Items excluded from operating profit based on longer-term investment returns but included in profit before tax attributable to shareholders of continuing operations, include goodwill impairment charges, short-term fluctuations in investment returns (i.e. actual less longer-term returns), actuarial gains and losses on defined benefit pension schemes and exceptional items.
A5: Adoption of IAS 32, IAS 39 and IFRS 4 at 1 January 2005
The following table demonstrates the effects of adoption of IAS 32, IAS 39 and IFRS 4 on the IFRS balance sheet at 1 January 2005.
Intangible assets attributable to shareholders: Deferred acquisition costs and acquired in-force value of long-term business 2,244 23 (456) (433) 1,811
Unallocated surplus of the with-profits funds: Reflecting application of ‘realistic’ basis provisions for UK regulated with-profits funds 8,315 8,315 8,315
Reflecting previous UK GAAP basis of provisioning 16,122 (7,807) (8,315) (16,122)
Core structural borrowings of shareholder-financed operations: Subordinated debt (other than Egg) 1,429 5 5 1,434
Other non-insurance liabilities: Obligations under funding, securities lending and sale and repurchase agreements 3,819 3,819
Net asset value attributable to unit holders of consolidated unit trusts and similar funds 808 808
Total other non-insurance liabilities 11,840 (68) 443 (65) 76 386 12,226
Notes The changes shown above include the impact of remeasurement for: (i) UK insurance operations
(a) The reduction in shareholders’ equity of £22 million includes £20 million relating to certain unit-linked and similar contracts that do not contain significant insurance risk and are therefore categorised as investment contracts under IFRS 4.
A5: Adoption of IAS 32, IAS 39 and IFRS 4 at 1 January 2005 continued
Notes continued (b) Changes to insurance assets and liabilities of the PAC with-profits fund following the improvement of accounting policy applied on adoption of IFRS 4. The changes correspond to those applicable if the Group had adopted FRS 27 under UK GAAP. As a result of the policy improvement, liabilities, deferred acquisition costs, deferred tax and unallocated surplus of UK regulated with-profits funds are remeasured as described in note A4. At 1 January 2005, the unallocated surplus is subject to a transition adjustment of £(7.8) billion. Shareholders’ equity is not affected by this change.
The unallocated surplus of £8.3 billion at 1 January 2005 post-IAS 39 and IFRS 4 adoption, comprises £8.0 billion for the PAC with-profits fund and £0.3 billion for Asian subsidiaries. The £8.0 billion for the PAC with-profits fund represents: £bn
The following standards, interpretations and amendments have either been effective and adopted in 2006 or have been issued but are not yet effective in 2006. This is not intended to be a complete list as only those standards, interpretations and amendments that are anticipated to have an impact upon the Group’s financial statements have been discussed.
Amendment to IAS 39, ‘Cash Flow Hedge Accounting of Forecast Intra-Group Transactions’
Issued in December 2005, the amendments to IAS 21 clarify the definition of a foreign operation and the recognition of exchange difference in a net investment in a foreign operation. The amendments are effective for annual periods beginning on or after 1 January 2006.
The adoption of these aforementioned amendments did not have a material impact on the financial statements of the Group.
IFRS 7 replaces IAS 30, ‘Disclosures in the Financial Statements of Banks and Similar Financial Institutions’, which dealt with disclosures for banking operations, and the disclosure requirements of IAS 32, ‘Financial Instruments: Disclosure and Presentation’. The latter, therefore, becomes a standard dealing wholly with presentation of financial instruments. IFRS 7 is intended to complement the principles for recognising, measuring and presenting financial assets and financial liabilities in IAS 32 and IAS 39, ‘Financial Instruments: Recognition and Measurement’. The objective of IFRS 7 is to require entities to provide disclosures in their financial statements to enable the users of financial statements to evaluate the significance of financial instruments for the entity’s financial position and performance and the nature and extent of risks arising from financial instruments to which the entity is exposed and how the entity manages those risks. Consequential amendments have been made to other standards as a result of the release of IFRS 7, notably IAS 1, ‘Presentation of Financial Statements’, and IFRS 4, ‘Insurance Contracts’.
Revised IFRS 4, ‘Implementation Guidance’, was issued in December 2005 and is effective in conjunction with the adoption of IFRS 7 as discussed above. The revisions relate to disclosures around insurance contracts.
IFRS 8 requires entities to adopt the ‘management approach’ to reporting the financial performance of its operating segments. The amount of each operating segment item to be reported is the measure reported to the chief operating decision maker, which in some instances will be non-GAAP. IFRS 8 will require the Group to provide an explanation of the basis on which the segment information is prepared and a reconciliation to the amount recognised in the Group’s consolidated financial statements. This standard is effective for accounting periods beginning on or after 1 January 2009.
IFRIC 9 will require the Group to assess whether an embedded derivative is required to be separated from the host contract and accounted for as a derivative when it first becomes a party to the contract. Subsequent reassessment is prohibited unless there is a change in the terms of the contract that significantly modifies the cash flows that otherwise would be required under the contract, in which case a reassessment is required. This interpretation became effective for annual periods beginning on or after 1 June 2006.
Broker-dealer and fund management (including Curian losses of £8m (2005: £10m)) 10 14
Operating profit from continuing operations based on longer-term investment returns (note i) 893 957
Short-term fluctuations in investment returns on shareholder-backed business (note vi) 162 211
(ii) Effect of changes to assumptions, estimates and bases of determining life assurance liabilities The results of the Group’s long-term business operations are affected by changes of assumptions and bases of preparation. These are described in notes D2(f), D3(f) and D4(f). In particular, the operating result for UK insurance operations for 2006 has benefited from a credit of £46 million due to altered regulatory requirements, as explained in note D2(f), whilst the operating result for Asian long-term business in 2005 benefited by a net of £52 million for changes in Singapore and Taiwan as described in note D4(f).
(b) The risk margin reserve (RMR) charge for 2006 is based on an average annual RMR of 23 basis points (2005: 24 basis points) on a book value of US$43.9bn (2005: US$43.3bn)
(v) Goodwill impairment charge The charge for goodwill impairment of £120 million in 2005 related to the Japan life business. There was no impairment charge for goodwill in 2006. Further details of the Group’s goodwill are shown in notes H1 and H2.
(vi) Short-term fluctuations in investment returns on shareholder-backed business The fluctuations arise as follows: £m £m
(b) As a result of the April 2005 scheme valuation and subsequent discussions, the contribution levels for future ongoing service of active members were approximately doubled. The charge of £20 million in 2005 reflected the actuarial provision for this increase in expenses for certain insurance contracts.
(viii) Share-based payments The charge for share-based payments for Prudential schemes is for the SAYE and Group performance-related schemes.
UK insurance operations 31 M&G 2 Egg 12 Unallocated corporate 5
Basic earnings per share is calculated by dividing the earnings attributable to ordinary shareholders by the weighted average number of ordinary shares outstanding during the year, excluding those held in employee share trusts, which are treated as cancelled.
Net of tax Basic Diluted Before tax Tax Minority and minority earnings earnings (note B1) (note F5) interests interests per share per share 2006 £m £m £m £m Pence Pence
Based on operating profit based on longer-term investment returns 893 (257) 1 637 26.4p 26.4p
Shareholders’ share of actuarial and other gains and losses on defined benefit pension schemes (50) 15 – (35) (1.5)p (1.5)p
A reconciliation of the weighted average number of ordinary shares used for calculating basic and diluted earnings per share is set out as below: (millions) (millions)
Weighted average shares for calculation of basic earnings per share 2,413 2,365
Number of shares that would have been issued at fair value on assumed option exercise (7) (9)
Final dividend for prior period (2005: 11.02p, 2004: 10.65p per share) 267 252
Insurance products and investment products* Insurance products Investment products gross premiums gross inflows Total £m £m £m £m £m £m
Department of Work and Pensions rebate business 161 244 – – 16 24
Individual and bulk annuities: Bulk annuity reinsurance from the Scottish Amicable Insurance Fund* 560 – – – 56 –
GIC – Medium Term Notes 437 634 – – 44 63
New business premiums for regular premium products are shown on an annualised basis. Department of Work and Pensions rebate business is classified as single recurrent business. Internal vesting business is classified as new business where the contracts include an open market option.
This segment comprises long-term products that contain both a significant and insignificant element of insurance risk. The products are managed together and not classified in this way other than for accounting purposes. This segment also includes activity of the PAC withprofits funds’ venture investments managed by PPM Capital and other investment subsidiaries held for the purpose of supporting the
This segment consists of products provided by the Group’s online banking subsidiary, Egg. The nature of these products and the managing of the business differ from the risks inherent in the other business segments, and the regulatory environment of the banking industry differs from that of the other business segments. Note I8 includes details of the agreement in January 2007 to sell Egg Banking plc.
Long-term and fund Unallocated Intra-group business Banking management to a segment eliminations Total 2006 £m £m £m £m £m £m
Broker-dealer Long-term and fund Unallocated Intra-group business Banking management to a segment eliminations Total 2005 £m £m £m £m £m £m
Held for sale assets (note H9) 463 – – 463 – – – – 463
Cash and cash equivalents (note H10) 1,979 852 909 3,740 132 684 515 – 5,071
Policyholder liabilities and unallocated surplus of with-profits funds: Investment contract liabilities with discretionary participation features
(note H13): Subordinated debt (other than Egg) – – – – – – 1,538 – 1,538
Egg subordinated debt (note H13) – – 451 451 – – – – 451
Deferred acquisition costs 35 – – 35 – – – – 35
Cash and cash equivalents (note H10) 1,195 26 725 1,946 202 504 934 – 3,586
Notes on the Group financial statements continued 134 Prudential plc Annual Report 2006
UK insurance US Asian operations Egg Total UK operations operations Unallocated Intra-group Group (note D2) M&G (note E) operations (note D3) (note D4) to a segment eliminations total £m £m £m £m £m £m £m £m £m
Banking customer accounts (note G1) – – 5,830 5,830 – – – – 5,830
Policyholder liabilities and unallocated surplus of with-profits funds: Insurance contract liabilities
(note H13): Subordinated debt (other than Egg) – – – – – – 1,646 – 1,646
A significant part of the Group’s business involves the acceptance and management of risk. The Group’s risk management model requires the primary responsibility for risk management at an operational level to rest with business unit chief executives. The second line of defence of risk comprises oversight functions reporting to the Group Chief Executive together with business unit risk functions and risk management committees. The third line of defence comprises independent assurance from Internal Audit reporting to business unit and
The Group Risk Framework requires that all of the Group’s businesses and functions establish processes for identifying, evaluating and managing the key risks faced by the Group. The risk management of the Group has been given additional focus by the creation in 2005 of a new role of Group Chief Risk Officer (CRO). The CRO oversees all aspects of the Group’s risk management, including Financial Risk,
As a provider of financial services, including insurance, the Group’s business is the managed acceptance of risk. The system of internal control is an essential and integral part of the risk management process. As part of the annual preparation of its business plan, all of the
Businesses are required to confirm annually that they have undertaken risk management during the year as required by the Group Risk
The Group’s internal control framework includes detailed procedures set out in financial and actuarial procedure manuals. The Group prepares an annual business plan with three-year projections. Executive management and the Board receive monthly reports on the
The insurance operations of the Group all prepare a financial condition report which is presented to the Board, together with regular reports from the Group Finance Director on the financial position of the Group.
The Group publishes separately within its Group Annual Report a section on key risk factors, which discusses inherent risks in the business and trading environment.
Further analysis of the credit risks for Jackson is shown in note D3 and for Egg in note E7.
Prudential manages its assets and liabilities locally, in accordance with local regulatory requirements and reflecting the differing types of liabilities Prudential has in each business. As a result of the diversity of products offered by Prudential and the different regulatory environments in which it operates, Prudential employs different methods of asset/liability management, on both an in-force and new business basis. Stochastic modelling of assets and liabilities is undertaken in the Group’s insurance operations to assess economic capital requirements for different confidence intervals and time horizons. In addition, reserve adequacy testing under a range of scenarios and dynamic solvency analysis is carried out, including under certain scenarios mandated by the US, the UK and Asian regulators.
Investments Contracts (GICs). Perfect matching is not possible for interest-sensitive and fixed index annuities because of the nature of the liabilities (which include guaranteed surrender values) and options for prepayment contained in the assets. The US supervisory authorities require Jackson to calculate projections to test Jackson’s ability to run off its liabilities with assets equal to statutory reserves in a number of specified future economic scenarios. If Jackson is unable to satisfy all of these tests, which are carried out at least annually, then it may be required to establish additional statutory reserves.
It is Prudential’s policy that cash or corresponding assets cover amounts at risk through derivative transactions. Derivative financial instruments used to facilitate efficient portfolio management and for investment purposes are carried at fair value with changes in fair value included in long-term investment returns.
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, Prudential
• Prudential Corporation Asia – non-participating term, whole life, and unit-linked policies, together with accident and health policies.
Contracts of the Group, which are classified as investment contracts that do not contain discretionary participation features, whose assets and liabilities were required to be remeasured from 1 January 2005 under these two standards can be summarised as: • UK – certain unit-linked savings and similar contracts; • Jackson – GICs and funding agreements
Acquisition costs are deferred to the extent that it is appropriate to recognise an asset that represents the entity’s contractual right to benefit from providing investment management services and are amortised as the entity recognises the related revenue. IAS 18 further reduces the costs potentially capable of deferral to incremental costs only. Deferred acquisition costs are amortised to the income statement in line with service provision.
Under a traditional GIC, the policyholder makes a lump sum deposit. The interest rate paid is fixed and established when the contract is issued. Funding agreements are of a similar nature but the interest rate may be floating, based on a rate linked to an external index.
The US GAAP accounting requirements for such contracts are very similar to those under IFRS on the amortised cost model for liability measurement.
For the purposes of calculating Group economic capital, Group economic solvency is defined as the position where both: (a) the capital balance of the parent company is positive, and (b) all business units are solvent on the applicable local regulatory basis. This definition of solvency allows the Group’s capital position to be assessed on an economic basis while taking into account the actual regulatory constraints at the business unit level.
Notes D2(b), D3(b), 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 2006 as described in section D2(d)(ii).
The UK business also has products with guaranteed annuity option features, mostly within SAIF, as described in section D2(b). 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(b). Jackson’s derivative programme seeks to manage the exposures as described in section D3(c). The most significant exposure for the Group arises on Taiwan whole of life policies as described in section D4(h).
Notes on the Group financial statements continued 140 Prudential plc Annual Report 2006
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.
The business covered by the EEV basis results includes both investment contracts as well as insurance contracts (as defined under IFRS 4).
Investment contracts form a relatively small part of the Group’s long-term business as demonstrated by the carrying value of policyholder liabilities shown in the Group balance sheet.
