Non-executive directors Keki Dadiseth (note 4) 102 102 Howard Davies 153 153 Michael Garrett 93 93 Ann Godbehere 158 158 Bridget Macaskill (note 5) 65 65 Paul Manduca 156 156 Kathleen O’Donovan 98 98 James Ross (note 6) 33 33 Lord Turnbull 129 129
Total non-executive directors 987 987 * Benefi ts include (where provided) the cost of providing the use of a car and driver, medical insurance, security arrangements and expatriate benefi ts. † Pension benefi ts are described in the section on ‘Pensions and long-term savings’ in the 2011 Directors’ remuneration report. ‡ Value of anticipated long-term incentive plan releases is the total of cash paid plus, for shares released, the value of the released shares based on the share price at 31 December 2011. This fi gure does not include releases from other share plans or all-employee share plans. Dividend equivalents will be released on these vested shares.
Notes 1 John Foley and Mike Wells were appointed to the Board on 1 January 2011. 2 Barry Stowe’s benefi ts relate primarily to his expatriate status, including costs of £184,489 for housing, £32,077 for children’s education, £35,093 for home leave and a £245,114 Executive Director Location Allowance.
3 Mike Wells’ bonus fi gure excludes a contribution of US$12,250 from a profi t sharing plan which has been made into a 401(k) retirement plan. This is included in the table on pension contributions.
The performance condition attached to the 2009 GPSP award was met in full and 100 per cent of the proportion of the award which was outstanding was released during 2012. Achievement against the shareholder capital value performance measure attached to the 2009 UK BUPP award was 12.5 per cent per annum (on a compound basis), so 87.5 per cent of the outstanding portion of this award was released during 2012. This award was the last that Nick Prettejohn had outstanding under a Prudential long-term incentive plan.
The performance condition attached to the 2010 GPSP award was met in full and 100 per cent of the award will be released during 2013. Achievement of the SCV performance measure attached to the 2010 Jackson BUPP award was 22.68 per cent per annum (on a compound basis), so 100 per cent of the outstanding portion of this award will be released during 2013.
No awards were made to Clark Manning under any long-term incentive plan during 2011 or 2012 and none will be made in any subsequent year.
No other amounts were paid during the fi nancial year or were receivable by directors (or past directors) in connection with leaving the organisation.
Prudential shares. 2 In 2009 and 2010, a scrip dividend equivalent and in 2011 and 2012 a DRIP dividend equivalent were accumulated on these awards. 3 On 31 December 2012, the performance period of the 2010 GPSP awards came to an end. Prudential’s TSR performance was 139.9 per cent of the TSR
performance of the peer index. On this basis, it is anticipated that awards granted under this plan in 2010 will vest in full. This will result in 104,089 shares vesting for Rob Devey, 66,238 shares for Michael McLintock, 208,179 shares for Nic Nicandrou, 129,076 shares for Barry Stowe and 510,986 shares for Tidjane Thiam under this plan. Dividend equivalents will be released on these vested shares.
Business-specifi c cash-based long-term incentive plans Details of all outstanding awards under cash-based long-term incentive plans are set out in the table below. The performance period for all M&G Executive LTIP awards is three years while the performance period for all JNL LTIP awards is four years: Year of initial award
Note Under the M&G Executive LTIP, the value of each unit at award is £1. The value of units changes based on M&G’s profi t growth and investment performance over the performance period. For the 2009 award of 1,830,189 units, the unit price at the end of the performance period was £2.96 which resulted in a payment of £5,417,359 to Michael McLintock during 2012. For the 2010 award of 987,179 units, the unit price at the end of the performance period was £2.65. This will result in payment of £2,616,024 to Michael McLintock in 2013.
