Notes on the Group financial statements Section A: Background and accounting policies 170 A1: Nature of operations 170 A2: Basis of preparation 170 A3: Critical accounting policies, estimates and judgements 176 A4: Significant accounting policies 189 A5: New accounting pronouncements
Section B: Summary of results 192 B1: Segment disclosure – income statement 196 B2: Earnings per share 197 B3: Dividends 198 B4: Exchange translation 198 B5: Group statement of financial position 212 B6: New business
Section D: Life assurance business 220 D1: Group overview 227 D2: UK insurance operations 245 D3: US insurance operations 267 D4: Asian insurance operations 276 D5: Capital position statement for life assurance businesses
Section I: Other notes 349 I1: Acquisition of United Overseas Bank Life Assurance
Statement of directors’ responsibilities and independent auditor’s report 383 �Statement of directors’ responsibilities in respect of the Annual Report and the financial statements 384 Independent auditor’s report to the members of
European Embedded Value (EEV) basis supplementary information 385 �Operating profit based on longer-term investment returns
– EEV basis 387 �Summarised consolidated income statement – EEV basis 388 Earnings per share – EEV basis 388 �Dividends per share 388 �Movement in shareholders’ equity (excluding non-controlling interests) – EEV basis 390 Net asset value per share – EEV basis 390 �Summary statement of financial position – EEV basis 391 �Notes on the EEV basis supplementary information 433 �Statement of directors’ responsibilities in respect of the
Earned premiums, net of reinsurance F2 25,277 24,211 Investment return F2 9,360 21,769 Other income F2 1,869 1,666
Benefits and claims and movement in unallocated surplus of with-profits funds, net of reinsurance (29,289) (40,518)
Attributable to: Equity holders of the Company 1,490 1,431 Non-controlling interests 4 5
Available-for-sale securities: Unrealised valuation movements on securities of US insurance operations classified as available-for-sale: D3(a) Unrealised holding gains arising during the year 912 1,170 Deduct net (gains)/add back net losses included in the income statement on disposal
Other comprehensive income for the year, net of related tax 212 729
Attributable to: Equity holders of the Company 1,702 2,160 Non-controlling interests 4 5
Reserves Profit for the year – – 1,490 – – 1,490 4 1,494 Other comprehensive income Exchange movements on foreign operations and net investment hedges, net of related tax – – – (100) – (100) – (100) Unrealised valuation movements, net of related change in amortisation of deferred income and acquisition costs and related tax – – – – 312 312 – 312
Net increase/(decrease) in equity – 17 857 (100) 312 1,086 (1) 1,085
Net increase in equity – 13 1,018 251 478 1,760 12 1,772 At beginning of year 127 1,843 3,964 203 134 6,271 32 6,303
Intangible assets attributable to shareholders: Goodwill H1(a) 1,465 1,466 Deferred acquisition costs and other intangible assets H1(b) 5,069 4,667
Investments of long-term business and other operations: Investment properties H7 10,757 11,247 Investments accounted for using the equity method H8 70 71 Financial investments*: G1 Loans 9,714 9,261 Equity securities and portfolio holdings in unit trusts 87,349 86,635 Debt securities 124,498 116,352 Other investments 7,509 5,779 Deposits 10,708 9,952
Other non-insurance liabilities: Obligations under funding, securities lending and sale and repurchase agreements G1 3,114 4,199 Net asset value attributable to unit holders of consolidated unit trusts and similar funds G1 3,840 3,372 Deferred tax liabilities H4 4,211 4,224 Current tax liabilities H4 930 831 Accruals and deferred income 736 707 Other creditors G1 2,544 2,321 Provisions H14 529 729 Derivative liabilities G1,G3 3,054 2,037 Other liabilities G1,H15 1,249 1,129
Cash flows from financing activities Structural borrowings of the Group: I10 Shareholder-financed operations: note (iv) Issue of subordinated debt, net of costs 340 – Redemption of senior debt (333) – Bank loan – 250 Interest paid (286) (251) With-profits operations: note (v) Interest paid (9) (9) Equity capital: note (vi) Issues of ordinary share capital H11 17 13 Dividends paid B3 (642) (449)
Net increase in cash and cash equivalents 658 1,268 Cash and cash equivalents at beginning of year 6,631 5,307 Effect of exchange rate changes on cash and cash equivalents (32) 56
Notes (i) This measure is the formal profit before tax measure under IFRS but it is not the result attributable to shareholders. (ii) Other non-cash items consist of the adjustment of non-cash items to profit before tax together with other net items, net
purchases of treasury shares and other net movements in equity. (iii) The acquisition of subsidiaries in 2011 related to the PAC with-profits fund’s purchase of Earth & Wind and Alticom venture
investments with an outflow of £53 million. In 2010 the acquisition of United Overseas Bank Life Assurance Limited (UOB) resulted in an outflow of cash from investing activities of £133 million with the remaining outflow of £12 million relating to the PAC with-profits fund purchase of Meterserve (see note I8(iii)).
(iv) Structural borrowings of shareholder-financed operations comprise the core debt of the parent company, a PruCap bank loan and Jackson surplus notes. Core debt excludes borrowings to support short-term fixed income securities programmes, non-recourse borrowings of investment subsidiaries of shareholder-financed operations and other borrowings of shareholder-financed operations. Cash flows in respect of these borrowings are included within cash flows from operating activities.
ack gro u n d an d acco u n tin g p o licies
Insurance contract accounting With the exception of certain contracts described in note D1, the contracts issued by the Group’s life assurance business are classified as insurance contracts and investment contracts with discretionary participating features. As permitted by IFRS 4, assets and liabilities of these contracts are accounted for under previously applied GAAP. Accordingly, except as described below, the modified statutory basis (MSB) of reporting as set out in the revised Statement of Recommended Practice (SORP) issued by the Association of British Insurers (ABI) has been applied. In 2005, the Group elected to improve its IFRS accounting for UK regulated with-profits funds by the voluntary application of the UK accounting standard FRS 27, ‘Life Assurance’. Under this standard, the main accounting changes that were required for UK with-profits funds were: • derecognition of deferred acquisition costs and related deferred tax, and • replacement of MSB liabilities with adjusted realistic basis liabilities.
b Critical accounting estimates and judgements Investments Determining the fair value of financial investments when the markets are not active The Group holds certain financial investments for which the markets are not active. These can 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 eg market illiquidity. When the markets are not active, there is generally no or limited observable market data to account for financial investments at fair value. The determination of whether an active market exists for a financial investment requires management’s judgement. If the market for a financial investment of the Group is not active, the fair value is determined by using valuation techniques. The Group establishes fair value for these financial investments by using quotations from independent third-parties, such as brokers or pricing services or by using internally developed pricing models. Priority is given to publicly available prices from independent sources when available, but overall the source of pricing and/or the valuation technique 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 valuation techniques include the use of 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 and may include a number of assumptions relating to variables such as credit risk and interest rates. Changes in assumptions relating to these variables could positively or negatively impact the reported fair value of these financial investments. The financial investments measured at fair value are classified into the following three level hierarchy on the basis of the lowest level of inputs that is significant to the fair value measurement of the financial investment concerned: Level 1: Quoted prices (unadjusted) in active markets for identical assets and liabilities; Level 2: Inputs other than quoted prices included within level 1 that are observable either directly or indirectly
(ie derived from prices); and Level 3: Significant inputs for the asset or liability that are not based on observable market data (unobservable inputs).
At 31 December 2011, £4,565 million (2010: £4,573 million) of the financial investments (net of derivative liabilities) valued at fair value were classified as level 3. Of these £800 million (2010: £866 million) are held to back shareholder non-linked business and so changes to these valuations will directly impact shareholders’ equity. Further details of the classification of financial instruments are given in note G1.
in a n cia l state m e n ts A : B
Determining impairments relating to financial assets i Available-for-sale securities Financial investments carried on an available-for-sale basis are represented by Jackson’s debt securities portfolio. The consideration of evidence of impairment requires management’s judgement. In making this determination the factors considered include, for example: • Whether the decline of the financial investment’s fair value is substantial; A substantial decline in fair value might be indicative of a credit loss event that would lead to a measurable decrease in the estimated future cash flows; • The impact of the duration of the security on the calculation of the revised estimated cash flows; • The duration of a security to maturity helps to inform whether assessments of estimated future cash flows that are higher than market value are reasonable; • The duration and extent to which the amortised cost exceeds fair value; This factor provides an indication of how the contractual cash flows and effective interest rate of a financial asset compares with the implicit market estimate of cash flows and the risk attaching to a ‘fair value’ measurement. The length of time for which that level of difference has been in place may also provide further evidence as to whether the market assessment implies an impairment loss has arisen; and
For Jackson’s residential mortgage-backed and other asset-backed securities, all of which are classified as available-for-sale, the model used to analyse cash flows, begins with the current delinquency experience of the underlying collateral pool for the structure, by applying assumptions about how much of the currently delinquent loans will eventually default, and multiplying this by an assumed loss severity. Additional factors are applied to anticipate ageing effect. After applying a cash flow simulation an indication is obtained as to whether or not the security has suffered, or is anticipated to suffer, contractual principal or interest payment shortfall. If a shortfall applies an impairment charge is recorded. The difference between the fair value and book cost for unimpaired securities designated as available-for-sale, is accounted for as unrealised gains or losses, with the movements in the accounting period being included in other comprehensive income. The Group’s review of fair value involves several criteria, including economic conditions, credit loss experience, other issuer-specific developments and future cash flows. These assessments are based on the best available information at the time. Factors such as market liquidity, the widening of bid/ask spreads and a change in cash flow assumptions can contribute to future price volatility. If actual experience differs negatively from the assumptions and other considerations used in the consolidated financial statements, unrealised losses currently in equity may be recognised in the income statement in future periods. The preceding note in this section provides explanation on how fair value is determined when the markets for the financial investments are not active. Further, additional details on the impairments of the available-for-sale securities of Jackson are described in notes D3 and G5.
ii Assets held at amortised cost Financial assets classified as loans and receivables under IAS 39 are carried at amortised cost using the effective interest rate method. Certain mortgage loans of the UK insurance operations have been designated at fair value through profit and loss as this loan portfolio is managed and evaluated on a fair value basis and these are included within loans in the balance sheet. The loans and receivables include loans collateralised by mortgages, deposits and loans to policyholders. In estimating future cash flows, the Group looks at the expected cash flows of the assets and applies historical loss experience of assets with similar credit risks that has been adjusted for conditions in the historical loss experience which no longer exist or for conditions that are expected to arise. The estimated future cash flows are discounted using the financial asset’s original or variable effective interest rate and exclude credit losses that have not yet been incurred. The risks inherent in reviewing the impairment of any investment include: the risk that market results may differ from expectations, facts and circumstances may change in the future and differ from estimates and assumptions, or the Group may later decide to sell the asset as a result of changed circumstances.
Accordingly, insurers must perform a product classification exercise across their portfolio of contracts issued to determine the allocation to these various categories. IFRS 4 permits the continued usage of previously applied GAAP for insurance contracts and investment contracts with discretionary participating features. Except for UK regulated with-profits funds, as described subsequently in section A4(b), this basis has been applied by the Group. For investment contracts that do not contain discretionary participating features, IAS 39 and, where the contract includes an investment management element, IAS 18,’Revenue’, apply measurement principles to assets and liabilities attaching to the contract.
Variable annuity contracts written by Jackson may provide for guaranteed minimum death, income, or withdrawal benefit features. In general terms, liabilities for these benefits are accounted for under US GAAP by using estimates of future benefits and fees under best estimate assumptions. For variable annuity business the key assumption is the investment return from the separate accounts, which for all years included was 8.4 per cent per annum (after deduction of external fund management fees) determined using a mean reversion methodology. Under the mean reversion methodology, projected returns over the next five years are flexed (subject to capping) so that, combined with the actual rates of return for the current and the previous two years the 8.4 per cent rate is maintained. The projected rates of return are capped at no more than 15 per cent for each of the next five years. Further details are explained in note D3(g). These returns affect the level of future expected profits through their effects on the fee income with consequential impact on the amortisation of deferred acquisition costs as described below and the required level of provision for guaranteed minimum death benefit claims. For traditional life insurance contracts, provisions for future policy benefits are determined using the net level premium method and assumptions as of the issue date as to mortality, interest, policy lapses and expenses plus provisions for adverse deviation. Except to the extent of mortality experience, which primarily affects profits through variations in claim payments and the guaranteed minimum death benefit reserves, the profits of Jackson are relatively insensitive to changes in insurance risk. This reflects the principally spread and fee-based nature of Jackson’s business.
Deferred acquisition costs Significant costs are incurred in connection with acquiring new insurance business. Except for acquisition costs of with-profits contracts of the UK regulated with-profits funds, which are accounted for under the realistic FSA regimes as described in note A4, these costs are accounted for in a way that is consistent with the principles of the ABI SORP with deferral and amortisation against margins in future revenues on the related insurance policies. In general, this deferral is presentationally shown by an explicit carrying value for deferred acquisition costs (DAC) in the balance sheet. However, in some Asian operations the deferral is implicit through the reserving methodology. The recoverability of the explicitly and implicitly deferred acquisition costs is measured and are deemed impaired if the projected margins are less than the carrying value. To the extent that the future margins differ from those anticipated, then an adjustment to the carrying value will be necessary. The deferral and amortisation of acquisition costs is of most relevance to the Group’s results for shareholder-financed long-term business of Jackson and Asian operations. The majority of the UK shareholder-backed business is individual and group annuity business where the incidence of acquisition costs is negligible.
Pensions The Group applies the requirements of IAS 19, ‘Employee benefits’ and associated interpretations including IFRIC 14 ’IAS 19 – The Limit on a Defined Benefit Asset, Minimum Funding Requirements and their Interaction’, to its defined benefit pension schemes. The principal defined benefit pension scheme is the Prudential Staff Pension Scheme (PSPS). For PSPS the terms of the trust deed restrict shareholders’ access to any underlying surplus. Accordingly, applying the interpretation of IFRIC 14, any underlying IAS 19 basis surplus is not recognised for IFRS reporting. The financial position for PSPS recorded in the IFRS financial statements reflects the higher of any underlying IAS 19 deficit and any obligation for deficit funding. The economic participation in the surplus or deficits attaching to the PSPS and the smaller Scottish Amicable Pensions Scheme (SAPS) are shared between the PAC with-profits sub-fund (WPSF) and shareholder operations. The economic interest reflects the source of contributions over the scheme life, which in turn reflects the activity of the members during their employment. In the case of PSPS, movements in the apportionment of the financial position for PSPS between the WPSF and shareholders’ funds in 2011 reflect the 70/30 ratio applied to the base deficit position as at 31 December 2005 but with service cost and contributions for ongoing service apportioned by reference to the cost allocation for activity of current employees. For SAPS the ratio is estimated to be approximately 50/50 between the WPSF and shareholders’ funds. Due to the inclusion of actuarial gains and losses in the income statement rather than being recognised in other comprehensive income, the results of the Group are affected by changes in interest rates for corporate bonds that affect the rate applied to discount projected pension payments, changes in mortality assumptions and changes in inflation assumptions.
Goodwill Goodwill impairment testing requires the exercise of judgement by management as to prospective future cash flows. Further information is disclosed in note H1.
For the Group’s continuing operations, hedge accounting under IAS 39 is not usually applied. The exceptions, where hedge accounting has been applied in 2011 and 2010, are summarised in note G3. Where the hedge relationship has been de-designated and re-designated, the fair value adjustment to the hedged item up to the point of de-designation continues to be reported as part of the basis of the hedged item and is amortised to the income statement based on a recalculated effective interest rate over the residual period to the first break clause date of the perpetual subordinated capital securities. For UK with-profits funds the derivative programme is undertaken as part of the efficient management of the portfolio as a whole. As noted in note D2 value movements on the with-profits funds investments are reflected in changes in asset-share liabilities to policyholders or the liability for unallocated surplus. Shareholders’ profit and equity are not affected directly by value movements on the derivatives held.
For shareholder-backed UK annuity business the derivatives are held to contribute to the matching as far as practical, of asset returns and duration with those of liabilities to policyholders. The carrying value of these liabilities is sensitive to the return on the matching financial assets including derivatives held. Except for the extent of minor mismatching, value movements on derivatives held for this purpose do not affect shareholders’ profit or equity. For Jackson an extensive derivative programme is maintained. Value movements on the derivatives held can be very significant in their effect on shareholder results. The Group has chosen generally not to seek to construct the Jackson derivative programme so as to facilitate hedge accounting where theoretically possible, under IAS 39. Further details on this aspect of the Group’s financial reporting are described in note A3.
Other insurance contracts (ie contracts which contain significant insurance risk as defined under IFRS 4) For these contracts UK GAAP has been applied, which reflects the MSB. Under this basis the following approach applies: i Other UK insurance contracts Other UK insurance contracts that contain significant insurance risk include unit-linked, annuity and other non-profit business. For the purposes of local regulations, segregated accounts are established for linked business for which policyholder benefits are wholly or partly determined by reference to specific investments or to an investment-related index. The interest rates used in establishing policyholder benefit provisions for pension annuities in the course of payment are adjusted each year. Mortality rates used in establishing policyholder benefits are based on published mortality tables adjusted to reflect actual experience.
ii Overseas subsidiaries The assets and liabilities of insurance contracts of overseas subsidiaries are determined initially using local GAAP bases of accounting with subsequent adjustments where necessary to comply with the Group’s accounting policies.
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 the locked in assumptions 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 statement of financial position 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 separate account returns, which for 2011 and 2010 was 8.4 per cent. The impact of using this return is reflected in two principal ways, namely: i Through the projected expected gross profits which are used to determine the amortisation of deferred acquisition costs. This is applied through the use of a mean reversion technique which is described in more detail in note D3; and ii The required level of provision for guaranteed minimum death benefit claims.
Jackson accounts for the majority of its investment portfolio on an available-for-sale basis (see investment policies above) whereby unrealised gains and losses are recognised in other comprehensive income. As permitted by IFRS 4, Jackson has used shadow accounting. Under shadow accounting, to the extent that recognition of unrealised gains or losses on available-for-sale securities causes adjustments to the carrying value and amortisation patterns of DAC and deferred income, these adjustments are recognised in other comprehensive income to be consistent with the treatment of the gains or losses on the securities. More precisely, shadow DAC adjustments reflect the change in DAC that would have arisen if the assets held in the statement of financial position had been sold, crystallising unrealised gains or losses, and the proceeds reinvested at the yields currently available in the market.
