For investment contracts which do not contain discretionary participating features, the accounting reflects the deposit nature of the arrangement, with premiums and claims reflected as deposits and withdrawals and taken directly to the balance sheet.
Acquisition costs Costs of acquiring new insurance business, principally commissions, marketing and advertising costs and certain other costs associated with policy issuance and underwriting that are not reimbursed by policy charges, are specifically identified and capitalised as part of deferred acquisition costs (DAC), which are included as an asset in the balance sheet. The DAC asset in respect of insurance contracts is amortised against margins in future revenues on the related insurance policies, to the extent that the amounts are recoverable out of the margins. Recoverability of the unamortised DAC asset is assessed at the time of policy issue and reviewed if profit margins have declined.
investment management features of the contracts. The Group’s investment contracts primarily comprise certain unit-linked savings contracts in the UK and Asia and contracts with fixed and guaranteed terms in the US (such as guaranteed investment contracts and annuity-certains).
The assumptions used in the stochastic models are calibrated to produce risk-free returns on each asset class. Volatilities of, and correlations between, investment returns from different asset classes are as determined by the Group’s Portfolio Management Group but are also market consistent.
Under FRS 27 for the UK with-profits funds: • No deferred acquisition costs and related deferred tax are recognised; and • adjusted realistic basis liabilities instead of MSB liabilities are recognised.
Adjusted realistic basis liabilities represent the Peak 2 basis realistic liabilities for with-profits business included in Form 19 of the FSA regulatory returns, but after excluding the element for the shareholders’ share of the future bonuses. This latter item is recognised as a liability for the purposes of regulatory returns but, for accounting purposes under FRS 27, consistent with the current basis of financial reporting, shareholder transfers are recognised only on declaration.
Jackson The future policyholder benefit provisions for Jackson’s conventional protection-type policies are determined using the net level premium method under US GAAP principles and assumptions as of the issue date as to mortality, interest, policy lapses and expenses plus provisions for adverse deviations. For non-conventional protection-type policies, the policyholder benefit provision included within policyholder liabilities in the consolidated balance sheet is the policyholder account balance.
For the business of Jackson, the determination of the expected emergence of margins, against which the amortisation profile of the DAC asset is established, is dependent on certain key assumptions. For single premium deferred annuity business, the key assumption is the expected long-term spread between the earned rate and the rate credited to policyholders. For variable annuity business, the key assumption is the expected long-term level of equity market returns which, for 2008 and 2007, was 8.4 per cent per annum implemented using a mean reversion methodology. These returns affect the level of future expected profits through their effects on fee income and the required level of provision for guaranteed minimum death benefit claims.
Although the basis of valuation of Prudential’s overseas operations is in accordance with the requirements of the Companies Act 1985 and ABI SORP, the valuation of policyholder benefit provisions for these businesses may differ from that determined on a UK MSB for UK operations with the same features.
Gains arising on the purchase of reinsurance contracts by Jackson are deferred and amortised over the contract duration. Any loss is recognised in the income statement immediately.
Investment contracts (contracts which do not contain significant insurance risk as defined under IFRS 4) For investment contracts with discretionary participation features, the accounting basis is consistent with the accounting for similar with-profits insurance contracts. Other investment contracts are accounted for on a basis that reflects the hybrid nature of the arrangements whereby part is accounted for as a financial instrument under IAS 39 and the investment management service component is accounted for under IAS 18.
Where the Group exercises significant influence or has the power to exercise significant influence over an entity, generally through ownership of 20 per cent or more of the entity’s voting rights, but does not control the entity, then this is considered to be an investment in an associate. With the exception of those referred to below, the Group’s investments in associates are recorded at the Group’s share of the associates’ net assets. The carrying value of investments in associates is adjusted each year for the Group’s share of the entities’ profit or loss. This does not apply to investments in associates held by the Group’s insurance or investment funds including the venture capital business or mutual funds and unit trusts, which are carried at fair value through profit and loss.
The consolidated financial statements of the Group include the assets, liabilities and results of the Company and subsidiary undertakings in which Prudential has a controlling interest, using accounts drawn up to 31 December 2008 except where entities have non-coterminous year ends. In such cases, the information consolidated is based on the accounting period of these entities and is adjusted for material changes up to 31 December. Accordingly, the information consolidated is deemed to cover the same period for all entities throughout the Group. The results of subsidiaries are included in the financial statements from the date acquired to the effective date of disposal. All inter-company transactions are eliminated on consolidation. Results of asset management activities include those for managing internal funds.
Leases of investment property where the Group has substantially all the risks and rewards of ownership are classified as finance leases (leasehold property). Finance leases are capitalised at the lease’s inception at the lower of the fair value of the leased property and the present value of the minimum lease payments. Where a lease has a contingent rent element, the rent is calculated in accordance with individual lease terms and charged as an expense as incurred.
For the Group’s defined benefit schemes, if the present value of the defined benefit obligation exceeds the fair value of the scheme assets, then a liability is recorded in the Group’s balance sheet. By contrast, if the fair value of the assets exceeds the present value of the defined benefit obligation then the surplus will only be recognised if the nature of the arrangements under the Trust deed, and funding arrangements between the Trustee and the Company support the availability of refunds or recoverability through agreed reductions in future contributions. In addition, if there is a constructive obligation for the Company to pay deficit funding, this is also recognised.
Deferred taxes are provided under the liability method for all relevant temporary differences, being the difference between the carrying amount of an asset or liability in the balance sheet and its value for tax purposes. IAS 12, ‘Income Taxes’ does not require all temporary differences to be provided for, in particular, the Group does not provide for deferred tax on undistributed earnings of subsidiaries where the Group is able to control the timing of the distribution and the temporary difference created is not expected to reverse in the foreseeable future. The tax effects of losses available for carry forward are recognised as an asset. Deferred tax assets are only recognised when it is probable that future taxable profits will be available against which these losses can be utilised. Deferred tax related to charges or credits taken directly to equity is also credited or charged directly to equity and is subsequently recognised in the income statement together with the deferred gain or loss.
Segments In accordance with IAS 14, ‘Segment Reporting’ the Group reports its results and certain other financial information by primary and secondary segments. The Group’s primary segments are its business segments, namely, insurance operations and asset management. The Group’s secondary segments are its geographical segments, namely, UK, US and Asia.
Foreign currency borrowings that have been used to provide a hedge against Group equity investments in overseas subsidiaries are translated at year end exchange rates and movements taken directly to shareholders’ equity. Other foreign currency monetary items are translated at year end exchange rates with changes recognised in the income statement. Foreign currency transactions are translated at the spot rate prevailing at the time.
d Presentation of supplementary analysis of profit before tax attributable to shareholders The Group provides supplementary analysis of profit before tax attributable to shareholders that distinguishes operating profit based on longer-term investment returns from other constituent elements of the total profit.
Operating profit based on longer-term investment returns The Group continues to use operating profit based on longer-term investment returns as a supplemental measure of its results. For the purposes of measuring operating profit, investment returns on shareholder-financed business are based on the expected longer-term rates of return. This reflects the particular features of long-term insurance business where assets and liabilities are held for the long term and for which the accounting basis for insurance liabilities under current IFRS is not generally conducive to demonstrating trends in underlying performance for life businesses exclusive of changes in market conditions. In determining profit on this basis the following key elements are applied to the results of the Group’s shareholder-financed operations.
There are two exceptions to the basis described above for determining operating results based on longer-term investment returns. These are for: • Unit-linked and US variable annuity business.
Non-participating business Bifurcation for the effect of determining the movement in the carrying value of liabilities to be included in operating results based on longer-term investment returns, and the residual element for the effect of using year end rates in the balance sheet.
Guaranteed Minimum Death Benefit (GMDB) product features For unhedged GMDB liabilities accounted for under IFRS using ‘grandfathered’ US GAAP, such as in the Japanese business, the change in carrying value is determined under SOP 03-01, which partially reflects changes in market conditions. Under the company’s supplementary basis of reporting the operating profit reflects the change in liability based on longer-term market conditions with the difference between the charge to the operating result and the movement reflected in the total result included in short-term fluctuations in investment returns.
b US operations – embedded derivatives for variable annuity guarantee features Under IFRS, the Guaranteed Minimum Withdrawal Benefit (GMWB) and Guaranteed Minimum Income Benefit (GMIB) reinsurance are required to be fair valued as embedded derivatives. The movements in carrying values are affected by changes in the level of observed implied equity volatility and changes to the discount rate applied from period to period. For these embedded derivatives, as described in note D3(i), the discount rate applied reflects AA corporate bond curve rates. For the purposes of determining operating profit based on longer-term investment returns the charge for these features is determined using historical longer-term equity volatility levels and long-term average AA corporate bond rate curves.
The exception is for the impact on credit risk provisioning of actual downgrades during the year. As this feature arises due to short-term market conditions the effect on the altered valuation rate of interest is included in the category of short-term fluctuations in investment returns as shown in note B1.
The effects of other changes to credit risk provisioning including the introduction of the short-term allowance for credit risk described in note D2(g) and D2(i) are included in the operating result, as in the net effect of changes to the valuation rate of interest applied to portfolio rebalancing to align more closely with management benchmark.
iv Fund management and other non-insurance businesses For these businesses, where the business model is more conventional than for life assurance, it is inappropriate to include returns in the operating result on the basis described above. Instead it is appropriate to generally include realised gains and losses (including impairments) in the operating result with unrealised gains and losses being included in short-term fluctuations. In some instances it may also be appropriate to amortise realised gains and losses on derivatives and other financial instruments to operating results over a time period that reflects the underlying substance of the arrangements.
Accounting pronouncements adopted in 2008 IFRIC 14, ‘IAS 19 – The Limit on a Defined Benefit Asset, Minimum Funding Requirements and their Interaction’ IFRIC 14 provides guidance on assessing the limit in IAS 19 on the amount of the surplus that can be recognised as an asset and clarifies the impact of minimum funding requirements on such assets. It also addresses when a minimum funding requirement might give rise to a liability. IFRIC 14 was adopted by the EU in December 2008 and is effective for accounting periods beginning after 31 December 2008.
• ‘Fair value through profit and loss’ financial assets are permitted to be reclassified into the ‘available-for-sale’ category.
The amendments to IFRS 7 result in additional disclosures in accordance with the amendments to IAS 39. The amendments to IAS 39 and IFRS 7 are effective 1 July 2008 applied on a prospective basis from the date of reclassification. Any reclassification made on or after 1 November 2008 takes effect from the date of the reclassification. Any reclassification made before 1 November 2008 can take effect from 1 July 2008 or a subsequent date.
Accounting pronouncements not yet effective IFRS 8, ‘Operating Segments’ IFRS 8 requires entities to adopt the ‘management approach’ to reporting the financial performance of its operating segments similar to the requirements under the US standard SFAS 131, ‘Disclosures about Segments of an Enterprise and Related Information’. 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. The Group is currently assessing the impact of these amendments on its financial statements.
Amendments to IAS 1,’Presentation of Financial Statements: A Revised Presentation’ The revised version of IAS 1 is aimed at improving users’ ability to analyse and compare the information given in the financial statements.
The changes require information in financial statements to be aggregated on the basis of shared characteristics and introduce a statement of comprehensive income. The revisions also include changes to the titles of some of the financial statements to reflect their functions more clearly: for example the balance sheet is renamed a statement of financial position, though the new titles are not mandatory. This revised standard is effective for IASB compliant financial statements for accounting periods beginning on or after 1 January 2009. The Group is currently assessing the impact of these amendments on its financial statements.
Amendment to IFRS 2, ‘Share-based Payment: Vesting Conditions and Cancellations’ The amendment to IFRS 2 clarifies that vesting conditions are service conditions and performance conditions only. Other features of a share-based payment are not vesting conditions. It also specifies that all cancellations, whether by the entity or by other parties, should receive the same accounting treatment. This amendment is effective for accounting periods beginning on or after 1 January 2009. The Group is currently assessing the impact of this amendment but it is not expected to have a material impact on the financial statements of the Group.
Revised IFRS 3, ’Business Combinations’ and Amendments to IAS 27, ‘Consolidated and Separate Financial Statements’ The revised IFRS 3 and amended IAS 27 are the outcomes of the second phase of the IASB’s and the US Financial Accounting Standards Board’s (FASB) joint business combination project. The more significant changes from the revised IFRS 3 include: • The immediate expensing of acquisition-related costs rather than inclusion in goodwill; and • recognition and measurement at fair value of contingent consideration at acquisition date with subsequent changes to income.
Amendments to IAS 32, ‘Financial instruments: Presentation’ and IAS 1, ‘Presentation of financial statements’ – Puttable Financial Instruments and Obligations Arising on Liquidation The amendments to IAS 32 and IAS 1 requires entities to classify puttable financial instruments and instruments, or components of instruments, that impose on the entity an obligation to deliver to another party a pro rata share of the net assets of the entity only on liquidation as equity, provided the financial instruments have particular features and meet specific conditions. The amendments may have the effect of altering the accounting for external fund holder investments in consolidated funds from minority interests to liabilities. These amendments also have consequential amendments to IFRS 7 and IAS 39.
These amendments are effective for IASB compliant financial statements for accounting periods beginning on or after 1 January 2009. The Group is currently assessing the impact of these amendments on its financial statements.
Amendment to IAS 39, ‘Financial instruments: Recognition and Measurement’ – Eligible Hedged Items This amendment to IAS 39 clarifies how the principles that determine whether a hedged risk or portion of cash flows is eligible for designation should be applied in particular situations. This amendment is effective for IASB compliant financial statements for accounting periods beginning on or after 1 July 2009. The Group is currently assessing the impact of this amendment but it is not expected to have a material impact on the financial statements of the Group.
The Group is currently assessing the impact of this interpretation but it is not expected to have a material impact on the financial statements of the Group.
Improving Disclosures about Financial Instruments (Amendments to IFRS 7) On 5 March 2009, the IASB issued amendments to IFRS 7 which require enhanced disclosures about fair value measurements and liquidity risk. The amendments include the introduction of a three-level hierarchy for fair value measurement disclosures and require additional disclosures about the relative reliability of fair value measurements.
Apart from IFRS 8, the Amendments to IAS 1 and the Amendment to IFRS 2, all of the other aforementioned pronouncements have not been adopted for use in the EU at 31 December 2008. Subsequent to the 31 December 2008, the improvements to IFRSs and the amendments to IAS 32 and IAS 1 have also been adopted for use in the EU.
US operations Jacksonnotes ii,iii 406 444 Broker dealer and asset management (including Curian losses of £3m (2007: £5m)) 7 8
Other income and expenditure Investment return and other income 89 86 Interest payable on core structural borrowings (172) (168) Corporate expenditure: Group Head Office (130) (129) Asia Regional Head Office (41) (38)
Operating profit from continuing operations based on longer-term investment returnsnote i 1,347 1,201 Short-term fluctuations in investment returns on shareholder-backed businessnote iv (1,783) (137) Shareholders’ share of actuarial and other gains and losses on defined benefit pension schemesnote v (14) (1)
Operating profit based on longer-term investment returns is a supplemental measure of results. For the purposes of measuring operating profit, investment returns on shareholder-financed business and movements in policyholders’ liabilities are based on expected long-term rates of return as discussed in note A4. The expected long-term rates of return are intended to reflect historical real rates of return and, where appropriate, current inflation expectations adjusted for consensus economic and investment forecasts. The significant operations that require adjustment for the difference between actual and long-term investment returns are Jackson and certain businesses of the Group’s Asian operations. The amounts included in operating results for long-term capital returns for debt securities comprise two components. These are a risk margin reserve based charge for expected defaults, which is determined by reference to the credit quality of the portfolio, and amortisation of interest-related gains and losses for operating results based on longer-term results to the date when sold bonds would otherwise have matured.
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(i), D3(i) and D4(i).
Notes continued iii Jackson operating results based on longer-term investment returns.
Debt securities: Amortisation of interest related realised gains and losses 24 31 Risk margin reserve charge for longer-term credit related losses (41) (37)
Average Annual Average Annual book expected losses book expected losses value RMR value RMR Moody’s rating category (US $m) (bps) US $m £m (US $m) (bps) US $m £m
Related change to amortisation of deferred acquisition costs 23 13 20 10
Risk margin reserve charge for longer-term credit related losses (76) (41) (76) (37)
General The short-term fluctuations in investment returns for 2008 primarily reflect temporary market value movements on the portfolio of investments held by the Group’s shareholder-backed operations. Default losses were incurred during 2008 in respect of Lehman Brothers and Washington Mutual, with total losses (including losses on sale) for these in respect of the Group's shareholder-backed business operations being £110 million and £91 million respectively of which the majority was incurred in Jackson. Excluding Lehman Brothers and Washington Mutual there was only one other default in 2008 which resulted in a loss of £5 million. There were no default losses in 2007.
Asian insurance operations The fluctuations for Asian operations in 2008 primarily relates to £(81) million for Vietnam, reflecting a significant fall in the Vietnamese bond and equity markets, and £(65) million for Taiwan, which reflects the decrease in Taiwanese equity markets and a £(40) million reduction in the value of an investment in a CDO fund. For 2007, the £(71) million of short-term fluctuations primarily reflect value movements in Taiwan on the value of debt securities arising from increases in interest rates and a £(30) million reduction of the investment in a CDO fund, partially offset by strong equity market movements in Vietnam.
US insurance operations The short-term fluctuations in investment returns for US insurance operations for the year comprise of the following items: £m £m
Interest related gains (losses) Arising in the year (25) 31 Less: amortisation gains and losses arising in current and prior years to operating profit based on longer-term investment returns (28) (37)
Total short-term fluctuations related to debt securities (535) (27) Derivatives (other than equity related): market value movements (net of related change to amortisation of deferred acquisition costs)† (369) (19) Equity type investments: actual less longer-term return (net of related change to amortisation of deferred acquisition costs) (69) 42 Other items (net of related change to amortisation of deferred acquisition costs)‡ (85) (14)
Bond deteriorating Recoveries/ Defaults write downs bonds reversals Total £m £m £m £m £m
Further details on the impairment losses for Jackson are described in note D3(a). †The £369 million value movement is for freestanding derivatives held to manage the fixed annuity and other general account business. Under IAS 39, unless hedge accounting is applied, value movements on derivatives are recognised in the income statement. Except in respect of variable annuity business, the value movements on derivatives held by Jackson are separately identified within short-term fluctuations in investment returns.
