Michael McLintock M&G Executive LTIP 2008 1,141 2,990 – 31 Dec 10
In the 2010 Annual Report, the value shown for Michael McLintock’s 2010 M&G Executive LTIP award was the expected value rather than the face value of the award. This has been amended in the table above.
See page 142 for a description of the JNL LTIP. Performance over the period from 2007 to 2010 resulted in a payment of £857,617 to Mike Wells in 2011. Performance over the period from 2008 to 2011 will result in a payment of £826,975 to Mike Wells during 2012. The awards above were made before Mike Wells became an executive director. Mike Wells was not made a 2011 JNL LTIP award and it is anticipated that no further awards will be made to him under this Plan.
Notes 1 The Deferred Share Awards in 2010 and 2011 for Barry Stowe and Mike Wells were made in ADRs (1 ADR = 2 Prudential plc shares). The figures in the table are represented in terms of Prudential shares.
Outstanding share options The following table sets out the share options held by the directors in the UK Savings Related Share Option Scheme (SAYE) as at the end of the period. No other directors held shares in any other option scheme.
Tidjane Thiam 25 Apr 08 551 638.5 01 Jun 11 30 Nov 11 1,705 1,705 – John Foley 25 Apr 08 551 638.5 01 Jun 13 29 Nov 13 2,953 2,953 Tidjane Thiam 16 Sep 11 465.8666 638.5 01 Dec 14 29 May 15 965 965 Nic Nicandrou 16 Sep 11 465.8666 638.5 01 Dec 16 31 May 17 3,268 3,268 Rob Devey 16 Sep 11 465.8666 638.5 01 Dec 16 31 May 17 3,268 3,268
Increase in transfer value less contributions made by directors during 2011
Rob Devey 43 5 John Foley 55 37 Michael McLintock 50 19 55 5 3 1,102 856 232 22 Nic Nicandrou 46 5 Barry Stowe 54 2 Tidjane Thiam 49 9 Mike Wells 51 19
Lord Turnbull Harvey McGrath Chairman, Remuneration Committee Chairman 12 March 2012
International Financial Reporting Standards (IFRS) basis results Statutory IFRS basis results
Profit after tax attributable to equity holders of the Company IFRS Income Statement 163 £1,490m £1,431m Basic earnings per share IFRS Income Statement 163 58.8p 56.7p Dividends per share declared and paid in reporting period IFRS note B3 197 25.19p 20.17p Shareholders’ equity, excluding non-controlling interest IFRS Statement of financial position 167 £9,117m £8,031m
Profit from continuing operations before tax attributable to shareholders (including actual investment returns) IFRS note B1 192 £1,943m £1,461m
Operating earnings per share after related tax and non-controlling interests (including 2010 exceptional tax credit) IFRS note B2 196 63.9p 68.3p
Dividends per share in respect of the reporting period (including interim dividend of 7.95p (2010: 6.61p) and final dividend of 17.24p (2010: 17.24p) declared after the end of the reporting period) IFRS note B3 197 25.19p 23.85p
Shareholders’ equity, excluding non-controlling interests EEV statement of financial position 390 £19,637m £18,207m
Operating profit based on longer-term investment returns Consistent with previous reporting practice, the Group provides supplementary analysis of IFRS profit before tax attributable to shareholders and analyses its EEV basis results, so as to distinguish operating profit based on longer-term investment returns from other elements of total profit. On both the IFRS and EEV bases, operating earnings per share are calculated using operating profits based on longer-term investment returns, after related tax and non-controlling interests. These profits exclude short-term fluctuations in investment returns and the shareholders’ share of actuarial and other gains and losses on defined benefit pension schemes. The operating profit based on longer-term investment returns for 2010 also excludes the costs associated with the terminated AIA transaction and the gain arising upon the dilution of the Group’s holding in PruHealth. Under the EEV basis, where additional profit and loss effects arise, operating profit based on longer-term investment returns also excludes the mark to market value movements on core borrowings and the effect of changes in economic assumptions. After adjusting for related tax and non-controlling interests, the amounts excluded from operating profit based on longer-term investment returns are included in the calculation of earnings per share.
Primary statements 163 Consolidated income statement 164 Consolidated statement of comprehensive income 165 Consolidated statement of changes in equity 167 Consolidated statement of financial position 169 Consolidated statement of cash flows
Section E: Asset management (including US broker dealer) and other operations 285 E1: Income statement for asset management operations 287 E2: Statement of financial position for asset management operations 289 E3: Regulatory and other surplus 290 E4: Sensitivity of profit and shareholders’ equity to market and other financial risk 290 E5: Other operations
Section F: Income statement notes 291 F1: Segmental information 293 F2: Revenue 295 F3: Acquisition costs and other expenditure 296 F4: Finance costs: Interest on core structural borrowings of shareholder-financed operations 296 F5: Tax 304 F6: Allocation of investment return between policyholders and shareholders 306 F7: Benefits and claims and movements in unallocated surplus of with-profits funds, net of reinsurance
Section G: Financial assets and liabilities 307 G1: Financial instruments – designation and fair values 316 G2: Market risk 321 G3: Derivatives and hedging 322 G4: Derecognition and collateral 323 G5: Impairment of financial assets
Section H: Other information on statement of financial position items 324 H1: Intangible assets attributable to shareholders 328 H2: Intangible assets attributable to with-profits funds 329 H3: Reinsurers’ share of insurance contract liabilities 330 H4: Tax assets and liabilities 331 H5: Accrued investment income and other debtors 332 H6: Property, plant and equipment 333 H7: Investment properties 334 H8: Investments in associates and joint ventures 336 H9: Properties held for sale 337 H10: Cash and cash equivalents 337 H11: Shareholders’ equity: Share capital, share premium and reserves 339 H12: Insurance contract liabilities and unallocated surplus of with-profits funds 340 H13: Borrowings 342 H14: Provisions and contingencies 348 H15: Other liabilities
Limited in 2010 350 I2: Changes to Group’s holdings 350 I3: Staff and pension plans 363 I4: Share-based payments 366 I5: Key management remuneration 367 I6: Fees payable to auditor 367 I7: Related party transactions 368 I8: Subsidiary undertakings 370 I9: Commitments 370 I10: Cash flows 370 I11: Post balance sheet events
Parent company financial statements 371 Balance sheet of the parent company 372 Notes on the parent company financial statements
European Embedded Value (EEV) basis supplementary information 434 �Independent auditor’s report to Prudential plc on the European Embedded Value (EEV) basis supplementary information
Benefits and claims (31,060) (40,608) Outward reinsurers’ share of benefit and claims F1 746 335 Movement in unallocated surplus of with-profits funds H12 1,025 (245)
Acquisition costs and other expenditure F3 (5,005) (4,799) Finance costs: interest on core structural borrowings of shareholder-financed operations F4 (286) (257)
Profit before tax (being tax attributable to shareholders’ and policyholders’ returns)* 1,926 2,072 Tax credit (charge) attributable to policyholders’ returns F5 17 (611)
Profit before tax attributable to shareholders B1 1,943 1,461 Tax charge F5 (432) (636) Less: tax attributable to policyholders’ returns (17) 611 Tax charge attributable to shareholders’ returns† F5 (449) (25)
Earnings per share (in pence) Based on profit attributable to the equity holders of the Company: Basic B2 58.8p 56.7p * This measure is the formal profit before tax measure under IFRS but it is not the result attributable to shareholders. The 2010 profit before tax is stated after £377 million of pre-tax costs of the terminated AIA transaction. See Note B1.
† The 2010 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.
Other comprehensive income: Exchange movements on foreign operations and net investment hedges: Exchange movements arising during the year B4 (32) 217 Related tax (68) 34
Total 811 1,221 Related change in amortisation of deferred income and acquisition costs H1 (331) (496) Related tax (168) (247)
Total comprehensive income for the year – – 1,490 (100) 312 1,702 4 1,706
Reserve movements in respect of share-based payments – – 44 – – 44 – 44 Change in non-controlling interests arising principally from purchase and sale of property partnerships of the PAC with-profits fund and other consolidated investment funds – – – – – – (5) (5)
Reserves Profit for the year – – 1,431 – – 1,431 5 1,436 Other comprehensive income Exchange movements on foreign operations and net investment hedges, net of related tax – – – 251 – 251 – 251 Unrealised valuation movements, net of related change in amortisation of deferred income and acquisition costs and related tax – – – – 478 478 – 478
Total comprehensive income for the year – – 1,431 251 478 2,160 5 2,165 Dividends B3 – – (511) – – (511) – (511) Reserve movements in respect of share-based payments – – 37 – – 37 – 37 Change in non-controlling interests arising principally from purchase and sale of property partnerships of the PAC with-profits fund and other consolidated investment funds – – – – – – 7 7
Share capital and share premium New share capital subscribed (including shares issued in lieu of cash dividends) H11 – 75 – – – 75 – 75 Reserve movements in respect of shares issued in lieu of cash dividends H11 – (62) 62 – – – – – Treasury shares Movement in own shares in respect of share-based payment plans – – (4) – – (4) – (4) Movement in Prudential plc shares purchased by unit trusts consolidated under IFRS – – 3 – – 3 – 3
Intangible assets attributable to with-profits funds: In respect of acquired subsidiaries for venture fund and other investment purposes H2(a) 178 166 Deferred acquisition costs and other intangible assets H2(b) 89 110
Liabilities Policyholder liabilities and unallocated surplus of with-profits funds: Insurance contract liabilities H12 180,363 171,291 Investment contract liabilities with discretionary participation features G1 29,745 25,732 Investment contract liabilities without discretionary participation features G1 16,967 17,704 Unallocated surplus of with-profits funds H12 9,215 10,253
Core structural borrowings of shareholder-financed operations: Subordinated debt H13 2,652 2,718 Other H13 959 958
Other borrowings: Operational borrowings attributable to shareholder-financed operations G1,H13 3,340 3,004 Borrowings attributable to with-profits operations G1,H13 972 1,522
Harvey McGrath Tidjane Thiam Nic Nicandrou Chairman Group Chief Executive Chief Financial Officer
Cash flows from operating activities Profit before tax (being tax attributable to shareholders’ and policyholders’ returns)note (i) 1,926 2,072 Non-cash movements in operating assets and liabilities reflected in profit before tax: Investments (8,854) (24,594) Other non-investment and non-cash assets (1,038) (1,161) Policyholder liabilities (including unallocated surplus) 10,874 24,287 Other liabilities (including operational borrowings) (845) 1,332 Interest income and expense and dividend income included in result before tax (7,449) (7,514) Other non-cash items note (ii) 18 139 Operating cash items: Interest receipts 6,365 6,277 Dividend receipts 1,302 1,412 Tax paid (561) (302)
Cash and cash equivalents at end of year H10 7,257 6,631
(v) Interest paid structural borrowings of with-profits operations relate solely to the £100 million 8.5 per cent undated subordinated guaranteed bonds which contribute to the solvency base of the Scottish Amicable Insurance Fund (SAIF), a ring-fenced sub-fund of the PAC with-profits fund. Cash flows in respect of other borrowings of with-profits funds, which principally relate to consolidated investment funds, are included within cash flows from operating activities.
(vi) Cash movements in respect of equity capital in 2010 exclude scrip dividends. The scrip dividend alternative has been replaced by the Dividend Re-investment Plan (DRIP) from the 2010 final dividend.
Prudential plc (the Company) together with its subsidiaries (collectively, the Group or Prudential) is an international financial services group with its principal operations in Asia, the US and the UK. Prudential offers a wide range of retail financial products and services and asset management services throughout these territories. The retail financial products and services principally include life insurance, pensions and annuities as well as collective investment schemes. In Asia, the Group has operations in Hong Kong, Malaysia, Singapore, Indonesia and other Asian countries. The life insurance products offered by the Group’s operations in Asia include with-profits (participating) and non-participating term, whole life and endowment and unit-linked policies. In Asia, unit-linked policies are usually sold with insurance riders such as health covers. In the US, the Group’s principal subsidiary is Jackson National Life Insurance Company (Jackson). The principal products written by Jackson are fixed annuities (interest-sensitive, fixed indexed and immediate annuities), variable annuities (VA), life insurance and institutional products. The Group operates in the UK through its subsidiaries, primarily The Prudential Assurance Company Limited (PAC), Prudential Annuities Limited (PAL), Prudential Retirement Income Limited (PRIL) and M&G Investment Management Limited. Long-term business products written in the UK are principally with-profits deposit administration, other conventional and unitised with-profits policies and non-participating pension annuities in the course of payment. Long-term business written in the UK also includes unit-linked products. Prudential plc is a public limited company incorporated and registered in England and Wales. The registered office is: Laurence Pountney Hill London EC4R 0HH UK Companies House registered number: 1397169
The consolidated financial statements consolidate the Group and the Group’s interest in associates and jointly-controlled entities. The parent company financial statements present information about the Company as a separate entity and not about the Group. The consolidated financial statements have been prepared and approved by the directors in accordance with International Financial Reporting Standards (IFRS) as issued by the International Accounting Standards Board (IASB) and as endorsed by the European Union (EU) as required by EU law (IAS regulation EC 1606/2032). The Company has elected to prepare its parent company financial statements in accordance with UK Generally Accepted Accounting Practice (GAAP). These are presented on pages 371 to 382. A reconciliation to IFRS has also been provided for shareholders’ equity and profit for the year of the parent company. The Group has applied all IFRS standards and interpretations adopted by the EU that are effective for financial years commencing on or before 1 January 2011. The Group has applied the same accounting policies in preparing the 2011 results as for 2010 except for the adoption of the new accounting pronouncements effective in 2011. Further details on the new accounting pronouncements and accounting policy changes are provided in note A5.
A3: Critical accounting policies, estimates and judgements a Critical accounting policies Prudential’s discussion and analysis of its financial condition and results of operations are based upon Prudential’s consolidated financial statements, which have been prepared in accordance with IFRS as issued by the IASB and as endorsed by the EU. EU-endorsed IFRS may differ from IFRS as issued by the IASB if, at any point in time, new or amended IFRSs have not been endorsed by the EU. As at 31 December 2011, there were no unendorsed standards effective for the two years ended 31 December 2011 affecting the consolidated financial information of Prudential and there were no differences between IFRSs endorsed by the EU and IFRSs issued by the IASB in terms of their application to Prudential. Accordingly, Prudential’s financial information for the two years ended 31 December 2011 is prepared in accordance with IFRS as issued by the IASB. Prudential adopts mandatory requirements of new or altered EU-adopted IFRS standards where required, and may consider earlier adoption where permitted and appropriate in the circumstances. The preparation of these financial statements requires Prudential to make estimates and judgements that affect the reported amounts of assets, liabilities, and revenues and expenses, and related disclosure of contingent assets and liabilities. On an ongoing basis, Prudential evaluates its estimates, including those related to long-term business provisioning, the fair value of assets and the declaration of bonus rates. Prudential bases its estimates on historical experience and on various other assumptions that are believed to be reasonable under the circumstances, the results of which form the basis for making judgements about the carrying value of assets and liabilities that are not readily apparent from other sources. Actual results may differ from these estimates under different assumptions or conditions. Critical accounting policies are defined as those that are reflective of significant judgements and uncertainties, and potentially give rise to different results under different assumptions and conditions. Prudential believes that its critical accounting policies are limited to those described below.
The critical accounting policies in respect of the items discussed below are critical for the Group’s results insofar as they relate to the Group’s shareholder-financed business. In particular this applies for Jackson which is the largest shareholder-backed business in the Group. The policies are not critical in respect of the Group’s with-profits business. This distinction reflects the basis of recognition of profit and accounting treatment of unallocated surplus of with-profits funds as a liability. Additional explanation is provided later in this note and cross-referenced notes as to why the distinction between with-profits business and shareholder-backed business is relevant. The items discussed below and in cross-referenced notes explain the effect of changes in estimates and the effect of reasonably likely changes in the key assumptions underlying these estimates as of the latest statement of financial position date so as to provide analysis that recognises the different accounting effects on profit and loss or equity. In order to provide relevant analysis that is appropriate to the circumstances applicable to the Group’s businesses, the explanations refer to types of business, fund structure, the relationship between asset and policyholder liability measurement, and the differences in the method of accounting permitted under IFRS 4, ‘Insurance Contracts’ for accounting for insurance contract assets, policyholder liabilities and unallocated surplus of the Group’s with-profits funds.
The results included in the financial statements for 2011 and 2010 reflect this basis. Unallocated surplus represents the excess of assets over policyholder liabilities for the Group’s with-profits funds that have yet to be appropriated between policyholders and shareholders. The Group has elected to account for unallocated surplus wholly as a liability with no allocation to equity. This treatment reflects the fact that shareholders’ participation in the cost of bonuses arises only on distribution. Shareholder profits on with-profits business reflect one-ninth of the cost of declared bonus. For Jackson, applying the MSB as applicable to overseas operations which permits the application of local GAAP in some circumstances, the assets and liabilities of insurance contracts are accounted for under insurance accounting prescribed by US GAAP. For the assets and liabilities of insurance contracts of Asian operations, the local GAAP is applied with adjustments, where necessary, to comply with UK GAAP. For the operations in India, Japan, Taiwan and Vietnam, countries where local GAAP is not appropriate in the context of the previously applied MSB, accounting for insurance contracts is based on US GAAP. For participating business, the liabilities include provisions for the policyholders’ interest in realised investment gains and other surpluses that, where appropriate, have yet to be declared as bonuses. The usage of these bases of accounting has varying effects on the way in which product options and guarantees are measured. For UK regulated with-profits funds, options and guarantees are valued on a market consistent basis. The basis is described in note D2(g)(ii). For other operations, a market consistent basis is not applied under the accounting basis described in note A4. Details of the guarantees, basis of setting assumptions, and sensitivity to altered assumptions are described in notes D3 and D4.
Valuation and accounting presentation of fair value movements of derivatives and debt securities of Jackson Under IAS 39, ‘Financial Instruments: Recognition and Measurement’, derivatives are required to be carried at fair value. Unless net investment hedge accounting is applied, value movements on derivatives are recognised in the income statement. For derivative instruments of Jackson, the Group has considered whether it is appropriate to undertake the necessary operational changes to qualify for hedge accounting so as to achieve matching of value movements in hedging instruments and hedged items in the performance statements. In reaching the decision a number of factors were particularly relevant. These were: • IAS 39 hedging criteria have been designed primarily in the context of hedging and hedging instruments that are assessable as financial instruments that are either stand-alone or separable from host contracts, rather than, for example, duration characteristics of insurance contracts; • the high hurdle levels under IAS 39 of ensuring hedge effectiveness at the level of individual hedge transactions; • the difficulties in applying the macro hedge provisions under IAS 39 (which are more suited to banking arrangements) to Jackson’s derivative book, the complexity of asset and liability matching of US life insurers such as those with Jackson’s product range; and • whether it is possible or desirable, without an unacceptable level of costs and constraint on commercial activity, to achieve the accounting hedge effectiveness required under IAS 39.
Segmental analysis of results and earnings attributable to shareholders The Group uses operating profit based on longer-term investment returns as the segmental measure of its results. The basis of calculation is disclosed in note A4(d). For shareholder-backed business, with the exception of debt securities held by Jackson and assets classified as loans and receivables, all financial investments and investment property are designated as assets at fair value through profit and loss. Short-term fluctuations in investment returns on such assets held by with-profits funds, do not affect directly reported shareholder results. This is because (i) the unallocated surplus of with-profits funds is accounted for as liabilities and (ii) excess or deficits of income and expenditure of the funds over the required surplus for distribution are transferred to or from unallocated surplus. However, for shareholder-backed businesses the short-term fluctuations affect the result for the year and the Group provides additional analysis of results before and after short-term fluctuations in investment returns.
