage interest rate and currency exposures. The Company’s policy is that amounts at risk through derivative transactions are covered by cash or by corresponding assets. For 2005, these instruments are carried at fair value with changes in fair value included in the profit and loss account. Prior to this, derivative financial instruments held by the
Prior to the adoption of FRS 26, borrowings were recognised at fair value, net of transaction costs. Any premium or discount from the nominal value was shown net. Transaction costs and premiums or discounts were amortised on a straight-line basis.
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.
4. Investments of the Company Shares in Loans to subsidiary subsidiary undertakings undertakings £m £m
PCA Life Assurance Company Limited* Insurance Taiwan *Owned by a subsidiary undertaking of the Company.
Each subsidiary has one class of ordinary shares and operates mainly in its country of incorporation, except for Prudential Retirement
6. Borrowings Long-term loans Other borrowings Total £m £m £m £m £m £m
€20m Medium Term Subordinated Notes 2023 (note iv) 14 14 14 14
Borrowings are repayable as follows: Within 1 year or on demand – 130 1,461 1,231 1,461 1,361
Notes (i) On 16 August 2005, the Company redeemed the US$250 million borrowings on maturity.
(iii) Interest on the US$1,000 million borrowings has been swapped into floating rate payments at three month US$ Libor plus 0.80 per cent. This derivative instrument has been hedge accounted for as a fair value hedge upon the adoption of FRS 26, ‘Financial Instruments: Measurement’ in 2005.
(iv) The ¤20 million Medium Term Subordinated Notes were issued at 20-year Euro Constant Maturity Swap (capped at 6.5 per cent). At 31 December 2005, these had been swapped into borrowings of £14 million with interest payable at three month £Libor plus 1.2 per cent.
(v) These borrowings support a short-term fixed income securities reinvestment programme.
(vii) 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.
Derivative financial instruments held to manage interest rate and currency profile: Interest rate swaps 29 22
The Company has a US$1,000 million fair value hedge in place which hedges the interest exposure on the US$1,000 million, 6.5 per cent perpetual subordinated capital securities.
Changing any one of the underlying assumptions used in determining the fair value would not have a significant impact on the value of the derivative financial instruments.
8. Pension liabilities The majority of UK Prudential staff are members of the Group’s pension schemes. The largest scheme is the Prudential Staff Pension
The deficit of PSPS has been apportioned between the Company and the unallocated surplus of the Prudential Assurance Company’s
(PAC) with-profits fund based on the weighted cumulative activity attaching to the contributions paid into the scheme in the past. For 2004 and prior, 20 per cent of the deficit has been attributed to the Company and 80 per cent to the PAC with-profits fund. For 2005, following further detailed consideration of the sourcing of previous contributions, the ratio for PSPS has been altered to 30/70 for the allocation of the deficit between the Company and the PAC with-profits fund.
The key assumptions adopted for FRS 17 basis valuations in PSPS were: Rate of increase in salaries 4.80 4.80 4.70
Credit to profit and loss account: Credit (charge) to statement of total recognised gains and losses: Additional losses on change of estimate of allocation of opening deficit between the Company and the PAC with-profits fund (59) 18 (41)
Actual less expected return on pension scheme assets (11% (2004: 3%) of pension scheme assets) 500 104
Experience losses on scheme liabilities (0% (2004: 1%) of present value of scheme liabilities) – (25)
A summary of the ordinary shares in issue is set out below: Share Share capital premium Number of 2005 2005
Transfer to retained profit in respect of shares issued in lieu of cash dividends – (51)
At 31 December 2005, there were options subsisting under share option schemes to subscribe for 12,503,956 (2004: 13,254,966) shares at prices ranging from 266 pence to 715 pence (2004: 266 pence to 723 pence) and exercisable by the year 2012 (2004: 2011). In addition, there were 4,668,534 (2004: 5,153,308) conditional options outstanding under the Restricted Share Plan exercisable at nil cost in the balance of a 10-year period. Further information on the Group’s employee share options is given in note I2 ‘Share-based payments’ of the notes on the financial statements of the Group.
10. Profit of the Company and reconciliation of movement in shareholders’ funds The profit of the Company for the year was £118 million (2004: £125 million as restated). After dividends of £378 million (2004: £323 million as restated), actuarial losses on pension scheme of £21 million (2004: £7 million) and a transfer from the share premium account of £51 million
(2004: £116 million) in respect of shares issued in lieu of cash dividends and an FRS 26 adjustment in respect of prior years of negative £13 million, retained profit at 31 December 2005 amounted to £774 million (2004: £1,017 million as restated). The Company employs no staff.
