Total Discontinued Long-term Asset Unallocated Intra-group continuing banking business management to a segment eliminations operations operations Total
B6: Group balance sheet continued This analysis is shown below for the Group balance sheet at 31 December 2007.
UK US Asia insurance ment to a elimina- Group D2 D3 D4 operations E2 segment tions total
Held for sale assetsH9 30 – – 30 – – – 30 160 Prudential plc Annual Report 2007
Total policyholder liabilities and unallocated surplus of with-profits funds 138,542 34,848 17,179 190,569 – – – 190,569
Borrowings attributable to with-profits fundsG1,H13 987 – – 987 – – – 987
B6: Group balance sheet continued This analysis is shown below for the Group balance sheet at 31 December 2006.
Held for sale assetsH9 463 – – 463 – – – 463 – 463 162 Prudential plc Annual Report 2007
UK US Asia insurance ment to a elimina- continuing continued Group D2 D3 D4 operations E2 segment tions operations operations total
Liabilities Banking customer accountsG1 – – – – – – – – 5,554 5,554 Policyholder liabilities and unallocated surplus of with-profits funds: Investment contract liabilities with discretionary participation featuresG1 28,665 – 68 28,733 – – – 28,733 – 28,733
Egg subordinated debtH13 – – – – – – – – 451 451
Operational borrowings attributable to shareholder-financed operationsG1,H13 11 743 – 754 4 2,032 – 2,790 2,819 5,609
Total internal funds under management 146,931 38,829 18,290 204,050 199,841 164 Prudential plc Annual Report 2007
The Group’s internal control processes are detailed in the Group Governance Manual. This is supported by the Group risk framework, which provides an overview of the Group-wide philosophy and approach to risk management. Where appropriate, more detailed policies and procedures have been developed at Group and/or business unit levels. These include Group-wide mandatory policies on certain operational rissks, including: health, safety, fraud, money laundering, bribery, business continuity, information security and operational security. Additional guidelines are provided for some aspects of actuarial and finance activity.
The Group’s risk reporting framework forms an important part of the Group’s business planning process. Business units carry out a review of risks as part of the annual preparation of their three-year business plan. This involves an assessment of the impact and likelihood of key risks and of the effectiveness of controls in place to manage them, and is reviewed regularly throughout the year. In addition, business unit dialogue meetings involving Group and business unit executive management are held regularly to review opportunities and risks to business objectives. Any mitigation strategies involving large transactions (e.g. a material derivative transaction) would be subject to scrutiny at Group level before implementation.
Additional information on the Group’s risk framework is included in the risk management section of the Group’s operating and financial review.
ii Capital requirements: The objectives of the limits are to ensure that (a) the Group is economically solvent, (b) the Group achieves its desired target rating to meet its business objectives, (c) supervisory intervention is avoided, (d) any potential capital strains are identified, and (e) accessible capital is available to meet business objectives. The two measures used are EU Insurance Groups Directive (IGD) capital requirements and economic capital requirements.
i Overview continued c Risk mitigation Prudential employs a range of risk mitigation strategies aimed at reducing the impact of a variety of risks. Key mitigation strategies include: adjustment of asset portfolios to reduce investment risks (such as duration mismatches or overweight counterparty exposures); use of derivatives to hedge market risks; reinsurance programmes to limit insurance risk; and corporate insurance programmes to limit impact of operational risks. Revisions to business plans (such as reassessment of bonus rates on participating business and scaling back of target new business volumes) may also be used as a mitigating strategy.
d Asset – liability management The Group’s approach is explained in section (vi) below.
Approximately 70 per cent of the Group’s IFRS basis shareholders’ equity at 31 December 2007 arose in Prudential’s US and Asian operations. To mitigate the exposure of the US component there are US$1.55 billion of borrowings held centrally. The Group has also entered into a US$2 billion net investment hedge (see note G3). Net of the currency position arising from these instruments some 40 per cent of the Group’s shareholders’ funds are represented by net assets in currencies other than sterling.
c Liquidity risk Liquidity risk is the risk that Prudential may be unable to meet payment of obligations in a timely manner at a reasonable cost or the risk of unexpected increases in the cost of funding at appropriate maturities or rates. Liquidity management in each business seeks to ensure that, even under adverse conditions, Prudential has access to the funds necessary to cover surrenders, withdrawals and maturing liabilities.
iii Market and financial risks continued Further analysis of the credit quality for Jackson is shown in note D3 and for discontinued Egg banking operations in note J7. Additional details on the credit quality of the debt security portfolios of UK and Asian insurance operations are shown in notes D2 and D4.
Prudential is exposed to certain fiscal risks arising from changes in tax laws and enforcement policies and in reviews by taxation authorities of tax positions taken by Prudential in recent years. Prudential manages this risk and risks associated with changes in other legislation and regulation through ongoing review by relevant departments of proposed changes to legislation and by membership of relevant trade and professional committees involved in commenting on draft proposals in these areas.
vi Asset/liability management Prudential manages its assets and liabilities locally, in accordance with local regulatory requirements and reflecting the differing types of liabilities of each business unit. Stochastic asset-liability modelling is carried out locally by business units to perform dynamic solvency testing and assess capital requirements. Reserve adequacy testing under a range of scenarios and dynamic solvency analysis is carried out, including under certain scenarios mandated by the US, the UK and Asian regulators.
In addition, the Group as a whole is currently subject to the solvency requirements of the Insurance Groups Directive (IGD) as implemented by the FSA. Previously, whilst Prudential owned Egg, it was required to comply with the broadly equivalent requirements of the Financial Conglomerates Directive (FCD), as implemented by the FSA. Under both the IGD and FCD a continuous parent company solvency test is applied. Under this test the surplus capital held in each of the regulated subsidiaries is aggregated with the free assets of non-regulated subsidiaries. From this total Group borrowings are deducted, other than subordinated debt issues which qualify as capital. No credit for the benefit of diversification is allowed for under this approach. The test is passed when this aggregate number is positive, and a negative result at any point in time is a notifiable breach of UK regulatory requirements.
At 31 December 2006, Prudential met the requirements of the FCD. In addition, during 2007, Prudential met the ‘hard test’ of the FSA under both the FCD and IGD. The IGD position as at 31 December 2007 will be submitted to the FSA by 30 April 2008 and at the time of preparation of these financial statements the surplus capital under the test was estimated to be around £1.4 billion.
Economic capital provides a realistic and consistent view of Prudential’s capital requirements, allowing for diversification benefits. Two types of ‘economic capital’ approaches are applied. These are: — Group economic capital under which the capital requirement is determinable based on a multi-year projection thus taking into account the long-term nature of Prudential’s liabilities; and
— One-year Value at Risk Capital (1-yr VaR Capital). This capital is the amount required to withstand a maximum loss over a time period of one year consistent with a confidence level of 99.5 per cent. In additional to its risk management applications, the 1-yr VaR Capital framework is used for Individual Capital Assessments in the UK and anticipated to form the basis of Prudential’s capital modelling for future regulatory reporting developments, such as Solvency II.
D1: Group overview a Products and classification for IFRS reporting The measurement basis of assets and liabilities of long-term business contracts is dependent upon the classification of the contracts under IFRS. Under IFRS 4, contracts are initially classified as being either ‘insurance’ contracts, if the level of insurance risk in the contracts is significant, or investment contracts, if the risk is insignificant.
The insurance contracts of the Group’s shareholder-backed business fall broadly into the following categories: — UK insurance operations – bulk and individual annuity business, written primarily by Prudential Retirement Income Limited and other categories of non-participating UK business; — Jackson
For investment contracts that do not contain discretionary participation features, IAS 39 and, where the contract includes an investment management element, IAS 18, apply measurement principles to assets and liabilities attaching to the contract that may diverge from those previously applied.
Contracts of the Group, which are classified as investment contracts that do not contain discretionary participation features, can be summarised as: — UK – certain unit-linked savings and similar contracts; — Jackson – GICs and funding agreements – minor amounts of ‘annuity certain’ contracts; and
— Prudential Corporation Asia – minor amounts for a number of small categories of business.
D1: Group overview continued i Certain UK unit-linked savings and similar contracts continued Sterling reserves Prudent provisions established for possible future expenses not covered by future margins at a policy level reflecting the regulatory approach in the UK are not permitted under IFRS 4.
b Concentration of risk i Business accepted The Group has a broadly based exposure to life assurance risk. This is achieved through the geographical spread of the Group’s operations and, within those operations, through a broad mix of product types. In addition, looking beyond pure insurance risk, the Group considers itself well developed in its approach to assessment of diversification benefits through its economic capital framework that is used for internal business management. The economic capital methodology seeks to apply a single yardstick to assess and quantify all risks attaching to the Group’s insurance business and associated capital requirements.
The Group regularly determines the level of capital required to cover the risks to its existing contractual and discretionary insurance liabilities on an economic basis and its internal target solvency level. This level of required capital is determined after allowance for diversification across risk and geographies and the capturing of future shareholders’ transfers from the business units. This level is then compared with available capital on an equivalent basis (i.e. IFRS shareholders’ equity after eliminating goodwill and including subordinated debt capital and valuation differences). The required capital is then analysed into its contributing parts by risk type namely market risk (including interest and equity risk), credit risk, underwriting, persistency and operational risk.
D1: Group overview continued c Guarantees Notes D2(c), D3(c), D4(b) and D4(h) provide details of guarantee features of the Group’s life assurance products. In the UK, guarantees of the with-profits products are valued for accounting purposes on a market consistent basis for 2007 as described in section D2(e)(ii). The UK business also has products with guaranteed annuity option features, mostly within SAIF, as described in section D2(c). There is little exposure to financial options and guarantees in the shareholder-backed business of the UK operations. The US business annuity products have a variety of option and guarantee features as described in section D3(c). Jackson’s derivative programme seeks to manage the exposures as described in section D3(d). The most significant exposure for the Group arises on Taiwan whole of life policies as described in section D4(h)(iii).
d Amount, timing and uncertainty of future cash flows from insurance contracts The factors that affect the amount, timing and uncertainty of future cash flows from insurance contracts depend upon the businesses concerned as described in subsequent sections. In general terms, the Group is managed by reference to a combination of measures. These measures include IFRS basis earnings, net shareholder cash flow to or from business units from or to central funds, and movements in the present value of future expected distributable earnings of in-force long-term insurance business. The latter item when added to the net assets is commonly referred to as Embedded Value.
Recognising this, a pragmatic approach has been used. A constant margin of 50 basis points (2006: 50 basis points) has been added to the risk margin derived for market risk to cover the non-diversifiable non-market risks associated with the business.
In addition, the profitability of the Group’s life assurance businesses and, as described in Section E, Asset management business, is indirectly affected by the performance of the assets covering policyholder liabilities and related capital.
With-profits business Net neutral direct exposure (Indirect exposure only) Investment performance Persistency risk to (including Prudential subject to smoothing future shareholder Annuities Limited) through declared bonuses transfers
Fixed indexed Derivative hedge Incidence of equity Spread difference Lapse risk but the annuity business programme to the participation features between earned rate effects of extreme extent not fully hedged and rate credited to events are mitigated against liability and policyholders by the use of fund performance swaption contracts
Non-participating business Taiwan Interest rate and price risk Long-term interest rates
For Jackson at the level of operating profit based on longer-term investment returns, the results are sensitive to market conditions to the extent of income earned on spread-based products and equity-based exposure not covered by the equity derivative programmes. However, the main effect is on Jackson IFRS total profit and equity. IFRS profit or loss and equity arise from the accounting rather than economic effect of market value movements on assets and derivatives attaching to fixed annuity, term and institutional business.
For Asian operations, other than possibly for the impact of any alteration to assumed long-term interest rates in Taiwan, the operating profit based on longer-term investment returns is mainly affected by the impact of market levels on unit-linked business persistency, and other insurance risk.
— With-profits business Shareholder results of UK with-profits business are sensitive to market risk only through the indirect effect of investment performance on declared policyholder bonuses.
The financial assets covering the liabilities for those types of business are subject to market risk. However, for the annuity business the same considerations as described above for PRIL apply, whilst the liabilities of the unit-linked business change in line with the matching linked assets. Other liabilities of the PAC non-profit sub-fund are broadly insensitive to market risk.
By contrast, the IFRS insurance liabilities for these types of business of Jackson, by the application of grandfathers GAAP under IFRS 4, are measured on US GAAP bases which with the exception of certain items covered by the equity hedging programme, are generally insensitive to temporary changes in market conditions or the short-term returns on the attaching asset portfolios.
Excluding these short-term effects, the factors that most significantly affect the Jackson IFRS operating result based on long-term investment returns are: Variable annuity business – net effect of market risk arising from incidence of guarantee features and variability of asset management fees offset by derivative hedging performance.
Fixed annuity business – the spread differential between the earned rate and the rate credited to policyholders; and Fixed index annuity business – the spread differential between the earned rate and the rate credited to policyholders and incidence of equity index participation features.
D1: Group overview continued Asian operations For Asian with-profits business the same features apply as described above for UK with-profits business. Similarly, as for other parts of the Group, for unit-linked business the main factor affecting IFRS basis results is investment performance through asset management fees.
The sensitivity of the IFRS basis results of the Group’s Asian operations to market risk is primarily restricted to the nonparticipating business.
By contrast, Group IFRS operating profit is particularly sensitive to longevity shocks that result in changes of assumption for the UK shareholder-backed annuity business.
f Duration of liabilities Under the terms of the Group’s contracts, as for life assurance contracts generally, the contractual maturity date is the earlier of the end of the contract term, death, other insurable events or surrender. The Group has therefore chosen to provide details of liability duration that reflect the actuarially determined best estimate of the likely incidence of these factors on contract duration. Details are shown in sections D2(j), D3(j) and D4(i).
D2: UK insurance operations a Summary balance sheet In order to explain the different types of UK business and fund structure, the balance sheet of the UK insurance operations may be analysed by the assets and liabilities of the Scottish Amicable Insurance Fund (SAIF), the PAC with-profits sub-fund, PRIL, unit-linked and other business. The assets and liabilities of these funds and subsidiaries are shown in the table below.
Investments of long-term business and other operations: Financial investments: Equity securities and portfolio holdings in unit trusts 6,946 40,756 352 41,108 107 12,659 9 12,775 60,829 60,246
Liabilities Policyholder liabilities and unallocated surplus of with-profits funds: Investment contract liabilities
Investment contract liabilities without discretionary participation features – 14 – 14 – 12,059 – 12,059 12,073 11,453
Unallocated surplus of with-profits funds (reflecting application of ‘realistic’ provisions for UK regulated with-profits funds) – 12,486 1,719 14,205 – – – – 14,205 13,511
Borrowings attributable to with-profits funds 112 875 – 875 – – – – 987 1,776
Defined Charges Participating Sub-fund. ii SAIF is a separate sub-fund within the PAC long-term business fund.
v The loans of the Group’s UK insurance operations of £1,245 million comprise mortgage loans of £449 million, policy loans of £35 million and other loans of £761 million. The mortgage loans are collateralised by properties. Other loans are all commercial loans and comprise mainly syndicated loans held by the PAC with-profits fund.
D2: UK insurance operations continued Notes continued vii Other investments comprise: £m
Fund Limited Limited Total Limited business business Total Total £m £m £m £m £m £m £m £m £m
Where no external ratings are available internal ratings produced by the Group’s asset management operations, which are prepared on the Company’s assessment of a comparable basis to external ratings, are used where possible. Of the total debt securities held at 31 December 2007 which are not externally rated, £2,972 million were internally rated AAA to A-, £2,844 million were internally rated BBB+ to B- and £593 million were unrated. The majority of unrated debt security investments were held in SAIF and the PAC with-profits fund and relate to convertible debt and other investments which are not covered by ratings analysts nor have an internal rating attributed to them.
As detailed in note D2(i) below the primary sensitivity of IFRS basis profit or loss and shareholders’ equity relates to non-linked shareholder-backed business which covers other funds and subsidiaries in the table above.
These products are written primarily in: — One of three separate sub-funds of the PAC long-term fund, namely the with-profits sub-fund, the SAIF, and the non-profit sub-fund; — Prudential Annuities Limited, which is owned by the PAC with-profits sub-fund; — Prudential Retirement Income Limited, a shareholder-owned subsidiary; or — Other shareholder-backed subsidiaries writing mainly non-profit unit-linked business.
Beyond the generic guarantees described above, there are very few explicit options or guarantees such as minimum investment returns, surrender values or annuities at retirement and any granted have generally been at very low levels.
On 31 December 2007, Prudential completed the transfer of 62,000 with-profits annuity policies from Equitable Life, with assets of approximately £1.7 billion. The policies transferred form part of the Defined Charge Participating Sub-Fund of Prudential’s with-profit fund. Profits to shareholders will emerge on a ‘charges less expenses’ basis and policyholders will be entitled to 100 per cent of the investment earnings.
At 31 December 2007, £29.5 billion (2006: £29.0 billion) of investments relate to annuity business of PAL and PRIL. These investments are predominantly in debt securities (including retail price index-linked bonds to match retail price index-linked annuities), loans and deposits and are duration matched with the estimated duration of the liabilities they support.
The fund is solely for the benefit of policyholders of SAIF. Shareholders have no interest in the profits of this fund although they are entitled to asset management fees on this business.