For the derivatives programme attaching to the fixed annuity and other general account business the Group has continued its approach of not seeking to apply hedge accounting under IAS 39. This decision reflects the inherent constraints for hedge accounting investments and life assurance assets and liabilities under ‘grandfathered’ US GAAP under IFRS 4.
‡The £85 million charge for 2008 for other items shown above comprises £70 million for the difference between the charge for embedded derivatives included in the operating result and the charge to the total result, and £15 million of other items. For embedded derivatives the operating result reflects the application of 10-year average AA corporate bond rate curves and a static historical equity volatility assumption. The total result reflects the application of year end AA corporate bond rate curves and current equity volatility levels. Additional details are explained in note D3(i).
Sale of investment in India Mutual fund in May 2008 giving rise to a transfer to operating profit of £47 million for the crystallised gain, and value reduction in the period, prior to sale, of £24 million (71) Unrealised value movements on swaps held centrally to manage Group assets and liabilities (38) Unrealised value movements on Prudential Capital’s bond portfolio (190) Unrealised value movements on centrally held investments (14)
Other gains and losses Movement in the provision for deficit funding of PSPS (13) – Less: amount attributable to the PAC with-profits sub-fund 9 –
The 2008 and 2007 actuarial gains and losses shown in the table above related to the Scottish Amicable, M&G and the small Taiwan defined benefit pension schemes. The amounts did not include actuarial gains and losses for the Prudential Staff Pension Scheme (PSPS). Following the Group’s adoption of IFRIC 14 for pension schemes in 2008, PSPS pension surplus was not recognised in the Group’s financial statements with the 2007 comparatives adjusted accordingly. In addition, as a result of the adoption of IFRIC 14, the Group has recognised a liability for deficit funding to 5 April 2010 in respect of PSPS. The change in the period in relation to this liability is recognised above as other gains and losses on defined benefit pension schemes.
The gains of £71 million on change of assumptions comprises the effect of an increase in the risk discount rate combined with the effect of decreases in inflation rates.
Further details on the Group’s defined benefit pension schemes and the effect of the accounting policy change are shown in note I1.
Based on loss for the year from continuing operations (450) 59 (5) (396) (16.0)p (16.0)p
Based on profit for the year from continuing operations 1,063 (354) (3) 706 28.8p 28.8p
Based on profit for the year 1,285 (335) (3) 947 38.7p 38.6p *Discontinued operations in 2007 related entirely to UK Banking operations following the sale on 1 May 2007 of Egg Banking plc to Citi. Note I9 provides details of the sale of Egg.
Number of shares A reconciliation of the weighted average number of ordinary shares used for calculating basic and diluted earnings per share is set out as below: Weighted average shares for calculation of basic earnings per share 2,472 2,445 Shares under option at end of year 7 9 Number of shares that would have been issued at fair value on assumed option exercise (6) (6)
Weighted average shares for calculation of diluted earnings per share 2,473 2,448
A final dividend of 12.91 pence per share was proposed by the directors on 18 March 2009. Subject to shareholders’ approval, the dividend will be paid on 22 May 2009 to shareholders on the register at the close of business on 14 April 2009. The dividend will absorb an estimated £322 million of shareholders’ funds. A scrip dividend alternative will be offered to shareholders.
The exchange rates applied were: Closing Closing Opening rate at Average rate at Average rate at
Local currency: £ 31 Dec 2008 for 2008 31 Dec 2007 for 2007 1 Jan 2007
Investment products Insurance products gross inflows gross premiums note ii Total
GIC – Medium Term Notes 337 527 – – 34 53
Total mature life and pensions 512 531 137 140 188 193
Market Market gross and other 1 Jan 2007 inflows Redemptions movements 31 Dec 2007
The format of the tables shown above is consistent with the distinction between insurance and investment products as applied for previous financial reporting periods. With the exception of some US institutional business, products categorised as ‘insurance’ refer to those classified as contracts of long-term insurance business for regulatory reporting purposes, i.e. falling within one of the classes of insurance specified in part II of Schedule 1 to the Regulated Activities Order under FSA regulations.
iii The tables for 2007 above include the transfer of 62,000 with-profits annuity policies from Equitable Life on 31 December 2007 with assets of approximately £1.7 billion. The transfer represented APE of £174 million.
The Group’s primary reporting segments are insurance operations, asset management and, prior to disposal, banking. The Group’s secondary reporting segments are geographical, namely the UK, the US and Asia. Details of disclosures in accordance with the requirements of IAS 14 for segment assets and liabilities are shown below.
Details of the primary reporting segments are as follows: Insurance operations This segment comprises long-term products that contain both significant and insignificant elements 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 with-profits funds’ venture investments and other investment subsidiaries held for the purpose of supporting the Group’s insurance operations.
Unallocated Insurance Asset to a Intra-group operations management segment eliminations Total
Segment assets by geographical segment UK 161,334 US 42,758 Asia 20,789 Intra-group eliminations (5,499)
Other non-investment and non-cash assetsH3-H6 4,962 1,819 1,416 8,197 135 3,553 (5,608) 6,277 Investment of long-term business and other operations: Investments accounted for using the equity method – – – – – 10 – 10
By business segment D2 D3 D4 tions E2 tions) tions total
(reflecting application of ’realistic’ basis provisions for UK regulated with-profits funds)D2eii,H12 8,254 – 160 8,414 – – – 8,414
Total policyholder liabilities and unallocated surplus of with-profits fundsnote b 115,961 45,361 21,069 182,391 – – – 182,391
Operational borrowings attributable to shareholder-financed operationsG1,H13 54 511 130 695 4 1,278 – 1,977
This analysis is shown below for the Group balance sheet by business segment at 31 December 2007.
Other non-investment and non-cash assetsH3-H6 4,110 994 689 5,793 426 4,292 (5,499) 5,012 Investment of long-term business and other operations: Investments accounted for using the equity method – – – – – 12 – 12
Borrowings attributable to with-profits fundsG1,H13 987 – – 987 – – – 987 Other non-insurance liabilities:G1,H4,H9,H14,H15
Intangible assets attributable to with-profits funds: In respect of acquired subsidiaries for venture fund and other investment purposes 174 – – – – – 174 192 Deferred acquisition costs and other intangible assets 126 – – – – – 126 19
Equity securities and portfolio holdings in unit trusts 31,821 29,211 1,067 23 – – 62,122 86,157
Held for sale assetsH9 – – – – – – – 30
(reflecting application of ‘realistic’ basis provisions for UK regulated with-profits funds)D2eii,H12 8,414 – – – – – 8,414 13,959
Borrowings attributable to with-profits fundsG1,H13 1,308 – – – – – 1,308 987 Other non-insurance liabilities: Obligations under funding, securities lending and sale and repurchase agreements 1,570 – 4,002 – – – 5,572 4,081
Insurance operations opera- manage- to a Group UK US Asia tions ment segment total £m £m £m £m £m £m £m
Directly held investments, net of derivative liabilities* 137,090 36,037 13,174 186,301 2,821 236 189,358
Net cash inflow from operating activities 3,128 2,612 2,731 8,471 317 (210) 8,578 Realised gains (losses) in the year 4,660 (47) 1,484 6,097 8 (16) 6,089 Unrealised gains (losses) in the year (2,789) 636 (128) (2,281) (22) 3 (2,300)
Directly held investments, net of derivative liabilities 117,852 45,308 20,676 183,836 3,011 45 186,892 *The above reconciliation analyses the movement of directly held investments net of derivative liabilities. The deduction of derivative liabilities reflects the fact that these are considered an integral part of the Group’s investment portfolio and the exclusion from investments is merely a matter of required balance sheet presentation. The analysis excludes investments held in the balance sheet as a result the consolidation of Open-Ended Investment Companies (OEICS) and unit trusts, as the Group’s exposure is merely to its share of the value of the fund as a whole rather than to the underlying investments and other assets and liabilities.
ii Group exposure to holdings in asset-backed securities and monoline insurers a Asset-backed securities The Group’s exposure to holdings in asset-backed securities which comprise residential mortgage-backed securities (RMBS), CDO funds and other asset-backed securities (ABS), at 31 December 2008 is as follows: 2008 £m
Shareholder-backed operations: UK insurance operationsnote i 1,075 US insurance operationsnote ii 7,464 Asian insurance operationsnote iii 15 Other operationsnote iv 407
Total 14,266 i UK insurance operations The UK insurance operations’ exposure to asset-backed securities at 31 December 2008 is analysed as follows: 2008 £m
The UK insurance operations’ exposure to asset-backed securities is mainly made up of exposure to AAA rated securities as shown in the table above.
Total 7,464 *Including the Group’s economic interest in Piedmont and other consolidated CDO funds. Further details on Jackson’s RMBS sub-prime and Alt-A securities are given in note D3(d).
iii Asian insurance operations The Asian insurance operations’ exposure to asset-backed securities is primarily held by the with-profits operations. The £328 million asset-backed securities exposure of the Asian with-profits operations comprises: 2008 £m
Total 407 b Direct holdings in monoline insurers The Group has no significant exposure to direct holdings in monoline insurers at 31 December 2008.
Shareholders’ transfers post tax (284) – (23) (307) Investment-related items and other movements (16,331) (4,552) (4,293) (25,176) Foreign exchange translation differences (2,481) 12,753 5,589 15,861
Prudential’s risk governance 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 governance framework is based on the concept of ‘three lines of defence’: Risk management, risk oversight and independent assurance. Primary responsibility for strategy, performance management and risk control lies with the Board, the Group Chief Executive and the chief executives of each business unit. Risk oversight is provided by Group-level risk committees, chaired by the Chief Financial Officer with representation from business units and Group Head Office functions. The committees’ oversight is supported by the Group Chief Risk Officer. Independent assurance on the Group’s and business unit internal control and risk management systems is provided by Group-wide Internal Audit reporting to the Group and business unit audit committees.
The Group’s risk reporting framework forms an important part of the Group’s business planning process. Business units review their risks as part of the annual preparation of their business plans and review opportunities and risks against business objectives regularly with Group executive management.
Additional information on the Group’s risk framework is included in the risk and capital management section of the Group’s business review.
The management of the risk attached to the Group’s financial instruments and insurance liabilities, together with the inter-relationship with the management of capital may be summarised in the following sections.
i Earnings volatility: The objectives of the limits are to ensure that (a) the volatility of earnings is consistent with stakeholder expectations, (b) the Group has adequate earnings (and cash flows) to service debt and expected dividends and (c) that earnings (and cash flows) are managed properly across geographies and are consistent with the Group’s funding strategies. The two measures used currently are European Embedded Value (EEV) operating profit based on longer-term investment returns and International Financial Reporting Standards (IFRS) operating profit based on longer-term investment returns.
ii Capital requirements: The objectives of the limits are to ensure that (a) the Group meets the economic capital requirements at all times, (b) the Group achieves its desired target rating to meet its business objectives and (c) supervisory intervention is avoided. The two measures used are EU Insurance Groups Directive (IGD) capital requirements and economic capital requirements.
The Group’s risk appetite framework forms an integral part of its annual business planning cycle. Throughout the year, the Group risk function monitors the Group’s risk profile against the agreed limits. Using submissions from business units, Group risk function calculates the Group position (allowing for diversification effects between business units) relative to the limits implied by the risk appetite statements.
The current market dislocation and increased risk of default led the Group to place an increased emphasis on the management of market and credit risk in the course of 2008. Market risk is managed such that as conditions evolve the risk profile is maintained within risk appetite in addition to business unit operational limits on credit risk, the Group sets counterparty risk limits at Group level. Limits on the total Group-wide exposures to a single counterparty are specified within different credit rating ‘categories’. Actual exposures are monitored against these limits on a monthly basis.
Further details of the Group’s use of derivatives are explained in note G3.
For businesses that are most sensitive to interest rate changes, such as immediate annuity business, Prudential uses cash flow analysis to create a portfolio of fixed income securities whose value changes in line with the value of liabilities when interest rates change. This type of analysis helps protect profits and the capital position from changing interest rates. In the UK, the cash flow analysis is used in Prudential’s annuity business while, in the US, it is used for its interest-sensitive and fixed index annuities and stable value products such as Guaranteed Investment Contracts (GICs). Perfect matching is not possible, for example because of the nature of the liabilities (which might include guaranteed surrender values) and options for prepayment contained in the assets or the unavailability of assets with a sufficiently long duration.
All of Prudential’s investments are held either for risk management or investment purposes. This is because almost all of the investments support policyholder or customer liabilities of one form or another. Any assets that Prudential holds centrally that are not supporting customer liabilities are predominantly invested in short-term fixed income and fixed maturity securities.
Foreign exchange risk Prudential faces foreign exchange risk, primarily because its presentation currency is pounds sterling, whereas approximately 53 per cent of Prudential’s operating profit from continuing operations based on longer-term investment returns, as described in note B1, for the year ended 31 December 2008, came from Prudential’s US and Asian operations. The exposure relating to the translation of reported earnings is not separately managed although its impact is reduced by interest payments on foreign currency borrowings and by the adoption of average exchange rates for the translation of foreign currency revenues.
Approximately 83 per cent of the Group’s IFRS basis shareholders’ equity at 31 December 2008 arose in Prudential’s US and Asian operations (2007: approximately 70 per cent). To mitigate the exposure of the US component there are US$1.55 billion of borrowings held centrally. The Group has also entered into a US$2 billion net investment hedge which was reduced to US$600 million in December 2008 (see note G3). Net of the currency position arising from these instruments some 49 per cent of the Group’s shareholders’ funds are represented by net assets in currencies other than sterling.
Further analysis of the credit quality for the Group is shown in note B6. Additional details on the credit quality of the debt security portfolios of UK, US and Asian insurance operations are shown in notes D2, D3 and D4, respectively.
v Non-financial risks – operational, business environment and strategic risk Operational risk is the risk of direct or indirect loss resulting from inadequate or failed internal processes, people, systems or from external events. Business environment risk may arise from exposure to forces in the external environment that could significantly change the fundamentals that drive the business’s overall objectives and strategy. Strategic risk may arise from ineffective, inefficient or inadequate senior management processes for the development and implementation of business strategy in relation to the business environment and the Group’s capabilities.
Prudential is exposed to operational, business environment and strategic risk in the course of running its businesses. Prudential processes a large number of complex transactions across numerous and diverse products, and is subject to a number of different legal and regulatory regimes. Prudential has a significant number of third-party relationships that are important to the distribution and processing of its products, as market counterparties and as business partners.
Regulatory capital requirements apply at an individual company level for the Group’s life assurance and asset management business. These are described in sections D5 and E3 respectively.
At 31 December 2007, Prudential met the requirements of the IGD. In addition, during 2008, Prudential met the ‘hard test’ of the FSA under the IGD. The IGD position as at 31 December 2008 will be submitted to the FSA by 30 April 2009 and at the time of preparation of these financial statements the surplus capital under the test was estimated to be around £1.7 billion before allowing for the 2008 final dividend giving a solvency ratio of 160 per cent. This is composed of the Group’s IGD surplus at 31 December 2008 which is estimated at £1.4 billion and of an additional £0.3 billion which the FSA has allowed the Group to include in the Group’s IGD surplus going forward as a result of an innovative structure the Group has developed. The £0.3 billion additional capital reflects the Group’s ability to realise a portion of the shareholders’ economic interest in the future transfers from the PAC with-profits fund. The intended sale of the Taiwan agency business announced on 20 February 2009, as discussed in note I10, will when completed increase the IGD surplus capital by approximately £0.8 billion, further strengthening IGD surplus capital to £2.5 billion.
Prudential’s capital performance metrics are based on economic capital, which provides a realistic and consistent view of our capital requirements across the Group, allowing for diversification benefits. Economic capital also provides valuable insights into our risk profile and is used both for risk measurement and capital management.
Insurance contracts Insurance contracts are permitted to be accounted for under previously applied GAAP. The Group has chosen to adopt this approach. However, as an improvement to accounting policy, permitted by IFRS 4, the Group has applied the measurement principles for with-profits contracts of UK regulated entities and disclosures of the UK Standard FRS 27 from 1 January 2005. An explanation of the provisions under FRS 27 is provided in note D2.
Under the previously applied GAAP, UK GAAP, the assets and liabilities of contracts are reported in accordance with the MSB of reporting as set out in the ABI SORP.
The insurance contracts of the Group’s shareholder-backed business fall broadly into the following categories: • UK insurance operations – bulk and individual annuity business, written primarily by Prudential Retirement Income Limited and other categories of non-participating UK business; • Jackson
b Concentration of risk i Business accepted The Group’s exposure to life assurance risks is well-diversified. This is achieved through the geographical spread of the Group’s operations and, within those operations, through a broad mix of product types.
Credit risk remains one of the largest risk exposures. This reflects the relative size of exposure in Jackson and the UK shareholder annuities business. An example of the diversification benefits for Prudential is that adverse scenarios do not affect all business units in the same way, providing natural hedges within the Group. For example, the Group’s US business is sensitive to increasing interest rates, whereas, in contrast, several business units in Asia benefit from increasing rates. Conversely, these Asian business units are sensitive towards low interest rates, whereas for certain products in the US benefits from falling interest rates. The economic capital framework also takes into account situations where factors are correlated, for example the extent of correlation between UK and US economies.
The Group manages concentration of credit risks by setting limits on the maximum exposure to each counterparty based on their credit ratings. Business units are also required to disclose to the Group risk function all material risks, along with information on their severity and likelihood, and mitigating actions taken or planned.
ii Ceded business The Group cedes certain business to other insurance companies. Although the ceding of insurance does not relieve the Group of liability to its policyholders, the Group participates in such agreements for the purpose of managing its loss exposure. The Group evaluates the financial condition of its reinsurers and monitors concentration of credit risk from similar geographic regions, activities or economic characteristics of the reinsurers to minimise its exposure from reinsurer insolvencies. There are no significant concentrations of reinsurance risk. At 31 December 2008, 98 per cent (2007: 98 per cent) of the reinsurance recoverable insurance assets were ceded by the Group’s UK and US operations, of which 91 per cent (2007: 88 per cent) of the balance were from reinsurers with Standard & Poor’s rating AA- and above. As a result of downgrading subsequent to the year end based on the ratings at the time of signing these consolidated financial statements, 93 per cent of the reinsurance recoverable insurance assets ceded by the Group UK and US operations were rated A and above with 39 per cent were rated AA- and above.
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 projected cash flows are those expected to arise under the contracts such as those arising from premiums, claims and expenses after appropriate allowance for future lapse behaviour and mortality and morbidity experience. The cash flows also include the expected future cash flows on assets covering liabilities and encumbered capital.