The valuation of the future cash flows also takes account of the ‘time value’ of option and guarantee features of the Group’s long-term business contracts. The time value reflects the variability of economic outcomes in the future. Where appropriate, a full stochastic valuation is undertaken to determine the value of the in-force business. Common principles are adopted across the Group for the stochastic asset model classes, for example, separate modelling of individual asset classes but with allowance for correlation between the various asset classes. In deriving the time value of financial options and guarantees, management actions in response to emerging investment and fund solvency conditions are modelled. In all instances, the modelled actions are in accordance with approved local practice and therefore reflect the options actually available to management. For the PAC with-profits sub-fund, the actions are consistent with those set out in the Principles and Practices of Financial Management.
• With-profits business – investment performance subject to smoothing through declared bonuses; • unit-linked business – investment performance through fund management fees; and
• annuity business – mortality experience and assumptions and credit risk.
• Variable annuity business – fund management performance and incidence of guarantee features of the contracts; • fixed annuity business – spread differential between earned rate and rate credited to policyholder; and
• fixed indexed annuity business – spread differential between earned rate and rate credited to policyholder and incidence of equity index participation features.
• non-participating business – return on assets covering the Taiwan whole of life policies.
In the years 2002 to 2006, claims paid on the Group’s life assurance contracts including those now classified as investment contracts under IFRS 4 ranged from £11.8 billion to £15.9 billion. Indicatively it is to be expected that of the Group’s policyholder liabilities
Notes on the Group financial statements continued 142 Prudential plc Annual Report 2006
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, 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.
Other non-investment and non-cash assets 320 2,530 292 2,822 482 1,109 1,591 4,733 4,457
Amicable Excluding Prudential Prudential unit-linked UK insurance operations Insurance Prudential Annuities Retirement and other
Fund Annuities Limited Total Income business Total Total (note ii) Limited (note iii) (note iv) Limited (note v) Total 2006 2005 £m £m £m £m £m £m £m £m £m
Notes (i) For the purposes of this table and subsequent explanation, references to the WPSF also include, for convenience, the amounts attaching to the Defined Charges Participating Sub-fund.
(ii) Scottish Amicable Insurance Fund (SAIF) is a separate sub-fund within the PAC long-term business fund.
Prudential’s long-term products in the UK consist of life insurance, pension products and pension annuities.
With-profits products provide returns to policyholders through bonuses that are ‘smoothed’. There are two types of bonuses: ‘annual’
The WPSF held a provision of £47 million at 31 December 2006 (2005: £52 million) to honour guarantees on a small amount of guaranteed annuity products. SAIF’s exposure to guaranteed annuities is described below.
At 31 December 2006, £29.0 billion (2005: £25.3 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.
SAIF is a ring-fenced sub-fund of the PAC long-term fund formed following the acquisition of the mutually owned Scottish Amicable Life
Assurance Society in 1997. No new business may be written in SAIF, although regular premiums are still being paid on policies in force at the time of the acquisition and incremental premiums are permitted on these policies.
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 investment management fees on this business.
Prudential UK insurance operations also have an extensive book of unit-linked policies of varying types and provide a range of other non-profit business such as credit life and protection contracts. These contracts do not contain significant financial guarantees.
Prudential’s UK annuity business employs fixed income investments (including UK retail price index-linked assets) because the liabilities consist of guaranteed payments for as long as each annuitant or surviving partner is alive. Retail price index-linked assets are used to back pension annuities where the payments are linked to the RPI.
Except through the second order effect on investment management fees, the unit-linked business of the UK insurance operations is not exposed to market risk. The lack of exposure arises from the contract nature whereby policyholder benefits reflect asset value movements of the unit-linked funds.
For with-profits business written in the WPSF or SAIF, a market consistent valuation is performed (as described in section (ii) below).
The actual renewal expenses charged to SAIF will continue to be based on the tariff arrangement specified in the Scottish Amicable Life
Notes on the Group financial statements continued 146 Prudential plc Annual Report 2006
The FSA’s Peak 2 calculation under the new realistic regime, which came fully into effect for the first time for 2004 regulatory reporting requires the value of liabilities to be calculated as: • the with-profits benefits reserve (WPBR); plus
The WPBR is primarily based on the retrospective calculation of accumulated asset shares but is adjusted to reflect future expected policyholder benefits and other outgoings. By contrast, the Peak 1 basis addresses, at least explicitly, only declared bonuses.
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 and mismatching risk.
The mortality assumptions are set in light of recent population and internal experience. The assumptions used are percentages of standard actuarial mortality tables with an allowance for future mortality improvements. Where annuities have been sold on an enhanced basis to impaired lives an additional age adjustment is made. The percentages of the standard table used are selected according to the source of business. The range of percentages used is set out in the following tables: PAL PRIL
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.
(2005: £750 million) in aggregate. The gains and losses recognised in profit and loss for these contracts were immaterial.
(C = 2004) with 75% of medium cohort improvement table with a minimum annual improvement of 0.75%
(C = 2004) with medium cohort improvement table with a minimum annual improvement of 1.25%
AM92 minus 4 years of medium cohort improvement table with a minimum annual improvement of 0.75%
(f) Effect of changes in assumptions used to measure insurance assets and liabilities
Liabilities for PAL were increased by £47 million for the effect of change of assumptions for renewal expenses. As PAL is owned by the
The changes to the FSA rules allow insurance liabilities for this business to incorporate more realism. In particular this is achieved by: • setting technical provisions for expenses not directly attributable to one particular contract at a homogenous risk group level and not, as previously, at an individual contract level for all non-profit business; and
For with-profits business the only significant change for 2005 was an altered basis of recognising liabilities and unallocated surplus for
As described in section A4, the Group provides supplementary analysis of its profit before shareholder tax, distinguishing operating profit based on longer-term investment returns from short-term fluctuations in investment returns, actuarial gains and losses on defined benefit pension schemes, and exceptional items. In addition to the £36 million charge described above, an additional £20 million charge for 2005 for the effect of change of assumption for renewal expenses, which relates to an increase in ongoing future pension scheme contributions as described in section B1, was recorded as part of actuarial and other gains and losses excluded from operating profit but included in total profit before shareholder tax.
The net charge of £36 million comprised amounts in respect of PAC (£35 million charge), Prudential Holborn Life (£2 million credit) and
Note 2005 comparatives have been adjusted to reflect refinements to the methodology in UK insurance operations, for the effect of interest rate movements.
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.
A decrease in assumed mortality rates of one per cent would decrease gross profits by approximately £34 million (2005: £33 million).
A decrease in credit default assumptions of five basis points would increase gross profits by £64 million (2005: £65 million). A decrease in renewal expenses (excluding investment management expenses) of five per cent would increase gross profits by £14 million (2005: £12 million). The effect on profits would be approximately symmetrical for changes in assumptions that are directionally opposite to those explained above.
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(d) 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. To ascribe particular amounts payable to these contracts in future years does not provide appropriate information.
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 2006 and 2005 for that purpose for insurance contracts, as defined by IFRS, i.e. those containing significant insurance risk, and investment contracts, which do not.
Other non-investment and non-cash assets – 1,588 1,588 83 1,671 1,888
Policyholder liabilities: Investment contract liabilities without discretionary participation features (GIC and annuity certain) – 1,562 1,562 – 1,562 1,502
Operational borrowings attributable to shareholder-financed operations – 743 743 – 743 1,085 *Assets and liabilities attaching to variable annuity business that are not held in the separate account are shown within other business.
Policy reserves and liabilities on non-linked business: Reserves for future policyholder benefits and claims payable 935 971
At 31 December 2006, interest-sensitive fixed annuities accounted for 31 per cent (2005: 36 per cent) of policy and contract liabilities of
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.
Jackson hedges the equity return risk on fixed indexed products using futures and options linked to the relevant index. The cost of these hedges is taken into account in setting the index participation rates and caps. Jackson bears the investment and surrender risk on these products.
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.
The primary differences between VAs and interest-sensitive or fixed indexed annuities are investment risk and return. If a policyholder chooses a VA, the rate of return depends upon the performance of the selected fund portfolio. Policyholders may allocate their investment to either the fixed or variable account. Investment risk on the variable account is borne by the policyholder, while investment risk on the fixed account is borne by Jackson through guaranteed minimum fixed rates of return. At 31 December 2006, approximately 13 per cent (2005: 19 per cent) of VA funds were in fixed accounts.
Jackson’s main exposures to market risk are through its exposure to interest rate risk and equity risk. Approximately 89 per cent (2005: 88 per cent) of its general account investments support interest-sensitive and fixed indexed annuities, life business and surplus and 11 per cent (2005: 12 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.
Value movements on the derivatives are reported within the income statement. Under the Group’s accounting policies supplementary analysis of the profit before taxes attributable to shareholders is provided as shown in note B1. In preparing this analysis, value movements on Jackson derivative contracts, other than for certain equity-based product management activities, are included within short-term fluctuations in investment returns and excluded from operating results based on longer-term investment returns. Value movements on derivative instruments used for certain equity-based product management activities are included within operating results based on longer-term investment returns, as the value movements broadly offset the economic impact of changed levels of benefit payments and reserves as equity markets fluctuate. The types of derivative used by Jackson and their purpose are as follows: • interest rate swaps generally involve the exchange of fixed and floating payments over the life of the agreement without an exchange of the underlying principal amount. These agreements are used for hedging purposes; • forwards consist of interest spreadlock agreements, in which Jackson locks in the forward interest rate differential between a swap and the corresponding US Treasury security. The forwards are held as a hedge of corporate spreads; • put-swaption contracts provide the purchaser with the right, but not the obligation, to require the writer to pay the present value of a long-duration interest rate swap at future exercise dates. Jackson purchases and writes put-swaptions with maturities up to 10 years.
As noted above, Jackson is exposed to equity risk through the options embedded in the fixed indexed liabilities and GMDB and GMWB
guarantees included in certain VA benefits. This risk is managed using a comprehensive equity hedging programme to minimise the risk of a significant economic impact as a result of increases or decreases in equity market levels while taking advantage of naturally offsetting exposures in Jackson’s operations. Jackson purchases external futures and options that hedge the risks inherent in these products, while also considering the impact of rising and falling separate account fees. As a result of this hedging programme, if the equity markets were to increase, Jackson’s free-standing derivatives would decrease in value. However, over time, this movement would be broadly offset by increased separate account fees and reserve decreases, net of the related changes to amortisation of deferred acquisition costs. Due to the nature of the free-standing and embedded derivatives, this hedge, while highly effective on an economic basis, may not completely mute the immediate impact of the market movements as the free-standing derivatives reset immediately while the hedged liabilities reset more slowly (see note (d) for further details on the valuation of the guarantees) and fees are recognised prospectively. It is estimated that an immediate increase in the equity markets of 10 per cent would result in a net accounting charge of up to £20 million, excluding the impact on future separate account fees. The actual impact on financial results would vary contingent upon the volume of new product sales and lapses, changes to the derivative portfolio, correlation of market returns and various other factors including volatility, interest rates and elapsed time.
For statutory reporting in the US, debt securities are classified into six quality categories specified by the Securities Valuation Office of the National Association of Insurance Commissioners (NAIC). The categories range from Class 1 (the highest) to Class 6 (the lowest).
Performing securities are designated as Classes 1 to 5. Securities in or near default are designated Class 6. Securities designated as
The following table shows the quality of publicly traded and SEC Rule 144A traded debt securities held by the US operations as at 31 December 2006 and 2005: Carrying value Carrying value £m % of total £m % of total
The following table shows the quality of the non-SEC Rule 144A traded private placement portfolio: Carrying value Carrying value £m % of total £m % of total
The following table shows the quality of residential and commercial mortgage-backed securities: £m £m (unless (unless otherwise otherwise stated) stated)
Residential mortgage-backed securities rated AAA or equivalent by a nationally recognised statistical ratings organisation (including Standard & Poor’s, Moody’s and Fitch): Percentage of total 61.9% 86.9%
Commercial mortgage-backed securities rated investment grade: Percentage of total 93.2% 98.5%
Under the MSB of reporting applied under IFRS 4 for insurance contracts, providing the requirements of the Companies Act, UK GAAP
standards and the ABI SORP are met, it is permissible to reflect the previously applied UK GAAP basis. Accordingly, and consistent with the basis explained in note A4, in the case of Jackson the carrying values of insurance assets and liabilities are consolidated into the Group accounts based on US GAAP.
• any probable future loss on the contract (i.e. premium deficiency).
VA contracts written by Jackson may, as described above, provide for GMDB, GMIB and GMWB features. In general terms, liabilities for these benefits are accounted for under US GAAP by using estimates of future benefits and fees under best estimate persistency assumptions.
GMDB liability was valued using a series of deterministic investment performance scenarios, a mean investment return of 8.4 per cent
(2005: 8.4 per cent) and assumptions for lapse, mortality and expense that are the same as those used in amortising the capitalised acquisition costs.
The assumptions used for calculating the direct GMIB liability at 31 December 2006 and 2005 are consistent with those used for calculating the GMDB liability.
Notes on the Group financial statements continued 158 Prudential plc Annual Report 2006
With the exception of the GMDB, GMIB and GMWB features of VA contracts, the financial guarantee features of Jackson’s contracts are in most circumstances not explicitly valued, but the impact of any interest guarantees would be reflected as they are earned in the current account value (i.e. the US GAAP liability).
Institutional products are accounted for as investment contracts under IFRS with the liability classified as being in respect of financial instruments rather than insurance contracts, as defined by IFRS 4. In practice, there is no material difference between the IFRS and
Duration Contracts and Separate Accounts’ reserve increase of £13 million due to increasing the mortality assumption. Several smaller changes relating to single premium whole life surrenders and annuity mortality and annuitisation rates, resulted in a £19 million benefit on adjusting amortisation of DAC. Combined with other minor modifications, the resulting net impact of all changes during the year was a decrease in pre-tax profits of £7 million.
The sensitivity of the value of in-force business and net worth to changes in key assumptions is as follows: £m £m
Mortality and morbidity – 5% decrease in base rates (i.e. increased longevity) 75 90
Notes 2005 comparatives have been adjusted to reflect the effect of equity falls where the impact of associated hedging activity on variable annuity business is now included.
The principal determinants of variations in operating profit based on longer-term returns are: • growth in the size of assets under management covering the liabilities for the contracts in force; and
For the purpose of determining longer-term returns, adjustment is necessary for the normalisation of investment returns to remove the effects of short-term volatility in investment returns.
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
Except to the extent of mortality experience, which primarily affects profits through variations in claim payments and GMDB reserves, the profits of Jackson are relatively insensitive to changes in insurance risk.
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 2006 and 2005 is as follows: Fixed Fixed annuity and annuity and other other business usiness
Expected maturity: Note (i) The presentation of the 2005 maturity profile has been altered to a discounted basis from the previously published undiscounted basis to conform to the current year’s presentation.