Shareholders’ funds at beginning of year as restated including FRS 26 adjustments 2,683
Prior year adjustment on adoption of FRS 17 and FRS 21 (note 3) – 169
14. Post-balance sheet events In December 2005, the Company announced its intention to acquire the minority interest in Egg representing approximately 21.7 per cent of the existing issued share capital of Egg. Under the terms of the offer, Egg shareholders would receive 0.2237 new ordinary shares in the
Standards (IFRS) as adopted by the European Union (EU) and have elected to prepare the parent company financial statements in accordance with UK Accounting Standards.
Act 1985. They have general responsibility for taking such steps as are reasonably open to them to safeguard the assets of the
remuneration report and corporate governance statement that comply with that law and those regulations.
We have audited the consolidated and parent company financial statements (the ‘financial statements’) of Prudential plc for the year ended 31 December 2005 which comprise the consolidated income statement, the consolidated and parent company balance sheets, the consolidated cash flow statement, the statement of change in shareholders’ equity and the related notes on pages 62 to 195. These financial statements have been prepared under the accounting policies set out therein. We have also audited the information in the directors’ remuneration report on pages 52 to 57 that is described as having been audited.
This report is made solely to the Company’s members, as a body, in accordance with Section 235 of the Companies Act 1985. Our audit work has been undertaken so that we might state to the
The directors’ responsibilities for preparing the Annual Report and the Group financial statements in accordance with applicable law and International Financial Reporting Standards (IFRS) as adopted by the European Union (EU), and for preparing the parent company financial statements and the directors’ remuneration report in accordance with applicable law and UK Accounting
Standards (UK Generally Accepted Accounting Practice) are set out in the statement of directors’ responsibilities on page 196.
We review whether the corporate governance statement reflects the Company’s compliance with the nine provisions of the 2003
FRC Combined Code specified for our review by the Listing Rules of the FSA, and we report if it does not. We are not required to consider whether the Board’s statements on internal control cover all risks and controls, or form an opinion on the effectiveness of the Group’s corporate governance procedures or its risk and control procedures.
Practices Board. An audit includes examination, on a test basis, of evidence relevant to the amounts and disclosures in the financial statements and the part of the directors’ remuneration report to be audited. It also includes an assessment of the significant estimates and judgments made by the directors in the preparation of the financial statements, and of whether the accounting policies are appropriate to the Group’s and Company’s circumstances, consistently applied and adequately disclosed.
In our opinion: ■ The Group financial statements give a true and fair view, in accordance with IFRS as adopted by the EU, of the state of the
Group’s affairs as at 31 December 2005 and of its profit for the year then ended; ■ the Group financial statements have been properly prepared in accordance with the Companies Act 1985 and Article 4 of the
IFRS transition rules, and consistent with the approach of groups with significant banking operations, where retrospective application is complex and onerous, the 2005 results include the effects of adoption of the standards IAS 32, IAS 39 and IFRS 4 for the Group’s insurance and other operations from 1 January 2005 rather than 1 January 2004. The 2004 comparative results in those statements are therefore prepared on an inconsistent basis.
The ‘pro forma IFRS basis’ comparative results shown below for 2004, reflect the estimated effect on the Group’s 2004 results if IAS 32,
The main purpose of providing this pro forma information is to present the operating results for the UK insurance business and short-term fluctuations in investment returns for Jackson National Life (JNL) on a consistent basis. Under IAS 39 and IFRS 4, the assets and liabilities of certain unit-linked and similar contracts of the UK insurance business are subject to remeasurement. For JNL derivatives held for economic hedging purposes are fair valued under IAS 39 with value movements recorded in the income statement giving rise to significant levels of volatility. In addition, debt securities of JNL are fair valued with value movements taken directly to shareholders’ reserves through the statement of changes in equity.