Reinsurance In the normal course of business, the Group seeks to reduce loss exposure by reinsuring certain levels of risk in various areas of exposure with other insurance companies or reinsurers. An asset or liability is recognised in the consolidated statement of financial position representing premiums due to, or payments due from reinsurers and the share of benefits and claims recoverable from reinsurers. The measurement of reinsurance assets is consistent with the measurement of the underlying direct insurance contracts. The treatment of any gains or losses arising on the purchase of reinsurance contracts is dependent on the underlying accounting basis of the entity concerned amongst other things.
The Group has consolidated special purpose entities (SPEs), such as funds holding collateralised debt obligations (CDOs), where evaluation of the substance of the relationship between the SPE and the Group indicates that the Group is deemed to control the SPE under IFRS. The Group holds investments in internally and externally managed open-ended investment companies (OEICs) and unit trusts. These are consolidated where the Group’s percentage ownership level is 50 per cent or greater. The Group’s percentage ownership levels in these entities can fluctuate from day to day according to changes in the Group’s and third-party participation in the funds. In instances where the Group’s ownership of internally managed funds declines marginally below 50 per cent and, based on historical analysis and future expectations the decline in ownership is expected to be temporary, the funds continue to be consolidated as subsidiaries under IAS 27, ‘Consolidated and Separate Financial Statements’. 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 including any goodwill and intangibles arising upon initial acquisition. 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 as permitted by IAS 28, ‘Investments in Associates’, are carried at fair value through profit and loss. The Group’s investments in joint ventures are recognised using proportional consolidation whereby the Group’s share of an entity’s individual balances are combined line-by-line with similar items into the Group financial statements.
Share-based payments The Group offers share award and option plans for certain key employees and a Save As You Earn (SAYE) plan for all UK and certain overseas employees. The arrangements for distribution to employees of shares held in trust relating to share award plans and for entitlement to dividends depend upon the particular terms of each plan. Shares held in trust relating to these plans are conditionally gifted to employees. The compensation expense charged to the income statement is primarily based upon the fair value of the options granted, the vesting period and the vesting conditions. Vesting conditions exclude the ability of an employee to voluntarily exit a scheme and such exits are treated as an acceleration of vesting and hence a shortening of the period over which the expense is charged. The Group revises its estimate of the number of options likely to be exercised at each statement of financial position date and adjusts the charge to the income statement accordingly. Where the share-based payment depends upon vesting outcomes attaching to market-based performance conditions, additional modelling is performed to estimate the fair value of the awards. No subsequent adjustment is then made to the fair value charge for awards that do not vest on account of these performance conditions not being met. The Company has established trusts to facilitate the delivery of Prudential plc shares under employee incentive plans and savings-related share option schemes. None of the trusts that hold shares for employee incentive and savings plans continue to hold these shares once they are issued to employees. The cost to the Company of acquiring these treasury shares held in trusts is shown as a deduction from shareholders’ equity.
Tax The Group’s UK subsidiaries each file separate tax returns. Jackson and other foreign subsidiaries, where permitted, file consolidated income tax returns. In accordance with UK tax legislation, where one domestic UK company is a 75 per cent owned subsidiary of another UK company or both are 75 per cent owned subsidiaries of a common parent, the companies are considered to be within the same UK tax group. For companies within the same tax group, trading profits and losses arising in the same accounting period may be offset for purposes of determining current and deferred taxes. Current tax expense is charged or credited to operations based upon amounts estimated to be payable or recoverable as a result of taxable operations for the current year. To the extent that losses of an individual UK company are not offset in any one year, they can be carried back for one year or carried forward indefinitely to be offset against profits arising from the same company. 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 statement of financial position 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 more likely than not, that future taxable profits will be available against which these losses can be utilised. Deferred tax related to charges or credits taken to other comprehensive income is also credited or charged to other comprehensive income and is subsequently recognised in the income statement together with the deferred gain or loss. The tax charge for long-term business includes tax expense on with-profits funds attributable to both the policyholders and the shareholders. Different tax rules apply under UK law depending upon whether the business is life insurance or pension business. Tax on the life insurance business is based on investment returns less expenses attributable to that business. Tax on the pension business is based on the shareholders’ profits or losses attributable to that business. 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. Deferred tax is measured at the tax rates that are expected to apply to the period when the asset is realised or the liability settled, based on tax rates (and laws) that have been enacted or are substantively enacted at the end of the reporting period.
Basis of presentation of tax charges Tax charges in the income statement reflect the aggregate of the shareholder tax on the long-term business result and on the Group’s other results. Under UK Listing Authority rules, profit before tax is required to be presented. This requirement, coupled with the fact that IFRS does not contemplate tax charges which are attributable to policyholders and unallocated surplus of with-profits funds and unit-linked policies, necessitates the reporting of total tax charges within the presented results. The result before all taxes (ie ‘profit before tax’ as shown in the income statement) represents income net of post-tax transfers to unallocated surplus of with-profits funds, before tax attributable to policyholders and unallocated surplus of with-profits funds, unit-linked policies and shareholders. Separately within the income statement, ‘profit before tax attributable to shareholders’ is shown after deduction of taxes attributable to policyholders and unallocated surplus of with-profits funds and unit-linked policies. Tax charges on this measure of profit reflect the tax charges attributable to shareholders. In determining the tax charges attributable to shareholders, the Group has applied a methodology consistent with that previously applied under UK GAAP reflecting the broad principles underlying the tax legislation of life assurance companies.
Business acquisitions and disposals Business acquisitions are accounted for by applying the purchase method of accounting, which adjusts the net assets of the acquired company to fair value at the date of purchase. The excess of the acquisition consideration over the fair value of the assets and liabilities of the acquired entity is recorded as goodwill. Expenses related to acquiring new subsidiaries are expensed in the period in which they are incurred. Should the fair value of the identifiable assets and liabilities of the entity exceed the acquisition consideration then this amount is recognised immediately in the income statement. Income and expenses of acquired entities are included in the income statement from the date of acquisition. Income and expenses of entities sold during the period are included in the income statement up to the date of disposal. The gain or loss on disposal is calculated as the difference between sale proceeds, net of selling costs, less the net assets of the entity at the date of disposal. For life insurance company acquisitions, the adjusted net assets include an identifiable intangible asset for the present value of in-force business which represents the profits that are expected to emerge from the acquired insurance business. The present value of in-force business is calculated using best estimate actuarial assumptions for interest, mortality, persistency and expenses and is amortised over the anticipated lives of the related contracts in the portfolio. The net carrying amount of insurance liabilities acquired less the value of in-force business, represents the fair value of the insurance liabilities acquired. An intangible asset may also be recognised in respect of acquired investment management contracts representing the fair value of contractual rights acquired under these contracts.
Segments Under IFRS 8, ‘Operating Segments’, the Group determines and presents operating segments based on the information that is internally provided to the Group Executive Committee (GEC), which is the Group’s chief operating decision maker. An operating segment is a component of the Group that engages in business activities from which it may earn revenues and incur expenses, including revenues and expenses that relate to transactions with any of the Group’s other components. An operating segment’s operating results are reviewed regularly by the GEC to make decisions about resources to be allocated to the segment and assess its performance, and for which discrete financial information is available. The operating segments identified by the Group reflect the Group’s organisational structure, which is by both geography (Asia, US and UK) and by product line (insurance operations and asset management). Insurance operations principally comprise of products that contain both significant and insignificant elements of insurance risk. The products are managed together and there is no distinction between these two categories other than for accounting purposes. This segment also includes the commission earned on general insurance business and investment subsidiaries held to support the Group’s insurance operations. Asset management comprises both internal and third-party asset management services, inclusive of portfolio and mutual fund management, where the Group acts as an advisor, and broker-dealer activities. The nature of the products and the managing of the business differ from the risks inherent in the insurance operations segments, and the regulatory environment of the asset management industry differs from that of the insurance operations segments. The Group’s operating segments determined in accordance with IFRS 8, are as follows: Insurance operations • Asia • US (Jackson) • UK
The Group’s operating segments are also its reportable segments with the exception of Prudential Capital which has been incorporated into the M&G operating segment for the purposes of segment reporting. The performance measure of operating segments utilised by the Company is IFRS operating profit attributable to shareholders based on longer-term investment returns. This measure excludes the recurrent items of short-term fluctuations in investment returns and the shareholders’ share of actuarial and other gains and losses on defined benefit pension schemes. In addition for 2010 this measure excluded costs associated with the terminated AIA transaction and gain arising upon the dilution of the Group’s holding in PruHealth. Operating earnings per share is based on operating profit based on longer-term investment returns, after tax and non-controlling interests. Further details on the determination of the performance measure of operating profit based on longer-term investment returns is provided below in note A4 (d). Segment results that are reported to the Group Executive Committee include items directly attributable to a segment as well as those that can be allocated on a reasonable basis. Unallocated items are mainly in relation to the Group Head Office and the Asian Regional Head Office.
• Assets backing unit-linked and US variable annuity business separate account liabilities. For such business, the policyholder unit liabilities are directly reflective of the asset value movements. Accordingly, the operating results based on longer-term investment returns reflect the current period value movements in unit liabilities and the backing assets.
In the case of other shareholder-financed business, the measurement of operating profit based on longer-term investment returns 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 of life businesses exclusive of the effects of short-term fluctuations in market conditions. In determining the profit on this basis, the following key elements are applied to the results of the Group’s shareholder-financed operations as reflected in the segment results shown in note B1.
i Debt and equity-type securities Longer-term investment returns for both debt and equity-type securities comprise longer-term actual income receivable for the period (interest/dividend income) and longer-term capital returns. In principle, for debt securities, the longer-term capital returns comprise two elements. The first element is a risk margin reserve (RMR) based charge for the expected level of defaults for the period, which is determined by reference to the credit quality of the portfolio. The difference between impairment losses in the reporting period and the RMR charge to the operating result is reflected in short-term fluctuations in investment returns. The second element is for the amortisation of interest-related realised gains and losses to operating results based on longer-term investment returns to the date when sold bonds would have otherwise matured. The shareholder-backed operation for which the distinction between impairment losses and interest-related realised gains and losses is in practice relevant to a significant extent is Jackson. Jackson has used the ratings by Nationally Recognised Statistical Ratings Organisations (NRSRO) or ratings resulting from the regulatory ratings detail issued by the National Association of Insurance Commissioners (NAIC) developed by external third parties such as PIMCO or Black Rock Solutions to determine the average annual RMR. Further details of the RMR charge, as well as the amortisation of interest related realised gains and losses, for Jackson are shown in note B1(iv) of the financial statements.
For debt securities backing non-linked shareholder-financed business of the UK insurance operations (other than the annuity business) and of the Asian insurance operations, the realised gains and losses are principally interest related. Accordingly, all realised gains and losses to date for these operations are being amortised over the period to the date those securities would otherwise have matured, with no explicit RMR charge. At 31 December 2011 the level of unamortised interest-related realised gains and losses related to previously sold bonds for the Group was a net gain of £462 million (31 December 2010: £373 million).
For equity-type securities, the longer-term rates of return are estimates of the long-term trend investment return for income and capital having regard to past performance, current trends and future expectations. Equity-type securities held for shareholder-financed operations other than the UK annuity business, unit-linked and US variable annuity are of significance for the US and Asian insurance operations. Different rates apply to different categories of equity-type securities. As at 31 December 2011, the equity-type securities for US insurance non-separate account operations amounted to £902 million (31 December 2010: £852 million). For these operations, the longer term rates of return for income and capital applied in 2011 ranged from 5.9 per cent to 7.5 per cent for equity-type securities such as common and preferred stock and portfolio holdings in mutual funds and from 7.9 per cent to 9.5 per cent for certain other equity-type securities such as investments in limited partnerships and private equity funds (2010: 6.5 per cent to 7.9 per cent and 8.5 per cent to 9.9 per cent, respectively). For Asian insurance operations, investments in equity securities held for non-linked shareholder-financed operations amounted to £590 million as at 31 December 2011 (31 December 2010: £506 million). Of this balance, £88 million (31 December 2010: £101 million) related to the Group’s 7.37 per cent (31 December 2010: 8.66 per cent) stake in China Life Insurance Company of Taiwan. This £88 million (31 December 2010: £101 million) investment is in the nature of a trade investment for which the determination of longer-term investment returns is on the basis as described in note (e) below. For the investments representing the other equity securities which had year end balances of £502 million (31 December 2010: £405 million), the rates of return applied in the years 2011 and 2010 ranged from 1.7 per cent to 13.8 per cent with the rates applied varying by territory. The longer-term rates of return discussed above for equity-type securities are determined after consideration by the Group’s in-house economists of long-term expected real government bond returns, equity risk premium and long-term inflation. These rates are broadly stable from period to period but may be different between countries, reflecting, for example, differing expectations of inflation in each territory. The assumptions are for returns expected to apply in equilibrium conditions. The assumed rates of return do not reflect any cyclical variability in economic performance and are not set by reference to prevailing asset valuations.
Note: US operations – Embedded derivatives for variable annuity guarantee features
Examples where such bifurcation is necessary are: a Asia i Vietnamese participating business For the participating business in Vietnam the liabilities include policyholders’ interest in investment appreciation and other surplus. Bonuses paid in a reporting period and accrued policyholders’ interest in investment appreciation and other surpluses primarily reflect the level of realised investment gains above contract specific hurdle levels. For this business, operating profit based on longer-term investment returns includes the aggregate of longer-term returns on the relevant investments, a credit or charge equal to movements on the liability for the policyholders’ interest in realised investment gains (net of any recovery of prior deficits on the participating pool), less amortisation over five years of current and prior movements on such credits or charges. The overall purpose of these adjustments is to ensure that investment returns included in operating results equal longer-term returns but that in any one reporting period movements on liabilities to policyholders caused by investment returns are substantially matched in the presentation of the supplementary analysis of profit before tax attributable to policyholders.
ii 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 FASB ASC subtopic 944-80, Financial Services – Insurance – Separate Accounts (formerly SOP 03-1), which partially reflects changes in market conditions. Under the company’s segmental 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 UK shareholder-backed annuity business With one exception, the operating result based on longer-term investment returns reflects the impact of all value movements on policyholder liabilities for annuity business in PRIL and the PAC non-profit sub-fund. The exception is for the impact on credit risk provisioning of actual downgrades during the period. As this feature arises due to short-term market conditions, the effect of downgrades, if any, in a particular period, on the overall provisions for credit risk is included in the category of short-term fluctuations in investment returns. The effects of other changes to credit risk provisioning are included in the operating result, as is the net effect of changes to the valuation rate of interest due to portfolio rebalancing to align more closely with the Group’s internal benchmark.
v Fund management and other non-insurance businesses For these businesses 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. For this purpose impairments are calculated as the credit loss determined by comparing the projected cash flows discounted at the original effective interest rate to the carrying value. 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 economic substance of the arrangements.
The following standards, interpretations and amendments have either been adopted for the first time in 2011 or have been issued but are not yet effective in 2011, including those which have not yet been adopted in the EU. This is not intended to be a complete list as only those standards, interpretations and amendments that could have an impact upon the Group’s financial statements have been discussed. The accounting policies applied by the Group in determining the IFRS basis results in this report are the same as those previously applied in the Group’s consolidated financial statements for the year ended 31 December 2010, except for the adoption of the new accounting pronouncements in 2011 as described below.
Amendment to IFRIC 14, ‘Prepayment of a minimum funding requirement’ This amendment removes an unintended consequence of IFRIC 14 relating to voluntary pension pre-payments when there is a minimum funding requirement. IFRIC 14 was amended to require an asset to be recognised for any surplus arising from voluntary pre-payment of minimum funding contributions in respect of future service. The adoption of this amendment did not have an impact on the Group’s financial statements.
Profit after tax and non controlling interests 1,490 (75) 1,415 1,431 (125) 1,306 Shareholders’ equity 9,117 (553) 8,564 8,031 (510) 7,521
For further information, please refer to note D3(g) and the additional unaudited financial information note III(a).
d Accounting pronouncements not yet endorsed by the EU The following accounting pronouncements potentially relevant to the Group have been issued but not yet endorsed for use in the EU.
Standards on consolidation, joint arrangements and disclosures: IFRS 10, ‘Consolidated financial statements’, IFRS 11, ‘Joint arrangements’, IFRS 12, ‘Disclosure of interests in other entities’, IAS 27, ‘Consolidated and separate financial statements’, and IAS 28, ‘Investments in associates and joint ventures’ In May 2011, the IASB issued a package of five new standards as listed above to address the scope of the consolidation reporting standards. IFRS 10 replaces all of the guidance on control and consolidation in IAS 27 and SIC 12, ‘Consolidation – Special purpose entities’. IAS 27 was amended to deal only with requirements on separate financial statements, which have been carried forward largely unchanged. IFRS 10 provides a single consolidation model. The key changes include revised definition of control so that the same criteria which focus on the need to have both power and variable returns are applied to all entities. The remaining standards of IFRS 11, IFRS 12 and consequential amendments to IAS 28 include replacement of the previous guidance on interests in joint ventures and on the disclosure requirements. IFRS 11 includes a new definition of joint ventures and unlike the previous guidance, proportionate consolidation is no longer permitted for joint ventures. IFRS 12 sets out the disclosure requirements for subsidiaries, joint ventures, associates and unconsolidated structured entities. These standards are effective for annual periods beginning on or after 1 January 2013. Early application is permitted; though entities must adopt all five standards in the package. IFRS 10 excludes guidance specifically for investment entities, as the IASB continues to work on this with an exposure draft issued on 25 August 2011. The Group’s investments in joint ventures are currently recognised using proportional consolidation. With the application of IFRS 11, the Group’s investments in joint ventures will be accounted for on a single line equity method. This is a presentational change and is not expected to have an impact on the Group’s results and financial position. The Group is still assessing the full impact of this standard in particular on the Group’s consolidated investment funds (including OEICs and unit trusts).
IFRS 13, ‘Fair value measurements’ IFRS 13 creates a uniform framework to explain how to measure fair value and aims to enhance fair value disclosures, but it does not change when to measure fair value or require additional fair value measurements. The standard requires additional disclosure on the fair value of non-financial assets and liabilities and enhanced disclosure for recurring Level 3 fair value measurements. IFRS 13 is effective for prospective application on 1 January 2013. The Group is still assessing the full impact of this standard, but these amendments are not expected to have a material effect on the Group’s financial statements.