Provision is made for the risks attaching to some SAIF unitised with-profits policies that have MVR-free dates and for those SAIF products which have a guaranteed minimum benefit on death or maturity of premiums accumulated at four per cent per annum.
The Group’s main exposure to guaranteed annuities in the UK is through SAIF and a provision of £563 million was held in SAIF at 31 December 2007 (2006: £561 million) to honour the guarantees. As SAIF is a separate sub-fund solely for the benefit of policyholders of SAIF this provision has no impact on the financial position of the Group’s shareholders’ equity.
d Exposure to market risk i Non-linked life and pension business For with-profits business, the absence of guaranteed surrender values and the flexibility given by the operation of the bonus system means that the majority of the investments backing the with-profits business are in equities and real estate with the balance in debt securities, deposits and loans.
The FPRL must include a market consistent valuation of costs of guarantees, options and smoothing, less any related charges, and this amount must be determined using either a stochastic approach, hedging costs or a series of deterministic projections with attributed probabilities.
iii Annuity business The contract liabilities for PAL and PRIL are based on the FSA regulatory solvency basis. The valuation is then modified for IFRS reporting purposes to remove some of the margins for prudence within the assumptions, and contingency reserves, which are required under the solvency basis applied for regulatory purposes, but not for financial accounting.
The contract liabilities are the discounted value of future claim payments, adjusted for investment expenses and future administration costs. The interest rates used for discounting claim payments are derived from the yields on the assets held with an allowance for default risk.
D2: UK insurance operations continued iv Unit-linked (non-annuity) and other non-profit business The majority of other long-term business written in the UK insurance operations is unit-linked business or other business with similar features. For these contracts the attaching liability reflects the unit value obligation and provision for expenses and mortality risk. The latter component is determined by applying mortality assumptions on a basis that is appropriate for the policyholder profile.
For those contracts where the level of insurance risk is insignificant the assets and liabilities arising under the contracts are distinguished between those that relate to the financial instrument liability and acquisition costs and deferred income that relate to the component of the contract that relates to investment management. Acquisition costs and deferred income are recognised consistent with the level of service provision in line with the requirements of IAS 18.
f Reinsurance The Group’s UK insurance business cedes only minor amounts of business outside the Group. During 2007, reinsurance premiums for externally ceded business were £59 million (2006: £58 million) and reinsurance recoverable insurance assets were £335 million (2006: £510 million) in aggregate. The gains and losses recognised in profit and loss for these contracts were immaterial.
For UK insurance operations, the 2007 results have been determined after making changes to mortality assumptions for the annuity business and other assumptions for the WPSF and releasing excess margins in the aggregate liabilities that had previously been set aside as an indirect extra allowance for longevity related risks.
c The effects of the strengthening of other assumptions for the WPSF of £62 million is net of a release of PAL’s expense reserve of £11 million and other additional margins in PAL’s liabilities of £40 million. d The release of projected benefit related margins primarily relates to modelling improvements that have been made during 2007. e The release of investment-related margins includes £48 million in respect of default margins for shareholder-backed business and £199 million for
f A release of expense reserves has been made following recent expense reductions. g This amount reflects the release of other additional margins in the liabilities that are no longer appropriate in light of the explicit strengthening of the mortality assumptions.
For with-profits business, there was no significant change in assumptions in 2006.
In 2006, the FSA made regulatory changes for UK regulated shareholder-backed non-participating business. These changes were confirmed in the December 2006 policy statement PS06/14.
Under IFRS 4, the effect of this change is accounted for as a change in estimate and there was a consequent increase in operating profit based on longer-term investment returns of £46 million.
In addition to the £46 million credit described above, a charge of £4 million was recognised in 2006 for the effect of change of assumption for renewal and termination expenses mainly in respect of PAC.
h Amount, timing and uncertainty of future cash flows from insurance contracts At 31 December 2007, the EEV basis value of in-force business of 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 £5,334 million (2006: £4,835 million). This value has been determined after applying the principles of valuation described in note D1 and the following key assumptions: Risk discount rate for in-force business at the start of the year 7.85 8.0 Pre-tax expected long-term nominal rates of investment return: UK equities 8.55 8.6 Overseas equities 8.1 to 10.2 8.6 to 9.3
– other business 6.25 5.3 Expected long-term rate of inflation 3.2 3.1 Post-tax expected long-term nominal rate of return for the with-profits sub-fund pensions business (where no tax applies) 7.85 7.5 Life business 6.9 6.6 Pre-tax expected long-term nominal rate of return for annuity business:note ii
With-profits sub-fund business For with-profits business (including non-participating business of PAL which is owned by the WPSF) adjustments to liabilities and any related tax effects are recognised in the income statement. However, except for any impact on the annual declaration of bonuses, shareholders’ profit for with-profits business is unaffected. This is because IFRS basis profits for with-profits business, which are determined on the same basis as on preceding UK GAAP, solely reflect one-ninth of the cost of bonuses declared for the year.
Unallocated surplus represents the excess of assets over policyholder liabilities of the fund. As unallocated surplus of the WPSF is recorded as a liability, movements in its value do not affect shareholders’ profits or equity.
The level of unallocated surplus is particularly sensitive to the level of investment returns on the portion of the life fund assets that represents the surplus. The effects for 2007 and 2006 are demonstrated in note D5.
ii Shareholder-backed annuity business Profits from shareholder-backed annuity business are most sensitive to: — the extent to which the duration of the assets held closely matches the expected duration of the liabilities under the contracts. Assuming close matching, the impact of short-term asset value movements as a result of interest rate movements will broadly offset changes in the value of liabilities caused by movements in valuation rates of interest; — actual versus expected default rates on assets held; — the difference between long-term rates of return on corporate bonds and risk-free rates; — the variance between actual and expected mortality experience; — the extent to which expected future mortality experience gives rise to changes in the measurement of liabilities; and — changes in renewal expense levels.
D2: UK insurance operations continued A decrease in assumed mortality rates of one per cent would decrease gross profits by approximately £35 million (2006: £34 million). A decrease in credit default assumptions of five basis points would increase gross profits by £72 million (2006: £64 million). A decrease in renewal expenses (excluding asset management expenses) of five per cent would increase gross profits by £13 million (2006: £14 million). The effect on profits would be approximately symmetrical for changes in assumptions that are directionally opposite to those explained above.
Profits from unit-linked and similar contracts primarily arise from the excess of charges to policyholders, for management of assets under the Company’s stewardship, over expenses incurred. The former is most sensitive to the net accretion of funds under management as a function of new business and lapse and mortality experience. The accounting impact of the latter is dependent upon the amortisation of acquisition costs in line with the emergence of margins (for insurance contracts) and amortisation in line with service provision (for the investment management component of investment contracts). By virtue of the design features of most of the contracts which provide low levels of mortality cover, the profits are relatively insensitive to changes in mortality experience.
iv Shareholder exposure to interest rate risk and other market risk By virtue of the fund structure, product features and basis of accounting described in note D2(c) and (e), the policyholder liabilities of the UK insurance operations are, except for pension annuity business, not generally exposed to interest rate risk. For pension annuity business, liabilities are exposed to fair value interest rate risk. However, the net exposure to the PAC WPSF (for PAL) and shareholders (for liabilities of PRIL and the non-profit sub-fund) is very substantially ameliorated by virtue of the close matching of assets with appropriate duration.
The estimated sensitivity of the UK non-linked shareholder backed business (principally pension annuities business) to a movement in interest rates of one per cent as at 31 December 2007 and 2006 is as follows: Fall of 1% Rise of 1% Fall of 1% Rise of 1%
In addition the shareholder backed portfolio of UK non-linked insurance operations covering liabilities and shareholders’ equity includes equity securities and investment property. Excluding any second order effects on the measurement of the liabilities for future cash flow to the policyholder, a 10 per cent fall in their value would have given rise to a £86 million and £42 million reduction in pre-tax profit for 2007 and 2006. After related deferred tax there would have been a £62 million and £29 million reduction in shareholders’ equity at 31 December 2007 and 2006 respectively.
j Duration of liabilities With the exception of most unitised with-profits bonds and other whole of life contracts the majority of the contracts of the UK insurance operations have a contract term. However, in effect, the maturity term of contracts reflects the earlier of death, maturity, or lapsation. In addition, with-profit contract liabilities as noted in note D2(e) above include projected future bonuses based on current investment values. The actual amounts payable will vary with future investment performance of SAIF and the WPSF.
D2: UK insurance operations continued The tables below show the carrying value of the policyholder liabilities. Separately, the Group uses cash flow projections of expected benefit payments as part of the determination of the value of in-force business when preparing EEV basis results. The tables below also show the maturity profile of the cash flows used for 2007 and 2006 for that purpose for insurance contracts, as defined by IFRS, i.e. those containing significant insurance risk, and investment contracts, which do not.
Profit for the year 300 301 Items recognised directly in equity: Exchange movements (42) (377)
Unrealised valuation movements on securities classified as available-for-sale: Unrealised holding losses arising during the year (231) (208) Less losses included in the income statement (13) 7
Total items of income and expense recognised directly in equity (144) (453)
Total income and expense for the year 156 (152) Transfers to Central companies (122) (91)
Net increase (decrease) in equity 34 (243) Shareholders’ equity at beginning of year 2,656 2,899
In addition, for Jackson, included within the movements in shareholders’ equity is a net reduction in value of Jackson’s debt securities classified as ‘available-for-sale’ under IAS 39 of £244 million. This reduction reflects the effects of widened credit spreads in the US bond market partially offset by the effect of reduced US interest rates and a steepening yield curve. These movements do not reflect defaults or permanent impairments.
Total Book value 18,771 19,466 Net unrealised (loss) gain (136) (246) 110
Included within the movement in unrealised losses for the debt securities of Jackson of £244 million as shown above was a value reduction of £55 million relating to the sub-prime and Alt-A securities as referred to in section G2.
Variable annuity Fixed separate account annuity, GIC US insurance operations assets and and other liabilities business 2007 2006 note i note i Total Total £m £m £m £m
Other non-investment and non-cash assets – 1,651 1,651 1,588 Investments of long-term business and other operations: Financial investments: Equity securities and portfolio holdings in unit trusts 15,027 480 15,507 11,710
Core structural borrowings of shareholder-financed operations – 125 125 127 Operational borrowings attributable to shareholder-financed operations – 591 591 743 Other non-insurance liabilities – 4,288 4,288 4,255
Jackson’s mortgage loan portfolio does not include any single-family residential mortgage loans and is therefore not exposed to the risk of defaults associated with residential sub-prime mortgage loans.
In addition to the policyholder liabilities above, Jackson has entered into a programme of funding arrangements under contracts which, in substance, are almost identical to GICs. The liabilities under these funding arrangements totalled £2,607 million (2006: £2,552 million) and are included in ‘other non-insurance liabilities’ in the balance sheet above.
The following table shows the quality of residential and commercial mortgage-backed securities: Carrying Carrying value value £m £m (unless (unless otherwise otherwise stated) stated)
Included within other debt securities of £1,573 million in the summary shown above are £944 million (2006: £1,133 million) of asset backed securities held directly by Jackson, of which £817 million (2006: £791 million) were NAIC designation 1 and £127 million (2006: £342 million) NAIC designation 2. In addition, other debt securities includes £316 million (2006: £405 million) in respect of securities held by the Piedmont trust entity (see note G1) and £313 million (2006: £485 million) from the consolidation of investment funds managed by PPM America.
D3: US insurance operations continued In addition to the ratings disclosed above, the following table summarises by rating the debt securities held by US insurance operations as at 31 December 2007 using Standard and Poor’s (S&P), Moody’s and Fitch ratings: 2007 £m
S&P – AAA 3,896 S&P – AA+ to AA- 1,187 S&P – A+ to A- 3,657 S&P – BBB+ to BBB- 5,415 S&P – Other 1,113
The amounts within Other which are not rated by S&P, Moody’s or Fitch have the following NAIC classifications: 2007 £m
Included in debt securities are £2,863 million (2006: £2,859 million) of securities which are not quoted on active markets and are valued using valuation techniques.
D3: US insurance operations continued Jackson defines its exposure to sub-prime mortgages as investments in residential mortgage-backed securities in which the underlying borrowers have a US Fair Isaac Credit Organisation (FICO) credit score of 659 or lower.
Fair value of securities as a percentage of book value Fair value Unrealised loss Fair value Unrealised loss
At 31 December 2007, the gross unrealised losses in the balance sheet for the sub-prime and Alt-A securities in an unrealised loss position were £56 million. Sub-prime and Alt-A securities with unrealised losses of £37 million in the balance sheet at 31 December 2007 have been in an unrealised loss position for less than one year with the remaining securities with unrealised losses of £19 million being in an unrealised loss position for more than one year.
The policyholder of an interest-sensitive fixed annuity pays Jackson 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. Jackson makes benefit payments at a future date as specified in the policy based on the value of the policyholder’s account at that date.
The policy provides that at Jackson’s discretion it may reset the interest rate, subject to a guaranteed minimum. The minimum guarantee varies from 1.5 per cent to 5.5 per cent (2006: 1.5 per cent to 5.5 per cent) depending on the jurisdiction of issue and the date of issue, with 80 per cent (2006: 80 per cent) of the fund at three per cent or less. The average guarantee rate is 3.1 per cent (2006: 3.1 per cent).
Approximately 30 per cent (2006: 35 per cent) of the interest-sensitive fixed annuities Jackson wrote in 2007 provide for a market value adjustment, that could be positive or negative, on surrenders in the surrender period of the policy. This formulabased 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.
Fixed indexed annuities Fixed indexed annuities accounted for seven per cent (2006: seven per cent) of Jackson’s policy and contract liabilities at 31 December 2007. Fixed indexed annuities vary in structure, but generally are deferred annuities that enable policyholders to obtain a portion of an equity-linked return (based on participation rates and caps) but provide a guaranteed minimum return. These guaranteed minimum rates are generally set at three per cent.
Immediate annuities At 31 December 2007, immediate annuities accounted for two per cent (2006: two per cent) of Jackson’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 Jackson’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.
Jackson issues VA contracts where it contractually guarantees to the contractholder either a) return of no less than total deposits made to the contract adjusted for any partial withdrawals, b) total deposits made to the contract adjusted for any partial withdrawals plus a minimum return, or c) the highest contract value on a specified anniversary date adjusted for any withdrawals following the contract anniversary. These guarantees include benefits that are payable in the event of death (guaranteed minimum death benefit (GMDB)), annuitisation (guaranteed minimum income benefit (GMIB)), or at specified dates during the accumulation period (guaranteed minimum withdrawal benefit (GMWB)) and guaranteed minimum accumulation benefit (GMAB). Jackson hedges these risks using equity options and futures contracts as described in note D3(d).
Under a funding agreement, the policyholder either makes a lump sum deposit or makes specified periodic deposits. Jackson agrees to pay a rate of interest, which may be fixed but which is usually a floating short-term interest rate linked to an external index. The average term of the funding arrangements is one to two years. Funding agreements terminable by the policyholder with less than 90 days’ notice account for less than one per cent (2006: less than one per cent) of total policyholder reserves.
d Risk management Jackson’s main exposures are to market risk through its exposure to interest rate risk and equity risk. Approximately 90 per cent (2006: 89 per cent) of its general account investments support interest-sensitive and fixed indexed annuities, life business and surplus and 10 per cent (2006: 11 per cent) support institutional business. All of these types of business contain considerable interest rate guarantee features and, consequently, require that the assets that support them are primarily fixed income or fixed maturity.
Prudential is exposed primarily to the following risks in the US arising from fluctuations in interest rates: — The risk of loss related to meeting guaranteed rates of accumulation following a sharp and sustained fall in interest rates; — the risk of loss related to policyholder withdrawals following a sharp and sustained increase in interest rates; and — the risk of mismatch between the expected duration of certain annuity liabilities and prepayment risk and extension risk inherent in mortgage-backed securities.
VA contracts written by Jackson may, as described above, provide for GMDB, GMIB, GMWB and GMAB 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.
The GMDB liability is determined each period end by estimating the expected value of death benefits in excess of the projected account balance and recognising the excess ratably over the life of the contract based on total expected assessments. At 31 December 2007, the GMDB liability was valued using a series of deterministic investment performance scenarios, a mean investment return of 8.4 per cent (2006: 8.4 per cent) and assumptions for lapse, mortality and expense that are the same as those used in amortising the capitalised acquisition costs.
GMIB benefits are essentially fully reinsured, subject to annual claim limits. As this reinsurance benefit is net settled, it is considered to be a derivative under IAS 39 and is, therefore, recognised at fair value with the change in fair value included as a component of short-term derivative fluctuations.
The fair values of the GMWB, GMIB and GMAB reinsurance derivatives are calculated based on actuarial assumptions related to the projected cash flows, including benefits and related contract charges, over the expected lives of the contracts, incorporating expectations regarding policyholder behaviour in varying economic conditions. As the nature of these cash flows can be quite varied, stochastic techniques are used to generate a variety of market return scenarios for evaluation. The generation of these scenarios and the assumptions as to policyholder behaviour involve numerous estimates and subjective judgements, including those regarding expected market volatility, correlations of market returns and discount rates, utilisation of the benefit by policyholders under varying conditions, and policyholder lapsation. At each valuation date, Jackson assumes expected returns based on risk-free rates as represented by the LIBOR forward curve rates as of that date and market volatility as determined with reference to implied volatility data and evaluations of historical volatilities for various indices. The risk-free spot rates as represented by the LIBOR spot curve as of the valuation date are used to determine the present value of expected future cash flows produced in the stochastic process.