PruCap award 2010 172,993 6,133 179,126 – 14 Dec 12 14 Dec 12 612 881 Deferred 2011 annual
Michael McLintock Deferred 2008 annual incentive award 2010 137,700 137,700 – 31 Dec 11 15 Mar 12 519.5 780 Deferred 2009 annual incentive award 2010 74,840 2,653 77,493 31 Dec 12 552.5 Deferred 2010 annual incentive award 2011 77,988 2,765 80,753 31 Dec 13 721.5 Deferred 2011 annual
Nic Nicandrou Awards under appointment terms 2009 68,191 68,191 – 31 Mar 12 29 Mar 12 639 750 Deferred 2009 annual incentive award 2010 26,342 934 27,276 31 Dec 12 552.5 Deferred 2010 annual incentive award 2011 48,155 1,707 49,862 31 Dec 13 721.5 Deferred 2011 annual
Deferred 2008 annual incentive award 2009 22,643 22,643 – 31 Dec 11 15 Mar 12 349.5 780
Deferred 2010 annual incentive award 2011 56,316 1,998 58,314 31 Dec 13 721.5
Deferred 2011 annual incentive award 2012 50,648 1,798 52,446 31 Dec 14 750
2009 After Tax Deferral Program awardnote (3) 2010 32,250 32,250 15 Mar 13 520
Deferred 2010 Group Deferred Bonus Plan award 2011 90,854 3,226 94,080 31 Dec 13 721.5
Deferred 2011 annual incentive award 2012 93,034 3,302 96,336 31 Dec 14 750
Market price at 31 December 2012 Beginning End Beginning of period Granted Exercised Cancelled Forfeited Lapsed End of period
Notes 1 No gains were made by directors in 2012 on the exercise of SAYE options (2011: £665). 2 No price was paid for the award of any option. 3 The highest and lowest closing share prices during 2012 were 911.5 pence and 633.5 pence respectively.
Prudential TSR v FTSE 100 and peer group index – total returns % over five years to December 2012
F in an cial statem en ts 145Prudential plc Annual Report 2012
EEV basis supplementary information 364 Independent auditor’s report to Prudential plc on the
Primary statements 147 Consolidated income statement 148 Consolidated statement of comprehensive income 149 Consolidated statement of changes in equity 151 Consolidated statement of fi nancial position 153 Consolidated statement of cash fl ows
Section D: Life assurance business 192 D1: Group overview 197 D2: UK insurance operations 213 D3: US insurance operations 231 D4: Asia insurance operations 238 D5: Capital position statement for life assurance businesses
Section E: Asset management (including US broker-dealer) and other operations 247 E1: Income statement for asset management operations 249 E2: Statement of fi nancial position for asset management operations 250 E3: Regulatory and other surplus for asset management operations 251 E4: Sensitivity of profi t and shareholders’ equity to market and other fi nancial risk 251 E5: Other operations
Section F: Income statement notes 252 F1: Segmental information 254 F2: Revenue 256 F3: Acquisition costs and other expenditure 257 F4: Finance costs – Interest on core structural borrowings of shareholder-fi nanced operations 257 F5: Tax
Statement of directors’ responsibilities and independent auditor’s report 324 Statement of directors’ responsibilities in respect of the annual report and the fi nancial statements 325 Independent auditor’s report to the members of Prudential plc
Additional unaudited fi nancial information 366 Additional unaudited fi nancial information
in an cial statem en ts Primary statements Prudential plc Annual Report 2012
Benefi ts and claims and movement in unallocated surplus of with-profi ts funds, net of reinsurance (45,953) (29,289)
Earnings per share (in pence) Based on profi t attributable to the equity holders of the Company: * The Group has adopted updated US GAAP requirements for deferred acquisition costs as an improvement to its accounting policy under IFRS 4 for those operations of the Group which measure insurance assets and liabilities substantially by reference to US GAAP principles. Accordingly, the 2011 comparative results and related notes have been adjusted from those previously published for the retrospective application of the change as if the new accounting policy had always applied, as described in note A5.
Other comprehensive income: Exchange movements on foreign operations and net investment hedges: Exchange movements arising during the year B4 (214) (37) Related tax (2) (68)
Total 862 811 Related change in amortisation of deferred acquisition costs H1(b) (270) (275) Related tax (205) (187)
Total comprehensive income for the year 2,368 1,663 * The Group has adopted updated US GAAP requirements for deferred acquisition costs as an improvement to its accounting policy under IFRS 4 for those operations of the Group which measure insurance assets and liabilities substantially by reference to US GAAP principles. Accordingly, the 2011 comparative results and related notes have been adjusted from those previously published for the retrospective application of the change as if the new accounting policy had always applied, as described in note A5.