Insurance contracts Product classification IFRS 4 requires contracts written by insurers to be classified as either ‘insurance contracts’ or ‘investment contracts’ depending on the level of insurance risk transferred. Insurance risk is a pre-existing risk, other than financial risk, transferred from the contract holder to the contract issuer. If significant insurance risk is transferred by the contract then it is classified as an insurance contract. Contracts that transfer financial risk but not significant insurance risk are termed investment contracts. Furthermore, some contracts, both insurance and investment, contain discretionary participating features representing the contractual right to receive additional benefits as a supplement to guaranteed benefits: a that are likely to be a significant portion of the total contract benefits, b whose amount or timing is contractually at the discretion of the insurer, and c that are contractually based on asset or fund performance, as discussed in IFRS 4.
Valuation assumptions i Contracts of with-profits funds The Group’s with-profits funds write with-profits and other protection type policies classified as insurance contracts and investment contracts with discretionary participating features. For UK regulated with-profits funds, the contract liabilities are valued by reference to the UK Financial Services Authority’s (FSA) realistic basis as described in section A4(b). In aggregate, this basis 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. The basis of determining liabilities for the Group’s with-profits business has little or no effect on the results attributable to shareholders. This is because movements on liabilities of the with-profits funds are absorbed by the unallocated surplus. Except through indirect effects, or in remote circumstances as described below, changes to liability assumptions are therefore reflected in the carrying value of the unallocated surplus, which is accounted for as a liability rather than shareholders’ equity. A detailed explanation of the basis of liability measurement is contained in note D2(g)(ii). The Group’s other with-profits contracts are written in with-profits funds that operate in some of the Group’s Asian operations. The liabilities for these contracts and those of Prudential Annuities Limited, which is a subsidiary company of the PAC with-profits fund, are determined differently. For these contracts the liabilities are estimated using actuarial methods based on assumptions relating to premiums, interest rates, investment returns, expenses, mortality and surrenders. The assumptions to which the estimation of these reserves is particularly sensitive are the interest rate used to discount the provision and the assumed future mortality experience of policyholders. For liabilities determined using the basis described above for UK regulated with-profits funds, and the other liabilities described in the preceding paragraph, changes in estimates arising from the likely range of possible changes in underlying key assumptions have no direct impact on the reported profit. This lack of sensitivity reflects the with-profits fund structure, basis of distribution, and the application of previous GAAP to the unallocated surplus of with-profits funds as permitted by IFRS 4. Changes in liabilities of these contracts that are caused by altered estimates are absorbed by the unallocated surplus of the with-profits funds with no direct effect on shareholders’ equity. The Company’s obligations and more detail on such circumstances are described in note H14.
ii Other contracts Contracts, other than those of with-profits funds, are written in shareholder-backed operations of the Group. The significant shareholder-backed product groupings and the factors that may significantly affect IFRS results due to experience against assumptions or changes of assumptions vary significantly between business units. For some types of business the effect of changes in assumptions may be significant, whilst for others, due to the nature of the product, assumption setting may be of less significance. The nature of the products and the significance of assumptions are discussed in notes D2, D3 and D4. From the perspective of shareholder results the key sensitivity relates to the assumption for allowance for credit risk for UK annuity business, as described in note D2(g)(iii).
Jackson Jackson offers individual fixed annuities, fixed index annuities, immediate annuities, variable annuities, individual and variable life insurance and institutional products. With the exception of institutional products and an incidental amount of business for annuity certain contracts, which are accounted for as investment contracts under IAS 39, all of Jackson’s contracts are accounted for under IFRS 4 as insurance contracts by applying US GAAP, the previous GAAP used before IFRS adoption. The accounting requirements under these standards and the effect of changes in valuation assumptions are considered below for fixed annuity, variable annuity and traditional life insurance contracts. Fixed annuity contracts, which are investment contracts under US GAAP terminology, are accounted for by applying in the first instance a retrospective deposit method to determine the liability for policyholder benefits. This is then augmented by potentially three additional amounts, namely deferred income, any amounts previously assessed against policyholders that are refundable on termination of the contract, and any premium deficiency, ie, any probable future loss on the contract. These types of contracts contain considerable interest rate guarantee features. Notwithstanding the accompanying market risk exposure, 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 Jackson’s fixed annuity 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.
Asian operations The insurance products written in the Group’s Asian operations principally cover with-profits business, unit-linked business, and other non-participating business. The results of with-profits business are relatively insensitive to changes in estimates and assumptions that affect the measurement of policyholder liabilities. As for the UK business, this feature arises because unallocated surplus is accounted for by the Group as a liability. The results of Asian unit-linked business are also relatively insensitive to changes in estimates or assumptions. The remaining non-participating business in Asia has some limited sensitivity to interest rates. Further details are provided in D4(j).
Asian operations For those territories applying US GAAP to insurance assets and liabilities, as permitted by the ABI SORP, principles similar to those set out in the Jackson paragraph above are applied to the deferral and amortisation of acquisition costs. For other Asian territories, the general principles of the ABI SORP are applied with, as described above, deferral of acquisition costs being either explicit or implicit through the reserving basis.
A4: Significant accounting policies a Financial instruments other than financial instruments classified as long-term business contracts Investment classification Under IAS 39, subject to specific criteria, financial instruments should be accounted for under one of the following categories: financial investments at fair value through profit and loss, financial investments held on an available-for-sale basis, financial investments held-to-maturity or loans and receivables. Upon initial recognition, financial investments are measured at fair value plus, in the case of a financial asset or financial liability not at fair value through profit or loss, transaction costs that are directly attributable to the acquisition or issue of the financial asset or financial liability. These IAS 39 classifications have been changed by IFRS 9 ‘Financial Investments: Classification and Measurement’ which is not required to be adopted until 2015 and is still subject to EU endorsement. This standard has not been adopted by the Group in 2011. The Group holds financial investments on the following bases: i Financial assets and liabilities at fair value through profit and loss – this comprises assets and liabilities designated by management as fair value through profit and loss on inception and derivatives that are held for trading. These investments are measured at fair value with all changes thereon being recognised in investment income; ii Financial investments on an available-for-sale basis – this comprises assets that are designated by management and/or do not fall into any of the other categories. Available-for-sale financial assets are initially recognised at fair value plus attributable transaction costs. For available-for-sale debt securities, the difference between their cost and par value is amortised to the income statement using the effective interest rate. Available-for-sale financial assets are subsequently measured at fair value. Interest income is recognised on an effective interest basis in the income statement. Except for foreign exchange gains and losses on debt securities, not in functional currency, which are included in the income statement, unrealised gains and losses are recognised in other comprehensive income (ie outside of the income statement). Upon disposal or impairment, accumulated unrealised gains and losses are transferred from other comprehensive income to the income statement as realised gains or losses; and iii Loans and receivables – this comprises non-quoted investments that have fixed or determinable payments and are not designated as fair value through profit and loss or available-for-sale. These investments include loans collateralised by mortgages, deposits, loans to policyholders and other unsecured loans and receivables. These investments are initially recognised at fair value plus transaction costs. Subsequently, these investments are carried at amortised cost using the effective interest method.
Use of fair values The Group uses current bid prices to value its investments with quoted prices. Actively traded investments without quoted prices are valued using prices provided by third parties. If there is no active established market for an investment, the Group applies an appropriate valuation technique such as a discounted cash flow technique. Additional details are provided in note G1.
Derivatives and hedge accounting Derivative financial instruments are used to reduce or manage investment, interest rate and currency exposures, to facilitate efficient portfolio management and for investment purposes. The Group may designate certain derivatives as hedges. This includes fair value hedges, cash flow hedges and hedges of net investments in foreign operations. If the criteria for hedge accounting are met then the following accounting treatments are applied from the date at which the designation is made and the accompanying requisite documentation is in place: i Hedges of net investments in foreign operations – the effective portion of any change in fair value of derivatives or other financial instruments designated as net investment hedges are recognised in other comprehensive income (ie outside of the income statement). The ineffective portion of changes in the fair value of the hedging instrument is recorded in the income statement. The gain or loss on the hedging instrument recognised directly in other comprehensive income, is recognised in the income statement on disposal of the foreign operation; ii Fair value hedges – movements in the fair value of the hedged item attributable to the hedged risk are recognised in the income statement; and iii Cash flow hedges – the effective portion of changes in the fair value of derivatives designated as cash flow hedges is recognised in other comprehensive income (ie outside of the income statement). Movements in fair value relating to the ineffective portion are booked in the income statement. Amounts recognised in other comprehensive income are recorded in the income statement in the periods in which the hedged item affects profit or loss.
Embedded derivatives Embedded derivatives are present in host contracts issued by various Group companies, in particular for Jackson. They are embedded within other non-derivative host financial instruments and insurance contracts to create hybrid instruments. Embedded derivatives meeting the definition of an insurance contract are accounted for under IFRS 4. Where economic characteristics and risks of the embedded derivatives are not closely related to the economic characteristics and risks of the host instrument, and where the hybrid instrument is not measured at fair value with the changes in fair value recognised in the income statement, the embedded derivative is bifurcated and carried at fair value as a derivative in accordance with IAS 39. In addition, the Group applies the requirement of IFRS 4 to not separate and fair value surrender options embedded in host contracts and with-profits investment contracts whose strike price is either a fixed amount or a fixed amount plus interest. Further details on the valuation basis for embedded derivatives attaching to Jackson’s life assurance contracts are provided in note D3(g).
Derecognition of financial assets and liabilities The Group’s policy is to derecognise financial assets when it is deemed that substantially all the risks and rewards of ownership have been transferred. The Group also derecognises a financial asset when the contractual rights to the cash flows from the financial asset expire. Where the Group neither transfers nor retains substantially all the risks and rewards of ownership, the Group will derecognise the financial asset where it is deemed that the Group has not retained control of the financial asset. Where the transfer does not result in the Group transferring the right to receive the cash flows of the financial assets, but does result in the Group assuming a corresponding obligation to pay the cash flows to another recipient, the financial assets are also accordingly derecognised providing all of the following conditions are met: • the Group has no obligation to pay amounts to the eventual recipients unless it collects the equivalent amounts from the original asset, • the Group is prohibited by the terms of the transfer contract from selling or pledging the original asset, and • the Group has an obligation to remit any cash flows it collects on behalf of the eventual recipients without material delay.
: B ack gro u n d an d acco u n tin g p o licies b Long-term business contracts Income statement treatment Premiums and claims Premium and annuity considerations for conventional with-profits policies and other protection type insurance policies are recognised as revenue when due. Premiums and annuity considerations for linked policies, unitised with-profits and other investment type policies are recognised as revenue when received or, in the case of unitised or unit-linked policies, when units are issued. These amounts exclude UK premium taxes and similar duties where Prudential collects and settles taxes borne by the customer. Policy fees charged on linked and unitised with-profits policies for mortality, asset management and policy administration are recognised as revenue when related services are provided. Claims paid include maturities, annuities, surrenders and deaths. Maturity claims are recorded as charges on the policy maturity date. Annuity claims are recorded when each annuity instalment becomes due for payment. Surrenders are charged to the income statement when paid and death claims are recorded when notified. For investment contracts which do not contain discretionary participating features, the accounting is carried out in accordance with IAS 39 to reflect the deposit nature of the arrangement, with premiums and claims reflected as deposits and withdrawals and taken directly to the statement of financial position as movements in the financial liability balance.
Acquisition costs With the exception of costs incurred in respect of with-profits contracts valued on a realistic basis, costs of acquiring new insurance business, principally commissions, marketing and advertising costs and certain other costs associated with policy issuance and underwriting that are not reimbursed by policy charges, are specifically identified and capitalised as part of deferred acquisition costs (DAC), which are included as an asset in the statement of financial position. The DAC asset in respect of insurance contracts is amortised against margins in future revenues on the related insurance policies, to the extent that the amounts are recoverable out of the margins. Recoverability of the unamortised DAC asset is assessed at the time of policy issue and reviewed if profit margins have declined. Under IFRS, investment contracts (excluding those with discretionary participation features) accounted for as financial liabilities in accordance with IAS 39 which also offer investment management services, require the application of IAS 18 for the revenue attached to these services. The Group’s investment contracts primarily comprise certain unit-linked savings contracts in the UK and Asia and contracts with fixed and guaranteed terms in the US (such as guaranteed investment contracts and annuity-certains) all of which offer an investment service. Incremental, directly attributable acquisition costs relating to the investment management element of these contracts are capitalised and amortised in line with the related revenue. If the contracts involve up-front charges, this income is also deferred and amortised through the income statement in line with contractual service provision.
FRS 27 realistic basis liabilities are underpinned by the FSA’s Peak 2 basis of reporting. This Peak 2 basis requires the value of liabilities to be calculated as: • a with-profits benefits reserve (WPBR), plus • future policy related liabilities (FPRL), plus • the realistic current liabilities of the fund.
Unallocated surplus 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 on investments.
Asian operations Except for the operations in India, Japan, Taiwan and Vietnam, the future policyholder benefit provisions for Asian businesses are determined in accordance with methods prescribed by local GAAP adjusted to comply, where necessary, with UK GAAP. For the Hong Kong business, which is a branch of the PAC, and the Singapore and Malaysian operations, the valuation principles and sensitivities to changes of assumptions of conventional with-profits and other protection-type policies are similar to those described above for equivalent products written by the UK operations. Refinements to the local reserving methodology are generally treated as change in estimates, dependent on the nature of the change. For the operations in India, Japan, Taiwan and Vietnam countries where local GAAP is not appropriate in the context of the previously applied MSB, accounting for insurance contracts is based on US GAAP. For these operations the business written is primarily non-participating linked and participating business. The future policyholder benefit provisions for non-linked business are determined using the net level premium method, with an allowance for surrenders, maintenance and claim expenses. Rates of interest used in establishing the policyholder benefit provisions vary by operation depending on the circumstances attaching to each block of business. Where appropriate, liabilities for participating business for these three operations include provisions for the policyholders’ interest in realised investment gains and other surpluses that have yet to be declared as bonuses. Although the basis of valuation of Prudential’s overseas operations is in accordance with the requirements of the Companies Act 2006 and ABI SORP, the valuation of policyholder benefit provisions for these businesses may differ from that determined on a UK MSB for UK operations with the same features. These differences are permitted under IFRS 4.
A4: Significant accounting policies continued c Other assets, liabilities, income and expenditure Basis of consolidation The Group consolidates those entities it is deemed to control. The degree of control is determined by the ability of the Group to govern the financial and operating policies of an entity in order to obtain benefits. Consideration is given to other factors such as potential voting rights.
Pension schemes The Group operates a number of pension schemes around the world. The largest of these schemes is the PSPS, a defined benefit scheme. The Group also operates defined contribution schemes. Defined contribution schemes are schemes where the Company pays contributions into a fund and the Company has no legal or constructive obligation to pay further contributions should the assets of that fund be insufficient to pay the employee benefits relating to employee service in both current and prior periods. Defined benefit schemes are post-employment benefit plans that are not defined contribution schemes. For the Group’s defined benefit schemes, if the present value of the defined benefit obligation exceeds the fair value of the scheme assets, then a liability is recorded in the Group’s statement of financial position. By contrast, if the fair value of the assets exceeds the present value of the defined benefit obligation then the surplus will only be recognised if the nature of the arrangements under the trust deed, and funding arrangements between the Trustee and the Company support the availability of refunds or recoverability through agreed reductions in future contributions. In addition, if there is a constructive obligation for the Company to pay deficit funding, this is also recognised.
: B ack gro u n d an d acco u n tin g p o licies
Property, plant and equipment All property, plant and equipment such as owner occupied property, computer equipment and furniture and fixtures, are carried at depreciated cost. Costs including expenditure directly attributable to the acquisition of the assets are capitalised. Depreciation is calculated and charged on a straight-line basis over an asset’s estimated useful life. The residual values and useful lives are reviewed at each statement of financial position date. If the carrying amount of an asset is greater than its recoverable amount then its carrying value is written down to that recoverable amount. Leasehold improvements to owner occupied property are depreciated over the shorter of the economic life and the life of the lease. Assets held under finance leases are capitalised at their fair value.
Intangible assets Intangible assets acquired on the purchase of a subsidiary or portfolio of contracts are fair valued at acquisition. Other intangible assets, such as software, are valued at the price paid to acquire them. Intangible assets are carried at cost less amortisation and any accumulated impairment losses. Amortisation calculated is charged on a straight-line basis over the estimated useful life of the assets. The residual values and useful lives are reviewed at each statement of financial position date.
Asset management operations • M&G (including Prudential Capital) • Eastspring investments (the new brand name for Asian asset management) • US broker-dealer and asset management (including Curian)
Foreign exchange The Group’s consolidated financial statements are presented in pounds sterling, the Group’s presentation currency. Accordingly, the results and financial position of foreign subsidiaries must be translated into the presentation currency of the Group from their functional currencies, ie the currency of the primary economic environment in which the entity operates. All assets and liabilities of foreign subsidiaries are converted at year end exchange rates whilst all income and expenses are converted at average exchange rates where this is a reasonable approximation of the rates prevailing on transaction dates. The impact of these currency translations is recorded as a separate component in the Statement of comprehensive income. Foreign currency borrowings that are used to provide a hedge against Group equity investments in overseas subsidiaries are translated at year end exchange rates and movements recognised in other comprehensive income. Other foreign currency monetary items are translated at year end exchange rates with changes recognised in the income statement. Foreign currency transactions are translated at the spot rate prevailing at the time.
d Operating profit based on longer-term investment returns The Group provides supplementary analysis of profit before tax attributable to shareholders that distinguishes operating profit based on longer-term investment returns from other constituent elements of the total profit. Except in the case of the assets backing the UK annuity business, unit-linked and US variable annuity separate account liabilities, operating profit based on longer-term investment returns for shareholder-financed business is determined on the basis of expected longer-term investment returns. In the case of assets backing the UK annuity business, unit-linked and US variable annuity separate account liabilities, the basis of determining operating profit based on longer-term investment returns is as follows: • Assets backing UK annuity business liabilities. For UK annuity business, policyholder liabilities are determined by reference to current interest rates. The value movements of the assets covering liabilities are closely correlated with the related change in liabilities. Accordingly, asset value movements are recorded within the ‘operating results based on longer-term investment returns’. Policyholder liabilities include a margin for credit risk. Variations between actual and best estimate expected impairments are recorded as a component of short-term fluctuations in investment returns; and
The GMIB liability, which is fully reinsured, subject to a deductible and annual claim limits, is accounted for in accordance with FASB ASC Subtopic 944-80 Financial Services – Insurance – Separate Accounts (formerly SOP 03-1) under IFRS using ‘grandfathered’ US GAAP. As the corresponding reinsurance asset is net settled, it is considered to be a derivative under IAS 39 and the asset is therefore recognised at fair value. As the GMIB benefit is economically reinsured the mark to market element of the reinsurance asset is included as a component of short-term fluctuations in investment returns.
iii Other derivative value movements Generally, derivative value movements are excluded from operating results based on longer-term investment returns (unless those derivative value movements broadly offset changes in the accounting value of other assets and liabilities included in operating profit). The principal example of non-equity based derivatives (for example interest rate swaps and swaptions) whose value movements are excluded from operating profit arises in Jackson. Non-equity based derivatives are primarily held by Jackson as part of a broadly-based hedging programme for features of Jackson’s bond portfolio (for which value movements are booked in the statement of comprehensive income rather than the income statement), product liabilities (for which US GAAP accounting as ‘grandfathered’ under IFRS 4 does not fully reflect the economic features being hedged), and the interest rate exposure attaching to equity based embedded derivatives.