Amendments to IAS 1, ‘Presentation of financial statements’ This amendment changes the requirement for the disclosure of items presented in other comprehensive income, requiring items to be presented separately based on whether or not they may be recycled to profit or loss in the future. The amendment is effective from 1 January 2013. The Group is still assessing the full impact of these amendments but is expecting the amendments to be presentational with no significant impact on the Group’s results and financial position.
Asian operations Insurance operations notes (i),(ii) 709 536 Development expenses (5) (4)
Total Asian insurance operations after development expenses 704 532 Eastspring Investments 80 72
US operations Jackson (US insurance operations) notes (i),(ii),(iii) 694 833 Broker-dealer and asset management 24 22
RPI to CPI inflation measure change on defined benefit pension schemes note (vi) 42 – Solvency II implementation costs (55) (45) Restructuring costs note (vii) (16) (26)
Operating profit based on longer-term investment returns 2,070 1,941 Short-term fluctuations in investment returns on shareholder-backed business note (viii) (148) (123) Shareholders’ share of actuarial and other gains and losses on defined benefit pension schemes note (ix) 21 (10) Costs of terminated AIA transaction note (x) – (377) Gain on dilution of Group holdings I2 – 30
Notes (i) Operating profit based on longer-term investment returns. The Group provides supplementary analysis of IFRS profit before tax attributable to shareholders so as to distinguish operating profit based on longer-term investment returns from other elements of total profit. Operating profit based on longer-term investment returns is the basis on which management regularly reviews the performance of Prudential’s segments as defined by IFRS 8. Further discussion on the determination of operating profit based on longer-term investment returns is provided in note A4(d).
(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 to assumptions, estimates and bases of preparation. These are described in notes D2(i), D3(i) and D4(i). (iii) Jackson operating results based on longer-term investment returns. IFRS basis operating profits for US operations include the following amounts (net of related change in amortisation of deferred acquisition costs, where applicable) so as to derive longer-term investment returns.
Debt securities: Amortisation of interest related realised gains and losses 64 63 Risk margin reserve charge for longer-term credit related losses (see (iv) below) (53) (55) Equity type investments: Longer-term returns 51 51
(iv) The risk margin reserve (RMR) charge for longer-term credit related losses included in operating profit based on longer-term investment returns of Jackson for 2011 is based on an average annual RMR of 25 basis points (2010: 26 basis points) on average book values of US$44.4 billion (2010: $44.2 billion) as shown below: Moody’s rating category (or equivalent under NAIC ratings of MBS)
Risk margin reserve charge to operating profit for longer-term credit related losses (85) (53) (85) (55)
Consistent with the basis of measurement of insurance assets and liabilities for Jackson’s IFRS results, the charges and credits to operating profits based on longer-term investment returns are partially offset by related changes to amortisation of deferred acquisition costs.
(v) UK operations transferred its general insurance business to Churchill in 2002, with general insurance commission representing the commission received net of expenses for Prudential-branded general insurance products as part of this arrangement.
(vi) During 2011 the Group altered its inflation measure basis for future statutory increases to pension payments for certain tranches of its UK defined benefit pension schemes. This reflects the UK Government’s decision to replace the basis of indexation from Retail Prices Index (RPI) with Consumer Prices Index (CPI). This resulted in a credit to the operating profit before tax of £42 million.
Asian insurance operations The short-term fluctuations for Asian insurance operations of negative £92 million (2010: positive £114 million) in part reflects equity market falls in Taiwan and a partial reversal of unrealised gains recognised in prior years on the Group’s 7.37 per cent (2010: 8.66 per cent) stake in China Life Insurance Company of Taiwan.
Residential mortgage-backed securities: Total residential mortgage-backed securities – (21) (12) 7 (26) (123)
(c) The amount of £632 million in 2011 (2010: £365 million) relates to the net equity hedge accounting effect of the equity-based derivatives and associated guarantee liabilities of Jackson’s variable and fixed index annuity business. The details of the value movements excluded from operating profit based on longer-term investment returns are as described in note A4(d)(iii). The principal movements are for (i) value for free-standing and GMWB ‘not for life’ embedded derivatives, (ii) accounting values for GMDB and GMWB ‘for life’ guarantees and (iii) related changes to DAC amortisation. These movements include the effect of lower interest rates which were particularly significant in 2011. The value movements on derivatives held to manage this and other interest rate exposure are included in the £472 million (2010: loss of £15 million) described above in note (b).
(ix) Shareholders’ share of actuarial and other gains and losses on defined benefit pension schemes
Actuarial gains and losses Actual less expected return on scheme assets 9 31 Experience gains (losses) on scheme liabilities 19 (5) Gains (losses) on changes of assumptions for scheme liabilities 12 (41)
Based on operating profit based on longer-term investment return 2,070 (448) (4) 1,618 63.9p 63.8p
Short-term fluctuations in investment returns on shareholder-backed business (148) 4 – (144) (5.7)p (5.7)p
Shareholders’ share of actuarial and other gains and losses on defined benefit pension schemes 21 (5) – 16 0.6p 0.6p
Based on profit for the year 1,943 (449) (4) 1,490 58.8p 58.7p
Based on operating profit based on longer-term investment return 1,941 (213) (5) 1,723 68.3p 68.2p
Short-term fluctuations in investment returns on shareholder-backed business (123) 92 – (31) (1.2)p (1.2)p
Shareholders’ share of actuarial and other gains and losses on defined benefit pension schemes (10) 3 – (7) (0.3)p (0.3)p
Based on profit for the year including exceptional tax credit 1,461 (25) (5) 1,431 56.7p 56.6p * The tax charge attributable to shareholders’ return included an exceptional tax credit of £158 million which primarily related to the impact of a settlement agreed with the UK tax authorities.
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 2,533 2,524 Shares under option at end of year 13 13 Number of shares that would have been issued at fair value on assumed option exercise (8) (8)
Weighted average shares for calculation of diluted earnings per share 2,538 2,529
Dividends declared and paid in reporting period Parent company: Interim dividend (2011: 7.95p; 2010: 6.61p) 203 168 Final/second interim dividend for prior period (2011: 17.24p; 2010: 13.56p) 439 343
Dividends paid in cash, as set in the consolidated statement of cash flows for 2011 were £642 million. As a result of shares issued in lieu of dividends of £62 million in 2010 dividends paid in cash, were £449 million in 2010.The scrip dividend alternative was replaced by the Dividend Re-investment Plan from the 2010 final dividend.
Parent company dividends relating to reporting period: Dividend per share Interim dividends are recorded in the period in which they are paid. Final dividends are recorded in the period in which they are approved by shareholders. The final dividend for the year ended 31 December 2010 of 17.24 pence per ordinary share was paid to eligible shareholders on 26 May 2011 and the 2011 interim dividend of 7.95 pence per ordinary share was paid to eligible shareholders on 22 September 2011. The 2011 final dividend of 17.24 pence per ordinary share will be paid on 24 May 2012 in sterling to shareholders on the principal register and the Irish branch register at 6.00 pm BST on Friday, 30 March 2012 (the ‘Record Date’), and in Hong Kong dollars to shareholders on the Hong Kong branch register at 4.30 pm Hong Kong time on the Record Date (HK Shareholders). Holders of US American Depositary Receipts (US Shareholders) will be paid their dividends in US dollars on or about five days after the payment date of the dividend to shareholders on the principal register. The final dividend will be paid on or about 31 May 2012 in Singapore dollars to shareholders with shares standing to the credit of their securities accounts with The Central Depository (Pte.) Limited (CDP) at 5.00 pm Singapore time on the Record Date (SG Shareholders). The dividend payable to the HK Shareholders will be translated using the exchange rate quoted by the WM Company at the close of business on 12 March 2012. The exchange rate at which the dividend payable to the SG Shareholders will be translated into SG$ will be determined by CDP. The dividend will distribute an estimated £439 million of shareholders’ funds. In line with 2010, shareholders on the principal register and Irish branch register will be able to participate in a Dividend Reinvestment Plan.
To explain more comprehensively the assets, liabilities and capital of the Group’s businesses, it is appropriate to provide analyses of the Group’s statement of financial position by operating segment and type of business. The tables below aggregate the three asset management segments for ease of presentation and hence should be read in conjunction with the associated tables on asset management in note E2.
Properties held for sale H9 – 3 – 3 – – – 3 Cash and cash equivalents H10 2,965 271 1,977 5,213 1,735 309 – 7,257
Liabilities Policyholder liabilities and unallocated surplus of with-profits funds: Insurance contract liabilitiesH12 82,732 67,278 30,353 180,363 – – – 180,363 Investment contract liabilities with discretionary participation featuresG1 29,348 – 397 29,745 – – – 29,745 Investment contract liabilities without discretionary participation featuresG1 14,944 1,911 112 16,967 – – – 16,967 Unallocated surplus of with-profits funds (reflecting application of ‘realistic’
basis provisions for UK regulated with-profits funds)D2, H12 9,165 – 50 9,215 – – – 9,215
Operational borrowings attributable to shareholder-financed operationsG1,H13 103 127 141 371 13 2,956 – 3,340
Borrowings attributable to with-profits operations 972 – – 972 – – – 972 Other non-insurance liabilities:G1,H13 Obligations under funding, securities lending and sale and repurchase agreementsG1 1,945 1,169 – 3,114 – – – 3,114 Net asset value attributable to unit holders of consolidated unit trusts and similar fundsG1 2,043 18 1,101 3,162 678 – – 3,840 Deferred tax liabilitiesH4 1,349 2,093 513 3,955 5 251 – 4,211 Current tax liabilitiesH4 553 – 116 669 106 155 – 930 Accruals and deferred income 321 – 103 424 290 22 – 736 Other creditorsG1 2,829 548 660 4,037 4,493 245 (6,231) 2,544 ProvisionsH14 266 13 47 326 133 70 – 529 Derivative liabilitiesG1,G3 1,298 887 480 2,665 182 207 – 3,054 Other liabilitiesG1,H15 209 379 590 1,178 31 40 – 1,249
Liabilities Policyholder liabilities and unallocated surplus of with-profits funds: Insurance contract liabilitiesH12 84,152 58,641 28,498 171,291 – – – 171,291 Investment contract liabilities with discretionary participation featuresG1 25,613 – 119 25,732 – – – 25,732 Investment contract liabilities without discretionary participation featuresG1 15,765 1,882 57 17,704 – – – 17,704 Unallocated surplus of with-profits funds (reflecting application of ‘realistic’
basis provisions for UK regulated with-profits funds)D2, H12 10,187 – 66 10,253 – – – 10,253
Operational borrowings attributable to shareholder-financed operationsG1,H13 162 90 189 441 3 2,560 – 3,004
Borrowings attributable to with-profits operations 1,522 – – 1,522 – – – 1,522 Other non-insurance liabilities:G1,H13 Obligations under funding, securities lending and sale and repurchase agreements G1 2,398 1,801 – 4,199 – – – 4,199 Net asset value attributable to unit holders of consolidated unit trusts and similar fundsG1 1,755 33 1,126 2,914 458 – – 3,372 Deferred tax liabilitiesH4 1,738 1,776 495 4,009 5 210 – 4,224 Current tax liabilitiesH4 399 34 70 503 33 295 – 831 Accruals and deferred income 340 – 109 449 244 14 – 707 Other creditorsG1 1,939 511 1,122 3,572 4,039 471 (5,761) 2,321 ProvisionsH14 442 19 61 522 157 50 – 729 Derivative liabilitiesG1,G3 792 799 222 1,813 78 146 – 2,037 Other liabilitiesG1,H15 276 355 437 1,068 21 40 – 1,129
Intangible assets attributable to with-profits funds: In respect of acquired subsidiaries for venture fund and other investment purposes 178 – – – – – 178 166 Deferred acquisition costs and other
Properties held for saleH9 – – 3 – – – 3 257 Cash and cash equivalentsH10 2,564 1,245 1,404 1,735 309 – 7,257 6,631
Unallocated surplus of with-profits funds (reflecting application of ‘realistic’ basis provisions for UK regulated with-profits funds)H12 9,215 – – – – – 9,215 10,253
Total policyholder liabilities and unallocated surplus of with-profits funds 102,784 71,129 62,377 – – – 236,290 224,980
Operational borrowings attributable to shareholder- financed operationsG1,H13 – 1 370 13 2,956 – 3,340 3,004
Directly held investments, net of derivative liabilities 139,722 62,706 29,982 232,410 3,204 (5) 235,609
Directly held investments, net of derivative liabilities 140,152 70,859 31,429 242,440 3,677 (190) 245,927 * 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 of the consolidation of 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.
In the table above, with the exception of some mortgage-backed securities within Jackson, Standard & Poor’s (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. For some mortgage-backed securities within Jackson, the table above includes these securities using the regulatory ratings detail issued by the NAIC. These regulatory ratings levels were established by external third parties (PIMCO for residential mortgage-backed securities and BlackRock Solutions for commercial mortgage-backed securities). Notes D2(d), D3(d), D4(d) and E2 provide further details on the credit risks of debt securities by segment.
ii Group exposure to holdings in asset-backed securities The Group’s exposure to holdings in asset-backed securities, which comprise residential mortgage-backed securities (RMBS), commercial mortgage-backed securities (CMBS), CDO funds and other asset-backed securities (ABS), at 31 December 2011 is as follows: Shareholder-backed operations (excluding assets held in unit-linked funds): UK insurance operationsnote (i) 1,358 1,181 US insurance operationsnote (ii) 5,380 6,135 Asian insurance operationsnote (iii) 176 113 Other operations 594 437
With-profits operations: UK insurance operationsnote (i) 5,351 5,237 Asian insurance operationsnote (iii) 454 435
(i) All of the exposure of the shareholder-backed business relates to the UK market and primarily relates to investments held by PRIL. (ii) Exposure of the with-profits operations relates to exposure to: (ii) US insurance operations US insurance operations’ exposure to asset-backed securities at 31 December 2011 comprises: RMBS Sub-prime (2011: 20% AAA, 4% AA) 207 224 Alt-A (2011: 12% AAA, 4% AA) 310 415 Prime including agency (2011: 3% AAA, 76% AA) 2,074 2,145 CMBS (2011: 35% AAA, 12% AA) 2,169 2,375 CDO funds (2011: 16% AAA, 0% AA)*, including £nil million exposure to sub-prime 44 162 Other ABS (2011: 23% AAA, 17% AA), including £6.6 million exposure to sub-prime 576 814 * Including the Group’s economic interest in Piedmont and other consolidated CDO funds.
(iii) Asian insurance operations The Asian insurance operations’ exposure to asset-backed securities is primarily held by the with-profits operations. The £454 million (2010: £435 million) asset-backed securities exposure of the Asian with-profit operations comprises: CMBS 149 251 CDO funds and ABS 305 184
o f resu lts iii Sovereign debt Sovereign debt represented 16 per cent or £9.2 billion of the debt portfolio backing shareholder business at 31 December 2011. 43 per cent of this was rated AAA and 94 per cent investment grade. Of the Group’s holdings in Continental Europe of £690 million, 87 per cent was AAA rated. Shareholder exposure to the eurozone sovereigns of Portugal, Italy, Ireland, Greece and Spain (PIIGS) is £44 million. The Group does not have any sovereign debt exposure to Greece, Portugal, Ireland or France. The exposure of the Group’s shareholder and with-profits funds to sovereign debt (including credit default swaps that are referenced to sovereign debt) at 31 December 2011 is as follows: Shareholder sovereign debt £m
Continental Europe Italy 43 52 Spain 1 33 44 85 Germany 598 602 Other Europe (principally Isle of Man and Belgium) 48 62 690 749 United Kingdom 3,254 2,801 United States 2,448 2,615 Other, predominantly Asia 2,850 332
United States – 1,362 1,362 352 2 354 1,716 Other, predominantly Asia – 246 246 562 33 595 841
In addition to the exposures held by the shareholder-backed business, the Group held the following banks’ securities at 31 December 2011 within its with-profits funds.
Portugal – 7 7 – – – 7 Ireland – – – – – – – Italy – 45 45 49 2 51 96 Greece 5 – 5 – – – 5 Spain 137 – 137 1 – 1 138 142 52 194 50 2 52 246 Austria – – – – – – – Belgium – – – – – – – France – 80 80 47 17 64 144 Germany – 7 7 – – – 7 Luxembourg – 7 7 – – – 7 Netherlands – 80 80 14 28 42 122 United Kingdom 319 385 704 772 74 846 1,550
in a n cia l state m e n ts B
Net flows (3,192) 7,368 1,569 5,745 Shareholders transfers post tax (223) – (24) (247) Investment-related items and other movements 13,172 3,464 2,235 18,871 Foreign exchange translation differences (208) 1,380 2,081 3,253 Dilution of Group’s holdings (27) – – (27) Acquisition of UOB Life Assurance Limited – – 968 968
The items above represent the amount attributable to changes in policyholder liabilities and unallocated surplus of with-profits funds as a result of each of the components listed.
The policyholder liabilities shown include investment contracts without discretionary participation features (as defined in IFRS 4) and their full movement in the year. The items above are shown gross of reinsurance.
Asian operations 2,970 2,495 63,726 80,597 66,696 83,092 US operations 12,581 11,439 – – 12,581 11,439 UK operations 5,130 5,910 25,981 26,372 31,111 32,282
Insurance products – new business premiums and contributions notes (i), (ii)
Group Total 18,889 18,177 1,792 1,667 3,681 3,485 Group Total – excluding India 18,754 18,092 1,704 1,487 3,580 3,297
Asian insurance operations Hong Kong 180 107 313 276 331 287 Indonesia 250 141 338 269 363 283 Malaysia 79 58 215 198 223 204 Philippines 95 64 20 17 30 23 Singapore 371 318 198 143 235 175 Thailand 11 15 26 25 27 26 Vietnam 1 1 42 41 42 41
SE Asian operations including Hong Kong 987 704 1,152 969 1,251 1,039 Chinanote (iv) 46 103 54 48 59 58 Korea 71 66 94 89 101 96 Taiwan 217 146 126 105 148 120
Total Asian operations – excluding India note (iii) 1,321 1,019 1,426 1,211 1,559 1,313 India 135 85 88 180 101 188
(ii) Investment products referred to in the table for funds under management above are unit trust, mutual funds and similar types of retail fund management arrangements. These are unrelated to insurance products that are classified as ‘investment contracts’ under IFRS 4, as described in the preceding paragraph, although similar IFRS recognition and measurement principles apply to the acquisition costs and fees attaching to this type of business.