D3: US insurance operations continued Certain institutional products representing obligations issued in currencies other than US dollars have been hedged for changes in exchange rates using cross-currency swaps. The fair value of derivatives embedded in funding agreements, as well as foreign currency transaction gains and losses, are included in the carrying value of the trust instruments supported by funding agreements recorded in other non-insurance liabilities.
The operating profit based on longer-term investment returns of £444 million for US insurance operations for 2007 has been determined after taking account of several changes of assumptions during the year. Generally, assumptions were modified in 2007 to conform to more recent experience. These changes included revisions to the assumptions regarding mortality rates, resulting in an increase in operating profits of £14 million, and utilisation of free partial withdrawal options, resulting in a decrease to operating profits of £4 million. In addition, several smaller changes relating to lapse rates and other assumptions resulted in a decrease of £2 million in operating profits. Combined with other minor modifications, the resulting net impact of all changes during the year was an increase in pre-tax profits of £8 million.
h Amount, timing and uncertainty of future cash flows from insurance contracts At 31 December 2007, 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 £1,386 million (2006: £1,320 million). This value has been determined after applying the principles of valuation described in note D1. The key assumptions in these projections are the risk discount rates, which are 8.1 per cent (2006: 8.4 per cent) for variable annuity business and 4.8 per cent (2006: 5.6 per cent) for other business, and the expected ultimate spread between the earned rate and the rate credited to policyholders for single premium deferred annuity business of 1.75 per cent.
The sensitivity of the value of in-force business and net worth to changes in key assumptions is as follows: Economic assumptions: Discount rates – 1% increase (129) (127) 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 – 10% rise 58 46 Equity/property market values – 10% fall (63) (58)
Non-economic assumptions: Maintenance expenses – 10% decrease 30 32 Lapse rates – 10% decrease 123 110 Mortality and morbidity – 5% decrease in base rates (i.e. increased longevity) 74 75
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 Jackson, industry experience and future expectations. A detailed analysis of actual experience is measured by internally developed mortality and persistency studies. For variable annuity business, the key assumption is the expected long-term level of equity market returns, which for 2007 and 2006 was 8.4 per cent per annum implemented using a mean reversion methodology. These returns affect the level of future expected profits through their effects on the fee income and the required level of provision for guaranteed minimum death benefit claims.
— Variations in fees and other income, offset by variations in market value adjustment payments and, where necessary, strengthening of liabilities.
A 10 per cent decrease in their value would have given rise to an estimated £76 million (2006: £66 million) reduction in pre-tax profit, net of related changes in amortisation of DAC, for 2007. After related deferred tax there would have been an estimated £50 million (2006: £43 million) reduction in shareholders’ equity at 31 December 2007. A 10 per cent increase in their value would have an approximately equal and opposite effect on profit and shareholders’ equity.
Pre-tax profit effect Operating profit based on longer-term investment returns (15) (2) 11 1 Short-term fluctuations in investment returns (87) (71) 123 81
Related effect on charge for deferred tax 36 26 (47) (29)
j Duration of liabilities 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 2007 and 2006 is as follows: Fixed Fixed annuity annuity and other and other business business
With-profits Unit-linked operations business assets and 2007 2006 note i liabilities Other Total Total £m £m £m £m £m
Other non-investment and non-cash assets 134 58 570 762 602 Investments of long-term business and other operations: Financial investments: Equity securities and portfolio holdings in unit trusts 4,472 4,728 604 9,804 6,894
Liabilities Policyholder liabilities and unallocated surplus of with-profits funds: Investment contract liabilities with discretionary participation features 84 – – 84 68 Investment contract liabilities without discretionary participation features 37 – – 37 27 Unallocated surplus of with-profits funds 146 – – 146 88
Moody’s – Baa1 to Baa3 12 7 – 19 Moody’s – Other 58 – – 58
Summary policyholder liabilities (net of reinsurance) and unallocated surplus The policyholder liabilities (net of reinsurance of £12 million (2006: £8 million)) and unallocated surplus shown in the table above reflect the following balances: With-profits business 6,397 5,410 Unallocated surplus of Asian with-profit operations 146 88 Unit-linked business 6,971 4,134 Other business 3,653 3,249
Subject to local market circumstances and regulatory requirements, the guarantee features described in note D2(c) in respect of UK business broadly apply to similar types of participating contracts written in the Hong Kong branch, Singapore and Malaysia. Participating products have both guaranteed and non-guaranteed elements.
— Surrender values Surrender values are guaranteed for non-participating products and on the guaranteed portion of participating products. The surrender value of declared reversionary bonuses are also guaranteed once vested.
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 main variable that determines the amounts payable under the contracts is the duration of the contracts, which is determined by death or surrender. The sensitivity of the IFRS result for these contracts is shown in note (h) below.
Whole of life contracts with floor levels of policyholder benefits that accrue at rates set at inception are also written in the Korean life operations, though to a much less significant extent than in Taiwan. The Korean business has non-linked liabilities and linked liabilities at 31 December 2007 of £261 million and £728 million respectively (2006: £226 million and £316 million respectively). The business is much less sensitive to returns than Taiwan with a higher proportion of linked and health business.
D4: Asian insurance operations continued The method for determining liabilities of insurance contracts for UK GAAP, and hence IFRS, purposes for some Asian operations is based on US GAAP principles and this method applies to contracts with cash value and interest rate guarantees. Following standard US GAAP procedure, premium deficiency reserve calculations are performed each year to establish whether the carrying values of the liabilities are sufficient.
c Exposure to market risk The Asian operations sell with-profits and unit-linked policies and, although the with-profits business generally has a lower terminal bonus element than in the UK, the investment portfolio still contains a proportion of equities and, to a lesser extent, property. Non-participating business is largely backed by debt securities or deposits. With the principal exception of Taiwan’s whole of life policy book, as described in note (h) below, the exposure to market risk of the Group arising from its Asian operations is at modest levels. This arises from the fact that the Asian operations have a balanced portfolio of with-profits, unit-linked and other types of business.
f Effect of changes in bases and assumptions used to measure insurance assets and liabilities There are no changes of assumptions that had a material impact on the 2007 and 2006 results of Asian operations.
g Amount, timing and uncertainty of future cash flows from insurance contracts At 31 December 2007, the EEV basis value of in-force business of the Asian operations, after taking account of the cost of encumbered capital and the cost of the time value of financial options and guarantees was £2,770 million (2006: £1,628 million).
The sensitivity of the value of in-force business and net worth to changes in key assumptions is as follows: Economic assumptions: Discount rates – 1% increase (386) (271) 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 – 10% rise 234 154 Equity/property market values – 10% fall (136) (99)
Profit before tax attributable to shareholders (16) (33) 20 34 Profit for the year (10) (21) 13 25 Shareholders’ equity, excluding goodwill, attributable to Asian operations (124) (116) 151 143
iii Other business Taiwan whole of life business – interest rate risk on deferred acquisition costs and policyholders’ liabilities The principal other business of Asian operations is the traditional whole of life business written in Taiwan.
The in-force business of the Taiwan life operation includes traditional whole of life policies where the premium rates have been set by the regulator at different points for the industry as a whole. Premium rates were set to give a guaranteed minimum sum assured on death and a guaranteed surrender value on early surrender based on prevailing interest rates at the time of policy issue. Premium rates also included allowance for mortality and expenses. The required rates of guarantee have fallen over time as interest rates have reduced from a high of eight per cent to current levels of around 2.5 per cent. The current low level of bond rates in Taiwan gives rise to a negative spread for the majority of these policies. The current cash cost of funding in-force negative spread in Taiwan is around £45 million a year.
The adequacy of the liability is also sensitive to the level of the projected long-term rate on bonds. 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 altered, the carrying value of the deferred acquisition costs and policyholder liabilities would potentially be affected.
Interest rate risk for other business excluding Taiwan In addition to the sensitivity of the Taiwan results to the impact of current period and longer-term interest rates on liability adequacy tests, as described above, the other business and solvency capital of Asian operations are also sensitive to the vagaries of routine movements in interest rates.
D4: Asian insurance operations continued Equity price risk The principal holders of equity securities are the Taiwan, Singapore and Vietnam businesses. For the Taiwan and Singapore operations market changes have a direct effect on profit and loss with no matching effect on the carrying value of policyholder liabilities. This is also true for the Vietnam business. However, to the extent that equity investment appreciation is realised through sales of securities then policyholders’ liabilities are adjusted to the extent that policyholders’ participate.
i Duration of liabilities 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: Policyholder liabilities 17,033 12,801
D5: Capital position statement for life assurance businesses a Summary statement The Group’s estimated capital position for life assurance businesses with reconciliations to shareholders’ equity is shown below. Available capital for each fund or group of companies is determined by reference to local regulation at 31 December 2007 and 2006.
Jackson surplus notesnote iv – – – – 125 – 125 Adjustment from IAS 19 basis pension surplus attributable to WPSF to pension liability for regulatory purposesnote vii – (530) (530) – – – (530)
Other liabilities: Insurance contracts: With-profits liabilities of non-UK regulated funds 2,973 2,973
Total policyholder liabilities shown in the consolidated balance sheet 13,620 76,339 89,959 34,378 34,848 17,033 176,218
Total PAC assurance equity of with- subsidiaries Asian life Total life other
WPSF profits and funds assurance assurance 31 December 2006 SAIF note i fund note ii Jackson subsidiaries operations
D5: Capital position statement for life assurance businesses continued b Basis of preparation, capital requirements and management 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.
Determination of the ECR involves the comparison of two separate measurements of the firm’s resources requirement, which the FSA refers to as the ‘twin peaks’ approach.
The two separate peaks are: i the requirement comprised by the mathematical reserves plus the ‘Long-Term Insurance Capital Requirement’ (LTICR), together known as the ‘regulatory peak’; and ii a calculation of the ‘realistic’ present value of the insurer’s expected future contractual liabilities together with projected ‘fair’ discretionary bonuses to policyholders, plus a risk capital margin, together known as the ‘realistic peak’.
As noted in section D2(e)(ii), PAC has discretion in its management actions in the case of adverse investment conditions. Management actions encompass, but are not confined to, investment allocation decisions, levels of reversionary bonuses, crediting rates and total claim values. To illustrate the flexibility of management actions, rates of regular bonus are determined for each type of policy primarily by targeting them at a prudent proportion of the long-term expected future investment return on the underlying assets. The expected future investment return is reduced as appropriate for each type of policy to allow for items such as expenses, charges, tax and shareholders’ transfers. However, the rates declared may differ by product type, or by date of payment of the premiums or date of issue of the policy, if the accumulated annual bonuses are particularly high or low relative to a prudent proportion of the achieved investment return.
Other UK life assurance subsidiaries and funds The available capital of £982 million (2006: £903 million) reflects the excess of regulatory basis assets over liabilities of the subsidiaries and funds, before deduction of the capital resources requirement of £841 million (2006: £809 million).
Vietnam Mathematical reserves are calculated using a modified net premium approach, using a stable set of assumptions agreed with the regulator.
The capital requirement is determined as four per cent of reserves plus a specified percentage of sums at risk of 0.1 per cent of sums at risk for policies with original term less than or equal to five years or 0.3 per cent of sums at risk for policies with original term more than five years.
Korea Policy reserves for traditional business are determined on net premium reserve basis using pricing mortality and prescribed standard interest rates.
For linked business, the value of units is held together with the non-unit reserves calculated in accordance with regulatory standard actuarial methodology.
The capital requirement in Korea is determined as four per cent of the policy reserves and expected claims after reinsurance. Insurance companies in Korea are expected to maintain a level of free surplus in excess of the capital requirements with the usual level of solvency margin being around 200 per cent of the required capital.
Changes in management policy – – – 12 12 Changes in regulatory requirements – – (7) – (7) New business and other factors 367 112 175 47 701
Detail on the movement for 2006 is as follows: 2006 £m
Changes in management policy – – – – – Changes in regulatory requirements – 80 – – 80 New business and other factors 648 67 (174) (2) 539
ii Jackson The increase of £168 million in 2007 reflects an underlying increase of £203 million (applying the 2007 year end exchange rate of 1.99) and £35 million of exchange translation loss.
D5: Capital position statement for life assurance businesses continued f Intra-group arrangements in respect of SAIF Should the assets of SAIF be inadequate to meet the guaranteed benefit obligations to the policyholders of SAIF, the PAC long-term fund would be liable to cover any such deficiency.
Asset management in the US is undertaken through PPM America which manages assets for the Group’s US, UK and Asian affiliates plus also provides investment services to other affiliated and unaffiliated institutional clients including CDOs, private investment funds, institutional accounts and mutual funds. In addition, broker-dealer activities are undertaken in the US where trades in securities are carried out for both third party customers and for its own account.
Other operations covers unallocated corporate activities and includes the head office functions.
Assets Intangible assets: Deferred acquisition costs 6 – – 6 6
Liabilities Intra Group debt represented by operational borrowings at Group levelnote iv 2,477 – – 2,477 2,032 Net asset value attributable to external holders of consolidated fundsnote iii 1,234 – – 1,234 513
iv Intra Group debt represented by operational borrowings at Group level Operational borrowings for M&G are in respect of Prudential Capital’s short-term fixed income security programme and comprise £2,422 million of commercial paper and £55 million of medium-term notes.
ii Other sensitivities to other financial risks for asset management operations The principal sensitivities to other financial risk of asset management operations are credit risk on the bridging loan portfolio (as described in note E2) of M&G’s Prudential Capital operation and the indirect effect of changes to market values of funds under management. Due to the nature of the asset management operations there is limited direct sensitivity to movements in interest rates. Total debt securities held at 31 December 2007 by asset management operations were £882 million (2006: £678 million), the majority of which are held by the Prudential Capital operation of M&G. Debt securities held by M&G are in general variable rate bonds and so market value is limited in sensitivity to interest rate movements and consequently any change in interest rates would not have a material impact on profit or shareholder’s equity. Asset management operations do not hold significant investments in property or equities.
Asset management (1,053) (797) Unallocated corporate (363) (135) Intra group charges eliminated on consolidation 268 284
F1: Segmental information continued Secondary segment information Although the Company is UK registered, the Group manages its business on a global basis. The operations are based in three main geographical areas: UK, US and Asia.
Long-term business premiums Insurance contract premiums 17,308 13,805 Investment contracts with discretionary participation feature premiums 874 1,249 Inwards reinsurance premiums 177 1,103 Less: reinsurance premiums ceded (171) (171)
Realised and unrealised gains and losses on securities at fair value through profit and loss 2,630 5,964 Realised and unrealised gains and losses on derivatives at fair value through profit and loss 270 932 Realised gains and losses on available-for-sale securities, previously recognised directly in equity 13 (7) Realised gains and losses on loans 47 (3) Interestnotes i,ii 5,857 5,827
Notes i Interest income is calculated on the effective interest rate method for all financial assets that are not at fair value through profit and loss. ii Interest income includes £2 million (2006: £3 million) accrued in respect of impaired securities. iii Fee income includes £31 million (2006: £34 million) relating to financial instruments that are not held at fair value through profit and loss.
These fees primarily related to prepayment fees, late fees and syndication fees.
Acquisition costsnotes i,ii 1,030 1,238 Staff and pension costsI1 1,070 647 Administrative and operating costsnote iii 2,423 2,327
iii Administrative and operating costs include total depreciation and amortisation expense amounting to £523 million (2006: £516 million). Of this amount, £413 million (2006: £305 million) relates to amortisation of deferred acquisition costs of insurance contracts and asset management contracts, which is primarily borne by the long-term business segment. Of the remainder of the depreciation and amortisation charge of £110 million (2006: £167 million), £98 million (2006: £156 million) relates to long-term business, £8 million (2006: £8 million) to asset management and £4 million (2006: £3 million) to other operations.
F5: Tax a Total tax expense by nature of expense An analysis of the total tax expense of continuing operations recognised in the income statement by nature of expense (benefit) is as follows: Current tax expense: Corporation tax 806 688 Adjustments in respect of prior years (185) (34)
Deferred tax arising from: Origination and reversal of temporary differences (170) 556 (Benefit) expense from a previously unrecognised tax loss, tax credit or temporary difference from a prior period (50) 31
The total tax expense arises as follows: Current tax expense: Deferred tax (credit) expense:
In April 2008 the standard corporation tax rate for the UK will change from 30% to 28%. Deferred tax at the end of 2007 for UK operations has been provided at the new rate of 28 per cent on the basis that materially all of the temporary differences are expected to reverse once the new rate has taken effect. The effect on the deferred tax assets and liabilities at 31 December 2007 was £20 million.
In 2007, a deferred tax credit of £54 million (2006: £41 million) has been taken directly to reserves. Other movements in deferred tax totalling £46 million credit mainly comprise of foreign exchange losses and as a result of the disposal of operations. When these amounts are taken with the deferred tax credit shown above, the result is a decrease of £320 million in the Group’s net deferred tax liability (2006: increase of £546 million).
In 2007, there is a tax credit of £19 million relating to discontinued banking operations (2006: £45 million) (see note J1).
b Reconciliation of effective tax rate The total tax expense is attributable to shareholders and policyholders as summarised in the income statement.