D1: Group overview continued e Sensitivity of IFRS basis profit or loss and equity to market and other risks i Overview of risks by business unit The financial assets and liabilities attaching to the Group’s life assurance business are, to varying degrees, subject to market and insurance risk and other changes of experience assumptions that may have a material effect on IFRS basis profit or loss and equity.
Three key points are to be noted, namely: • The Group’s with-profit and unit-linked funds absorb most market risk attaching to the fund’s investments. Except for second order effects, for example on asset management fees and shareholders’ share of cost of bonuses for with-profits business, shareholder results are not directly affected by market value movements on the assets of these funds; • the Group’s shareholder results are most sensitive to market risks for assets of shareholder-backed business; and • the main exposures of the Group’s IFRS basis results to market risk for life assurance operations on investments of shareholder-backed business are for debt securities.
The most significant items for which the IFRS basis profit or loss and equity for the Group’s life assurance business is sensitive to these variables are shown in the following tables. The distinction between direct and indirect exposure is not intended to indicate the relative size of the sensitivity.
(including Prudential subject to smoothing future shareholder Annuities Limited) through declared bonuses transfers
Fixed indexed Derivative hedge Incidence of equity annuity business programme to the participation features extent not fully hedged against liability and fund performance
These risks are reflected in volatile profit or loss and shareholders’ equity for derivative value movements and impairment losses, and, in addition, for shareholders’ equity for value movements on fixed income securities classified as ‘available for sale’ under IAS 39
For Jackson at the level of operating profit based on longer-term investment returns, the results are sensitive to market conditions to the extent of income earned on spread-based products and equity-based exposure (excluding movement in market implied volatility and based on average Corporate AA interest rates) not mitigated by the equity and interest derivative programmes. Jackson’s total profit and equity are exposed to similar market movements (including the effects of movements in market implied volatility and actual Corporate AA interest rates). In each case, IFRS profit or loss and equity movements arise from the accounting rather than economic effect of market value movements on assets and derivatives attaching to fixed annuity, term and institutional business.
Jackson’s derivative programme is used to substantially mitigate equity market risk attaching to its equity-based products and interest rate risk associated with its spread-based products. Movements in interest rates and credit spreads materially affect the carrying value of derivatives which are used to manage the liabilities to policyholders and backing investment assets of fixed annuity and other general account business. Combined with the use of US GAAP measurement for the asset and liabilities for the insurance contracts, which is largely insensitive to current period market movements, the Jackson total profit (i.e. including shortterm fluctuations in investment returns) is very sensitive to market movements. In addition to these effects the Jackson IFRS equity is sensitive to the impact of interest rate and credit spread movements on the value of fixed income securities. Movements in unrealised appreciation on these securities are included as movement in equity (i.e. outside the income statement).
M&G profits are affected primarily by movements in the growth in funds under management and of the effect any impairment on the loan book and fair value movements on debt securities held by Prudential Capital.
Investment performance is a key driver of bonuses, and hence the shareholders’ share of cost of bonuses. Due to the ‘smoothed’ basis of bonus declaration the sensitivity to investment performance in a single year is low. However, over multiple periods it is important.
• Prudential Annuities Limited (PAL) PAL’s business is not with-profit, it writes annuity business. However, as PAL is owned by the PAC with-profits sub-fund, changes in the carrying value of PAL’s assets and liabilities are reflected in the liability for unallocated surplus which as described above, changes to which do not affect shareholder results.
The main market risk sensitivity for PRIL arises from interest rate risk on the debt securities which substantially represent IFRS equity. This equity comprises the net assets held within the long-term fund of the company that cover regulatory basis liabilities that are not recognised for IFRS reporting purposes, for example contingency reserves, and shareholder capital held outside the long-term fund.
• Other shareholder-backed unit-linked business Due to the matching of policyholder liabilities to attaching asset value movements the UK unit-linked business is not directly affected by market or credit risk. The principal factor affecting the IFRS results is investment performance through asset management fees.
Jackson The IFRS basis results of Jackson are highly sensitive to market risk on the assets covering liabilities other than variable annuity business segregated in the separate accounts.
Excluding these short-term effects, the factors that most significantly affect the Jackson IFRS operating result based on longterm investment returns are: • Variable annuity business – net effect of market risk arising from the incidence and valuation guarantee features and variability of asset management fees offset by derivative hedging performance. The net effect of market risk in Jackson’s guarantees and derivatives included in operating result excludes the impact of changes in market implied volatility. Further movements in reserves for guarantees reflected in operating result are also based on a long-term average Corporate AA credit curve instead of the actual Corporate AA credit curve at the valuation date; • fixed annuity business – the spread differential between the earned rate and the rate credited to policyholders; and • fixed index annuity business – the spread differential between the earned rate and the rate credited to policyholders and incidence of equity index participation features, net of the related hedging performance.
In addition, the total profit for Jackson is affected by the level of impairment losses on the debt securities portfolios, short-term value movements on derivatives held to manage the fixed annuity and other general account business, other temporary value movements on portfolio investments, and those arising on revaluing the embedded derivative components of variable annuity liabilities for the effects of short-term movements in AA corporate bond rate curves and equity volatility levels.
Asian operations For Asian with-profits business the same features apply as described above for UK with-profits business. Similarly, as for other parts of the Group, for unit-linked business the main factor affecting IFRS basis results is investment performance through asset management fees.
This sensitivity is primarily reflected through the volatility of asset returns coupled with the fact that the accounting carrying value of liabilities to policyholders are only partially sensitive to changed market conditions. As for UK shareholder-backed operations and Jackson, the IFRS profit is distinguished in the Group’s supplementary analysis so as to distinguish operating profits based on longer-term investment return and short-term fluctuations in investment returns.
iii Impact of diversification on risk exposure The Group enjoys significant diversification benefits. This arises because not all risk scenarios will happen at the same time and across all geographic regions. The Group tests the sensitivities of results to different correlation factors such as: Correlation across geographic regions • Financial risk factors • Non-financial risk factors.
D2: UK insurance operations a Summary balance sheet In order to explain the different types of UK business and fund structure, the balance sheet of the UK insurance operations may be analysed by the assets and liabilities of the Scottish Amicable Insurance Fund (SAIF), the PAC with-profits sub-fund, unit-linked, annuity (principally PRIL) and other business. The assets and liabilities of these funds and subsidiaries are shown in the table below.
Held for sale assets – – – – – – – – 30
Operational borrowings attributable to shareholder-financed operations – – – – – 54 54 54 12
Net asset value attributable to unit holders of consolidated unit trusts and similar funds – 924 19 943 555 38 593 1,536 1,751
(2007: £449 million), policy loans of £29 million (2007: £35 million) and other loans of £1,172 million (2007: £761 million). The mortgage loans are collateralised by properties. Other loans are all commercial loans and comprise mainly syndicated loans held by the PAC with-profits fund.
Less: Investments held by consolidated investment funds – – – – – (1,179) (1,179)
Directly held investments, net of derivative liabilities 14,165 74,294 15,261 89,555 17,237 16,133 137,090
Net cash inflow from operating activities (829) 1,100 (216) 884 595 2,478 3,128
Movement in the year of directly held investments, net of derivative liabilities (612) 3,716 (793) 2,923 810 1,977 5,098
Less: Investments held by consolidated investment funds – – – – – (662) (662)
Net cash inflow from operating activities (1,245) (1,396) (211) (1,607) 811 2,928 887
Movement in the year of directly held investments, net of derivative liabilities (3,529) (17,672) (1,419) (19,091) (2,914) 1,198 (24,336)
Directly held investments, net of derivative liabilities 10,024 60,338 13,049 73,387 15,133 19,308 117,852
Assumption changes (shareholder-backed business)note D2(i) – – (34) (34) Investment-related items and other movements 6,256 749 223 7,228 Foreign exchange translation differences (62) – (5) (67)
Assumption changes (shareholder-backed business)note D2(i) – – 447 447 Investment-related items and other movements (13,049) (2,952) (777) (16,778) Foreign exchange translation differences (2,483) 2 – (2,481)
Amicable Prudential Prudential assets and other Insurance Annuities Annuities and long-term
The Group’s main exposure to guaranteed annuities in the UK is through SAIF and a provision of £391 million was held in SAIF at 31 December 2008 (2007: £563 million) to honour the guarantees. As SAIF is a separate sub-fund solely for the benefit of policyholders of SAIF this provision has no impact on the financial position of the Group’s shareholders’ equity.
D2: UK insurance operations continued iv Unit-linked (non-annuity) and other non-profit 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.
The assumptions for asset management expenses are based on the charges specified in agreements with the Group’s asset management operations, plus a margin for adverse deviation for non-profit business.
The FSA’s Peak 2 calculation under the realistic regime requires the value of liabilities to be calculated as: • The with-profits benefits reserve (WPBR); plus • future policy related liabilities (FPRL); plus • the realistic current liabilities of the fund.
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. Asset shares are calculated as the accumulation of all items of income and outgo that are relevant to each policy type. Income comprises credits for premiums, investment returns (including unrealised gains), and miscellaneous profits. Outgo comprises charges for tax (including an allowance for tax on unrealised gains), guarantees and smoothing, mortality and morbidity, shareholders’ profit transfers, miscellaneous losses, and expenses and commission (net of any tax relief).
The weighted components of the bond spread over swap rates for shareholder-backed fixed and linked annuity business for PRIL on the IFRS basis at 31 December 2008 based on the asset mix at that date are as follows: Adjustment Pillar I from
By comparison, for 2007, the weighted components of the bond spread over swap rates for shareholder-backed fixed and linked annuity business on the IFRS basis at 31 December 2007 based on the asset mix of the portfolio at that date were as follows: Adjustment Pillar I from
Credit risk allowance Long-term expected defaultsnote ii 13 – 13 Long-term credit risk premiumnote iii 10 (3) 7 Short-term allowance for credit risknote iv 10 (10) –
Notes i Bond spread over swap rates reflect market observed data to credit spreads. ii Long-term expected defaults; this is derived by applying Moody’s data from 1970 to 2004 uplifted by between 100 per cent (B) and 200 per cent
(AAA) according to credit rating on the annuity asset portfolio. The credit rating assigned to each asset held is based on external credit rating and for this purpose the credit rating assigned to each asset held is the lowest credit rating published by Moody’s, Standard and Poors and Fitch.
iii Long-term credit risk premium; this provides compensation against the risk of potential volatility in the level of defaults and is derived by applying the 95th percentile from Moody’s data from 1970 to 2004 to the annuity asset portfolio.
iv During the second half of 2007, corporate bond spreads widened significantly and the methodology was reviewed to ensure that it still made appropriate allowance for credit risk. As a result of this review a short-term allowance for credit risk was established to allow for the concern that credit ratings applied by rating agencies to individual bonds might be over optimistic.
The approach for IFRS, however, aims to establish liabilities that are closer to ‘best estimate’. The very prudent Pillar I regulatory basis reflects the overriding objective of ensuring sufficient provisions and capital to ensure payments to policyholders can be made. In previous years long-term IFRS default assumptions were set mid-way between the EEV and Pillar I assumptions. At 31 December 2008, in light of the increase uncertainty surrounding future credit default experience, the IFRS long-term assumptions have been strengthened to bring them into line with the long-term Pillar I default assumptions. In addition a short-term allowance for credit risk has been established but at a lower level than allowed for in the Pillar I regulatory basis.
In payment 102% – 126% PNMA00 84% – 117% PNFA00 97% – 102% PNMA00 88% – 98% PNFA00 (C = 2000) with medium (C = 2000) with 75% (C = 2000) with medium (C = 2000) with 75% cohort improvement of medium cohort cohort improvement of medium cohort table with a minimum improvement table table with a minimum improvement table annual improvement with a minimum annual annual improvement with a minimum annual of 2.25% up to age 90, improvement of 1.25% of 2.25% up to age 90, improvement of 1.25% tapering to zero at up to age 90, tapering tapering to zero at up to age 90, tapering age 120 to zero at age 120 age 120 to zero at age 120
Release of other margins: Projected benefit related 10 10 Investment related: Additional credit default margins (369) note b(413) Deflation risk margins (30) (32)
The 2007 results for shareholder-backed annuity business were determined after making changes to mortality assumptions with a resulting charge of £276 million and releasing excess margins in the aggregate liabilities that had previously been set aside as an indirect extra allowance for longevity related risks of £310 million as shown in the table below.
For UK insurance operations, the 2007 results were determined after making changes to mortality assumptions for the annuity business and other assumptions for the WPSF and releasing excess margins in the aggregate liabilities that had previously been set aside as an indirect extra allowance for longevity related risks, as shown below.
j Sensitivity of IFRS basis profit or loss and equity to market and other risks The risks to which the IFRS basis results of the UK insurance operations are sensitive are asset/liability matching, mortality experience and payment assumptions for shareholder-backed annuity business. Further details are described below.
The main factors that influence the determination of bonus rates are the return on the investments of the fund, the effect of inflation, taxation, the expenses of the fund chargeable to policyholders and the degree to which investment returns are smoothed. Mortality and other insurance risk are relatively minor factors.
D2: UK insurance operations continued ii Shareholder-backed annuity business Profits from shareholder-backed annuity business are most sensitive to: • The extent to which the duration of the assets held closely matches the expected duration of the liabilities under the contracts. Assuming close matching, the impact of short-term asset value movements as a result of interest rate movements will broadly offset changes in the value of liabilities caused by movements in valuation rates of interest; • actual versus expected default rates on assets held; • the difference between long-term rates of return on corporate bonds and risk-free rates; • the variance between actual and expected mortality experience; • the extent to which expected future mortality experience gives rise to changes in the measurement of liabilities; and • changes in renewal expense levels.
In light of the recent market conditions, the Group has extended the range of the movements in interest rates that are reasonably possible to occur at 31 December 2008 in its interest rate sensitivity analysis. Consequently, in addition to the movement in interest rates of one per cent as applied at 31 December 2007, for 2008, the Group has also estimated the sensitivity to movement in interest rates of two per cent. The estimated sensitivity of the UK non-linked shareholder-backed business (principally pension annuities business) to a movement in interest rates of one per cent as at 31 December 2008 and 2007 and of a movement in interest rates of two per cent as at 31 December 2008 are as follows.
Net sensitivity of profit after tax and shareholders’ equity 279 133 (125) (241) 110 (120)
Insurance Investment Insurance Investment contracts contracts Total PAL PRIL Total contracts contracts Total 2007 £m
Insurance Investment Insurance Investment contracts contracts Total PAL PRIL Total contracts contracts Total
(Loss) profit for the year (580) 300 Items recognised directly in equity: Exchange movements 785 (42)
Unrealised valuation movements on securities classified as available-for-sale: Unrealised holding losses arising during the year (3,197) (231) Less losses included in the income statement 487 (13)
Related change in amortisation of deferred income and acquisition costs 1,070 88
Total items of income and expense recognised directly in equity (286) (144)
A portion of the impairment losses arising in 2008 arose on residential mortgage-backed securities (RMBS). The impairment testing for RMBS was determined using a cash flow modelling approach designed to estimate future principal losses on underlying collateral mortgage loans supporting the investments in the structures. Principal loss estimates were based on the current delinquency/foreclosure statistics for the underlying pools. In aggregate, the more severe the current delinquency/foreclosure statistics for an underlying pool, the higher the principal losses projected. Projected underlying losses for each collateral pool are then run through a model of the bond structure to calculate the expected future cash flows of the bond. This cash flow simulation will indicate the extent of estimated future principal losses on securitisation tranches held by Jackson. In 2008, the collateral performance of these RMBS has deteriorated coupled with the deterioration of the market price of these securities.
Note D3(d) below shows fair value of certain structured debt securities of Jackson when the markets are not active due to market illiquidity.
Total Book value 26,896 18,771 Net unrealised (loss) gain (2,897) (2,710) (51) (136)
assets and and other liabilities business note i note i Total Total £m £m £m £m
Assets Intangible assets attributable to shareholders: Deferred acquisition costs and other intangible assets – 3,962 3,962 1,928
Core structural borrowings of shareholder-financed operations – 173 173 125 Operational borrowings attributable to shareholder-financed operations – 511 511 591 Other non-insurance liabilities: Obligations under funding, securities lending and sale and repurchase agreements – 3,321 3,321 2,721
Net asset value attributable to unit holders of consolidated unit trusts and similar funds – 88 88 65
Derivative assetsnote G3 675 390 Partnerships in investment pools and other 581 372
Partnerships in investment pools and other comprise primarily investments in limited partnerships. These include interest in the PPM America Private Equity Fund and diversified investments in 157 (2007: 164) other partnerships by independent money managers that generally invest in various equities and fixed income loans and securities.
Net cash inflow (outflow) from operating activities 3,227 (615) 2,612 Realised gains (losses) in the year – (47) (47) Unrealised gains (losses) in the year 620 16 636 Foreign exchange translation differences (187) (414) (601)
Movement in the year of directly held investments, net of derivative liabilities (489) 7,160 6,671
c Reconciliation of movement in policyholder liabilities A reconciliation of the total policyholder liabilities of US insurance operations from the beginning of the year to the end of the year is as follows: Variable annuity Fixed annuity, US insurance separate account GIC and other operations liabilities business Total £m £m £m
The positive investment-related and other movement during 2008 within fixed annuity, GIC and other business principally represents interest credited to the policyholder account and increases in reserves for variable annuity guarantees. Variable annuity separate account liabilities are mainly impacted by market movements.
Corporate security and commercial loans: Publicly traded and SEC Rule 144A traded 13,198 10,345 Non-SEC Rule 144A traded 3,273 2,613
Total debt securities 24,249 19,002 i Credit quality 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 Class 3, 4, 5 and 6 are non-investment grade securities. Generally, securities rated AAA to A by nationally recognised statistical ratings organisations are reflected in Class 1, BBB in Class 2, BB in Class 3 and B and below in Classes 4 to 6. If a designation is not currently available from the NAIC, Jackson’s investment adviser, PPM America, provides the designation for the purposes of disclosure below.