(iii) New business sales for the Group’s Japanese insurance subsidiary, which ceased selling new business with effect from 15 February 2010, have been excluded from the 2010 comparative.
(v) The Prudential’s European operation is based in Ireland and sells products into Jersey, Guernsey, Isle of Man, Gibraltar, Cyprus, Malta, Belgium, Spain and UK.
in a n cia l state m e n ts C : G
As a provider of financial services, including insurance, the management of risk lies at the heart of the Group’s business. The control procedures and systems established within the Group are designed to manage, rather than eliminate, the risk of failure to meet business objectives. They can only provide reasonable and not absolute assurance against material misstatement or loss, and focus on aligning the levels of risk-taking with the achievement of business objectives. The Group’s internal control processes are detailed in the Group Governance Manual. This is supported by the Group Risk Framework, which provides an overview of the Group-wide philosophy and approach to risk management. Where appropriate, more detailed policies and procedures have been developed at Group and/or business unit levels. These include Group-wide mandatory policies on certain operational risks, including health, safety, fraud, money laundering, bribery, business continuity, information security and operational security, and policies on certain financial risks. Additional guidelines are provided for some aspects of actuarial and financial activity. 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, which has established the Group Risk Committee to assist in providing leadership, direction and oversight, and with the Group Chief Executive and the chief executive of each business unit. Risk oversight is provided by Group-level risk committees, chaired by the Group Chief Risk Officer or the Chief Financial Officer. Independent assurance on the Group’s internal control and risk management systems is provided by the Group Audit Committee, supported by the Group-wide Internal Audit. The Group’s risk reporting framework forms an important part of the Group’s business processes and planning. Business units review their risks as well as opportunities as part of their business plans, and risks against business objectives are regularly discussed with Group executive management.
The Group’s risk framework includes its appetite for risk exposures as well as its approach to risk management. Under this approach, the Group continuously assesses the Group’s top risks and monitors its risk profile against approved limits. Prudential defines and monitors aggregate risk limits based on financial and non-financial stresses for its earnings volatility, liquidity and capital requirements.
The two measures used are the EU Insurance Groups Directive (IGD) capital requirements and internal economic capital requirements. In addition, capital requirements are monitored on a local statutory basis. The Group’s risk appetite framework forms an integral part of our annual business planning cycle. The Group Risk Committee is responsible for reviewing the risks inherent in the Group’s business plan and for providing the Board with input on the risk/reward trade-offs implicit therein. This review is supported by our Group Risk function, which uses submissions by business units to calculate the Group’s aggregated position (allowing for diversification effects between business units) relative to the limits contained within the risk appetite statements.
i Use of derivatives In the UK business, most of our equity exposure is incurred in the with-profits fund, which includes a large inherited estate. The inherited estate itself is partially protected against falls in equity markets through an active hedging policy.
ii Asset/liability management Prudential actively manages its assets and liabilities, testing the adequacy of its reserves and the strength of the solvency position through a combination of analysis, scenarios and stochastic modelling.
A stochastic approach models the inter-relationship between asset and liability movements, taking into account asset correlation and policyholder behaviour, under a large number of possible scenarios. These scenarios are projected forward over time and the liabilities and solvency position of the fund are calculated in each scenario in each future year. This allows the identification of which extreme scenarios will have the most adverse effects and what the best estimate outcome may be. The fund’s policy on management actions, including bonus and investment policy, is set, such that they are consistent with the available capital and the targeted risk of default. This differs from a deterministic model, which would only consider the results from one carefully selected scenario. 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. For businesses that are most sensitive to equity price changes, Prudential uses stochastic modelling and scenario testing to look at the expected future returns on its investments under different scenarios that best reflect the large diversity in returns that equities can produce. This allows Prudential to devise an investment and with-profits policyholder bonus strategy that, on the model assumptions, allows it to optimise returns to its policyholders and shareholders over time, while maintaining appropriate financial strength. Prudential uses this method extensively in connection with its UK with-profits business.
The Group publishes separately within ‘Additional Information’ of its Group Annual Report, a section on key risk factors, which discusses inherent risks in the business and trading environment.
ii Credit risk The risk of loss for our business or of adverse change in the financial position, resulting from fluctuations in the credit standing of issuers of securities, counterparties and any debtors in the form of default or other significant credit event (eg downgrade or spread widening). Some of Prudential’s businesses, in particular Jackson, the PAC with-profits fund and Prudential’s UK pension annuity business hold large amounts of investments that contain credit risk on which a certain level of default is expected. These expected losses are considered when Prudential determines the crediting rates, deposit rates and premium rates for the products that will be supported by these assets. Certain OTC derivatives contain a credit risk element that is controlled through the evaluation of collateral agreements and master netting agreements on interest rate and currency swaps. Prudential is also exposed to credit-related losses in the event of non-performance by counterparties. Further analysis of the credit quality of debt securities held by the Group is shown in note B5. 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.
For example, the assumption that Prudential makes about future expected levels of mortality is particularly relevant for its UK annuity business where, in exchange for their accumulated pension fund, pension annuity policyholders receive a guaranteed payment, for as long as they live. Prudential conducts extensive research into longevity risk using data from its substantial annuitant portfolio. As part of its pension annuity pricing and reserving policy, Prudential UK assumes that current rates of mortality continuously improve over time at levels based on adjusted data from the Continuous Mortality Investigations (CMI) projections as published by the Institute and Faculty of Actuaries. Prudential’s persistency assumptions reflect recent past experience for each relevant line of business, and any expectations of future persistency. Where appropriate, allowance is also made for the relationship, which is either assumed or historically observed, between persistency and investment returns, and for the resulting additional risk.
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 products, and is subject to a number of different legal and regulatory, including tax, regimes. Prudential also has a significant number of third-party relationships that are important to the distribution and processing of our products. This results in reliance upon the operational performance of these outsourcing partners. Prudential’s systems and processes incorporate controls that are designed to manage and mitigate the operational risks associated with its activities. Business units are required to confirm that they have implemented the necessary controls to evidence compliance with the UK Corporate Governance Code and the Hong Kong Code on Corporate Governance Practices. The Group has an operational risk management framework and policy in place that facilitates both the qualitative and quantitative analysis of operational risk exposures. The output of this framework, in particular management information on key operational risk and control assessments, scenario analysis, internal incidents and external incidents, is reported by the business units and presented to the Group Operational Risk Committee. This information also supports business decision-making and lessons-learned activities; the ongoing improvement of the control environment; determining the operational risk capital requirements; and determination of the adequacy of Prudential’s corporate insurance programme. With regard to business environment risk, the Group has a wide-ranging programme of active and constructive engagement with governments, policymakers and regulators in our key markets and with relevant international institutions. Such engagement is undertaken both directly and indirectly via trade associations. The Group has procedures in place to monitor and track political and regulatory developments. Where appropriate, the Group provides submissions and technical input to officials and others, either via submissions to formal consultations or through interactions with officials. With regard to strategic risk, both business units and Group Head Office are required to adopt a forward-looking approach to risk management when performing risk assessments and the annual strategic planning process. This supports the identification of potential threats and the initiatives needed to address them, as well as competitive opportunities. The impact on the underlying businesses and/or Group-wide risk profile is also considered to ensure that strategic initiatives are within the Group’s risk appetite. The European Union (EU) is developing a new solvency framework for insurance companies, referred to as ‘Solvency II’. The Solvency II Directive, which sets out the new framework, was formally approved by the Economic and Financial Affairs Council in November 2009, and is currently anticipated to be transposed into local regulations and to take effect for supervisors from 2013, with implementation currently anticipated from 2014. Solvency II represents a regulatory risk due to the uncertainty of what the rules will be when finalised, their potential impacts and the timing of their introduction. The risks are that the Group may not be able to respond sufficiently quickly to the strategic implication of the change given levels of uncertainty around the content and timing; operational risk in terms of the scale and complexity of the delivery and uncertainty over timelines; and the additional capital that the Company may be required to hold. Solvency II is covered in more detail in the Regulatory Capital requirements section below.
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. In addition, the Group as a whole is subject to the capital adequacy requirements of the EU IGD as implemented by the Financial Services Authority (FSA) in the UK. The IGD pertains to groups whose activities are primarily concentrated in the insurance sector. The IGD capital adequacy requirements involves aggregating surplus capital held in our regulated subsidiaries, from which Group borrowings, except those subordinated debt issues that qualify as capital, are deducted. The test is passed when this aggregate number is positive: a negative result at any point in time is a notifiable breach of UK regulatory requirements. Due to the geographically diverse nature of Prudential’s operations, the application of these requirements to Prudential is complex. In particular, for many of the Group’s Asian operations, the assets, liabilities and capital requirements have to be recalculated based on FSA regulations as if the companies were directly subject to FSA regulation.
Offset by: • investment market-related impacts of £0.6 billion, • final 2010 dividend of £0.4 billion and interim 2011 dividend of £0.2 billion, • external financing costs and other central costs, net of tax, of £0.5 billion, and • net impact of £0.1 billion arising from issuance of the $550 million perpetual subordinated Tier 1 securities in January 2011 and repayment of the ¤500 million subordinated notes in December 2011.
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 withprofits 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 Modified Statutory Basis (MSB) of reporting as set out in the ABI SORP. The insurance contracts of the Group’s shareholder-backed businesses 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
in a n cia l state m e n ts D : L
Profit and loss and shareholders’ equity are volatile for these risks as they affect the values of derivatives and embedded derivatives and impairment losses. In addition, shareholders’ equity is volatile for the incidence of these risks on unrealised appreciation of fixed income securities classified as available-for-sale under IAS 39
D1: Group overview continued ii IFRS shareholder results – Exposures for market and other risk Key Group exposures Detailed analyses of sensitivity of IFRS basis profit or loss and shareholders’ equity to key market and other risks are provided in notes D2(j), D3(j), D4(j) and E4. The sensitivity analyses provided show the effect on profit or loss and shareholders’ equity to changes in the relevant risk variables, all of which are reasonably possible at the relevant balance sheet date. In the analysis of exposure to interest rate risk, given the low interest rate environment, certain of the sensitivities to a decrease of 2 per cent include the effect of reducing the rate to near zero where rates are lower than 2 per cent. The IFRS operating profit based on longer-term investment returns for UK insurance operations has high potential sensitivity for changes to longevity assumptions affecting the carrying value of liabilities to policyholders for UK shareholder-backed annuity business. In addition, at the total IFRS profit level the result is particularly sensitive to temporary value movements on assets backing US and Asia policyholder liabilities (which in general are measured on a basis that is insensitive to current market movements) and shareholder equity. 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 second order equity-based exposure in respect of variable annuity asset management fees. Further information is given below under the US insurance operations section of market and credit risk. Jackson’s derivative programme is used to manage interest rate risk associated with a broad range of products and substantially mitigate equity market risk attaching to its equity-based products. Movements in equity markets, 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. Combined with the use of US GAAP measurement (as ‘grandfathered’ under IFRS 4) for the insurance contracts assets and liabilities which is largely insensitive to current period market movements, the Jackson total profit (ie including short-term fluctuations in investment returns) is very sensitive to market movements. In addition to these effects the Jackson IFRS shareholders’ 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 shareholders’ equity (ie outside the income statement). See D3(j) for details of the hedging. For Asian operations, the operating profit based on longer-term investment returns is mainly affected by the impact of market levels on unit-linked business persistency, and other insurance risk. At the total IFRS profit level the Asian result is affected by short-term value movements on the asset portfolio for non-linked shareholder-backed business.
M&G profits are affected primarily by movements in the growth in funds under management and by the effect of any impairments on the loan book and fair value movements on debt securities held by Prudential Capital. In addition, total profits and shareholders’ equity are sensitive to market value movements and centrally held swaps. These are used to manage foreign currency and other macroeconomic exposures.
PAC non-profit sub-fund The PAC non-profit sub-fund principally comprises annuity business previously written by Scottish Amicable Life, unit-linked and other non-participating business. The financial assets covering the liabilities for those types of business are subject to market risk. However, for the annuity business the same considerations as described above for PRIL apply, whilst the liabilities of the unit-linked business change in line with the matching linked assets. Other liabilities of the PAC non-profit sub-fund are broadly insensitive to market risk.
D1: Group overview continued c Asian insurance operations For Asian with-profits business the same features apply as described above for UK with-profits business. Similarly, as for other parts of the Group, for unit-linked business the main factor affecting IFRS basis results is investment performance through asset management fees. The sensitivity of the IFRS basis results of the Group’s Asian operations to market risk is primarily restricted to the non-participating business. 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 segmental analysis so as to distinguish operating profits based on longer-term investment return and short-term fluctuations in investment returns.
f Duration of liabilities Under the terms of the Group’s contracts, as for life assurance contracts generally, the contractual maturity date is the earlier of the end of the contract term, death, other insurable events or surrender. The Group has therefore chosen to provide details of liability duration that reflect the actuarially determined best estimate of the likely incidence of these factors on contract duration. Details are shown in sections D2(k), D3(k) and D4(k). In the years 2007 to 2011, claims paid on the Group’s life assurance contracts including those classified as investment contracts under IFRS 4 ranged from £17 billion to £19 billion. Indicatively, it is to be expected that, of the Group’s policyholder liabilities (excluding unallocated surplus) at 31 December 2011 of £227.1 billion, the amounts likely to be paid in 2012 will be of a similar magnitude.
D2: UK insurance operations a Summary statement of financial position In order to show the statement of financial position by reference to the differing degrees of policyholder and shareholder economic interest of the different types of fund and business, the analysis below is structured to show separately assets and liabilities of the SAIF, the PAC with-profits sub-fund (WPSF), unit-linked assets and liabilities and annuity (principally PRIL) and other long-term business. £92.6 billion of the £142.4 billion of investments are held by SAIF and the PAC WPSF. Shareholders are exposed only indirectly to value movements on these assets.
Intangible assets attributable to with-profits funds: In respect of acquired subsidiaries for venture fund and other investment
Deferred tax assets – 99 2 101 – 130 130 231 214 Other non-investment and non-cash assets 413 1,799 107 1,906 364 2,088 2,452 4,771 4,631 Investment of long-term business and other operations: Investment propertiesnote (viii) 571 7,164 726 7,890 682 1,569 2,251 10,712 11,212 Investments accounted for using the equity method – – – – – 70 70 70 69 Financial investments: Loans note (v) 143 1,752 78 1,830 – 1,142 1,142 3,115 2,302 Equity securities and portfolio holdings in unit trusts 2,448 20,685 170 20,855 13,394 25 13,419 36,722 40,519 Debt securities 4,349 37,696 5,633 43,329 6,115 24,160 30,275 77,953 74,304 Other investmentsnote (vi) 281 3,550 306 3,856 87 344 431 4,568 3,998 Deposits 693 6,155 236 6,391 966 1,237 2,203 9,287 9,022
Equity and liabilities Equity Shareholders’ equity – – – – – 2,581 2,581 2,581 2,148 Non-controlling interests – 33 – 33 – – – 33 35
‘realistic’ basis provisions for UK regulated with-profits funds) note (vii) – 7,743 1,422 9,165 – – – 9,165 10,187
Operational borrowings attributable to shareholder-financed operations – – – – 1 102 103 103 162
Defined Charges Participating Sub-fund, which comprises 3.4 per cent of the total assets of the WPSF and includes the with-profits annuity business transferred to Prudential from the Equitable Life Assurance Society on 1 December 2007 (with assets of approximately £1.7 billion). Profits to shareholders on this with-profits annuity business emerge on a ‘charges less expenses’ basis and policyholders are entitled to 100 per cent of the investment earnings.
(v) UK Insurance operations The loans of the Group’s UK insurance operations comprise: SAIF and PAC WPSF Mortgage loans* 1,036 256 Policy loans 20 21 Other loans† 917 993
Total UK insurance operations loans 3,115 2,302 * The mortgage loans are collateralised by properties. By carrying value, 96 per cent of the £1,137 million held for shareholder-backed business relates to lifetime (equity release) mortgage business which has an average loan to property value of 27 per cent.
The unallocated surplus represents the excess of assets over policyholder liabilities for the Group’s with-profits funds. As allowed under IFRS 4, the Group has opted to continue to record unallocated surplus of with-profits funds wholly as a liability. The annual excess (shortfall) of income over expenditure of the with-profits funds, after declaration and attribution of the cost of bonuses to policyholders and shareholders, is transferred to (from) the unallocated surplus each year through a (charge) credit to the income statement. The balance retained in the unallocated surplus represents cumulative income arising on the with-profits business that has not been allocated to policyholders or shareholders. The balance of the unallocated surplus is determined after full provision for deferred tax on unrealised appreciation of investments.
Approximately 42.9 per cent (2010: 46.2 per cent) of the UK-held investment property is located in London and south east England including Buckinghamshire, Berkshire, East and West Sussex, Hampshire, Isle of Wight, Kent, Oxfordshire and Surrey, with 41.1 per cent (2010: 36.7 per cent) located throughout the rest of the UK and the remaining 16.0 per cent (2010: 17.1 per cent) located overseas.
Net cash (outflow) inflow from operating activities (1,154) 6,746 (8,184) (1,438) 638 1,034 (920) Realised gains in the year 349 2,047 785 2,832 607 64 3,852 Unrealised gains and losses and exchange movements
Shareholders’ transfers post-tax (223) – – (223) Switches (236) 236 – – Investment-related items and other movementsnote (b) 9,165 2,097 1,910 13,172 Dilution of Group’s holdings – – (27) (27) Foreign exchange translation differences (207) – (1) (208)
Comprising: – Policyholder liabilities 81,586 21,671 22,273 125,530 – Unallocated surplus of with-profits funds 10,187 – – 10,187
Shareholders’ transfers post-tax (216) – – (216) Switches (237) 237 – – Investment-related items and other movementsnote (b) 3,338 25 2,499 5,862 Foreign exchange translation differences (94) – – (94)
Notes (a) Net outflows increased from £3,192 million in 2010 to £5,080 million in 2011, principally as a result of stock transfer activity within the unit-linked business (2011 saw a large transfer out, while 2010 benefited from a large transfer in) and a lower level of bulk annuity transactions in 2011. (b) Investment-related items and other movements of £5,862 million was lower than the £13,172 million benefit seen in 2010 principally as a result of weaker performance of UK equity markets in 2011.