A4: Significant accounting policies continued iv Other liabilities to policyholders and embedded derivatives for product guarantees Under IFRS, the degree to which the carrying values of liabilities to policyholders are sensitive to current market conditions varies between territories depending upon the nature of the ‘grandfathered’ measurement basis. In general, in those instances where the liabilities are particularly sensitive to routine changes in market conditions, the accounting basis is such that the impact of market movements on the assets and liabilities is broadly equivalent in the income statement, and operating profit based on longer-term investments returns is not distorted. In these circumstances, there is no need for the movement in the liability to be bifurcated between the elements that relate to longer-term market conditions and short-term effects. However, for some types of business movements in liabilities do require bifurcation to ensure that at the net level (ie after allocated investment return and change for policyholder benefits) the operating result reflects longer-term market returns.
a Accounting pronouncements adopted in 2011 Improvements to IFRSs (2010) The 2010 annual improvements include minor changes to seven IFRSs. Amongst others, these include changes to the measurement of non-controlling interests under IFRS 3, ‘Business combinations’ and clarification on the required level of disclosure around credit risk and collateral held in IFRS 7, ‘Financial instruments: Disclosure’. The Group has reviewed and adopted these changes in 2011 with no significant impact on the Group’s results and financial position.
Amendments to IAS 24, ‘Related party disclosures’ The main revisions relate to exemption for government-related entities and are therefore not applicable to the Group. The amendment also clarifies and simplifies the definition of a related party albeit the nature of the change is minor. The adoption of these revisions did not have a significant impact on the Group’s related party disclosures.
IFRIC 19, ‘Extinguishing financial liabilities with equity instruments’ In November 2009, the IFRIC issued guidance on how to account for the extinguishment of a financial liability by the issue of equity instruments. The adoption of this interpretation did not have a material effect on the Group’s financial statements.
b Adoption of altered US GAAP requirements for Group IFRS reporting in 2012 In October 2010, the Emerging Issues Task Force of the US Financial Accounting Standards Board issued Update No 2010-26 on ‘Accounting for Costs Associated with Acquiring or Renewing Insurance Contracts’. The update was issued to address perceived diversity by companies preparing financial statements in accordance with US GAAP as regards the types of acquisition costs being deferred. Under US GAAP, costs that can be deferred and amortised are those that ‘vary with and are primarily related to the acquisition of insurance contracts’. The Update requires insurers to capitalise only those incremental costs directly related to acquiring a contract for financial statements for reporting periods starting after 15 December 2011. All other indirect acquisition expenses are required to be charged to the income statement as incurred expenses. Accordingly, the main impact of the Update is to disallow insurers from deferring costs that are not directly related to successful sales. Under the Group’s IFRS reporting, Prudential has the option to either continue with its current basis of measurement or improve its accounting policy under IFRS 4 to acknowledge the issuance of the Update. Prudential has chosen to continue with its current basis of measurement for reporting of its 2011 results and improve its policy in 2012 to apply the US GAAP update on the retrospective basis to the results of its US insurance operation Jackson National Life. The reason and timing for the change is to achieve consistency with the basis expected to be applied by peer competitor companies in the US market in their US GAAP financial statements. To ensure consistency it is also intended to make the change on the retrospective basis in 2012 for the Asian operations that historically have effectively applied US GAAP for measuring insurance assets and liabilities.
The effect of the change is as follows: Year ended 31 December 2011 £m Year ended 31 December 2010 £m
c Accounting pronouncements endorsed by the EU but not yet effective The following accounting pronouncements potentially relevant to the Group have been issued and endorsed for use in the EU but are not mandatory for adoption for the 31 December 2011 year end.
Amendments to IFRS 7, ‘Financial instruments: Disclosures – Transfers of financial assets’ The amendments, which were issued in October 2010 and are effective for annual periods beginning on or after 1 January 2012, introduce new disclosure requirements about transfers of financial assets. These include disclosures for financial assets that are not derecognised in their entirety and financial assets that are derecognised in their entity but for which the entity retains continuing involvement. The Group is evaluating the implications of the amendments but they are not expected to have a significant impact on the Group’s disclosures.
Amendments to IAS 12, ‘Income taxes’ On 20 December 2010, the IASB published amendments to IAS 12. The amendments are effective for annual periods beginning on or after 1 January 2012. The amendments require the measurement of deferred tax assets and liabilities arising from investment properties and plant, property and equipment valued at fair value on the presumption that the carrying amount of the asset will be, normally, recovered through sale. These amendments are not expected to have a material effect on the Group’s financial statements.
IFRS 9, ‘Financial instruments: Classification and measurement’ In November 2009, the IASB issued a new standard which altered the classification and measurement of financial assets. Under the new standard only two possible classifications arise, rather than the four existing classifications currently available under IAS 39, and will result in all financial assets being valued at amortised cost or fair value through profit and loss. In October 2010, the IASB issued requirements on the accounting for financial liabilities. These requirements maintain the existing amortised cost measurement for most liabilities but will require changes in fair value due to changes in the entity’s own credit risk to be recognised in the other comprehensive income (OCI) section of the comprehensive income statement, rather than within profit or loss for liabilities measured at fair value. In December 2011, the IASB issued Mandatory Effective Date and Transition Disclosures (Amendments to IFRS 9 and IFRS 7), which amended the effective date of IFRS 9 to annual periods beginning on or after 1 January 2015 (from the previous 1 January 2013), and modified the relief from restating comparative periods and the associated disclosures in IFRS 7. The Group is still assessing the full impact of this standard.
Amendments to IAS 19, ‘Employee benefits’ In June 2011, the IASB published an amended version of IAS 19 on the accounting for pensions and other post-employment and is effective for annual periods beginning on or after 1 January 2013. The key revisions to the standard include: • the removal of the corridor option for actuarial gains and losses, • presentation of all actuarial gains and losses in other comprehensive income rather than in profit and loss, • the replacement of the expected return on plan assets with an amount based on the liability discount rate in the determination of pension costs, and • enhanced disclosures, specifically on risks arising from defined benefit plans.
The Group does not apply the corridor option, therefore the removal of the corridor option has no impact to the Group. However, the Group currently presents actuarial gains and losses in the income statement, with the shareholder’s share presented below operating profit in the supplementary analysis of profit in the segmental income statement. With the revised standard, the actuarial gains and losses will be presented in the statement of comprehensive income. The Group is still assessing the full impact of the other amendments to the standard.
Offsetting Financial Assets and Financial Liabilities (Amendments to IAS 32, ‘Financial instruments: Presentation’ and IFRS 7 ‘Financial instruments: Disclosures’) In December 2011, the IASB published amendments to the application guidance of IAS 32 clarifying the criteria for offsetting financial assets and financial liabilities in the statement of financial position. In addition, the IASB has also published amendments to IFRS 7 to enhance current offsetting disclosures. The amendments to IAS 32 and IFRS 7 are effective for the annual periods beginning on or after 1 January 2013 and 2013, respectively. The Group is currently assessing the impact of these amendments.
The determination of the operating segments and performance measure of the operating segments of the Group are as detailed in note A4. Further segmentation of the income statement is provided in note F1 of these financial statements.
UK operations UK insurance operations: notes (i),(ii) Long-term business 683 673 General insurance commission note (v) 40 46
(vii) Restructuring costs are incurred in the UK as part of EEV covered business and represent one-off expenses incurred in securing expense savings. 2011: £16 million (2010: £26 million).
Insurance operations: Asia (92) 114 US (95) (378) UK 159 116 Other operations Other (120) 25
General overview of defaults The Group did not experience any defaults of its shareholder-backed debt securities portfolio in 2011 and 2010.
Total charges in the year note (a) (52) (213) Less: Risk margin charge included in operating profit based on longer-term investment returns note (iii) 70 73
Interest related realised gains: Arising in the year 158 224 Less: Amortisation of gains and losses arising in current and prior years to operating profit based on longer-term investment returns (84) (82)
Total short-term fluctuations related to debt securities 88 (1) Derivatives (other than equity related): market value movement
(net of related change to amortisation of deferred acquisition costs) note (b) 472 (15) Net equity hedge results (principally guarantees and derivatives, net of related change to amortisation of deferred acquisition costs) note (c) (632) (365) Equity type investments: actual less longer-term return
(net of related change to amortisation of deferred acquisition costs) A4(d)(i) – 3 Other items (net of related change to amortisation of deferred acquisition costs) (23) –
The short-term fluctuations shown in the table above are stated net of the related change to amortisation of deferred acquisition costs of £359 million (2010: £358 million) (see note H1).
Notes (a) The charges on the debt securities of Jackson comprise the following: Defaults £m
(b) The gain of £472 million (2010: loss of £15 million) is principally for the value movement of non-equity freestanding derivatives held to manage interest rate exposures, duration matching and for the GMIB reinsurance asset that is considered to be a derivative under IAS 39.
Under IAS 39, unless hedge accounting is applied value movements on derivatives are recognised in the income statement. For the derivatives programme attaching to the fixed annuity and other general account business, the Group has continued its approach of not seeking to apply hedge accounting under IAS 39. This decision reflects the inherent constraints of IAS 39 for hedge accounting investments and life assurance assets and liabilities under ‘grandfathered’ US GAAP under IFRS 4.
In addition to the items discussed above, for US insurance operations, included within the statement of comprehensive income is an increase in net unrealised gains on debt securities classified as available-for-sale of £811 million (2010: increase in net unrealised gains of £1,221 million). Temporary market value movements do not reflect defaults or impairments. Additional details on the movement in the value of the Jackson portfolio are included in note D3.
Other operations Short-term fluctuations of other operations were negative £120 million (2010: positive £25 million) representing unrealised value movements on investments, including centrally held swaps to manage foreign exchange and certain macro-economic exposures of the Group.
The losses of £12 million (2010: losses of £41 million) primarily reflect the effect of changes in the inflation rate, expected salary increases and risk discount rate. Further details on the Group’s defined benefit pension schemes are shown in note I3.
(x) The following costs were incurred in the first six months of 2010 in relation to the proposed, and subsequently terminated transaction, to purchase AIA Group Limited and related rights issue.
Of the £377 million total costs before tax, the £100 million associated with foreign exchange hedging has been recorded within ‘Investment return’ and the other £277 million has been recorded as ‘Other expenditure’ within ‘Acquisition costs and other expenditure’ in the consolidated income statement.
Based on operating profit based on longer-term investment returns, excluding exceptional tax credit 1,941 (371) (5) 1,565 62.0p 61.9p
Costs of terminated AIA transaction (377) 93 – (284) (11.3)p (11.3)p Gain on dilution of Group's holdings 30 – – 30 1.2 p 1.2p
Asian operations (30) 164 US operations 42 88 Unallocated to a segment (central funds) (44) (35)
The movements for Asian and US operations reflect the application of year end exchange rates to the assets and liabilities and average exchange rates to the income statement on translation of these operations into the presentation currency of the Group. The movement unallocated to a segment mainly reflects the translation of currency borrowings and forward contracts which have been designated as a net investment hedge against the currency risk of the net investment in Jackson. The exchange rates applied were: Local currency: £
o f resu lts a Group statement of financial position by operating segment i Position at 31 December 2011
Assets Intangible assets attributable to shareholders: Goodwill – – 235 235 1,230 – – 1,465 Deferred acquisition costs and other
Intangible assets attributable to with-profits funds: In respect of acquired subsidiaries for venture fund and other investment purposes 178 – – 178 – – – 178 Deferred acquisition costs and other
Deferred tax assets H4 231 1,392 115 1,738 129 409 – 2,276 Other non-investment and non-cash assets H3,H6 4,771 1,542 1,024 7,337 1,000 4,532 (6,231) 6,638 Investment of long-term business and other operations: Investment propertiesH7 10,712 35 10 10,757 – – – 10,757 Investments accounted for using the equity methodH8 70 – – 70 – – – 70 Financial investments: Loans note (d)(iv) 3,115 4,110 1,233 8,458 1,256 – – 9,714 Equity securities and portfolio holdings in unit trusts 36,722 38,036 11,997 86,755 594 – – 87,349 Debt securities note (d)(i) 77,953 27,022 17,681 122,656 1,842 – – 124,498 Other investments 4,568 2,376 470 7,414 78 17 – 7,509 Deposits 9,287 167 1,165 10,619 89 – – 10,708
Note (i) Further segmental analysis: The non-current assets of the Group comprise goodwill, intangible assets other than DAC and present value of acquired in-force business and property, plant and equipment included within ‘other non-investment and non-cash assets’. Items defined as financial instruments or related to insurance contracts are excluded. The Group’s total non-current assets at 31 December comprise: UK including insurance operations, M&G and Central operations 1,906 1,708 US 144 131 Asia* 681 615 * No individual country in Asia held non-current assets at the end of the year which exceeds 10 per cent of the Group total.
Equity and liabilities Equity Shareholders’ equity H11 2,581 4,271 2,349 9,201 1,783 (1,867) – 9,117 Non-controlling interests 33 – 5 38 5 – – 43
Total policyholder liabilities and unallocated surplus of with-profits funds 136,189 69,189 30,912 236,290 – – – 236,290
Assets Intangible assets attributable to shareholders: Goodwill – – 236 236 1,230 – – 1,466 Deferred acquisition costs and other
Intangible assets attributable to with-profits funds: In respect of acquired subsidiaries for venture fund and other investment purposes 166 – – 166 – – – 166 Deferred acquisition costs and other intangible
Deferred tax assetsH4 214 1,391 98 1,703 123 362 – 2,188 Other non-investment and non-cash assets H3,H6 4,631 1,225 788 6,644 995 4,146 (5,761) 6,024 Investment of long-term business and other operations: Investment propertiesH7 11,212 26 9 11,247 – – – 11,247 Investments accounted for using the equity methodH8 69 – 2 71 – – – 71 Financial investments: Loans note (d)(iv) 2,302 4,201 1,340 7,843 1,418 – – 9,261 Equity securities and portfolio holdings in unit trusts 40,519 31,501 14,464 86,484 151 – – 86,635 Debt securities note (d)(i) 74,304 26,366 14,108 114,778 1,574 – – 116,352 Other investments 3,998 1,199 382 5,579 59 141 – 5,779 Deposits 9,022 212 638 9,872 80 – – 9,952
Properties held for sale H9 254 3 – 257 – – – 257 Cash and cash equivalents H10 2,839 232 1,601 4,672 1,436 523 – 6,631
Equity and liabilities Equity Shareholders’ equity H11 2,148 3,815 2,149 8,112 1,787 (1,868) – 8,031 Non-controlling interests 35 – 5 40 4 – – 44
Total policyholder liabilities and unallocated surplus of with-profits funds 135,717 60,523 28,740 224,980 – – – 224,980
o f resu lts b Group statement of financial position by business type
Assets Intangible assets attributable to shareholders: Goodwill – – 235 1,230 – – 1,465 1,466 Deferred acquisition costs and other
Deferred tax assetsH4 101 2 1,635 129 409 – 2,276 2,188 Other non-investment and non-cash assets 2,622 457 4,258 1,000 4,532 (6,231) 6,638 6,024 Investment of long-term business and other operations: Investment propertiesH7 8,461 682 1,614 – – – 10,757 11,247 Investments accounted for using the equity methodH8 – – 70 – – – 70 7 1 Financial investments: Loansnote (d)(iv) 2,747 – 5,711 1,256 – – 9,714 9,261 Equity securities and portfolio holdings in unit trusts 26,047 59,890 818 594 – – 87,349 86,635 Debt securitiesnote (d)(i) 57,232 8,861 56,563 1,842 – – 124,498 116,352 Other investments 4,423 113 2,878 78 17 – 7,509 5,779 Deposits 7,207 1,544 1,868 89 – – 10,708 9,952
Equity and liabilities Equity Shareholders’ equity H11 – – 9,201 1,783 (1,867) – 9,117 8,031 Non-controlling interests 33 – 5 5 – – 43 44
Liabilities Policyholder liabilities and unallocated surplus of with-profits funds: Contract liabilities (including amounts in respect of contracts classified as investment contracts under IFRS 4) 93,569 71,129 62,377 – – – 227,075 214,727
in a n cia l state m e n ts B : Su m m ary
Net cash inflow from operating activities 1,329 7,306 2,167 10,802 329 120 11,251 Realised gains (losses) in the year 2,233 21 984 3,238 11 (148) 3,101 Unrealised gains and losses and exchange movements in the year 5,958 6,264 3,301 15,523 23 (17) 15,529 Dilution of PruHealth investment 56 – – 56 – – 56 Acquisition of UOB Life Assurance Ltd – – 1,004 1,004 – – 1,004
At 31 December 2010/1 January 2011 Total investments (including derivative assets) 141,426 63,505 30,943 235,874 3,282 141 239,297 Less: investments held by consolidated investment funds (912) – (739) (1,651) – – (1,651)
Net cash effect from purchases and sales of investments (920) 6,669 2,287 8,036 540 (95) 8,481 Realised gains (losses) in the year 3,852 102 503 4,457 17 – 4,474 Unrealised gains and losses and exchange movements
Movement in the year of directly held investments, net of derivative liabilities 430 8,153 1,447 10,030 473 (185) 10,318
At 31 December 2011 Total investments (including derivative assets) 142,427 71,746 32,556 246,729 3,859 17 250,605 Less: investments held by consolidated investment funds (977) – (647) (1,624) – – (1,624)
B5: Group statement of financial position continued d Debt securities and loans i Information on the credit risks of debt securities
S&P – AAA 9,928 133 1,423 11,484 1,109 12,593 26,838 S&P – AA+ to AA- 8,647 4,476 3,843 16,966 72 17,038 9,967 S&P – A+ to A- 21,474 6,382 3,055 30,911 250 31,161 29,959 S&P – BBB+ to BBB- 15,746 8,446 1,451 25,643 217 25,860 22,033 S&P – Other 3,175 999 2,137 6,311 35 6,346 6,048
Moody’s – Aaa 7,945 62 1,489 9,496 119 9,615 864 Moody’s – Aa1 to Aa3 651 15 128 794 12 806 521 Moody’s – A1 to A3 1,008 29 304 1,341 11 1,352 798 Moody’s – Baa1 to Baa3 1,030 67 131 1,228 – 1,228 1,119 Moody’s – Other 242 17 59 318 – 318 417
The £454 million (2010: £435 million) includes £398 million (2010: £341 million) held by investment funds consolidated under IFRS in recognition of the control arrangements for those funds and include an amount not owned by the Group with a corresponding liability of £20 million (2010: £7 million) on the statement of financial position for net asset value attributable to external unit-holders in respect of these funds, which are non-recourse to the Group. Of the £454 million, 75 per cent (2010: £435 million, 43 per cent) are investment graded by Standard and Poor’s.
Exposure to bank debt securities The Group held the following direct exposures to banks’ debt securities of shareholder-backed business at 31 December 2011.
Portugal – 24 24 – – – 24 Ireland – 13 13 – – – 13 Italy – 11 11 56 14 70 81 Greece – – – – – – – Spain 107 11 118 90 2 92 210 107 59 166 146 16 162 328 Austria – – – 9 – 9 9 Belgium – – – – – – – France 2 34 36 78 35 113 149 Germany – 28 28 1 – 1 29 Luxembourg – – – – – – – Netherlands – 7 7 81 64 145 152 United Kingdom 228 145 373 615 95 710 1,083
United States – 1,378 1,378 396 278 674 2,052 Other, predominantly Asia 1 384 385 341 20 361 746 iv Loans Information on the credit quality of the portfolio of loans, which almost wholly is for amounts which are neither past due or impaired is shown in notes D2, D3, D4 and E2. Details of allowances for loans, losses and amounts past due are shown in notes G1 and G2. No additional analysis is provided of the element of loans and receivables that were neither past due nor impaired from those of the total portfolio on the grounds of the immateriality of the difference between the neither past due nor impaired element and the total portfolio.