With-profits assets and 2006 2005 business liabilities Other Total Total £m £m £m £m £m
Investments of long-term business and other operations: Financial investments: Equity securities and portfolio holdings in unit trusts 3,102 3,179 617 6,898 4,959
Policyholder liabilities and unallocated surplus of with-profits funds: Investment contract liabilities with discretionary participation features 68 – – 68 80
Investment contract liabilities without discretionary participation features 27 – – 27 22
The policyholder liabilities (net of reinsurance of £8 million (2005: £8 million)) and unallocated surplus shown in the table above reflect the following balances: £m £m
Notes on the Group financial statements continued 162 Prudential plc Annual Report 2006
In general terms, the Asian participating products provide savings and protection where the basic sum assured can be enhanced by a profit share (or bonus) from the underlying fund as determined at the discretion of the insurers. The Asian operations’ non-participating term, whole life and endowment products offer savings and/or protection where the benefits are guaranteed or determined by a set of defined market related parameters. Unit-linked products combine savings with protection, the cash value of the policy depends on the value of the underlying unitised funds. Accident and Health (A&H) policies provide mortality or morbidity benefits and include health, disability, critical illness and accident coverage. A&H products are commonly offered as supplements to main life policies but can be sold separately.
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.
Non-participating long-term products are the only ones where the insurer is contractually obliged to provide guarantees on all benefits.
Product guarantees in Asia can be broadly classified into four main categories; namely premium rate, cash value and interest rate guarantees, policy renewability and convertibility options.
Cash value and interest rate guarantees are of three types: • Maturity values
Maturity values are guaranteed for non-participating products and on the guaranteed portion of participating products. Declared annual bonuses are also guaranteed once vested. Future bonus rates and cash dividends are not guaranteed on participating products.
The guarantees are borne by shareholders for non-participating and investment-linked (non-investment guarantees only) products.
Participating product guarantees are predominantly supported by the segregated life funds and their estates.
Under these contracts, the cost of premiums are also fixed at inception based on a number of assumptions at that time, including longterm 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.
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
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.
For the Singapore life business, under the basis applied previously for 2004 and earlier, liabilities of non-participating business were determined on a net premium basis using prescribed interest rates such that a very high degree of prudence resulted. This basis has been replaced under the Singapore risk-based capital framework, with one that, although still including provisions for adverse deviation, more accurately estimates the liability. This resulted in a change of estimate and reduction in the liability of £73 million.
above. The loss reflects the reduction in 2005 in the expected yields over the trending period to the assumed long-term rate of 5.5 per cent for Taiwanese government bonds.
Consistent with the application of US GAAP for Taiwanese insurance contracts under IFRS 4, this write-off resulted from a premium deficiency as defined under paragraphs 35-37 of SFAS 60, ‘Accounting and Reporting by Insurance Enterprises’ (SFAS 60), and a resulting unlocking of actuarial assumptions in accordance with paragraph 21 of SFAS 60.
Under the standard liability adequacy testing required by SFAS 60, the net amount for the present value of future payments for benefits and claims less present value of future premiums, determined using revised assumptions based on actual and anticipated experience, i.e. the best estimate amount, has been compared against the balance sheet liability for policy benefits less unamortised acquisition costs.
At 31 December 2006, 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 £1,628 million (2005: £1,226 million). The most significant businesses in Asia are in Hong Kong, Malaysia, Singapore and Taiwan. These businesses account for 75 per cent (2005: 77 per cent) of the total value of business in force for the Asian operations. These EEV basis in-force values have been determined after applying the principles of valuation described in section D1 and the following key assumptions for the four most significant businesses.
Risk Risk discount Expected discount Expected rate long-term rate long-term (in-force rate of Government (in-force rate of Government business)** inflation bond yield business)** inflation bond yield *Hong Kong business is predominantly US dollar denominated.
For Taiwan the same assumptions are applied as under IFRS (see note (d) above).
Interest rates (including consequential changes for assumed investment returns for all assets classes, market values of debt securities and all risk discount rates): Equity/Property yields – 1% rise 154 136
Correspondingly, the profit emergence reflects bonus declaration and is relatively insensitive to period by period fluctuations in insurance risk or interest rate movements.
The principal other non-participating 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 two per cent. The current low level of bond rates in Taiwan gives rise to a negative spread against the majority of these policies. The current cash cost of funding in-force negative spread in Taiwan is around £40 million a year.
The profits attaching to these contracts are particularly affected by the rates of return earned, and estimated to be earned, on the assets held to cover liabilities and on future investment income and contract cash flows. Under IFRS, the insurance contract liabilities of the
The liability adequacy test results are sensitive to the attainment of the trended rates during the trending period. Based on the current asset mix, margins in other contracts that are used in the assessment of the liability adequacy tests and currently assumed future rates of return, if interest rates were to remain at current levels in 2007 and the target date for attainment of the long-term bond yield deferred to 31 December 2014, the premium reserve, net of deferred acquisition costs, would be broadly sufficient. If interest rates were to remain at current levels in 2008 with a further one year delay in the progression period, then some level of write-off of deferred acquisition costs may be necessary. However, the amount of the charge based on current in-force business, which is estimated at £70-90 million, is sensitive to the previously mentioned variables.
For the Korean and Japanese life business exposures described in note (b) above, the results are comparatively unaffected by changes of assumption. The accounts basis value of liabilities for both operations are of a similar order of magnitude to those that apply for the purposes of Group solvency calculations under the Financial Conglomerates Directive (FCD).
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: £m £m
The Group’s 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 2006 and 2005. Parent company Other UK and life shareholders’ assurance equity of
Total PAC subsidiaries Asian life Total life other WPSF with-profits and funds assurance assurance subsidiaries Group
Held outside long-term funds: Held in long-term funds (note iii) – – – 700 – – 700 – – – 700
Shareholders’ share of realistic liabilities – (4,000) (4,000) – – – (4,000)
Jackson surplus notes (note iv) – – – – 127 – 127
Adjustment from IAS 19 basis pension surplus attributable to WPSF to pension liability for regulatory purposes (note vii) – (244) (244) – – – (244)
Notes on the Group financial statements continued 168 Prudential plc Annual Report 2006
assurance equity of Total PAC subsidiaries Asian life Total life other
WPSF with-profits and funds assurance assurance subsidiaries Group SAIF (note i) fund (note ii) Jackson subsidiaries operations M&G Egg and funds total
Shareholders’ share of realistic liabilities – (3,473) (3,473) – – – (3,473)
Other adjustments to restate these amounts to a regulatory basis (with
Notes on the Group financial statements continued 170 Prudential plc Annual Report 2006
(iii) The term shareholders’ equity held in long-term funds refers to the excess of assets over liabilities attributable to shareholders of funds which are required by law to be maintained with segregated assets and liabilities.
(iv) For regulatory purposes the Jackson surplus notes are accounted for as capital.
(vii) In determining the IAS 19 adjustment for the purposes of this table the surplus (deficit) in the Group’s main pension scheme used for the calculation includes amounts for investments in Prudential insurance policies (see note I1).
Each of the Group’s long-term business operations is capitalised to a sufficiently strong level for its individual circumstances. Details by the
As noted in section D2(d)(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.
In normal investment conditions, PAC expects changes to regular bonus rates to be gradual over time and changes are not expected to exceed one per cent per annum over any year. However, discretion is retained as to whether or not a regular bonus is declared each year, and there is no limit on the amount by which regular bonus rates can be changed.
For surrender benefits, any substantial fall in the market value of the assets of the with-profits sub-fund would lead to immediate changes in the application of MVRs for accumulating with-profits policies, firstly to increase the size of MVRs already being applied and, secondly, to extend the range of policies for which an MVR is applied.
The available capital of £903 million (2005: £759 million) reflects the excess of regulatory basis assets over liabilities of the subsidiaries and funds, before deduction of the capital resources requirement of £809 million (2005: £718 million).
The regulatory framework for Jackson is governed by the requirements of the US NAIC approved risk-based capital standards. Under the requirements life insurance companies report on a formula-based capital standard that they calculate by applying factors to various asset, premium and reserve items. The formula takes into account the risk characteristics of a company, including asset risk, insurance risk, interest rate risk and business risk.
The available capital shown above of £566 million (2005: £570 million) represents the excess of local regulatory basis assets over liabilities before deduction of required capital of £211 million (2005: £149 million). These amounts have been determined applying the local regulations in each of the operations.
A new risk-based regulatory framework was introduced at the start of 2005 to replace the previous framework that used a net premium approach.
The capital requirement is determined as four per cent of reserves plus a specified percentage of sums at risk. There is an overriding minimum capital requirement of 100 million Malaysian Ringgits.
In addition to the requirements at individual company level, FSA requirements under the FCD apply additional prudential requirements for the Group as a whole. Discussion of the Group’s estimated FCD position at 31 December 2006 is provided in the operating and financial review section of the Group’s 2006 Annual Report.
Total available capital for the Group’s life assurance operations has changed during 2006 as follows: Other UK subsidiaries Asian life
(ii) SAIF The decrease of £677 million in 2005 reflects the impact of FSA actuarial guidance note GN 45 as explained in note D2(f).
The increase of £461 million in 2005 reflects an underlying increase of £252 million (applying the 2005 year end exchange rate of 1.72) and £209 million of exchange translation gain.
(iv) Other UK life assurance subsidiaries and funds The increase in available capital in 2006 from changes in regulatory requirements of £80 million is primarily due to regulatory changes for UK regulated shareholder-backed non-participating business from the FSA’s policy statement PS06/14 confirmed in December 2006. The changes allow liabilities for this business to incorporate more economic realism. Additional details are shown in note D2.
For PAC and all other UK long-term insurers, long-term business assets and liabilities must, by law, be maintained in funds separate from those for the assets and liabilities attributable to non-life insurance business or to shareholders. Only the ‘established surplus’ – the excess of assets over liabilities in the long-term fund determined through a formal valuation – may be transferred so as to be available for other purposes. Distributions from the with-profits sub-fund to shareholders reflect the shareholders’ one-ninth share of the cost of declared policyholders’ bonuses.
For Jackson, capital retention is maintained at a level consistent with an appropriate rating by Standard & Poor’s. Currently Jackson is rated
AA. Jackson can pay dividends on its capital stock only out of earned surplus unless prior regulatory approval is obtained. Furthermore, dividends which exceed the greater of 10 per cent of Jackson’s statutory surplus or statutory net gain from operations for the prior year require prior regulatory approval.
Jackson for its interest-sensitive and fixed indexed annuities and stable value products.
The Group has presented the income statement and balance sheet for banking operations in a format that demonstrates the characteristics and principal operations specific to a bank. The format is different from that of the Group consolidated income statement and balance sheet; however, total (loss) profit for the year and net assets remain the same. To understand how the amounts presented from banking operations are consolidated in the Group financial statements, refer to the primary segmental information for the income statement in note
F1 and the primary segmental information for the balance sheet in note B5.
The (loss) profit included in the Group consolidated income statement in respect of banking operations is as follows: Note £m £m
Impairment losses on loans and cash advances to customers E5 (384) (241)
Discontinued operations above relate to Egg France and Funds Direct and have been treated as discontinued operations in the Group’s consolidated income statement. For further information on discontinued operations, see note F6.
Assets, liabilities and shareholders’ funds included in the Group consolidated balance sheet in respect of banking operations are as follows: £m £m
Egg uses financial instruments including derivatives for the purpose of supporting the strategic and operational business activities and to reduce and eliminate the risk of loss arising from changes in interest rates and foreign exchange rates.
The matching and controlled mismatching of the maturities and interest rates of assets and liabilities is fundamental to the management of a bank. It is unusual for banks ever to be completely matched since business transacted is often of uncertain terms and of different types.
Up to 1 month 3 months 1 year 5 years 1 month to 3 months to 1 year to 5 years and over Total
Loans and advances to banks 876 – – 2 25 903
Loans and advances to customers – 3,343 40 1,421 2,626 7,430
The composition of interest rate risk is closely monitored and managed on a day-to-day basis by the treasury function where professional expertise and systems exist to control it. This is primarily done via asset and liability models that look at the sensitivity of earnings to movements in interest rates to measure overall exposure which may then be hedged in accordance with the policy limits set by the ALCO.
Egg places 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 are monitored regularly and reviewed where appropriate.
Rest of Europe 244 399 *This includes £9,475 million (2005: £9,104 million) of off-balance sheet items, which mainly relate to unutilised credit limits on credit cards.
The following is a breakdown of the credit risk borne by Egg for financial assets and off-balance sheet items at 31 December 2006 and 2005: £m £m
Off-balance sheet items (including unutilised credit limits on credit cards) 9,475 9,104
At 31 December 2006, Egg had certain credit-related commitments in the form of unused credit limits on credit cards of £9,458 million
(2005: £10.9 billion) of which £3.9 billion (2005: £5.7 billion) related to derivative financial instruments and £1.8 billion (2005: £2.3 billion)
For further information on Egg’s securitisation of credit card receivables, see note G4.
Notes on the Group financial statements continued 180 Prudential plc Annual Report 2006
The segment results for the years ended 31 December 2006 and 2005 are as follows: £m £m
Long-term business, including post-tax transfers to unallocated surplus of with-profits funds (32,162) (36,997)
Profit for the year 875 760 *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, unit-linked policies and shareholders’ profits.
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.
Realised losses on available-for-sale securities, previously recognised directly in equity (7) (22)
Fee income from investment contract business, fund management, banking and broker-dealer services 1,024 926
Note (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.
Notes (i) Acquisition costs in 2006 comprise amounts related to insurance contracts of £1,165 million (2005: £1,307 million), and investment contracts and investment management contracts of £73 million (2005: £106 million). These costs include amortisation of £299 million (2005: £392 million) and £6 million (2005: £9 million) respectively.
(ii) Administrative and operating costs include total depreciation and amortisation expense amounting to £516 million (2005: £541 million). Of this amount, £305 million (2005: £401 million) relates to amortisation of deferred acquisition costs of insurance contracts and investment management contracts, which is primarily borne by the long-term business segment. Of the remainder of the depreciation and amortisation charge of £211 million (2005: £140 million), £156 million (2005: £101 million) relates to long-term business, £44 million (2005: £28 million) to banking, £8 million (2005: £8 million) to fund management and £3 million (2005: £3 million) to central companies.
Notes on the Group financial statements continued 182 Prudential plc Annual Report 2006
Finance costs consist of £177 million (2005: £175 million) interest on core debt of the parent company and related finance subsidiaries and
Jackson surplus notes and of £33 million (2005: £33 million) on Egg subordinated debt.
An analysis of the total tax expense of continuing operations recognised in the income statement by nature of expense (benefit) is as follows: £m £m
Benefit from a previously unrecognised tax loss, tax credit or temporary difference from a prior period – (2)
Current tax expense: Deferred tax expense: The total deferred tax expense arises as follows: £m £m
For the purposes of explaining the relationship between tax expense and accounting profit, it is appropriate to consider the sources of profit and tax by reference to those that are attributable to shareholders and policyholders, as follows: Attributable to Attributable to Attributable to Attributable to shareholders policyholders* Total shareholders policyholders* Total £m £m £m £m £m £m
Taxation charge: Variance from expected tax charge (note v(ii)) 27 – 27 112 – 112 *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.