D2: UK insurance operations continued d Information on credit risk of debt securities The following table summarises by rating the securities held by UK insurance operations as at 31 December 2011 and 2010: (i) UK insurance operations
Other annuity and long-term business £m 2011 Total £m 2010 Total £m
ife assu ran ce b u sin ess e Products and guarantees Prudential’s long-term products in the UK consist of life insurance, pension products and pension annuities. These products are written primarily in: • One of three separate sub-funds of the PAC long-term fund, namely the with-profits sub-fund, SAIF, and the non-profit sub-fund; • Prudential Annuities Limited, which is owned by the PAC with-profits sub-fund; • Prudential Retirement Income Limited, a shareholder-owned subsidiary; or • Other shareholder-backed subsidiaries writing mainly non-profit unit-linked business.
i With-profits products and PAC with-profits sub-fund Within the statement of financial position of UK insurance operations at 31 December 2011, as shown in note D2(a), there are policyholder liabilities and unallocated surplus of £81.6 billion (2010: £82.0 billion) that relate to the WPSF. These amounts include the liabilities and capital of Prudential Annuities Limited, a wholly-owned subsidiary of the fund. The WPSF mainly contains with-profits business but it also contains some non-profit business (unit-linked, term assurances and annuities). The WPSF’s profits are apportioned 90 per cent to its policyholders and 10 per cent to shareholders as surplus for distribution is determined via the annual actuarial valuation. The WPSF held a provision of £90 million at 31 December 2011 (2010: £24 million) to honour guarantees on a small amount of guaranteed annuity products. SAIF’s exposure to guaranteed annuities is described below. Beyond the generic guarantees described above, there are very few explicit options or guarantees such as minimum investment returns, surrender values or annuities at retirement and any granted have generally been at very low levels.
Regular bonus rates For regular bonuses, the bonus rates are determined for each type of policy primarily by targeting the bonus level at a prudent proportion of the long-term expected future investment return on underlying assets. The expected future investment return is reduced as appropriate for each type of policy to allow for items such as expenses, charges, tax and shareholders’ transfers. However, the rates declared may differ by product type or by the date of payment of the premium or date of issue of the policy or if the accumulated annual bonuses are particularly high or low relative to a prudent proportion of the achieved investment return. When target bonus levels change the PAC Board of Directors (PAC Board) has regard to the overall strength of the long-term fund when determining the length of time over which it will seek to achieve the amended prudent target bonus level. In normal investment conditions, PAC expects changes in regular bonus rates to be gradual over time, and these are not expected to exceed 1 per cent per annum over any year. However, the PAC Directors retain the discretion whether or not to declare a regular bonus each year, and there is no limit on the amount by which regular bonus rates can change.
Furthermore, in accordance with industry-wide regulatory requirements, the PAC Board has appointed: • an Actuarial Function Holder who provides the PAC Board with all actuarial advice; • a With-Profits Actuary whose specific duty is to advise the PAC Board on the reasonableness and proportionality of the manner in which its discretion has been exercised in applying the PPFM and the manner in which any conflicting interests have been addressed; and
• a With-Profits Committee of independent individuals, which assesses the degree of compliance with the PPFM and the manner in which conflicting rights have been addressed.
Smoothing of investment return In determining bonus rates for the UK with-profits policies, smoothing is applied to the allocation of the overall earnings of the UK with-profits fund of which the investment return is a significant element. The smoothing approach differs between accumulating and conventional with-profits policies to reflect the different contract features. In normal circumstances, Prudential does not expect most payout values on policies of the same duration to change by more than 10 per cent up or down from one year to the next, although some larger changes may occur to balance payout values between different policies. Greater flexibility may be required in certain circumstances, for example following a significant rise or fall in market values, and in such situations the PAC Board may decide to vary the standard bonus smoothing limits in order to protect the overall interests of policyholders.
Net income of the fund: Investment return 4,094 8,815 Claims incurred (6,411) (6,390) Movement in policyholder liabilities (614) (4,301) Add back policyholder bonuses for the year (as shown below) 1,945 2,019 Claims incurred and movement in policyholder liabilities (including charge for provision for asset shares and excluding policyholder bonuses) (5,080) (8,672) Earned premiums, net of reinsurance 3,404 3,148 Other income 17 9 Acquisition costs and other expenditure (696) (600) Tax charge (63) (528)
g Process for setting assumptions and determining contract liabilities i Overview The calculation of the contract liabilities involves the setting of assumptions for future experience. This is done following detailed review of the relevant experience including, in particular, mortality, expenses, tax, economic assumptions and, where applicable, persistency. For with-profits business written in the WPSF or SAIF, a market-consistent valuation is performed (as described in section (ii) below). Additional assumptions required are for persistency and the management actions under which the fund is managed. Assumptions used for a market-consistent valuation typically do not contain margins, whereas those used for the valuation of other classes of business do. Mortality assumptions are set based on the results of the most recent experience analysis looking at the experience over recent years of the relevant business. For non-profit business, a margin for adverse deviation is added. Different assumptions are applied for different product groups. For annuitant mortality, assumptions for current mortality rates are based on recent experience investigations and expected future improvements in mortality. The expected future improvements are based on recent experience and projections of the business and industry experience generally.
ii WPSF and SAIF The policyholder liabilities reported for the WPSF are primarily for two broad types of business. These are accumulating and conventional with-profits contracts. The policyholder liabilities of the WPSF are accounted for under FRS 27. The provisions have been determined on a basis consistent with the detailed methodology included in regulations contained in the FSA’s rules for the determination of reserves on the FSA’s ‘realistic’ Peak 2 basis. In aggregate, the regime has the effect of placing a value on the liabilities of UK with-profits contracts, which reflects the amounts expected to be paid based on the current value of investments held by the with-profits funds and current circumstances. These contracts are a combination of insurance and investment contracts with discretionary participation features, as defined by IFRS 4. 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.
D2: UK insurance operations continued iii Annuity business Credit risk provisions For IFRS reporting, the results for UK shareholder-backed annuity business are particularly sensitive to the allowances made for credit risk. The allowance is reflected in the deduction from the valuation rate of interest for discounting projected future annuity payments to policyholders that would have otherwise applied. Since mid-2007 there has been a significant increase in the actual and perceived credit risk associated with corporate bonds as reflected in the significant widening that has occurred in corporate bond spreads. Although bond spreads over swap rates have narrowed from their peak in March 2009, they are still high compared with the levels seen in the years immediately preceding the start of the dislocated markets in 2007. The allowance that should therefore be made for credit risk remains a particular area of judgement. The additional yield received on corporate bonds relative to swaps can be broken into the following constituent parts: (a) the expected level of future defaults, (b) the credit risk premium that is required to compensate for the potential volatility in default levels, (c) the liquidity premium that is required to compensate for the lower liquidity of corporate bonds relative to swaps, and (d) the mark to market risk premium that is required to compensate for the potential volatility in corporate bond spreads (and hence market values) at the time of sale.
(ii) Long-term expected defaults are derived by applying Moody’s data from 1970 to 2009 and the definition of the credit rating used is the second highest credit rating published by Moody’s, Standard and Poor’s and Fitch. (iii) Additional provisions comprise credit risk premium, which is derived from Moody’s data from 1970 to 2009, an allowance for a one notch downgrade of the portfolio subject to credit risk and an additional allowance for short-term defaults.
Movement in the credit risk allowance for PRIL for the year ended 31 December 2011 The movement during 2011 of the average basis points allowance for PRIL on Pillar 1 regulatory and IFRS bases are as follows: Pillar 1 regulatory basis (bps)
Total allowance for credit risk at 31 December 2010 68 42 Credit rating changes 2 2 Asset trading (1) (1) Asset mix (effect of market value movements) (2) (1) New business and other (1) –
In prior periods, surplus from favourable default experience has been retained within short-term allowances for credit risk on both the Pillar 1 and IFRS bases. For full year 2011 the retention of such surpluses continues to be applied to IFRS but not for Pillar 1. Overall the movement has led to the credit allowance for Pillar 1 purposes to be 33 per cent (2010: 43 per cent) of the bond spread over swap rates. For IFRS purposes it represents 20 per cent (2010: 26 per cent) of the bond spread over swap rates. The reserves for credit risk allowance at 31 December 2011 for the UK shareholder annuity fund were as follows: Pillar 1 regulatory basis £bn
Mortality The mortality assumptions are set in light of recent population and internal experience. The assumptions used are percentages of standard actuarial mortality tables with an allowance for future mortality improvements. Where annuities have been sold on an enhanced basis to impaired lives an additional age adjustment is made. The percentages of the standard table used are selected according to the source of business. In 2009, Prudential’s annuity business liabilities were determined using the CMI medium cohort projections with a floor. In November 2009, a new mortality projection model was released by the CMI. The new model was applied since the 2010 results with calibration to reflect an appropriate view of future mortality improvement. Prior to 2010, in recognition of the trend in assumed mortality improvements the Company had in previous years included margins in its annuity liabilities. In determining the 2010 results, based on the new model, the appropriate level of these margins was reassessed. See note D2(i) below for the net effect in 2010 of applying the new model, releases of margin and changes to other related mortality assumptions. The tables and range of percentages used are set out in the following tables: PAL (and annuity business with the WPSF) PRIL
AM92 minus 4 years 88% to 100% PCFA00 with future improvements in line with Prudential’s own calibration of the CMI 2009 mortality model, with a long-term improvement rate of 1.25%.
AF92 minus 4 years 93% to 94% PCMA00 with future improvements in line with Prudential’s own calibration of the CMI 2009 mortality model, with a long-term improvement rate of 2.25%.
In deferment 92% to 98% PCMA00 with future improvements in line with Prudential’s own calibration of the CMI 2009 mortality model, with a long-term improvement rate of 2.25%.
AF92 minus 4 years 94% to 95% PCMA00 with future improvements in line with Prudential’s own calibration of the CMI 2009 mortality model, with a long-term improvement rate of 2.25%.
AF92 minus 4 years 96% to 102% PNMA00 (C = 2000) with medium cohort improvement table with a minimum annual improvement of 2.25% up to age 90, tapering to zero at age 120.
h Reinsurance The Group’s UK insurance business cedes only minor amounts of business outside the Group. During 2011, reinsurance premiums for externally ceded business were £132 million (2010: £128 million) and reinsurance recoverable assets were £589 million (2010: £608 million) in aggregate. The gains and losses recognised in profit and loss for the 2011 and 2010 contracts were immaterial.
Other operating assumption changes In 2011, for the shareholder-backed business, the aggregate effect of assumption changes other than the allowance for credit risk described above was a net charge to the shareholder results of £9 million, comprising a number of individually small assumption changes. For the with-profits sub-fund, the aggregate effect of assumption changes in 2011 was a net charge to unallocated surplus of £59 million, relating to changes in mortality, expense, persistency and economic assumptions.
Other operating assumption changes Note D2(g)(iii) above explains the application of a new mortality projection model in 2010 to determine the Prudential’s annuity business. The net effect of applying the new model, releases of margins and changes to other related mortality assumptions for shareholder-backed business is a credit of £8 million. With a £38 million benefit from altered expense assumptions the overall credit for shareholder-backed business is £46 million. For the with-profits sub-fund, the aggregate effect of assumption changes in 2010 was a net charge to unallocated surplus of £62 million, relating to changes in mortality, expense, persistency and economic assumptions.
D2: UK insurance operations continued j Sensitivity of IFRS basis profit or loss and shareholders’ 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.
i With-profits business (a) SAIF Shareholders have no interest in the profits of SAIF but are entitled to the asset management fees paid on the assets of the fund.
(b) With-profits sub-fund business For with-profits business (including non-participating business of PAL which is owned by the WPSF) adjustments to liabilities and any related tax effects are recognised in the Group’s income statement. However, except for any impact on the annual declaration of bonuses, shareholders’ profit for with-profits business is unaffected. This is because IFRS basis profits for with-profits business, which are determined on the same basis as on the ‘grandfathered’ UK GAAP, solely reflect one-ninth of the cost of bonuses declared for the year. 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. Unallocated surplus represents the excess of assets over policyholder liabilities of the fund. As unallocated surplus of the WPSF is recorded as a liability, movements in its value do not affect shareholders’ profits or equity.
The level of unallocated surplus is particularly sensitive to the level of investment returns on the portion of the life fund assets that represents the surplus. The effects for 2011 and 2010 are demonstrated in note D5.
A decrease in assumed mortality rates of 1 per cent would decrease gross profits by approximately £64 million (2010: £53 million). A decrease in credit default assumptions of five basis points would increase gross profits by £137 million (2010: £119 million). A decrease in renewal expenses (excluding asset management expenses) of 5 per cent would increase gross profits by £25 million (2010: £23 million). The effect on profits would be approximately symmetrical for changes in assumptions that are directionally opposite to those explained above.
Carrying value of debt securities and derivatives 7,676 3,426 (2,820) (5,178) 6,547 2,938 (2,434) (4,481)
Policyholder liabilities (6,842) (3,060) 2,510 4,593 (5,977) (2,723) 2,109 3,929 Related deferred tax effects (208) (91) 77 146 (154) (58) 88 149
Net sensitivity of profit after tax and shareholders’ equity 626 275 (233) (439) 416 157 (237) (403)
Expected maturity: 0 to 5 years 47 32 41 25 25 25 34 28 31 35 5 to 10 years 24 26 25 22 22 22 25 22 24 24 10 to 15 years 13 19 16 18 18 18 18 18 18 17 15 to 20 years 8 14 10 13 13 13 11 12 11 11 20 to 25 years 5 7 6 9 10 9 7 9 7 7 Over 25 years 3 2 2 13 12 13 5 11 9 6 2010 £m
Expected maturity: 0 to 5 years 46 31 40 32 29 30 35 29 32 36 5 to 10 years 25 25 25 25 23 24 26 21 23 24 10 to 15 years 13 19 16 18 17 18 18 20 19 17 15 to 20 years 7 14 10 12 13 12 10 11 11 11 20 to 25 years 4 8 6 7 8 8 6 8 7 7 Over 25 years 5 3 3 6 10 8 5 11 8 5
Notes (i) The cash flow projections of expected benefit payments used in the maturity profile table above are from value of in-force business and exclude the value of future new business, including vesting of internal pension contracts.
(v) The maturity tables shown above have been prepared on a discounted basis. Details of undiscounted cash flow for investment contracts are shown in note G2.
Profit for the year (as above) 432 338 Items recognised in other comprehensive income: Exchange movements 42 85 Unrealised valuation movements on securities classified as available-for sale: Unrealised holding gains arising during the year 912 1,170 Deduct net (gains)/add back net losses included in the income statement (101) 51
Included within the movements in shareholders’ equity is a net increase in value of Jackson’s debt securities classified as ‘available-for-sale’ under IAS 39 of £811 million (2010: £1,221 million). With the exception of debt securities for US insurance operations classified as ‘available-for-sale’ under IAS 39, unrealised value movements on the Group’s investments are booked within the income statement. However, for debt securities classified as ‘available-for-sale’, unless impaired, fair value movements are recognised in other comprehensive income. Realised gains and losses, including impairments, are recorded in the income statement. This classification is applied for most of the debt securities of the Group’s US operations. In 2011, Jackson recorded £62 million (2010: £124 million) of impairment losses arising from: Residential mortgage-backed securities 21 71 Public fixed income – 1 Other 41 52
Fair value (as included in statement of financial position) 2,209 4,002
Assets fair valued at or above book value Book value* 22,504 20,743 Unrealised gain 2,303 689 34 1,580
† Translated at the average rate of $1.6037: £1. ‡ Debt securities for US operations included in the statement of financial position at 31 December 2011 comprise: Available-for-sale 27,016 26,325 Consolidated investment funds classified as fair value through profit and loss 6 41
ife assu ran ce b u sin ess ii Statement of financial position
Liabilities Policyholder: Contract liabilities (including amounts in respect of contracts classified as investment contracts under IFRS 4) note (iv) 37,833 31,356 69,189 60,523
Core structural borrowings of shareholder-financed operations – 160 160 159 Operational borrowings attributable to shareholder-financed operations – 127 127 90 Deferred tax liabilities – 2,093 2,093 1,776 Other non-insurance liabilities – 3,014 3,014 3,552
Total US insurance operations loans 4,110 4,201 * All of the mortgage loans are commercial mortgage loans which are collateralised by properties. The property types are mainly industrial, multi-family residential, suburban office, retail and hotel. The breakdown by property type is as follows: Industrial 28 31 Multi-family residential 23 18 Office 19 19 Retail 19 21 Hotels 11 10 Other – 1
The US insurance operations’ commercial mortgage loan portfolio does not include any single-family residential mortgage loans and is therefore not exposed to the risk of defaults associated with residential sub-prime mortgage loans. The average loan size is £6.6 million (2010: £6.6 million). The portfolio has a current estimated average loan to value of 68 per cent (2010: 73 per cent) which provides significant cushion to withstand substantial declines in value.
At 31 December 2011, Jackson had mortgage loans with a carrying value of £87 million where the contractual terms of the agreements had been restructured. In addition to the regular impairment review afforded all loans in the portfolio, restructured loans are also reviewed for impairment. An impairment will be recorded if the expected cash flows under the newly restructured terms discounted at the original yield (the pre-structured interest rate) are below the carrying value of the loan.
† Partnerships in investment pools and other comprise primarily investments in limited partnerships. These include interests in the PPM America Private Equity Fund and diversified investments in 167 (2010: 161) other partnerships by independent money managers that generally invest in various equities and fixed income loans and securities.
(iv) Summary policyholder liabilities (net of reinsurance) and reserves at 31 December 2011 The policyholder liabilities, net of reinsurers’ share of £907 million (2010: £694 million), reflect balances in respect of the following: Policy reserves and liabilities on non-linked business: Reserves for future policyholder benefits and claims payable 518 1,567 Deposits on investment contracts (as defined under IFRS ‘grandfathered’ US GAAP) 28,314 25,494 Guaranteed investment contracts 1,617 1,565 Unit-linked (variable annuity) business 37,833 31,203
In addition to the policyholder liabilities above, Jackson has entered into a programme of funding arrangements under contracts which, in substance, are almost identical to GICs. The liabilities under these funding arrangements totalled £1,070 million (2010: £1,411 million) and are included in ‘other non-insurance liabilities’ in the statement of financial position above.