NAIC designation: The following table shows the quality of residential and commercial mortgage-backed securities: Carrying Carrying value value £m £m (unless (unless otherwise otherwise stated) stated)
Residential mortgage-backed securities (included within debt securities) Total residential mortgage-backed securities 4,509 3,177 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 83.3% 85.7% Residential mortgage-backed securities rated NAIC 1: Percentage of total 94.1% 99.8% Commercial mortgage-backed securities (included within debt securities) Total commercial mortgage-backed securities 1,869 1,532 Commercial 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 84.9% 82.5% Commercial mortgage-backed securities rated NAIC 1: Percentage of total 97.1% 95.4%
In the table above, S&P ratings have been used where available. For securities where S&P ratings are not immediately available, those produced by Moody’s and then Fitch have been used as an alternative.
The amounts within Other which are not rated by S&P, Moody’s or Fitch have the following NAIC classifications: ii Determining the fair value of debt securities when the markets are not active Under IAS 39, unless categorised as ‘held to maturity’ debt securities are required to be fair valued. Where available, quoted market prices are used. However, where securities are in inactive markets, IAS 39 requires that valuation techniques be applied. Included in debt securities are debt securities with a fair value of £24,246 million (2007: £18,996 million) which are not quoted on active markets and for which fair value is determined using internal valuation techniques, or is provided by brokers or pricing services, where the specific securities have been valued using valuation techniques by these third-party providers. Jackson selects the source of pricing and/or the valuation technique with the objective of arriving at a fair value measurement which reflects the price at which an orderly transaction would take place between market participants on the measurement date. Jackson performs quantitative and qualitative analysis of prices received from third-parties e.g. independent brokers or pricing services to consider whether these prices represent fair value, particularly when the markets are not active for the securities concerned.
Debt securities of US insurance operations valued using internally derived valuation techniques in 2008 include certain assetbacked securities which had previously been valued using prices provided by a pricing service or brokers in the context of active markets. The use of such pricing sources has historically generated reliable fair values for these assets. The current market dislocations have caused a reassessment of the valuation process for these asset-backed securities. In particular, beginning at the end of the third quarter of 2008, the external prices obtained for certain asset-backed securities were deemed to be inappropriate in the current market conditions.
For the valuations at 31 December 2008, Jackson has therefore utilised internal valuation models, provided by PPM America, to derive fair values of all non agency residential mortgage-backed securities and asset-backed securities and certain commercial mortgage-backed securities. The use of internal valuation models has resulted in a fair value of these securities that was higher than those provided from pricing services and brokers of £760 million on a total amortised cost of £3.5 billion.
iii Sub-prime, Alt-A and CDO funds exposures Included within the debt securities of Jackson at 31 December 2008 are exposures to sub-prime and Alt-A mortgages and CDO funds as follows: Carrying Carrying value value
iv Debt securities classified as available-for-sale in an unrealised loss position Debt securities above are shown net of cumulative impairment losses on retained securities of £846 million (2007: £246 million).
The unrealised losses in the US insurance operations balance sheet on unimpaired securities are £(3,178) million (2007: £(439) million). This reflects assets with fair market value and book value of £17,422 million (2007: £10,291 million) and £20,600 million (2007: £10,730 million) respectively.
The following table shows the aged analysis for all the unrealised losses in the portfolio by reference to the length of time the securities have been in an unrealised loss position: Non- NonAged analysis of unrealised investment Investment investment Investment losses for the periods indicated grade grade Total grade grade Total
Included within the table above are amounts relating to sub-prime and Alt-A securities of: Fair Unrealised Fair Unrealised Fair value of securities as a percentage of book value value loss value loss
Sub-prime and Alt-A securities with unrealised losses of £91 million (2007: £37 million) in the balance sheet at 31 December 2008 have been in an unrealised loss position for less than one year with the remaining securities with unrealised losses of £121 million (2007: £19 million) being in an unrealised loss position for more than one year.
ii Variable annuities At 31 December 2008, VAs accounted for 39 per cent (2007: 45 per cent) of Jackson’s policy and contract liabilities. VAs are deferred annuities that have the same tax advantages and payout options as interest-sensitive and fixed indexed annuities.
Jackson issues VA contracts where it contractually guarantees to the contractholder either a) return of no less than total deposits made to the contract adjusted for any partial withdrawals, b) total deposits made to the contract adjusted for any partial withdrawals plus a minimum return, or c) the highest contract value on a specified anniversary date adjusted for any withdrawals following the contract anniversary. These guarantees include benefits that are payable in the event of death (guaranteed minimum death benefit (GMDB)), annuitisation (guaranteed minimum income benefit (GMIB)), or at specified dates during the accumulation period (guaranteed minimum withdrawal benefit (GMWB)) and guaranteed minimum accumulation benefit (GMAB). Jackson hedges these risks using equity options and futures contracts as described in note D3(f). The GMIB is reinsured.
Medium-term note funding agreements are generally issued to support trust instruments issued on non-US exchanges or to qualified investors (as defined by SEC Rule 144A). Through the funding agreements, Jackson agrees to pay a rate of interest, which may be fixed or floating, to the holders of the trust instruments.
Jackson uses free-standing derivative instruments for hedging purposes. Additionally, certain liabilities, primarily trust instruments supported by funding agreements, fixed indexed annuities, certain GMWB variable annuity features and reinsured GMIB variable annuity features contain embedded derivatives as defined by IAS 39, ‘Financial Instruments: Recognition and Measurement’. Jackson does not account for such derivatives as either fair value or cash flow hedges as might be permitted if the specific hedge documentation requirements of IAS 39 were followed. Financial derivatives, including derivatives embedded in certain host liabilities that have been separated for accounting and financial reporting purposes are carried at fair value.
Value movements on the derivatives are reported within the income statement. Under the Group’s accounting policies supplementary analysis of the profit before taxes attributable to shareholders is provided as shown in note B1. In preparing this analysis, value movements on Jackson’s 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, based on a static long-term volatility assumption and, for embedded liabilities, average Corporate AA interest rates, 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. Any differences in value movements on these derivatives between the static long-term volatility assumption and implied volatility or average Corporate AA interest rates and ending Corporate AA interest rates is reflected as a component of short-term fluctuations. The types of derivatives used by Jackson and their purpose are as follows: F in an cial statem en ts D
• 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; • 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. On a net basis, put-swaptions hedge against significant upward movements in interest rates; • equity index futures contracts and equity index call and put options are used to hedge Jackson’s obligations associated with its issuance of fixed indexed immediate and deferred annuities and certain VA guarantees. These annuities and guarantees contain embedded options which are fair valued for financial reporting purposes; • total return swaps in which Jackson receives equity returns or returns based on reference pools of assets in exchange for shortterm floating rate payments based on notional amounts, are held for both hedging and investment purposes; • cross-currency swaps, which embody spot and forward currency swaps and additionally, in some cases, interest rate swaps and equity index swaps, are entered into for the purpose of hedging Jackson’s foreign currency denominated funding agreements supporting trust instrument obligations; • spread cap options are used as a macro-economic hedge against declining interest rates. Jackson receives quarterly settlements based on the spread between the two-year and the 10-year constant maturity swap rates in excess of a specified spread; and
Note D3(j) parts (iii) and (iv) show the sensitivities of Jackson’s results through its exposure to equity risk and interest rate risk.
g Process for setting assumptions and determining contract liabilities 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.
Under US GAAP, investment contracts (as defined for US GAAP purposes) are accounted for by applying in the first instance a retrospective deposit method to determine the liability for policyholder benefits. This is then augmented by potentially three additional amounts. These amounts are for: • Any amounts that have been assessed to compensate the insurer for services to be performed over future periods (i.e. deferred income); • any amounts previously assessed against policyholders that are refundable on termination of the contract; and • any probable future loss on the contract (i.e. premium deficiency).
The GMDB liability is determined each period end by estimating the expected value of death benefits in excess of the projected account balance and recognising the excess ratably over the life of the contract based on total expected assessments. At 31 December 2008, the GMDB liability was valued using a series of deterministic investment performance scenarios, a mean investment return of 8.4 per cent (2007: 8.4 per cent) and assumptions for lapse, mortality and expense that are the same as those used in amortising the capitalised acquisition costs.
For periods prior to 2008, the fair values of Jackson’s GMWB reserves and GMIB reinsurance were calculated based on actuarial and capital market assumptions related to projected cash flows, including benefits and related contract charges, over the lives of the contracts, incorporating expectations concerning policyholder behaviour such as lapses, fund selection, resets and withdrawal utilisation. Because of the dynamic and complex nature of these cash flows, best estimate assumptions and a stochastic process involving the generation of thousands of scenarios that assume risk neutral returns consistent with swap rates and incorporating implied volatility data and evaluations of historical volatilities for various indices were used. Estimating these cash flows involved numerous estimates and subjective judgements including those regarding expected market rates of return, market volatility, correlations of market index returns to funds, fund performance, discount rates, utilisation of the benefit by policyholders under varying conditions and policyholder lapsation.
At each valuation date, Jackson assumed expected returns based on risk-adjusted spot rates as represented by the LIBOR forward curve as of that date and market volatility as determined with reference to implied volatility and evaluations of historical volatilities for various indices. The risk-adjusted spot rates as represented by the LIBOR spot curve as of the valuation date were used to determine the present value of expected future cash flows produced in the stochastic process. As GMWB obligations are relatively new in the marketplace, actual policyholder behaviour experience is limited. As a result, estimates of future policyholder behaviour are subjective and based on internal and external data. As markets change, mature and evolve and actual policyholder behaviour emerges, management continually evaluates the appropriateness of its assumptions for this component of the fair value model.
Effective 1 January 2008, Jackson re-evaluated certain assumptions used in the calculation of the reserves related to GMWB and GMIB reinsurance. As a result, Jackson now bases its volatility assumptions solely on implied market volatility with no reference to historical volatility levels and explicitly incorporates Jackson’s own credit risk in place of the risk-adjusted rates referenced above. Volatility assumptions are now based on a weighting of available market data on implied volatility for durations up to 12 years, at which point the projected volatility is held constant. Non-performance risk is incorporated into the calculation through the use of interest rates sourced from a AA corporate credit curve. Other risk margins, particularly for market illiquidity and policyholder behaviour are also incorporated into the model through the use of explicitly conservative assumptions. On a periodic basis, Jackson rationalises the resulting fair values based on comparisons to other models and market movements.
h Reinsurance The principal reinsurance ceded by Jackson outside the Group is on term life insurance, direct and assumed accident and health business and GMIB variable annuity guarantees. In 2008, the premiums for such ceded business amounted to £68 million (2007: £60 million). Net commissions received on ceded business and claims incurred ceded to external reinsurers totalled £10 million and £49 million, respectively, during 2008 (2007: £10 million and £47 million respectively). There were no deferred gains or losses on reinsurance contracts in either 2008 or 2007. The reinsurance asset for business ceded outside the Group was £800 million (2007: £436 million).
The effect of the change in respect of equity volatility is to increase the total loss for 2008 for Jackson by £126 million. The effect of the change for the reference basis for discounting is to reduce the total loss by £173 million.
The mean reversion methodology achieves this objective by dynamic adjustment to the level of expectations of short-term future investment returns. Under the methodology the projected returns for the next five years are, for the purposes of determining the amortisation profile, set so that normally combined with the actual returns for the current and preceding two years the average rate of return is 8.4 per cent. The mean reversion methodology does, however, include a cap of 15 per cent per annum on the project return for each of the next five years. For 2008 this capping effect applied to restrict the projected returns below the rate of approximately 20 per cent per annum level that would have otherwise applied. Projected returns after the next five years are set at 8.4 per cent.
Statement of changes in equity – ‘shadow DAC adjustments’ Consequent upon the negative unrealised valuation movement in 2008 of £(2,710) million (2007: £(244) million) there is a credit of £1,070 million (2007: £88 million) for altered ‘shadow’ amortisation booked within the statement of changes in equity. These adjustments reflect the changes to the pattern of reported gross profits that would have happened if the assets had been sold, crystallising the loss, and the proceeds reinvested at correspondingly higher current yields. In the event of further unrealised losses, this dynamic would be constrained under two circumstances. Firstly, the DAC asset would not be written up any further beyond the original deferral plus a provision for interest accrual on the asset. Secondly, and more generally, the write up of DAC would be constrained if not supported by expectations of future profitability.
ii Other sensitivities 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; • incidence of guarantees and the effectiveness of the related hedge programme; and • spread returns for the difference between investment returns and rates credited to policyholders.
For term business, acquisition costs are deferred and amortised in line with expected premiums. For annuity business, acquisition costs are deferred and amortised in line with expected gross profits on the relevant contracts. For interest-sensitive business, the key assumption is the expected long-term spread between the earned rate and the rate credited to policyholders, which is based on an annual spread analysis. In addition, expected gross profits depend on mortality assumptions, assumed unit costs and terminations other than deaths (including the related charges) all of which are based on a combination of actual experience of Jackson, industry experience and future expectations.
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 D3(g) for further details on the valuation of the guarantees) and fees are recognised prospectively.
Pre-tax profit, net of related changes in amortisation of DAC (255) (141) (98) (76) Related deferred tax effects 89 49 34 26
Net sensitivity of profit after tax and shareholders’ equity (166) (92) (64) (50)
iv Exposure to interest rate risk Notwithstanding the market risk exposure described in note D3(f), except in the circumstances of interest rate scenarios where the guarantee rates included in contract terms are higher than crediting rates that can be supported from assets held to cover liabilities, the accounting measurement of fixed annuity liabilities of Jackson products is not generally sensitive to interest rate risk. This position derives from the nature of the products and the US GAAP basis of measurement described in notes D3(e) and D3(g). The GMWB features attaching to variable annuity business represents embedded derivatives which are fair valued and so will be sensitive to changes in interest rate.
Debt securities and related derivatives are marked to fair value. Value movements on derivatives, again net of related changes to amortisation of DAC and deferred tax, are recorded within profit and loss. Fair value movements on debt securities, net of related changes to amortisation of DAC and deferred tax, are recorded within the statement of changes in equity. Similar to the sensitivity analysis to equity prices movement above, Jackson has extended the range of the movements in interest rates that are reasonably possible to occur at 31 December 2008 in its sensitivity analysis. In addition to the movement in interest rates of one per cent as applied at 31 December 2007, for 2008, Jackson has also estimated the sensitivity to movement in interest rates of two per cent. The estimated sensitivity of these items and policyholder liabilities to a one per cent decrease and increase in interest rates at 31 December 2008 and 2007 and to a two per cent decrease and increase in interest rates at 31 December 2008 is as follows: A 2% A 1% A 1% A 2% A 1% A 1% decrease decrease increase increase decrease increase
Related effect on charge for deferred tax 206 94 (95) (207) 36 (47)
Direct effect on carrying value of debt securities 2,476 1,238 (1,238) (2,476) 848 (848) Related effect on amortisation of DAC (619) (310) 310 619 (212) 212 Related effect on movement in deferred tax (650) (325) 325 650 (223) 223
(including (including GICs and GICs and similar Variable similar Variable contracts) annuity contracts) annuity
D4: Asian insurance operations a Summary balance sheet Asian insurance operations
With-profits Unit-linked business assets and note i liabilities Other Total Total £m £m £m £m £m
Summary policyholder liabilities (net of reinsurance) and unallocated surplus The policyholder liabilities (net of reinsurance of £24 million (2007: £12 million)) and unallocated surplus shown in the table above reflect the following balances: With-profits business 7,934 6,397 Unallocated surplus of Asian with-profits operations 160 146 Unit-linked business 7,220 6,971 Other business 5,731 3,653
At 31 December 2008, the policyholder liabilities (net of reinsurance) and unallocated surplus for Asian operations of £21.0 billion (2007: £17.2 billion) comprised the following: Hong Kong 5,100 3,901
Directly held investments, net of derivative liabilities 5,703 4,066 3,405 13,174
Net cash inflow from operating activities 858 1,965 (92) 2,731 Realised gains (losses) in the year 783 327 374 1,484 Unrealised gains (losses) in the year (255) 286 (159) (128) Foreign exchange translation differences 111 146 41 298
Less: Investments held by consolidated investment funds (218) 0 (465) (683)
c Reconciliation of movement in policyholder liabilities and unallocated surplus of with-profits funds A reconciliation of the total policyholder liabilities and unallocated surplus of with-profits funds of Asian insurance operations from the beginning of the year to the end of the year is as follows: Asian Unit-linked insurance
Of the £555 million (2007: £598 million) debt securities for other business which are not rated in the table above, £231 million (2007: £317 million) are in respect of government bonds, £221 million (2007: £83 million) corporate bonds rated as investment grade by local external ratings agencies, and nil (2007: £71 million) structured deposits issued by banks which are themselves rated but where the specific deposits have not been.
Whole of life contracts with floor levels of policyholder benefits that accrue at rates set at inception are also written in the Korean life operations, though to a much less significant extent than in Taiwan. The Korean business has non-linked liabilities and linked liabilities at 31 December 2008 of £312 million and £742 million respectively (2007: £261 million and £728 million respectively). The business is much less sensitive to returns than Taiwan with a higher proportion of linked and health business.
g Process for setting assumptions and determining liabilities The future policyholder benefit provisions for Asian businesses in the Group’s IFRS accounts and previously under the MSB, are determined in accordance with methods prescribed by local GAAP adjusted to comply, where necessary, with UK GAAP.
For the traditional business in Taiwan, the economic scenarios used to calculate the IFRS results reflect the assumption of a phased progression of bond yields from current rates to long-term expected rates. The projections assume that the current bond yields of around 1.4 per cent (2007: 2.5 per cent) trend towards 5.5 per cent (2007: 5.5 per cent) at 31 December 2018 (2007: 2013).
h Reinsurance The Asian businesses cede only minor amounts of business outside the Group with immaterial effects on reported profit. During 2008, reinsurance premiums for externally ceded business were £76 million (2007: £52 million) and the reinsurance assets were £24 million (2007: £12 million) in aggregate.
i Effect of changes in bases and assumptions used to measure insurance assets and liabilities a Changes in key assumptions For 2008, the result for Asian operations was reduced by the effect of a number of individually small assumptions changes of, in aggregate, £21 million. There were no changes of assumptions that had a material impact on the 2007 results for Asian operations.
The adequacy of the insurance contract liabilities is tested by reference to best estimates of expected investment returns on policy cash flows and reinvestment income. The assumed earned rates are used to discount the future cash flows. For 2008 the projection assumes that the current bond yields at 31 December 2008 of 1.4 per cent trend towards 5.5 per cent at 31 December 2018. This compares to the 2007 results for which the projections assume the current bond yields of around 2.5 per cent trend towards 5.5 per cent at 31 December 2013. Under the liability adequacy testing applied for IFRS the change of progression period had no effect on the carrying value of the deferred acquisition costs or liability to policyholders.