IFRS 4, the residual equity of the Group’s with-profits funds, i.e. unallocated surplus, is recorded as a liability with transfers to and from that liability reflected in pre-tax profits. This gives rise to anomalous effective tax rates for profits attributable to policyholders (as described in note (iv) below).
In meeting the reconciliation requirements set out in paragraph 81(c) of IAS 12, the presentation shown in this disclosure note seeks to ensure that the explanation of the relationship between tax expense and accounting profit draw properly the distinction between the elements of the profit and tax charge that are attributable to policyholders and shareholders as explained below in notes (iv) and (v), respectively. The shareholder elements are the components of the profit and tax charge that are of most direct relevance to investors, and it is this aspect that the IAS 12 requirement is seeking to explain for companies that do not need to account for both with-profits and unit-linked funds, where tax is borne by the Company on the policyholders’ behalf and which is not contemplated by IFRS requirements.
The investment return referrable to pension business, and some other less significant classes of business, is exempt from taxation, but tax is charged on the profit that shareholders derive from writing such business at the corporate rate of tax. The rules for taxing life insurance business are more complex. Initially, the UK regime seeks to tax the regulatory basis investment return less management expenses (I-E) on this business as it arises. However, in determining the actual tax charge, a calculation of the shareholder profits for taxation purposes from writing life insurance business also has to be made and compared with the I-E profit.
As noted above, it is necessary under IFRS requirements to include the total tax charge of the Company (both policyholder and shareholder elements) in the tax charge disclosed in the income statement.
For SAIF similar transfers are made. However, in the case of SAIF, a net nil balance is derived, reflecting the lack of shareholder interest in the financial performance of the fund (other than through investment management arrangements).
The accounting anomaly that arises under IFRS is that due to the fact that the net of tax profit attributable to with-profits policyholders is zero, the Company’s presentation of pre-tax profit attributable to policyholders reflects an amount that is the mirror image of the tax charge attributable to policyholders.
The net of tax profit attributable to policyholders for unit-linked business is thus zero.
(v) Reconciliation of tax charge on profits attributable to shareholders Asian
Profit before tax attributable to shareholders: Operating profit based on longer-term investment returns (note iii) 469 398 175 (149) 893
Expected tax rate (note i): Operating profit based on longer-term investment returns (note iii) 30% 35% 25% 30% 31%
Shareholders’ share of actuarial and other gains and losses on defined benefit pension schemes 30% 35% 25% 30% 30%
Variance from expected tax charge (note ii): Operating profit based on longer-term investment returns (note iii) 23 5 (10) 4 22
Shareholders’ share of actuarial and other gains and losses on defined benefit pension schemes 0 0 0 0 0
Actual tax charge: Operating profit based on longer-term investment returns (note iii) (118) (134) (54) 49 (257)
Shareholders’ share of actuarial and other gains and losses on defined benefit pension schemes 0 0 0 (50) (50)
Notes on the Group financial statements continued 186 Prudential plc Annual Report 2006
Profit before tax attributable to shareholders: Operating profit based on longer-term investment returns (note iii) 400 348 175 34 957
Shareholders’ share of actuarial and other gains and losses on defined benefit pension schemes (20) 0 3 (33) (50)
Expected tax rate (note i): Operating profit based on longer-term investment returns (note iii) 30% 35% 26% 30% 31%
Shareholders’ share of actuarial and other gains and losses on defined benefit pension schemes 30% 35% 0% 30% 32%
Expected tax charge based on expected tax rates: Operating profit based on longer-term investment returns (note iii) (120) (122) (46) (10) (298)
Shareholders’ share of actuarial and other gains and losses on defined benefit pension schemes 6 0 0 10 16
Variance from expected tax charge (note ii): Operating profit based on longer-term investment returns (note iii) 3 (1) (17) 127 112
Shareholders’ share of actuarial and other gains and losses on defined benefit pension schemes (1) 0 0 0 (1)
For 2005, the principal variances arise from differences between the standard corporation tax rate and actual rates for ‘other’ operations. This is due to a number of factors including: (a) The settlement of outstanding issues with HM Revenue and Customs (HMRC) at amounts below those previously provided. The settlements related to a range of issues affecting both shareholder and policyholder taxes. Many of the issues had been in dispute for several years. The principal issues resolved were as follows: Firstly, HMRC had disputed the deductibility of commissions paid on credit life (protection) insurance. Prudential’s treatment of the commissions was consistent with industry practice. At the start of 2005 it looked likely that the dispute would only be settled through litigation. However, it proved possible to negotiate a settlement acceptable to both parties.
Secondly, in 2000 Prudential transferred the insurance business previously carried on by two M&G subsidiaries into another subsidiary, Scottish Amicable Life (SAL). In 2002, Prudential transferred the entire business of SAL (including the old M&G business) into Prudential Assurance Company Limited. Both of these transactions were conducted under a statutory framework, which included obtaining High Court approval. The transactions were complex, leading to a difference in views between HMRC and Prudential as to the correct tax treatment of the transactions. These differences were resolved through a negotiated settlement.
(b) The tax credit arising from relief for excess expenses in respect of the shareholder-backed protection business.
(c) Prior year adjustments arising from routine revisions of tax returns.
For the purposes of the 2006 financial statements, Egg is reported as part of continuing operations. Note I8 provides details of the agreement to sell Egg after the balance sheet date.
Notes on the Group financial statements continued 188 Prudential plc Annual Report 2006
The Group designates all financial assets as either fair value through profit and loss, available-for-sale, or as loans and receivables.
Equity securities and portfolio holdings in unit trusts 78,892 – – 78,892 78,892
Fair value Total through profit Amortised carrying and loss cost IFRS 4 value Fair value 2006 £m £m £m £m £m
Net asset value attributable to unit holders of consolidated unit trust and similar funds 2,476 – – 2,476 2,476
Investment contracts without discretionary participation features 11,480 1,562 – 13,042 13,035
Equity securities and portfolio holdings in unit trusts 71,985 – – 71,985 71,985
Fair value Total through profit Amortised carrying and loss cost IFRS 4 value Fair value 2005 £m £m £m £m £m
Net asset value attributable to unit holders of consolidated unit trust and similar funds 965 – – 965 965
(iii) It is impractical to determine the fair value of investment contracts with discretionary participation features due to the lack of a reliable basis to measure such features.
The fair value estimates are made at a specific point in time, based upon available market information and judgements about the financial instruments, including estimates of the timing and amount of expected future cash flows and the credit standing of counterparties. Such estimates do not reflect any premium or discount that could result from offering for sale at one time the Group’s entire holdings of a particular financial instrument, nor do they consider the tax impact of the realisation of unrealised gains or losses. In some cases the fair value estimates cannot be substantiated by comparison to independent markets, nor can the disclosed value be realised in immediate settlement of the financial instrument.
The fair value of borrowings is based on quoted market prices, where available.
Notes on the Group financial statements continued 190 Prudential plc Annual Report 2006
In accordance with the Group’s Risk Management Framework, all internally generated calculations are subject to independent assessment by the Group’s Fair Value Committees which comprise members who are independent of the fund managers involved in the day-to-day trading in these assets.
(2005: a gain of £82 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 or shareholders’ equity.
The other financial investments which are not quoted on active markets were assets held by Jackson that had a fair value of £589 million
The US operations of Prudential had two groups of assets which were valued using valuation techniques – derivatives that are accounted for under IAS 39 on a fair value through profit and loss basis and securities held by the Piedmont trust entity, an 80 per cent Jackson held static trust formed as a result of a securitisation of asset-backed securities in 2003 that are accounted for on an available-for-sale basis.
As at 31 December 2006, the fair value of the derivative and Piedmont assets valued using valuation techniques was £184 million and £405 million, respectively (2005: £518 million and £700 million respectively).
The following table shows an analysis of the classes of financial assets and liabilities with direct exposure to interest rate risk. Each applicable class of the Group’s financial assets or liabilities is analysed between those exposed to fair value interest rate risk, cash flow interest rate risk and those with no direct interest rate risk exposure: Not directly
Fair value Cash flow exposed to interest interest interest rate risk rate risk rate risk Total 2006 £m £m £m £m
Not directly Fair value Cash flow exposed to interest interest interest rate risk rate risk rate risk Total 2005 £m £m £m £m
The following table sets out the Group’s commitments to lend funds at a fixed rate: Weighted Weighted average average interest interest
Term to maturity: Less than 1 year – – 16 11.9
Borrowings attributable to with-profits funds 1,223 3.0 – 7.6 1,339 6.0 – 10.0
Investment contracts without discretionary participation features 1,562 2.0 – 8.2 1,502 2.0 – 8.2
Banking customer accounts (note E2) 5,498 56 – – – – – 5,554
Obligations under funding, stocklending and sale and repurchase agreements 4,529 – – – – – – 4,529
As at 31 December 2006, the Group held 16 per cent (2005: 18 per cent) and 15 per cent (2005: 21 per cent) of its financial assets and financial liabilities respectively, in currencies, mainly US dollar and Euro, other than the functional currency of the relevant business unit.
The financial liabilities, of which 14 per cent (2005: 22 per cent) are held by the PAC with-profits fund, mainly relate to foreign currency borrowings.
Term Notes (MTN) liabilities and £34 million of net losses (2005: £18 million net gains), mainly arising on investments of the PAC withprofits 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.
master agreements and the Group has collateral agreements between the individual group entities and relevant counterparties in place under each of these market master agreements.
The total fair value balances of derivative assets and liabilities as at 31 December 2006 were as follows: UK insurance Banking Other operations US operations operations Total 2006 £m £m £m £m £m
UK insurance Banking Other operations US operations operations Total 2005 £m £m £m £m £m
The notional amount of the derivatives, distinguishing between UK insurance, US, banking and other operations was as follows: UK insurance operations US Banking operations
Egg uses derivative instruments for the purpose of supporting the strategic and operational business activities and reducing and eliminating the risk of loss arising from changes in interest rates and foreign exchange rates. Derivatives are used solely to hedge risk exposures and Egg does not take any trading position in derivatives.
Jackson has had a collar fair value hedge in place since 1 March 2005. This common stock equity collar transaction was entered into to protect the Company’s unrealised gain of US$5.9 million on an equity investment. The hedge expires in March 2008.
Egg has cash flow hedged certain balance sheet items which are 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 this cash flow hedge was £1,711 million (2005: £2,296 million). The cash flows are periodically updated based on the underlying banking portfolios. The net movement on ineffective positions of cash flow hedges recognised in the income statement in 2006 was a loss of £nil (2005: £0.2 million)
The Group has designated perpetual subordinated capital securities totalling US$1.55 billion as a net investment hedge to hedge the currency risks related to the net investment in Jackson. The carrying value of the subordinated capital securities was £763 million (2005: £865 million)
(2005: £10,594 million) (of which £7,592 million (2005: £8,250 million) was lent by the PAC with-profits fund) of securities and held collateral under such agreements of £11,814 million (2005: £11,112 million) (of which £7,934 million (2005: £8,657 million) was held by the PAC with-profits fund).
At 31 December 2006, the Group had entered into reverse repurchase transactions under which it purchased securities and had taken on the obligation to resell the securities for the purchase price of £1,435 million (2005: £1,214 million), together with accrued interest.
At 31 December 2006, the Group had pledged £263 million (2005: £403 million) for liabilities and held collateral of £212 million (2005: £193 million) in respect of over-the-counter derivative transactions.
During the year ended 31 December 2006, impairment losses of £416 million (2005: £278 million) were recognised. These were mainly for loans and advances to customers in Egg and available-for-sale securities held by Jackson.
Impairment losses recognised on available-for-sale securities amounted to £24 million (2005: £24 million). Of this amount, 76 per cent
(2005: 28 per cent) has been recorded on structured asset-backed securities, primarily due to reduced cash flow expectations on such securities that are collateralised by diversified pools of primarily below investment grade securities. 22 per cent (2005: 53 per cent) of the losses related to the impairment of fixed maturity securities of two (2005: five) individual corporate issuers, reflecting deteriorating business outlook of the companies concerned.
The impairment losses have been recorded in ‘acquisition costs and other operating expenditure’ in the income statement.
For 2006, the difference between the carrying value and book cost of equity securities in gross unrealised loss position was £(1) million
(2005: £(1) million). The following table shows the amounts of gross unrealised losses for fixed maturity securities classified as availablefor -sale under IFRS in an unrealised loss position for the time periods indicated as at 31 December 2006 and 31 December 2005.
in an unrealised loss position by maturity date of the securities as at 31 December 2006 and 31 December 2005.
Disposals (including, for 2005, goodwill of held for sale venture investment subsidiaries – see note H9) – (5)
Goodwill does not generate cash flows independently of other groups of assets and thus is assigned to cash generating units (CGUs) for the purposes of impairment testing. These CGUs are based upon how management monitors the business and represent the lowest level to which goodwill can be allocated on a reasonable basis. An allocation to CGUs of the Group’s goodwill attributable to shareholders is shown below: £m £m
‘Other’ represents goodwill amounts allocated across CGUs in Asia and US operations. These goodwill amounts are not individually material.
Company routinely compares the aggregate of net asset value and acquired goodwill on an IFRS basis of acquired life business with the value of the business as determined using the EEV methodology, as described in note D1. Any excess of IFRS over EEV carrying value is then compared with EEV basis value of current and projected future new business to determine whether there is any indication that the goodwill in the IFRS balance sheet may be impaired.
As a cross check to the discounted cash flow analysis, a review was undertaken of publicly available information for companies engaged in businesses comparable to the component businesses, including reported market prices for such companies’ shares. In addition, a review was undertaken of publicly available terms of transactions involving companies comparable to the component businesses. In particular, comparison has been made of the valuation multiples implied by the discounted cash flow analysis to current trading multiples of companies comparable to the component businesses, as well as to multiples achieved in precedent transactions.
Notes on the Group financial statements continued H: Other information on balance sheet items 200 Prudential plc Annual Report 2006
(ii) The risk discount rate. Differing discount rates have been applied in accordance with the nature of the individual component businesses.
‘beta’ factor for relative market risk of comparable UK listed asset managers. A similarly granular approach has been applied for the other component businesses of M&G.
Management believes that any reasonable change in the key assumptions would not cause the carrying amount of M&G to exceed its recoverable amount.
As noted above, the entire goodwill relating to the Japanese life operation of £120 million was deemed to be impaired in 2005 following impairment testing carried out. This testing was based on a recoverable amount for the Japanese company that was determined by calculating its value in use based on net present value cash flow projections. Such projections reflected existing business over the expected duration of the contracts and expected new business. A risk discount rate of five per cent was applied to the projected cash flows. On the basis of the results of this exercise, all goodwill held in relation to the Japanese business was written off in 2005.