: Su m m ary o f resu lts e Reconciliation of movement in policyholder liabilities and unallocated surplus of with-profits funds A reconciliation of the total policyholder liabilities and unallocated surplus of with-profits funds of the Group from the beginning of the year to the end of the year is as follows: Insurance operations £m
Policyholder liabilities 116,229 48,311 21,858 186,398 Unallocated surplus of with-profits funds 9,966 – 53 10,019
Comprising: – Policyholder liabilities 125,530 60,523 28,674 214,727 – Unallocated surplus of with-profits funds 10,187 – 66 10,253
Net flows (5,080) 7,824 2,178 4,922 Shareholders transfers post tax (216) – (30) (246) Investment-related items and other movements 5,862 136 365 6,363 Foreign exchange translation differences (94) 706 (341) 271
Comprising: – Policyholder liabilities 127,024 69,189 30,862 227,075 – Unallocated surplus of with-profits funds 9,165 – 50 9,215
* Averages have been based on opening and closing balances and adjusted for acquisition and disposals in the period and excluding unallocated surplus of with-profits funds.
The analysis above represents the impact of premiums, claims and investment movements on policyholders’ liabilities. It does not represent premiums, claims and investment movements as reported in the income statement, for example the premiums shown above will exclude any deductions for fees/charges and claims represent the policyholder liabilities provision released rather than the claim amount paid to the policyholder.
US insurance operations Fixed annuities 472 836 – – 47 84 Fixed index annuities 934 1,089 – – 93 109 Life 10 11 19 22 20 23 Variable annuities 10,909 9,481 – – 1,091 948 Wholesale 237 – – – 24 –
UK and Europe insurance operations Direct and partnership annuities 328 593 – – 33 59 Intermediated annuities 241 221 – – 24 22 Internal vesting annuities 1,223 1,235 – – 122 124
Corporate pensions 184 228 215 198 233 221 Onshore bonds 1,779 1,660 – – 178 166 Other products 780 774 44 56 122 133 Wholesale 336 945 – – 34 95
Total UK and Europe insurance operationsnote (v) 4,871 5,656 259 254 746 820
The format of the tables shown above is consistent with the distinction between insurance and investment products as applied for previous financial reporting periods. With the exception of some US institutional business, products categorised as ‘insurance’ refer to those classified as contracts of long-term insurance business for regulatory reporting purposes, ie falling within one of the classes of insurance specified in Part II of Schedule 1 to the Regulated Activities Order under FSA regulations.
(iv) New business and market gross inflows and redemptions have been translated at the average exchange rate for the year applicable. Funds under management at points in time are translated at the exchange rate applicable at those dates.
Additional information on the Group’s risk framework is included in the risk and capital management section. The management of the risk attached to the Group’s financial instruments and insurance liabilities, together with the inter-relationship with the management of capital, is summarised in the following sections.
Earnings volatility: The objectives of the limits are to ensure that: a the volatility of earnings is consistent with the expectations of stakeholders, b the Group has adequate earnings (and cash flows) to service debt, expected dividends and to withstand unexpected shocks, and c earnings (and cash flows) are managed properly across geographies and are consistent with funding strategies.
Liquidity: The objective is to ensure that the Group is able to generate sufficient cash resources to meet financial obligations as they fall due in business as usual and stressed scenarios.
Capital requirements: The limits aim to ensure that: a the Group meets its internal economic capital requirements, b the Group achieves its desired target rating to meet its business objectives, and c supervisory intervention is avoided.
The Group manages its actual risk profile against its tolerance of risk. To do this, the Group maintains risk registers that include details of the identified risks and of the controls and mitigating actions employed in managing them. The Group uses a range of risk management and mitigation strategies. The most important of these include: adjusting asset portfolios to reduce investment risks (such as duration mismatches or overweight counterparty exposures); using derivatives to hedge market risks; implementing reinsurance programmes to manage insurance risk; implementing corporate insurance programmes to limit the impact of operational risks; and revising business plans where appropriate. Any mitigation strategies involving large transactions, such as material derivative transactions, are subject to scrutiny at Group level before implementation.
In the US, to protect the shareholders against the volatility introduced by embedded options, Jackson uses both a comprehensive hedging programme and reinsurance. Jackson makes use of the natural offsets that exist between the variable annuity guarantees and the fixed index annuity book, and then uses a combination of over-the-counter (OTC) options and exchange-traded derivatives to hedge the residual risk, allowing for significant market shocks and limiting the amount of capital at risk. Internal positions are generally netted before any external hedge positions are considered. Jackson manages fixed annuity interest rate exposure through a combination of interest rate swaps and interest rate options to protect capital against rates rising quickly, and through the contractual ability to reset crediting rates annually. Prudential principally operates in the UK, the US, and in 13 countries and territories in Asia and the Middle East. The geographical diversity of the Group’s business means that Prudential is subject to the risk of exchange rate fluctuations. The Group does not generally seek to hedge foreign currency revenues, as these are substantially retained locally to support the growth of the Group’s business, and meet local regulatory and market requirements. However, in cases where a surplus arising in an overseas operation supports Group capital or shareholders’ interest, this exposure is hedged if it is economically optimal to do so. Currency borrowings, swaps and other derivatives are used to manage exposures. Further details of the Group’s use of derivatives are explained in note G3.
i Market risks Market risk is the risk of loss for our business, or of adverse change in the financial situation, resulting directly or indirectly from fluctuations in the level or volatility of market prices of assets and liabilities.
Equity and interest rate risk Prudential invests in equity type investments which are subject to equity price risk, as well as in bonds, mortgages and cash deposits, the values of which are subject to interest rate risk. The amount of risk borne by Prudential’s shareholders depends on the nature of its liabilities and the extent to which its customers share the investment risk through the structure of Prudential’s products. Prudential has some liabilities that contain guaranteed returns (for example, interest-sensitive fixed annuities and immediate annuities), which generally will be supported by fixed income investments. In the US, Jackson is a leading provider of variable annuities for which guarantees are included as part of the contract terms. GMDB are provided on all policies in this class, GMWB on 70 per cent of the book and GMIB on 5 per cent. To protect the shareholders against the volatility introduced by these embedded options, Jackson used both a comprehensive hedging programme and reinsurance. The GMIB is no longer offered, with existing coverage being reinsured. In the case of other liabilities, where customers share the investment risk, Prudential invests a substantial portion of the assets in equity and property investments that Prudential believes produce greater returns over the long-term.
Foreign exchange risk 70 per cent of Prudential’s operating profit based on longer-term investment returns, as described in note B1, for the year ended 31 December 2011, came from US and Asian operations. The resulting exposure from the translation of these reported earnings to Sterling is not separately managed, although its impact is reduced by interest payments on foreign currency borrowings and by the adoption of average exchange rates for the translation of foreign currency revenues. Approximately 77 per cent of the Group’s IFRS basis shareholders’ equity at 31 December 2011 arose in Prudential’s US and Asian operations (2010: approximately 79 per cent). To mitigate the exposure of the US component there are US$2.85 billion of borrowings held centrally, which are formally designated as net investment hedges at 31 December 2011. Net of the currency position arising from these borrowings some 57 per cent of the Group’s shareholders’ funds are represented by net assets in currencies other than sterling. Additional details on the market risks’ exposures of the UK, US and Asian insurance operations are provided in notes D2, D3 and D4, respectively.
iii Liquidity risk Liquidity risk is the risk of the Group being unable to generate sufficient cash resources or raise finance to meet financial obligations as they fall due in business as usual and stress scenarios. The assets of insurers are in general relatively liquid, whilst the majority of liabilities are long-term products held by policyholders. Prudential regularly monitors and analyses its liquidity position at the Group level and performs stress tests of this position. The liquidity of the Group is monitored on a monthly basis by comparing the predicted cash needs of the Group centre, to meet corporate and financing costs (net of expected dividends from the business units), to the liquid resources available to it. These liquid resources include cash held and cash that could be raised through internal resources (for example by reporting unencumbered bonds). The stresses consider changes to cash requirements, the availability of external financing and internal sources of liquidity and the sufficiency of external back-up lines. The holding company has significant internal sources of liquidity which are sufficient to meet all of our expected requirements for the foreseeable future without having to make use of external funding. The Group maintains £2.1 billion of undrawn syndicated and bilateral committed banking facilities, maturing between 2013 and 2017.
iv Insurance risk Insurance risk is the risk of loss for our business or of adverse change in the value of insurance liabilities, resulting from changes in the level, trend or volatility of a number of insurance risk drivers. This includes adverse mortality, longevity, morbidity, persistency and expense experience. Prudential needs to make assumptions about a number of factors in determining the pricing of its products and for reporting the results of its long-term business operations. In common with other industry participants, the profitability of the Group’s businesses depends on a mix of factors, including mortality and morbidity trends, persistency, investment performance, unit cost of administration and new business acquisition expenses.
Financial statements | Notes on the Group financial statements d: Risk exposures continued
The FSA has established a structure for determining how much hybrid debt can count as capital which is similar to that used for banks. It categorises capital as Tier 1 (equity and preference shares), Upper Tier 2 and Lower Tier 2. Up to 15 per cent of Tier 1 capital can be in the form of hybrid debt and is called ‘Innovative Tier 1’. At 31 December 2011, the Group held £1,823 million (2010: £1,463 million) of Innovative Tier 1 capital in the form of perpetual securities, £nil (2010: £nil) of Upper Tier 2 and £829 million (2010: £1,255 million) of Lower Tier 2 capital. In addition, Jackson held £160 million of surplus notes at the end of the financial year 2011 (2010: £159 million) which, although the US does not have a similar capital categorisation under its regulatory framework, are akin to the FSA’s Lower Tier 2 Capital and have been disclosed as such in note H13. Further details on Group borrowings are shown in note H13. At 31 December 2010, Prudential met the requirements of the IGD with £4.3 billion of surplus capital before allowing for the 2010 final dividend. In addition, during 2011, Prudential met the requirements of the FSA under the IGD. The IGD position as at 31 December 2011 will be submitted to the FSA by 30 April 2012, and at the time of preparation of these financial statements, the surplus capital under the test was estimated to be around £4.0 billion before allowing for the 2011 final dividend, giving a solvency ratio of circa 275 per cent. The main components of the decrease in IGD surplus during 2011 are: • net capital generation mainly through operating earnings (in-force releases less investment in new business, net of tax) of £1.5 billion.
Prudential’s approach to capital allocation takes into account a range of factors, especially risk-adjusted returns on capital, the impact of alternative capital measurement bases (accounting, regulatory, economic and ratings agency assessments), tax efficiency and wider strategic objectives. Prudential optimises capital allocation across the Group by using a consistent set of capital performance metrics across all business units to ensure meaningful comparison. Capital utilisation, return on capital and new business value creation are measured at a product level. The use of these capital performance metrics is embedded into our decision-making processes for product design and product pricing. Prudential’s capital performance metrics are based on economic capital, which provides a view of our capital requirements across the Group, allowing for realistic diversification benefits. Economic capital also provides valuable insights into our risk profile and is used both for risk measurement and capital management.
As noted above, the 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 expected to be transposed into local regulations and take effect for supervisors from 2013, with implementation for firms currently anticipated from 2014. The new approach is based on the concept of three pillars – minimum capital requirements, supervisory review of firms’ assessments of risk, and enhanced disclosure requirements. Specifically, Pillar 1 covers the quantitative requirements around own funds, valuation rules for assets and liabilities and capital requirements. Pillar 2 provides the qualitative requirements for risk management, governance and controls, including the requirement for insurers to submit an Own Risk and Solvency Assessment (ORSA), which will be used by the regulator as part of the supervisory review process. Pillar 3 deals with the enhanced requirements for supervisory reporting and public disclosure.
A key aspect of Solvency II is that the assessment of risks and capital requirements are intended to be aligned more closely with economic capital methodologies. Companies may be allowed to make use of internal economic capital models if approved by the local regulator. The European Parliament is currently discussing the Omnibus II Directive which, once approved, will amend certain aspects of the Solvency II Directive, including the implementation date as described above. The Omnibus II Directive is expected to be finalised during 2012. In addition, the European Commission is continuing to develop, in consultation with stakeholders including industry, detailed rules that complement the high-level principles in the Solvency II Directive, referred to as ‘implementing measures’. These are not expected to be finalised until later in 2012. Further guidance and technical standards are also currently being developed by the European Insurance and Occupational Pensions Authority (EIOPA). These are expected to be subject to a formal consultation and are unlikely to be finalised before early 2013. There remains significant uncertainty regarding the outcome from this process. In particular, the Solvency II rules relating to the determination of the liability discount rate and to the treatment of US business remain unclear, and Prudential’s capital position is sensitive to these outcomes. With reference to the liability discount rate, solutions to remove artificial volatility from the balance sheet have been suggested by policymakers as the regulations continue to evolve. These solutions, along with transitional arrangements for the treatment of US business, are continuing to be considered by the European Parliament as part of the process to reach agreement on the Omnibus II Directive. There is a risk that the effect of the final measures could be adverse for Prudential, including potentially that a significant increase in capital may be required to support its business, and that Prudential may be placed at a competitive disadvantage to other European and non-European financial services groups.
D1: Group overview a Products and classification for IFRS reporting The measurement basis of assets and liabilities of long-term business contracts is dependent upon the classification of the contracts under IFRS. Under IFRS 4, contracts are initially classified as being either ‘insurance’ contracts, if the level of insurance risk in the contracts is significant, or ‘investment’ contracts, if the insurance risk is insignificant.
Investment contracts Investment contracts are further delineated under IFRS 4 between those with and without discretionary participation features. For those contracts with discretionary participation features, IFRS 4 also permits the continued application of previously applied GAAP. The Group has adopted this approach, again subject to the FRS 27 improvement. For investment contracts that do not contain discretionary participation features, IAS 39 and, where the contract includes an investment management element, IAS 18, apply measurement principles to assets and liabilities attaching to the contract that may diverge from those previously applied. Contracts of the Group, which are classified as investment contracts that do not contain discretionary participation features, can be summarised as: • UK – certain unit-linked savings and similar contracts,
• Jackson – GICs and funding agreements – minor amounts of ‘annuity certain’ contracts, and
Deferred income reserves These are required to be established under IAS 18 with amortisation over the expected life of the contract. The majority of the relevant UK contracts are single premium with the initial deferred income reflecting the ‘front-end load’ ie the difference between the premium paid and the amount credited to the unit fund. Deferred income is amortised to the income statement in line with service provision. The amortisation profile is either on a straight-line basis or, if more appropriate, a further deferral of income recognition is applied.
b Concentration of risk i Business accepted The Group’s exposure to life assurance risks is well diversified. This is achieved through the geographical spread of the Group’s operations and, within those operations, through a broad mix of product types. As part of the risk management framework, the Group regularly monitors concentration of risk using a variety of risk monitoring tools including common scenario testing and sensitivity analysis of the Group capital and profitability metrics involving IGD, Group economic capital, EEV and IFRS help identify concentrations of risks by risk types, products and business units, as well as the benefits of diversification of risks. An example of the diversification benefits for Prudential is that adverse scenarios do not affect all business units in the same way, providing natural hedges within the Group. For example, the Group’s US business is sensitive to increasing interest rates, whereas, in contrast, several business units in Asia benefit from increasing rates. Conversely, these Asian business units are sensitive towards low interest rates, whereas certain products in the US benefit from falling interest rates. The economic capital framework also takes into account situations where factors are correlated, for example, the extent of correlation between UK and US economies. Business units are also required to disclose to the Group risk function all material risks, along with information on their severity and likelihood, and mitigating actions taken or planned. Credit risk remains one of the largest risk exposures. This reflects the relative size of exposure in Jackson and the UK shareholder annuities business. The Group manages concentration of credit risks by setting limits on the maximum exposure to each counterparty based on their credit ratings.
c Guarantees Notes D2(e), D3(e) and D4(e) provide details of guarantee features of the Group’s life assurance products. In the UK, guarantees of the with-profits products are valued for accounting purposes on a market consistent basis for 2011 as described in section D2(g)(ii). The UK business also has products with guaranteed annuity option features, mostly within the Scottish Amicable Insurance Fund (SAIF), as described in section D2(e). There is little exposure to financial options and guarantees in the shareholder-backed business of the UK operations. The US business annuity products have a variety of option and guarantee features as described in section D3(e). Jackson’s derivative programme seeks to manage the exposures as described in section D3(f).
d Sensitivity of EEV basis shareholders’ profit and equity for market and other risks The Group prepares supplementary EEV basis financial statements for half-yearly and annual publication. These statements include sensitivity disclosures which are part of the market risk information provided to key management. The 2011 EEV sensitivity disclosures are shown in note 16 of the EEV basis supplementary information in this Annual Report.
D1: Group overview continued e Sensitivity of IFRS basis profit or loss and shareholders’ equity to market and other risks i Overview of risks by business unit The financial and insurance assets and liabilities attaching to the Group’s life assurance business are, to varying degrees, subject to market and insurance risk and other changes of experience assumptions that may have a material effect on IFRS basis profit or loss and shareholders’ equity. Market risk is the risk that the fair value or future cash flows of a financial instrument or, in the case of liabilities of insurance contracts, their carrying value will fluctuate because of changes in market prices. Market risk comprises three types of risk, namely: • Currency risk: due to changes in foreign exchange rates; • Interest rate risk: due to changes in market interest rates; and • Other price risk: due to fluctuations in market prices (other than those arising from interest rate risk or currency risk).
Three key points are to be noted, namely: • The Group’s with-profit and unit-linked funds absorb most market risk attaching to the funds’ investments. Except for second order effects, for example, on asset management fees and shareholders’ share of cost of bonuses for with-profits business, shareholder results are not directly affected by market value movements on the assets of these funds; • The Group’s shareholder results are most sensitive to market risks for assets of the shareholder-backed business; and • The main exposures of the Group’s IFRS basis results to market risk for its life assurance operations on investments of the shareholder-backed business are for debt securities.
Lapse risk, but the effects of extreme events are mitigated by the application of market value adjustments and by the use of swaption contracts
With-profits business Net neutral direct exposure (Indirect exposure only) Investment performance subject to smoothing through declared bonuses
Interest rate and price risk Interest rates for those operations where the basis of insurance liabilities is sensitive to current market movements .
Prudential Annuities Limited (PAL) PAL writes annuity business. However, as PAL is owned by the PAC with-profits sub-fund, changes in the carrying value of PAL’s assets and liabilities are reflected in the liability for unallocated surplus which as described above, do not affect shareholder results.
Scottish Amicable Insurance Fund (SAIF) SAIF is a ring-fenced fund in which, apart from asset management fees, shareholders have no interest. Accordingly, the Group’s IFRS profit and equity are insensitive to the direct effects of market risk attaching to SAIF’s assets and liabilities.