In Hong Kong, adjustments have been made with a net overall effect of £10 million.
j Sensitivity of IFRS basis profit and equity to market and other risks Currency translation Consistent with the Group’s accounting policies, the profits of the Asian operations are translated at average exchange rates and shareholders’ equity at the closing rate for the reporting period. For 2008, the rates for the most significant operations are given in note B4.
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 Taiwan business are determined on the US GAAP basis as applied previously under UK GAAP. Under this basis, the policy liabilities are calculated on sets of assumptions, which are locked in at the point of policy inception, and a deferred acquisition cost is held in the balance sheet.
The adequacy of the insurance contract liabilities is tested by reference to best estimates of expected investment returns on policy cash flows and reinvested income. The assumed earned rates are used to discount the future cash flows. The assumed earned rates consist of a long-term best estimate determined by consideration of long-term market conditions and rates assumed to be earned in the trending period. For 2008 and 2007, it has been projected that rates of return for Taiwanese bond yields will trend from the current levels of some 1.4 per cent (2.5 per cent) to 5.5 per cent by 31 December 2018 (2007: 5.5 per cent by 2013).
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 2009 and 2010 and the target date for attainment of the long-term bond yield deferred to 31 December 2020, the premium reserve, net of deferred acquisition costs, would be sufficient. If interest rates were to remain at current levels beyond the end of 2009 with the date of the attainment of the long-term rate further delayed, the margin within the net GAAP reserve will reduce further.
However, the need to write off deferred acquisition costs or increase the liabilities, and by how much, would be affected by the impact of new business written between 31 December 2008 and the future reporting dates to the extent that the business is taken into account as part of the liability adequacy testing calculations for the portfolio of contracts.
Excluding with-profit and unit-linked business along with Taiwan, which is detailed above, 71 per cent (2007: 72 per cent) of the bond portfolio for other business of Asian operations at 31 December 2008 was held in Japan, Singapore and Vietnam with corporate bond rates varying from territory to territory and ranging from 1.17 per cent to 10.18 per cent at 31 December 2008 (1.5 per cent to 9.1 per cent at 31 December 2007) for these three countries. An analysis of movements in bond rates during previous periods and its impact on IFRS basis profit or loss and shareholders’ equity has been undertaken, with reasonably possible movements for these countries being considered to be 0.5 per cent for Japan, 1.0 per cent for Singapore and 1.5 per cent for Vietnam.
Based on these movements, plus indicative changes for bonds held in other Asian operations within the region, the impact on IFRS basis profit or loss and shareholders’ equity from a reasonably possible change in interest rates for Asian operations excluding Taiwan at 31 December 2008 has been assessed, with rate movements ranging from 0.5 per cent to 1.5 per cent (2007: 0.25 per cent to 1.0 per cent) dependent on country. Looking at the region in aggregate and noting that interest rates are unlikely to move consistently by the same degree from period to period, the range of movements considered to be reasonably possible would result in a change in IFRS profit or loss of plus or minus £56 million (2007: £30 million). These amounts, if they arose, would be recorded within the category short-term fluctuations in investment returns in the Group’s supplementary analysis of profit before tax. After adjusting for deferred tax the reasonably possible effect on shareholders’ equity is plus or minus £45 million
Equity price risk The principal holders of equity securities are the Taiwan, Singapore and Vietnam businesses. For the Taiwan and Singapore operations market changes have a direct effect on profit and loss with no matching effect on the carrying value of policyholder liabilities. This is also true for the Vietnam business. However, to the extent that equity investment appreciation is realised through sales of securities then policyholders’ liabilities are adjusted to the extent that policyholders’ participate.
In light of the recent market conditions, the Group has extended the range of reasonably possible movements in the value of equity prices at 31 December 2008. Consequently, in addition to the movement of 10 per cent as applied at 31 December 2007, for 2008, the Group has also estimated the sensitivity to movements of 20 and 40 per cent. The estimated sensitivity to a 10 per cent change in equity prices for shareholder-backed Asian other business, which would be reflected in the short-term fluctuation component of the Group’s supplementary analysis of profit before tax, at 31 December 2008 and 2007 and to a 20 and 40 per cent change in equity prices at 31 December 2008 would be as follows: A decrease A decrease A decrease A decrease of 40% of 20% of 10% of 10%
A 10, 20 or 40 per cent increase in their value would have an approximately equal and opposite effect on profit and shareholders’ equity to the sensitivities shown above. The low tax rate effect relates to the availability of losses in some of the territories.
k Duration of liabilities The Group uses cash flow projections of expected benefit payments as part of the determination of the value of in-force business when preparing EEV basis results. The maturity profile of the cash flows, taking account of expected future premiums and investment returns, is as follows: Policyholder liabilities 20,909 17,033
D5: Capital position statement for life assurance businesses a Summary statement The Group’s estimated capital position for life assurance businesses with reconciliations to shareholders’ equity is shown below. Available capital for each fund or group of companies is determined by reference to local regulation at 31 December 2008 and 2007.
Group shareholders’ equity Held outside long-term funds: Held in long-term fundsnote iii 920 – – 920 – 920
Shareholders’ share of realistic liabilities (2,028) (2,028) – – (2,028) Deferred acquisition costs of nonparticipating business not recognised for regulatory reporting purposes (3) (10) (13) (128) (3,962) (876) (4,979)
Jackson surplus notesnote iv – – – – 173 – 173 Investment and policyholder liabilities valuation differences between IFRS and regulatory basis for Jacksonnote ix 4,819 4,819
Adjustment from IAS 19 basis pension deficit attributable to WPSF to pension liability for regulatory purposesnote vii (147) (147) – – (147)
Other adjustments to restate these amounts to a regulatory basis (with SAIF and the WPSF on a Peak 2 realistic basis)note v 3 643 646 (474) 30 (41) 161
Investment contracts without discretionary participation features (principally unit-linked and similar contracts in the UK and GIC liabilities of Jackson)note vi – – – 11,584 2,885 32 14,501
WPSF profits funds subsidi- opera- Prudential aries and Group 31 December 2007 SAIF note i fund note ii Jackson aries tions Capital) funds total
Shareholders’ share of realistic liabilities – (4,178) (4,178) – – – (4,178) Deferred acquisition costs of nonparticipating business and goodwill not recognised for regulatory reporting purposes (4) (15) (19) (143) (1,928) (790) (2,880)
Jackson surplus notesnote iv – – – – 125 – 125 Adjustment from IAS 19 basis pension deficit attributable to WPSF to pension liability for regulatory purposesnote vii – (138) (138) – – – (138)
Total available capital resources of life assurance businesses on local regulatory bases – 8,720 8,720 982 2,251 874 12,827
Total subsidiaries Asian life Total life WPSF PAC with- and funds assurance assurance 31 December 2007 SAIF note i profits fund note ii Jackson subsidiaries operations
Total policyholder liabilities shown in the consolidated balance sheet 13,620 76,339 89,959 34,518 34,848 17,033 176,358
ii Excluding PAC shareholders’ equity that are included in ‘parent company and shareholders’ equity of other subsidiaries and funds’. 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.
vi Insurance business accounted for as financial instruments under IAS 39. vii In determining the IAS 19 adjustment for the purposes of this table the deficit in the Group’s main pension scheme used for the calculation includes amounts for investments in Prudential insurance policies (see note I1).
viii Asia 2007 comparative adjustments reflect adjustments for intra-group balances that are recognised on a local regulatory basis. ix The investment and policyholder liabilities valuation difference between IFRS and regulatory bases for Jackson is mainly due to not all investments being carried at fair value under the regulatory basis and also for the valuation difference on annuity reserves.
Available capital of the WPSF and SAIF of £5.4 billion (2007: £8.7 billion) represents the excess of assets over liabilities on the FSA realistic basis. Unlike the previously discussed FRS 27 basis, realistic liabilities on the regulatory basis include the shareholders’ share of future bonuses. These amounts are shown before deduction of the risk capital margin (RCM) which is estimated to be £2.1 billion at 31 December 2008 (2007: £2.0 billion).
The available capital of Jackson shown above of £2,758 million (2007: £2,251 million) reflects US regulatory basis assets less liabilities including asset valuation reserves. The asset valuation reserve is designed to provide for future credit-related losses on debt securities and losses on equity investments. Available capital includes a reduction for the effect of the interest maintenance reserve, which is designed by state regulators to defer recognition of non-credit related realised capital gains and losses and to recognise them rateably in the future.
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 Ringgit.
The capital requirement is determined as four per cent of reserves plus a specified percentage of 0.1 per cent of sums at risk for policies with original term less than or equal to five years or 0.3 per cent of sums at risk for policies with original term of more than five years. An additional capital requirement of Vietnamese Dong 200 billion is also required for companies transacting unit-linked business.
iv Group capital requirements In addition to the requirements at individual company level, FSA requirements under the IGD apply additional prudential requirements for the Group as a whole. Discussion of the Group’s estimated IGD position at 31 December 2008 is provided in the business review section of the Group’s 2008 Annual Report and in section C.
Changes in management policy – 372 – 60 432 Changes in regulatory requirements – – (57) 134 77 New business and other factors (3,209) 323 564 349 (1,973)
Changes in management policy – – – 12 12 Changes in regulatory requirements – – (7) – (7) New business and other factors 367 112 175 113 767
iv Asian life assurance subsidiaries Asia’s 2006 and 2007 comparative adjustments reflect the intra-group balances that are recognised on a local regulatory basis.
d Transferability of available capital 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.
Stochastic modelling of assets and liabilities is undertaken in the UK, Jackson and Asia to assess the economic capital requirements under different confidence intervals and time horizons. In addition, reserve adequacy testing under a range of scenarios and dynamic solvency testing is carried out, including under certain scenarios mandated by the UK, the US and Asian regulators.
Asset management in the UK is undertaken through M&G which is made up of three distinct businesses, being Retail, Wholesale and Finance, and whose operations include retail asset management, institutional fixed income, pooled life and pension funds, property and private finance.
The profit included in the income statement in respect of asset management operations for the year is as follows: Asset management operations
Notes on the Group financial statements E: Asset management (including US broker-dealer) and other operations
Liabilities Intra Group debt represented by operational borrowings at Group levelnote iv 1,278 – – 1,278 2,477 Net asset value attributable to external holders of consolidated fundsnote v 1,065 – – 1,065 1,234
The M&G loans of £1,763 million relates to bridging loan finance managed by Prudential Capital. The bridging loan finance assets generally have no external credit ratings available, with internal ratings prepared by the Group’s asset management operations as part of the risk management process rating £1,100 million BBB+ to BBB- and £663 million BB+ to BB-.
ii Debt securities Of the debt securities of £975 million for M&G at 31 December 2008, £959 million were rated AAA to A– by Standard and Poor’s or Aaa rated by Moody’s.
iv Intra Group debt represented by operational borrowings at Group level Operational borrowings for M&G are in respect of Prudential Capital’s short-term fixed income security programme and comprise £1,269 million of commercial paper and £9 million of medium-term notes.
Directly held investments, net of derivative liabilities 2,761 35 25 2,821
Net cash outflow from operating activities (601) – (14) (615) Realised gains in the year 9 – – 9 Unrealised (losses) in the year (148) (7) (1) (156) Foreign exchange translation differences 516 13 16 545
Movement in the year of directly held investments, net of derivative liabilities (224) 6 1 (217)
Notes on the Group financial statements E: Asset management (including US broker-dealer) and other operations continued
A 10 per cent increase in these rates and those of other Asian operations would have reduced reported profit before tax attributable to shareholders and shareholders’ equity, excluding goodwill attributable to Asia and PPM America asset management operations, by £5 million (2007: £7 million) and £26 million (2007: £18 million) respectively.
ii Other sensitivities to other financial risks for asset management operations The principal sensitivities to other financial risk of asset management operations are credit risk on the bridging loan portfolio (as described in note E2) of M&G’s Prudential Capital operation and the indirect effect of changes to market values of funds under management. Due to the nature of the asset management operations there is limited direct sensitivity to movements in interest rates. Total debt securities held at 31 December 2008 by asset management operations were £991 million (2007: £882 million), the majority of which are held by the Prudential Capital operation of M&G. Debt securities held by M&G are in general variable rate bonds and so market value is limited in sensitivity to interest rate movements and consequently any change in interest rates would not have a material impact on profit or shareholder’s equity. Asset management operations do not hold significant investments in property or equities.
The Group’s primary and secondary segments are described in detail in note B6.
Primary segment information The segment results for the years ended 31 December 2008 and 2007 are as follows: Revenue Insurance operations (10,798) 31,555 Asset management 664 1,397 Unallocated corporate 157 186 Intra group revenue eliminated on consolidation (290) (268)
Total revenue, net of reinsurance, per income statementnote i (10,267) 32,870
Insurance operations, including post-tax transfers from (to) unallocated surplus of with-profits funds 8,980 (30,533)
Asset management (524) (1,053) Unallocated corporate (553) (494) Intra group charges eliminated on consolidation 290 268
Total charges, net of reinsurance, per income statementnote i 8,193 (31,812)
Segment results – revenue less charges (continuing operations) Insurance operations (1,818) 1,022 Asset management 140 344 Unallocated corporate (396) (308)
(Loss) profit before tax (being tax attributable to shareholders’ and policyholders’ returns)note ii (2,074) 1,058 Tax attributable to policyholders’ returns 1,624 5
In its capacity as fund manager to fellow Prudential plc subsidiaries, M&G earns fees for asset management and related services. These services are charged at appropriate arm’s length prices, typically priced as a percentage of funds under management.
Total charges include a credit of £25,419 million (2007: charge of £11,295 million) for non-cash expenses other than depreciation and amortisation mainly due to the impact of negative market returns experienced during the year on benefit claims and movement in unallocated surplus of with-profits funds.
Secondary segment information Although the Company is UK registered, the Group manages its business on a global basis. The operations are based in three main geographical areas: UK, US and Asia.
Fee income from investment contract business and asset managementnote ii 1,109 1,039 Income from venture investments of the PAC with-profits fundsnote iii 37 1,418
Acquisition costsnotes i,ii 1,185 1,030 Staff and pension costs I1 913 1,402 Administrative and operating costsnote iv 361 2,427
ii Acquisition costs also include fee expenses relating to financial liabilities held at amortised costs of £nil (2007: £1 million). iii The total depreciation and amortisation expense is £618 million (2007: £523 million). Of this amount, £535 million (2007: £413 million) relates to amortisation of deferred acquisition costs of insurance contracts and asset management contracts, which is primarily borne by the long-term business segment. Of the remainder of the depreciation and amortisation charge of £83 million (2007: £110 million), £57 million (2007: £98 million) relates to long-term business, £10 million (2007: £8 million) to asset management and £16 million (2007: £4 million) to other operations.
Deferred tax arising from: Origination and reversal of temporary differences 1,629 222 (Expense) benefit in respect of a previously unrecognised tax loss, tax credit or temporary difference from a prior period (77) 50 Write down or reversal of a previous write down of a deferred tax asset (3) –
The total tax credit of £1,683 million for 2008 (2007: charge of £349 million) comprises a credit of £1,758 million (2007: charge of £28 million) for UK tax and a charge of £75 million (2007: £321 million) for overseas tax. This tax credit comprises tax attributable to policyholders and unallocated surplus of with-profits funds, unit-linked policies and shareholders. The tax credit attributable to shareholders of £59 million for 2008 (2007: charge of £354 million) comprises a credit of £95 million (2007: charge of £148 million) for UK tax and a charge of £36 million (2007: £206 million) for overseas tax.
The prior year adjustments primarily relate to the settlement of issues with HM Revenue Customs (HMRC) at an amount below previously provided, the reduction in amounts previously provided on outstanding issues with HMRC and the routine revision of tax returns.
In 2008, a deferred tax credit of £637 million (2007: £54 million) has been taken directly to reserves. Other movements in deferred tax totalling a £21 million credit is mainly comprised of foreign exchange movements. When these amounts are taken with the deferred tax credit shown above the result is a decrease of £2.2 billion (or £2.1 billion taking into account the restated 2007 comparative deferred tax as a result of the interpretation of IFRIC 14) in the Group’s net deferred tax liability (2007 decrease of £419 million).
The tax credit related to discontinued banking operations in 2007 which was all attributable to shareholders, amounted to £19 million.
i Summary of pre-tax (loss) profit and tax credit (charge) The income statement includes the following items: (Loss) profit before tax (2,074) 1,058 Tax attributable to policyholders’ returns 1,624 5
F5: Tax continued ii Overview 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
Taxation charge: Variance from expected tax charge (note v(ii)) (128) – (128) (27) – (27)
In meeting the reconciliation requirements set out in paragraph 81I 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. Due to the nature of the basis of taxation of UK life and pension business (as described in note (iii) below), and the significance of the results of the business to the Group, it is inappropriate to seek to explain the effective tax rate on profit before tax by traditional approach that would apply for other industries.
iii Basis of taxation for UK life and pension business Different rules apply under UK tax law for taxing pension business and life insurance business and there are detailed rules for apportioning the investment return and profits of the fund between the types of business.
The investment return referable 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.
The purpose of this approach is to ensure that the Company is always as a minimum taxed on the profit, as defined for taxation purposes by reference to the Company’s regulatory returns (rather than IFRS basis results), that it has earned. The shareholders’ portion of the long-term business is taxed at the shareholders’ rate, with the remaining portion taxed at rates applicable to the policyholders.
For with-profits business, total pre-tax profits reflect the aggregate of profits attributable to policyholders and shareholders. However, amounts attributable to the equity of with-profits funds are carried in the liability for unallocated surplus. Also, as described in note (iii), UK with-profits business is taxed on a basis that affects policyholders’ unallocated surplus of with-profits funds and shareholders. For the PAC with-profits sub-fund, transfers to and from unallocated surplus are recorded in the income statement, so that after charging the total tax borne by the fund, the net balance reflects the statutory transfer from the fund for the year. The statutory transfer represents 10 per cent of the actuarially determined surplus for the year that is attributable to shareholders.
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 asset management arrangements).