Present value of acquired in-force policies for insurance contracts as classified under IFRS 4 66 92
Total of deferred acquisition costs and acquired in-force value of long-term business contracts 2,497 2,405
The movement in deferred acquisition costs relating to insurance contracts attributable to shareholders is as follows: £m
Incremental costs associated with the origination of investment management contracts written by the Group’s insurance and fund management businesses are capitalised and amortised as the related revenue is recognised. Deferred acquisition costs related to investment management contracts are all internally generated.
IAS 18. The remainder of the PVAIF balance relates to insurance contracts and is accounted for under UK GAAP as permitted by IFRS 4.
The amortisation charge is included in ‘acquisition costs and other operating expenditure’ in the income statement.
In the 2005 financial statements the following details were included: • at 1 January 2005, goodwill in respect of acquired venture fund investment subsidiaries was £784 million; • during 2005, acquisitions amounted to £151 million and disposals (including held for sale subsidiaries) amounted to £328 million; and
• at 31 December 2005, the goodwill and other acquired intangible assets in respect of PAC with-profits fund were £607 million and £nil respectively.
All goodwill additions relate to the UK and the long-term business segments. Additional details on the acquisitions are provided in note I6.
These costs relate to non-participating business written by the PAC with-profits sub-fund. No deferred acquisition costs are established for the participating business.
Notes on the Group financial statements continued 204 Prudential plc Annual Report 2006
Deferred tax assets are recognised to the extent that they are regarded as recoverable, that is to the extent that, on the basis of all available evidence, it can be regarded as more likely than not that there will be suitable taxable profits from which the future reversal of the underlying temporary differences can be deducted. The UK taxation regime applies separate rules to trading and capital profits and losses. The distinction between temporary differences that arise from items of either a capital or trading nature may affect the recognition of deferred tax assets. Accordingly, for the 2006 results and balance sheet position at 31 December 2006, the possible tax benefit of approximately £333 million (2005: £333 million), which may arise from capital losses valued at approximately £1.7 billion (2005: £1.7 billion), is sufficiently uncertain that it has not been recognised. In addition, a potential deferred tax asset of £71 million (2005: £67 million), which may arise from trading losses of approximately £245 million (2005: £237 million), is sufficiently uncertain that it has not been recognised.
Of the £2,952 million (2005: £3,096 million) of accrued investment income and other debtors, £800 million (2005: £992 million) is expected to be settled after one year or more.
Notes on the Group financial statements continued 206 Prudential plc Annual Report 2006
Investment properties principally relate to the PAC with-profits fund and are carried at fair value. A reconciliation of the carrying amount of investment properties at the beginning and end of the year is set out below: £m £m
The income statement includes the following items in respect of investment properties: £m £m
Direct operating expenses (including repairs and maintenance expenses) arising from investment properties: That generated rental income during the year 118 133
That did not generate rental income during the year 8 7
Investment properties of £4,990 million (2005: £4,463 million) are held under finance leases. A reconciliation between the total of future minimum lease payments at the balance sheet date, and their present value is shown below: £m £m
Contingent rent is that portion of the lease payments that is not fixed in amount but is based on the future value of a factor that changes other than with the passage of time. Contingent rent recognised as an expense in 2006 amounted to £11 million (2005: £21 million).
The Group had three associates at 31 December 2006 (2005: one) that are accounted for using the equity method. The Group acquired two new associates in 2006, a 30 per cent interest in Apollo Education and Training Organisation Vietnam and a 25 per cent interest in
During the year, IfOnline issued further shares to its shareholders which diluted the Group’s holding to 28.8 per cent (2005: 38.6 per cent) of the total issued share capital. Total share capital comprises 29.9 per cent of the ordinary share capital, 96.0 per cent of the preference share capital, a £1 Founder share capital and £1 AN share capital. IfOnline is not a listed investment. Equity accounting is applied based on its reporting period of the year to 30 November and is adjusted for material changes up to 31 December. Accordingly, the information is deemed to cover the same period as that of the Group.
A summary of the movements in investments in associates accounted for using the equity method in 2006 and 2005 is set out below: Share of Share of Share of Total carrying capital reserves net assets Goodwill value £m £m £m £m £m
The Group’s associates that are carried at fair value through profit and loss comprise investments in OEICs, unit trusts, funds holding collateralised debt obligations, property unit trusts, and venture capital investments of the PAC with-profits fund managed by PPM
Capital, where the Group has significant influence. These investments are incorporated both in the UK and overseas, and some have year ends which are non-coterminous with that of the Group. In these instances, the investments are recorded at fair value at 31 December 2006 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 (2005: £2 billion) at 31 December 2006.
Joint ventures represent activities over which the Group exercises joint control through contractual agreement with one or more parties.
In January 2006, the Group sold its 50 per cent interest in Marlborough Stirling Mortgage Services Limited for £2.9 million. The profit on sale before tax of £1.7 million is included in investment income in the consolidated income statement.
The joint ventures have no significant contingent liabilities to which the Group is exposed nor does the Group have any significant contingent liabilities in relation to its interest in the joint ventures.
Assets and liabilities held for sale comprise investment property and consolidated venture subsidiaries of the PAC with-profits fund.
Investment properties are classified as held for sale when contracts have been exchanged but the sale has not been completed at the period end.
Major classes of assets and liabilities held for sale are as follows: £m £m
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: £m £m
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 £437 million and £263 million in 2006 and 2005, respectively. The remaining amounts, generally not available for use by the Group, predominantly consist of cash and cash equivalents held for the benefit of policyholders and loans and advances to banks held by Egg.
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 Euros 20 million (divided into 2,000,000,000 Euro preference shares of 1 cent each). None of the preference shares have been issued. A summary of the ordinary shares in issue is set out below: £m £m
Notes on the Group financial statements continued 210 Prudential plc Annual Report 2006
Issued shares of 5p each fully paid: At the beginning of the year 2,375,393,020 119 1,558
Shares issued in respect of acquisition of Egg minority interests 41,633,614 2 243
At 31 December 2006, there were options outstanding under Save As You Earn schemes to subscribe for 10,722,274 (2005: 12,503,956)
The cost of own shares of £79 million as at 31 December 2006 (2005: £97 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 2006, 7.5 million (2005: 10.7 million) Prudential plc shares with a market value of £52 million (2005: £59 million) were held in such trusts. In 2006, the Company purchased 2.3 million (2005: 1.4 million) shares in respect of employee incentive plans at a cost of £15 million (2005: £6 million). The maximum number of shares held in the year was 10.7 million which was at the beginning of the year. Of this total, 4.8 million (2005: 5.7 million) shares were held in trusts under employee incentive plans.
Of the total shares held in trust, 2.7 million (2005: 5 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 303 pence (2005: 286 pence).
(2005: 5 million) and the cost of acquiring these shares of £26 million (2005: £26 million) is included in cost of own shares. The market value of these shares as at 31 December 2006 was £34 million (2005: £28 million).
Liabilities acquired on purchase of insurance business (note I6) 837 0
US$300m 6.5% Perpetual Subordinated Capital Securities (notes iii and iv) 154 169
(v) The ¤20 million Medium Term Subordinated Notes were issued at 20-year Euro Constant Maturity Swap (capped at 6.5 per cent). These have been swapped into borrowings of £14 million with interest payable at three month £Libor plus 1.2 per cent.
Notes on the Group financial statements continued 212 Prudential plc Annual Report 2006
Non-recourse borrowings of investment subsidiaries (notes i and iii) 76 133
Non-recourse borrowings of venture fund investment subsidiaries 926 988 £100m 8.5% Undated Subordinated Guaranteed Bonds of Scottish Amicable Finance plc (note i) 100 100
Notes (i) The interests of the holders of the bonds issued by Scottish Amicable Finance plc, a subsidiary of the Scottish Amicable Insurance Fund, are subordinate to the entitlements of the policyholders of that fund.
(ii) Maturity analysis The following table sets out the maturity analysis of the Group’s borrowings attributable to with-profits funds: £m £m
The legal provisions of £11 million (2005: £11 million) relate predominantly to Jackson. Jackson has been named in civil proceedings, which appear to be substantially similar to other class action litigation brought against many life insurers in the US, alleging misconduct in the sale of insurance products. During 2006, an additional provision of £3 million was made, £2 million was paid and there was a £1 million exchange gain.
Restructuring provisions of £76 million (2005: £41 million) comprise £72 million (2005: £30 million) relating to restructuring activity of
UK insurance operations, £4 million (2005: £1 million) relating to Egg and £nil (2005: £10 million) relating to closure costs in Japan.
At 1 January 2005, a provision of £49 million was brought forward, and during 2005 an additional £1 million was provided, £11 million of unused provision was released, and £9 million was paid.
During 2006, an additional provision of £75 million was provided, £4 million of unused provision was released, and £29 million was paid.
In addition to the legal proceedings relating to Jackson mentioned above, the Group is involved in other litigation and regulatory issues arising in the ordinary course of business. Whilst the outcome of such matters cannot be predicted with certainty, the directors believe that the ultimate outcome of such litigation will not have a material adverse effect on the Group’s financial condition, results of operations, or cash flows.
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
Peak 2 basis of liabilities for the core policyholder liability, as reflected in the IFRS policy improvement to apply the UK GAAP standard
The change arising from the adoption of FRS 27 in 2005 is due to two factors, namely: (i) Under the FRS 27 basis, which follows the FSA realistic Peak 2 approach, best estimate assumptions apply. Previously a margin for adverse deviation was incorporated; and
The Peak 1 calculation is deterministic and excludes provision for terminal bonus. The Peak 2 calculation is stochastic and includes provision for terminal bonus.
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.
In addition, in the year ended 31 December 2006 Prudential Assurance’s main with-profits fund paid compensation of £11 million (2005: £24 million) in respect of mortgage endowment products mis-selling claims and at 31 December 2006 held a provision of £60 million
(2005: £52 million) within the main with-profits fund to honour guarantees on these products. The Group’s main exposure to guaranteed annuities in the UK is through SAIF and at 31 December 2006 a provision of £561 million (2005: £619 million) was held in SAIF to honour the guarantees. As SAIF is a separate sub-fund of the Prudential Assurance long-term business fund, the movement in this provision has no impact on shareholders.
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 the Company to support with-profits business by providing the benefits associated with smoothing and guarantees, by providing investment flexibility for the fund’s assets, by meeting the regulatory capital requirements that demonstrate solvency and by absorbing the costs of significant events or fundamental changes in its long-term business without affecting the bonus and investment policies. The size of the inherited estate fluctuates from year to year depending on the investment return and the extent to which it has been required to meet smoothing costs, guarantees and other events.
PAC believes that it would be beneficial if there were greater clarity as to the status of the inherited estate. As a result, PAC has announced that it has begun a process to determine whether it can achieve that clarity through a reattribution of the inherited estate.
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.
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 longterm 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.
Jackson has commitments for future payments related to equity index call options totalling £0.3 million at 31 December 2006 (2005: £3 million). The commitments were entered into in the normal course of business to hedge obligations associated with the issuance of equity index-linked immediate and deferred annuities. The final payment is due in 2007.
Notes on the Group financial statements continued 218 Prudential plc Annual Report 2006
Venture investment subsidiaries of the PAC with-profits fund (see below) 230 206
Other pension costs comprises £45 million (2005: £54 million) relating to defined benefit schemes and £27 million (2005: £23 million)
(2005: £171 million) of actuarial gains on an economic basis and £16 million (2005: £16 million) actuarial losses for amounts invested in Prudential insurance policies. The derivation of these amounts is shown in note (b)(i)7 below.
The Group also operates two smaller defined benefit schemes for UK employees in respect of Scottish Amicable and M&G activities.
As at 31 December 2006, the shareholders’ share of the surplus for PSPS and the deficits of the other schemes amounted to an £8 million deficit net of related tax relief (2005: £153 million deficit). These amounts are determined after including amounts invested by PSPS and the M&G scheme in Prudential policies as explained later in this note.
Under IAS 19 the basis of valuation differs markedly from the full triennial valuation basis. In particular, IAS 19 requires assets of the scheme to be valued at their market value at the year end, while pension liabilities are required to be discounted at a rate consistent with the current rate of return on a high quality corporate bond. As a result, the difference between IAS 19 basis assets and liabilities can be volatile. For those schemes such as PSPS, which hold a substantial proportion of their assets in equity investments, the volatility can be particularly significant. The economic basis (including investments of PSPS and the M&G scheme in Prudential policies as assets) for 2006, a £28 million (2005: £21 million) pre-tax shareholder charge to operating results based on longer-term returns arises. In addition, outside the operating result, but included in total profits is a pre-tax shareholder credit of £167 million (2005: £32 million) for net actuarial gains.
The actuarial gains primarily represent the difference between actual and expected investment returns for the schemes and the reduction in liabilities caused by an increase in the discount rate caused by increases in corporate bond returns.
In 2006, the PSPS asset allocation was altered away from equity investments such that at 31 December 2006 the market value of equities for the Group’s defined benefit schemes represented 31 per cent (2005: 52 per cent) of the total asset value whilst the bond portfolio accounted for 43 per cent (2005: 34 per cent). The asset allocation is shown in note 5.
This basis has been applied for 2006 to the asset and liability movements relating to the position at 1 January 2006, and also to the deficit funding paid in the year. However, the IAS 19 service cost for the year and employer contributions for ongoing service of current employees, have been apportioned in the ratio relevant to current activity. Reflecting these two elements, at 31 December 2006, the total share of the surplus on PSPS and the deficit on the smaller Scottish Amicable scheme attributable to the PAC with-profits fund amounted to a net surplus of £66 million net of related tax relief.
The discussions with the Scheme Trustee also led to an altered expectation in 2005 as to future discretionary increases. Previously, it had been the custom to award discretionary increases by reference to inflation levels. From 2005 it was intended that discretionary increases will in most circumstances not exceed 2.5 per cent.
Actuarial Valuation, or earlier if the Scheme Actuary recommends. Interim reviews are conducted annually based on changing economic circumstances and financial market levels.
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
The Trustee consults the Principal Employer, the Prudential Assurance Company, on these investment principles, but the ultimate responsibility for the investment of the assets of the scheme lies with the Trustee.
The actuarial assumptions used in determining benefit obligations and the net periodic benefit costs for the years ended 31 December were as follows: Discount rate 5.2 4.8
The tables used for PSPS at 31 December 2006 were: Male: 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 medium cohort improvements in future.
Using external actuarial advice provided by Watson Wyatt Partners for the valuation of PSPS and by Aon Limited for the M&G scheme, and internal advice for the Scottish Amicable scheme, the most recent full valuations have been updated to 31 December 2006, applying the principles prescribed by IAS 19.
Add back: investments in Prudential insurance policies (offset on consolidation in the Group financial statements against insurance liabilities) (287) (253)
I1: Staff and pension plans continued 5. Group economic financial position
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 £161 million at 31 December 2006 (2005: £147 million) in Prudential insurance policies.
Additionally, the PSPS scheme has invested £126 million at 31 December 2006 (2005: £106 million) in Prudential insurance policies.