(ii) Shareholder-backed business The factors that may significantly affect the IFRS results of UK shareholder-backed business are the mortality experience and assumptions, and credit risk attaching to the annuity business of Prudential Retirement Income Limited and the PAC non-profit sub-fund. The sensitivity to market risk for the main constituents elements of the shareholder-backed business of the UK insurance operations is as follows: Prudential Retirement Income Limited (PRIL) The assets covering PRIL’s liabilities are principally debt securities and other investments that are held to match the expected duration and payment characteristics of the policyholder liabilities. These liabilities are valued for IFRS reporting purposes by applying discount rates that reflect the market rates of return attaching to the covering assets. Except to the extent of any asset/liability duration mismatch which is reviewed regularly, and exposure to credit risk, the sensitivity of the Group’s results to market risk for movements in the carrying value of PRIL’s liabilities and covering assets is broadly neutral on a net basis. The main market risk sensitivity for PRIL arises from interest rate risk on the debt securities which substantially represent shareholders’ equity. This shareholders’ equity comprises the net assets held within the long-term fund of the company that cover regulatory basis liabilities that are not recognised for IFRS reporting purposes, for example contingency reserves, and shareholder capital held outside the long-term fund. The principal items affecting the IFRS results for PRIL are mortality experience and assumptions, and credit risk.
b US insurance operations (Jackson) The IFRS basis results of Jackson are highly sensitive to market risk on the assets covering liabilities other than variable annuity business segregated in the separate accounts.
Insurance and lapse risk The features described above cover the main sensitivities of IFRS profit and loss and equity for market and credit risk. Lapse and longevity risk may also be a key determination of IFRS basis results with variable impacts.
In the UK, adverse persistency experience can affect the level of profitability from with-profits and unit-linked business. For with-profits business in any given year, the amount represented by the shareholders’ share of cost of bonus may only be marginally affected. However, altered persistency trends may affect future expected shareholder transfers. By contrast, Group IFRS operating profit is particularly sensitive to longevity outlook that results in changes of assumption for the UK shareholder-backed annuity business.
Jackson is sensitive to lapse risk. However, Jackson uses swaption derivatives to ameliorate the effect of a sharp rise in interest rates, which would be the most likely cause of a sudden change in policyholder behaviour. In Asia, adverse persistency experience can impact the IFRS profitability of certain business written in the region. This risk is managed at a business unit level through monthly monitoring of experience and the implementation of management actions as necessary. These actions could include product enhancements, increased management focus on premium collection as well as other customer retention efforts. The potential financial impact of lapses is often mitigated through the specific features of the products, eg surrender charges.
Impact of diversification on risk exposure The Group enjoys significant diversification benefits. This arises because not all risk scenarios will happen at the same time and across all geographic regions. The Group tests the sensitivities of results to different correlation factors such as: Correlation across geographic regions • financial risk factors • non-financial risk factors
Correlation across risk factors • longevity risk • expenses • persistency • other risks
Annuity and other long-term business £m Total £m 2011 Group Total £m 2010 Group Total £m
Liabilities Policyholder liabilities and unallocated surplus of with-profits funds: Contract liabilities (including amounts in respect of contracts classified as investment contracts under IFRS 4) 8,555 67,098 5,323 72,421 21,281 24,767 46,048 127,024 125,530 Unallocated surplus of with-profits funds (reflecting application of
Borrowings attributable to with-profits funds 17 955 – 955 – – – 972 1,522
Notes (i) For the purposes of this table and subsequent explanation, references to the WPSF also include, for convenience, the amounts attaching to the
(vii) Unallocated surplus of with-profits funds Prudential’s long-term business written in the UK comprises predominantly life insurance policies under which the policyholders are entitled to participate in the returns of the funds supporting these policies. Business similar to this type is also written in certain of the Group’s Asian operations, subject to local market and regulatory conditions. Such policies are called with-profits policies. Prudential maintains with-profits funds within the Group’s long-term business funds, which segregate the assets and liabilities and accumulate the returns related to that with-profits business. The amounts accumulated in these with-profits funds are available to provide for future policyholder benefit provisions and for bonuses to be distributed to with-profits policyholders. The bonuses, both annual and final, reflect the right of the with-profits policyholders to participate in the financial performance of the with-profits funds. Shareholders’ profits with respect to bonuses declared on with-profits business correspond to the shareholders’ share of the cost of bonuses as declared by the Board of Directors. The shareholders’ share currently represents one-ninth of the cost of bonuses declared for with-profits policies.
(viii) Investment properties At 31 December 2011, the Group’s UK insurance operations had £10,712 million (2010: £11,212 million) of investment properties. The following table shows the property portfolio by type of investment. The properties are shown at market value below in accordance with the policies described in note A4.
Office buildings 4,443 41.5 4,617 41.2 Shopping centres/commercial 4,315 40.3 3,777 33.7 Retail warehouses/industrial 1,406 13.1 2,184 19.5 Development 383 3.6 402 3.6 Other 165 1.5 232 2.0
Movement in the year of directly held investments, net of derivative liabilities (145) 3,627 660 4,287 2,398 3,036 9,576
At 31 December 2010/1 January 2011 Total investments (including derivative assets) 9,704 70,576 14,496 85,072 20,795 25,855 141,426 Less: Investments held by consolidated investment funds – (140) (22) (162) (705) (45) (912)
Movement in the year of directly held investments, net of derivative liabilities (1,253) 6,187 (7,411) (1,224) 357 2,550 430
At 31 December 2011 Total investments (including derivative assets) 8,485 77,002 7,149 84,151 21,244 28,547 142,427 Less: Investments held by consolidated investment funds – (52) (23) (75) (793) (109) (977)
ife assu ran ce b u sin ess c Reconciliation of movement in policyholder liabilities and unallocated surplus of with-profits funds A reconciliation of the total policyholder liabilities and unallocated surplus of with-profits funds of UK insurance operations from the beginning of the year to the end of the year is as follows: Other shareholder-backed funds and subsidiaries
At 1 January 2010 87,495 19,035 19,665 126,195 Comprising: – Policyholder liabilities 77,529 19,035 19,665 116,229 – Unallocated surplus of with-profits funds 9,966 – – 9,966
Comprising: – Policyholder liabilities 80,976 21,281 24,767 127,024 – Unallocated surplus of with-profits funds 9,165 – – 9,165 * Excluding the unallocated surplus of the with-profits funds and as adjusted for corporate transactions in the period.
Moody’s – Aaa 263 2,350 1,169 3,519 1,411 2,153 599 7,945 765 Moody’s – Aa1 to Aa3 26 180 33 213 88 269 55 651 360 Moody’s – A1 to A3 41 456 125 581 51 290 45 1,008 632 Moody’s – Baa1 to Baa3 56 516 109 625 74 236 39 1,030 949 Moody’s – Other 16 152 6 158 37 24 7 242 233
Where no external ratings are available, internal ratings produced by the Group’s asset management operation, which are prepared on the Company’s assessment of a comparable basis to external ratings, are used where possible. The £7,615 million total debt securities held at 31 December 2011 (2010: £7,258 million) which are not externally rated are either internally rated or unrated. These are analysed as follows: Internal ratings or unrated: AAA to A- 2,726 2,210 BBB to B- 3,773 3,861 Below B- or unrated 1,116 1,187
The majority of unrated debt security investments were held in SAIF and the PAC with-profits fund and relate to convertible debt and other investments which are not covered by ratings analysts nor have an internal rating attributed to them. Of the £1,882 million PRIL and other annuity and long-term business investments which are not externally rated, £9 million were internally rated AAA, £114 million AA, £590 million A, £887 million BBB, £92 million BB and £190 million were internally rated B+ and below or unrated. During the year Standard and Poor’s withdrew its ratings of debt securities issued by a number of Sovereigns. Where these are no longer available Moody’s ratings have been used. This primarily impacts the UK and Asia insurance operations. As detailed in note D2(j) below, the primary sensitivity of IFRS basis profit or loss and shareholders’ equity relates to non-linked shareholder-backed business which covers ‘PRIL’ and ‘other annuity and long-term business’ in the table above.
With-profits products provide returns to policyholders through bonuses that are ‘smoothed’. There are two types of bonuses: ‘annual’ and ‘final’. Annual bonuses are declared once a year and, once credited, are guaranteed in accordance with the terms of the particular product. Unlike annual bonuses, final bonuses are guaranteed only until the next bonus declaration. The main factors that influence the determination of bonus rates are the return on the investments of the with-profits fund, inflation, taxation, the expenses of the fund chargeable to policyholders and the degree to which investment returns are smoothed. The overall rate of return earned on investments and the expectation of future investment returns are the most important influences on bonus rates. A high proportion of the assets backing the with-profits business are invested in equities and real estate. If the financial strength of the with-profits business is affected, then a higher proportion of fixed interest or similar assets might be held by the fund. Further details on the determination of the two types of the bonuses: ‘regular’ and ‘final’, the application of significant judgement, key assumptions and the degree of smoothing of investment returns in determining the bonus rates are provided below.
Final bonus rates A final bonus, which is normally declared yearly, may be added when a claim is paid or when units of a unitised product are realised.
The rates of final bonus usually vary by type of policy and by reference to the period, usually a year, in which the policy commences or each premium is paid. These rates are determined by reference to the asset shares for the sample policies but subject to the smoothing approach, explained below. In general, the same final bonus scale applies to maturity, death and surrender claims except that: • The total surrender value may be impacted by the application of a Market Value Reduction (MVR) which is for accumulating with-profits policies and is affected by the surrender bases (for conventional with-profits business); and
Application of significant judgement The application of the above method for determining bonuses requires the PAC Board to apply significant judgement in many respects, including in particular the following: • Determining what constitutes fair treatment of customers: Prudential is required by UK law and regulation to consider the fair treatment of its customers in setting bonus levels. The concept of determining what constitutes fair treatment, while established by statute, is not defined; • Smoothing of investment returns: This is an important feature of with-profits products. Determining when particular circumstances, such as a significant rise or fall in market values, warrant variations in the standard bonus smoothing limits that apply in normal circumstances requires the PAC Board to exercise significant judgement; and
Key assumptions As noted above, the overall rate of return on investments and the expectation of future investment returns are the most important influences in bonus rates, subject to the smoothing described below. Prudential determines the assumptions to apply in respect of these factors, including the effects of reasonably likely changes in key assumptions, in the context of the overarching discretionary and smoothing framework that applies to its with-profits business as described above. As such, it is not possible to specifically quantify the effects of each of these assumptions or of reasonably likely changes in these assumptions. Prudential’s approach, in applying significant judgement and discretion in relation to determining bonus rates, is consistent conceptually with the approach adopted by other firms that manage a with-profits business. It is also consistent with the requirements of UK law, which require all UK firms that carry out a with-profits business to define, and make publicly available, the Principles and Practices of Financial Management (PPFM) that are applied in the management of their with-profits funds. Accordingly, Prudential’s PPFM contains an explanation of how it determines regular and final bonus rates within the discretionary framework that applies to all with-profits policies, subject to the general legislative requirements applicable. The purpose of Prudential’s PPFM is therefore to: • explain the nature and extent of the discretion available, • show how competing or conflicting interests or expectations of: – different groups and generations of policyholders, and – policyholders and shareholders are managed so that all policyholders and shareholders are treated fairly, and • provide a knowledgeable observer (eg a financial adviser) with an understanding of the material risks and rewards from starting and continuing to invest in a with-profits policy with Prudential.
Net income of the fund before movement in unallocated surplus 1,676 2,172 Movement in unallocated surplus 485 70
Surplus for distribution allocated as follows: – 90% policyholders’ bonus (as shown above) 1,945 2,019 – 10% shareholders’ transfers 216 223 ii Annuity business Prudential’s conventional annuities include level, fixed-increase and inflation-linked annuities, the link being to the Retail Price Index (RPI) in the majority of cases. They are mainly written within the subsidiaries PAL, PRIL, the PAC non-profit sub-fund and the PAC with-profits sub-fund, but there are some annuity liabilities in Prudential Pensions Limited and SAIF. Prudential’s fixed-increase annuities incorporate automatic increases in annuity payments by fixed amounts over the policyholder’s life. The RPI annuities that Prudential offers provide for a regular annuity payment to which an additional amount is added periodically based on the increase in the UK RPI. Prudential’s with-profits annuities, which are written in the WPSF, combine the income features of annuity products with the investment smoothing features of with-profits products and enable policyholders to obtain exposure to investment return on the WPSF’s equity shares, property and other investment categories over time. Policyholders select a ‘required smoothed return’ bonus from the specific range Prudential offers for the particular product. The amount of the annuity payment each year depends upon the relationship between the required smoothed return bonus rate selected by the policyholder when the product is purchased and the smoothed return bonus rates Prudential subsequently declares each year during the term of the product. If the total bonus rates fall below the anticipated rate, then the annuity income falls. At 31 December 2011, £38.3 billion (2010: £35.6 billion) of investments relate to annuity business of PAL (including the business recaptured by PAC WPSF in 2011) and PRIL. These investments are predominantly in debt securities (including retail price indexlinked bonds to match retail price index-linked annuities), loans and deposits and are duration matched with the estimated duration of the liabilities they support.
D2: UK insurance operations continued iii SAIF SAIF is a ring-fenced sub-fund of the PAC long-term fund formed following the acquisition of the mutually owned Scottish Amicable Life Assurance Society in 1997. No new business may be written in SAIF, although regular premiums are still being paid on policies in force at the time of the acquisition and incremental premiums are permitted on these policies. The fund is solely for the benefit of policyholders of SAIF. Shareholders have no interest in the profits of this fund although they are entitled to asset management fees on this business. The process for determining policyholder bonuses of SAIF with-profits policies, which constitute the vast majority of obligations of the funds, is similar to that for the with-profits policies of the WPSF. However, in addition, the surplus assets in SAIF are allocated to policies in an orderly and equitable distribution over time as enhancements to policyholder benefits ie in excess of those based on asset share. Provision is made for the risks attaching to some SAIF unitised with-profits policies that have MVR-free dates and for those SAIF products which have a guaranteed minimum benefit on death or maturity of premiums accumulated at 4 per cent per annum. The Group’s main exposure to guaranteed annuities in the UK is through SAIF and a provision of £370 million was held in SAIF at 31 December 2011 (2010: £336 million) to honour the guarantees. As SAIF is a separate sub-fund solely for the benefit of policyholders of SAIF this provision has no impact on the financial position of the Group’s shareholders’ equity.
f Exposure to market risk i Non-linked life and pension business For with-profits business, the absence of guaranteed surrender values and the flexibility given by the operation of the bonus system means that a high proportion of the investments backing the with-profits business are in equities and real estate, with the balance in debt securities, deposits and loans. The investments supporting the protection business are small in value and tend to be assets of a fixed term duration, reflecting the guaranteed nature of the liabilities.
ii Pension annuity business Prudential’s UK annuity business mainly employs fixed income investments (including UK retail price index-linked assets) because the liabilities consist of guaranteed payments for as long as each annuitant or surviving partner is alive. Retail price index-linked assets are used to back pension annuities where the payments are linked to the RPI.
Maintenance and, for some classes of business, termination expense assumptions are expressed as per policy amounts. They are set based on the expenses incurred during the year, including an allowance for ongoing investment expenditure and allocated between entities and product groups in accordance with the operation’s internal cost allocation model. For non-profit business a margin for adverse deviation is added to this amount. Expense inflation assumptions are set consistent with the economic basis and based on the difference between yields on nominal gilts and index-linked gilts. The actual renewal expenses incurred on behalf of SAIF by other Group companies are recharged in full to SAIF. The assumptions for asset management expenses are based on the charges specified in agreements with the Group’s asset management operations, plus a margin for adverse deviation for non-profit business. Tax assumptions are set equal to current rates of taxation. For non-profit business excluding unit-linked business, the valuation interest rates used to discount the liabilities are based on the yields as at the valuation date on the assets backing the technical provisions. For fixed interest securities the gross redemption yield is used except for the PAL (including the business recaptured by PAC WPSF in 2011) and PRIL annuity business where the internal rate of return of the assets backing the liabilities is used. Properties are valued using the rental yield, and for equities it is the greater of the dividend yield and the average of the dividend yield and the earnings yield. An adjustment is made to the yield on non risk-free fixed interest securities and property to reflect credit risk. To calculate the non-unit reserves for linked business, assumptions have been set for the gross unit growth rate and the rate of inflation of maintenance expenses, as well as for the valuation interest rate as described above.
The WPBR is primarily based on the retrospective calculation of accumulated asset shares but is adjusted to reflect future expected policyholder benefits and other outgoings. Asset shares are calculated as the accumulation of all items of income and outgo that are relevant to each policy type. Income comprises credits for premiums, investment returns (including unrealised gains) and miscellaneous profits. Outgo comprises charges for tax (including an allowance for tax on unrealised gains), guarantees and smoothing, mortality and morbidity, shareholders’ profit transfers, miscellaneous losses, and expenses and commission (net of any tax relief). The FPRL must include a market-consistent valuation of costs of guarantees, options and smoothing, less any related charges, and this amount must be determined using either a stochastic approach, hedging costs or a series of deterministic projections with attributed probabilities.
The sum of (c) and (d) is often referred to as ‘liquidity premium’. The allowance for credit risk comprises (i) an amount for long-term best estimate defaults, and (ii) additional provisions for credit risk premium, downgrade resilience and short-term defaults. The weighted components of the bond spread over swap rates for shareholder-backed fixed and linked annuity business for PRIL at 31 December 2011 and 31 December 2010, based on the asset mix at the relevant balance sheet date are shown below.
Credit risk allowance: Long-term expected defaults note (ii) 15 – 15 Additional provisionsnote (iii) 51 (24) 27
Credit risk allowance: Long-term expected defaults note (ii) 16 – 16 Additional provisionsnote (iii) 52 (26) 26
Total allowance for credit risk at 31 December 2011 66 42
AM92 minus 4 years 86% to 97% 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%.
AM92 minus 4 years 84% to 117% PNFA00 (C = 2000) with 75% of medium cohort improvement table with a minimum annual improvement of 1.25% up to age 90, tapering to zero at age 120.
AM92 minus 4 years 87% to 98% PNFA00 (C = 2000) with 75% of medium cohort improvement table with a minimum annual improvement of 1.25% up to age 90, tapering to zero at age 120.
ife assu ran ce b u sin ess iv Unit-linked (non-annuity) and other non-profit business The majority of other long-term business written in the UK insurance operations is unit-linked business or other business with similar features. For these contracts the attaching liability reflects the unit value obligation and provision for expenses and mortality risk. The latter component is determined by applying mortality assumptions on a basis that is appropriate for the policyholder profile. For unit-linked business, the assets covering unit liabilities are exposed to market risk, but the residual risk when considering the unit-linked liabilities and assets together is limited to the effect on fund-based charges. For those contracts where the level of insurance risk is insignificant the assets and liabilities arising under the contracts are distinguished between those that relate to the financial instrument liability and acquisition costs and deferred income that relate to the component of the contract that relates to investment management. Acquisition costs and deferred income are recognised consistent with the level of service provision in line with the requirements of IAS 18.
Credit risk The approach to reserving for credit risk is set out in note D2(f)(iii).
ii Shareholder-backed annuity business Profits from shareholder-backed annuity business are most sensitive to: • The extent to which the duration of the assets held closely matches the expected duration of the liabilities under the contracts. Assuming close matching, the impact of short-term asset value movements as a result of interest rate movements will broadly offset changes in the value of liabilities caused by movements in valuation rates of interest; • Actual versus expected default rates on assets held; • The difference between long-term rates of return on corporate bonds and risk-free rates; • The variance between actual and expected mortality experience; • The extent to which changes to the assumed rate of improvements in mortality give rise to changes in the measurement of liabilities; and • Changes in renewal expense levels.