Short-term fluctuations in investment returns 54 370 59 88 571 Shareholders’ share of actuarial gains and losses on defined benefit pension schemes 1 – – 3 4
Operating profit based on longer-term investment returnsnote iii (35) 17 57 57 96
Short-term fluctuations in investment returns (23) (173) (8) (19) (223) Shareholders’ share of actuarial gains and losses on defined benefit pension schemes – – – (1) (1)
Profit before tax attributable to shareholders: Operating profit based on longer-term investment returnsnote iii 174 444 521 62 1,201 Short-term fluctuations in investment returns (71) (18) (47) (1) (137) Shareholders’ share of actuarial and other gains and losses on defined benefit pension schemes – – – (1) (1)
Expected tax credit (charge) based on expected tax rates: Operating profit based on longer-term investment returnsnote iii (37) (155) (156) (17) (365) Short-term fluctuations in investment returns 18 6 14 – 38 Shareholders’ share of actuarial and other gains and losses on defined benefit pension schemes – – – – –
Operating profit based on longer-term investment returnsnote iii (12) 22 (25) (1) (16) Short-term fluctuations in investment returns (17) 1 (2) 6 (12) Shareholders’ share of actuarial and other gains and losses on defined benefit pension schemes – – – 1 1
Actual tax rate: Operating profit based on longer-term investment returns 28% 30% 35% 29% 32%
The Group designates all financial assets as either fair value through profit and loss, available-for-sale, or as loans and receivables. Financial liabilities are designated as either fair value through profit and loss or amortised cost, or as investment contracts with discretionary participating features accounted for under IFRS 4 as described in note A4.
Fair value through Total profit Available- Loans and carrying and loss for-sale receivables value Fair value
Other investmentsnote iii 6,301 – – 6,301 6,301 Accrued investment income – – 2,513 2,513 2,513 2008 £m
Operational borrowings attributable to shareholder-financed operationsH13 – 1,977 – 1,977 1,977 Borrowings attributable to with-profits fundsH13 158 1,150 – 1,308 1,320 Obligations under funding, securities lending and sale and repurchase agreements – 5,572 – 5,572 5,676 Net asset value attributable to unit holders of consolidated unit trust and similar funds 3,843 – – 3,843 3,843 Investment contracts with discretionary participating featuresnote iv – – 23,446 23,446 – Investment contracts without discretionary
Notes on the Group financial statements G: Financial assets and liabilities
Other investmentsnote iii 4,396 – – 4,396 4,396 Accrued investment income – – 2,023 2,023 2,023 2007 £m
The fair values of the financial instruments for which fair valuation is required under IFRS and which are in an active market are determined by the use of current market bid prices for quoted investments, or by using quotations from independent thirdparties, such as brokers and pricing services. If the market for a financial investment of the Group is not active, the fair values of the financial instruments are established by using valuation techniques. These include financial investments which are not quoted on active markets and financial investments for which markets are no longer active as a result of market conditions e.g. market illiquidity. The valuation techniques used include comparison to recent arm’s length transactions, reference to other instruments that are substantially the same, discounted cash flow analysis, option adjusted spread models and, if applicable, enterprise valuation. These techniques may include a number of assumptions relating to variables such as credit risk and interest rates.
G1: Financial instruments – designation and fair values continued instruments. The source of pricing for the financial investments valued using valuation techniques could be from using quotations from independent third-parties, such as brokers and pricing services or by using valuation techniques modelled internally by the Group. Priority is given to publicly available prices from independent sources, when available but overall, the source of pricing is chosen with the objective of arriving at a fair value measurement which reflects the price at which an orderly transaction would take place between market participants on the measurement date.
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. Illiquid market conditions have resulted in inactive markets for certain of the Group’s financial instruments. As a result, there is generally no or limited observable market information for these instruments. Fair value estimates for financial instruments deemed to be in an illiquid market are based on judgements regarding current economic conditions, liquidity discounts, currency, credit and interest rate risks, loss experience and other factors. These fair values are estimates and involve considerable uncertainty and variability as a result of the inputs selected and may differ significantly from the values that would have been used had the ready market existed, and the differences could be material.
Use of valuation techniques The carrying value of financial investments (including derivative liabilities) on the balance sheet of the Group which are not quoted on active markets and for which fair value is determined using internal valuation techniques, or is provided by brokers or pricing services, where the specific securities have been valued using valuation techniques by these third-party providers are as follows: 2008 £m
The majority of the financial investments valued using valuation techniques were debt securities. The debt securities shown above include private debt securities such as private placements, project finance, asset securitisations and local authority securities. The securities are mainly long-dated and not regularly traded and are valued internally using market standard practices. The majority of the debt securities above are valued using matrix pricing, which is based on assessing credit quality of the underlying borrower to derive a suitable discount rate relative to government securities. Under matrix pricing, the debt securities are priced by taking the credit spreads on comparable quoted public debt securities and applied to the equivalent debt instruments factoring a specified liquidity premium. The majority of the parameters used in this valuation technique are readily observable in the market and, therefore, are not subject to interpretation.
Of the debt securities valued using valuation techniques held by the UK with-profits fund of £12,341 million at 31 December 2008 (2007: £10,640 million), £8,647 million (2007: £7,638 million) have been priced by independent third-parties and £3,694 million (2007: £3,002 million) determined using internal valuation techniques.
The debt securities held by the UK with-profits fund at 31 December 2008 of £12,341 million include US securities managed by PPM America with a value of £8,773 million. This amount comprises £8,738 million in respect of securities for which the fair value has been measured using valuation techniques for which all inputs significant to the measurement are based on observable market data. This categorisation corresponds to ‘Level 2’ assets under amendments to IFRS 7. £35 million is in respect of securities for which the fair value has been measured using valuation techniques that include any input significant to the measurement that is not based on observable market data i.e. ‘Level 3’ securities.
Of the debt securities valued using valuation techniques of £37,319 million (2007: £30,145 million) at 31 December 2008, debt securities with a fair value of £24,246 million (2007: £18,996 million) were held by the US insurance operations. The £24,246 million value at 31 December 2008 comprises ‘Level 2’ and ‘Level 3’ securities with values of £20,564 million and £3,681 million, respectively. Typical inputs used in pricing these debt securities include, but are not limited to, reported trades, benchmark yields, credit spreads, liquidity premiums, and/or estimated cash flows based on default and prepayment assumptions.
The majority of the debt securities of the US insurance operations are priced by independent pricing services and included as ‘Level 2’ securities. As a result of typical trading volumes and the lack of quoted market prices for most debt securities, independent pricing services will normally derive the security prices through recently reported trades for identical or similar securities, making adjustments through the reporting date based upon available market observable information. If there are no reported trades, the independent pricing services and brokers may use matrix or pricing model processes to develop a security price where future cash flow expectations are developed based upon collateral performance and discounted at relevant market rates.
Debt securities of US insurance operations valued using internally derived valuation techniques in 2008 include certain assetbacked securities which had previously been valued using prices provided by a pricing service or brokers in the context of active markets. The current market dislocations have caused a reassessment of the valuation process for these asset-backed securities. In particular, beginning at the end of the third-quarter of 2008, the external prices obtained for certain asset-backed securities were deemed to be inappropriate in the current market conditions. For the valuations at 31 December 2008, the US operations have therefore utilised internal valuation models, provided by PPM America, to derive fair values for all non-agency residential mortgage-backed securities and asset-backed securities and certain commercial mortgage-backed securities. Details of these asset-backed securities are provided in notes B6 and D3. The techniques used by PPM America include cash flow models based on spreads and, when available, market indices. The models used begin with current spread levels of similarly-rated securities to determine the market discount rate for the security. Additional risk premiums for illiquidity and non-performance are incorporated, if warranted, and included in the discount rate. Cash flows, as estimated by PPM America using issuer-specific default statistics and prepayment assumptions, are discounted to determine an estimated fair value. The use of internal valuation models has resulted in a fair value of these securities that was higher than those provided from pricing services and brokers of £760 million on a total amortised cost of £3.5 billion.
Financial liabilities Core structural borrowings of shareholder-financed operations 2,958 – – 2,958 Operational borrowings attributable to shareholder-financed operations 1,520 454 3 1,977 Borrowings attributable to with-profits funds 729 482 97 1,308 Obligations under funding, securities lending and sale and
Investment contracts without discretionary participation features 1,922 – 12,110 14,032 Derivative liabilities 244 145 691 1,080
Obligations under funding, securities lending and sale and repurchase agreements 5,572 – – – – – – 5,572 2007 £m
Total After 1 After 5 After 10 After 15 undis1 year year to years to years to years to Over counted or less 5 years 10 years 15 years 20 years 20 years value
The maturity profile above excludes certain corporate unit-linked business with gross policyholder liabilities of £8 billion (2007: £8 billion) which has no stated maturity.
Credit risk Of the total loans and receivables held £21 million (2007: £5 million) are past their due date but have not been impaired. Of the total past due but not impaired, £21 million (2007: £5 million) are less than one year past their due date. The Group expects full recovery of these loans and receivables. Financial assets that would have been past due or impaired had the terms not been renegotiated amounted to £1 million (2007: £nil).
The financial liabilities, of which 38 per cent (2007: 19 per cent) are held by the PAC with-profits fund, mainly relate to foreign currency borrowings.
UK US Asian insurance insurance insurance Asset Unallocated Group operations operations operations management to a segment total 2007 £m
The above derivative assets are included in ‘other investments’ in the primary statements. The notional amount of the derivatives, distinguishing between UK insurance and US operations, was as follows: 2008 £m
Cross-currency swaps* 658 648 602 – Equity index call options – 23 – –
*In addition, the other operations, including the Group Treasury function and the Asian operations, have cross-currency swap assets and liabilities with notional amounts of £1,503 million (2007: £730 million) and £605 million (2007: £1,401 million) respectively, forward currency contracts assets and liabilities with notional amounts of £1,419 million (2007: £983 million) and £2,310 million (2007: £773 million) respectively, interest rate swaps assets and liabilities of £1,407 million (2007: £2,799 million) and of £2,316 million (2007: £1,563 million), respectively, and cliquet options assets of £1,525 million (2007: £nil).
The Group uses various interest rate derivative instruments such as interest rate swaps to reduce exposure to interest rate volatility. The UK insurance operations use various currency derivatives in order to limit volatility due to foreign currency exchange rate fluctuations arising on securities denominated in currencies other than sterling. See also note G2 above. In addition, total return swaps and interest rate swaps are held for efficient portfolio management.
Some of the Group’s products, especially those sold in the US, have certain guarantee features linked to equity indexes. A mismatch between product liabilities and the performance of the underlying assets backing them, exposes the Group to equity index risk. In order to mitigate this risk, the relevant business units purchase swaptions, equity options and futures to match asset performance with liabilities under equity-indexed products.
In addition, Jackson had a common stock equity collar hedge entered into in March 2005. This was to protect Jackson’s unrealised gain of US$5.9 million on an equity investment. The hedge expired in March 2008.
Cash flow hedges Following the sale of Egg in 2007, the Group has no cash flow hedges in place.
At 31 December 2008, 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 £588 million (2007: £1,361 million), together with accrued interest.
Collateral and pledges under derivative transactions At 31 December 2008, the Group had pledged £1,154 million (2007: £260 million) for liabilities and held collateral of £829 million (2007: £292 million) in respect of over-the-counter derivative transactions.
The impairment losses have been recorded in ‘investment income’ in the income statement. In 2008, the Group realised gross losses on sales of available-for-sale securities of £184 million (2007: £86 million) with 55 per cent (2007: 46 per cent) of these losses related to the disposal of fixed maturity securities of six (2007: six) individual issuers, which were disposed of to rebalance the portfolio in the US operations in response to the unstable mortgage lending
The effect of those reasonably likely changes in the key assumptions underlying the estimates that underpin the assessment of whether impairment has taken place depends on the factors described in note A3. A key indicator of whether such impairment may arise in future, and the potential amounts at risk, is the profile of gross unrealised losses for fixed maturity securities accounted for on an available-for-sale basis by reference to the time periods by which the securities have been held continuously in an unrealised loss position and by reference to the maturity date of the securities concerned.
For 2008 the amounts of gross unrealised losses for fixed maturity securities classified as available-for-sale under IFRS in an unrealised loss position was £3,178 million (2007: £439 million). Notes B1 and D3 provide further details on the impairment charges and unrealised losses of Jackson’s available-for-sale securities.
Assessment of whether goodwill may be impaired With the exception of M&G, the goodwill attributable to shareholders in the balance sheet mainly relates to acquired life businesses. The 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.
The discounted cash flow valuation has been based on a five-year plan prepared by M&G, and approved by management, and cash flow projections for later years.
The value in use is particularly sensitive to a number of key assumptions as follows: i The set of economic, market and business assumptions used to derive the five-year plan. The direct and secondary effects of recent developments, e.g. the fall in global equity markets, are considered in arriving at the expectations for the financial projections for the plan.
iii The risk discount rate. Differing discount rates have been applied in accordance with the nature of the individual component businesses. For retail and institutional business a risk discount rate of 12 per cent has been applied to post-tax cash flows. This represents an average implied discount rate for comparable UK listed asset managers calculated by reference to risk-free rates, equity risk premiums of five per cent and an average ‘beta’ factor for relative market risk of comparable UK listed asset managers. A similar approach has been applied for the other component businesses of M&G.
The movement in the year comprises: Balance at 1 January 2,836 2,497
Deferred acquisition costs related to insurance contracts attributable to shareholders The movement in deferred acquisition costs relating to insurance contracts attributable to shareholders is as follows: Deferred acquisition costs at 1 January 2,644 2,315
b Deferred acquisition costs and other intangible assets Other intangible assets in the Group consolidated balance sheet attributable to with-profit funds consist of: Deferred acquisition costs related to insurance contracts attributable to the PAC with-profit fund 13 19 Distribution rights attributable to with-profit funds of the Asian insurance operations 113 –
Deferred acquisition costs related to insurance contracts attributable to the PAC with-profit fund The movement in deferred acquisition costs relating to insurance contracts attributable to the PAC with-profit fund is as follows: Additions – 1 Amortisation charge (6) (13)
Assets Of the £657 million (2007: £285 million) current tax recoverable, the majority is expected to be recovered in one year or less.
US insurance operations 1,969 657 Asian insurance operations 101 73 Other operations 303 116
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 significant increases in 2008 reflect the incidence of unrealised losses on the fixed income securities of US insurance operations, for which there is the intent and ability to hold for the longer term. In addition, deferred tax balances to UK shareholder-backed insurance business has increased reflecting losses carried forward on the tax basis which reflects the regulatory basis.
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 trading or capital nature may affect the recognition of deferred tax assets. Accordingly, for the 2008 results and balance sheet position at 31 December 2008, the possible tax benefit of approximately £211 million (2007: £280 million), which may arise from capital losses valued at approximately £1 billion (2007: £1.4 billion), is sufficiently uncertain that it has not been recognised. In addition, a potential deferred tax asset of £678 million (2007: £112 million), which may arise from tax losses and other potential temporary differences totalling £2.2 billion (2007: £350 million) is sufficiently uncertain that it has not been recognised. Forecasts as to when the tax losses and other temporary differences are likely to be utilised indicate that they may not be utilised in the short term.
Unrealised gains on investments 765 2,098 Balances relating to investment and insurance contracts 968 599 Short-term timing differences 1,490 693 Capital allowances 6 12
Property, plant and equipment comprise Group occupied properties, development property and tangible assets. A reconciliation of the carrying amount of these items from the beginning of the year to the end of the year is as follows: Group occupied Development Tangible Continuing Discontinued property property assets operations operations Total £m £m £m £m £m £m
Arising on acquisition of subsidiaries 5 – 33 38 – 38 Disposal of subsidiaries – – – – (57) (57) Deconsolidated venture fund investmentsI6 (69) – (261) (330) – (330)
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: Additions: Resulting from acquisitions 1,414 1,707 Resulting from expenditure capitalised 218 128 Resulting from acquisitions through business combinations 463 –
The income statement includes the following items in respect of investment properties: Rental income from investment properties 726 670 Direct operating expenses (including repairs and maintenance expenses)
Investment properties of £3,559 million (2007: £3,665 million) are held under finance leases. A reconciliation between the total of future minimum lease payments at the balance sheet date, and their present value is shown below: Future minimum lease payments at 31 December 963 979 Future finance charges on finance leases (863) (877)
Future minimum lease payments are due as follows: Less than 1 year 5 5
The present values of these minimum lease payments are: Less than 1 year 5 5
Share of profit for the year after tax – – – – –
Impairment of goodwill – – – (6) (6) Exchange translation and other movements 3 1 4 – 4 Share of loss for the year after tax – – – – –
The aggregate assets of these associates are approximately £8 billion (2007: £9 billion). Aggregate liabilities, excluding liabilities to unit holders and shareholders for unit trusts and OEICs, are approximately £2 billion (2007: £2 billion). Fund revenues, with revenue arising in unit trusts and OEICs deemed to constitute the investment return for these vehicles, were approximately £0.8 billion (2007: £0.5 billion) and net loss in the year, excluding unit trusts and OEICs where all investment returns accrue to unit holders or shareholders respectively, was approximately £0.3 billion (2007: profit of £0.2 billion).
Cash and cash equivalents consist of cash at bank and in hand, deposits held at call with banks, treasury bills and other short-term highly liquid investments with less than 90 days maturity from the date of acquisition. Cash and cash equivalents included in the cash flow statement comprise the following balance sheet amounts: Cash equivalents 593 423
Cash and cash equivalents held centrally are considered to be available for general use by the Group. These funds amount to £165 million and £394 million at 31 December 2008 and 2007, respectively. The remaining funds are considered not to be available for general use by the Group, and include funds held for the benefit of policyholders.
The authorised share capital of the Company is £220 million (2007: £220 million) (divided into 4,000,000,000 (2007: 4,000,000,000) ordinary shares of 5 pence each and 2,000,000,000 sterling preference shares of 1 pence each) and US$20 million (divided into 2,000,000,000 US dollar preference shares of 1 cent each) and 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: F in an cial statem en ts H
At 31 December 2008, there were options outstanding under Save As You Earn schemes to subscribe for 6,825,343 (2007: 9,017,442) shares at prices ranging from 266 pence to 617 pence (2007: 266 pence to 695 pence) and exercisable by the year 2015 (2014). In addition, there are 967,652 (2007: 2,037,220) conditional options outstanding under the RSP and 4,906,234 (2007: 3,485,617) under the GPSP exercisable at nil cost within a 10-year period.
Of the total shares held in trust, 0.4 million (2007: 1.5 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.
The Group has consolidated a number of authorised investment funds where it is deemed to control these funds under IFRS. Certain of these funds hold shares in Prudential plc. The total number of shares held by these funds at 31 December 2008 was 9.2 million (2007: 4.1 million) and the cost of acquiring these shares of £47 million (2007: £22 million) is included in the cost of own shares. The market value of these shares as at 31 December 2008 was £37 million (2007: £29 million).