Net cash inflow (outflow) from operating activities 7,294 (625) 6,669 Realised gains in the year – 102 102 Unrealised gains and losses and exchange movements in the year (664) 2,046 1,382
At 31 December 2011 Total investments (including derivative assets) 37,833 33,913 71,746 Less: Derivative liabilities note G3 – (887) (887)
D3: US insurance operations continued 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: US insurance operations
Net flowsnote (b) 6,978 846 7,824 Transfers from general to separate account 957 (957) – Investment-related items and other movementsnote (c) (1,735) 1,871 136 Foreign exchange translation differences 430 276 706
(2010: 1.57). Differences upon retranslation are included in foreign exchange translation differences of £706 million (2010: £1,380 million). (b) Net flows for the year were £7,824 million compared with £7,368 million in 2010, driven largely by increased new business volumes for the variable annuity business.
(c) Negative investment-related items and other movements in variable annuity separate account liabilities of £1,735 million in 2011 principally reflects the negative separate account return in the year including reductions to liabilities for fees levied, versus a significant increase in the equity market in 2010. This is offset by an increase in fixed annuity, GIC and other business investment and other movements primarily related to increase in the value of embedded derivatives and interest credited to policyholder accounts in the year.
ife assu ran ce b u sin ess d Information on credit risks of debt securities
Residential mortgage-backed securities (RMBS) 2,591 2,784 Commercial mortgage-backed securities (CMBS) 2,169 2,375 Other debt securities 620 976
In addition to the ratings disclosed above, the following table summarises by rating the debt securities, as at 31 December 2011 and 2010 using Standard and Poor’s (S&P), Moody’s, Fitch and implicit ratings of MBS based on NAIC valuations.
Total US debt securities 27,022 26,366 * The amounts within Other which are not rated by S&P, Moody or Fitch, nor are MBS securities using the revised regulatory ratings, have the following NAIC classifications: In the table above, with the exception of some mortgage-backed securities, 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.
For some mortgage-backed securities within Jackson, the table above includes these securities using the regulatory ratings detail issued by the NAIC. These regulatory ratings levels were established by external third parties (PIMCO for residential mortgage-backed securities and BlackRock Solutions for commercial mortgage-backed securities).
iv Debt securities classified as available-for-sale in an unrealised loss position The following tables show some key attributes of those securities that are in an unrealised loss position at 31 December 2011.
a Fair value of available-for-sale securities as a percentage of book value The following table shows the fair value of the debt securities in a gross unrealised loss position for various percentages of book value at 31 December: Fair value Unrealised loss Fair value Unrealised loss
D3: US insurance operations continued b Unrealised losses by maturity of available-for-sale securities
Less than 1 year – – 1 year to 5 years (7) (6)
c Age analysis of unrealised losses for the years indicated for available-for-sale securities The following table shows the age analysis of all the unrealised losses in the portfolio by reference to the length of time the securities have been in an unrealised loss position: Noninvestment
At 31 December 2011, the gross unrealised losses in the statement of financial position for the sub-prime and Alt-A securities in an unrealised loss position were £53 million (2010: £40 million). Of these losses £10 million (2010: £1 million) relate to securities that have been in an unrealised loss position for less than one year and £43 million (2010: £39 million) to securities that have been in an unrealised loss position for more than one year.
ife assu ran ce b u sin ess d Securities whose fair value were below 80 per cent of the book value As shown in the table (a) above, £158 million of the £246 million of gross unrealised losses at 31 December 2011 (2010: £224 million of the £370 million of gross unrealised losses) related to securities whose fair value was below 80 per cent of the book value. The analysis of the £158 million (2010: £224 million), by category of debt securities and by age analysis indicating the length of time for which their fair value was below 80 per cent of the book value, is as follows: Category analysis Fair value Unrealised loss Fair value Unrealised loss
Commercial mortgage-backed securities 6 (29) 8 (29) Other asset-backed securities 65 (58) 123 (105)
Age analysis of fair value being below 80 per cent for the period indicated: Age analysis Fair value Unrealised loss Fair value Unrealised loss 3 months to 6 months 45 (15) – – More than 6 months 148 (138) 339 (223)
i Fixed annuities Interest-sensitive annuities At 31 December 2011, interest-sensitive fixed annuities accounted for 16 per cent (2010: 19 per cent) of policy and contract liabilities of Jackson. Interest-sensitive fixed annuities are primarily deferred annuity products that are used for asset accumulation in retirement planning and for providing income in retirement. They permit tax-deferred accumulation of funds and flexible payout options. The policyholder of an interest-sensitive fixed annuity pays Jackson a premium, which is credited to the policyholder’s account. Periodically, interest is credited to the policyholder’s account and in some cases administrative charges are deducted from the policyholder’s account. Jackson makes benefit payments at a future date as specified in the policy based on the value of the policyholder’s account at that date. The policy provides that at Jackson’s discretion it may reset the interest rate, subject to a guaranteed minimum. At 31 December 2011, Jackson had fixed interest rate annuities totalling £16.9 billion (US$26.2 billion) in account value with minimum guaranteed rates ranging from 1.0 per cent to 5.5 per cent and a 2.83 per cent average guaranteed rate. Approximately 48 per cent (2010: 45 per cent) of the interest-sensitive fixed annuities Jackson wrote in 2011 provide for a market value adjustment that could be positive or negative, on surrenders in the surrender period of the policy. This formula-based adjustment approximates the change in value that assets supporting the product would realise as interest rates move up or down. The minimum guaranteed rate is not affected by this adjustment.
Fixed indexed annuities Fixed indexed annuities (FIA) accounted for 9 per cent (2010: 9 per cent) of Jackson’s policy and contract liabilities at 31 December 2011. Fixed indexed annuities vary in structure, but generally are deferred annuities that enable policyholders to obtain a portion of an equity-linked return (based on participation rates and caps) but provide a guaranteed minimum return. These guaranteed minimum rates are generally set at 1.0 to 3.0 per cent. Jackson hedges the equity return risk on fixed indexed products using futures and options linked to the relevant index as well as through offsetting equity exposure in the VA product. The cost of these hedges is taken into account in setting the index participation rates or caps. Jackson bears the investment and surrender risk on these products.
ii Variable annuities At 31 December 2011, VAs accounted for 63 per cent (2010: 58 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. The primary differences between VAs and interest-sensitive or fixed indexed annuities are investment risk and return. If a policyholder chooses a VA, the rate of return depends upon the performance of the selected fund portfolio. Policyholders may allocate their investment to either the fixed or a selection of variable accounts. Investment risk on the variable account is borne by the policyholder, while investment risk on the fixed account is borne by Jackson through guaranteed minimum fixed rates of return. At 31 December 2011, approximately 10 per cent (2010: approximately 12 per cent) of VA funds were in fixed accounts. 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 (GMDB), annuitisation (GMIB), or at specified dates during the accumulation period (GMWB and GMAB). Jackson hedges these risks using equity options and futures contracts as described in note D3(f). The GMAB was eliminated from Jackson’s product offerings in 2011. The GMIB is no longer offered, with existing coverage being reinsured.
The types of derivatives used by Jackson and their purpose are as follows: • Interest rate swaps generally involve the exchange of fixed and floating payments over the period for which Jackson holds the instrument 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. Put-swaptions hedge against significant movements in interest rates; • Equity index futures contracts and equity index options (including various call, put options and put spreads) 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 short-term 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; and
• any amounts previously assessed against policyholders that are refundable on termination of the contract, and • any probable future loss on the contract (ie premium deficiency).
The direct GMIB liability is determined by estimating the expected value of the annuitisation benefits in excess of the projected account balance at the date of annuitisation and recognising the excess ratably over the accumulation period based on total expected assessments. GMIB benefits are essentially fully reinsured, subject to annual claim limits. As this reinsurance benefit is net settled, it is considered to be a derivative under IAS 39 and is, therefore, recognised at fair value with the change in fair value included as a component of short-term derivative fluctuations.
Volatility assumptions are based on a weighting of available market data on implied volatility for durations up to ten years, at which point the projected volatility is held constant. Non-performance risk is incorporated into the calculation through the use of discount 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. With the exception of the GMDB, GMIB, GMWB and GMAB features of VA contracts, the financial guarantee features of Jackson’s contracts are in most circumstances not explicitly valued, but the impact of any interest guarantees would be reflected as they are earned in the current account value (ie the US GAAP liability). For traditional life insurance contracts, provisions for future policy benefits are determined under US GAAP using the net level premium method and assumptions as of the issue date as to mortality, interest, policy lapses and expenses plus provisions for adverse deviation. Institutional products are accounted for as investment contracts under IFRS with the liability classified as being in respect of financial instruments rather than insurance contracts, as defined by IFRS 4. In practice, there is no material difference between the IFRS and US GAAP basis of recognition and measurement for these contracts. Certain institutional products representing obligations issued in currencies other than US dollars have been hedged for changes in exchange rates using cross-currency swaps. The fair value of derivatives embedded in funding agreements, as well as foreign currency transaction gains and losses, are included in the carrying value of the trust instruments supported by funding agreements recorded in other non-insurance liabilities.
Deferred acquisition costs Under IFRS 4, the Group applies ‘grandfathered’ US GAAP for measuring the insurance assets and liabilities of Jackson. In the case of Jackson term business, acquisition costs are deferred and amortised in line with expected premiums. For annuity and interest-sensitive life business, acquisition costs are deferred and amortised in line with a combination of historical and future expected gross profits on the relevant contracts. For fixed and indexed annuity and interest-sensitive life business, the key assumption is the long-term spread between the earned rate on investments and the rate credited to policyholders, which is based on an annual spread analysis. Expected gross profits also depend on mortality assumptions, assumed unit costs and terminations other than deaths (including the related charges), all of which are based on a combination of actual experience of Jackson, industry experience and future expectations. A detailed analysis of actual mortality, lapse and expense experience is performed using internally developed experience studies. As with fixed and indexed annuity and interest-sensitive life business, acquisition costs for Jackson’s variable annuity products are amortised in line with the emergence of profits. The measurement of the amortisation in part reflects current period fees (including those for guaranteed minimum death, income, or withdrawal benefits) earned on assets covering liabilities to policyholders, and the historical and expected level of future gross profits which depends on the assumed level of future fees, as well as components related to mortality, lapse and expense.
The reduction in assumed future rates reflects in large part the elimination from the calculation in 2011, of the negative 2008 returns. Setting aside other complications and the growth in the book, the 2011 accelerated amortisation can be broadly equated as ‘paying back’ the benefit experienced in 2008. Separately, as explained in note A5 it is the Company’s intention to adopt the US Financial Accounting Standards Board requirements in EITF Update No 2010 -26 on ‘Accounting for Costs Associated with Acquiring or Renewing Insurance Contracts’ from 1 January 2012 into Prudential’s Group IFRS reporting for the results of Jackson and those Asian operations that use US GAAP for measuring insurance assets and liabilities. Under the Update, insurers are required to capitalise only those incremental costs directly related to acquiring a contract from 1 January 2012. This change has two principal effects on the 2011 and 2010 results, which are to be retrospectively adjusted in the 2012 Group financial statements.
(i) Charging of acquisition costs for business written in the year that can no longer be deferred.
– 27 per cent of operating profit, based on longer-term investment returns before DAC amortisation but after the charge for acquisition costs for business written in the year that can no longer be deferred; and
– 27 per cent of operating profit, based on longer-term investment returns before DAC amortisation but after the charge for acquisition costs for business written in the year that can no longer be deferred.
For 2012, the impact of application of the Update on the new business strain for non-incremental acquisition costs and amortisation charge to operating profits based on longer-term investment returns and the DAC balance in the statement of financial position is expected to follow a broadly similar pattern to those described above. On the assumption that market returns for 2012 are within the range of negative 15 per cent to positive 15 per cent, the estimated effect on the amortisation charge, under the new DAC basis described above, is a range from acceleration of £100 million to deceleration of £100 million.
Statement of changes in equity – ‘shadow DAC adjustments’ Consequent upon the positive unrealised valuation movement in 2011 of £811 million (2010: positive £1,221 million) there is a debit of £331 million (2010: £496 million debit) for altered ‘shadow’ DAC amortisation booked within other comprehensive income. These adjustments reflect movement from period to period, in the changes to the pattern of reported gross profits that would have happened if the assets reflected in the statement of financial position had been sold, crystallising the unrealised gains or losses, and the proceeds reinvested at the yields currently available in the market. At 31 December 2011, the cumulative ‘shadow DAC balance’ was negative £866 million (2010: negative £520 million).
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 2011, the premiums for such ceded business amounted to £72 million (2010: £83 million). Net commissions received on ceded business and claims incurred ceded to external reinsurers totalled £9 million and £84 million respectively during 2011 (2010: £12 million and £72 million respectively). There were no deferred gains or losses on reinsurance contracts in either 2011 or 2010. The reinsurance asset for business ceded outside the Group was £907 million (2010: £695 million).
Return of net deposits plus a minimum return GMDB 0-6% 31,571 2,914 64.2 years GMWB – Premium only 0% 2,325 195 GMWB* 0-5% 2,582 582* GMAB – Premium only 0% 54 2 Highest specified anniversary account value minus withdrawals post-anniversary GMDB 4,002 678 63.7 years GMWB – Highest anniversary only 1,855 423 GMWB* 735 217* Combination net deposits plus minimum return, highest specified anniversary account value minus withdrawals post-anniversary GMDB 0-6% 2,098 479 66.1 years GMIB 0-6% 1,661 575 4.2 years
Return of net deposits plus a minimum return GMDB 0-6% 25,540 2,106 64.0 years GMWB – Premium only 0% 2,742 149 GMWB* 0-5%† 1,996 415* GMAB – Premium only 0% 48 1 Highest specified anniversary account value minus withdrawals post-anniversary GMDB 3,742 466 63.3 years GMWB – Highest anniversary only 2,010 343 GMWB* 852 196* Combination net deposits plus minimum return, highest specified anniversary account value minus withdrawals post-anniversary GMDB 0-6% 1,768 311 65.7 years GMIB 0-6% 1,933 418 5.1 years * Amounts shown for GMWB comprise sums for the ‘not for life’ portion (where the guaranteed withdrawal base less the account value equals to the net amount at risk (NAR)), and a ‘for life’ portion (where the NAR has been estimated as the present value of future expected benefit payment remaining after the amount of the ‘not for life’ guaranteed benefits is zero).
† Ranges shown based on simple interest. The upper limits of 5 per cent, or 8 per cent simple interest are approximately equal to 4.1 per cent and 6 per cent respectively, on a compound interest basis over a typical 10-year bonus period. For example 1 + 10 x 0.5 is similar to 1.041 growing at a compound rate of 4.01 per cent for a further nine years.
As noted in note D3(f), Jackson is exposed to equity risk through the options embedded in the fixed indexed liabilities and GMDB and GMWB guarantees included in certain VA benefits as illustrated above. This risk is managed using an equity hedging programme to minimise the risk of a significant economic impact as a result of increases or decreases in equity market levels while taking advantage of naturally offsetting exposures in Jackson’s operations. Jackson purchases external futures and options that hedge the risks inherent in these products, while also considering the impact of rising and falling separate account fees. As a result of this hedging programme, if the equity markets were to increase further in the future, the net effect of 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 in the financial reporting the immediate impact of equity market movements as the free-standing derivatives reset immediately while the hedged liabilities reset more slowly and fees are recognised prospectively. The net effect of opposite impacts would be observed if the equity markets were to decrease.
Net sensitivity of profit after tax and shareholders' equity 174 97 (127) (291) 103 59 (64) (116)
Other exposure to equity risk In addition to the exposure explained above, Jackson is also exposed to equity risk from its holding of equity securities, partnerships in investment pools and other financial derivatives. A range of reasonably possible movements in the value of equity securities, partnerships in investment pools and other financial derivatives have been applied to Jackson’s holdings at 31 December 2011 and 2010. The table below shows the sensitivity to a 10 and 20 per cent fall in value and the impact that this would have on pre-tax profit, net of related changes in amortisation of DAC, profit after tax and shareholders’ equity.
Pre-tax profit, net of related changes in amortisation of DAC (121) (61) (143) (72)
ii Exposure to interest rate risk Notwithstanding the market risk exposure previously described, 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. The GMWB features attaching to variable annuity business (other than ‘for-life’) represents embedded derivatives which are fair valued and so will be sensitive to changes in interest rate.
Related effect on movement in deferred tax (537) (303) 303 537 (521) (285) 285 521
Total net effect on shareholders' equity 1,305 708 (669) (1,178) 1,190 621 (588) (1,082)
iii Currency translation Consistent with the Group’s accounting policies, the profits of the Group’s US operations are translated at average exchange rates and shareholders’ equity at the closing rate for the reporting period. For 2011, the rates were US$1.60 (2010: US$1.55) and US$1.55 (2010: $1.57) to £1 sterling, respectively. A 10 per cent increase or decrease in these rates would reduce or increase profit before tax attributable to shareholders, profit for the year and shareholders’ equity attributable to US insurance operations respectively as follows: A 10% increase in exchange rates
(ii) The required level of provision for guaranteed minimum death benefit claims.