From operating profit, based on longer-term investment returns after related tax and minority interests
Based on profit for the year after minority interests of £748m (2004: £602m) 31.6p 28.4p
Related change in amortisation of deferred income and acquisition costs 307 74
Less: pro forma adjustment reflected in adjusted shareholders’ equity at 1 January 2005
IAS 32, IAS 39 and IFRS 4 for insurance operations (251) –
Pro forma IFRS basis (i.e. transition adjustment in respect of banking and other non-insurance operations) (25) –
Broker-dealer and fund management (including Curian losses of £10m and £29m) 14 (14)
Operating profit from continuing operations based on longer-term investment returns before exceptional items 957 699 *IFRS basis operating profit from continuing operations based on longer-term investment returns excludes goodwill impairment charges, short-term fluctuations in investment returns and the shareholders’ share of actuarial and other gains and losses on defined benefit pension schemes. The amounts for these items are included in total IFRS profit as shown elsewhere in this Annual Report.
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 where regulated surrender values are set with reference to the interest rate environment prevailing at 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. Where interest rates in these markets remain lower than surrender values over a sustained period this could have an adverse impact on the
In all markets in which Prudential operates, its businesses are susceptible to general economic conditions and changes in investment returns which can change the level of demand for Prudential’s products. Past uncertain trends in international economic and investment climates which have adversely affected
Prudential’s business and profitability could be repeated. This adverse effect would be felt principally through reduced investment returns and credit defaults. In addition, falling investment returns could impair Prudential’s operational capability, including its ability to write significant volumes of new business.
Prudential conducts its businesses subject to regulation and associated regulatory risks, including the effects of changes in the laws, regulations, policies and interpretations and any accounting standards in the markets in which it operates.
Financial Services Authority’s (FSA) depolarisation reforms and the rules relating to stakeholder products could have a significant effect on types of products sold by Prudential, how its products are priced, distributed and sold and on shareholders’ return on with-profits business. Similar changes in regulation in other jurisdictions could also have an impact elsewhere in the Group.
with a directive expected during 2007 for implementation by member states. Inconsistent application of these directives by regulators in different EU member states may place Prudential at a competitive disadvantage to other European financial services groups.
International Financial Reporting Standards (IFRS) accounting policies and European Embedded Value (EEV) guidance may require a change in the reporting basis of future results or a restatement of reported 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 UK and internationally. This could be a review of business sold in the past under previously acceptable market practices at the time. Pending legal and regulatory actions include proceedings relating to aspects of Prudential’s business and operations which are typical of the business it operates in such as the requirement in the UK to provide redress to certain past purchasers of pension and mortgage endowment policies and regulatory reviews on products sold and industry practices, including in the latter case businesses it has closed.
It is possible that Prudential’s future performance could be affected by an unfavourable outcome in these matters.
Prudential believes competition will intensify across all regions in response to consumer demand, technological advances, the impact of consolidation, regulatory actions and other factors.
Prudential’s financial strength and credit ratings, which are intended to measure its ability to meet policyholder obligations, are an important factor affecting public confidence in most of Prudential’s products, and as a result its competitiveness.
Downgrades in Prudential’s ratings could have an adverse effect on its ability to market products and retain current policyholders.
Prudential’s ability to meet its contractual obligations. Prudential believes the credit rating downgrades it experienced in 2002 and 2003, together with the rest of the UK insurance industry, have not to date had a discernible impact on the performance of its business.
Prudential’s short-term debt is rated as P-1 by Moody’s, A1+ by
AA+ (stable outlook) by Standard & Poor’s and AA+ by Fitch.
Adverse experience in the operational risks inherent in Prudential’s business could have a negative impact on its results of operations.
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, 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.
Adverse experience against the assumptions used in pricing products and reporting business results could significantly affect Prudential’s 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. During the year, Prudential carried out a review of its mortality experience across all of its nonprofit annuity business. As a result of this review, it strengthened the realistic and statutory male assumptions and weakened the realistic female assumptions to align the realistic assumptions with recent experience. Prudential continues 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.
Operating profit from continuing operations based on longer-term investment returns 1,712 1,274
Analysed as profits (losses) from: Business in force 6 876 587
*EEV basis operating profit from continuing operations based on longer-term investment returns excludes goodwill impairment charges, short-term fluctuations in investment returns, the shareholders’ share of actuarial and other gains and losses on defined benefit pension schemes, the effect of changes in economic assumptions and changes in the time value of cost of options and guarantees caused by economic factors. The amounts for these items are included in total EEV profit. 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 supplementary information.