Reserves The translation reserve represents cumulative foreign exchange translation differences taken directly to equity in accordance with IFRS, net of related tax. In accordance with IFRS 1, cumulative translation differences are deemed to be zero at 1 January 2004, the date of transition to IFRS.
Income and expense included in the income statement 9,604 541 Foreign exchange translation differences (167) (7)
Parent company Subordinated debt: ¤500m 5.75% Subordinated Notes 2021note i 482 482 365 ¤20m Medium-Term Subordinated Notes 2023note ii 19 19 15 £435m 6.125% Subordinated Notes 2031 427 427 427 US$1,000m 6.5% Perpetual Subordinated
vi The Surplus Notes are unsecured and subordinated to all present and future indebtedness, policy claims and other creditor claims of Jackson. vii Maturity analysis
Borrowings in respect of short-term fixed income securities programmes Commercial paper 1,269 2,422 Medium-Term Notes 2008 – 48 Medium-Term Notes 2010 9 7
Other borrowings Bank loans and overdraftsnote iv 185 6 Obligations under finance leases 3 7
Notes i In all instances the holders of the debt instruments issued by these subsidiaries and funds do not have recourse beyond the assets of those subsidiaries and funds. ii This represents senior debt issued through the Federal Home Loan Bank of Indianapolis and is secured on collateral posted with FHLB by Jackson.
iv Bank loans and overdrafts include a short-term loan of £130 million in Asian operations (2007: £nil). v In addition to the operational borrowings shown in the table above, in October 2008 Prudential plc issued £200 million Floating Rate Notes 2009, which were wholly subscribed to by a Group subsidiary. These borrowings have been eliminated on consolidation. vi Maturity analysis
H13: Borrowings continued iii Maturity analysis The following table sets out the maturity analysis of the Group’s borrowings attributable to with-profits funds: £m £m
Provision after elimination of investments in Prudential insurance policies and matching policyholder liability from Group balance sheet 306 355
Comprising: Legal provisions 23 19 Restructuring provisions 21 35 Other provisions 111 166
In 2004 and 2005, UK insurance operations implemented restructurings relating to document management review, streamlining operations, and the relocation of activities to an offshore base in India. In December 2005, the Group announced an initiative for UK insurance operations to work more closely with M&G and in the process facilitate the realisation of substantial annualised pre-tax cost savings and opportunities for revenue synergies.
On 28 November 2007 UK insurance operations announced it had entered into a partnership agreement with Capita Group Plc (Capita) to outsource a large proportion of its in-force and new business policy administration. Under the terms of the proposed agreement, Capita will provide customer servicing, policy administration, new business processing, claims activity and related IT support.
At 1 January 2007, a provision of £72 million was brought forward, and during 2007 an additional £21 million was provided, £14 million of unused provision was released, and £44 million was paid.
Balance at beginning of year 448 401 Changes to actuarial assumptions and method of calculation (75) 71 Discount unwind 20 22 Redress to policyholders (46) (41) Payment of administrative costs (2) (5)
The pension mis-selling provision at 31 December 2008 set out above of £345 million is stochastically determined on a discounted basis. The average discount rate implied in the movement in the year is 4.0 per cent. The undiscounted amounts at 31 December 2008 expected to be paid in each of the years ending 31 December are as follows: 2008 £m
In February 2009, the FSA issued a revised consultation paper 09/09 proposing that future payments of compensation and redress for events occurring after 31 July 2009 may only be paid from assets attributable to shareholders.
In addition, in the year ended 31 December 2008 Prudential Assurance’s main with-profits fund paid compensation of £1 million (2007: £5 million) in respect of mortgage endowment products mis-selling claims and at 31 December 2008 held a provision of £54 million (2007: £55 million) in respect of further compensation. The movement in this provision has no impact on the Group’s profit before tax.
Guaranteed annuities Prudential Assurance used to sell guaranteed annuity products in the UK and at 31 December 2008 held a provision of £42 million (2007: £45 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 2008 a provision of £391 million (2007: £563 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.
Support for long-term business funds by shareholders’ funds As a proprietary insurance company, Prudential Assurance is liable to meet its obligations to policyholders even if the assets of the long-term funds are insufficient to do so. The assets, represented by the unallocated surplus of with-profits funds, in excess of amounts expected to be paid for future terminal bonuses and related shareholder transfers (‘the excess assets’) in the long-term funds could be materially depleted over time by, for example, a significant or sustained equity market downturn, costs of significant fundamental strategic change or a material increase in the pension mis-selling provision. In the unlikely circumstance that the depletion of the excess assets within the long-term fund was such that the Group’s ability to satisfy policyholders’ reasonable expectations was adversely affected, it might become necessary to restrict the annual distribution to shareholders or to contribute shareholders’ funds to the long-term funds to provide financial support.
In 1997, the business of SALAS, a mutual society, was transferred to Prudential Assurance. In effecting the transfer, a separate sub-fund, SAIF, was established within Prudential Assurance’s long-term business fund. This sub-fund contains all the withprofits business and all other pension business that was transferred. No new business has been or will be written in the sub-fund and the sub-fund is managed to ensure that all the invested assets are distributed to SAIF policyholders over the lifetime of SAIF
H14: Provisions and contingencies continued policies. With the exception of certain amounts in respect of the unitised with-profits life business, all future earnings arising in SAIF are retained for SAIF policyholders. Any excess (deficiency) of revenue over expense within SAIF during a period is offset by a transfer to (from) the SAIF unallocated surplus. Shareholders have no interest in the profits of SAIF but are entitled to the asset management fees paid on this business. With the exception of certain guaranteed annuity products mentioned earlier in this note, and certain products which include a minimum guaranteed rate of accumulation, the majority of SAIF with-profits policies do not guarantee minimum rates of return to policyholders.
At 31 December 2008, Jackson has unfunded commitments of £400 million (2007: £181 million) related to its investments in limited partnerships and of £24 million (2007: £104 million) related to commercial mortgage loans. These commitments were entered into in the normal course of business and the directors do not expect a material adverse impact on the operations to arise from them.
The Group has provided other guarantees and commitments to third-parties entered into in the normal course of business but the directors do not consider that the amounts involved are significant.
Creditors arising from direct insurance and reinsurance operations 552 538 Interest payable 139 76 Other items 199 177
Venture fund investment subsidiaries of the PAC with-profits fund (see below) – 21,184
Venture fund investment subsidiaries of the PAC with-profits fund (see below) – 423
Total for continuing operations 913 1,402 Discontinued banking operations – 21
As a result, changes were made to the basis of funding for the scheme with effect from that date. Based on that valuation, deficit funding amounts designed to eliminate the actuarial deficit over a 10 year period have been and are being made. Total contributions to the Scheme for deficit funding and employer’s contributions for ongoing service for current employees are expected to be of the order of £70-75 million per annum subject to a reassessment when the subsequent valuation is completed. In 2008, total contributions for the year including expenses and augmentations were £79 million (2007: £82 million). Deficit funding for PSPS is apportioned in the ratio of 70/30 between the PAC life fund and shareholder-backed operations following detailed consideration in 2005 of the sourcing of previous contributions. Employer contributions for ongoing service of current employees are apportioned in the ratio relevant to current activity. The PSPS valuation as at 5 April 2008 is currently being finalised.
The deficit of the Scottish Amicable Pension Scheme of £44 million (2007: £54 million) has been allocated 50 per cent to the PAC with-profits fund and 50 per cent to the PAC shareholders fund.
This adoption of the principles of IFRIC 14 has had an effect on the Group’s interest in the financial position of the Group’s main UK defined benefit pension scheme, PSPS. The change relates solely to the accounting measurement of the Group’s interest in the financial position of PSPS. Adoption of the principles of IFRIC 14 does not affect the Group’s interest in the Group’s other defined benefit pension schemes.
Under the terms of the Trust Deed, the Group has no unconditional right of refund to any surplus in PSPS. Also, the Group has no ability under the guidance in IFRIC 14 to anticipate a reduction in the level of future contributions for ongoing services from those currently being paid. In addition, the Group currently has a committed five-year deficit funding arrangement in place as agreed with the Trustees of the PSPS following the last triennial valuation of PSPS as at 5 April 2005.
The asset and liabilities of PSPS are unaffected by the impact of the adoption of IFRIC 14. PSPS is managed on an economic basis for the longer-term benefit of its current and deferred pensioners and active members. The surplus in PSPS is available to absorb future adverse asset value movements and, if required, strengthening in mortality assumptions. The fluctuating nature of the surplus is demonstrated by the increase in the underlying gross surplus from £528m at 31 December 2007 to £728m at 31 December 2008.
The effect of the change on the consolidated income statement, earnings per share and consolidated balance sheet are as follows: Adjustments made to the
Investment return 47 4 Benefit and claims and movement in unallocated surplus of with-profits funds 66 205 Other operating expenditure (173) (336)
Profit (loss) before tax (being tax attributable to shareholders’ and the policyholders’ returns) (60) (127) Tax attributable to policyholders’ returns 11 24
Profits (loss) before tax attributable to shareholders (49) (103) Tax attributable to shareholders’ (loss) profit 13 28
Increase (decrease) in Earnings per share earnings per share (in pence)
Basic and diluted based on profit (loss) from continuing operations attributable to equity holders of the company (1.5)p (3.1)p
Effect of As Effect of Previous adoption of Revised previously adoption of After basis IFRIC 14 basis published IFRIC 14 change
Operating profit based on longer-term investment returns 1,371 (24) 1,347 1,213 (12) 1,201
Shareholders’ share of actuarial and other gains and losses on defined benefit pension schemes 11 (25) (14) 90 (91) (1)
(Loss) profit for the year (360) (36) (396) 1,022 (75) 947 Other movements in reserves (608) – (608) (309) – (309) Shareholders’ equity at the beginning of the year 6,201 (139) 6,062 5,488 (64) 5,424
In addition, also on the economic basis, the PAC with-profits sub-fund was charged £10 million (2007: charge of £23 million) for its share of the pension charge of PSPS and Scottish Amicable and charged with £7 million (2007: £6 million) for its share of net actuarial and other losses on the scheme assets and liabilities. As shareholder profits for the PAC with-profits sub-fund reflects the surplus for distribution, these amounts are effectively absorbed by an increased charge in the income statement for the transfer to the liability for unallocated surplus.
The Trustee sets the general investment policy and specifies any restrictions on types of investment and the degrees of divergence permitted from the benchmark, but delegates the responsibility for selection and realisation of specific investments to the Investment Managers. In carrying out this responsibility, the Investment Managers are required by the Pensions Act 1995 to have regard to the need for diversification and suitability of investments. Subject to a number of restrictions contained within the relevant asset management agreements, the Investment Managers are authorised to invest in any class of investment asset.
The investment policies and strategies for the other two UK defined benefit schemes, the M&G Group Pension Scheme and the Scottish Amicable Staff Pension Scheme, which are both final salary schemes, follow similar principles, but have different target allocations reflecting the particular requirements of the schemes.
† The rates of 2.5 per cent shown are those for PSPS. Assumed rates of increase of pensions in payment for inflation for all other schemes are 3.0 per cent in 2008 (2007: 3.3 per cent).
The calculations are based on current actuarially calculated mortality estimates with a specific allowance made for future improvements in mortality, which is broadly in line with that adopted for the 92 series of mortality tables prepared by the Continuous Mortality Investigation Bureau of the Institute and Faculty of Actuaries. In 2007, the mortality assumptions were strengthened by including a floor to the medium cohort improvements.
The assumed life expectancies on retirement at age 60, based on the mortality table used was: 2008 years 2007 years
The mean term of the current PSPS liabilities is around 18 years. Using external actuarial advice provided by Watson Wyatt Partners for the valuation of PSPS and by Aon Limited for the
M&G scheme, and Hazell Carr for the Scottish Amicable scheme, the most recent full valuations have been updated to 31 December 2008, applying the principles prescribed by IAS 19.
5 Group economic financial position The economic financial position of the defined benefit pension schemes reflects the total assets of the schemes including investments in Prudential policies. This is to be contrasted with the IAS 19 basis assets of the 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.
Effect of the adoption of IFRIC 14 for pension schemes: Derecognition of PSPS surplus (728) – (728) (528) – (528) Set up obligation for deficit funding for PSPS until 5 April 2010 (65) – (65) (102) – (102)
The movements in the deficit on the ‘economic basis’ between scheme assets and liabilities were: Current service cost (19) (19) Curtailment credit 14 – Other finance income (2) 2 Cash costs and unwind of discount on opening provision for deficit funding for PSPS (29) (41)
Total credit net of finance income (7) (17) Cash cost and unwind of discount on opening provision for deficit funding for PSPS* (29) (41) Less: amount attributable to PAC with-profits fund 10 23
Charge to operating results, based on longer-term investment returns, attributable to shareholders (26) (35)
Other gains and losses: Change in the provision for deficit funding for PSPSb (13) – Less: amount attributable to PAC with-profits fund 9 –
a The gains of £71 million relating to changes in assumptions comprise the gains due to the effect of an increase in the risk discount rate combined with the effect of decreases in inflation rates.
At beginning (credit) gains (losses) with-profits At end of year note i above note ii above fund of year
The pension charges and credits which comprise service costs less net finance income for the Scottish Amicable Scheme and the cash costs and unwind of discount on pension provision for deficit funding for PSPS, and actuarial and other gains and losses are included within the income statement but also taken account of in determining the charge in the income statement for the transfer to the liability for unallocated surplus of with-profits funds.
6 Movement in IAS 19 basis financial position The change in the present value of the benefit obligation and the change in fair value of the assets for the total of the PSPS, Scottish Amicable, M&G and Taiwan schemes over the period were as follows: 2008 £m
Service cost – current charge only (19) (19) Curtailment credit 14 14 Interest cost (39) (39) Expected return on plan assets 26 11 37 37
IAS 19 basis: IAS 19 basis: change in Investments Economic change in Economic
Fair value of plan assets, beginning of year 366 161 527 527 Present value of benefit obligation, beginning of year (603) (603) Provision for deficit funding for PSPS (143) (143)
Cash costs and unwind of discount on the opening liability for deficit funding for PSPS (41) (41)
7 IAS 19 basis financial position as consolidated The IAS 19 basis pensions deficit can be summarised as follows: Fair value of plan assets, end of year 5,057 5,150 4,988 4,622 4,092 Present value of funded benefit obligation (4,493) (4,826) (5,023) (5,228) (4,777)
Present value of unfunded obligations (M&G scheme)* (180) (189) (187) (190) (140)
Deficit recognised in the balance sheet (306) (355) (380) (796) (825)
Components of net periodic pension cost Current service cost (45) (58) Curtailment credit 44 – Interest cost (289) (265) Expected return on assets – economic basis 336 309 Less: expected return on investments of scheme assets in Prudential insurance policies (22) (20) Expected return on assets – IAS 19 basis† 314 289
Actuarial gains and losses – IAS 19 basis* (as referred to in noteI1a) 10 (2)
Net periodic pension cost (included within acquisition and other operating expenditure in the income statement) (37) (70)
The actual return on scheme assets was a loss £20 million (2007: gain of £282 million) on an IAS 19 basis.
8 Sensitivity of the financial position of the PSPS, Scottish Amicable and M&G pension schemes to key variables The table below shows the sensitivity of the underlying PSPS, Scottish Amicable and M&G pension scheme liabilities at 31 December 2008 of £4,075 million, £398 million and £180 million respectively (2007: £4,361 million, £454 million and £189 million) to changes in discount rates and inflation rates.
Discount rate Increase by 0.2% from 6.1% to 6.3% Decrease in scheme liabilities by: PSPS 3.1% Scottish Amicable 4.6% M&G 4.2%
The Group maintains 10 main share award and share option plans relating to Prudential plc shares, which are described below. The Group Performance Share Plan (GPSP) is the incentive plan in which all executive directors and other senior executives within the Group can participate. This scheme was established as a replacement for the Restricted Share Plan (RSP) under which no further awards could be made after March 2006. Awards are granted either in the form of a nil cost option, conditional right over shares, or such other form that shall confer to the participant an equivalent economic benefit, with a vesting period of three years. The performance measure for the awards is that Prudential’s Total Shareholder Return (TSR) outperforms an index comprising of peer companies. Vesting of the awards between each performance point is on a straight line sliding scale basis. Participants are entitled to the value of reinvested dividends that would have accrued on the shares that vest. Shares are currently purchased in the open market by a trust for the benefit of qualifying employees.
The BUPP is an incentive plan created to provide a common framework under which awards would be made to senior employees and in the UK, Jackson and Asia include the Chief Executive Officers. Awards under this plan in 2007 and 2008 were based on growth in Shareholder Capital Value on the European Embedded Value (EEV) basis with performance measured over three years. Upon vesting, half of the vested award is released as shares and the other half 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 are relevant to each region and vesting of the awards between each performance point is on a straight line sliding scale basis.
The new Prudential Corporation Asia Long-Term Incentive Plan (PCA LTIP) is an incentive plan for senior employees and Chief Executive Officers replacing the Asia Business Unit Performance Plan (BUPP). Awards under the new PCA LTIP will vest after three years subject to the employee being in employment at the time of vesting without any performance conditions.
Awards will be discretionary and on a year by year basis determined by Prudential’s full year financial results and the employee’s contribution to the business. All awards will be in Prudential shares except for countries where share awards are not feasible due to securities and/or tax reasons, where awards will be replaced by the cash value of the shares that would otherwise have been transferred.
In addition, there are other share awards which included the 1,000 Day Long Term Incentive Plan (LTIP) and other arrangements. The 1,000 Day LTIP plan was a UK insurance operations performance-based plan in which the UK Remuneration Committee could, at any time up to 5 October 2005, select employees at its absolute discretion, for participation in the plan. The performance period was 1,000 days and, based on the final performance level being at, or above, the threshold level, the committee shall grant participants 10 per cent of the allocated award in 2005, 20 per cent in 2006 and the remaining 70 per cent in 2007. There are no beneficial interests, or any rights to dividends until such time as the awards are released, at nil cost, to participants. There are no outstanding shares awarded through this scheme.
Expected option life (years) 3.00 3.74 3.00 3.48 Weighted average exercise price (£) – 4.74 – 5.62
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 and awards other than the GPSP, for which the Group uses a Monte Carlo model in order to allow for the impact of the TSR performance conditions. These models are used to calculate fair values for share options and awards at the grant date based on the quoted market price of the stock at the measurement date, the amount, if any, that the employees are required to pay, the dividend yield, expected volatility, risk-free interest rates and exercise prices.