Fixed annuity and other business (including GICs and similar contracts) Variable annuity Total
Expected maturity: 0 to 5 years 47 47 47 50 50 50 5 to 10 years 27 30 29 27 29 28 10 to 15 years 11 13 12 11 12 12 15 to 20 years 6 6 6 5 6 5 20 to 25 years 5 2 3 3 2 3 Over 25 years 4 2 3 4 1 2
Equity and liabilities Equity Shareholders’ equity – – 2,349 2,349 2,149 Non-controlling interests – – 5 5 5
Operational borrowings attributable to shareholders-financed operations – – 141 141 189
Deferred tax liabilities 348 33 132 513 495 Other non-insurance liabilities 1,501 639 957 3,097 3,147
Notes (i) The statement of financial position for with-profits business comprises the with-profits assets and liabilities of the Hong Kong, Malaysia and
Directly held investments, net of derivative liabilities 9,214 9,735 3,577 22,526
At 31 December 2010/1 January 2011 Total investments (including derivative assets) 12,152 12,955 5,836 30,943 Less: Investments held by consolidated investment funds (382) (266) (91) (739) Less: Derivative liabilitiesnote G3 (120) – (102) (222)
Net cash inflow from operating activities 381 659 1,247 2,287 Realised gains in the year 310 149 44 503 Unrealised gains and losses and exchange movements in the year 444 (1,767) (20) (1,343)
Directly held investments, net of derivative liabilities 12,785 11,730 6,914 31,429
At 31 December 2010 / 1 January 2011 11,024 12,724 4,992 28,740 Comprising: – Policyholder liabilities 10,958 12,724 4,992 28,674 – Unallocated surplus of with-profits funds 66 – – 66
Premiums New business 162 1,136 723 2,021 In-force 1,110 1,163 785 3,058
Asia equity market losses in the second half of 2011. (e) The acquisition of UOB Life Assurance Limited reflects the liabilities acquired at the date of acquisition.
d Information on credit risks of debt securities The following table summarises the credit quality of the debt securities of the Asian insurance operations as at 31 December 2011 by rating agency ratings: With-profits business
S&P – AAA 1,259 38 126 1,423 2,934 S&P – AA+ to AA- 2,161 83 1,599 3,843 2,138 S&P – A+ to A- 1,560 564 931 3,055 2,843 S&P – BBB+ to BBB- 1,032 104 315 1,451 913 S&P – Other 786 707 644 2,137 1,773
Product guarantees in Asia can be broadly classified into four main categories, namely premium rate, cash value and interest rate guarantees, policy renewability and convertibility options. The risks on death coverage through premium rate guarantees are low due to appropriate product pricing.
h Reinsurance The Asian businesses cede only minor amounts of business outside the Group with immaterial effects on reported profit. During 2011, reinsurance premiums for externally ceded business were £226 million (2010: £146 million) and the reinsurance assets were £151 million (2010: £41 million) in aggregate.
j Sensitivity of IFRS basis profit and shareholders’ equity to market and other risks i Risks other than currency translation a With-profits business Similar principles to those explained for UK with-profits business apply to profit emergence for the Asian with-profits business. Correspondingly, the profit emergence reflects bonus declaration and is relatively insensitive to period-by-period fluctuations in insurance risk or interest rate movements.
b Unit-linked business As for the UK insurance operations, the profits and shareholders’ equity related to the Asian operations is primarily driven by charges related to invested funds. The sensitivity of profits and shareholders’ equity to changes in insurance risk and to interest rate risk are not material.
Taiwan 0.5 per cent). The pre-tax impacts, if they arose, would mostly be recorded within the category short-term fluctuations in investments returns in the
ii Equity price risk The non-linked shareholder business has limited exposure to equity and property investment (£600 million at 31 December 2011). Generally changes in equity and property investment values are not directly offset by movements in policyholder liabilities. However, for the Vietnam business, to the extent that equity investment appreciation is realised through sales of securities then policyholders’ liabilities are adjusted to the extent that policyholders participate. The estimated sensitivity to a 10 and 20 per cent change in equity and property prices for shareholder-backed Asian other business, which would be reflected in the short-term fluctuation component of the Group’s segmental analysis of profit before tax, at 31 December 2011 and 2010 would be as follows: Decrease of 20%
A 10 or 20 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 market risk sensitivities shown above reflect the impact of temporary market movements and, therefore, the primary effect of such movements would, in the Group’s segmental analysis of profits, be included within the short-term fluctuations in investment returns. In the equity risk sensitivity analysis shown above, the Group has considered the impact of an instantaneous 20 per cent fall in equity markets. If equity markets were to fall by more than 20 per cent, the Group believes that this would not be an instantaneous fall but rather this would be expected to occur over a period of time during which the Group would be able to put in place mitigating management actions.
ife assu ran ce b u sin ess iii Insurance risk Many of the territories in Asia are exposed to mortality/morbidity risk and provision is made within policyholder liabilities on a prudent regulatory basis to cover the potential exposure. If these prudent assumptions were strengthened by 5 per cent (estimated at one in ten year shock) then it is estimated that post-tax profit would be impacted by approximately £27 million (2010: £21 million). Mortality/morbidity has a symmetrical effect on portfolio and so a weakening of mortality/morbidity assumptions would have an approximately equal and opposite similar impact.
ii Currency translation Consistent with the Group’s accounting policies, the profits of the Asian insurance operations are translated at average exchange rates and shareholders’ equity at the closing rate for the reporting period. For 2011, the results for the most significant operations are given in note B4. A 10 per cent increase or decrease in these rates would have reduced or increased profit before tax attributable to shareholders, profit for the year and shareholders’ equity, excluding goodwill, attributable to Asian operations respectively as follows: 10% increase in exchange rates 10% decrease in exchange rates £m £m £m £m
Profit before tax attributable to shareholders note (i) (57) (65) 70 80 Profit for the year (46) (58) 56 71 Shareholders’ equity, excluding goodwill, attributable to Asian operations (228) (193) 278 236
Note (i) Sensitivity on profit (loss) before tax ie aggregate of the operating profit based on longer-term investment returns and short-term fluctuations in investment returns.
k Duration of liabilities The table below shows the carrying value of policyholder liabilities. Separately the Group uses cash flow projections of expected benefit payments as part of the determination of the value of in-force business when preparing EEV basis results. The table below also shows the maturity profile of the cash flows, taking account of expected future premiums and investment returns used for that purpose for 2011 and 2010: Expected maturity: 0 to 5 years 22 24 5 to 10 years 19 20 10 to 15 years 15 15 15 to 20 years 13 12 20 to 25 years 10 10 Over 25 years 21 19
Group shareholders' equity Held outside long-term funds: Net assets – – – 930 4,271 2,114 7,315 229 (1,514) 6,030 Goodwill – – – – – 235 235 1,153 77 1,465
Total – – – 930 4,271 2,349 7,550 1,382 (1,437) 7,495 Held in long-term funds note (iii) – – – 1,622 – – 1,622 – – 1,622
Adjustments to regulatory basis Unallocated surplus of with-profits funds note (i) – 9,165 9,165 – – 50 9,215 Shareholders' share of realistic
Deferred acquisition costs of non-participating business not recognised for regulatory reporting purposes and goodwill – (6) (6) (111) (3,880) (979) (4,976)
Jackson surplus notes note (iv) – – – – 160 – 160 Investment and policyholder liabilities valuation differences between IFRS and regulatory basis for Jackson note (viii) – – – – 1,002 – 1,002
regulated with-profits funds: Insurance contracts 7,934 28,256 36,190 – – 6,777 42,967 Investment contracts (with
Other liabilities: Insurance contracts: With-profits liabilities of non-UK regulated funds – – – – – 5,419 5,419 Unit-linked, including variable annuity – 1,847 1,847 6,387 37,833 12,015 58,082 Other life assurance business 209 13,365 13,574 24,734 29,445 6,142 73,895 Investment contracts without discretionary participation features (principally unit-linked and similar contracts in the UK and GIC liabilities of Jackson)note (vi) – 17 17 14,927 1,911 112 16,967
Group shareholders' equity Held outside long-term funds: Net assets – – – 716 3,815 1,913 6,444 254 (1,532) 5,166 Goodwill – – – – – 236 236 1,153 77 1,466
Adjustment from IAS 19 basis pension deficit attributable to WPSF to pension liability for regulatory purposes note (vii) – 60 60 – – – 60
Valuation difference on PAL between IFRS basis and regulatory basis – (1,202) (1,202) – – – (1,202)
With-profits liabilities of non-UK regulated funds – – – – – 5,555 5,555
Unit-linked, including variable annuity – 2,128 2,128 8,882 31,203 12,724 54,937
Other life assurance business 268 13,067 13,335 19,297 27,438 4,935 65,005 Investment contracts without discretionary participation features (principally unit-linked and similar contracts in the UK and GIC liabilities of Jackson)note (vi) – – – 15,765 1,882 57 17,704
Total policyholder liabilities shown in the consolidated statement of financial position 9,759 71,827 81,586 43,944 60,523 28,674 214,727
(ii) Excluding PAC shareholders’ equity that is 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 ring-fenced with segregated assets and liabilities. (iv) For regulatory purposes the Jackson surplus notes are accounted for as capital. (v) Other adjustments to shareholders’ equity and unallocated surplus include amounts for the value of non-participating business for UK
(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 which, on Group consolidation, are eliminated against equivalent liabilities in the statement of financial position of UK insurance operations (see note I3).
D5: Capital position statement for life assurance businesses continued b Basis of preparation, capital requirements and management Each of the Group’s long-term business operations is capitalised to a sufficiently strong level for its individual circumstances. Details of the Group’s major operations are shown below.
i UK insurance operations The FSA rules which govern the Prudential regulation of insurance form part of the Prudential Sourcebook for Insurers, the General Prudential Sourcebook and Interim Prudential Sourcebook for Insurers. Overall, the net requirements of the General Prudential Sourcebook are intended to align the capital adequacy requirements for insurance business more closely with those of banking and investment firms and building societies, for example, by addressing tiers of capital, rather than looking at net admissible assets. An insurer must hold capital resources equal at least to the minimum capital requirement (MCR). The Prudential Sourcebook for Insurers also contains rules on Individual Capital Assessments. Under these rules and the rules of the General Prudential Sourcebook all insurers must assess for themselves the amount of capital needed to back their business. If the FSA views the results of this assessment as insufficient, it may draw up its own Individual Capital Guidance for a firm, which can be superimposed as a requirement.
PAC WPSF and SAIF Under FSA rules, insurers with with-profits liabilities of more than £500 million must hold capital equal to the higher of the MCR and the enhanced capital requirement (ECR). The ECR is intended to provide a more risk responsive and ‘realistic’ measure of a with-profits insurer’s capital requirements, whereas the MCR is broadly speaking equivalent to the previous required minimum margin under the Interim Prudential Sourcebook and satisfies the minimum EU Standards. Determination of the ECR involves the comparison of two separate measurements of the firm’s resources requirement, which the FSA refers to as the ‘twin peaks’ approach.
As noted in section D2(g)(ii), PAC has discretion in its management actions in the case of adverse investment conditions. Management actions encompass, but are not confined to, investment allocation decisions, levels of reversionary bonuses, crediting rates and total claim values. To illustrate the flexibility of management actions, rates of regular bonus are determined for each type of policy primarily by targeting them at a prudent proportion of the long-term expected future investment return on the underlying assets. The expected future investment return is reduced as appropriate for each type of policy to allow for items such as expenses, charges, tax and shareholders’ transfers. However, the rates declared may differ by product type or by date of payment of the premiums or date of issue of the policy, if the accumulated annual bonuses are particularly high or low relative to a prudent proportion of the achieved investment return. When target bonus levels change, the PAC Board has regard to the overall financial strength of the long-term fund when determining the length of time over which it will seek to achieve the amended product target bonus level.
For surrender benefits, any substantial fall in the market value of the assets of the with-profits sub-fund would lead to changes in the application of MVRs for accumulating with-profits policies, firstly to increase the size of MVRs already being applied, and secondly, to extend the range of policies for which an MVR is applied.
Other UK life assurance subsidiaries and funds The available capital of £1,937 million (2010: £1,707 million) reflects the excess of regulatory basis assets over liabilities of the subsidiaries and funds, before deduction of the capital resources requirement of £1,194 million (2010: £1,086 million). The capital resources requirement for these companies broadly reflects a formula which, for active funds, equates to a percentage of regulatory reserves plus a percentage of death strains. Death strains represent the payments made to policyholders upon death in excess of amounts explicitly allocated to fund the provisions for policyholders’ claims and maturities.
iii Asian operations The available capital shown above of £1,493 million (2010: £1,378 million) represents the excess of local regulatory basis assets over liabilities before deduction of required capital of £608 million (2010: £572 million). These amounts have been determined applying the local regulations in each of the operations. The businesses in Asia are subject to local capital requirements in the jurisdictions in which they operate. The Hong Kong business branch of PAC and its capital requirements are subsumed within those of the PAC long-term fund. For the other material Asian operations, the details of the basis of determining regulatory capital and regulatory capital requirements are as follows: Singapore In Singapore a risk-based regulatory framework applies rather than one based on a net premium approach.
For participating business, a gross premium reserve on the guaranteed and non-guaranteed benefits determined using best estimate assumptions is held. The amount held is subject to a minimum of a gross premium reserve on the guaranteed benefits, determined using best estimate assumptions along with provisions of risk margin for adverse deviations (PRADs) discounted at the risk-free rate. For non-participating business, gross premium reserves determined using best estimate assumptions along with provisions of risk margin for adverse deviations discounted at the risk-free rate are held. For linked business the value of units is held together with a non-unit reserve calculated in accordance with standard actuarial methodology. The risk-free rate is derived from a yield curve of zero-coupon spot yields of Malaysian Government Securities. Participating fund surplus is not allowed to be used to support a deficit (if any) and the capital requirement of the non-participating business. The capital requirement is calculated based on a prescribed series of risk charges with a multiplier of 175 per cent being applied to the total risk charges. The multiplier of 175 per cent is the capital target agreed between the regulator and the company.
Vietnam Mathematical reserves are calculated using a modified net premium approach, set of assumptions agreed with the regulator. The capital requirement is determined as 4 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 (£6 million) is also required for companies transacting unit-linked business.
(iv) Asian life assurance subsidiaries The increase of £115 million in 2011 reflects an underlying increase of £134 million (applying the relevant 2011 year end exchange rates) and £19 million of exchange translation loss.
The increase of £251 million in 2010 reflected an underlying increase of £127 million (applying the relevant 2010 year end exchange rates)
and £124 million of exchange translation gain. The underlying increase of available capital in 2010 included the effects of the acquisition of UOB Life Assurance Limited in Singapore in February 2010.
(v) New business and other factors comprise the effect of changes in new business, valuation interest rate, investment return, foreign exchange and other factors.
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. Accordingly, the excess of assets over liabilities of the PAC long-term fund is retained within that company. The retention of the capital enables it to support with-profits and other business of the fund by, for example, providing the benefits associated with smoothing and guarantees. It also provides investment flexibility for the fund’s assets by meeting the regulatory capital requirements that demonstrate solvency and by absorbing the costs of significant events or fundamental changes in its long-term business, without affecting the bonus and investment policies. For other UK long-term business subsidiaries, the amounts retained within the companies are at levels which provide an appropriate level of capital strength in excess of the regulatory minimum.
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 statutory net gain from operations for the prior year or 10 per cent of Jackson’s statutory surplus require prior regulatory approval. For Asian subsidiaries, the amounts retained within the companies are at levels that provide an appropriate level of capital strength in excess of the local regulatory minimum. For ring-fenced with-profits funds, the excess of assets over liabilities is retained with distribution tied to the shareholders’ share of bonuses through declaration of actuarially determined surplus. The Singapore and Malaysian businesses may, in general, remit dividends to the UK, provided the statutory insurance fund meets the capital adequacy standard required under local statutory regulations.
a The profit included in the income statement in respect of asset management operations for the year is as follows: Eastspring Investments note (iii) Total
Revenue, (excluding revenue of consolidated investment funds and NPH broker-dealer fees) 1,042 249 292 1,583 1,423
Revenue of consolidated investment fundsnote (i) 9 – – 9 11 NPH broker-dealer feesnote (i) – 405 – 405 369
Charges, (excluding charges of consolidated investment funds and NPH broker-dealer fees) (710) (225) (212) (1,147) (1,003)
Operating profit from asset management operations 301 246 Operating profit from Prudential Capital 56 38
Assets Intangible assets: Goodwillnote (iii) 1,153 16 61 1,230 1,230 Deferred acquisition costs and other intangibles assets 12 1 3 16 13
Other non-investment and non-cash assets 868 179 82 1,129 1,118 Financial investments: Loansnote (i) 1,256 – – 1,256 1,418 Equity securities and portfolio holdings in unit trusts 587 – 7 594 151 Debt securitiesnote (ii) 1,834 – 8 1,842 1,574 Other investments 72 1 5 78 59 Deposits 30 28 31 89 80
Equity and liabilities Equity Shareholders’ equity 1,382 129 272 1,783 1,787 Non-controlling interests 5 – – 5 4
All loans in the portfolio are currently paying interest on scheduled coupon dates and no interest has been capitalised or deferred. All loans are in compliance with their covenants at 31 December 2011. The loans in the portfolio generally have ratchet mechanisms included within the loan agreements at inception so that margins increase over time to encourage early repayment or have had margins increased to reflect revised commercial terms.
sset m an agem en t (in clu d in g U
M&G AAA to A- by Standard and Poor's or Aaa rated by Moody's 1,547 1,468 Other 287 92
(iii) The M&G statement of financial position includes the assets and liabilities in respect of Prudential Capital. (iv) Intragroup 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: Commercial paper 2,706 2,311 Medium-term notes 250 249
(v) Consolidated investment funds The M&G statement of financial position shown above includes investment funds which are managed on behalf of third parties. In respect of these funds, the statement of financial position includes the following, which are non-recourse to M&G and the Group: Cash and cash equivalents 348 304 Total investments 415 167 Other net assets and liabilities (85) (13) Net asset value attributable to external unit holders (678) (458)
Reconciliation of movement in investments A reconciliation of the total investments of asset management operations from the beginning of the year to the end of the year is as follows: M&G
At 1 January 2010 Total investments (including derivative assets) 2,835 15 40 2,890 Less: Derivative liabilitiesnote G3 (49) – – (49)
At 31 December 2010/1 January 2011 Total investments (including derivative assets) 3,203 23 56 3,282 Less: Derivative liabilitiesnote G3 (78) – – (78)
Net cash inflow (outflow) from operating activities 538 6 (4) 540 Realised gains in the year 17 – – 17 Unrealised gains and losses and exchange movements in the year (83) – (1) (84)
Movement in the year of directly held investments, net of derivative liabilities 472 6 (5) 473
At 31 December 2011 Total investments (including derivative assets) 3,779 29 51 3,859 Less: Derivative liabilities (182) – – (182)
Regulatory and other surplus Beginning of year 187 122 123 432 322 Gains during the year 252 12 62 326 312 Movement in capital requirement (3) – (11) (14) (23)
The movement in the year reflects gains driven by profits generated during the year and also changes in regulatory requirements. Distributions consist of dividends paid up to the parent company. The M&G figures include those for Prudential Capital.
E4: Sensitivity of profit and shareholders’ equity to market and other financial risk i Currency translation Consistent with the Group’s accounting policies, the profits of Eastspring Investments and asset management operations are translated at average exchange rates and shareholders’ equity at the closing rate for the reporting period. The rates for the most significant operations are shown in note B4. A 10 per cent increase in the relevant exchange rates would have reduced reported profit before tax attributable to shareholders and shareholders’ equity, excluding goodwill attributable to Eastspring Investments and US asset management operations, by £9 million (2010: £9 million) and £30 million (2010: £28 million) respectively.