Summarised consolidated income statement – EEV basis Year ended 31 December 2005
Effect of changes in economic assumptions and time value of cost of options and guarantees 10 (302) (48)
Profit from continuing operations for the financial year after tax before minority interests 1,591 1,231
From operating profit, based on longer-term investment returns, after related tax and minority interests
Based on profit (loss) from discontinued operations after minority interests of £3m (2004: £(67)m) 0.1p (3.1)p
Dividends declared and paid in the reporting period: Current year interim dividend 5.30p 5.19p
Profit for the year attributable to equity holders of the Company 1,582 1,138
Items taken directly to equity: Cumulative effect of IAS 32, IAS 39 and IFRS 4, net of applicable taxes, at 1 January 2005 (25) –
Movement on Prudential plc shares purchased by unit trusts consolidated under IFRS 3 14
Shareholders’ capital and reserves, at beginning of year (excluding minority interests): As previously reported on the achieved profits basis 8,596 7,005
Adjustments on implementation of statutory IFRS (excluding IAS 32, IAS 39 and IFRS 4) 17 165 15
Shareholders’ capital and reserves at end of year (excluding minority interests) 13, 14, 17 10,301 8,614
Shareholders’ capital and reserves (excluding minority interests) 14, 17 10,301 8,614 *Including liabilities in respect of insurance products classified as investment contracts under IFRS 4.
The supplementary information on pages 204 to 229 was approved by the Board of Directors on 15 March 2006.
1. Basis of preparation The EEV basis results have been prepared in accordance with the EEV principles issued by the CFO Forum of European Insurance
The EEV results for the Group include the results for the covered business on the EEV basis. These results are then combined with the
The exceptions are for the closed Scottish Amicable Insurance Fund (SAIF) and in respect of the Group’s defined benefit pension schemes. SAIF is closed to new business and the assets and liabilities of the fund are wholly attributable to the policyholders of the fund. As regards the Group’s defined benefit pension schemes, the deficits attaching to the Prudential Staff Pension Scheme (PSPS)
with-profits fund and shareholder-backed long-term business. Further details are explained in note 2f.
The directors are responsible for the preparation of the supplementary information in accordance with the EEV Principles.
The embedded value is the present value of the shareholders’ interest in the earnings distributable from assets allocated to covered business after sufficient allowance has been made for the aggregate risks in that business. The shareholders’ interest in the Group’s long-term business comprises: ■ Present value of future shareholder cash flows from in-force covered business (value of in-force business), less a deduction for the cost of locked-in (encumbered) capital; ■ locked-in (encumbered) capital; and
The total profit that emerges over the lifetime of an individual contract as calculated using the embedded value basis is the same as that calculated under the IFRS basis and, prior to IFRS adoption, the MSB under UK Generally Accepted Accounting Principles (GAAP).
However, since the embedded value basis reflects discounted future cash flows under this methodology the profit emergence is advanced, thus more closely aligning the timing of the recognition of profits with the efforts and risks of current management actions, particularly with regard to business sold during the year.
Where the capital is held within a with-profits long-term fund, the value placed on surplus assets in the fund is already discounted to reflect its release over time and no further adjustment is necessary in respect of solvency capital. However, where business is funded directly by shareholders, the capital requires adjustment to reflect the cost of that capital to shareholders.
With-profits products provide returns to policyholders through bonuses that are smoothed. There are two types of bonuses: annual and final. Annual bonuses are declared once a year, and once credited, are guaranteed in accordance with the terms of the particular product.
Unlike annual bonuses, final bonuses are guaranteed only until the next bonus declaration. The with-profits sub-fund held a provision on the Pillar 1 Peak 2 basis of £52 million (2004: £49 million) at 31 December 2005 to honour guarantees on a small amount of guaranteed annuity products.
Fixed annuities also present a risk that policyholders will exercise their option to surrender their contracts in periods of rapidly rising interest rates, possibly requiring JNL to liquidate assets at an inopportune time.
JNL also issues fixed index annuities that enable policyholders to obtain a portion of an equity-linked return while providing a guaranteed minimum return. The guaranteed minimum returns would be of a similar nature as those described above for fixed annuities. In the case of the potential equity participation, JNL hedges this risk by purchasing futures and options on the relevant index.
The most significant book of non-participating business in the Group’s Asian operations is Taiwan’s whole of life contracts. For these contracts there are floor levels of policyholder benefits that accrue at rates set at inception which are set by reference to minimum returns established by local regulation at the time of inception. These rates do not vary subsequently with market conditions. 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.