Profit before tax attributable to shareholders 1,166 1,372 Tax attributable to shareholders’ profits: Tax expense (401) (1,241) Less: tax attributable to policyholders’ returns 19 849
Taxation charge: Variance from expected tax charge (note v(ii)) (26) – (26) 26 – 26 *For the column entitled ‘Attributable to policyholders’, the profit before tax represents income, net of post-tax transfers to unallocated surplus of with-profits funds, before tax attributable to policyholders and unallocated surplus of with-profits funds and unit-linked policies.
F5: Tax continued Due to the requirements of the financial reporting standards IAS 1 and IAS 12, the profit before tax and tax charge reflect the aggregate of amounts that are attributable to shareholders and policyholders.
The combined effect of these features is such that providing a reconciliation of the tax charge attributable to policyholders to an expected charge based on the standard corporate rate of tax on IFRS basis profits attributable to policyholders is not relevant.
Notes on the Group financial statements F: Income statement notes continued
F5: Tax continued v Reconciliation of tax charge on profits attributable to shareholders 2007 £m
Operating profit based on longer-term investment returnsnote iii (25) 22 (12) 1 (14)
Short-term fluctuations in investment returns 12 7 1 6 26 Shareholders’ share of actuarial and other gains and losses on defined benefit pension schemes – – – (25) (25)
iii Operating profit based on longer-term investment returns is net of attributable restructuring costs and development expenses.
Operating profit based on longer-term investment returnsnote iii 23 5 (10) 4 22
Egg Banking plc. Comparative results for 2006 have been adjusted accordingly from those previously published.
Financial assets Cash and cash equivalents – – 4,951 4,951 4,951
Fair value through Total profit Amortised IFRS 4 carrying and loss cost basis value value Fair value
Financial assets Cash and cash equivalents – – 5,071 5,071 5,071
Fair value through Total profit Available- Loans and carrying and loss for-sale receivables value Fair value 2006 £m
The estimated fair value of derivative financial instruments reflects the estimated amount the Group would receive or pay in an arm’s length transaction. This amount is determined using quotations from independent third parties or valued internally using standard market practices. In accordance with the Group’s risk management framework, all internally generated valuations are subject to independent assessment against external counterparties’ valuations.
The fair value of borrowings is based on quoted market prices, where available. Refer to section A4 for the determination of fair value for investment contracts without fixed and guaranteed terms (notably
These debt securities include 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. The majority of the debt securities above are valued using matrix pricing, which is based on assessing credit quality of the underlying borrower to derive a suitable discount rate relative to government securities. Under matrix pricing, the debt securities are priced by taking the credit spreads on comparable quoted public debt securities and applied to the equivalent debt instruments factoring a specified liquidity premium. The majority of the parameters used in this valuation technique are readily observable in the market and, therefore, are not subject to interpretation.
Whilst management believes that the estimates and assumptions employed in developing the fair value estimates are reasonable and present management’s best estimate of such values, a reasonable range of values exists with respect to most assumptions utilised in determining these values. As a result of the potentially significant variability in the estimates of the assumptions used in these models, the range of reasonable estimates of the fair value of these securities is significant.
The total amount of the change in fair value estimation using valuation techniques, including valuation techniques based on assumptions not wholly supported by observable market prices or rates, recognised in the income statement in 2007 was a gain of £101 million (2006: gain of £47 million) for the with-profits fund investments. Changes in values of assets of the with-profits funds are reflected in policyholder liabilities and unallocated surplus. Due to the liability accounting treatment of unallocated surplus, changes in values of securities held by with-profits funds have no direct effect on the profit or loss attributable to shareholders or shareholders’ equity.
The total amount of the change in fair value estimation using valuation techniques, including those based on assumptions not wholly supported by observable market prices or rates, recognised in the income statement in 2007 and which was attributable to shareholders, was a gain of £138 million (2006: gain of £68 million) for the PRIL and US investments.
The interest expense on financial liabilities not at fair value through profit and loss for the year ended 31 December 2007 from continuing operations was £842 million (2006: £890 million).
Borrowings attributable to with-profits funds 1,486 219 71 1,776 – 1,776 Obligations under funding, securities lending and sale and repurchase agreements 851 3,381 – 4,232 – 4,232 Investment contracts without discretionary
Obligations under funding, stocklending and sale and repurchase agreements 4,081 – – – – – – 4,081 2006 £m
Total After After After After undis1 year 1 year to 5 years to 10 years to 15 years to Over counted or less 5 years 10 years 15 years 20 years 20 years value 2006 £bn
Total After After After After undis1 year 1 year to 5 years to 10 years to 15 years to Over counted or less 5 years 10 years 15 years 20 years 20 years value
The maturity profile above excludes certain corporate unit-linked business with gross policyholder liabilities of £8 billion which has no stated maturity.
Credit risk Of the total loans and receivables held £5 million (2006: £137 million) are past their due date but have not been impaired, with £5 million (2006: £20 million) relating to continuing operations and £nil (2006: £117 million) to discontinued banking operations. Of the total past due but not impaired, £5 million (2006: £122 million) are less than one year past their due date and £nil (2006: £15 million) between two years and three years past their due date. The Group expects full recovery of these loans and receivables. Financial assets that would have been past due or impaired had the terms not been renegotiated amounted to £nil (2006: £19 million).
Details with regards to loans and advances to customers by discontinued banking operations are provided in note J5. In addition, during the year the Group took possession of £7 million (2006: £7 million) of other collateral held as security, which mainly consists of assets that could be readily convertible into cash.
Group exposure to holdings in sub-prime and Alt-A assets, monoline insurers and CDO funds Included in the total of debt securities of £83,984 million at 31 December 2007 are the following holdings: i Sub-prime and Alt-A securities
Further details on Jackson’s sub-prime and Alt-A securities are given in section D3(b)
The holdings of UK insurance operations are primarily in PFI and utility stocks.
US insurance operations (65% AAA, 8% AA)* 260 Asian insurance operations (72% AAA, 28% AA-) 62 UK insurance operations – PRIL (AAA) 36 Other operations (AAA) 19
UK insurance operations (79% AAA, 8% AA) Asian operations (AAA) 240
Total 676 *Including the Group’s economic interest in Piedmont (as described in section G1) and other consolidated CDO funds.
The financial liabilities, of which 19 per cent (2006: 14 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 (note G3 below).
The amount of exchange gains recognised in the income statement in 2007, except for those arising on financial instruments measured at fair value through profit and loss, is £102 million (2006: £73 million). This constitutes £109 million (2006: £107 million) gains on Medium Term Notes (MTN) liabilities and £7 million of net losses (2006: £34 million net losses), mainly arising on investments of the PAC with-profits fund. The gains on MTN liabilities are fully offset by value movements on cross-currency swaps, which are measured at fair value through profit and loss.
Derivatives 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.
UK Other Total insurance US continuing continuing operations operations operations operations 2006 £m
The above derivative assets and derivative liabilities are included in ‘other investments’ and ‘other liabilities’ in the primary statements.
Inflation swaps 1,758 1,319 – – Credit default swaps 4,181 59 – – Single stock options – – – – Credit derivatives – – 3 20 Put options – – 3,642 – Equity options – – 5,545 11 FTSE swap – – – – Total return swaps 956 955 226 –
As at 31 December 2006 Asset Liability Asset Liability Asset Liability
G3: Derivatives and hedging continued As part of the efficient portfolio management of the PAC with-profits fund, the fund may, from time to time, invest in cash-settled forward contracts over Prudential plc shares, which are accounted for consistently with other derivatives. This is in order to avoid a mismatch of the with-profits investment portfolio with the investment benchmarks set for its equity-based investment funds. The contracts will form part of the long-term investments of the with-profits fund. These contracts are subject to a number of limitations for legal and regulatory reasons.
For the purpose of reducing currency risk, Egg used forward exchange contracts and currency swaps.
Hedging The Group has formally assessed and documented the effectiveness of the following hedges under IAS 39: Fair value hedges The Group uses interest rate derivatives to hedge the interest exposures on its US$1 billion, 6.5 per cent perpetual subordinated capital securities and US$300 million, 6.5 per cent perpetual subordinated capital securities. Where the hedge relationship is de-designated and re-designated, the fair value adjustment to the hedged item up to the point of de-designation continues to be reported as part of the basis of the hedged item and is amortised to the income statement based on a recalculated effective interest rate over the residual period to the first break clause date of the perpetual subordinated capital securities.
Cash flow hedges Following the sale of Egg in 2007, the Group has no cash flow hedges in place. In 2006 Egg had cash flow hedged certain balance sheet items which were subject to interest rate risk using interest rate and cross currency interest rate swaps, with the effective part of any gain or loss on the swaps recognised directly in equity. As at 31 December 2006, the notional amount of the cash flow hedge was £1,711 million and the fair value was an asset of £9 million. The cash flows were periodically updated based on the underlying banking portfolios. There was no ineffective portion of the cash flow hedge recognised in the income statement in 2006.
Securities lending and reverse repurchase agreements The Group has entered into securities lending (including repurchase agreements) whereby blocks of securities are loaned to third parties, primarily major brokerage firms. The amounts above the fair value of the loaned securities required to be held as collateral by the agreements depend on the quality of the collateral, calculated on a daily basis. The loaned securities are not removed from the Group’s consolidated balance sheet, rather they are retained within the appropriate investment classification. Collateral typically consists of cash, debt securities, equity securities and letters of credit. At 31 December 2007, the Group had lent £17,172 million (2006: £11,418 million) (of which £11,461 million (2006: £7,592 million) was lent by the PAC with-profits fund) of securities and held collateral under such agreements of £18,125 million (2006: £11,814 million) (of which £12,105 million (2006: £7,934 million) was held by the PAC with-profits fund).
The impairment losses have been recorded in ‘acquisition costs and other operating expenditure’ in the income statement. In 2007, the Group realised gross losses on sales of available-for-sale securities of £86 million (2006: £58 million). 46 per cent
M&G The recoverable amount for the M&G CGU has been determined by calculating its value in use. This has been calculated by aggregating the present value of future cash flows expected to be derived from the component businesses of M&G (based upon management projections) and its current surplus capital.
Notes on the Group financial statements H: Other information on balance sheet items
H1: Intangible assets attributable to shareholders continued Japanese life company The aggregate goodwill impairment of £120 million at 31 December 2007 and 2006 relates to the goodwill held in relation to the Japanese life operation which was impaired in 2005.
Deferred acquisition costs related to insurance contracts attributable to shareholders The movement in deferred acquisition costs relating to insurance contracts attributable to shareholders is as follows: Deferred acquisition costs at 1 January 2,315 2,200
Deferred acquisition costs related to investment management contracts attributable to shareholders Incremental costs associated with the origination of investment management contracts written by the Group’s insurance and asset management businesses are capitalised and amortised as the related revenue is recognised. Deferred acquisition costs related to investment management contracts are all internally generated.
The present value of future profits of acquired asset management contracts relates to unit-linked contracts acquired as part of the M&G acquisition in 1999.
All goodwill figures shown above reflect the cost. These have no impairment losses or other write-offs. All goodwill additions relate to the UK and the long-term business segments. Following the sale by the Group of PPM Capital in November 2007, the Group no longer controls venture fund investments and consequently has ceased to consolidate these operations, with these carried as investments of long-term business at fair value through profit and loss going forwards. Additional details on the changes in consolidated entities are provided in note I6.
Management believes that any reasonable change in the key assumptions would not have given rise to an impairment charge.
Assets Of the £285 million (2006: £404 million) current tax recoverable, the majority is expected to be recovered in one year or less.
Unprovided deferred income tax liabilities on temporary differences associated with investments in subsidiaries, associates and interests in joint ventures are considered to be insignificant due to the availability of various UK tax exemptions and reliefs.
Other debtors Surplus in respect of PSPS defined benefit pension schemes:I1*
Net surplus after elimination of investments in Prudential insurance policies and matching policyholder liability from Group balance sheet 388 –
Of the £3,320 million (2006: £2,952 million) of accrued investment income and other debtors, £452 million (2006: £800 million) is expected to be settled after one year or more.
Reclassification from held for investment – 268 – 268 – 268
Reclassification from held for investment – 120 – 120 – 120 Reclassification from held for sale – 8 – 8 – 8
Net (loss) gains from fair value adjustments (1,128) 813 Net foreign exchange differences 14 (42) Transfers to held for sale assets (25) (32) Transfers to development properties (121) (268)
arising from investment properties: That generated rental income during the year 117 118 That did not generate rental income during the year – 8
H7: Investment properties continued Investment properties of £3,665 million (2006: £4,990 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: Future minimum lease payments at 31 December 979 400 Future finance charges on finance leases (877) (325)
The present values of these minimum lease payments are: Less than 1 year 5 3
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: Less than 1 year 679 658
Associates carried at fair value through profit and loss 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 2007 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 (2006: £2 billion) at 31 December 2007.
The summarised financial data for the Group’s share of investments in joint ventures is as follows: Financial position Current assets 1,277 91 Non-current assets 173 638
During 2006, ICICI Prudential Life Insurance Company Limited invested its own capital of £1.4 million into the joint venture to fund the operational needs of the business.
As at 31 December 2006, one venture subsidiary, Pharmacia Diagnostics, was classified as held for sale. The disposal of this subsidiary was completed on 18 January 2007.
Gains on disposal of held for sale assets and liabilities are recorded in ‘investment income’ within the income statement. Major classes of assets and liabilities held for sale are as follows: Assets Goodwill – 138 Intangible assets – 112 Property, plant and equipment – 48 Other assets – 105 Investment properties 30 60
H10: Cash and cash equivalents Cash and cash equivalents consist of cash in hand, balances with banks, and certain short-term deposits and debt instruments. Cash and cash equivalents included in the cash flow statement comprise the following balance sheet amounts: Cash equivalents 423 260
Cash and cash equivalents held in the parent company and finance subsidiaries are considered to be available for use by the Group. These funds amount to £339 million and £437 million in 2007 and 2006, respectively. The remaining amounts, generally not available for use by the Group, include cash and cash equivalents held for the benefit of policyholders and, in 2006, loans and advances to banks held by Egg.
The cost of own shares of £60 million as at 31 December 2007 (2006: £79 million) is deducted from retained earnings. The Company has established trusts to facilitate the delivery of shares under employee incentive plans and savings-related share option schemes. At 31 December 2007, 6.6 million (2006: 7.5 million) Prudential plc shares with a market value of £47 million (2006: £52 million) were held in such trusts. In 2007, the Company purchased 1.2 million (2006: 2.3 million) shares in respect of employee incentive plans at a cost of £9 million (2006: £15 million). The maximum number of shares held in the year was 8.5 million which was at the beginning of the year. Of this total, 5.1 million (2006: 4.8 million) shares were held in trusts under employee incentive plans.
Of the total shares held in trust, 1.5 million (2006: 2.7 million) shares were held by a qualifying employee share ownership trust. These shares are expected to be fully distributed in the future on maturity of savings-related share option schemes at a weighted average exercise price of 274 pence (2006: 303 pence).
The hedging reserve consists of the portion of the cash flow hedge that is determined to be an effective hedge, net of related tax. The available-for-sale reserve includes gains or losses arising from changes in fair value of available-for-sale securities, net of related tax.
Income and expense included in the income statement 7,811 2,296 Foreign exchange translation differences (5,034) (27)
Income and expense included in the income statement 9,590 760 Foreign exchange translation differences (167) (8)
Central companies Subordinated debt: ¤500m 5.75% Subordinated Notes 2021note i 365 365 335 ¤20m Medium-Term Subordinated Notes 2023note ii 15 15 13
Senior debt: US operations US$250m 8.15% Surplus Notes 2027note vi 125 125 127
– – – – 451 *These debt classifications are consistent with the treatment of capital for regulatory purposes, as defined in the FSA Handbook. † The senior debt ranks above subordinated debt in the event of liquidation.
In January 2008, this was swapped back into fixed rate payments at 6.5 per cent. iv The US$250 million 6.75 per cent borrowings and the US$300 million 6.5 per cent borrowings can be converted, in whole or in part, at the Company’s option and subject to certain conditions, on any interest payment date falling on or after 23 March 2010 and 23 March 2011 respectively, into one or more series of Prudential preference shares.
vi The Surplus Notes are unsecured and subordinated to all present and future indebtedness, policy claims and other creditor claims of the US operations.
vii Maturity analysis The following table sets out the maturity analysis of the Group’s core structural borrowings: £m £m
Total continuing operations 3,081 2,790 Discontinued banking operationsnote v – 2,819
The interest rate on this debt is variable based on a market rate and was 4.45 per cent at 31 December 2007. iii In 2006, this constituted senior and subordinated notes and mortgage loans. During 2007, the notes were repaid. iv Piedmont is an investment trust investing in certain asset-backed and mortgage-backed securities in the US. These borrowings pertain to debt instruments issued to external parties.
The following table sets out the maturity analysis of the Group’s borrowings attributable to with-profits funds: £m £m
(Surplus) deficit, gross of deferred tax, based on scheme assets held, including investments in Prudential insurance policies: Attributable to PAC with-profits fund (i.e. absorbed by the liability for unallocated surplus) 27 (73) Attributable to shareholder-financed operations (i.e. to shareholders’ equity) 54 8
Provision after elimination of investments in Prudential insurance policies and matching policyholder liability from Group balance sheet 253 222
Restructuring provisions Restructuring provisions of £35 million (2006: £76 million) comprise £35 million (2006: £72 million) relating to restructuring activity of UK insurance operations and £nil (2006: £4 million) relating to discontinued banking operations.