On the ‘economic basis’, after including the underlying assets represented by the investments in Prudential insurance policies as scheme assets, the assets of the schemes at 31 December were: Total value of assets 5,275 100 4,875 100
The present value of the liabilities of the four schemes at 31 December 2006 was £5,210 million (2005: £5,418 million). The resulting scheme surplus or deficit arising from the excess of assets over liabilities or vice versa at 31 December 2006 comprised surplus of £73 million
Notes on the Group financial statements continued 222 Prudential plc Annual Report 2006
Estimated pension scheme liability attributable to shareholder operations – economic basis
Movements on the pension scheme deficits (determined on the ‘economic basis’), to the extent attributable to shareholder operations are as follows: Actuarial and other gains and losses
Current service cost (69) (65) Finance income (expense): Interest on pension scheme liabilities (255) (257) Expected return on pension scheme assets 295 279
Charge to operating results, based on longer-term investment returns, attributable to shareholders (28) (21)
(ii) Actuarial and other gains and losses This comprises: £m £m
Credit for Service revised cost less Actuarial estimate of net finance gains PSPS deficit Contributions income (losses) allocation paid by PAC At beginning (note i (note ii (note ii with-profits At end of year above) above) above) fund of year 2006 £m £m £m £m £m £m
The charges and credits for service cost, net finance income, and actuarial and other gains and losses are included within the income statement but 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 4,622 253 4,875 4,875
Fair value of plan assets, end of year 4,988 287 5,275 5,275
Fair value of plan assets, end of year 4,622 253 4,875 4,875
*Including £115 million credit for past service costs as described above.
The IAS 19 basis net pensions deficit can be summarised as follows: £m £m £m
Less: expected return on investments of scheme assets in Prudential insurance policies (16) (11)
Less: actuarial gains on investments of scheme assets in Prudential insurance policies (16) (16)
Actuarial gains – IAS 19 basis (as referred to in note I1(a)) 469 155
The long-term expected rate of return has been taken to be the weighted average (by market value) of the long-term expected rates of return on each major asset class shown below: Plan assets (IAS 19 basis)
Fair value of plan assets, end of year (IAS 19 basis) 4,988 4,622 4,092
Present value of the benefit obligation, end of year (5,210) (5,418) (4,917)
Experience adjustments on plan assets (IAS 19 basis) 140 527 112
The table below shows the sensitivity of the PSPS liabilities at 31 December 2006 of £4,607 million to changes in discount rates, inflation rates and mortality assumptions.
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%
Notes on the Group financial statements continued 226 Prudential plc Annual Report 2006
At 31 December 2006, 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.
In the year ended 31 December 2006, two new incentive plans were created and approved by shareholders at the Annual General
Meeeting. The Group Performance Share Plan (GPSP) and the Business Unit Performance Plan (BUPP) were established and directors were authorised to implement these schemes in the UK and other countries in which Prudential operates.
The RSP was, until March 2006, the Group’s long-term incentive plan for executive directors and other senior executives designed to provide rewards linked to shareholder return. Each year participants were granted a conditional option to receive a number of shares.
For performance at 50th percentile, an award of 25 per cent of the maximum award is made. The maximum grant is made only if the TSR
ranking of the Company is 20th percentile or above. Between these points, the size of the grant made is calculated on a straight-line sliding scale. This performance measure was chosen when the RSP was introduced as it reflected a combination of market practice, an assessment of Prudential’s main competitors and the focus of UK investors at that time. In normal circumstances, directors may take up their right to receive shares at any time during the following seven years.
basis with performance measured over three years. Upon vesting, half of the awards would be released as shares and the other half would be released in cash. Participants are entitled to receive the value of reinvested dividends over the performance period for those shares that vest. The growth parameters for the awards would be relevant to each region and vesting of the awards between each performance point is on a straight-line sliding scale basis.
The Prudential International Savings-Related Share Option Scheme operates on a similar basis to the UK Savings-Related Share Option
No options may be granted under the three savings-related schemes described above if such grant would cause the number of shares which have been issued, or which remain issuable pursuant to options granted in the preceding 10 years under the scheme and other share option schemes operated by the Company, or which have been issued under any other share incentive scheme of the Company, to exceed 10 per cent of the Company’s issued ordinary share capital at the proposed date of grant.
Movements in share awards outstanding under the Group’s share-based compensation plans relating to Prudential plc shares at 31 December 2006 and 2005 were as follows: Number of Number of awards awards Awards outstanding (millions) (millions)
The following table provides a summary of the range of exercise prices for Prudential plc options (including conditional options)
Monte Carlo option-pricing models using the following assumptions: RSP and Other Other GPSP options RSP options
Under IFRS, compensation costs for all share-based compensation plans are determined using the Black-Scholes model and the Monte
Carlo model. Share options and awards are valued using the share price at the date of grant. The compensation costs for all awards and options are recognised in net income over the plans’ respective vesting periods. The Group uses the Black-Scholes model to value all options other than the RSP and GPSP. For these options, the Group uses a Monte Carlo model in order to allow for the impact of the
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 RSP, volatility and correlation of the comparator group with the Group are required. These assumptions are based on the TSR of the comparators over a period up to the grant date equal to the performance period. For grants in 2006, an average comparator volatility of 24 per cent and an average correlation of comparators of 19 per cent were used. In addition, for the GPSP, volatility and correlation between Prudential and an index constructed from a simple average of the TSR growth of 10 companies is required. For grants in 2006, an average index volatility and correlation of 14 per cent and 71 per cent respectively, were used.
In addition, all outstanding executive share options became exercisable and awards under the RSP were assessed against the performance conditions. None of the awards met the performance conditions and they have therefore lapsed in February 2006 following consideration of the performance measurement results by the Remuneration Committee. At 31 December 2006, SAYE options to acquire 135,003 Egg shares remains outstanding because certain employees chose not to take any action.
In 2005, the Group maintained three main share award and share option plans relating to Egg shares, which are described below.
Outstanding at beginning of year 0.5 0.7 1.15 1.16 0.3 0.4 1.20 1.20
Outstanding and exercisable at the end of year – 0.5 – 1.15 – 0.3 1.24 1.20
Outstanding at beginning of year 3.2 3.0 0.86 0.85 0.9 1.0 0.83 0.84
Notes on the Group financial statements continued 232 Prudential plc Annual Report 2006
Outstanding and exercisable at the end of year – 9.3 – 1.42
Total key management remuneration amounts to £13,524,000 (2005: £13,688,000). This comprises salaries and short-term benefits of £8,927,000 (2005: £8,087,000), post-employment benefits of £1,032,000 (2005: £1,020,000), termination benefits of £291,000
Based Payments’ (see note I2) and £1,406,000 (2005: £1,127,000) of deferred share awards.
Total key management remuneration includes total directors’ emoluments of £11,084,000 as shown in the directors’ remuneration report on pages 83 to 95, and additional amounts in respect of pensions, share-based payments and termination benefits. Further information on directors’ remuneration is given in the directors’ remuneration report.
Notes on the Group financial statements continued 234 Prudential plc Annual Report 2006
Fees payable to the Company’s auditor for the audit of the Company’s annual accounts 2.3 2.2
Fees payable to the Company’s auditor and its associates for other services: Audit of subsidiaries and associates pursuant to legislation 3.8 3.6
The format of the table has altered from last year in order to comply with new disclosure requirements and the 2005 comparative figures have been restated accordingly. In addition, there were fees of £0.2 million (2005: £0.1 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
Transactions between the Company and its subsidiaries are eliminated on consolidation.
In addition, the Company has transactions and outstanding balances with certain unit trusts, OEICs, collateralised debt obligations and similar entities which are not consolidated and where a Group company acts as manager. These entities are regarded as related parties for the purposes of IAS 24. The balances are included in the Group’s 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
Apart from the transactions with directors referred to below, no director had an interest in shares, transactions or arrangements that requires disclosure, other than those given in the directors’ remuneration report. Key management remuneration is disclosed in note I3.
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
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.
and the statutory capital and surplus of Jackson was US$3.7 billion (£1.9 billion) (2005: US$3.4 billion (£2.0 billion)). The Group capital position statement for life assurance businesses is set out in note D5.
The Company accounts for the purchase of minority interests using the economic entity method. Accordingly, £167 million has been charged to retained earnings representing the difference between the consideration paid (including expenses) of £251 million and the share of net assets acquired of £84 million.
The PAC with-profits fund acquired a number of venture capital holdings through PPM Capital in which the Group is deemed to have a controlling interest, in aggregate with, if applicable, other holdings held by, for example, the PSPS. There were three such acquisitions in 2006 and 2005. These were acquisitions for: • 53 per cent of the voting equity interests of Histoire D’or, a jewellery retail company, in April 2006; • 51 per cent of the voting equity interests of Azzuri Communications, a business IT service company, in June 2006; and
• 75 per cent of the voting equity interests of BST Safety Textiles Luxembourg S.a.r.l. (BST), an airbag production company, in August 2005.
The results of the aggregated ventures acquisitions in 2006 and 2005 have been included in the consolidated financial statements of the
Group commencing on the respective dates of acquisition and contributed a loss of £7.7 million (2005: loss of £0.1 million) to earnings within the income statement, which is also reflected as part of the change in unallocated surplus of the with-profits fund.
Aggregate goodwill of £336 million (2005: £105 million) has been recognised for the excess of the cost over the Group’s interest in the net fair value of the entities’ assets, liabilities, and contingent liabilities acquired in 2006.
S.a.r.l., all venture subsidiaries of the PAC with-profits fund, were disposed of for cash consideration of £133 million. Goodwill of £46 million and cash and cash equivalents of £19 million were disposed of. Note that, in addition, one venture subsidiary was classified as held for sale at 31 December 2006 (see note H9).
Future minimum lease payments for non-cancellable operating leases fall due during the following periods: Not later than 1 year 53 61
The total minimum future sublease rentals to be received on non-cancellable operating leases for land and buildings for the year ended 31 December 2006 was £1 million (2005: £2 million).
Minimum lease rental payments for the year ended 31 December 2006 of £50 million (2005: £55 million) are included in the consolidated income statement.
Notes on the Group financial statements continued 238 Prudential plc Annual Report 2006
In addition, the Company has agreed in principle, outline terms with Citi with respect to a UK distribution agreement through which
Prudential will provide life and pensions products to Egg’s customer base for a five-year period.
Local currency: £ 31 Dec 2006 for 2006 31 Dec 2005 for 2005 1 Jan 2005
Structural borrowings of shareholder-financed operations comprise core debt of the parent company and related finance subsidiaries,
The outflows for 2005 are included in cash flows from operating activities.
Prior to 2006, no intangible assets other than goodwill had been identified for the acquired venture investment subsidiaries of the PAC
Pension assets (liabilities) (net of related deferred tax) 8 34 (80)
The Company has not prepared a cash flow statement on the basis that its cash flow is included within the cash flow statement in the consolidated financial statements. The Company is also exempt under the terms of FRS 8 from disclosing related party transactions with entities that are part of the Group or investees of the Group.
In addition, the Company has taken advantage of the exemption within FRS 25, ‘Financial Instruments: Disclosure and Presentation’ from the disclosure requirements of this standard on the basis that the Company is included in the publicly available consolidated financial statements of the Group which include disclosures that comply with IAS 32, ‘Financial Instruments: Disclosure and Presentation’, which is equivalent to FRS 25.
‘Employee Benefits’. The amended disclosures are shown in note 8. The measurement change from this amendment where pension assets should now be valued at current bid value rather than mid-market value, has an immaterial effect on the Company’s results.
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.
Foreign currency borrowings that have been used to finance or provide a hedge against Group equity investments in overseas subsidiaries, are translated at year end exchange rates. The impact of these currency translations is recorded within the profit and loss account for the year.
The 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.
A pension surplus or deficit is recorded as the difference between the present value of the scheme liabilities and the fair value of the scheme assets.
Notes on the parent company financial statement continued 242 Prudential plc Annual Report 2006
Egg Banking plc was a subsidiary of Egg plc. At 31 December 2005, the ordinary shares of Egg plc were listed and there was only one class of shares of which 78 per cent was owned by the Company, one per cent owned by other companies within the Prudential Group and 21 per cent owned by shareholders external to the Prudential Group.
In December 2005, the Company announced its intention to acquire the minority interests in Egg and the whole of those interests were acquired in the first half of 2006. Under the terms of the offer, Egg shareholders received 0.2237 new ordinary shares in the Company for each Egg share resulting in the issue of 41.6 million new shares in the Company.
Core structural borrowings: US$1,000m 6.5% Perpetual Subordinated Capital Securities (note iii) 484 554 – – 484 554
US$300m 6.5% Perpetual Subordinated Capital Securities (notes iv and v) 149 169 – – 149 169
Other borrowings (note vii): Floating Rate Notes 2007 – – 5 – 5 –
Long-term loans Other borrowings Total £m £m £m £m £m £m
Borrowings are repayable as follows: Within 1 year or on demand – – 2,022 1,461 2,022 1,461
Notes (i) In February 2006, £1.3 million of the original bond issue of £250 million was redeemed.
(iii) Interest on the US$1,000 million 6.5 per cent borrowings has been swapped into floating rate payments at three month US$Libor plus 0.80 per cent.
(v) Interest on the US$300 million 6.5 per cent borrowings has been swapped into floating rate payments at three month US$Libor plus 0.0225 per cent.
(viii) Under the terms of the Group’s arrangements with its main UK banker, the bank has a right of set off between credit balances (other than those of long-term funds) and all overdrawn balances of those Group undertakings with similar arrangements.
(ix) The interests of the holders of the Subordinated Notes and the Subordinated Capital Securities are subordinate to the entitlements of other creditors of the Company.
Derivative financial instruments held to manage interest rate and currency profile: Inflation-linked swap – 67 – 82
The change in fair value of the derivative financial instruments of the Company was a gain before tax of £131 million (2005: a loss before tax of £85 million).
The derivative financial instruments were valued internally using standard market practices. In accordance with the Company’s risk management framework, all internally generated valuations are subject to independent assessment against external counterparties’ valuations.
For the purposes of preparing consolidated financial statements, the Group applies IFRS basis accounting including IAS 19, ‘Employee
Total contributions to the scheme for deficit funding and employer contributions for ongoing service for current employees are expected to be of the order of £70 to 75 million per annum over a 10-year period. However, in 2006, total contributions for the year to 5 April 2006 were £137 million. This amount reflects the increased level of current contributions for ongoing service and deficit funding backdated to 6 April 2005. These amounts compared to total contributions in 2005 of £19 million.
Rate of increase in pension payments for inflation: Rate used to discount scheme liabilities 5.2 4.8
The long-term expected rates of return have been determined after applying due consideration to the requirements of paragraph 54 of FRS 17, in particular, taking account of the values of the assets.
After deducting deferred tax, the amounts reflected in the balance sheet of the Company are: 34 (80) (83)
Fair value of pension scheme assets, end of year 4,748 4,397 *The contributions include deficit funding and ongoing contributions.