Assumptions specific to the stochastic calculations such as equity volatility and credit losses reflect local market conditions and are based on a combination of actual market data, historic market data and an assessment of long-term economic conditions. Common principles have been adopted across the Group for the stochastic asset models, for example, separate modelling of individual asset classes but with allowance for correlation between the various asset classes. Details of the key characteristics of each model are given in note 3.
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 EEV Prudential does not take credit for the significant diversification benefits that exist within the Group. For with-profits business written in a segregated life fund, as is the case in the UK and Asia, the capital available in the fund is sufficient to meet the encumbered capital requirements.
■ UK: economic capital requirements for annuity business are fully met by Pillar I requirements being 4 per cent of mathematical reserves
(as used for achieved profits reporting), which are also sufficient to meet Pillar II requirements; ■ US: level of capital that has previously been locked in for achieved profits reporting, namely 235 per cent of the risk-based capital required by the National Association of Insurance Commissioners at the Company Action Level (CAL), is sufficient to meet the economic capital requirement; ■ Asia: economic capital target is substantially higher than local statutory requirements in total. Economic capital requirements vary by territory, but in aggregate, the encumbered capital is equivalent to the amount required under the Financial Conglomerates Directive (FCD).
Under the CFO Forum Principles, discount rates used to determine the present value of future cash flows are set equal to risk-free rates plus a risk margin. The risk margin should reflect any risk associated with the emergence of distributable earnings that is not allowed for elsewhere in the valuation. Prudential has selected a granular approach to better reflect changes in risk inherent in each product group.
For Prudential’s UK annuity business, which is well matched, the predominant risks are credit risk and longevity risk. For this line of business the achieved profits methodology for embedded values has been carried over and the risk discount rate has been derived by comparison to a market consistent valuation.
Finance theory cannot be used to determine the appropriate component of beta for non-diversifiable non-market risks since there is no observable risk premium associated with it that is akin to the equity risk premium. Recognising this, a pragmatic approach has been used.
For the PAC with-profits sub-fund, the shareholders’ interest in the estate is derived by increasing terminal bonus rates so as to exhaust the estate over the lifetime of the in-force with-profits business. In those few extreme scenarios where the total assets of the life fund are insufficient to meet policyholder claims in full, the excess cost is fully attributed to shareholders.
The other two much smaller schemes are the Scottish Amicable and M&G schemes. There is also a small scheme in Taiwan.
Under IFRS the deficits attaching to these schemes are accounted for in accordance with the provisions of IAS 19. The deficits represent the difference between the market value of the schemes’ assets and the discounted value of projected future benefit payments to retired members and deferred pensioners and, to the extent of service to date, current employed members.
For PSPS the deficit is allocated between the PAC with-profits sub-fund and shareholder-backed operations by reference to the activities of the members of the scheme during their period of service. For the 2004 year end the deficit was allocated in the ratio 80/20. For the 2005 year end, following further detailed consideration of the sourcing of previous contributions by Group companies and funds, this ratio has been altered to 70/30 for the allocation of the deficit between the with-profits sub-fund and shareholder-backed operations.
Additional details on the effect of the movement on the deficits of the Group’s defined benefit pension schemes is set out in note 9.
Best estimate assumptions are used for the projections, where best estimate is defined as the mean of the distribution of all possible outcomes. The assumptions are reviewed actively and changes are made when evidence exists that changes in future experience are reasonably certain.
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 fixed interest securities. This ‘active’ basis of assumption setting has been applied in preparing the results of all the Group’s
Post-tax expected long-term nominal rate of return: Pension business (where no tax applies) 7.1 6.8
Hong Kong Hong Kong China (note iii) India Indonesia Japan Korea China (note iii) India Indonesia Japan Korea 31 Dec 31 Dec 31 Dec 31 Dec 31 Dec 31 Dec 31 Dec 31 Dec 31 Dec 31 Dec 31 Dec 31 Dec 2005 2005 2005 2005 2005 2005 2004 2004 2004 2004 2004 2004
Taiwan Taiwan Malaysia Philippines Singapore (note ii) Thailand Vietnam Malaysia Philippines Singapore (note ii) Thailand Vietnam 31 Dec 31 Dec 31 Dec 31 Dec 31 Dec 31 Dec 31 Dec 31 Dec 31 Dec 31 Dec 31 Dec 31 Dec 2005 2005 2005 2005 2005 2005 2004 2004 2004 2004 2004 2004
(iv) Assumed equity yields The most significant equity holdings in the Asian operations are in Hong Kong, Singapore and Malaysia. The mean equity return assumptions for those territories at 31 December 2005 (2004) were 8.6 per cent (7.3 per cent), 9.3 per cent (9.75 per cent) and 12.8 per cent (12.25 per cent). To obtain the mean, an average over all simulations of the accumulated return at the end of the projection period is calculated. The annual average return is then calculated by taking the root of the average accumulated return minus 1.