H14: Provisions and contingencies continued UK restructuring In 2004 and 2005, Prudential implemented restructurings relating to document management review, streamlining operations, and the relocation of activities to an offshore base in India. In December 2005, the Group announced an initiative for UK insurance operations to work more closely with Egg and M&G and in the process facilitate the realisation of substantial annualised pre-tax cost savings and opportunities for revenue synergies.
During 2007, an additional provision of £21 million was provided, £14 million of unused provision was released, and £44 million was paid.
On 28 November 2007 Prudential UK announced it had entered into a partnership agreement with Capita Group Plc (‘Capita’) to outsource a large proportion of its in-force and new business policy administration. Under the terms of the proposed agreement, Capita will provide customer servicing, policy administration, new business processing, claims activity and related IT support to Prudential UK.
Pension mis-selling review In 1988, the UK government introduced new pensions legislation intended to encourage more individuals to make their own arrangements for their pensions. During the period from April 1988 to June 1994, many individuals were advised by insurance companies, Independent Financial Advisers and other intermediaries to not join, to transfer from or to opt out of their occupational pension schemes in favour of private pension products introduced under the UK Income and Corporation Taxes Act 1988. The UK insurance regulator (previously the Personal Investment Authority, now the FSA), subsequently determined that many individuals were incorrectly advised and would have been better off not purchasing the private pension products sold to them. Industry participants are responsible for compensating the persons to whom private pensions were mis-sold. As a result, the FSA required that all UK life insurance companies review their potential cases of pension mis-selling and pay compensation to policyholders where necessary and, as a consequence, record a provision for the estimated costs. The Group met the requirement of the FSA to issue offers to all cases by 30 June 2002.
H14: Provisions and contingencies continued The table below summarises the change in the pension mis-selling provision for the years ended 31 December 2007 and 2006. The change in the provision is included in benefits and claims in the income statement and the movement in unallocated surplus of with-profits funds has been determined accordingly.
The liability accounting for the contracts which are the subject of the mis-selling provision is reflected in two elements, namely the core policyholder liability determined on the basis applied for other contract liabilities and the mis-selling provision. The overall liability for these contracts remains appropriate in the context of the accounting for policyholder liabilities that determines the calculation of both elements. However, the constituent elements are reallocated and remeasured for the changes arising from the application of the realistic Peak 2 basis of liabilities for the core policyholder liability, as reflected in the IFRS policy improvement to apply the UK GAAP standard FRS 27 as described in section A4.
H14: Provisions and contingencies continued This review was completed on 30 June 2002. The assurance will continue to apply to any policy in force at 31 December 2003, both for premiums paid before 1 January 2004, and for subsequent regular premiums (including future fixed, RPI or salary related increases and Department of Work and Pensions rebate business). The assurance has not applied to new business since 1 January 2004. New business in this context consists of new policies, new members to existing pension schemes plus regular and single premium top-ups, transfers and switches to existing arrangements. The maximum amount of capital support available under the terms of the assurance will reduce over time as claims are paid on the policies covered by it.
The Group is exposed to mortgage endowment products in respect of policies issued by Scottish Amicable Life plc (SAL) and policies issued by Scottish Amicable Life Assurance Society (SALAS) which were transferred into SAIF. At 31 December 2007, provisions of £5 million (2006: £5 million) in SAL and £43 million (2006: £45 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.
Other matters Inherited estate of the PAC long-term fund The assets of the main with-profits fund within the long-term fund of PAC comprise the amounts that it expects to pay out to meet its obligations to existing policyholders and an additional amount used as working capital. The amount payable over time to policyholders from the 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 PAC’s long-term insurance fund. This enables PAC 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.
H14: Provisions and contingencies continued Given the size of the Group’s with-profits business any proposal is likely to be time consuming and complex to implement and is likely to involve a payment to policyholders from shareholders’ funds. If a reattribution is completed, the inherited estate will continue to provide working capital for the long-term insurance fund.
Support for long-term business funds by shareholders’ funds As a proprietary insurance company, the Group is liable to meet its obligations to policyholders even if the assets of the long-term funds are insufficient to do so. The assets, represented by the ‘unallocated surplus of with-profits funds’, in excess of amounts expected to be paid for future terminal bonuses and related shareholder transfers (the excess assets) in the long-term funds could be materially depleted over time by, for example, a significant or sustained equity market downturn, costs of significant fundamental strategic change or a material increase in the pension mis-selling provision. In the unlikely circumstance that the depletion of the excess assets within the long-term fund was such that the Group’s ability to satisfy policyholders’ reasonable expectations was adversely affected, it might become necessary to restrict the annual distribution to shareholders or to contribute shareholders’ funds to the long-term funds to provide financial support.
The Group has provided other guarantees and commitments to third parties entered into in the normal course of business but the directors do not consider that the amounts involved are significant.
Creditors arising from direct insurance and reinsurance operations 538 521 Interest payable 76 89 Derivative liabilities 1,080 510 Other items 177 378
Venture fund investment subsidiaries of the PAC with-profits fund (see below) 21,184 8,898
Total for continuing operations 1,070 647 Discontinued banking operations 21 76
Of the £423 million (2006: £230 million) costs of employment for venture fund investment subsidiaries, £349 million (2006: £189 million) relates to wages and salaries, £70 million (2006: £27 million) relates to social security costs and £4 million (2006: £14 million) relates to pension costs. Following the change of control arrangements put in place at the same time as the sale by the Group of PPM Capital in November 2007, the Group no longer controls those venture fund investment subsidiaries managed by the sold entity and consequently has ceased to consolidate these operations subsequent to this, with the average number of staff employed and costs of employment for 2007 detailed above reflecting the period prior to disposal.
Of the £21 million (2006: £76 million) costs of employment for discontinued banking operations, £18 million (2006: £64 million) relates to wages and salaries, £2 million (2006: £7 million) relates to social security costs and £1 million (2006: £5 million) relates to pension costs.
b Pension plans i Defined benefit plans 1 Summary The Group business operations operate a number of pension schemes. The specific features of these plans vary in accordance with the regulations of the country in which the employees are located, although they are, in general, funded wholly by the Group and based either on a cash balance formula or on years of service and salary earned in the last year or years of employment. The largest defined benefit scheme is the principal UK scheme, namely the Prudential Staff Pension Scheme (PSPS). Eighty-seven per cent (2006: 88 per cent) of the liabilities of the Group defined benefit schemes are accounted for within PSPS.
Defined benefit schemes in the UK are generally required to be subject to full actuarial valuation every three years to assess the appropriate level of funding for schemes having regard to their commitments. These valuations include assessments of the likely rate of return on the assets held within the separate trustee administered funds. PSPS was last actuarially valued as at 5 April 2005 and this valuation demonstrated the scheme to be 94 per cent funded, with a shortfall of actuarially determined assets to liabilities of six per cent, representing a deficit of £243 million.
The finalisation of the valuation as at 5 April 2005 was accompanied by changes to the basis of funding for the scheme with effect from that date. Deficit funding amounts designed to eliminate the actuarial deficit over a 10 year period have been and are being made based on that valuation. Total contributions to the Scheme for deficit funding and employer’s contributions for ongoing service for current employees are expected to be of the order of £70-75 million per annum over a 10-year period. In 2007, total contributions for the year including expenses and augmentations were £82 million (2006: £137 million). The 2006 amount reflected an increased level of contributions for ongoing service and deficit funding backdated to 6 April 2005 including expenses and augmentations.
2 Corporate Governance The rules of the Group’s largest pension arrangement, the defined benefit section of PSPS, a final salary scheme, specify that, in exercising its investment powers, the Trustee’s objective is to achieve the best overall investment return consistent with the security of the assets of the scheme. In doing this, regard is had to the nature and duration of the scheme’s liabilities. The Trustee sets the benchmark for the asset mix, following analysis of the liabilities by the Scheme’s Actuary and, having taken advice from the Investment Managers, then selects benchmark indices for each asset type in order to measure investment performance against a benchmark return.
I1: Staff and pension plans continued The Trustee sets the general investment policy and specifies any restrictions on types of investment and the degrees of divergence permitted from the benchmark, but delegates the responsibility for selection and realisation of specific investments to the Investment Managers. In carrying out this responsibility, the Investment Managers are required by the Pensions Act 1995 to have regard to the need for diversification and suitability of investments. Subject to a number of restrictions contained within the relevant asset management agreements, the Investment Managers are authorised to invest in any class of investment asset. However, the Investment Managers will not invest in any new class of investment asset without prior consultation with the Trustee.
The tables used for PSPS at 31 December 2007 were: Male: 100 per cent PMA92 with CMIR17 improvements to the valuation date and medium cohort improvements subject to a floor of 1.75% up to the age of 90, decreasing linearly to zero by age of 120 (2006: 100 per cent PMA92 with CMIR17 improvements to the valuation date and medium cohort improvements in future); and Female: 100 per cent PFA92 with CMIR17 improvements to the valuation date and 75% medium cohort improvements subject to a floor of 1% up to the age of 90 and decreasing linearly to zero by age of 120 (2006: 100 per cent PFA92 with CMIR17 improvements to the valuation date and medium cohort improvements in future).
The assumed life expectancies on retirement at age 60, based on the mortality table used was: 2007 Years 2006 Years
M&G scheme, and internal advice for the Scottish Amicable scheme, the most recent full valuations have been updated to 31 December 2007, applying the principles prescribed by IAS 19.
5 Group economic financial position The economic financial position of the defined benefit pension schemes reflects the total assets of the schemes including investments in Prudential policies. This is to be contrasted with the IAS 19 basis assets of the PSPS and M&G schemes, as consolidated into the Group balance sheet, which exclude investments in Prudential insurance policies which on the financial statement presentation are offset against policyholder liabilities.
i The surplus or deficits on the PSPS and Scottish Amicable schemes are partially attributable to the PAC with-profits fund; and ii The M&G pension scheme has invested £172 million at 31 December 2007 (2006: £161 million) in Prudential insurance policies. Additionally, the PSPS scheme has invested £140 million at 31 December 2007 (2006: £126 million) in Prudential insurance policies. As required by IFRS, this amount of scheme asset is eliminated against the policyholder liability and hence, for the purposes of preparing the consolidated balance sheet, the IAS 19 basis net pension asset (liability) is £312 million (2006: £287 million) lower than the ‘economic basis’ surplus of £447 million (2006: ‘economic basis’ surplus of £65 million).
On the ‘economic basis’, after including the underlying assets represented by the investments in Prudential insurance policies as scheme assets, the balance sheets of the schemes at 31 December were: Other Other schemes schemes
I1: Staff and pension plans continued The movements in the surplus (deficit) on the ‘economic basis’ between scheme assets and liabilities were: Current service cost (58) (69)
Charge to operating results (based on longer-term Actuarial gains Contributions investment attributable to paid by
Notes i Charge to operating results (based on longer-term investment returns)
Total charge net of finance income (14) (29) Less: amount attributable to PAC with-profits fund (9) 1
I1: Staff and pension plans continued Notes continued ii Actuarial gains and losses
Actual less expected return on pension scheme assets (8) 156 Experience (losses) gains on scheme liabilities (14) 18 Changes in assumptions underlying the present value of scheme liabilitiesa 317 311
Actuarial 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 90 167 a The gains of £317 million relating to changes in assumptions comprises the gains due to changes in economic assumptions of £509 million which are partially offset by a charge of £192 million for the effect of strengthened mortality assumptions for the UK schemes.
Estimated pension scheme surplus (deficit) attributable to PAC with-profits fund – economic basis Movements on the pension scheme surplus (deficits) (determined on the ‘economic basis’ under which PSPS and M&G scheme assets include investments in Prudential insurance policies) are as follows: 2007 £m
The charges and credits for service cost, net finance income, and actuarial gains and losses are included within the income statement but also taken account of in determining the charge in the income statement for the transfer to the liability for unallocated surplus of with-profits funds.
Fair value of plan assets, beginning of year 4,988 287 5,275 5,275 Present value of benefit obligation, beginning of year (5,210) (5,210)
Service cost – current charge only (58) (58) Interest cost (265) (265) Expected return on plan assets 289 20 309 309
Service cost – current charge only (69) (69) Interest cost (255) (255) Expected return on plan assets 279 16 295 295
Fair value of plan assets, end of year 4,988 287 5,275 5,275 Present value of benefit obligation, end of year (5,210) (5,210)
Present value of unfunded obligations (M&G scheme)* (189) (187) (190) (140)
Components of net periodic pension cost Current service cost (58) (69) Interest cost (265) (255) Expected return on assets – economic basis 309 295 Less: expected return on investments of scheme assets in Prudential insurance policies (20) (16) Expected return on assets – IAS 19 basis† 289 279
Pension cost charge (as referred to in noteI1a) (34) (45) Actuarial gains – economic basis 295 485 Less: actuarial gains on investments of scheme assets in Prudential insurance policies 1 (16) Actuarial gains – IAS 19 basis (as referred to in noteI1a) 296 469
† In determining the expected return on plan assets for 2007, the 5.9 per cent rate shown below has been applied to the opening assets.
I1: Staff and pension plans continued 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) 5,150 4,988 4,622 4,092 Present value of the benefit obligation, end of year (5,015) (5,210) (5,418) (4,917)
Total employer contributions expected to be paid into the Group defined benefit schemes for the year ending 31 December 2008 amounts to £90 million (2007: £93 million).
8 Sensitivity of PSPS financial position to key variables The table below shows the sensitivity of the PSPS liabilities at 31 December 2007 of £4,361 million (2006: £4,607 million) to changes in discount rates, inflation rates and mortality assumptions.
Assumption Change in assumption Impact on scheme liabilities on IAS 19 basis
Discount rate Decrease by 0.2% from 5.2% to 5.0% Increase scheme liabilities by 3.6% Discount rate Increase by 0.2% from 5.2% to 5.4% Decrease scheme liabilities by 3.4% Rate of inflation Decrease by 0.2% from 3.0% to 2.8% Decrease scheme liabilities by 1.3%
9 Transfer value of PSPS scheme At 31 December 2007, it is estimated that the assets of the scheme are broadly sufficient to cover the liabilities of PSPS on a ‘buyout’ basis including an allowance for expenses. The ‘buyout’ basis refers to a basis that might apply in the circumstance of a transfer to another appropriate financial institution. In making this assessment it has been assumed that a more conservative investment strategy applies together with a more prudent allowance for future mortality improvements and no allowance for discretionary pension increases.
ii Other pension plans The Group operates various defined contribution pension schemes including schemes in Jackson and Asia. As noted earlier, the cost of the Group’s contributions for continuing operations to these schemes in 2007 was £28 million (2006: £22 million).
I2: Share-based payments a Relating to Prudential plc shares The Group maintains 10 main share award and share option plans relating to Prudential plc shares, which are described below.
The GPSP is the incentive plan in which all executive directors and other senior executives within the Group can participate. This scheme was established as a replacement for the Restricted Share Plan (RSP) under which no further awards could be made after March 2006. Awards are granted either in the form of a nil cost option, conditional right over shares, or such other form that shall confer to the participant an equivalent economic benefit, with a vesting period of three years. The performance measure for the awards is that Prudential’s Total Shareholder Return (TSR) outperforms an index comprising of peer companies. Vesting of the awards between each performance point is on a straight line sliding scale basis. Participants are entitled to the value of reinvested dividends that would have accrued on the shares that vest. Shares are currently purchased in the open market by a trust for the benefit of qualifying employees.
Certain senior executives have annual incentive plans with awards paid in cash up to the target level of their plan. The portion of any award for above target performance is made in the form of awards of shares deferred for three years, with the release of shares subject to close periods. The shares are held in the employee share trust and shares equivalent to dividends otherwise payable will accumulate for the benefit of award holders during the deferral period up to the release date.
The other arrangements relate to various awards that have been made without performance conditions to individual employees, typically in order to secure their appointment or ensure retention.
Movements in share options outstanding under the Group’s share-based compensation plans relating to Prudential plc shares during 2007 and 2006 were as follows: Weighted Weighted average average
Movements in share awards outstanding under the Group’s share-based compensation plans relating to Prudential plc shares at 31 December 2007 and 2006 were as follows: Number of Number of awards awards
Expected option life (years) 3.0 3.48 3.00 3.42 Weighted average exercise price (£) – 5.62 – 5.06
The expected volatility is measured as 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. For the GPSP, volatility and correlation between Prudential and an index constructed from a simple average of the TSR growth of 11 companies is required. For grants in 2007, an average index volatility and correlation of 18 per cent and 72 per cent respectively, were used.
Total key management remuneration amounts to £15,670,000 (2006: £13,524,000). This comprises salaries and short-term benefits of £9,496,000 (2006: £8,927,000), post-employment benefits of £967,000 (2006: £1,020,000), termination benefits of £nil (2006: £291,000) and share-based payments of £5,207,000 (2006: £3,286,000).
The share-based payments charge is the sum of £3,456,000 (2006: £1,880,000), which is determined in accordance with IFRS 2, ‘Share-Based Payments’ (see note I2) and £1,751,000 (2006: £1,406,000) of deferred share awards.