Pension (charge) credit attributable to the Company (13) 29 £m £m £m
Actual less expected return on scheme assets (3% (2005: 11%) (2004: 3%) of assets) 141 500 104
Experience gains (losses) on scheme liabilities (0% (2005: 0%) (2004: 1%) of liabilities) 17 – (25)
The actuarial gains before tax of £118 million (2005: actuarial losses of £30 million) attributable to the Company are recorded in the statement of total recognised gains and losses. Cumulative actuarial gains as at 31 December 2006 amount to £143 million
The authorised share capital of the Company is £220 million (2005: £170 million) (divided into 4,000,000,000 (2005: 3,000,000,000)
Transfer to retained profit in respect of shares issued in lieu of cash dividends – – (75)
At 31 December 2006, there were options subsisting under share option schemes to subscribe for 10,722,274 (2005: 12,503,956) shares at prices ranging from 266 pence to 715 pence (2005: 266 pence to 715 pence) and exercisable by the year 2013 (2005: 2012). In addition, there were 4,113,481 (2005: 4,668,534) conditional options outstanding under the Restricted Share Plan exercisable at nil cost in the balance of a 10-year period. No further options will be issued under the Restricted Share Plan which has been replaced by the Group
Performance Share Plan. There were 1,623,637 (2005: nil) conditional options outstanding under the Group Performance Share Plan exercisable at nil cost in the balance of a 10-year period. Further information on the Group’s employee share options is given in note I2
10. Profit of the Company and reconciliation of movement in shareholders’ funds
The profit after tax of the Company for the year was £834 million (2005: £118 million). After dividends of £398 million (2005: £378 million), actuarial gains net of tax in respect of the pension scheme of £83 million (2005: losses of £21 million) and a transfer from the share premium account of £75 million (2005: £51 million) in respect of shares issued in lieu of cash dividends, retained profit at 31 December 2006 amounted to £1,368 million (2005: £774 million). The Company employs no staff.
Actuarial gains (losses) recognised in respect of the pension scheme net of related tax (note 8) 83 (21)
Information on directors’ remuneration is given in the directors’ remuneration report section within this Annual Report. Further information on the transactions of the directors with the Company and the Group is given in notes I3 ‘Key management remuneration’
and I5 ‘Related party transactions’ of the notes on the financial statements of the Group.
A final dividend of 11.72 pence per share was proposed by the directors on 14 March 2007. Subject to shareholders’ approval, the dividend will be paid on 22 May 2007 to shareholders on the register at the close of business on 13 April 2007. The dividend will absorb an estimated £287 million of shareholders’ funds. A scrip dividend alternative will be offered to shareholders.
On 29 January 2007, the Company announced that it had entered into a binding agreement to sell Egg Banking plc, Prudential’s UK
banking business, to Citi. Under the terms of the agreement, the consideration payable to the Company by Citi is £575 million in cash, subject to adjustment to reflect any change in net asset value between 31 December 2006 and completion. As a consequence of this agreement, it is appropriate to impair the carrying value of the Company’s investment by £301 million as shown in note 4.
The transaction is subject to regulatory approvals and is expected to complete by the end of April 2007.
as adopted by the EU to present fairly the financial position and performance of the Group; the Companies Act 1985 provides in relation to such financial statements that references in the relevant part of that Act to financial statements giving a true and fair view are references to their achieving a fair presentation.
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
Under applicable law and regulations, the directors are also responsible for preparing a directors’ report, directors’
remuneration report on pages 83 to 95 that is described as having been audited.
responsibilities on page 250. Our responsibility is to audit the financial statements and the part of the directors’ remuneration report to be audited in accordance with relevant legal and regulatory requirements and International Standards on Auditing
Companies Act 1985 and, as regards the Group financial statements, Article 4 of the International Auditing Standards
IAS Regulation; • the parent company financial statements give a true and fair view, in accordance with United Kingdom Generally Accepted
Accounting Practice, of the state of the parent company’s affairs as at 31 December 2006; • the parent company financial statements and the part of the directors’ remuneration report to be audited have been properly prepared in accordance with the Companies Act 1985; and
*EEV basis operating profit from continuing operations based on longer-term investment returns excludes goodwill impairment charges, short-term fluctuations in investment returns, the mark to market value movements on core borrowings, the shareholders’ share of actuarial and other gains and losses on defined benefit pension schemes, the effect of changes in economic assumptions and changes in the time value of cost of options and guarantees caused by economic factors. The amounts for these items are included in total EEV profit. The directors believe that operating profit, as adjusted for these items, better reflects underlying performance. Profit on ordinary activities and basic earnings per share include these items together with actual investment returns. This basis of presentation has been adopted consistently throughout this supplementary information.
European Embedded Value (EEV) basis supplementary information Year ended 31 December 2006 252 Prudential plc Annual Report 2006
Based on profit from discontinued operations after minority interests – 0.1p
Total – based on total profit for the financial year after minority interests of £2,212m (2005: £1,582m) 91.7p 66.9p
Unrealised valuation movements on Egg securities classified as available-for-sale (2) (1)
Cumulative adjustments at 31 December 2006, net of related tax, for Jackson assets backing surplus and required capital 16(vi) 7 –
Shareholders’ capital and reserves at end of year (excluding minority interests) 15, 16 11,883 10,301
M&G: Asian operations: Other operations: Holding company net borrowings (1,542) (1,724)
Based on EEV basis shareholders’ funds of £11,883m (2005: £10,301m) 486p 432p
Shareholders’ capital and reserves (excluding minority interests) 16 11,883 10,301 *Including liabilities in respect of insurance products classified as investment products under IFRS 4.
The supplementary information on pages 252 to 280 was approved by the Board of directors on 14 March 2007.
The EEV basis results have been prepared in accordance with the EEV principles issued by the CFO Forum of European Insurance
SAIF is a ring-fenced sub-fund of the PAC long-term fund, established by a Court approved Scheme of Arrangement in October 1997.
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 longterm 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
Notwithstanding the basis of presentation of results (as explained in notes 4 and 6) no smoothing of market or account balance values, unrealised gains or investment returns is applied in determining the embedded value or the profit before tax.
Notes on the EEV basis supplementary information 256 Prudential plc Annual Report 2006
Annual bonuses are declared once a year and, once credited, are guaranteed in accordance with the terms of the particular product.
The Group’s main exposure to guaranteed annuity options in the UK is through SAIF and a provision on the Pillar 1 Peak 2 basis of £561 million (2005: £619 million) was held in SAIF at 31 December 2006 to honour the guarantees.
The principal options and guarantees in Jackson are associated with the fixed annuity and variable annuity lines of business.
of the fund relates to policies with guarantees of three per cent or less. The average guarantee rate is 3.2 per cent (2005: 3.3 per cent).
Variable annuity contracts may contain guarantees of certain minimum payments in the event of death, withdrawal or annuitisation.
The most significant book of non-participating business in the Group’s Asian operations is Taiwan’s whole of life contracts. For these contracts there are floor levels of policyholder benefits that accrue at rates set at inception by reference to minimum returns established by local regulation. These rates do not vary subsequently with market conditions. Under these contracts the cost of premiums are also fixed at inception based on a number of assumptions at that time, including long-term interest rates, mortality assumptions and expenses.
(the intrinsic value). The other part arises from the variability of economic outcomes in the future (the time value).
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.
Prudential does not take credit for the significant diversification benefits that exist within the Group. For with-profits business written in a segregated life fund, as is the case in the UK and Asia, the capital available in the fund is sufficient to meet the encumbered capital requirements.
• UK: 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; • US: the level of encumbered capital has been set as 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; • Asia: the economic capital requirement is substantially higher than local statutory requirements in total. Economic capital requirements vary by territory, but in aggregate, the encumbered capital is equivalent to the amount required under the Financial Conglomerates
The table below summarises the levels of encumbered capital as a percentage of the relevant statutory requirement: Capital as a percentage of relevant statutory requirement
Under the EEV Principles, discount rates used to determine the present value of future cash flows are set equal to risk-free rates plus a risk margin. The risk margin should reflect any non-diversifiable risk associated with the emergence of distributable earnings that is not allowed for elsewhere in the valuation. Prudential has selected a granular approach to better reflect differences in risk inherent in each product group. The risk discount rate so derived does not reflect a market beta but instead reflects the expected volatility associated with the cash flows in the embedded value model.
The risk allowance in the risk discount rate is determined as follows: Market risk
Under CAPM, the beta of a portfolio or product measures its relative market risk.
CAPM does not include any allowance for non-market risks since these are assumed to be fully diversifiable. For EEV purposes, however, a risk margin is added for non-diversifiable non-market risks and to cover Group level risks.
Bonus rates are projected from current levels and varied in accordance with assumed management actions applying in the emerging investment and fund solvency conditions.
In all instances, the modelled actions are in accordance with approved local practice and therefore reflect the options actually available to management. For the PAC with-profits sub-fund, the actions assumed are consistent with those set out in the Principles and Practices of
Under IFRS the surpluses or deficits attaching to these schemes are accounted for in accordance with the provisions of IAS 19. The surpluses or deficits represent the difference between the market value of the schemes’ assets and the discounted value of projected future benefit payments to retired members and deferred pensioners and, to the extent of service to date, current employed members.
For PSPS the surplus or deficit at the reporting date is allocated between the PAC with-profits sub-fund and shareholder-backed operations by reference to the activities of the members of the scheme during their period of service. For the 2005 year end the deficit at that time was allocated in the ratio 70/30. This ratio has continued to be applied to movements in the financial position that relate to opening assets and liabilities at 1 January 2006. However, the service charge and contribution for ongoing service are allocated by reference to the cost allocation for current business.
Under the EEV basis the IAS 19 basis surplus or deficit is initially allocated in the same manner. The shareholders’ 10 per cent interest in the PAC with-profits sub-fund estate is determined after inclusion of the portion of the IAS 19 basis surplus or deficit attributable to the fund. Adjustments under EEV in respect of accounting for surpluses or deficits on defined benefit schemes are reflected as part of ‘Other
Separately, the projected cash flows of in-force covered business include contributions to the defined benefit schemes for future service based on the contribution basis applying to the schemes at the time of the preparation of the results.
Notes on the EEV basis supplementary information continued 260 Prudential plc Annual Report 2006
An exception to this general rule is that for countries where long-term fixed interest markets are underdeveloped, investment return assumptions and risk discount rates are based on an assessment of longer-term economic conditions. Except for the countries listed above, this basis is appropriate for the Group’s Asian operations.
Expected returns on equity and property asset classes are derived by adding a risk premium, also based on the long-term view of
Prudential’s economists in respect of each territory, to the risk-free rate. In the UK, the equity risk premium is 4.0 per cent (2005: 4.0 per cent) above risk-free rates. The equity risk premium in the US is also 4.0 per cent (2005: 4.0 per cent). In Asia, equity risk premiums range from 3.0 per cent to 5.8 per cent (2005: 3.0 per cent to 5.75 per cent). Best estimate assumptions for other asset classes, such as corporate bond spreads, are set consistently.
The table below summarises the principal financial assumptions: UK insurance operations
US 10-year treasury bond rate at end of period 4.8 4.4
(notes iii, (notes iii, China iv, v) India Indonesia Japan Korea China iv, v) India Indonesia Japan Korea 31 Dec 31 Dec 31 Dec 31 Dec 31 Dec 31 Dec 31 Dec 31 Dec 31 Dec 31 Dec 31 Dec 31 Dec
Malaysia Singapore Taiwan Malaysia Singapore Taiwan (notes iv, v) Philippines (notes iv, v) (notes ii, v) Thailand Vietnam (notes iv, v) Philippines (notes iv, v) (notes ii, v) Thailand Vietnam 31 Dec 31 Dec 31 Dec 31 Dec 31 Dec 31 Dec 31 Dec 31 Dec 31 Dec 31 Dec 31 Dec 31 Dec
(ii) For traditional business in Taiwan, the economic scenarios used to calculate the 2006 and 2005 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 of around 2 per cent trend towards 5.5 per cent at 31 December 2013 (2005: 2 per cent trend towards 5.5 per cent at 31 December 2012).
In projecting forward the Fund Earned Rate, allowance is made for the mix of assets in the fund, future investment strategy, and further market value depreciation of bonds held as a result of assumed future yield increases. These factors, together with the assumption of the phased progression in bond yields, give rise to an average assumed Fund Earned Rate that trends from 2.1 per cent for 2006 to 5.7 per cent for 2014. The assumed Fund Earned Rate falls to 1.4 per cent in 2007 and remains below 2.1 per cent for a further five years. This feature is due to the depreciation of bond values as yields rise. Thereafter, the assumed Fund Earned Rate fluctuates around a target of 5.9 per cent. This projection compares with that applied for the 2005 results of a grading from an assumed rate of 2.3 per cent for 2005 to 5.4 per cent for 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 larger proportion of the in-force Hong Kong business.
• 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
The rates to which the model has been calibrated are set out below: Mean returns have been derived as the annualised arithmetic average return across all simulations and durations.
Standard deviations have been calculated by taking the annualised variance of the returns over all the simulations, taking the square root and averaging over all durations in the projection. For bonds the standard deviations relate to the yields on bonds of the average portfolio duration. For equity and property, they relate to the total return on these assets. The standard deviations applied are as follows: Standard deviation
• 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 ranges from 18.6 per cent to 28.1 per cent
The stochastic cost of guarantees is only of significance for the Hong Kong, Singapore, Malaysia and Taiwan operations.
Persistency, mortality and morbidity assumptions are based on an analysis of recent experience but also reflect expected future experience. Where relevant, when calculating the time value of financial options and guarantees, policyholder withdrawal rates vary in line with the emerging investment conditions according to management’s expectations.
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, to the extent not allocated to the PAC with-profits sub-fund, is charged to the EEV basis result as incurred.
To the extent applicable, presentation of the EEV profit for the year is consistent with the basis 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
With the exception of debt securities held by Jackson, investment gains and losses during the year (to the extent that changes in capital values do not directly match changes in liabilities) are included directly in the profit for the year and shareholders’ funds as they arise.
Investment returns reflect those earned on a market basis over the period without smoothing, but after appropriate adjustments for movements in the additional shareholders’ interest recognised on the EEV basis.
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 sub-fund. The surplus or deficit is determined by applying the requirements of IAS 19.
• the impact of altered economic and other assumptions on the discounted value of scheme liabilities.
These items are recorded in the income statement but, consistent with the IFRS basis of presentation, are excluded from operating results.
(d) Effect of changes in economic assumptions and time value of cost of options and guarantees
Movements in the value of in-force business caused by changes in economic assumptions and the time value of cost of options and guarantees resulting from changes in economic factors are recorded in non-operating results.
Annual premium and contribution equivalents are calculated as the aggregate of regular new business amounts and one-tenth of single new business amounts.