The close matching by the Group of assets of appropriate duration to annuity liabilities is based on maintaining economic and regulatory capital. The measurement of liabilities under capital reporting requirements and IFRS is not the same with contingency reserves and some other margins for prudence within the assumptions required under the FSA regulatory solvency basis not included for IFRS reporting purposes. As a result IFRS equity is higher than regulatory capital and therefore more sensitive to interest rate and credit risk. The estimated sensitivity of the UK non-linked shareholder-backed business (principally pension annuities business) to a movement in interest rates is as follows: Decrease of 2%
In addition, the shareholder-backed portfolio of UK non-linked insurance operations covering liabilities and shareholders’ equity includes equity securities and investment property. Excluding any second order effects on the measurement of the liabilities for future cash flows to the policyholder, a fall in their value would have given rise to the following effects on pre-tax profit, profit after tax, and shareholders’ equity.
Net sensitivity of profit after tax and shareholders’ equity (239) (120) (220) (110)
D2: UK insurance operations continued k Duration of liabilities With the exception of most unitised with-profits bonds and other whole of life contracts the majority of the contracts of the UK insurance operations have a contract term. However, in effect, the maturity term of contracts reflects the earlier of death, maturity or lapsation. In addition, with-profits contract liabilities as noted in note D2(g) include projected future bonuses based on current investment values. The actual amounts payable will vary with future investment performance of SAIF and the WPSF. The tables above show the carrying value of the policyholder liabilities. Separately, the Group uses cash flow projections of expected benefit payments as part of the determination of the value of in-force business when preparing EEV basis results. The tables in the accompanying notes below show the maturity profile of the cash flows used for that purpose for insurance contracts, as defined by IFRS, ie those containing significant insurance risk, and investment contracts, which do not.
(ii) Benefit payments do not reflect the pattern of bonuses and shareholder transfers in respect of the with-profits business. (iii) Investment contracts under Other comprise certain unit-linked and similar contracts accounted for under IAS 39 and IAS 18. (iv) For business with no maturity term included within the contracts, for example with-profits investment bonds such as Prudence Bonds, an assumption is made as to likely duration based on prior experience.
D3: US insurance operations a Summary results and statement of financial position i Results and movements in shareholders’ equity
Operating profit based on longer-term investment returns 694 833 Short-term fluctuations in investment returns (95) (378)
Total unrealised valuation movements 811 1,221 Related change in amortisation of deferred income and acquisition costs (331) (496) Related tax (168) (247)
Net increase in shareholders’ equity 456 804 Shareholders’ equity at beginning of year 3,815 3,011
Further details on the impairment losses recognised in the year are shown in note B1. Jackson’s portfolio of debt securities is managed proactively with credit analysts closely monitoring and reporting on the credit quality of its holdings. Jackson continues to review its investments on a case-by-case basis to determine whether any decline in fair value represents an impairment. In addition, investments in structured securities are subject to a rigorous review of their future estimated cash flows, including expected and stress case scenarios, to identify potential shortfalls in contractual payments (both interest and principal). Impairment charges are recorded on structured securities when the Company forecasts a contractual payment shortfall. Situations where such a shortfall would not lead to a recognition of a loss are rare. However, some structured securities do not have a single determined set of future cash flows and instead, there can be a reasonable range of estimates that could potentially emerge. With this variability, there could be instances where the projected cash flow shortfall under management’s base case set of assumptions is so minor that relatively small and justifiable changes to the base case assumptions would eliminate the need for an impairment loss to be recognised. The impairment loss reflects the difference between the fair value and book value. In 2011 there was a movement in the statement of financial position value for debt securities classified as available-for-sale from a net unrealised gain of £1,210 million to a net unrealised gain of £2,057 million. The gross unrealised gain in the statement of financial position increased from £1,580 million at 31 December 2010 to £2,303 million at 31 December 2011, while the gross unrealised loss decreased from £370 million at 31 December 2010 to £246 million at 31 December 2011.
Assets fair valued at below book value Book value* 2,455 4,372 Unrealised (loss)/gain (246) 122 2 (370)
Fair value (as included in statement of financial position) 24,807 22,323
Total Book value* 24,959 25,115 Net unrealised gain 2,057 811 36 1,210
Fair value (as included in statement of financial position)‡ 27,016 26,325 * Book value represents cost/amortised cost of the debt securities.
Assets Intangible assets attributable to shareholders: Deferred acquisition costs and other intangibles – 3,900 3,900 3,559
Deferred tax assets – 1,392 1,392 1,391 Other non-investment and non-cash assets – 1,542 1,542 1,225 Investments of long-term business and other operations: Investment properties – 35 35 26 Financial investments: Loansnote (ii) – 4,110 4,110 4,201 Equity securities and portfolio holdings in unit trustsnote (v) 37,833 203 38,036 31,501 Debt securities – 27,022 27,022 26,366 Other investmentsnote (iii) – 2,376 2,376 1,199 Deposits – 167 167 212
Notes (i) Assets and liabilities attaching to variable annuity business that are not held in the separate account are shown within other business. (ii) Loans The loans of the Group’s US insurance operations comprise: Mortgage loans* 3,559 3,641 Policy loans† 551 548 Other loans – 12
† The policy loans are fully secured by individual life insurance policies or annuity policies. These loans are accounted for at amortised cost, less any impairment.
(iii) Other investments comprise: Derivative assets* note G3 1,677 645 Partnerships in investment pools and other† 699 554 * In the US, Prudential uses derivatives to reduce interest rate risk, to facilitate efficient portfolio management to match liabilities under annuity policies, and for certain equity-based product management activities. After taking account of the derivative liability of £887 million (2010: £799 million), which is also included in the statement of financial position, the derivative position for US operations is a net asset of £790 million (2010: net liability of £154 million).
(v) Equity securities and portfolio holdings in unit trusts includes investments in mutual funds, the majority of which are equity based.
ife assu ran ce b u sin ess b Reconciliation of movement in investments A reconciliation of the total investments of US insurance operations from the beginning of the year to the end of the year is as follows: Variable annuity separate account assets and liabilities £m
At 1 January 2010 Total investments (including derivative assets) 20,639 28,937 49,576 Less: Derivative liabilities – (461) (461)
At 31 December 2010/1 January 2011 Total investments (including derivative assets) 31,203 32,302 63,505 Less: Derivative liabilities note G3 – (799) (799)
Movement in the year of directly held investments, net of derivative liabilities 6,630 1,523 8,153
Net flows 5,758 1,610 7,368 Transfers from general to separate account 1,411 (1,411) – Investment-related items and other movements 2,875 589 3,464 Foreign exchange translation differencesnote (a) 520 860 1,380
At 31 December 2011 37,833 31,356 69,189 Average policyholder liability balances 2011 34,518 30,338 64,856 2010 25,921 28,496 54,417
Notes (a) Movements in the year have been translated at an average rate of 1.60 (2010: 1.55). The closing balance has been translated at closing rate of 1.55
Corporate and government security and commercial loans: Government 2,163 2,440 Publicly traded and SEC Rule 144A securities 16,281 14,747 Non-SEC Rule 144A securities 3,198 3,044
Total US debt securities 27,022 26,366 i Credit quality For statutory reporting in the US, debt securities are classified into six quality categories specified by the Securities Valuation Office of the National Association of Insurance Commissioners (NAIC). The categories range from Class 1 (the highest) to Class 6 (the lowest). Performing securities are designated as Classes 1 to 5. Securities in or near default are designated Class 6. Securities designated as Class 3, 4, 5 and 6 are non-investment grade securities. Generally, securities rated AAA to A by nationally recognised statistical ratings organisations are reflected in Class 1, BBB in Class 2, BB in Class 3 and B and below in Classes 4 to 6. If a designation is not currently available from the NAIC, Jackson’s investment adviser, PPM America, provides the designation for the purposes of disclosure below. The following table shows the quality of the publicly traded and SEC Rule 144A debt securities by NAIC classifications: Carrying value Carrying value £m % of total £m % of total
Other debt securities of £620 million (2010: £976 million) are made up as shown in the following table: Asset-backed securities held by Jackson – NAIC designation 1 474 527 Asset-backed securities held by Jackson – NAIC designation 2 90 135 Securities held by Piedmont trust entity – 211 Investments managed by PPM America 6 42 Other 50 61
S&P – AAA 133 4,187 S&P – AA+ to AA- 4,476 801 S&P – A+ to A- 6,382 5,156 S&P – BBB+ to BBB- 8,446 8,202 S&P – Other 999 866
Moody’s – Aaa 62 34 Moody’s – Aa1 to Aa3 15 32 Moody’s – A1 to A3 29 36 Moody’s – Baa1 to Baa3 67 73 Moody’s – Other 17 135
Implicit ratings of MBS based on NAIC valuations (see below) NAIC 1 2,577 3,083 NAIC 2 147 181 NAIC 3-6 368 232
ii Determining the fair value of debt securities when the markets are not active Under IAS 39, unless categorised as ‘held to maturity’ or ‘loans and receivables’ debt securities are required to be fair valued. Where available, quoted market prices are used. However, where securities do not have an externally quoted price based on regular trades or where markets for the securities are no longer active as a result of market conditions, IAS 39 requires that valuation techniques be applied. IFRS 7 requires classification of the fair values applied by the Group into a three level hierarchy. Note G1 sets out further details of the Group’s approach to determining fair value and classifies these fair values into a three level hierarchy as required by IFRS 7. At 31 December 2011, 0.1 per cent of Jackson’s debt securities were classified as level 3 (31 December 2010: 0.3 per cent) comprising of fair values where there are significant inputs which are not based on observable market data.
iii Asset-backed securities funds exposures Included within the debt securities of Jackson at 31 December 2011 are exposures to asset-backed securities as follows: 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 Group’s economic interest in Piedmont and other consolidated CDO funds.
Included within the table above are amounts relating to sub-prime and Alt-A securities of: Fair value Unrealised loss Fair value Unrealised loss
Immediate annuities At 31 December 2011, immediate annuities accounted for 1 per cent (2010: 2 per cent) of Jackson’s policy and contract liabilities. Immediate annuities guarantee a series of payments beginning within a year of purchase and continuing over either a fixed period of years and/or the life of the policyholder. If the term is for the life of the policyholder, then Jackson’s primary risk is mortality risk. The implicit interest rate on these products is based on the market conditions that exist at the time the policy is issued and is guaranteed for the term of the annuity.
ife assu ran ce b u sin ess iii Life insurance Jackson’s life insurance products accounted for 7 per cent (2010: 7 per cent) of Jackson’s policy and contract liabilities at 31 December 2011. The products offered include term life, universal life and variable universal life. Term life provides protection for a defined period and a benefit that is payable to a designated beneficiary upon death of the insured. Universal life provides permanent individual life insurance for the life of the insured and includes a savings element. Variable universal life is a type of life insurance policy that combines death benefit protection with the ability for the policyholder account to be invested in separate account funds. At 31 December 2011, Jackson had interest-sensitive life (universal life type) business in force with total account value of £2.9 billion (US$4.5 billion), with minimum guaranteed interest rates ranging from 3.0 per cent to 6.0 per cent with a 4.93 per cent average guaranteed rate.
iv Institutional products Jackson’s institutional products consist of GICs, funding agreements (including agreements issued in conjunction with Jackson’s participation in the US Federal Home Loan Bank programme) and medium-term note funding agreements. At 31 December 2011, institutional products accounted for 4 per cent of policy and contract liabilities (2010: 5 per cent). Under a traditional GIC, the policyholder makes a lump sum deposit. The interest rate paid is fixed and established when the contract is issued. If deposited funds are withdrawn earlier than the specified term of the contract, an adjustment is made that approximates a market value adjustment. Under a funding agreement, the policyholder either makes a lump sum deposit or makes specified periodic deposits. Jackson agrees to pay a rate of interest, which may be fixed but which is usually a floating short-term interest rate linked to an external index. The average term of the funding arrangements is one to two years. In 2011 and 2010, there were no funding agreements terminable by the policyholder with less than 90 days’ notice. Medium-term note funding agreements are generally issued to support trust instruments issued on non-US exchanges or to qualified investors (as defined by SEC Rule 144A). Through the funding agreements, Jackson agrees to pay a rate of interest, which may be fixed or floating, to the holders of the trust instruments.
f Exposure to market risk and risk management Jackson’s main exposures are to market risk through its exposure to interest rate risk and equity risk. Approximately 92 per cent (2010: 91 per cent) of its general account investments support interest-sensitive and fixed indexed annuities, life business and surplus and 8 per cent (2010: 9 per cent) support institutional business. All of these types of business contain considerable interest rate guarantee features and, consequently, require that the assets that support them are primarily fixed income or fixed maturity. Jackson is exposed primarily to the following risks in the US arising from fluctuations in interest rates: • the risk of loss related to meeting guaranteed rates of accumulation following a sharp and sustained fall in interest rates, • the risk of loss related to policyholder withdrawals following a sharp and sustained increase in interest rates, and • the risk of mismatch between the expected duration of certain annuity liabilities and prepayment risk and extension risk inherent in mortgage-backed securities.
Jackson is also exposed to the following risks in the US arising from equity market movements: • the risk of loss related to the incidence of benefits related to guarantees issued in connection with its VA contracts, and • the risk of loss related to meeting contractual accumulation requirements in FIA contracts.
Jackson enters into financial derivative transactions, including those noted below to reduce and manage business risks. These transactions manage the risk of a change in the value, yield, price, cash flows, or quantity of, or a degree of exposure with respect to assets, liabilities or future cash flows, which Jackson has acquired or incurred. Jackson uses free-standing derivative instruments for hedging purposes. Additionally, certain liabilities, primarily trust instruments supported by funding agreements, fixed indexed annuities, certain GMWB variable annuity features and reinsured GMIB variable annuity features contain embedded derivatives as defined by IAS 39, ‘Financial Instruments: Recognition and Measurement’. Jackson does not account for such derivatives as either fair value or cash flow hedges as might be permitted if the specific hedge documentation requirements of IAS 39 were followed. Financial derivatives, including derivatives embedded in certain host liabilities that have been separated for accounting and financial reporting purposes are carried at fair value. Value movements on the derivatives are reported within the income statement. In preparing Jackson’s segment profit as shown in note B1, value movements on Jackson’s derivative contracts, are included within short-term fluctuations in investment returns and excluded from operating results based on longer-term investment returns.
• Credit default swaps, represent agreements under which Jackson has purchased default protection on certain underlying corporate bonds held in its portfolio. These contracts allow Jackson to sell the protected bonds at par value to the counterparty if a default event occurs in exchange for periodic payments made by Jackson for the life of the agreement. Jackson does not write default protection using credit derivatives.
g Process for setting assumptions and determining contract liabilities Under the MSB of reporting applied under IFRS 4 for insurance contracts, providing the requirements of the Companies Act, UK GAAP standards and the ABI SORP are met, it is permissible to reflect the previously applied UK GAAP basis. Accordingly, and consistent with the basis explained in note A4, in the case of Jackson, the carrying values of insurance assets and liabilities are consolidated into the Group accounts based on US GAAP. Under US GAAP, investment contracts (as defined for US GAAP purposes) are accounted for by applying in the first instance a retrospective deposit method to determine the liability for policyholder benefits. This is then augmented by potentially three additional amounts. These amounts are for: • any amounts that have been assessed to compensate the insurer for services to be performed over future periods (ie deferred income),
VA contracts written by Jackson may, as described above, provide for GMDB, GMIB, GMWB and GMAB features. In general terms, liabilities for these benefits are accounted for under US GAAP by using estimates of future benefits and fees under best estimate persistency assumptions. In accordance with US GAAP, the ‘grandfathered’ basis for IFRS, which specifies how certain guarantee features should be accounted for, the GMDB and the ‘for life’ portion of GMWB liabilities are not fair valued but are instead determined each period end by estimating the expected value of benefits in excess of the projected account balance and recognising the excess ratably over the life of the contract based on total expected assessments. At 31 December 2011, these liabilities were valued using a series of deterministic investment performance scenarios, a mean investment return of 8.4 per cent (2010: 8.4 per cent) and assumptions for lapse, mortality and expense that are the same as those used in amortising the capitalised acquisition costs.
Mean reversion technique Under US GAAP (as ‘grandfathered’ under IFRS 4) the projected gross profits, against which acquisition costs are amortised, reflect an assumed long-term level of investment return from the separate accounts which, for Jackson, is 8.4 per cent after deduction of net external fund management fees. This is applied to the period end level of separate account assets after application of a mean reversion technique that removes a portion of the effect of levels of short-term variability in current market returns. Under the mean reversion technique applied by Jackson, the projected level of return for each of the next five years is adjusted from period to period so that in combination with the actual rates of return for the preceding two years and the current year, the 8.4 per cent annual return is realised on average over the entire eight-year period. Projected returns after the mean reversion period revert back to the 8.4 per cent assumption. However, to ensure that the methodology does not over anticipate a reversion to trend following adverse markets, the mean reversion technique has a cap and floor feature whereby the projected returns in each of the next five years can be no more than 15 per cent per annum and no less than 0 per cent per annum (both gross of asset management fees) in each year. The capping feature was relevant in late 2008, 2009 and 2010 due to the very sharp market falls in 2008. At 31 December 2011, the projected rate of return for the next five years is less than 8.4 per cent. If Jackson had not applied the mean reversion methodology and had instead applied a constant 8.4 per cent from asset values at 31 December 2011, the Jackson DAC balance would increase by approximately £38 million from £3,880 million to £3,918 million (31 December 2010 decrease of £80 million from £3,543 million to £3,463 million).
Sensitivity of amortisation charge In 2008, the application of the mean reversion technique benefited the results by £110 million. In 2009 and 2010, whilst the cap was in effect, the credit of £39 million for decelerated amortisation and the charge of £11 million for accelerated amortisation reflected the difference between market returns for the period and the assumed level of 15 per cent. For 2011, the separate account return (net of all fees) was approximately negative 4 per cent. The DAC amortisation charge included in operating profit includes £232 million of accelerated amortisation. This amount reflects the combined effect of: (i) the separate account performance in the year as it compares with the assumed level for the year; and (ii) the reduction in the previously assumed future rates of return for the upcoming five years from 15 per cent, to a level somewhat below the middle of the corridor (of 0 and 15 per cent), so that in combination with the historical returns, the 8-year average in the mean reversion calculation is the 8.4 per cent long-term assumption.
For 2011 and 2010, £156 million and £158 million of acquisition costs will be charged to the operating results of Jackson for these years. These charges are for the non-incremental acquisition costs for new business written in these years, as shown in note Y, representing 12 per cent of APE of £1,251 million and 14 per cent of £1,164 million, respectively.
On application of the Update, Jackson’s: (i) deferred acquisition costs balance for business in force at 31 December 2011 will be retrospectively reduced by 20 per cent, from £3,880 million to £3,095 million; (ii) amortisation charge to the 2011 operating profit based on longer-term investment returns is retrospectively adjusted by 18 per cent from £619 million (comprising £387 million core charge and £232 million accelerated amortisation) to £506 million (comprising £316 million core charge and £190 million accelerated amortisation). The core charge alters from representing 29 per cent to: – 24 per cent of operating profit, based on longer-term investment returns before DAC amortisation and the charge for acquisition costs for business written in the year that can no longer be deferred, and
(iii) amortisation charge to the 2010 operating profit based on longer-term investment returns is retrospectively adjusted by 16 per cent from £334 million (comprising £323 million core charge and £11 million accelerated amortisation) to £280 million (comprising £271 million core charge and £9 million accelerated amortisation). The core charge alters from representing 28 per cent to: – 23 per cent of operating profit based on longer-term investment returns before DAC amortisation and the charge for acquisition costs for business written in the year that can no longer be deferred, and
i Effect of changes in assumptions used to measure insurance assets and liabilities In 2011 and 2010, there were no changes of assumptions that had a material impact on the results of US insurance operations.