Fees payable to the Company’s auditor for the audit of the Company’s annual accounts 1.8 2.3 Fees payable to the Company’s auditor and its associates for other services: Audit of subsidiaries and associates pursuant to legislation 4.4 3.8 Other services supplied pursuant to legislation 2.9 4.0 Other services relating to taxation 0.4 0.2 Valuation and actuarial services 0.7 0.0 Services relating to corporate finance transactions 0.2 0.7 All other services 1.0 1.3
In addition, there were fees incurred of £0.2 million (2006: £0.2 million) for the audit of pension schemes. The Audit Committee regularly monitors the non-audit services provided to the Group by its auditor and has developed a formal Auditor Independence Policy which sets out the types of services that the auditor 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.
In addition, the Company has transactions and outstanding balances with certain unit trusts, OEICs, collateralised debt obligations and similar entities which are not consolidated and where a Group company acts as manager. These entities are regarded as related parties for the purposes of IAS 24. The balances are included in the Group’s balance sheet at fair value or amortised cost in accordance with their IAS 39 classifications. The transactions are included in the income statement and include amounts paid on issue of shares or units, amounts received on cancellation of shares or units and paid in respect of the periodic charge and administration fee. Further details of the aggregate assets, liabilities, revenues, profits or losses and reporting dates of entities considered to be associates under IFRS are disclosed in note H8.
Various executive officers and directors of Prudential may from time to time purchase insurance, asset management or annuity products, or be granted mortgages or credit card facilities marketed by Prudential Group companies in the ordinary course of business on substantially the same terms, including interest rates and security requirements, as those prevailing at the time for comparable transactions with other persons.
ii Dividend restrictions and minimum capital requirements Certain Group subsidiaries are subject to restrictions on the amount of funds they may transfer in the form of cash dividends or otherwise to the parent company. UK insurance companies are required to maintain solvency margins which must be supported by capital reserves and other resources, including unrealised gains on investments. Jackson can pay dividends on its capital stock only out of earned surplus unless prior regulatory approval is obtained. Furthermore, without the prior regulatory approval, dividends cannot be distributed if all dividends made within the preceding 12 months exceed the greater of Jackson’s statutory net gain from operations or 10 per cent of Jackson’s statutory surplus for the prior year. In 2008, the maximum amount of dividends that can be paid by Jackson without prior regulatory approval is US$490 million (£246 million) (in 2007: US$412 million (£211 million)). The Group’s Asian subsidiaries, mainly the Singapore and Malaysia businesses, may remit dividends to the Group, in general, provided the statutory insurance fund meets the capital adequacy standard required under local statutory regulations.
On 29 January 2007, the Company announced that it had entered into a binding agreement to sell Egg Banking plc to Citi. On 1 May 2007, the Company completed the sale. Additional details regarding the disposal are set out in note J.
iv PAC with-profits fund acquisition The PAC with-profits fund acquired a number of venture capital holdings through PPM Capital and M&G in which the Group was deemed to have a controlling interest, in aggregate with, if applicable, other holdings held by, for example, the PSPS. Following the disposal of PPM Capital by the Group in November 2007, the Group is no longer deemed to have a controlling interest in investments managed by PPM capital and consequently any subsequent investments have not been consolidated into the Group and the investments previously consolidated ceased to be consolidated from the date of disposal of PPM Capital. There were two venture investment acquisitions in 2007 and three in 2006. These were acquisitions for: — 71 per cent of the voting equity interest of Orizon AG, an employment hiring agency, in March 2007; and — 78 per cent of the voting equity interest of Red Funnel, a ferry company, in June 2007.
Cash and cash equivalents 20 18 Other current assets 26 31 Property, plant and equipment 38 45 Intangible assets other than goodwill 1 139 Other non-current assets 3 100 Less liabilities, including current liabilities and borrowings (304) (581)
As a result SUSPA, TJ Hughes, Sterigenics, Muller & Weygandt, TMF Group, JOST, Histoire D’or, Azzuri Communications, Paramount plc and Orizon AG ceased to be consolidated as subsidiary undertakings from the date of disposal of PPM Capital.
Future minimum lease payments for non-cancellable operating leases fall due during the following periods: Not later than 1 year 38 53 Later than 1 year and not later than 5 years 126 142 Later than 5 years 111 160
The total minimum future sublease rentals to be received on non-cancellable operating leases for land and buildings for the year ended 31 December 2007 was £0.4 million (2006: £1 million).
I8: Cash flows Structural borrowings of shareholder-financed operations comprise core debt of the holding company and central finance subsidiaries, Jackson surplus notes and, prior to disposal, Egg debenture loans. Core debt excludes borrowings to support short-term fixed income securities programmes and non-recourse borrowings of investment subsidiaries and consolidated investment funds of shareholder-financed operations. Cash flows in respect of these borrowings are included within cash flows from operating activities.
Cash flows relating to discontinued operations, as detailed in note J1, are inflows of £157 million and £184 million for the period of ownership in 2007 and 2006 respectively. All of these relate to cash flows from operating activities except for an outflow of £33 million in 2006 which relates to financing activities.
Discontinued banking operations relate entirely to UK banking operations following the sale on 1 May 2007 of Egg Banking plc to Citi. Consideration payable to the Company was, net of expenses, £527 million cash. The reduction from the £575 million consideration noted in the original announcement primarily reflected Egg’s post-tax operating loss of £49 million for the period from 1 January 2007 to the date of sale. Cash and cash equivalents disposed of were £1,065 million. Accordingly, the cash outflow for the Group arising from the disposal of Egg, as shown in the consolidated cash flow statement, was £538 million. Prior to the disposal the Group undertook banking operations almost wholly through its subsidiary, Egg Banking plc. Financial information in respect of Egg Banking plc, together with amounts in respect of its former parent Egg plc and its associate IFonline, have been included in this note. Note I6 shows details of the purchase of the minority interests in Egg plc in 2006.
Short-term fluctuations in investment returns – 7 Profit on sale of Egg Banking plc 290 –
Tax on operating loss based on longer-term investment returns 19 47 Tax on short-term fluctuations in investment returns – (2) Tax on profit on sale of Egg Banking plc 0 –
Fee and commission income includes £27 million (2006: £83 million) relating to financial instruments held at amortised cost. These fees primarily related to balance transfer fees and late payment fees.
J2: Balance sheet for discontinued banking operations Assets, liabilities and shareholders’ funds included in the Group consolidated balance sheet as at 31 December 2006 in respect of discontinued banking operations are as follows: 2006 £m
Liabilities Deposits by banks 2,220 Customer accounts 5,554 Debt securities issued 599 Derivative financial instruments 154 Other liabilities 228 Subordinated liabilities 451
J3: Risk management overview Through Egg the Group offered banking and credit card products and intermediated services. Through its normal operations, Egg was exposed to a number of risks, the most significant of which was credit, operational, liquidity, market and currency risk. The overall responsibility for risk management and the risk appetite of Egg was set by the Egg Board and responsibility for managing these risks resided with the Egg executive committee. The exposure to specific risks was monitored by the Egg executive committee through separate committees: the retail credit committee was responsible for retail credit risk, the wholesale credit committee was responsible for wholesale credit risk, the operational risk committee was responsible for operational risk and the asset and liability committee (ALCO) was responsible for liquidity, market and currency risk.
Egg used financial instruments including derivatives for the purpose of supporting the strategic and operational business activities and to reduce and eliminate the risk of losses arising from changes in interest rates and foreign exchange rates.
Surplus retail and wholesale liabilities were invested in debt securities, including certificates of deposits, government gilts and other high investment grade assets.
J4: Maturities of assets and liabilities and liquidity risk Liquidity risk was defined for Egg as not having sufficient financial resources available to meet its obligations as they fell due or if such resources could only be secured at excessive cost. Egg used various methods including predictions of daily cash positions to monitor and manage liquidity risk. Maturity mismatches between lending and funding were managed within internal risk policy limits. It ensured that it held sufficient assets, which were immediately realisable into cash without significant exposure to market risk or costs, to cover a realistic estimate of retail funds that could be withdrawn. While a significant proportion of retail savings balances were on instant access terms, in practice the majority of such funds represented a relatively stable and consistent funding base for Egg.
From From From Up to 1 month 3 months 1 year 5 years 1 month to 3 months to 1 year to 5 years and over Total
Assets Cash and balances with central banks 6 – – – – 6 Loans and advances to banks 876 – – 2 25 903 Loans and advances to customers 1 2,725 42 1,338 2,087 6,193
Balance at the beginning of the year 518 335 Amounts written off (141) (201) New and additional provisions 149 384 Balance at time of disposal of Egg Banking plc (526) –
Impairment losses on loans and advances to customers of Egg were based on an actual loss model and all impairments were only being held against debt that had objective evidence of either an individual or a collective impairment. For individually assessed impaired assets this was established by the delinquency state of debt based on the number of payments they are in arrears. For collectively assessed impaired assets this assessment was based on the level of accounts operating out of agreed terms showing other objective evidence of impairment from which behaviour analysis impairment is projected by using Markov probability matrices.
The composition of interest rate risk was closely monitored and managed on a day-to-day basis by the treasury function where professional expertise and systems existed to control it. This was primarily done via asset and liability models that looked at the sensitivity of earnings to movements in interest rates to measure overall exposure which could then be hedged in accordance with the policy limits set by the ALCO.
For the purpose of reducing interest rate risk, Egg used a number of derivative instruments such as interest rate swaps and forward rate agreements (see note G3).
Financial assets and liabilities not held at fair value through profit and loss and the weighted average effective interest rate for those balances at 31 December 2006 are provided below: £m %
Assets Debt securities available-for-sale* 1,935 5.3 Loans and receivables 7,096 9.0
At 31 December 2006, Egg held £357 million of assets and £1,751 million of liabilities with foreign currency exposure.
J7: Credit risk Egg took on exposure to credit risk, which was the risk that a counterparty would be unable to pay amounts in full when due. To limit this risk, Egg placed limits on the amount of risk accepted in relation to a particular borrower, groups of borrowers, and to particular geographical segments. The acceptable risk levels were monitored regularly and reviewed where appropriate.
Total* 18,619 *This includes £9,475 million of off-balance sheet items, which mainly relate to unutilised credit limits on credit cards.
Notes on the Group financial statements J: Discontinued banking operations continued
J7: Credit risk continued The following is a breakdown of the credit risk borne by Egg for financial assets and off-balance sheet items at 31 December 2006: 2006 £m
Egg held significant concentrations of credit risk with other financial institutions. At 31 December 2006, this was estimated at £8.7 billion of which £3.9 billion related to derivative financial instruments and £1.8 billion to credit default swaps. Egg also had significant credit exposure in asset-backed security products which totalled approximately £403 million at 31 December 2006. With regard to loans and advances to customers, Egg had significant concentrations of credit risk in respect of its unsecured lending on credit cards, personal loans and mortgage lending secured on property in the UK.
Egg issued debt securities in order to finance certain portfolios of loans and investment assets. These obligations were secured on Egg’s assets. The securitised assets and the related liabilities were presented gross within the relevant headings in the balance sheet under the ‘gross presentation’ method.
The financial statements of the parent company on pages 290 to 299 were approved by the Board of directors on 13 March 2008.
Balance sheet of the parent company 290 Prudential plc Annual Report 2007
Parent com pany 1 Nature of operations Prudential plc (the Company) is a parent holding company. The Company together with its subsidiaries (collectively, the Group) is an international financial services group with its principal operations in the UK, the US and Asia. The Group operates in the UK through its subsidiaries, primarily The Prudential Assurance Company Limited, Prudential Annuities Limited, Prudential Retirement Income Limited, M&G Investment Management Limited and, prior to disposal, Egg Banking plc. On 29 January 2007 the Company announced that it had entered into a binding agreement to sell its Egg banking business to Citi, as described in note 4. On 1 May 2007, the Company completed the sale. 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 is responsible for the financing of each of its subsidiaries.
3 Significant accounting policies Shares in subsidiary undertakings Shares in subsidiary undertakings are shown at the lower of cost and estimated realisable value.
Derivatives 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. Derivative financial instruments are carried at fair value with changes in fair value included in the profit and loss account.
3 Significant accounting policies continued Dividends Dividends are recognised in the period in which they are declared. Dividends declared after the balance sheet date in respect of the prior reporting period are treated as a non-adjusting event.
Pensions The Company assumes a portion of the pension surplus or deficit of the Group’s largest pension scheme, the Prudential Staff Pension Scheme (PSPS). Further details are disclosed in note 8. The Company applies the requirements of FRS 17 (as amended in December 2006) to its portion of PSPS surplus or deficit.
The assets and liabilities of the defined benefit pension schemes of the Prudential Group are subject to a full triennial actuarial valuation using the projected unit method. Estimated future cash flows are then discounted at a high quality corporate bond rate to determine its present value. These calculations are performed by independent actuaries.
Actuarial gains and losses as a result of the changes in assumptions, the difference between actual and expected investment return on scheme assets and experience variances are recorded in the statement of total recognised gains and losses.
At beginning of year 6,085 2,841 Transfer from a subsidiary undertaking 1,754 – Additional investment in subsidiary undertakings 38 – Disposal of Egg Banking plc (575) – Transfer to a subsidiary undertaking (151) 151 Net repayment of loans – (183)
On 29 January 2007, the Company announced that it had entered into a binding agreement to sell Egg Banking plc to Citi. Under the terms of the agreement, the consideration payable to the Company by Citi was £575 million cash, subject to adjustments to reflect any change in net asset value between 31 December 2006 and completion, and the carrying value of the Company’s investment at 31 December 2006 was reduced to £575 million. On 1 May 2007, the Company completed the sale.
5 Subsidiary undertakings The principal subsidiary undertakings of the Company at 31 December 2007, all wholly owned except PCA Life Assurance Company Limited, were: Main activity Country of incorporation
The Prudential Assurance Company Limited Insurance England and Wales Prudential Annuities Limited* Insurance England and Wales Prudential Retirement Income Limited (PRIL)* Insurance Scotland M&G Investment Management Limited* Investment management England and Wales Jackson National Life Insurance Company* Insurance US Prudential Assurance Company Singapore (Pte) Limited* Insurance Singapore PCA Life Assurance Company Limited* (99% owned) Insurance Taiwan *Owned by a subsidiary undertaking of the Company.
Total core structural borrowings 2,363 2,330 – – 2,363 2,330 Other borrowings:vii
Floating Rate Notes 2007 – – – 5 – 5 Medium-Term Notes 2008 – – 48 – 48 –
Borrowings are repayable as follows: Within 1 year or on demand – – 2,470 2,022 2,470 2,022
Recorded in the balance sheet as: Subordinated liabilitiesnote viii 1,566 1,533 Debenture loans 797 797
vi In 2006, hedge accounting under FRS 26 was applied for the US$300 million borrowings at the Group consolidated level only. For 2007 onwards, hedge accounting is also applied at the Company level.
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. In addition, in 2007 the Company designated a US$300 million fair value hedge which hedges the interest exposure on the US$300 million 6.5 per cent perpetual subordinated capital securities.
8 Pension scheme financial position The majority of UK Prudential staff are members of the Group’s pension schemes. The largest scheme is the Prudential Staff Pension Scheme (PSPS) which is primarily a closed defined benefit scheme. At 31 December 2007, on the FRS 17, ‘Retirement Benefits’ basis of valuation, PSPS accounted for 87 per cent (2006: 88 per cent) of the liabilities of the Group’s defined benefit schemes.
At 31 December 2005, the allocation of surpluses and deficits attaching to PSPS between the Company and the unallocated surplus of the Prudential Assurance Company’s (PAC) with-profits funds was apportioned in the ratio 30/70 between the Company and the PAC with-profits fund following detailed consideration of the sourcing of previous contributions. This ratio was applied to the base deficit position at 1 January 2006 and for the purpose of determining the allocation of the movements in that position up to 31 December 2007. The FRS 17 service charge and ongoing employer contributions are allocated by reference to the cost allocation for current activity.
Defined benefit schemes are generally required to be subject to full actuarial valuation every three years to assess the appropriate level of funding for schemes having regard to their commitments. These valuations include assessments of the likely rate of return on the assets held within the separate trustee administered funds. PSPS was last actuarially valued as at 5 April 2005 using the projected unit method. This valuation demonstrated the scheme to be 94 per cent funded, with a shortfall of actuarially determined assets to liabilities of six per cent, representing a deficit of £243 million.
8 Pension scheme financial position continued Using external actuarial advice provided by the professionally qualified actuaries, Watson Wyatt Partners, for the valuation of PSPS, the most recent full valuations have been updated to 31 December 2007 applying the principles prescribed by FRS 17.
Employee contributions 2 1 Actuarial gains (314) (249) Benefit payments (207) (194)
Fair value of scheme assets, end of year 4,889 4,748 *The contributions include deficit funding and ongoing contributions.