■ 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.
■ variable annuity equity and bond returns have been stochastically generated using a regime-switching log-normal model with parameters determined by reference to historical data. The volatility of equity fund returns ranges from 18.6 per cent to 28.1 per cent, depending on risk class, and the volatility of bond funds ranges from 1.4 per cent to 1.8 per cent.
The mean stochastic returns are consistent with the mean deterministic returns for each country. The volatility of equity returns ranges from 18 per cent to 26 per cent, and the volatility of government bond returns ranges from 1.6 per cent to 8.9 per cent.
Persistency, mortality and morbidity assumptions are based on an analysis of recent experience but also reflect expected future experience. Where relevant, when calculating the time value of in-force business, policyholder withdrawal rates vary in line with the emerging investment conditions according to management’s expectations.
Current taxation and other legislation has been assumed to continue unaltered except where changes have been announced and the relevant legislation passed.
To the extent applicable, presentation of the EEV profit for the year is consistent with the basis the Group applies for analysis of IFRS
With the exception of debt securities held by JNL, investment gains and losses during the year (to the extent that changes in capital values do not directly match changes in liabilities) are included directly in the profit for the year and shareholders’ funds as they arise.
However, it is assumed that fixed income investments will normally be held until maturity. Therefore, unrealised gains and losses on these securities are not reflected in either the EEV or statutory basis results and, except on realisation or impairment of investments, only income received and the amortisation of the difference between cost and maturity values are recognised to the extent attributable to shareholders.
This is consistent with the basis of valuation of future cash flows of in-force business, which inter alia, reflects spread basis earnings which are not directly affected by short-term value movements in fixed income securities. Similar principles apply to value movements on JNL’s derivatives that are fair valued for IFRS reporting with value movements booked in the IFRS income statement.
For the purposes of determining the long-term returns for debt securities of shareholder-backed operations, a risk margin charge is included which reflects the expected long-term rate of default based on the credit quality of the portfolio. Interest-related realised gains and losses are amortised to the operating results over the maturity period of the sold bonds. For equity-related investments of
Movements on the shareholders’ share of deficits of the Group’s defined benefit pension schemes adjusted for contributions paid in the year are recorded within the income statement. Consistent with the basis of distribution of bonuses and the treatment of the estate described in notes 2d) and 2e), the shareholders’ share incorporates 10 per cent of the proportion of the deficits attributable to the PAC
with-profits sub-fund. The deficits are determined by applying the requirements of IAS 19.
Actuarial gains and losses comprise: ■ The difference between actual and expected return on the scheme assets; ■ experience gains and losses on scheme liabilities; and
■ the impact of altered economic and other assumptions on the discount value of scheme liabilities.
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.
The EEV profit for the year for covered business is calculated initially at the post-tax level. The post-tax profit is then grossed up for presentation purposes at the effective rate of tax. In general, the effective rate corresponds to the corporation tax rate on shareholder profits of the business concerned. Under achieved profits, except for JNL, this basis also applied. For JNL, under achieved profits pre-tax results were determined by applying the risk discount rate to pre-tax cash flows adjusted for the impact of capital charges.
The principal exchange rates applied are: Closing rate at Average Closing rate at Average Opening rate at Local currency: £ 31 Dec 2005 for 2005 31 Dec 2004 for 2004 1 Jan 2004 5. Operating profit and margins from new business a) Profit
In determining the EEV basis value of new business written in the year the policies incept, premiums are included in projected cash flows on the same basis of distinguishing annual and single premium business as set out for statutory basis reporting.
5. Operating profit and margins from new business continued b) Margins
New business premiums reflect those premiums attaching to covered business including premiums for contracts classified as investment products for IFRS basis reporting. New business premiums for regular premium products are shown on an annualised basis. Department of Work and Pensions rebate business is classified as single recurrent premium business. Internal vesting annuity business is classified as new business where the contracts include an open market option.
New business contributions are determined by applying the economic and non-economic assumptions applying at the end of the year.