Account balances of contracts with guarantees were invested in variable separate accounts as follows: Mutual fund type: Equity 28,902 23,841 Bond 4,251 3,417 Balanced 3,846 3,345 Money market 677 451
At 31 December 2011, based on the hedges in place at that time, the estimated sensitivity of Jackson’s pre-tax profit for VA business, net of related changes in amortisation of DAC (excluding the impact on future separate account fees), profit after tax and shareholders’ equity to immediate increases and decreases in equity markets is as follows: Decrease of 20%
Pre-tax profit, net of related changes in amortisation of DAC (excluding impact on future separate account fees) 267 149 (195) (447) 159 90 (98) (178)
Net sensitivity of profit after tax and shareholders’ equity (79) (40) (93) (47)
A 10 or 20 per cent increase in their value is estimated to have an approximately equal and opposite effect on profit and shareholders’ equity to the sensitivities shown above. 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.
Policyholder liabilities (925) (446) 395 753 (547) (243) 219 416 Related effect on amortisation of DAC (151) (69) 36 48 47 23 (34) (63)
Related effect on charge for deferred tax (166) (77) 56 97 (120) (50) 32 62
Other comprehensive income Direct effect on carrying value of debt securities 2,679 1,513 (1,513) (2,679) 2,663 1,454 (1,454) (2,663)
Note (i) Sensitivity on profit before tax ie aggregate of the operating profit based on longer-term investment returns and short-term fluctuations in investment returns.
In addition, the total profit (loss) for Jackson is affected by the level of impairment losses on the debt securities portfolio, net effect of market risk arising from the incidence and valuation of guarantee features, guaranteed benefit payments and equity index participation features, offset by variability of benefit related fees and equity derivative hedging performance, short-term value movements on derivatives held to manage the fixed annuity and other general account business, and other temporary value movements on portfolio investments classified as fair value through profit and loss.
For term business, acquisition costs are deferred and amortised in line with expected premiums. For annuity business, acquisition costs are deferred and amortised in line with expected gross profits on the relevant contracts. For interest-sensitive business, the key assumption is the expected long-term spread between the earned rate and the rate credited to policyholders, which is based on an annual spread analysis. In addition, expected gross profits depend on mortality assumptions, assumed unit costs and terminations other than deaths (including the related charges) all of which are based on a combination of actual experience of Jackson, industry experience and future expectations. A detailed analysis of actual experience is measured by internally developed expense, mortality and persistency studies. Except to the extent of mortality experience, which primarily affects profits through variations in claim payments and GMDB reserves, the profits of Jackson are relatively insensitive to changes in insurance risk. 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(g) above; and
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 used for that purpose for 2011 and 2010: Fixed annuity and other business (including GICs and similar contracts) Variable annuity Total
Assets Intangible assets attributable to shareholders: Goodwill – – 235 235 236 Deferred acquisition costs and other intangible assets – – 1,027 1,027 962
Intangible assets attributable to with-profits funds: Deferred acquisition costs and other intangible assets 83 – – 83 97 Deferred tax assets – 2 113 115 98 Other non-investment and non-cash assets 303 93 628 1,024 788 Investments of long-term business and other operations: Investment properties – – 10 10 9 Investments accounted for using the equity method – – – – 2 Financial investments: Loans 774 – 459 1,233 1,340 Equity securities and portfolio holdings in unit trusts 2,744 8,663 590 11,997 14,464 Debt securities 9,554 2,746 5,381 17,681 14,108 Other investments 286 26 158 470 382 Deposits 123 578 464 1,165 638
Liabilities Policyholder liabilities and unallocated surplus of with-profits funds: Contract liabilities (including amounts in respect of contracts classified as investment contracts under IFRS 4) 12,593 12,015 6,254 30,862 28,674 Unallocated surplus of with-profits fundsnote (ii) 50 – – 50 66
Singapore with-profits operations. Assets and liabilities of other participating business are included in the column for ‘Other business’. (ii) For the purposes of the presentation of unallocated surplus of with-profits within the statement of financial position, the Hong Kong branch balance is reported within the unallocated surplus of the PAC with-profits sub-fund of the UK insurance operations.
Summary policyholder liabilities (net of reinsurance) and unallocated surplus At 31 December 2011, the policyholder liabilities (net of reinsurance of £151 million (2010: £41 million)), and unallocated surplus for Asian operations of £30.8 billion (2010: £28.7 billion) comprised the following: Singapore 9,323 9,731 Hong Kong 8,279 6,621 Malaysia 2,829 2,544 Indonesia 1,809 1,475 Korea 1,852 1,897 Taiwan 1,429 968 Other countries 5,240 5,463
ife assu ran ce b u sin ess b Reconciliation of movement in investments A reconciliation of the total investments of Asian insurance operations from the beginning of the year to the end of the year is as follows: With-profits business £m
At 1 January 2010 Total investments (including derivative assets) 9,547 9,953 3,890 23,390 Less: Investments held by consolidated investment funds (270) (218) (230) (718) Less: Derivative liabilities (63) – (83) (146)
Directly held investments, net of derivative liabilities 11,650 12,689 5,643 29,982
Movement in the year of directly held investments, net of derivative liabilities 1,135 (959) 1,271 1,447
At 31 December 2011 Total investments (including derivative assets) 13,481 12,013 7,062 32,556 Less: Investments held by consolidated investment funds (366) (278) (3) (647)
D4: Asian insurance operations continued c Reconciliation of movement in policyholder liabilities and unallocated surplus of with-profits funds A reconciliation of the total policyholder liabilities and unallocated surplus of with-profits funds of Asian insurance operations from the beginning of the year to the end of the year is as follows: With-profits business £m
At 1 January 2010 8,861 9,717 3,333 21,911 Comprising: – Policyholder liabilities 8,808 9,717 3,333 21,858 – Unallocated surplus of with-profits funds 53 – – 53
Premiums New business 141 1,072 452 1,665 In-force 897 1,130 616 2,643
Net flows 271 590 708 1,569 Shareholders’ transfers post tax (24) – – (24) Investment-related items and other movements 693 1,405 137 2,235 Foreign exchange translation differences 719 1,009 353 2,081 Acquisition of UOB Life Assurance Limited note (e) 504 3 461 968
Net flows 339 770 1,069 2,178 Shareholders’ transfers post tax (30) – – (30) Investment-related items and other movements note (d) 1,274 (1,154) 245 365 Foreign exchange translation differences note (a) 36 (325) (52) (341)
Notes (a) Movements in the period have been translated at the average exchange rate for the year ended 31 December 2011. The closing balance has been translated at the closing spot rates as at 31 December 2011. Differences upon retranslation are included in foreign exchange translation differences. (b) Net flows have increased by £609 million from £1,569 million in 2010 to £2,178 million in 2011, primarily reflecting increased flows from new business and the growth in the in-force book. (c) The rate of surrenders for unit-linked and other shareholder business (expressed as a percentage of opening liabilities) was 9.8 per cent compared with 13.8 per cent in 2010. (d) The investment-related and other items and other movements for unit-linked business of negative £1,154 million in 2011 was mainly driven from
Moody’s – Aaa 818 222 449 1,489 65 Moody’s – Aa1 to Aa3 47 61 20 128 115 Moody’s – A1 to A3 191 17 96 304 130 Moody’s – Baa1 to Baa3 109 4 18 131 95 Moody’s – Other 34 9 16 59 49
The following table analyses debt securities of ‘Other business’ which are not externally rated: Government bonds 244 350 Corporate bonds rated as investment grade by local external ratings agencies 776 666 Structured deposits issued by banks which are rated, but specific deposits are not – 5 Other 45 22
D4: Asian insurance operations continued e Products and guarantees The life insurance products offered by the Group’s Asian operations include a range of with-profits and non-participating term, whole life, endowment and unit-linked policies. The Asian operations also offer health, disability, critical illness and accident coverage to supplement its core life products. The terms and conditions of the contracts written by the Asian operations and, in particular, the products’ options and guarantees, vary from territory to territory depending upon local market circumstances. In general terms, the Asian participating products provide savings and protection where the basic sum assured can be enhanced by a profit share (or bonus) from the underlying fund as determined at the discretion of the insurers. The Asian operations’ non-participating term, whole life and endowment products offer savings and/or protection where the benefits are guaranteed or determined by a set of defined market-related parameters. Unit-linked products combine savings with protection, the cash value of the policy depends on the value of the underlying unitised funds. Health and Protection (H&P) policies provide mortality or morbidity benefits and include health, disability, critical illness and accident coverage. H&P products are commonly offered as supplements to main life policies but can be sold separately. Subject to local market circumstances and regulatory requirements, the guarantee features described in note D2(e) in respect of UK business broadly apply to similar types of participating contracts written in the Hong Kong branch, Singapore and Malaysia. Participating products have both guaranteed and non-guaranteed elements. Non-participating long-term products are the only ones where the Group is contractually obliged to provide guarantees on all benefits. Investment-linked products have the lowest level of guarantee, if any.
Whole of life contracts with floor levels of policyholder benefits that accrue at rates set at inception and do not vary subsequently with market conditions are written in the Korean life operations. This is to a much lesser extent than the policies written by the Taiwan agency business which was sold in the first half of 2009, as Korea has a much higher proportion of linked and health business. The Korean business has non-linked liabilities and linked liabilities at 31 December 2011 of £447 million and £1,407 million respectively (2010: £408 million and £1,491 million respectively). The other area of note in respect of guarantees is the Japanese business where pricing rates are higher than current bond yields. Lapse risk is a feature in that policyholders could potentially surrender their policies on guaranteed terms if interest rates significantly increased leaving the potential for losses if bond values had depreciated significantly. However, the business is matched to a relatively short realistic liability duration. The method for determining liabilities of insurance contracts for UK GAAP, and IFRS, purposes for some Asian operations is based on US GAAP principles and this method applies to contracts with cash value and interest rate guarantees. Following standard US GAAP procedure, premium deficiency reserve calculations are performed each year to establish whether the carrying values of the liabilities are sufficient. On the US GAAP basis the calculations are deterministic, that is to say based on a single set of projections, and expected long-term rates of return are applied.
ife assu ran ce b u sin ess f Exposure to market risk The Asian operations sell with-profits and unit-linked policies and, although the with-profits business generally has a lower terminal bonus element than in the UK, the investment portfolio still contains a proportion of equities. Non-participating business is largely backed by debt securities or deposits. The exposure to market risk of the Group arising from its Asian operations is therefore at modest levels. This arises from the fact that the Asian operations have a balanced portfolio of with-profits, unit-linked and other types of business.
g Process for setting assumptions and determining liabilities The future policyholder benefit provisions for Asian businesses in the Group’s IFRS accounts and previously under the MSB, are determined in accordance with methods prescribed by local GAAP adjusted to comply, where necessary, with UK GAAP. For Asian operations in countries where local GAAP is not well established and in which the business written is primarily non-participating and linked business, US GAAP is used as the most appropriate reporting basis. This basis is applied in Japan, Vietnam, Taiwan and India. The future policyholder benefit provisions for non-linked business are determined using the net level premium method, with an allowance for surrenders, maintenance and claims expenses. Rates of interest used in establishing the policyholder benefit provisions vary by operation depending on the circumstances attaching to each block of business.
In 2011, IFRS operating profit based on longer-term investment returns for Asian insurance operations included a net £38 million credit arising from a small number of items that are not anticipated to reoccur in future periods.
In 2010, one-off changes made to reserving assumptions resulted in a release from liabilities of £19 million.
D4: Asian insurance operations continued c Other business i Interest rate risk Asian operations offer a range of insurance and investment products, predominately with-profits and non-participating term, whole life endowment and unit-linked. Excluding with-profit and unit-linked business, the results of the Asian business are sensitive to the vagaries of routine movements in interest rates. For the purposes of analysing sensitivity to variations in interest rates, it has been determined for the majority of territories that a movement of 1 per cent in the 10-year government bond rate can be considered reasonably possible. At 31 December 2011, 10-year government bond rates vary from territory to territory and range from 0.99 per cent to 12.88 per cent (2010: 1.1 per cent to 12.25 per cent). Exception to this arises in Japan and Taiwan where reasonably possible interest rate movements have been determined as 0.5 per cent (2010: Japan and Taiwan 0.5 per cent). These reasonably possible changes would have the following impact: Decrease of 1%
Pre-tax profit 73 110 Related deferred tax (where applicable) (22) (41)
Note (i) One per cent sensitivity (except for Japan and Taiwan (0.5 per cent)) has been used in all territories (2010: one per cent except Japan and
Group’s segmental analysis of profit before tax. At 31 December 2011, an increase in the rates of 1 per cent (2010: 1 per cent except Japan and Taiwan 0.5 per cent) is estimated to have the effect of decreasing pre-tax profit by £159 million (2010: £112 million). After adjusting these results for deferred tax the reasonable possible effect on shareholders’ equity is a decrease of £125 million (2010: £82 million).
Net effect on profit and shareholders' equity (96) (48) (93) (47)
D5: Capital position statement for life assurance businesses a Summary statement The Group’s estimated capital position for life assurance businesses with reconciliations to shareholders’ equity is shown below. Available capital for each fund or group of companies is determined by reference to local regulation at 31 December 2011 and 2010.
Parent company and shareholders ’ equity of other subsidiaries and funds
Adjustment from IAS 19 basis pension deficit attributable to WPSF to pension liability for regulatory purposes note (vii) – 16 16 – – – 16
Valuation difference on PAL between IFRS basis and regulatory basis – (640) (640) – – – (640)
Other adjustments to restate these amounts to a regulatory basis (with SAIF and the WPSF on a Peak 2 realistic basis) note (v) – (2) (2) (504) 974 73 541
Total available capital resources of life assurance businesses on local regulatory bases – 6,139 6,139 1,937 2,527 1,493 12,096
Total policyholder liabilities shown in the consolidated statement of financial position 8,555 72,421 80,976 46,048 69,189 30,862 227,075
Total – – – 716 3,815 2,149 6,680 1,407 (1,455) 6,632 Held in long-term funds note (iii) – – – 1,399 – – 1,399 – – 1,399
Adjustments to regulatory basis Unallocated surplus of with-profits funds note (i) – 10,187 10,187 – – 66 10,253 Shareholders' share of realistic
Jackson surplus notes note (iv) – – – – 159 – 159 Investment and policyholder liabilities valuation differences between IFRS and regulatory basis for Jackson note (viii) – – – – 1,900 – 1,900
Other adjustments to restate these amounts to a regulatory basis (with SAIF and the WPSF on a Peak 2 realistic basis) note (v) – 706 706 (292) 576 156 1,146
Total available capital resources of life assurance businesses on local regulatory bases – 6,800 6,800 1,707 2,907 1,378 12,792
regulated with-profits funds: Insurance contracts 9,115 31,395 40,510 – – 5,284 45,794 Investment contracts (with
Notes (i) WPSF unallocated surplus includes amounts related to the Hong Kong branch. Policyholder liabilities of the Hong Kong branch are included in the amounts of Asian life assurance subsidiaries.
regulated with-profits funds, deferred tax, admissibility and other items measured differently on the regulatory basis. For Jackson the principal reconciling item is deferred tax related to the differences between IFRS and regulatory basis as shown in the table above and other methodology differences.
(viii) The investment and policyholder liabilities valuation difference between IFRS and regulatory bases for Jackson is mainly due to not all investments being carried at fair value under the regulatory basis and also due to the valuation difference on annuity reserves.
Available capital of the WPSF and SAIF of £6.1 billion (2010: £6.8 billion) represents the excess of assets over liabilities on the FSA realistic basis. Unlike the previously discussed FRS 27 basis, realistic liabilities on the regulatory basis include the shareholders’ share of future bonuses. These amounts are shown before deduction of the risk capital margin (RCM) which is estimated to be £2.0 billion at 31 December 2011 (2010: £1.5 billion). The FSA’s basis of setting the RCM is to target a level broadly equivalent to a Standard & Poor’s credit rating of BBB and to judge this by ensuring there are sufficient assets to absorb a one in 200 year event. The RCM calculation achieves this by setting rules for the determination of margins to cover defined stress changes in asset values and yields for market risk, credit risk and termination risk for with-profits policies.
In normal investment conditions, PAC expects changes to regular bonus rates to be gradual over time and changes are not expected to exceed 1 per cent per annum over any year. However, discretion is retained as to whether or not a regular bonus is declared each year, and there is no limit on the amount by which regular bonus rates can be changed. As regards smoothing of maturity and death benefits, in normal circumstances PAC 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 (either sudden or over a period of years) and in such situations the PAC Board may decide to vary the standard bonus smoothing limits to protect the overall interests of policyholders.
ii Jackson The regulatory framework for Jackson is governed by the requirements of the US NAIC approved risk-based capital standards. Under these requirements life insurance companies report using a formula-based capital standard that they calculate by applying factors to various asset, premium and reserve items and separate model-based calculations of risk associated primarily with variable annuity products. The risk-based capital formula takes into account the risk characteristics of a company, including asset risk, insurance risk, interest rate risk, market risk and business risk. The available capital of Jackson shown above of £2,527 million (2010: £2,907 million) reflects US regulatory basis assets less liabilities including asset valuation reserves. The asset valuation reserve is designed to provide for future credit-related losses on debt securities and losses on equity investments. Available capital includes a reduction for the effect of the interest maintenance reserve, which is designed by state regulators to defer recognition of non-credit related realised capital gains and losses and to recognise them rateably in the future. Jackson’s risk-based capital ratio is significantly in excess of regulatory requirements. At 31 December 2011, Jackson had a permitted practice in effect as granted by the local regulator allowing Jackson to carry certain interest rate swaps at book value, as if statutory hedge accounting were in place, instead of at fair value as would have been otherwise required. Jackson was also required to demonstrate the effectiveness of its interest rate swap programme pursuant to the Michigan Insurance Code. The total effect of this permitted practice net of tax was to decrease statutory surplus by £305 million at 31 December 2011.
Indonesia For linked business the value of units is held together with a non-unit reserve calculated in accordance with standard actuarial methodology. Solvency capital is determined using a risk-based capital approach. Insurance companies in Indonesia are expected to maintain the level of net assets above 120 per cent of solvency capital. Due to the 2008 financial crisis, the local regulator provided relief in solvency capital and the measure continued until 1 January 2012 when it was withdrawn. The withdrawal of this temporary relief did not have a significant impact on the Group’s Indonesia business.
Korea Policy reserves for traditional business are determined on net premium reserve basis using pricing mortality and prescribed standard interest rates. For linked business, the value of units is held together with the non-unit reserves calculated in accordance with regulatory standard actuarial methodology. In April 2009, the capital requirement in Korea moved to being based on a risk-based regulatory framework with a two-year transition period where insurers could choose between the prior and new framework. The risk-based regulatory framework was adopted in 2009 by the Company. Under the risk-based framework, insurance companies in Korea are expected to maintain a level of free surplus in excess of the capital requirements with the general target level of solvency margin being in excess of 150 per cent of the risk-based capital.
iv Group capital requirements In addition to the requirements at individual company level, FSA requirements under the IGD apply additional prudential requirements for the Group as a whole. Discussion of the Group’s estimated IGD position at 31 December 2011, together with market risk sensitivity disclosure provided to key management, is provided in the business review section of the Group’s 2011 Annual Report and in section C.
c Movements in total available capital Total available capital for the Group’s life assurance operations has changed as follows: 2011 £m
Available capital at 31 December 2009 6,432 1,607 2,488 1,129 11,656 Changes in assumptions (83) 30 – (2) (55) Changes in management policy 364 – – – 364 Changes in regulatory requirements – – (60) – (60) New business and other factorsnote (v) 87 70 479 251 887
Notes (i) WPSF The decrease in 2011 of £661 million reflects primarily the negative effect of the lower interest rate used to value projected policyholder benefit payments, partially offset by the positive impact of investment returns earned on the opening available capital. The increase in 2010 reflects primarily the positive effect of changes in management policy of £364 million in respect of hedge strategy, asset allocation and other risk alignment changes.