The share-based payments charge is the sum of £4,624,000 (2007: £3,456,000), which is determined in accordance with IFRS 2, ‘Share-Based Payments’ (see note I2) and £1,563,000 (2007: £1,751,000) of deferred share awards.
Total key management remuneration includes total directors’ emoluments of £12,683,000 (2006: £11,959,000) as shown in the directors’ remuneration table and related footnotes in the directors’ remuneration report, and additional amounts in respect of pensions and share-based payments. Further information on directors’ remuneration is given in the directors’ remuneration report.
Fees payable to the Company’s auditor for the audit of the Company’s annual accounts 1.6 1.8 Fees payable to the Company’s auditor and its associates for other services: Audit of subsidiaries and associates pursuant to legislation 5.0 4.4 Other services supplied pursuant to legislation 2.4 2.9 Other services relating to taxation 0.6 0.4 Valuation and actuarial services 0.7 0.7 Services relating to corporate finance transactions – 0.2 All other services 0.5 1.0
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 are disclosed in note H8.
In 2007, prior to disposal, three directors had credit cards with the discontinued banking operations. In 2008 and 2007, other transactions with directors were de-minimis both by virtue of their size and in the context of the directors’ financial positions. As indicated above, all of these transactions are on terms broadly equivalent to those that prevail in arm’s length transactions.
The Prudential Assurance Company Limited Insurance England and Wales Prudential Annuities Limited* Insurance England and Wales Prudential Retirement Income Limited (PRIL)* Insurance Scotland M&G Investment Management Limited* Asset management England and Wales Jackson National Life Insurance Company* Insurance US Prudential Assurance Company Singapore (Pte) Limited* Insurance Singapore PCA Life Assurance Company Limited* (99% owned) Insurance Taiwan *Owned by a subsidiary undertaking of the Company.
On 20 February 2009, the Company announced that it had entered into an agreement to transfer the assets and liabilities of its agency distribution business and its agency force in Taiwan to China Life Insurance Company Ltd of Taiwan. The business being transferred represents 94 per cent of its in-force liabilities in Taiwan. Further details are set out in note I10.
On 1 May 2007, the Company completed the sale of Egg Banking plc to Citi. Additional details regarding the disposal are set out in note I9.
On 9 November 2007, the Company completed the sale of PPM Capital, its direct private equity business.
There were no acquisitions or disposals of subsidiaries during the year. Subsequent to the year end, on 20 February 2009, the Company announced that it had entered into an agreement to transfer the assets and liabilities of its agency distribution business and its agency force in Taiwan to China Life Insurance Company Ltd of Taiwan, subject to regulatory approval. Additional details regarding this transfer are set out in note I10.
The table below identifies the net assets of these acquisitions and minor business purchases by existing venture holdings and reconciles the net assets to the consideration paid: 2007 £m
Cash and cash equivalents 20 Other current assets 26 Property, plant and equipment 38 Intangible assets other than goodwill 1 Other non-current assets 3 Less liabilities, including current liabilities and borrowings (304)
Following the disposal of PPM Capital, SUSPA, TJ Hughes, Sterigenics, Muller & Weygandt, TMF Group, JOST, Histoire D’or, Azzuri Communications, Paramount plc and Orizon AG ceased to be consolidated as subsidiary undertakings and goodwill and other intangible assets, net of amortisation, relating to these investments were derecognised accordingly.
The total minimum future sublease rentals to be received on non-cancellable operating leases for land and buildings for the year ended 31 December 2008 was £0.2 million (2007: £0.4 million).
ii Capital commitments The Group has provided, from time to time, certain guarantees and commitments to third-parties including funding the purchase or development of land and buildings and other related matters. At 31 December 2008, the aggregate amount of contractual obligations to purchase and develop investment properties amounted to £1 million (2007: £64 million).
Operating loss based on longer-term investment returns (68) Profit on sale of Egg Banking plc 290
Tax on operating loss based on longer-term investment returns 19 Tax on profit on sale of Egg Banking plc 0
Fee and commission income in 2007 includes £27 million relating to financial instruments held at amortised cost. These fees primarily related to balance transfer fees and late payment fees. Fee and commission expense in 2007 includes fee expenses relating to financial liabilities held at amortised cost of £4 million which related to treasury fees.
I10: Post balance sheet events i Intended sale of legacy agency book and agency force in Taiwan to China Life Insurance of Taiwan On 20 February 2009, the Company announced that it had entered into an agreement to sell the assets and liabilities of its agency distribution business and its agency force in Taiwan to China Life Insurance Company Ltd of Taiwan (‘China Life’) for the nominal sum of NT$1, subject to regulatory approval.
Net movement 188 Equity brought forward at 1 January 2008 289
Equity carried forward at 31 December 2008 477 *Comprising £66 million for solvency capital and £27 million for business development.
Current assets Debtors: Amounts owed by subsidiary undertakings 1,986 3,291 Deferred tax 111 – Other debtors 11 25
Amounts owed to subsidiary undertakings (3,341) (2,455) Tax payable (311) (332) Sundry creditors (19) (6) Accruals and deferred income (44) (44)
Total net assets (excluding pension) 3,209 3,019 Pension asset (net of related deferred tax) 8 36 117
The financial statements of the parent company on pages 306 to 315 were approved by the Board of directors on 18 March 2009.
On 20 February 2009, the Company announced that it had entered into an agreement subject to regulatory approval to transfer the assets and liabilities of its agency distribution business and its agency force in Taiwan to China Life Insurance Company Ltd of Taiwan. Further details are set out in note I10 ‘Post Balance Sheet Events’ of the Group financial statements.
Where scrip dividends are issued, the value of such shares, measured as the amount of the cash dividend alternative, is credited to reserves and the amount in excess of the nominal value of the shares issued is transferred from the share premium account to retained profit.
Pensions The Company assumes a portion of the pension surplus or deficit of the Group’s largest pension scheme, the Prudential Staff Pension Scheme (PSPS) and applied the requirements of FRS 17 (as amended in December 2006) to its interest in the PSPS surplus or deficit. Further details are disclosed in note 8.
The principal subsidiary undertakings of the Company at 31 December 2008, all wholly-owned except PCA Life Assurance Company Limited, were: Main activity Country of incorporation
On 20 February 2009, the Company announced that it had entered into an agreement to transfer the assets and liabilities of its agency distribution business and its agency force in Taiwan to China Life Insurance Company Ltd of Taiwan. The business being transferred represents 94 per cent of the in-force liabilities in Taiwan. Further details are set out in note I10 ‘Post Balance Sheet Events’ of the Group financial statements.
Total core structural borrowings 2,781 2,363 – – 2,781 2,363 Other borrowings: Medium-Term Notes 2008note vii – – – 48 – 48 Floating Rate Notes 2009note viii – – 200 – 200 – Medium-Term Notes 2010note vii – – 9 7 9 7
Borrowings are repayable as follows: Within 1 year or on demand 249 – 1,469 2,470 1,718 2,470
Recorded in the balance sheet as: Subordinated liabilitiesnote ix 1,983 1,566 Debenture loans 798 797
The Company has a US$1,000 million and a US$300 million fair value hedge in place which hedges the interest exposures on the US$1,000 million 6.5 per cent perpetual subordinated capital securities and the US$300 million 6.5 per cent perpetual subordinated capital securities, respectively. Subsequent to the year end, in January 2009, the interest rate swap to hedge the interest exposure on the US$1,000 million 6.5 per cent perpetual subordinated capital securities was cancelled. 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.
The majority of UK Prudential staff are members of the Group’s pension schemes. The largest scheme is the Prudential Staff Pension Scheme (PSPS) which is primarily a closed defined benefit scheme. At 31 December 2008, on the FRS 17, ‘Retirement Benefits’ basis of valuation, the underlying pension liabilities of PSPS accounted for 87 per cent (2007: 87 per cent) of the liabilities of the Group’s defined benefit schemes.
At 31 December 2005, the allocation of surpluses and deficits attaching to PSPS between the Company and the unallocated surplus of the Prudential Assurance Company’s (PAC) with-profits funds was apportioned in the ratio 30/70 between the Company and the PAC with-profits fund following detailed consideration of the sourcing of previous contributions. This ratio was applied to the base deficit position at 1 January 2006 and for the purpose of determining the allocation of the movements in that position up to 31 December 2008. The FRS 17 service charge and ongoing employer contributions are allocated by reference to the cost allocation for current activity.
Defined benefit schemes are generally required to be subject to full actuarial valuation every three years to assess the appropriate level of funding for schemes having regard to their commitments. These valuations include assessments of the likely rate of return on the assets held within the separate trustee administered funds. PSPS was last actuarially valued as at 5 April 2005 using the projected unit method. This valuation demonstrated the scheme to be 94 per cent funded, with a shortfall of actuarially determined assets to liabilities of six per cent, representing a deficit of £243 million. As a result, changes to the basis of funding for the scheme from 2006 onwards were made. Deficit funding amounts designed to eliminate the actuarial deficit over a 10-year period have been and are being made. Based on this valuation, 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 subject to a reassessment when the subsequent valuation is completed. In 2008, total contributions for the year, including expenses and augmentations, were £79 million (2007: £82 million). The PSPS valuation as at 5 April 2008 is currently being finalised.
Further details on the PSPS scheme, including mortality assumptions, are shown in note I1 ‘Staff and pension plans’ of the notes on the financial statements of the Group.
The surplus in the scheme recognised in the balance sheet of the Company represents the element of the amount which is recoverable through reduced future contribution and is net of the apportionment to the PAC with-profits fund.
Fair value of scheme assets, beginning of year 4,889 4,748 Expected return on scheme assets 299 276 Employee contributions 1 2 Employer contributions* 79 82 Actuarial losses (259) (12) Benefit payments (206) (207)
Pension credit (charge) and actuarial gains (losses) of PSPS The pension charge recognised in the Company’s profit and loss account is as follows: Pension credit (charge) Operating charge: Service costs (26) (39) Finance income (expense): Interest on scheme liabilities (250) (234) Expected return on scheme assets 299 276
Experience gains (losses) on scheme liabilities (3% (2007: 0%) (2006: 0%) (2005: 0%) (2004: 1%) of liabilities) 127 (10) 17 – (25)
Total actuarial gains (2% (2007: 7%) (2006: 8%) (2005: 2%) (2004: (1)%) of the present value of the scheme liabilities) 68 302 390 95 (49)
The actuarial gains (losses) attributable to the Company are net of the apportionment to the PAC with-profits funds and correspond to the surplus (deficit) recognised on the balance sheet of the Company. In 2008, the actuarial losses attributable to the Company included an amount of £164 million for the unrecognised portion of surplus which has not been deducted from the pension credit (charge).
The actuarial losses before tax of £143 million (2007: gains of £91 million) attributable to the Company net of related tax are recorded in the statement of total recognised gains and losses. Cumulative actuarial gains as at 31 December 2008 amount to £91 million (2007: £234 million).
The 2005 actuarial losses attributable to the Company reflected the changed estimate of allocation in the deficit of PSPS from a ratio of 20/80 between the Company and the PAC with-profits fund prior to 2005 to a ratio of 30/70 from 2005 onwards.
Total employer contributions expected to be paid into the PSPS defined benefit scheme for the year ending 31 December 2009 amount to £78 million, subject to a reassessment when the valuation as at 5 April 2008 is completed.
The authorised share capital of the Company at both 31 December 2008 and 31 December 2007 was £220 million (divided into 4,000,000,000 ordinary shares of 5 pence each and 2,000,000,000 sterling preference shares of 1 pence each) and US$20 million (divided into 2,000,000,000 US dollar preference shares of 1 cent each) and €20 million (divided into 2,000,000,000 Euro preference shares of 1 cent each). None of the preference shares has been issued. A summary of the ordinary shares in issue is set out below: Share Share Number of capital premium
Further information on the adoption of UITF 44 is provided in note 2.
Company law requires the directors to prepare Group and parent company financial statements for each financial year.
The directors are responsible for keeping proper accounting records that disclose with reasonable accuracy at any time the financial position of the parent company and enable them to ensure that its financial statements comply with the Companies Act 1985. They have general responsibility for taking such steps as are reasonably open to them to safeguard the assets of the Group and to prevent and detect fraud and other irregularities.
We have also audited the information in the directors’ remuneration report on pages 102 to 127 that is described as having been audited.
Respective responsibilities of directors and auditor The directors’ responsibilities for preparing the Annual Report and the Group financial statements in accordance with applicable law and International Financial Reporting Standards (IFRS) as adopted by the European Union (EU), and for preparing the parent company financial statements and the directors’ remuneration report in accordance with applicable law and United Kingdom Accounting Standards (United Kingdom Generally Accepted Accounting Practice) are set out in the statement of directors’ responsibilities on page 316. 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 (UK and Ireland).
We planned and performed our audit so as to obtain all the information and explanations which we considered necessary in order to provide us with sufficient evidence to give reasonable assurance that the financial statements and the part of the directors’ remuneration report to be audited are free from material mis-statement, whether caused by fraud or other irregularity or error. In forming our opinion we also evaluated the overall adequacy of the presentation of information in the financial statements and the part of the directors’ remuneration report to be audited.
Long-term business 1,309 1,042 Asset management 52 72 Development expenses (26) (15)
US operations New business 5(b) 293 285 Business in force 6 293 342
UK operations New business 5(b) 273 277 Business in force 6 764 578
Other income and expenditure Investment return and other income 7 47 49 Interest payable on core structural borrowings (172) (168) Corporate expenditure: Group Head Office (GHO) (130) (129) Asia Regional Head Office (41) (38)
Operating profit from continuing operations based on longer-term investment returns 2,961 2,530
Analysed as profits (losses) from: New business 5(b) 1,307 1,205 Business in force 6 1,625 1,319
†Restructuring costs comprise the charge of £28 million recognised on an IFRS basis and an additional £4 million recognised on the EEV basis for the shareholders’ share of costs incurred by the PAC with-profits fund.
The results for continuing operations shown above exclude those in respect of discontinued banking operations, which were sold on 1 May 2007. In addition, there have been some minor adjustments to 2007 comparatives, as detailed in notes 4f, 5 and 20.
Operating profit from continuing operations based on longer-term investment returns 2,961 2,530 Short-term fluctuations in investment returns 9 (5,127) 174 Mark to market value movements on core borrowings 10 656 223 Shareholders’ share of actuarial and other gains and losses on defined benefit pension schemes 11 (15) (5) Effect of changes in economic assumptions and time value of cost of options and guarantees 12 (581) 748
(Loss) profit from continuing operations before tax (including actual investment returns) (2,106) 3,670 Tax attributable to shareholders’ (loss) profit 13 771 (927)
Based on (loss) profit from continuing operations after tax and minority interests
Discontinued operations Based on profit from discontinued operations after tax and minority interests – 9.9p
Total – based on (loss) profit for the year after tax and minority interests of £(1,338)m (2007: £2,963m) (54.1)p 121.2p
Shareholders’ equity at end of year (excluding minority interests) 15,16 14,956 14,600
Comprising: Asian operations: Net assets 5,431 3,837 Acquired goodwill 172 172
*Return on embedded value is based on EEV operating profit from continuing operations after tax and minority interests as a percentage of opening EEV basis shareholders’ equity.
Share capital 125 123 Share premium 1,840 1,828 IFRS basis shareholders’ reserves 3,093 4,111
Total IFRS basis shareholders’ equity 5,058 6,062 Additional EEV basis retained profit 9,898 8,538
The EEV results for the Group are prepared for ‘covered business’, as defined by the EEV Principles. Covered business represents the Group’s long-term insurance business for which the value of new and in-force contracts is attributable to shareholders. The EEV basis results for the Group’s covered business are then combined with the IFRS basis results of the Group’s other operations.
As regards the Group’s defined benefit pension schemes, the liabilities attaching to the Prudential Staff Pension Scheme (PSPS) and Scottish Amicable Pension Scheme are excluded from the EEV value of UK operations and included in the total for Other operations. The amounts are partially attributable to the PAC with-profits fund and shareholder-backed long-term business and partially to other parts of the Group. In addition to the amounts recognised as attributable to shareholders under IFRS basis, a 10 per cent share of the amount attributable to the PAC with-profits fund is recognised for EEV reporting purposes.
The value of future new business is excluded from the embedded value. Notwithstanding the basis of presentation of results (as explained in note 6) no smoothing of market or account balance values, unrealised gains or investment return is applied in determining the embedded value or profit before tax. Separately, the analysis of profit is delineated between operating profit based on longer-term investment returns and other constituent items, as explained in note 4.
In determining the new business contribution for UK immediate annuity and lifetime mortgage business, which is interest rate sensitive, it is appropriate to use point of sale economic assumptions, consistent with how the business is priced. For other business within the Group end of period economic assumptions are used.
Fixed income securities backing the free surplus and required capital for Jackson are accounted for at fair value. However, consistent with the treatment applied under IFRS for securities classified as available-for-sale, movements in unrealised appreciation on these securities are accounted for in equity rather than in the income statement, as shown in the movement in shareholders’ equity.
The annual result is affected by the movement in this cost from year to year which comprises a charge against new business profit and generally a release in respect of the reduction in capital requirements for business in force as this runs off.
Non-participating long-term products are the only ones where the insurer is contractually obliged to provide guarantees on all benefits. 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 guaranteed maturity and surrender values reflect the pricing basis. On 20 February 2009, the Company announced that it had agreed to transfer the agency business of the Taiwan Life business to China Life, as detailed in note 21.
UK insurance operations The only significant financial options and guarantees in the UK insurance operations arise in the with-profits fund and SAIF. With-profits products provide returns to policyholders through bonuses that are smoothed. There are two types of bonuses: annual and final. Annual bonuses are declared once a year and, once credited, are guaranteed in accordance with the terms of the particular product. Unlike annual bonuses, final bonuses are guaranteed only until the next bonus declaration. The with-profits fund held a provision on the Pillar I Peak 2 basis of £42 million (2007: £45 million) at 31 December 2008 to honour guarantees on a small amount of guaranteed annuity option products.
The Group’s main exposure to guaranteed annuity options in the UK is through SAIF and a provision on the Pillar I Peak 2 basis of £391 million (2007: £563 million) was held in SAIF at 31 December 2008 to honour the guarantees.