Unwind of discount and other expected returns (note i) 424 351
(iii) The £47 million charge primarily relates to the cost of capital attaching to liability strengthening on the regulatory basis for annuity business.
Less: allocation of investment return on centrally held capital in respect of Asian business to operating result of Asian operations (21) (22)
Less: projected fund management result in respect of covered business incorporated in opening EEV value (24) (22)
Actual investment return on investments less long-term returns included within operating profit: Actual realised gains less default assumption and amortisation of interest-related realised gains and losses for fixed maturity securities 5 51 Actual less long-term return on equity-based investments and other items 58 22
*This adjustment arises due to market returns being higher than the assumed long-term rate of return. This gives rise to higher than expected year end values of variable annuity assets under management with a resulting effect on the projected value of future account values, and hence future profitability.
10. Effect of changes in economic assumptions and time value of cost of options and guarantees The profits (losses) on changes in economic assumptions and time value of cost of options and guarantees resulting from changes in economic factors for in-force business included within the profit on ordinary activities before tax arise as follows: Change in Change in time value time value
Note (i) Consistent with prior periods for the Taiwan operation, the projections include an assumption of phased progression of the bond yields of around 2 per cent towards 5.5 per cent at 31 December 2012 as described in note 3b(ii). This takes into account the effect on bond values of interest rate movements. The principal cause of the £265 million charge for the effect of changed economic assumptions is the reduction in short-term earned rates in Taiwan. This reduction has the effect of delaying the emergence of the expected long-term rate.
Tax (credit) charge on effect of changes in economic assumptions and time value of cost of options and guarantees (39) 19
The profit for the year for covered business is in most cases calculated initially at the post-tax level. The post-tax profit for covered business is then grossed up for presentation purposes at the effective rates of tax applicable to the countries and years concerned. In the UK this is the UK corporation tax rate of 30 per cent. For JNL the federal rate of 35 per cent is applied to gross up movements on the value of in-force business. Effects on statutory tax for the period affect the overall tax rate. For Asia, similar principles apply subject to the availability of taxable profits.
Operating profit after tax and minority interests from continuing operations 1,339 916
Total EPS from continuing operations: Total profit before tax 2,244 1,784
Total profit after tax and minority interests from continuing operations 1,579 1,205
Long-term business operations (notes ii and iii): Smoothed shareholders’ funds (note i) 4,558 4,067
Jackson National Life (net of surplus note borrowings of £183m (2004: £162m) note vi): Before capital charge: Excluding assets in excess of target surplus 2,566 1,817
(ii) A charge is deducted from the annual result and balance sheet value for the cost of capital for the Group’s long-term business operations. The cost is the difference between the nominal value of solvency capital and the present value, at risk discount rates, of the projected releases of this capital and the investment earnings on the capital. Where solvency capital is held within a with-profits long-term fund, the value placed on surplus assets in the fund is already discounted to reflect its release over time and no further adjustment is necessary in respect of solvency capital.
(iii) 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.
(v) Under IFRS, subject to impairment testing, goodwill is no longer amortised from the date of adoption i.e. 1 January 2004. Acquired goodwill of the Japan life business has been subject to an impairment charge included in the 2005 results of £120 million.
13. Shareholders’ funds – segmental analysis continued Notes continued (vi) Net core structural borrowings of shareholder-financed operations comprise: £m £m
(vii) With the exception of the share of pension scheme deficits attributable to the PAC with-profits fund, 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 deficit for the defined benefit pension scheme reflects the statutory net of tax IFRS provision of £113 million (2004: £105 million), augmented by £29 million (2004: £47 million) for the shareholders’ share of the net of tax deficit attributable to the PAC with-profits fund.