(ii) Jackson The decrease of £380 million in 2011 reflects an underlying decrease of £402 million (applying the 2011 year end exchange rate of $1.55:£1) and £22 million of exchange translation gain.
The increase of £419 million in 2010 reflected an underlying increase of £340 million (applying the 2010 year end exchange rate of $1.57:£1)
and £79 million of exchange translation gain. The underlying movement of the available capital of Jackson included the effects of capital contributions, dividends paid to the parent company, impairment losses and also the effects of hedging transactions.
Available capital of the non-insurance business units is transferable to the life assurance businesses after taking account of an appropriate level of operating capital, based on local regulatory solvency targets, over and above basis liabilities. The economic capital model described in section D1 (concentration of risks) takes into account restrictions on mobility of capital across the Group, with capital transfers to and from business units triggered at a solvency level consistent with these targets. The model takes into account restrictions on the availability to the Group of the estate of the various with-profits funds throughout the Group.
f Intragroup arrangements in respect of SAIF Should the assets of SAIF be inadequate to meet the guaranteed benefit obligations to the policyholders of SAIF, the PAC long-term fund would be liable to cover any such deficiency. Due to the quality and diversity of the assets in SAIF and the ability of SAIF to revise guaranteed benefits in the event of an asset shortfall, the directors believe that the probability of either the PAC long-term fund or the Group’s shareholders’ funds, under their obligation to maintain the capital position of long-term funds generally, having to contribute to SAIF is remote.
Charges of consolidated investment fundsnote (i) (9) – – (9) (11) NPH broker-dealer feesnote (i) – (405) – (405) (369)
Comprising: Operating profit based on longer-term investment returns 357 24 80 461 378 Short-term fluctuations in investment returnsnote (ii) (29) – – (29) 47 Shareholder’s share of actuarial gains and losses on defined benefit pension schemes 4 – – 4 (5)
Notes (i) Under IFRS 8, disclosure details are required of segment revenue. The segment revenue of the Group’s asset management operations is required to include two items that are for amounts which, reflecting their commercial nature, are also wholly reflected as charges within the income statement. After allowing for these charges, there is no effect on profit from these two items which are: (a) Investment funds which are managed on behalf of third parties and are consolidated under IFRS in recognition of the control arrangements for the funds. The gains and losses of these funds are non-recourse to M&G and the Group, and
(b) NPH broker-dealer fees which represent commissions received, which are then paid on to the writing brokers on sales of investment products. The presentation in the table above shows the amounts attributable to these two items so that the underlying revenue and charges can be seen. (ii) Short-term fluctuations in investment returns for M&G are primarily in respect of unrealised value movements on Prudential Capital’s bond portfolio. (iii) Included within Eastspring Investments revenue and charges are £44 million of commissions (2010: £60 million).
Underlying profit before performance-related fees 280 229 Performance-related fees 21 17
Total M&G operating profit based on longer-term investment returns 357 284
The difference between the fees and other income shown above in respect of asset management operations, and the revenue figure for M&G shown (excluding consolidated investment funds) in the main table primarily relates to total revenue of Prudential Capital (including short-term fluctuations) of £96 million (2010: £136 million) and commissions which have been netted off in arriving at the fee income of £702 million (2010: £612 million) in the table above. The difference in the presentation of commission is aligned with how management reviews the business.
Assets, liabilities and shareholders’ funds included in the Group consolidated statement of financial position in respect of asset management operations are as follows: M&G
Liabilities Core structural borrowing of shareholder-financed operations 250 – – 250 250 Intra-group debt represented by operational borrowings at
Group levelnote (iv) 2,956 – – 2,956 2,560 Net asset value attributable to external holders of consolidated unit trusts and similar fundsnote (v) 678 – – 678 458 Other non-insurance liabilitiesnote (vi) 2,074 141 82 2,297 2,020
Notes (i) Loans The M&G loans relate to loans and receivables managed by Prudential Capital. These assets are generally secured but have no external credit ratings. Internal ratings prepared by the Group’s asset management operations, as part of the risk management process, are: Loans and receivables internal ratings: A+ to A- 129 213 BBB+ to BBB- 1,000 873 BB+ to BB- 89 219 B+ to B- 38 113
(ii) Debt securities Of the total debt securities at 31 December 2011 of £1,842 million, the following amounts were held by M&G.
Total intragroup debt represented by operational borrowings at Group level 2,956 2,560
(vi) Other non-insurance liabilities consists primarily of intragroup balances, derivatives, liabilities and other creditors.
Directly held investments, net of derivative liabilities 2,786 15 40 2,841
Net cash inflow from operating activities 310 8 11 329 Realised gains in the year 11 – – 11 Unrealised gains and losses and exchange movements in the year 18 – 5 23
Directly held investments, net of derivative liabilities 3,125 23 56 3,204
ii Sensitivities to other financial risks for asset management operations The principal sensitivities to other financial risk of the Group’s asset management operations are credit risk on the bridging loan portfolio as described in note E2 of the Prudential Capital operation and the indirect effect of changes to market values of funds under management. Due to the nature of the asset management operations there is limited direct sensitivity to movements in interest rates. Total debt securities held at 31 December 2011 by asset management operations were £1,842 million (2010: £1,574 million), the majority of which are held by the Prudential Capital operation. Debt securities held by M&G and Prudential Capital are in general variable rate bonds and so market value is limited in sensitivity to interest rate movements and consequently any change in interest rates would not have a material impact on profit or shareholder’s equity. The Group’s asset management operations do not hold significant investments in property or equities.
Outward reinsurers’ share of benefits and claims note (iv) 290 280 176 – – – 746 – 746 Movement in unallocated surplus of with-profits funds note (iii) 485 – 540 – – – 1,025 – 1,025
Finance costs: interest on core structural borrowings of shareholder-financed operations – (13) – (15) – – (28) (258) (286)
Profit (loss) from continuing operations before tax attributable to shareholders 900 599 612 332 24 80 2,547 (604) 1,943
Outward reinsurers’ share of benefits and claims note (iv) 243 49 43 – – – 335 – 335 Movement in unallocated surplus of with-profits funds note (iii) 70 – (315) – – – (245) – (245)
Acquisition costs and other operating expenditure note F3 (1,093) (395) (1,662) (628) (576) (179) (4,533) (266) (4,799)
Finance costs: interest on core structural borrowings of shareholder-financed operations – (13) – – – – (13) (244) (257)
Costs of terminated AIA transaction – – – – – – – (377) (377) Gain on dilution of Group’s holdings 30 – – – – – 30 – 30
Notes (i) The measure is the formal profit (loss) before tax measure under IFRS but is not the result attributable to shareholders. (ii) Investment return principally comprises: – interest and dividends, – realised and unrealised gains and losses on securities and derivatives classified as fair value through profit and loss under IAS 39, and – realised gains and losses, including impairment losses, on securities classified as available-for-sale under IAS 39. (iii) The movement in unallocated surplus of with-profits funds for Asia above includes movement relating to the Hong Kong branch of PAC.
(iv) The increase in the credit for outwards reinsurers’ share of benefits and claims for Jackson from 2010 to 2011 arises from the fair value movement on the GMIB reinsurance in 2011. As the GMIB reinsurance is net settled it is considered to be a derivative under IAS 39. The movement was particularly high in 2011 due to the reduction in US interest rates in 2011.
Investment return Realised and unrealised gains and losses on securities at fair value through profit and loss 866 14,728 Realised and unrealised losses and gains on derivatives at fair value through profit and loss 86 (891) Realised losses on available-for-sale securities, previously recognised in other comprehensive income 101 (51) Realised losses on loans (43) (12) Interest notes (i),(ii) 6,440 5,976 Dividends 1,304 1,394 Other investment return 606 625
Fee income from investment contract business and asset managementnotes (iii),(iv) 1,869 1,666
In their capacity as fund managers to fellow Prudential Group subsidiaries, M&G, Eastspring Investments and US asset management businesses generate fees for investment management and related services. These services are charged at appropriate arm’s length prices, typically priced as a percentage of funds under management. Intragroup fees included within asset management revenue were earned by the following asset management segment: Intragroup revenue generated by: M&G 162 165 Eastspring Investments 93 77 US broker-dealer and asset management (including Curian) 68 72
In 2010 a further £10 million of intragroup revenue was recorded between UK insurance operations for services, typically charged as a percentage of funds under management. Revenue from external customers of Asian, US and UK insurance operations shown above are net of outwards reinsurance premiums of £226 million, £72 million and £131 million respectively (2010: £146 million, £83 million and £128 million respectively). In Asia, revenue from external customers from no individual country exceeds 10 per cent of the Group total. The largest country is Singapore with a total revenue from external customers of £1,383 million (2010: Hong Kong £1,246 million). Due to the nature of the business of the Group, there is no reliance on any major customers.
Acquisition costs incurred 2,264 2,024 Acquisition costs deferred less amortisation of acquisition costs (635) (918) Administration costs and other expenditure 3,524 3,496 Movements in amounts attributable to external unit holders (148) 197
(ii) There were no fee expenses relating to financial liabilities held at amortised cost included in acquisition costs in 2011 and 2010. (iii) The total depreciation and amortisation expense of £641 million (2010: £309 million) relates to amortisation of deferred acquisition costs of insurance contracts and asset management contracts, which is primarily borne by the insurance operations. The segmental analysis of total depreciation and amortisation expense is as follows: Insurance operations: UK 55 35 US 278 (6)
Asset management operations: M&G 7 8 US 1 2 Eastspring Investments 4 4
(iv) Interest expense, excluding interest on core structural borrowings of shareholder-financed operations, amounted to £123 million (2010: £113 million) and is included within total acquisition costs and other operating expenditure as part of investment management expenses. The segmental analysis of this interest expense is as follows: Insurance operations: UK 49 28 US 31 33 Asia 10 13
(v) Movements in amounts attributable to external unit holders comprises £28 million (2010: £61 million) for UK insurance operations and £120 million (2010: £136 million) for Asian insurance operations.
Asia regional office: Gross costs (86) (90) Recharges to Asia operations 35 42
Finance costs of £286 million (2010: £257 million) comprise £258 million (2010: £244 million) interest on core debt of the parent company, £13 million (2010: £13 million) on US insurance operations’ surplus notes and £15 million (2010: nil) on PruCap’s bank loan.
F5: Tax a Total tax charge by nature of expense An analysis of the total tax benefit (expense) of continuing operations recognised in the income statement by nature of benefit (expense) is as follows: Current tax expense: Corporation tax (775) (378) Adjustments in respect of prior years 33 287
Tax credit (charge) to policyholders' returns (410) 427 17 (611) Tax charge attributable to shareholders (332) (117) (449) (25)
The principal reason for the reduction in the tax charge attributable to policyholders’ returns relates to a decrease in deferred tax on unrealised gains and losses on investments. The tax charge attributable to shareholders of £449 million for 2011 (2010: charge of £25 million) comprises: Tax charge attributable to shareholders Current tax Deferred tax Total Total
In 2011, a deferred tax charge of £187 million (2010: charge of £287 million) has been taken through other comprehensive income. Other movements in deferred tax totalling a £22 million charge is mainly comprised of foreign exchange movements. When these amounts are taken with the deferred tax charge shown above the result is a decrease of £0.1 billion in the Group’s net deferred tax liability (2010: increase of £0.9 billion).
i Summary of pre-tax profit and tax charge The income statement includes the following items: Profit before tax 1,926 2,072 Tax credit (charge) attributable to policyholders’ returns 17 (611)
Profit before tax attributable to shareholders 1,943 1,461 Tax attributable to shareholders’ profits: Tax charge (432) (636) Less: tax attributable to policyholders’ returns (17) 611
Profit for the year 1,494 1,436 ii Overview For the purposes of explaining the relationship between tax expense and accounting profit, it is appropriate to consider the sources of profit and tax by reference to those that are attributable to shareholders and policyholders, as follows: Attributable to shareholders
Profit (loss) before tax 1,943 (17) 1,926 1,461 611 2,072 Taxation charge: Expected tax rate 29% 100% 28% 28% 100% 49%
iii Basis of taxation for UK life and pension business Different rules apply under UK tax law for taxing pension business and life insurance business and there are detailed rules for apportioning the investment return and profits of the fund between the types of business. The investment return referable to pension business, and some other less significant classes of business, is exempt from taxation, but tax is charged on the profit that shareholders derive from writing such business at the corporate rate of tax. The rules for taxing life insurance business are more complex. Initially, the UK regime seeks to tax the regulatory basis investment return less management expenses (I-E) on this business as it arises. However, in determining the actual tax charge, a calculation of the shareholder profits for taxation purposes from writing life insurance business also has to be made and compared with the I-E profit. If the shareholder profit is higher than the I-E amount, extra income is attributable to the I-E calculation until the I-E profit equals the shareholder profit. If on the other hand, the I-E profit is the greater, then an amount equal to the shareholder profit is taxed at the corporate rate of tax, with the remainder of the I-E profit being taxed at the lower policyholder rate of tax. The purpose of this approach is to ensure that the Company is always at a minimum taxed on the profit, as defined for taxation purposes by reference to the Company’s regulatory returns (rather than IFRS basis results), that it has earned. The shareholders’ portion of the long-term business is taxed at the shareholders’ rate, with the remaining portion taxed at rates applicable to the policyholders. It is to be noted that the calculations described are determined using data from the regulatory basis returns rather than the IFRS basis results.
F5: Tax continued iv Profits attributable to policyholders and related tax As noted above, it is necessary under IFRS requirements to include the total tax charge of the Company (both policyholder and shareholder elements) in the tax charge disclosed in the income statement.
Profit (loss) before tax attributable to shareholders: Operating profit based on longer-term investment returnsnote (iii) 704 694 723 (51) 2,070 Short-term fluctuations in investment returns (92) (95) 159 (120) (148) Shareholders’ share of actuarial and other gains and losses on defined benefit pension schemes – – 18 3 21
Expected tax (charge) credit based on expected tax rates: Operating profit based on longer-term investment returns (169) (243) (195) 14 (593) Short-term fluctuations in investment returnsnote (iii) 18 33 (43) 32 40 Shareholders’ share of actuarial and other gains and losses on defined benefit pension schemes – – (5) (1) (6)
Actual tax (charge) credit: Operating profit based on longer-term investment returns (122) (200) (190) 64 (448) Short-term fluctuations in investment returnsnote (iii) (2) 33 (35) 8 4 Shareholders’ share of actuarial and other gains and losses on defined benefit pension schemes – – (4) (1) (5)
Profit (loss) before tax attributable to shareholders: Operating profit based on longer-term investment returnsnote (iii) 532 833 719 (143) 1,941 Short-term fluctuations in investment returns 114 (378) 116 25 (123) Shareholders’ share of actuarial and other gains and losses on defined benefit pension schemes – – (5) (5) (10) Costs of terminated AIA transaction – – – (377) (377) Gain on dilution of Group's holdings – – 30 – 30
Expected tax rate:note (i) Operating profit based on longer-term investment returns 22% 35% 28% 28% 29% Short-term fluctuations in investment returnsnote (iii) 25% 35% 28% 28% 52% Shareholders’ share of actuarial and other gains and losses on defined benefit pension schemes – – 28% 28% 20% Costs of terminated AIA transaction – – – 28% 28% Gain on dilution of Group's holdings – – 28% – 28%
Expected tax (charge) credit based on expected tax rates: Operating profit based on longer-term investment returns (117) (292) (201) 40 (570) Short-term fluctuations in investment returnsnote (iii) (29) 132 (32) (7) 64 Shareholders’ share of actuarial and other gains and losses on defined benefit pension schemes – – 1 1 2 Costs of terminated AIA transaction – – – 106 106 Gain on dilution of Group's holdings – – (8) – (8)
Operating profit based on longer-term investment returns (58) (249) (183) 277 (213) Short-term fluctuations in investment returns (8) 132 (32) – 92 Shareholders’ share of actuarial and other gains and losses on defined benefit pension schemes – – 1 2 3 Costs of terminated AIA transaction – – – 93 93 Gain on dilution of Group's holdings – – – – –
* 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.
• For Asian operations the expected tax rates reflect the corporation tax rates weighted by reference to the source of profits of operations contributing to the aggregate business result. • The expected tax rate for Other operations reflects the mix of business between UK and overseas operations, which are taxed at a variety of rates. The rates will fluctuate from year to year dependent on the mix of profits.
(b) Jackson For 2011 and 2010, the benefit reflects the deduction from taxable income of a proportion of dividends received attributable to the variable annuity business. (c) UK insurance operations For 2011 the benefit reflects the effect of the reduction in UK corporation tax rate on deferred tax liabilities and the different tax bases of UK life business, partially offset by routine revisions to prior period tax returns. For 2010, the benefit arises from routine revisions to prior period tax returns and the different tax bases of UK life business.
(d) Other operations For 2011 the settlement of outstanding issues with HMRC at an amount below that previously provided, partly offset by prior year adjustments arising from the revisions of prior period tax returns. For 2010, an exceptional tax credit which primarily related to the impact of the settlement agreed with the UK tax authorities and the ability to recognise a deferred tax credit on various tax losses which we were previously unable to recognise, partly offset by the inability to fully recognise a tax credit in respect of non deductible capital costs incurred in relation to the terminated AIA transaction.
UK operations Policyholder returns Scottish Amicable Insurance Fund (SAIF) 321 1,075 Assets held to back unit-linked liabilities 208 2,119 With-profits fund (excluding SAIF) 4,094 8,815
Shareholder returns Prudential Retirement Income Limited (PRIL) 2,153 1,717 Other business 956 834
Changes in shareholder investment returns for US operations reflect primarily movements in the investment income, movements in the value of derivative instruments, and realised gains and losses. The derivatives are held to manage general account assets and liabilities, and variable annuity guarantees under a dynamic hedging programme. Separately reflecting Jackson’s types of business an allocation is made to policyholders through the application of crediting rates. The majority of the investments held to back the US general account business are debt securities for which the available-for-sale designation is applied for IFRS basis reporting. Under this designation the return included in the income statement reflects the aggregate of investment income and realised gains and losses (including impairment losses). However, movements in unrealised appreciation or depreciation are recognised in other comprehensive income. The return on these assets is attributable to shareholders.
Increase in policyholder liabilities (2,950) (7,973) (1,655) (12,578) Movement in unallocated surplus of with-profits funds(note) 540 – 485 1,025
in a n cia l state m e n ts G : F
Financial assets Cash and cash equivalents – – 6,631 6,631 6,631 Deposits – – 9,952 9,952 9,952 Equity securities and portfolio holdings in unit trusts 86,635 – – 86,635 86,635 Debt securitiesnote (i) 90,027 26,325 – 116,352 116,352 Loansnote (ii) 227 – 9,034 9,261 9,488 Other investmentsnote (iii) 5,779 – – 5,779 5,779 Accrued investment income – – 2,668 2,668 2,668 Other debtors – – 903 903 903