The transaction reflects the arrangement entered into in June 2006 for the reinsurance of non-profit immediate pension annuity liabilities of SAIF to Prudential Retirement Income Limited (PRIL), a shareholder-owned subsidiary of the Group. SAIF is a closed ring-fenced subfund of the PAC long-term fund established by a Court approved Scheme of Arrangement in October 1997, which is solely for the benefit of SAIF policyholders. Shareholders have no interest in the profits of this fund, although they are entitled to investment management fees on this business. Accordingly, it is not part of covered business for EEV reporting purposes. The inclusion of the transaction betweeen
SAIF and PRIL as new business, reflects the transfer from SAIF to Prudential shareholders’ funds of longevity risk, the requirement to set aside supporting capital and the entitlement to surpluses arising on this block of business arising from the reinsurance arrangement.
Consistent with the transfer from uncovered to covered business and reflecting the transfers above, the transaction has been accounted for as new business for EEV basis reporting purposes.
Pensions (DWP) rebate business for SAIF. These are excluded from the table above with comparatives restated accordingly. The amounts of new SAIF DWP rebate business written was £60 million in 2006 and £83 million in 2005.
(i) Jackson net of tax profit Before capital charge 182 150 Capital charge (14) (13)
Included within pre-tax new business profits shown in the table above are profits arising from fund management business falling within the scope of covered business of: £m £m
Present Annual value premium and of new New business premiums contribution business Pre-tax new New business margin equivalent premiums business Single Regular (APE) (PVNBP) contribution (APE) (PVNBP)
New business margins are shown on two bases, namely the margins by reference to the Annual Premium Equivalents (APE) and the
Present Value of New Business Premiums (PVNBP). APEs are calculated as the aggregate of regular new business amounts and one-tenth of single new business amounts. PVNBPs are calculated as single premiums plus the present value of expected premiums of new regular premium business, allowing for lapses and other assumptions made in determining the EEV new business contribution.
New business contributions represent profits determined by applying the economic and non-economic assumptions applying at the end of the year.
Unwind of discount and other expected returns (note i) 254 162
(ii) The £148 million cost of strengthened persistency assumption for 2005 applies to a number of products, primarily in respect of with-profits bonds.
(iii) The £47 million charge for 2005 primarily relates to the cost of capital attaching to liability strengthening on the regulatory basis for annuity business.
Charges in respect of these items are reflected in the EEV and IFRS results on an annual basis.
(vi) Expense assumptions The 2005 EEV basis financial statements included note disclosure explaining that in determining the appropriate expense assumptions for 2005 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. Without this factor there would have been a charge for altered expense assumptions of approximately £55 million. The half year 2006 EEV basis results were prepared on the same basis.
Notes continued With the agreement to sell Egg Banking plc the actions necessary to implement these plans have been reassessed and additional initiatives put in place, as announced on
(vii) Jackson The principal component of the £42 million credit in 2006 for other profit is £31 million of favourable mortality experience variance.
Less: allocation of investment return on centrally held capital in respect of Taiwan business to operating result of Asian operations (18) (21)
Less: projected fund management result in respect of covered business incorporated in opening
The charge of £53 million comprises £50 million recognised on the IFRS basis and an additional £3 million recognised on the EEV basis for the shareholders’ share of costs incurred by the PAC with-profits sub-fund. The costs relate to the initiative announced in December 2005 for UK insurance operations to work more closely with Egg and M&G.
Notes on the EEV basis supplementary information continued 270 Prudential plc Annual Report 2006
Share of investment return of funds managed by PPM America that are consolidated into
Investment return related 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 17 4 *This adjustment arises due to market returns being higher than the assumed long-term rate of return. This gives rise to higher than expected year end values of variable annuity assets under management with a resulting effect on the projected value of future account values, and hence future profitability.
(iii) Short-term fluctuations for Asian operations of £286 million in 2006 were due to strong market performance in most territories, in particular in Vietnam (£108 million) relating to increases in both bond and equity portfolios and in Hong Kong (£73 million) where an increase in the investment return on the equity portfolio more than offset the reductions in bond prices. Short-term fluctuations in Taiwan were £46 million and £41 million in Singapore.
10. Mark to market value movements on core borrowings £m £m
Core borrowings of the Group are marked to market value under EEV. As the liabilities are generally held to maturity or for the long term, no deferred tax asset has been established on the increase (compared to IFRS) in carrying value. Accordingly, no deferred tax charge
11. Actuarial and other gains and losses on defined benefit pension schemes
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
Notes (i) The effect of changes in economic assumptions for UK insurance operations reflects primarily movements in gilt rates of return which affect assumed rates of return and discount rates, as described in note 3.
Total tax charge on operating profit from continuing operations 587 363
Tax charge (credit) on actuarial and other gains and losses on defined benefit pension schemes 62 (14)
Notes (i) The profit for the year for covered business is in most cases calculated initially at the post-tax level. The post-tax profit for covered business is then grossed up for presentation purposes at the effective rates of tax applicable to the countries and periods concerned. In the UK, this is the UK corporation tax rate of 30 per cent. For Jackson, the US federal rate of 35 per cent is applied to gross up movements on the value of in-force business. Effects on statutory tax for the period affect the overall tax rate. For Asia, similar principles apply subject to the availability of taxable profits.
(iv) The tax charge for Jackson 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 have resulted in a reallocation from free surplus to the value of in-force business of £44 million.
(v) 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.
Operating profit after tax and minority interests from continuing operations 1,390 1,339
Total EPS from continuing operations: Total profit before tax 3,072 2,244
Total profit after tax and minority interests from continuing operations 2,212 1,579
The average number of shares reflects the average number in issue adjusted for shares held by employee trusts and consolidated unit trusts and OEICs which are treated as cancelled.
Long-term business operations (notes i and ii): Smoothed shareholders’ funds (note iii) 5,155 4,558
Jackson (net of surplus note borrowings of £158m (2005: £183m) note vi): Shareholders’ funds before capital charge 3,420 3,465
(v) Under IFRS, subject to impairment testing, goodwill is no longer amortised. Acquired goodwill of the Japanese life business was subject to an impairment charge of £120 million which was included in the 2005 results.
(vi) Net core structural borrowings of shareholder-financed operations comprise: £m £m
Holding company net borrowings (1,542) (1,724) Core structural borrowings – Jackson (158) (183)
(vii) With the exception of the share of pension scheme surpluses (deficits) attributable to the PAC with-profits sub-fund which are included in other operations’ net liabilities, and the borrowings as described in note vi, the amounts shown for the items in the table above that are referenced to this note have been determined on the statutory IFRS basis. The pension scheme surplus (deficit) net of tax attributable to shareholders relating to the Prudential Staff Pension and Scottish Amicable Pension Schemes are determined as shown below: £m £m
Total operating profit (loss) based on longer-term investment returns 652 708 815 2,175 (199) 1,976
Short-term fluctuations in investment returns (note 9) 378 63 286 727 18 745
Mark to market value movements on core borrowings (note 10) 3 3 82 85
Tax on actuarial and other gains and losses on defined benefit pension schemes (62) (62)
Intra group dividends (including statutory transfer) (271) (113) (90) (474) 474
Movement in own shares in respect of share-based payment plans 6 6
Movement on Prudential plc shares purchased by unit trusts consolidated under IFRS 0 0
Cumulative adjustment at 31 December 2006, net of related tax, for Jackson assets backing surplus and required capital (note vi) 7 7 7
Shareholders’ capital and reserves at 31 December 2006 (notes (iii) and 15) 5,813 3,303 2,548 11,664 219 11,883
(iv) Other transfers (from) to long-term business operations to other operations represents: Total
UK long-term insurance Asian business operations Jackson operations operations £m £m £m £m
(v) The other adjustment for UK insurance operations is merely technical in nature and is a reallocation of shareholders’ funds from net worth to central funds to more closely align the corporate and business unit structure for EEV reporting purposes. The Jackson other adjustment of £12 million is mainly for a tax related benefit arising from the US basis of filing.
(vi) Previously the valuation placed on the assets backing Jackson’s surplus and required capital reflected the fact that generally they are held for the longer-term and excluded the short-term differences between market value and amortised cost. For the balance sheet at 31 December 2006 and prospectively these short-term value adjustments are now incorporated. At 31 December 2006, the balance sheet adjustment, net of related tax is an increase of £7 million. For 31 December 2005, the adjustment, if it had been booked at that date, was an increase of £19 million. Future movements for this item, consistent with the basis applied under IFRS for available-for-sale securities, will be booked in the statement of movement in shareholders’ capital and reserves.
UK long-term insurance Asian business Other Group operations Jackson operations operations operations total EEV basis shareholders’ funds at 31 December 2006 £m £m £m £m £m £m
Comprising: Value of in-force business before deduction of cost of capital and of guarantees 5,129 1,578 2,156 8,863
UK long-term insurance Asian business Other Group operations Jackson operations operations operations total EEV basis shareholders’ funds at 1 January 2006 £m £m £m £m £m £m
Notes on the EEV basis supplementary information continued 276 Prudential plc Annual Report 2006
Shareholders’ capital and reserves at 1 January 2006 (note vii) 835 2,882 3,717 6,751 10,468
New business contribution (notes ii, iii) (554) 383 (171) 898 727
Existing business – transfer to net worth (note v) 943 (290) 653 (653) 0
Changes of non-operating assumptions and experience variances and minority interests 44 48 92 494 586
Other transfers from net worth (note ix) (76) – (76) – (76)
(vi) Value of in-force business includes the value of future margins from current in-force business less the cost of holding encumbered capital.
(vii) Included in the EEV basis shareholders’ funds of long-term business operations of £11,664 million (2005: £10,468 million) is £257 million (2005: £174 million) in respect of fund management business falling within the scope of covered business as follows: £m £m
Adjustment for net of tax fund management projected profits of covered business (22)
Adjustment for investment return net of related tax on economic capital for Taiwan operations held centrally (13) Other adjustments (41)
insurance Asian Total operations Jackson operations long-term 2006 £m £m £m £m
Notes on the EEV basis supplementary information continued 278 Prudential plc Annual Report 2006
UK insurance Asian Total operations Jackson operations long-term 2005 £m £m £m £m
Interest rates – 1% increase (notes i, iii) 69 (144) 49 (26)
Interest rates – 1% decrease (notes i, iii) (99) 55 (126) (170)
Equity/property market values – 10% fall (note iii) (480) (55) (75) (610)
Asian operations *Taiwan sensitivity to starting bond rates (i.e. the starting bond rate for the progression to the assumed long-term rate): increase decrease
Embedded in the in the value at starting starting 31 Dec 2006 bond rates bond rates £m £m £m
Embedded in the in the value at starting starting 31 Dec 2005 bond rates bond rates £m £m £m
(ii) Jackson sensitivities for 2006 to one per cent movements in interest rates include the effect on net worth as detailed in note 16 (vi).
The tables below show the sensitivity of the embedded value as at 31 December 2006 (2005) and the new business contribution after the effect of required capital for 2006 and 2005 to: • ten per cent proportionate decrease in maintenance expenses (a 10 per cent sensitivity on a base expense assumption of £10 per annum would represent an expense assumption of £9 per annum); • ten 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 for 2006
Change representing effect on: UK insurance Asian Total operations Jackson operations long-term 2005 £m £m £m £m
CFO Forum of European Insurance Companies and expanded by the Additional Guidance on European Embedded Value
When compliance with the EEV Principles is stated, those principles require the directors to prepare supplementary information in accordance with the Embedded Value Methodology (EVM)
In preparing the EEV supplementary information, the directors have: • prepared the supplementary information in accordance with the
Guidance on European Embedded Value Disclosures issued in October 2005 (together ‘the EEV Principles’) using the methodology and assumptions set out on pages 256 to 264. The
EEV supplementary information should be read in conjunction with the Group’s financial statements which are on pages 99 to 249.
As described in the statement of directors’ responsibilities on this page, the directors’ responsibilities include preparing the supplementary information on the EEV basis in accordance with the EEV Principles. Our responsibilities, as independent auditor, in relation to the supplementary information are established in the
EEV Principles using the methodology and assumptions set out on pages 256 to 264. We also report if we have not received all the information and explanations we require for this audit.
Board. An audit includes examination, on a test basis, of evidence relevant to the amounts and disclosures in the supplementary information. It also includes an assessment of the significant estimates and judgements made by the directors in the preparation of the supplementary information, and of whether the accounting policies applied in the preparation of the supplementary information are appropriate to the Group’s circumstances, consistently applied and adequately disclosed.
In our opinion, the EEV basis supplementary information for the year ended 31 December 2006 has been properly prepared in accordance with the EEV Principles using the methodology and assumptions set out on pages 256 to 264.
Registrars on 0870 600 0190 and request a dividend mandate form. Alternatively, you may download a form from the Company website www.prudential.co.uk/prudential-plc/investors/
The evergreen scrip is subject to shareholders’ approval, at the 2007 Annual General Meeting, of a resolution authorising directors to offer scrip dividend to shareholders until the 2012 Annual
Size of shareholding shareholder accounts shareholder accounts Number of shares number of shares
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The Company’s Registrars, Lloyds TSB Registrars, offer a postal dealing facility for buying and selling Prudential plc ordinary shares, telephone 0870 242 4244. They also offer a telephone and internet dealing service, Shareview, which provides a simple and convenient way of selling Prudential plc shares. For telephone sales call 0870 850 0852 between 8.30am and 4.30pm, Monday to
prudential-plc/investors/shareholder_services/ Further information about ShareGift may be obtained on 020 7337 0501 or from www.ShareGift.org There are no implications for capital gains tax purposes (no gain or loss) on gifts of shares to charity and it is also possible to obtain income tax relief.
The Company operates a branch register for Irish shareholders. All enquiries regarding Irish branch register accounts should be directed to Capita Corporate Registrars Plc, Unit 5, Manor Street Business
Park, Manor Street, Dublin 7. Telephone: 00 353 1 810 2400.
Forward-Looking Statement This report may contain certain ‘forward-looking statements’ with respect to certain of Prudential's plans and its current goals and expectations relating to its future financial condition, performance, results, strategy and objectives. Statements containing the words ‘believes’, ‘intends’, ‘expects’, ‘plans’, ‘seeks’ and ‘anticipates’, and words of similar meaning, are forward-looking. By their nature, all forward-looking statements involve risk and uncertainty because they relate to future events and circumstances which are beyond Prudential's control including among other things, UK domestic and global economic and business conditions, market related risks such as fluctuations in interest rates and exchange rates, and the performance of financial markets generally; the policies and actions of regulatory authorities, the impact of competition, inflation, and deflation; experience in particular with regard to mortality and morbidity trends, lapse rates and policy renewal rates; the timing, impact and other uncertainties of future acquisitions or combinations within relevant industries; and the impact of changes in capital, solvency or accounting standards, and tax and other legislation and regulations in the jurisdictions in which Prudential and its affiliates operate. This may for example result in changes to assumptions used for determining results of operations or re-estimations of reserves for future policy benefits. As a result, Prudential's actual future financial condition, performance and results may differ materially from the plans, goals, and expectations set forth in Prudential's forward-looking statements. Prudential undertakes no obligation to update the forward-looking statements contained in this report or any other forward-looking statements it may make.
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