Other operations consist of unallocated corporate activities relating to Group Head Office and the Asia regional head office, with net expenditure for the year of £483 million (2010: £450 million) as detailed in note B1. An analysis of the assets and liabilities of Other operations is shown in note B5. The Group holds certain derivatives that are used to manage foreign currency movements and macroeconomic exposures. The fair value of these derivatives is sensitive to the combined effect of movements in exchange rates, interest rate and inflation rate. The possible permutations cover a wide range of scenarios. For indicative purposes, a reasonably possible range of fair value movements could be plus or minus approximately £75 million.
in a n cia l state m e n ts F: In co m e statem en t n o tes
Gross premiums earned 5,678 12,650 7,378 – – – 25,706 – 25,706 Outward reinsurance premiums (131) (72) (226) – – – (429) – (429)
Benefits and claims and movements in unallocated surplus of with-profits funds, net of reinsurance (11,273) (12,651) (5,365) – – – (29,289) – (29,289)
Acquisition costs and other operating expenditure note F3 (1,239) (700) (1,562) (704) (630) (212) (5,047) 42 (5,005)
Total charges, net of reinsurance (12,512) (13,364) (6,927) (719) (630) (212) (34,364) (216) (34,580)
Profit (loss) before tax (being tax attributable to shareholders’ and policyholders’ returns)note (i) 832 599 663 332 24 80 2,530 (604) 1,926
Tax charge attributable to policyholders’ returns 68 – (51) – – – 17 – 17
Operating profit (loss) based on longer-term investment returns 723 694 704 357 24 80 2,582 (512) 2,070
Short-term fluctuations in investment returns on shareholder-backed business 159 (95) (92) (29) – – (57) (91) (148)
Shareholders’ share of actuarial and other gains and losses on defined benefit pension schemes 18 – – 4 – – 22 (1) 21
Gross premiums earned 6,371 11,817 6,380 – – – 24,568 – 24,568 Outward reinsurance premiums (128) (83) (146) – – – (357) – (357)
Earned premiums, net of reinsurance 6,243 11,734 6,234 – – – 24,211 – 24,211 Investment return note (ii) 14,374 4,576 2,744 186 1 3 21,884 (115) 21,769 Other income 233 (24) 139 768 597 248 1,961 (295) 1,666
Profit (loss) before tax (being tax attributable to shareholders’ and policyholders’ returns)note (i) 1,396 455 721 326 22 72 2,992 (920) 2,072
Short-term fluctuations in investment returns on shareholder-backed business 116 (378) 114 47 – – (101) (22) (123)
For the purpose of the presentation of unallocated surplus of with-profits funds within the statement of financial position, the Hong Kong branch balance is shown within the unallocated surplus of the PAC with-profits sub-fund.
Long-term business premiums Insurance contract premiums 24,831 23,647 Investment contracts with discretionary participation feature premiums 735 750 Inwards reinsurance premiums 140 171 Less: reinsurance premiums ceded (429) (357)
Notes (i) The segmental analysis of interest income is as follows: Insurance operations: UK 4,286 4,371 US 1,717 1,014 Asia 339 412
(ii) Interest income includes £8 million (2010: £8 million) accrued in respect of impaired securities. (iii) Fee income includes £13 million (2010: £11 million) relating to financial instruments that are not held at fair value through profit and loss. These fees primarily related to prepayment fees, late fees and syndication fees. (iv) The following table provides additional segmental analysis of revenue from external customers: Asia US UK Intragroup Total
Revenue from external customers: Insurance operations 6,373 11,710 6,476 (10) 24,549 Asset management 248 597 768 (314) 1,299 Unallocated corporate – – 29 – 29 Intragroup revenue eliminated on consolidation (77) (72) (175) 324 –
Revenue from external customers is made up of the following: Earned premiums, net of reinsurance 25,277 24,211 Fee income from investment contract business and asset management (presented as ‘Other income’) 1,869 1,666
Notes (i) The acquisition costs as shown in the table above relate to policy acquisition costs. Acquisition costs from business combinations are included within other expenditure. Acquisition costs in 2011 comprise amounts related to insurance contracts of £1,564 million (2010: £941 million), and investment contracts and asset management contracts of £65 million (2010: £165 million).
(vi) The total amounts for acquisition costs and other expenditure shown above includes Corporate Expenditure shown in note B1 (Segment disclosure – income statement). The charge for Corporate Expenditure comprises: Group head office: Regular and project costs (156) (150) Provision for property leases and other non-recurrent items (12) (25)
Deferred tax arising from: Origination and reversal of temporary differences 253 (518) Credit (expense) in respect of a previously unrecognised tax loss, tax credit or temporary difference from a prior period 57 (27)
The current tax charge of £742 million includes £16 million (2010: charge of £13 million) in respect of the tax charge for Hong Kong. The Hong Kong current tax charge is calculated as 16.5 per cent for all periods on either (i) 5 per cent of the net insurance premium or (ii) the estimated assessable profits, depending on the nature of the business written. The total tax charge comprises tax attributable to policyholders and unallocated surplus of with-profits funds, unit-linked policies and shareholders as shown below.
The total deferred tax credit/(charge) arises as follows: Unrealised gains and losses on investments 129 (217) Balances relating to investment and insurance contracts 108 (28) Short-term timing differences 66 (431) Capital allowances 2 (8) Unused tax losses 5 139
F5: Tax continued b Reconciliation of effective tax rate The total tax charge is attributable to shareholders and policyholders as summarised in the income statement.
* For the column entitled ‘Attributable to policyholders’, the profit before tax represents income, net of post-tax transfers to unallocated surplus of with-profits funds, before tax attributable to policyholders and unallocated surplus of with-profits funds and unit-linked policies.
Due to the requirements of the financial reporting standards IAS 1 and IAS 12, the profit (loss) before tax and tax charge reflect the aggregate of amounts that are attributable to shareholders and policyholders. Profit (loss) before tax comprises profit attributable to shareholders and pre-tax profit attributable to policyholders of linked and with-profits funds and unallocated surplus of with-profits funds. The total tax charge for linked and with-profits business includes tax expense on unit-linked and with-profits funds attributable to policyholders, the unallocated surplus of with-profits funds and the shareholders’ profits. This feature arises from the basis of taxation applied to life and pension business, principally in the UK, but with similar bases applying in certain Asian operations, and is explained in note (iii) below. Furthermore, the basis of preparation of Prudential’s financial statements incorporates the additional feature that, as permitted under IFRS 4, the residual equity of the Group’s with-profits funds, ie unallocated surplus, is recorded as a liability with transfers to and from that liability reflected in pre-tax profits. This gives rise to anomalous effective tax rates for profits attributable to policyholders (as described in note (iv) below). In meeting the reconciliation requirements set out in paragraph 81(c) of IAS 12, the presentation shown in this disclosure note seeks to ensure that the explanation of the relationship between tax expense and accounting profit draw properly the distinction between the elements of the profit and tax charge that are attributable to policyholders and shareholders as explained below in notes (iv) and (v) respectively. 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 the traditional approach that would apply for other industries. The shareholder elements are the components of the profit and tax charge that are of most direct relevance to investors, and it is this aspect that the IAS 12 reconciliation requirement is seeking to explain for companies that do not need to account for both with-profits and unit-linked funds, where tax is borne by the Company on the policyholders’ behalf and which is not contemplated by the IFRS requirement.
The tax expense attributable to policyholders is a combination of current and deferred tax charges and reflects the nature of the income and expenditure of the with-profits and unit-linked funds. The current tax charge element reflects the element for the funds, determined on the I-E basis (as described in note (iii) above) that is attributable to policyholders. For policyholder deferred tax, normally the most significant element reflects the movement on unrealised appreciation on investments. These investments are accounted for under IAS 39 on a fair value through profit or loss basis with attaching deferred tax charges or credits. 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). The accounting anomaly that arises under IFRS is that due to the fact that the net of tax profit attributable to with-profits policyholders is zero, the Company’s presentation of pre-tax profit attributable to policyholders reflects an amount that is the mirror image of the tax charge attributable to policyholders. For unit-linked business, pre-tax profits also reflect the aggregate of profits attributable to policyholders and shareholders. The pre-tax profits attributable to policyholders represent fees earned that are used to pay tax borne by the Company on policyholders’ behalf. The net of tax profit attributable to policyholders for unit-linked business is thus zero. The combined effect of these features is such that providing a reconciliation of the tax charge attributable to policyholders to an expected charge based on the standard corporate rate of tax on IFRS basis profits attributable to policyholders is not relevant. In summary, for accounting purposes, in all cases and for all reporting periods, the apparent effective rate for profit attributable to policyholders and unallocated surplus is 100 per cent. However, it is to be noted that the 100 per cent rate does not reflect a rate paid on the profits attributable to policyholders. It instead reflects the basis of accounting for unallocated surplus coupled with the distinction made for performance reporting between sources of profit attributable to shareholders, policyholders and unallocated surplus and IFRS requirements in respect of reporting of all pre-tax profits and all tax charges irrespective of policyholder or shareholder economic interest.
in a n cia l state m e n ts F: In co m e statem en t n o tes v Reconciliation of tax charge on profit attributable to shareholders for continuing operations: 2011 £m (except for tax rates)
Short-term fluctuations in investment returns 20% 35% 27% 27% 28% Shareholders’ share of actuarial and other gains and losses on defined benefit pension schemes 0% 0% 27% 27% 27%
Variance from expected tax charge:note (ii) Operating profit based on longer-term investment returns 47 43 5 50 145 Short-term fluctuations in investment returnsnote (iii) (20) – 8 (24) (36) Shareholders’ share of actuarial and other gains and losses on defined benefit pension schemes – – 1 – 1
Variance from expected tax charge:note (ii) Operating profit based on longer-term investment returns 59 43 18 237 357 Short-term fluctuations in investment returnsnote (iii) 21 – – 7 28 Shareholders’ share of actuarial and other gains and losses on defined benefit pension schemes – – – 1 1 Costs of terminated AIA transaction – – – (13) (13) Gain on dilution of Group's holdings – – 8 – 8
Actual tax (charge) credit: Operating profit based on longer-term investment returns,
(ii) For 2011 and 2010, the principal variances arise from a number of factors, including: (a) Asian long-term operations For 2011 and 2010, profits in certain countries which are not taxable along with utilising brought forward tax losses on which no deferred tax assets were previously recognised, partly offset by the inability to fully recognise deferred tax assets on losses being carried forward. The increase in the overall Asia tax rate from 2010 to 2011 primarily reflects recent fiscal developments in Indonesia affecting the life insurance industry.
(iii) Operating profit based on longer-term investment returns is net of attributable restructuring costs and development expenses. Related tax charges are determined on the basis of current taxation legislation.
Investment return is attributable to policyholders and shareholders. A key feature of the accounting policies under IFRS is that the investment return included in the income statement relates to all investment assets of the Group, irrespective of whether the return is attributable to shareholders, or to policyholders or the unallocated surplus of with-profits funds, the latter two of which have no net impact on shareholders’ profit. The table below provides a breakdown of the investment return for each regional operation attributable to each type of business.
US operations Policyholder returns Assets held to back (separate account) unit-linked liabilities (869) 3,520
Shareholder returns Realised gains and losses (including impairment losses on available-for-sale bonds) (238) 21 Value movements on derivative hedging programme for general account business 841 20 I nterest/dividend income and value movements on other financial instruments for which fair value movements are booked in the income statement 1,714 1,016
The investment return related to the types of business above does not impact shareholders’ profits directly. However, there is an indirect impact, for example, investment-related fees or the effect of investment return on the shareholders’ share of the cost of bonuses of with-profits funds. Investment returns for unit-linked and similar products have reciprocal impact on benefits and claims, with a decrease in market returns on the attached pool of assets affecting policyholder benefits on these products. Similarly for with-profits funds there is a close correlation between increases or decreases in investment returns and the level of combined charge for policyholder benefits and movement on unallocated surplus that arises from such returns.
Shareholder returns For shareholder-backed non-participating business of the UK (comprising PRIL and other non-linked non-participating business) and of the Asian operations, the investment return is not directly attributable to policyholders and therefore does impact shareholders’ profit directly. However, it should be noted that for UK shareholder-backed annuity business, principally PRIL, where the durations of asset and liability cash flows are closely matched, the discount rate applied to measure liabilities to policyholders (under ‘grandfathered’ UK GAAP and under IFRS 4) reflects movements in asset yields (after allowances for the future defaults) of the backing portfolios. Therefore, the net impact on the shareholders’ profits of the investment return of the assets backing liabilities of the UK shareholderbacked annuity business is after taking into account the consequential effect on the movement in policyholder liabilities.
Benefits and claims represent payments, including final bonuses, to policyholders in respect of maturities, surrenders and deaths plus the change in technical provisions (which primarily represents the movement in amounts owed to policyholders). Benefits and claims are amounts attributable to policyholders. The movement in unallocated surplus of with-profits funds represents the transfer to (from) the unallocated surplus each year through a charge (credit) to the income statement of the annual excess (shortfall) of income over expenditure of the with-profits funds, after declaration and attribution of the cost of bonuses to policyholders and shareholders. Benefits and claims and movements in unallocated surplus of with-profits funds net of reinsurance can be further analysed as follows: Asia US UK Total
Financial assets Cash and cash equivalents – – 7,257 7,257 7,257 Deposits – – 10,708 10,708 10,708 Equity securities and portfolio holdings in unit trusts 87,349 – – 87,349 87,349 Debt securitiesnote (i) 97,482 27,016 – 124,498 124,498 Loansnote (ii) 279 – 9,435 9,714 9,828 Other investmentsnote (iii) 7,509 – – 7,509 7,509 Accrued investment income – – 2,710 2,710 2,710 Other debtors – – 987 987 987
Financial liabilities Core structural borrowings of shareholder-financed operationsH13 and note (i) – 3,611 – 3,611 3,815 Operational borrowings attributable to shareholder-financed operationsH13 – 3,340 – 3,340 3,340 Borrowings attributable to with-profits fundsH13 39 933 – 972 978 Obligations under funding, securities lending and sale and repurchase agreements – 3,114 – 3,114 3,144 Net asset value attributable to unit holders of consolidated unit trust and similar funds 3,840 – – 3,840 3,840 Investment contracts with discretionary participation featuresnote (iv) – – 29,745 29,745 – Investment contracts without discretionary participation features 15,056 1,911 – 16,967 17,008 Other creditors 281 2,263 – 2,544 2,544 Derivative liabilities 3,054 – – 3,054 3,054 Other liabilities – 1,249 – 1,249 1,249
Financial liabilities Core structural borrowings of shareholder-financed operationsH13 and note (i) – 3,676 – 3,676 3,866 Operational borrowings attributable to shareholder-financed operationsH13 – 3,004 – 3,004 2,991 Borrowings attributable to with-profits fundsH13 82 1,440 – 1,522 1,524 Obligations under funding, securities lending and sale and repurchase agreements – 4,199 – 4,199 4,236 Net asset value attributable to unit holders of consolidated unit trust and similar funds 3,372 – – 3,372 3,372 Investment contracts with discretionary participation featuresnote (iv) – – 25,732 25,732 – Investment contracts without discretionary participation features 15,822 1,882 – 17,704 17,652 Other creditors – 2,321 – 2,321 2,321 Derivative liabilities 2,037 – – 2,037 2,037 Other liabilities – 1,129 – 1,129 1,129
Notes (i) As at 31 December 2011, £523 million (2010: £685 million) of convertible bonds were included in debt securities and £702 million
Determination of fair value The fair values of the financial assets and liabilities of the Group have been determined on the following bases. The fair values of the financial instruments for which fair valuation is required under IFRS are determined by the use of current market bid prices for exchange-quoted investments, or by using quotations from independent third parties, such as brokers and pricing services or by using appropriate valuation techniques. Investments valued using valuation techniques include financial investments which by their nature do not have an externally quoted price based on regular trades and financial investments for which markets are no longer active as a result of market conditions eg 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. Changes in assumptions relating to these variables could positively or negatively impact the reported fair value of these instruments. When determining the inputs into the valuation techniques used 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 from selling the financial instrument being fair valued. In some cases the disclosed value cannot be realised in immediate settlement of the financial instrument. The loans and receivables have been shown net of provisions for impairment. The fair value of loans has been estimated from discounted cash flows expected to be received. The rate of discount used was the market rate of interest. The estimated fair value of derivative financial instruments reflects the estimated amount the Group would receive or pay in an arm’s length transaction. This amount is determined using quoted prices if exchange listed, quotations from independent third parties or valued internally using standard market practices. In accordance with the Group’s risk management framework, all internally generated valuations are subject to assessment against external counterparties’ valuations. For investment contracts in the US with fixed and guaranteed terms the fair value is determined based on the present value of future cash flows discounted at current interest rates.
Generally, no adjustment is made to the prices obtained from independent third parties. Adjustment is made in only limited circumstances, where it is determined that the third-party valuations obtained do not reflect fair value (eg either because the value is stale and/or the values are extremely diverse in range). These are usually securities which are distressed or that could be subject to a debt restructure or where reliable market prices are no longer available due to an inactive market or market dislocation. In these instances, prices are derived using internal valuation techniques including those as described above in this note 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 techniques used require a number of assumptions relating to variables such as credit risk and interest rates. Examples of such variables include an average credit spread based on the corporate bond universe and the relevant duration of the asset being valued. Prudential measures the input assumptions based on the best available information at the measurement dates. Securities valued in such manner are classified as level 3 where these significant inputs are not based on observable market data. Of the total level 2 debt securities of £94,378 million at 31 December 2011 (31 December 2010: £89,948 million), £6,847 million are valued internally (31 December 2010: £6,638 million). The majority of such securities are valued using matrix pricing, which is based on assessing the credit quality of the underlying borrower to derive a suitable discount rate relative to government securities of a comparable duration. Under matrix pricing, the debt securities are priced taking the credit spreads on comparable quoted public debt securities and applying these to the equivalent debt instruments factoring in 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.
Unit-linked and variable annuity separate account Equity securities and portfolio holdings in unit trusts 59,662 198 30 59,890 Debt securities 4,160 4,698 3 8,861 Other investments (including derivative assets) 18 95 – 113 Derivative liabilities (2) (7) – (9)