Total pension credit (charge) 3 (7) Less: amount attributable to the PAC with-profits fund (15) (6)
Actuarial gains (losses): Actual less expected return on scheme assets (0% (2006: 3%)
Total actuarial gains (7% (2006: 8%) (2005: 2%) (2004: (1)%) of the present value of the scheme liabilities) 302 390 95 (49)
Less: amount attributable to PAC with-profits fund (211) (272) (66) 39
PSPS deficit between the Company and the PAC with-profits fund – – (59) –
Actuarial gains (losses) attributable to the Company 91 118 (30) (10)
9 Share capital and share premium The authorised share capital of the Company at both 31 December 2007 and 31 December 2006 was £220 million (divided into 4,000,000,000 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) and ¤20 million (divided into 2,000,000,000 Euro preference shares of 1 cent each). None of the preference shares has been issued. A summary of the ordinary shares in issue is set out below: Share Share Number of capital premium
At beginning of year 2,444,312,425 122 1,822 Shares issued under share option schemes 803,818 – 6 Shares issued in lieu of cash dividends 24,900,997 1 175 Transfer to retained profit in respect of shares issued in lieu of cash dividends – – (175)
Net movement in shareholders’ funds (195) 855 Shareholders’ funds at beginning of year 3,312 2,457
e In certain instances the Company has guaranteed that its subsidiaries will meet their obligations when they fall due for payment.
Company law requires the directors to prepare Group and parent company financial statements for each financial year. Under that law the directors are required to prepare the Group financial statements in accordance with International Financial Reporting 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.
In preparing the Group and parent company financial statements, the directors are required to: — Select suitable accounting policies and then apply them consistently; — make judgements and estimates that are reasonable and prudent; — for the Group financial statements, state whether they have been prepared in accordance with IFRS as adopted by the EU; — for the parent company financial statements, state whether applicable UK Accounting Standards have been followed, subject to any material departures disclosed and explained in the parent company financial statements; and
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 Company’s members those matters we are required to state to them in an auditor’s report and for no other purpose. To the fullest extent permitted by law, we do not accept or assume responsibility to anyone other than the Company and the Company’s members as a body, for our audit work, for this report, or for the opinions we have formed.
We read other information contained in the Annual Report and consider whether it is consistent with the audited financial statements. We consider the implications for our report if we become aware of any apparent mis-statements or material inconsistencies with the financial statements. Our responsibilities do not extend to any other information.
— the information given in the directors’ report is consistent with the financial statements.
Long-term business 1,046 829 Asset management 72 50 Development expenses (15) (15)
US operations New business 5(b) 285 259 Business in force 6 342 449
UK operations New business 5(b) 277 266 Business in force 6 582 420
Analysed as profits (losses) from: New business 5(b) 1,215 1,039 Business in force 6 1,317 1,184
European Embedded Value (EEV) basis supplementary information Year ended 31 December 2007 302 Prudential plc Annual Report 2007
Summarised consolidated income statement – EEV basis Year ended 31 December 2007
Operating profit from continuing operations based on longer-term investment returns 2,542 2,133 Short-term fluctuations in investment returns 9 174 738 Mark to market value movements on core borrowings 10 223 85 Shareholders’ share of actuarial gains and losses on defined benefit pension schemes 11 116 207 Effect of changes in economic assumptions and time value of cost of options and guarantees 12 748 59
Profit from continuing operations before tax (including actual investment returns) 3,803 3,222 Tax attributable to shareholders’ profit 13 (961) (904)
Profit from continuing operations for the year after tax before minority interests 2,842 2,318 Discontinued operations (net of tax) 1 241 (105)
Discontinued operations Based on profit (loss) from discontinued operations after tax and minority interests 9.9p (4.3)p
Profit for the year attributable to equity shareholders 3,062 2,212 Items taken directly to equity: Exchange movements 4(h) 64 (359) Unrealised valuation movements on Egg securities classified as available-for-sale (2) (2) Movement on cash flow hedges (3) 7 Related tax 3 (74)
Mark to market value movements on Jackson assets backing surplus and required capital* (13) 7
Net increase in shareholders’ equity 16 2,896 1,582 Shareholders’ equity at beginning of year (excluding minority interests) 11,883 10,301
Shareholders’ equity at end of year (excluding minority interests) 15,16 14,779 11,883
Other operations: Holding company net borrowings at market value (873) (1,542) Other net assets (liabilities) 36 (232)
Net asset value per share (in pence) Based on EEV basis shareholders’ equity of £14,779m (2006: £11,883m) 598p 486p Number of issued shares at year end (millions) 2,470 2,444 *The mark to market value movements on Jackson assets backing surplus and required capital for 2006 represents the cumulative adjustment as at 304 Prudential plc Annual Report 2007
Policyholder liabilities (net of reinsurers’ share) and unallocated surplus of with-profits funds (189,786) (177,642) Less shareholders’ accrued interest in the long-term business 8,578 6,395
Shareholders’ equity (excluding minority interests) 16 14,779 11,883 *Including liabilities in respect of insurance products classified as investment products under IFRS 4.
SAIF is a ring-fenced sub-fund of the Prudential Assurance Company (PAC) long-term fund, established by a Court approved Scheme of Arrangement in October 1997. SAIF is closed to new business and the assets and liabilities of the fund are wholly attributable to the policyholders of the fund. In 2006, a bulk annuity arrangement between SAIF and Prudential Retirement Income Limited (PRIL), a shareholder-owned subsidiary, took place as explained in note 5a. Reflecting the altered economic interest for SAIF policyholders and Prudential shareholders, this arrangement represents a transfer from long-term business of the Group that is not ‘covered’ to business that is ‘covered’ with consequential effect on the EEV basis results.
As regards the Group’s defined benefit pension schemes, the surplus or deficit attaching to the Prudential Staff Pension Scheme (PSPS) and Scottish Amicable Pension Scheme are excluded from the EEV value of UK operations and included in the total for Other operations. The surplus and deficit amounts are partially attributable to the PAC with-profits fund and shareholder-backed long-term business and partially to other parts of the Group. In addition to the IFRS basis surplus or deficit, the shareholders’ 10 per cent share of the PAC with-profits fund’s interest in the movement on the financial position of the schemes is recognised for EEV reporting purposes.
2 Methodology a Embedded value Overview 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 — shareholders’ net worth in excess of encumbered capital.
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. 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.
Financial options and guarantees Nature of options and guarantees in Prudential’s long-term business Asian operations Subject to local market circumstances and regulatory requirements, the guarantee features described below in respect of UK business broadly apply to similar types of participating contracts principally written in the PAC Hong Kong branch, Singapore and Malaysia. Participating products have both guaranteed and non-guaranteed elements.
UK insurance operations The only significant financial options and guarantees in the UK insurance operations arise in the with-profits fund and SAIF. With-profits products provide returns to policyholders through bonuses that are smoothed. There are two types of bonuses: annual and final. Annual bonuses are declared once a year and, once credited, are guaranteed in accordance with the terms of the particular product. Unlike annual bonuses, final bonuses are guaranteed only until the next bonus declaration. The with-profits fund held a provision on the Pillar I Peak 2 basis of £45 million (2006: £47 million) at 31 December 2007 to honour guarantees on a small amount of guaranteed annuity option products.
Beyond the generic features and the provisions held in respect of guaranteed annuities described above, there are very few explicit options or guarantees of the with-profits fund such as minimum investment returns, surrender values, or annuity values at retirement and any granted have generally been at very low levels.
The economic assumptions used for the stochastic calculations are consistent with those used for the deterministic calculations. 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 an allowance for correlation between the various asset classes. Details of the key characteristics of each model are given in note 3.
— US operations: the level of encumbered capital has been set to an amount at least equal to 235 per cent of the risk-based capital required by the National Association of Insurance Commissioners at the Company Action Level (CAL), which is sufficient to meet the economic capital requirement.
— UK insurance operations: the economic capital requirements for annuity business are fully met by Pillar I requirements being four per cent of mathematical reserves, which are also sufficient to meet Pillar II requirements.
Allowance for risk The risk allowance in the risk discount rate is determined as follows: Market risk Under the Capital Asset Pricing Methodology (CAPM) the discount rate is determined as: Discount rate = risk-free rate + (beta x equity risk premium)
Under CAPM, the beta of a portfolio or product measures its relative market risk. The risk discount rates reflect the market risk inherent in each product group and hence the volatility of product cash flows.
Diversifiable non-market risks No allowance is required for non-market risks where these are assumed to be fully diversifiable. The majority of non-market risks are considered to be diversifiable.
d Management actions In deriving the time value of financial options and guarantees, management actions in response to emerging investment and fund solvency conditions have been modelled. Management actions encompass, but are not confined to, the following areas: — investment allocation decisions; — levels of reversionary bonuses and credited rates; and — total claim values.
e With-profits business and the treatment of the estate For the PAC with-profits fund, the shareholders’ interest in the estate is derived by increasing final 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.
For PSPS the surplus or deficit at the reporting date is allocated between the PAC with-profits fund and shareholder-backed operations by reference to the activities of the members of the scheme during their period of service. At 31 December 2005, the deficit of PSPS was apportioned in the ratio 70/30 between the with-profits fund and shareholder-backed operations following detailed consideration of the sourcing of previous contributions. This ratio was applied to the base deficit position at 1 January 2006 for the purposes of determining the allocation of the movement in that position up to 31 December 2007. The IAS 19 service charge and ongoing employer contributions are allocated by reference to the cost allocation for current activity.
Expected returns on equity and property asset classes in respect of each territory are derived by adding a risk premium, also based on the long-term view of Prudential’s economists, to the risk-free rate. In Asia, equity risk premiums range from 3.0 per cent to 6.0 per cent (2006: 3.0 per cent to 5.8 per cent). In the US and the UK, the equity risk premium is 4.0 per cent above risk-free rates for both 2007 and 2006. Best estimate assumptions for other asset classes, such as corporate bond spreads, are set consistently.
Assumed investment returns reflect the expected future returns on the assets held and allocated to the covered business at the valuation date.
Risk discount rate: Expected long-term rate of inflation 2.75 5.0 1.75 2.25 3.0 6.0 3.0 5.5 1.75 2.25 3.75 5.5 310 Prudential plc Annual Report 2007
Notes i The weighted risk discount rates for Asian operations shown above have been determined by weighting each country’s risk discount rates by reference to the EEV basis operating result for new business and the closing value of in-force business. ii For traditional business in Taiwan, the economic scenarios used to calculate the 2007 and 2006 EEV basis results reflect the assumption of a phased progression of the bond yields from the current rates applying to the assets held to the long-term expected rates. The projections assume that in the average scenario, the current bond yields at 31 December 2007 of around 2.5 per cent (2006: around 2 per cent) trend towards 5.5 per cent at 31 December 2013.
Consistent with the EEV methodology applied, a constant discount rate has been applied to the projected cash flows. iii The assumptions shown are for US dollar denominated business which comprises the largest proportion of the in-force Hong Kong business. iv The mean equity return assumptions for the most significant equity holdings in the Asian operations were: Hong Kong 8.1 8.7
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.
v For 2007, cash rates rather than government bond yields were used in setting the risk discount rates for Malaysia, Singapore, Taiwan and for Hong Kong dollar denominated business. For 2006, cash rates were used for these operations and for all Hong Kong business (i.e. including US dollar denominated business).
Post-tax expected long-term nominal rate of return for the PAC with-profits fund: Pension business (where no tax applies) 7.85 7.5 Life business 6.9 6.6
Notes i The risk discount rates for new business and business in force for UK insurance operations reflect weighted rates based on the type of business. ii The assumed long-term rate for corporate bonds for 2007 for with-profits business reflects the purchase of credit default swaps. iii The pre-tax rates of return for annuity business are based on the gross redemption yield on the backing assets net of a best estimate allowance for future defaults.
US operations (Jackson) — Interest rates are projected using a log-normal generator calibrated to actual market data; — Corporate bond returns are based on Treasury securities plus a spread that has been calibrated to current market conditions and varies by credit quality; and — Variable annuity equity and bond returns have been stochastically generated using a regime-switching log-normal model with parameters determined by reference to historical data. The volatility of equity fund returns for both 2007 and 2006 ranges from 18.6 per cent to 28.1 per cent, depending on risk class, and the standard deviation of bond returns ranges from 1.4 per cent to 1.7 per cent (2006: 1.4 per cent to 2.0 per cent).
3 Assumptions continued UK insurance operations — Interest rates are projected using a two-factor model calibrated to actual market data; — The risk premium on equity assets is assumed to follow a log-normal distribution; — The corporate bond return is calculated as the return on a zero-coupon bond plus a spread. The spread process is a mean reverting stochastic process; and — Property returns are modelled in a similar fashion to corporate bonds, namely as the return on a riskless bond, plus a risk premium, plus a process representative of the change in residual values and the change in value of the call option on rents.
Asia development and Regional Head Office expenses are charged to EEV basis results as incurred. No adjustment is made to the embedded value of covered business as the amounts of expenditure that relate to operating expenses are not material. Similarly, corporate expenditure for Group Head Office (GHO), to the extent not allocated to the PAC with-profits fund, is charged to the EEV basis result as incurred.
4 Accounting presentation a Analysis of profit before tax To the extent applicable, presentation of the EEV profit for the year is consistent with the basis that the Group applies for analysis of IFRS basis profits before shareholder taxes between operating and non-operating results. Operating results reflect the underlying results of the Group’s continuing operations including longer-term investment returns. Operating results include the impact of routine changes of estimates and non-economic assumptions. Non-operating results include certain recurrent and exceptional items that primarily do not reflect the performance in the year of the Group’s continuing operations.
The results for any covered business conceptually reflects the aggregate of the IFRS results and the movements on the additional shareholders’ interest recognised on the EEV basis. Thus the start point for the calculation of the EEV results for Jackson, as for other businesses, reflects the market value movements recognised on the IFRS basis.
Separately, from 31 December 2006, fixed income securities backing the free surplus and required capital are accounted for at fair value. However, consistent with the treatment applied under IFRS for securities classified as available-for-sale, movements in unrealised appreciation on these securities are accounted for in equity rather than in the income statement.
c Pension costs Profit before tax Movements on the shareholders’ share of surplus or deficit 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 surplus or deficit attributable to the PAC with-profits fund. The surplus or deficit is determined by applying the requirements of IAS 19.
The exchange movements in 2007 and 2006 recorded within the movements in shareholders’ equity (and for 2007, in note 16) for long-term business and other operations comprise amounts in respect of: Long-term business operations: Asian operations 80 (169) US operations (53) (432)
Total mature life and pensions 531 654 140 126 193 191 1,023 1,151
5 Premiums, operating profit and margins from new business continued Notes i The tables shown above are provided as an indicative volume measure of transactions undertaken in the reporting period that have the potential to generate profits for shareholders. The amounts shown are not, and not intended to be, reflective of premium income recorded in the IFRS income statement.
ii The tables above include the transfer of 62,000 with-profit annuity policies from Equitable Life on 31 December 2007 with assets of approximately £1.7 billion. The transfer represented an APE of £174 million.
Note i US Operations net of tax profit: Before capital charge 197 182 Capital charge (12) (14)
5 Premiums, operating profit and margins from new business continued c Margins
New business margins are shown on two bases, namely the margins by reference to the Annual Premium and Contribution Equivalents (APE) and the Present Value of New Business Premiums (PVNBP). New business contributions represent profits determined by applying the economic and non-economic assumptions as at the end of the year. The table of new business premiums and margins above excludes SAIF DWP rebate premiums.
Unwind of discount and other expected returnsnote i 340 254 Changes in operating assumptionsnote iia 54 45 Experience variances and other itemsnote iib (1) 16
On value of in-force business and required capital 187 202 On surplus assets 53 49
Notes i For Asian operations and UK insurance operations, unwind of discount and other expected returns is determined by reference to the value of in-force business, required capital and surplus assets at the start of the year as adjusted for the effect of changes in economic and operating assumptions reflected in the current year. For the unwind of discount for UK insurance operations included in operating results based on longer-term returns a further adjustment is made. For UK insurance operations the amount represents the unwind of discount on the value of in-force business at the beginning of the year (adjusted for the effect of current year assumption changes), the expected return on smoothed surplus assets retained within the PAC with-profits fund and the expected return on shareholders’ assets held in other UK long-term business operations. Surplus assets retained within the PAC with-profits fund are smoothed for this purpose to remove the effects of short-term investment volatility from operating results. In the balance sheet and for total profit reporting, asset values and investment returns are not smoothed. For US operations the return on surplus assets is shown separately.
The £54 million profit from the effect of changes in operating assumptions for 2007 includes a benefit arising from reductions in corporate tax rates in China, Malaysia and Singapore. After grossing up the net of tax benefits totalling £25 million for notional tax of £7 million, the effect on the pre-tax operating result based on longer-term investment returns for Asian operations for 2007 is a credit of £32 million. Also included is a credit of £51 million for the effect of changes in expense assumptions, mainly relating to Singapore (£37 million) and Korea (£21 million) both due to increases in investment margins, a further credit of £17 million for the effect of changes in mortality and morbidity assumptions, offset by a charge of £51 million for the effect of changes in persistency assumptions mainly arising in Singapore (£29 million) as a result of changes in a number of product-related features and updated maturity assumptions and in Taiwan (£15 million) from an increase in lapse rates, reflecting recent experience.
The £45 million profit from the effect of changes in operating assumptions for 2006 for Asian operations includes £24 million in respect of higher assumed investment management margins based on current experience, a further £24 million for the net effect of altered lapse rates across a number of territories and similarly a net £20 million for changes to mortality and morbidity assumptions offset by a charge of £23 million for other items.
b Experience variances and other items Experience variances and other items, a net charge of £1 million for 2007 (2006: credit of £16 million), include a credit of £47 million (2006: £35 million) for mortality and morbidity experience variance relating to better than expected experience across most territories and a charge of £27 million (2006: £26 million) for expense experience variances in China of £12 million (2006: £14 million) and India of £15 million (2006: £12 million). The negative expense variances in China and India are primarily a reflection of the expenses for new business being in excess of the target levels factored into the valuation of new business for these operations which are at a relatively early stage of development. On the basis of current plans, the target level for India and existing China operations are planned to be attained in 2011. Also for 2007 there is a charge of £11 million in respect of Vietnam for higher than expected investment fees payable on asset managers’ performance, a credit of £4 million (2006: £18 million) in respect of the investment return on capital held centrally in respect of Taiwan and £14 million (2006: £11 million) of other charges.