Total UK long-term insurance Asian business Other Group operations JNL operations operations operations total £m £m £m £m £m £m
Short-term fluctuations in investment returns (note 8) 995 65 41 1,101 (100) 1,001
Effect of changes in economic assumptions and time value of cost of options and guarantees (note 10) (50) 8 (260) (302) (302)
Tax on effect of changes in economic assumptions and time value of cost of options and guarantees 15 (3) 27 39 39
Profit (loss) for the financial year 928 584 193 1,705 (123) 1,582
Adjustment for net of tax losses of Curian subsidiary owned by JNL (2) (2) 2
Movement in Prudential plc shares purchased by unit trusts consolidated under IFRS 3 3
Shareholders’ capital and reserves at 1 January 2005 4,228 2,506 1,565 8,299 315 8,614
Shareholders’ capital and reserves at 31 December 2005 (note 13) 5,132 3,348 1,988 10,468 (167) 10,301
14. Reconciliation of movement in shareholders’ funds continued Long-term business operations
UK long-term insurance Asian business Other Group operations JNL operations operations operations total EEV basis shareholders’ funds at 1 January 2005 £m £m £m £m £m £m
EEV basis shareholders’ funds at 1 January 2005 4,228 2,506 1,565 8,299 315 8,614
Profit after tax from continuing operations 178 416 594 1,111 1,705
Amounts injected, released and transferred to (from) life and related businesses (48) 11 (37) (7) (44)
Shareholders’ capital and reserves at 31 December 2005 835 2,882 3,717 6,751 10,468
Notes (i) Net worth consists of statutory solvency capital (or economic capital where higher) and unencumbered capital.
(ii) Value of in-force business includes the value of future margins from current in-force business less the cost of holding encumbered capital.
(iv) Included in the EEV basis shareholders’ funds of long-term business operations of £10,468 million (2004: £8,299 million) is £174 million (2004: £200 million) in respect of fund management business falling within the scope of covered business as follows: £m £m
UK insurance operations 120 123 Jackson National Life 12 20 Asian operations 42 57
In each sensitivity calculation, all other assumptions remain unchanged except where they are directly affected by the revised economic conditions.
Embedded value of Interest rates % of embedded value long-term operations 1% increase 1% decrease 1% increase 1% decrease
Asian operations *Taiwan sensitivity to starting bond rates (i.e. the starting bond rate for the progression to the assumed long-term rate): 1% increase 1% decrease
insurance Asian Total operations JNL operations long-term 2004 £m £m £m £m
insurance Asian Total operations JNL operations long-term 2005 £m £m £m £m
17. Reconciliation of 2004 achieved profits basis results to EEV basis results New business profits
Cost of time value of options and guarantees (5) (29) 4 (30)
Fund management business falling within the scope of covered business 10 4 3 17
Impact of adoption of EEV basis: Allocation of investment return on centrally held capital, in respect of Asian businesses to operating result of Asian operations (22)
Projected fund management result for 2004 in respect of covered business incorporated in opening EEV value (22)
Changes consequent on adoption of IFRS: Timing difference on recognition of dividend declared after balance sheet date 253
Achieved profits basis shareholders’ funds, net of minority interests – as previously published 8,596
Achieved profits basis shareholders’ funds, net of minority interests – as restated for the adoption of IFRS 8,761
Impact of adoption of EEV basis: Changes in economic assumptions 32
The directors have chosen to prepare supplementary information in accordance with the EEV Principles issued in May 2004 by the
In our opinion, the EEV basis supplementary information for the year ended 31 December 2005 has been properly prepared in accordance with the EEV Principles using the methodology and assumptions set out on pages 208 to 214.
The 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 which commenced on 22 March 2006. Further details of the scrip dividend alternative will be mailed to shareholders in early April 2006.
Annual Report for all future years may do so by contacting Lloyds
TSB Registrars in writing at the address above or by calling
Depositary Share represents two ordinary shares. All enquiries regarding ADR holder accounts should be directed to JP Morgan, the authorised depositary bank, at JP Morgan Service Center,
Securities and Exchange Commission (SEC) in the US as such requirements apply to foreign companies and files its Form 20-F
All enquiries regarding Irish branch register accounts should be directed to Capita Corporate Registrars Plc, Unit 5, Manor Street
Business Park, Manor Street, Dublin 7. Telephone: 00 353 1 810 2400.
M&G independently manages assets on behalf of a wide range of retail and institutional investors. M&G also acts as fund manager on many of the life and pensions products sold by Prudential in the UK and Europe, as well as managing Prudential’s balance sheet for profit.
M&G and Prudential branded mutual funds are distributed to retail investors in the UK, Europe and South Africa. M&G manages £14.6 billion of retail assets, invested in equities, fixed income and property.
■ Banking – unsecured personal loans, credit cards, mortgages and savings accounts
IFRS operating profit increased 35 per cent to £400 million in 2005.
Record APE sales of £515 million were up 13 per cent on prior year. New business profit margin (% of APE) of 41 per cent up from 32 per cent in the prior year.
We have strong franchises in three of the largest and most attractive markets in the world, where rising wealth and changing demographics are fuelling demand for life insurance and other long-term savings and protection products.