6 Operating profit from business in force continued Notes continued iii US operations
The principal component of the £42 million credit in 2006 for other items is £31 million of favourable mortality experience variance. iv UK insurance operations a Effect of change in UK corporate tax rate At 31 December 2007, a change to reduce the UK corporate tax rate from 30 per cent to 28 per cent in 2008 had been enacted in the legislative process. Accordingly, the 2007 results incorporate the effects of this change in projecting the tax cash flows attaching to in force business. Under the convention applied for EEV basis reporting, profits are generally determined on a post-tax basis and then grossed up at the prevailing corporate tax rates to derive pre-tax results. The effect of the change in the UK corporate tax rate is to give rise to a benefit to the value of business in force at 1 January 2007 of £48 million. After grossing up this amount for notional tax of £19 million, the effect on the pre-tax operating results based on longer-term investment returns for UK insurance operations for 2007 is a credit of £67 million.
b Annuity business For UK insurance operations there is a net nil charge or credit for both the 2007 and 2006 results. However, the 2007 results for annuity business have been determined after a strengthening of explicit mortality assumptions and the release of excess margins in the aggregate liabilities that had previously been set aside as an indirect extra allowance for longevity related risks.
The overall impact of the assumption changes and release of margins for 2007 is as follows: £m
Strengthening of mortality assumptionsnote 1 (312) Release of margins: Projected benefit relatednote 2 144 Investment relatednote 3 82 Expense relatednote 4 29 1 The mortality assumptions have been strengthened such that the previous future improvement assumptions of medium cohort for males and 75 per cent of medium cohort for females are now subject to a minimum level of improvement in future years.
2 The release of projected benefit related margins relates to modelling improvements that have been made during 2007 and the effect of hedging inflationary increases on certain deferred annuity business.
3 The release of investment related margins predominantly relates to £38 million in respect of default margins and £43 million for adjustments to the assumed liquidity premium. The resulting assumptions for expected defaults and liquidity premium, after allowing for the release of margins, remain appropriate given economic conditions at 31 December 2007.
4 A release of expense reserves has been made following recent expense reductions, on which the related cost of capital on the EEV basis is £29 million.
6 Operating profit from business in force continued Notes continued d Expense assumptions The 2006 EEV basis financial statements included note disclosure which explained that in determining the appropriate expense assumptions account had been taken of the cost synergies that were expected to arise with some certainty from the initiative announced in December 2005 from UK insurance operations working more closely with Egg and M&G and the effect of the end to end review of the UK business, which was under way at the time.
IFRS basis 86 58 Less: allocation of investment return on centrally held capital in respect of Taiwan business to the operating result of Asian operations (4) (18) Less: projected asset management result in respect of covered business incorporated in opening
The charge of £20 million (2006: £41 million) comprises £19 million (2006: £38 million) recognised on the IFRS basis and an additional £1 million (2006: £3 million) recognised on the EEV basis for the shareholders’ share of costs incurred by the PAC with-profits fund.
Investment return related (loss) gain due primarily to changed expectation of profits on in-force variable annuity business in future periods based on current period equity returns*, net of related hedging activity (16) 17 *This adjustment arises due to market returns being (lower) higher than the assumed long-term rate of return. This gives rise to (lower) 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.
12 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 from continuing operations before tax (including actual investment returns) arise as follows: Change in Change in time value time value
Change in of cost of Change in of cost of economic options and economic options and assumptions guarantees Total assumptions guarantees Total 322 Prudential plc Annual Report 2007
ii The credit of £81 million for US operations in 2007 arises from the decrease in risk discount rate, partially offset by the negative effect of a reduction in the assumed future rate of return for separate account variable annuity business. Both changes reflect the 0.7 per cent decrease in the 10-year treasury bond rate (as shown in note 3).
Total tax charge on operating profit from continuing operations based on longer-term investment returns 694 634
ii Including tax relief on Asia development expenses and restructuring costs borne by UK insurance operations. iii The 2007 tax charge incorporates the notional tax gross up of £26 million attaching to the change of corporate tax rates in China, Malaysia, Singapore and the UK as detailed in notes 6ii a and 6iv a.
iv The tax credit for 2006 on the effect of changes in economic assumptions includes a credit of £9 million in respect of a change in the tax rate for Malaysia. v The 2006 tax charge for US operations of £251 million includes a charge in respect of prior years of £29 million and a charge of £26 million in respect of a change in valuation of deferred tax under EEV to reflect discounting over a period of four to 11 years depending upon the type of business concerned. These adjustments also resulted in a reallocation from free surplus to the value of in-force business of £44 million.
vi Comparative results for 2006 have been adjusted from those previously published to exclude discontinued banking operations.
Total profit after tax and minority interests from continuing operations 2,821 2,315 Total EPS from continuing operations 115.3p 96.0p
Shareholders’ funds before capital charge 3,689 3,420 Capital chargenote v (84) (117) EEV basis shareholders’ funds 3,605 3,303
Smoothed shareholders’ fundsnote vii 6,031 5,155 Actual shareholders’ funds less smoothed shareholders’ funds 466 658 EEV basis shareholders’ funds 6,497 5,813
Other operations Holding company net borrowings at market valuenote iv (873) (1,542) Other net assets (liabilities)note iii 36 (232)
15 Shareholders’ funds – segmental analysis continued Notes i A charge is deducted from the annual result and embedded value for the cost of capital supporting the Group’s long-term business operations.
This capital is referred to as encumbered capital. The cost is the difference between the nominal value of the capital and the discounted value of the projected releases of this capital allowing for investment earnings (net of tax) on the capital. Where encumbered capital is held within a with-profits fund, the value placed on surplus assets in the fund is already discounted to reflect its release over time and no further adjustment is necessary in respect of encumbered capital.
IFRS basis surplus (relating to shareholder-backed operations) 98 19 Additional EEV surplus (relating to shareholders’ 10 per cent share of the IFRS basis surplus (deficit) attributable to the PAC
Holding company* cash and short-term investments 1,456 – 1,456 1,119 – 1,119 Core structural borrowings – central funds (at market value) (2,367) 38 (2,329) (2,485) (176) (2,661)
v In determining the cost of capital for Jackson, it has been assumed that an amount at least equal to 235 per cent of the risk-based capital required by the National Association of Insurance Commissioners (NAIC) at the Company Action Level must be retained. The impact of the related capital charge is to reduce Jackson’s shareholders’ funds by £84 million (2006: £117 million).
Tax on short-term fluctuations in investment returns (43) 3 12 (28) 6 (22) Tax on shareholders’ share of actuarial gains and losses on defined benefit pension schemes (32) (32) Tax on effect of changes in economic assumptions and time value of cost of options and guarantees (56) (31) (126) (213) (213)
Movement in own shares in respect of share-based payment plans 7 7 Movement on Prudential plc shares purchased by unit trusts consolidated under IFRS 4 4 New share capital subscribed 182 182 Mark to market value movements on Jackson assets backing surplus and required capital (13) (13) (13)
16 Reconciliation of movement in shareholders’ funds continued Notes i Profits are translated at average exchange rates, consistent with the method applied for statutory IFRS basis results. The amounts recorded above for exchange rate movements reflect the difference between 2006 and 2007 exchange rates as applied to shareholders’ funds at 1 January 2007 and the difference between 31 December 2007 and average 2007 rates for profits.
ii Investment in operations reflects increases in share capital. This includes certain non-cash items as a result of timing differences. iii For the purposes of the table above, goodwill related to Asia long-term operations (as shown in note 15) is included in Other operations. iv Other transfers (from) to long-term business operations to other operations represent: Total UK long-term
Adjustment for net of tax asset management projected profits of covered business (9) (2) (16) (27) Adjustment for investment return, net of related tax, on economic capital for Taiwan operations held centrally (3) (3)
EEV basis shareholders’ equity at 31 December 2007 3,726 3,605 6,497 13,828 951 14,779
EEV basis shareholders’ equity at 1 January 2007 £m £m £m £m £m £m
Comprising: Value of in-force business before deduction of cost of capital and of guarantees 2,156 1,578 5,129 8,863
Profit for the year from long-term business operations 743 30 773 1,726 2,499
Total net worth (236) (171) Value of in-force business 1,101 898
Free Total net in-force Total surplus Required worth business long-term note vii capital note iv note viii business £m £m £m £m £m iv Net worth is based on statutory solvency capital (or economic capital where higher) and unencumbered capital. v Existing business transfer to net worth
17 Reconciliation of net worth and value of in-force business continued vi Other movements
(2006: £257 million) in respect of asset management business falling within the scope of covered business as follows: £m £m
Asian operations 204 120 US operations 12 12 UK insurance operations 133 125 x Other transfers from net worth 16iv £m
Adjustment for net of tax asset management projected profits of covered business (27) Adjustment for investment return, net of related tax, on economic capital for Taiwan operations held centrally (3) Other adjustments (10)
18 Sensitivity of results to alternative assumptions continued Notes i Asian operations
If it had been assumed in preparing the 2007 results for Taiwan that interest rates remained at the current level of around 2.5 per cent until 31 December 2008 and the progression period in bond yields was delayed by a year so as to end on 31 December 2014, there would have been a reduction in the Taiwan embedded value of £70 million.
b Sensitivity analysis – non-economic assumptions The tables below show the sensitivity of the embedded value as at 31 December 2007 (31 December 2006) and the new business contribution after the effect of encumbered capital for 2007 and 2006 to: — 10 per cent proportionate decrease in maintenance expenses (a 10 per cent sensitivity on a base assumption of £10 per annum would represent an expense assumption of £9 per annum); — 10 per cent proportionate decrease in lapse rates (a 10 per cent sensitivity on a base assumption of five per cent would represent a lapse rate of 4.5 per cent per annum); and
Change representing effect on: Embedded value of long-term operations at 31 December 2006
Under the terms of engagement we are required to report to the Company our opinion as to whether the supplementary information has been properly prepared in accordance with the EEV Principles using the methodology and assumptions set out on pages 306 to 313. We also report if we have not received all the information and explanations we require for this audit.
A dditional inform ation 336 Risk factors 340 Shareholder information 342 How to contact us
Prudential’s businesses are inherently subject to market fluctuations and general economic conditions.
For some non unit-linked 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 by regulators with reference to the interest rate environment prevailing at time of policy issue. This results in a mismatch due to the duration and uncertainty of the liability cash flows and the lack of sufficient assets of a suitable duration. This residual asset/liability mismatch risk can be managed but not eliminated. Where interest rates in these markets remain lower than interest rates used to calculate surrender values over a sustained period this could have an adverse impact on the Group’s reported profit.
In all markets in which Prudential operates, its businesses are susceptible to general economic conditions and changes in investment returns, which can also 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 higher credit defaults. In addition, falling investment returns could impair its ability to write significant volumes of new business. Prudential, in the normal course of business, enters into a variety of transactions, including derivative transactions with counterparties. Failure of any of these counterparties, particularly in conditions of major market disruption, to discharge their obligations, or where adequate collateral is not in place, could have an adverse impact on Prudential’s results.
The current EU Insurance Groups Directive (IGD) requires European financial services groups to demonstrate net aggregate surplus capital in excess of solvency requirements at the Group level in respect of shareholder-owned entities. The test is a continuous requirement, so that Prudential needs to maintain a somewhat higher amount of regulatory capital
The Group’s accounts are prepared in accordance with current international financial reporting standards (IFRS) applicable to the insurance industry. The International Accounting Standards Board (IASB) introduced a framework that it described as Phase I that permitted insurers to continue to use the statutory basis of accounting that existed in their jurisdictions prior to January 2005. The IASB has published proposals in its Phase II discussion paper that would introduce significant changes to the statutory reporting of insurance entities that prepare accounts according to IFRS. It is uncertain in what form the proposals in the discussion paper will be taken forward into a definitive IFRS and when such changes might take effect.
The resolution of several issues affecting the financial services industry could have a negative impact on Prudential’s reported results or on its reputation or on its relations with current and potential customers. 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 such as the requirement in the UK to provide redress to certain past purchasers of pension and mortgage endowment policies, changes to the tax regime affecting products and regulatory reviews on products sold and industry practices, including in the latter case businesses it has closed.
Regulators particularly, but not exclusively, in the US and the UK are moving towards a regime based on principles-based regulation which brings an element of uncertainty. These regulators are increasingly interested in the approach that product providers use to select third-party distributors. In some case product providers can be held responsible for the deficiencies of third-party distributors.
In the US, federal and state regulators have focused on, and continue to devote substantial attention to, the mutual fund, fixed index and variable annuity and insurance product industries. This includes new regulations in respect of the suitability of broker-dealers’ sales of certain products. As a result of publicity relating to widespread perceptions of industry abuses, there have been numerous regulatory inquiries and proposals for legislative and regulatory reforms.
Prudential is, and may be in the future, subject to legal actions and disputes in the ordinary course of its insurance, investment management and other business operations. These legal actions and disputes may relate to aspects of Prudential’s businesses and operations that are specific to Prudential, or that are common to companies that operate in Prudential’s markets. Legal actions and disputes may arise under contracts, regulations or from a course of conduct taken by Prudential, and may be class actions. Although Prudential believes that it has adequately reserved in all material aspects for the costs of litigation and regulatory matters, no assurance can be provided that such reserves are sufficient. Given the large or indeterminate amounts of damages sometimes sought, and the inherent unpredictability of litigation and disputes, it is possible that an adverse outcome could, from time to time, have an adverse effect on Prudential’s results of operation or cash flows.
Within the UK, Prudential’s principal competitors in the life insurance market include many of the major retail financial services companies including, in particular, Aviva, Legal & General, HBOS and Standard Life.
In Asia, the Group’s main regional competitors are international financial companies, including AIG, Allianz, AXA, ING and Manulife. In a number of markets, local companies have a very significant market presence.
As a holding company, Prudential is dependent upon its subsidiaries to cover operating expenses and dividend payments. Prudential’s insurance and investment management operations are generally conducted through direct and indirect subsidiaries. As a holding company, Prudential’s principal sources of funds are dividends from subsidiaries, shareholder-backed funds, the shareholder transfer from Prudential’s long-term funds and any amounts that may be raised through the issuance of equity, debt and commercial paper. Certain of the subsidiaries are regulated and therefore have restrictions that can limit the payment of dividends, which in some circumstances could limit the Group’s ability to pay dividends to shareholders.
Prudential operates in a number of markets through joint ventures and other arrangements with third parties. These arrangements involve certain risks that Prudential does not face with respect to its consolidated subsidiaries.
Prudential operates, and in certain markets is required by local regulation to operate, through joint ventures. Prudential’s ability to exercise management control over its joint venture operations and its investment in them depends on the terms of the joint venture agreements, in particular, the allocation of control among, and continued co-operation between, the joint venture participants. Prudential may also face financial or other exposure in the event that any of its joint venture partners fails to meet its obligations under the joint venture or encounters financial difficulty. In addition, a significant proportion of the Group’s product distribution is carried out through arrangements with third parties not controlled by Prudential and is dependent upon continuation of these relationships. A temporary or permanent disruption to these distribution arrangements could affect Prudential’s results of operations.
Calls to 0871 numbers are charged at eight pence per minute from a BT landline. Other telephony providers costs may vary.
Evergreen scrip dividend scheme The Company will be offering an evergreen scrip dividend scheme in respect of the final dividend for the year ending 31 December 2007. The number of new shares each participating shareholder will be entitled to, is calculated by dividing the total cash dividend due at the record date (11 April 2008) by the scrip reference price.
Electronic communications Shareholders are encouraged to elect to receive shareholder documents electronically by registering with Shareview at http:// www.shareview.co.uk This will save on printing and distribution costs, creating environmental benefits. When you register, you will be sent an email notification to say when shareholder documents are available on our website and you will be provided with a link to that information. When registering, you will need your shareholder reference number which can be found on your share certificate or proxy form. Please contact Equiniti if you require any assistance or further information.
American Depositary Receipts (ADRs) The Company’s ordinary shares are listed on the New York Stock Exchange in the form of American Depositary Shares, evidenced by ADRs and traded under the symbol PUK. Each American 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, P O Box 3408, South Hackensack, NJ 07606-3408, USA. Telephone 001 201 680 6630 or log on to
Form 20-F The Company is subject to the reporting requirements of the Securities and Exchange Commission (SEC) in the USA as such requirements apply to foreign companies and files its Form 20-F with the SEC. Copies of Form 20-F can be found on the Company’s website at prudential-plc/investors/financialreports/ or on the SEC’s website at
Prudential Corporation Asia 13th Floor One International Finance Centre 1 Harbour View Street Central Hong Kong www.prudentialcorporation-asia.com
Jackson National Life Insurance Company 1 Corporate Way Lansing Michigan 48951 United States www.jnl.com
Institutional Analyst and Investor Enquiries Tel +44 (0)20 7548 3511 E-mail investor.relations@prudential.co.uk