Total comprehensive income for the year – – 2,197 (216) 387 2,368 – 2,368
Reserve movements in respect of share-based payments – – 42 – – 42 – 42 Change in non-controlling interests arising principally from purchase and sale of property partnerships of the PAC with-profi ts fund and other consolidated investment funds – – – – – – (38) (38)
Share capital and share premium New share capital subscribed H11 – 17 – – – 17 – 17
Net increase (decrease) in equity – 17 782 (105) 349 1,043 (1) 1,042
At beginning of year: As previously reported 127 1,856 4,982 454 612 8,031 44 8,075 Effect of change in accounting policy for deferred acquisition costs – – (520) (67) 77 (510) – (510)
Intangible assets attributable to shareholders: Goodwill H1(a) 1,469 1,465 1,466 Deferred acquisition costs and other intangible assets H1(b) 4,267 4,234 3,901
§ Included within fi nancial investments are £3,015 million (2011: £7,843 million) of lent securities and £2,012 million of loans and debt securities covering liabilities for funds withheld under reinsurance arrangement of the Group’s US operations from the purchase of REALIC, as discussed in note I1.
Equity Shareholders’ equity H11 10,359 8,564 7,521 Non-controlling interests 5 43 44
Core structural borrowings of shareholder-fi nanced operations: Subordinated debt H13 2,577 2,652 2,718 Other H13 977 959 958
Other non-insurance liabilities: Obligations under funding, securities lending and sale and repurchase agreements G1 2,436 3,114 4,199 Net asset value attributable to unit holders of consolidated unit trusts and similar funds G1 4,345 3,840 3,372 Deferred tax liabilities H4 3,970 3,929 3,968 Current tax liabilities H4 445 930 831 Accruals and deferred income 833 736 707 Other creditors G1 2,781 2,544 2,321 Provisions H14 601 529 729 Derivative liabilities G1,G3 2,829 3,054 2,037 Other liabilities‡ G1,H15 3,454 1,249 1,129
The consolidated fi nancial statements on pages 147 to 314 were approved by the Board of directors on 12 March 2013 and signed on its behalf.
Cash fl ows from operating activities Profi t before tax (being tax attributable to shareholders' and policyholders' returns)note (i) 3,188 1,811 Non-cash movements in operating assets and liabilities refl ected in profi t before tax: Other non-investment and non-cash assets (801) (999) Policyholder liabilities (including unallocated surplus) 26,710 10,874 Other liabilities (including operational borrowings) (969) (859)
Interest income and expense and dividend income included in result before tax (7,772) (7,449) Other non-cash items note (ii) 128 108 Operating cash items: Interest receipts 6,483 6,365 Dividend receipts 1,530 1,302 Tax paid (925) (561)
Interest paid (9) (9) Equity capital: Issues of ordinary share capital H11 17 17 Dividends paid B3 (655) (642)
Net (decrease) increase in cash and cash equivalents (772) 658 Cash and cash equivalents at beginning of year 7,257 6,631 Effect of exchange rate changes on cash and cash equivalents (101) (32)
Notes (i) This measure is the formal profi t before tax measure under IFRS but it is not the result attributable to shareholders. (ii) Other non-cash items consist of the adjustment of non-cash items to profi t before tax together with other net items, net purchases of treasury shares and other net movements in equity.
(v) Interest paid on structural borrowings of with-profi ts 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-profi ts fund. Cash fl ows in respect of other borrowings of with-profi ts funds, which principally relate to consolidated investment funds, are included within cash fl ows from operating activities.
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-profi ts (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 fi xed annuities (interest-sensitive, fi xed indexed and immediate annuities), variable annuities (VA), life insurance and institutional products.
Prudential plc is a public limited company incorporated and registered in England and Wales. The registered offi ce is: Laurence Pountney Hill London EC4R 0HH UK Companies House registered number: 1397169
The preparation of these fi nancial statements requires Prudential to make estimates and judgements that affect the reported amounts of assets, liabilities, 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 and the fair value of assets.
Critical accounting policies are defi ned as those that are refl ective of signifi cant 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.
155Notes on the Group fi nancial statements Prudential plc Annual Report 2012 F
Overseas operations: 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, until 2012, Vietnam (as discussed in note A5), the local GAAP is not appropriate in the context of the previously applied MSB. For these countries the insurance assets and liabilities are measured principally by reference to US GAAP. For participating business the liabilities include provisions for the policyholders’ interest in investment gains and other surpluses that have yet to be declared as bonuses.
Valuation and accounting presentation of fair value movements of derivatives and debt securities of Jackson These policies are critical because of their signifi cance to the volatility of the income statement result and shareholders’ equity. 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.
Taking account of these considerations the Group has decided that, except for occasional circumstances, it is not appropriate to seek to achieve hedge accounting under IAS 39. As a result of this decision the total income statement results are more volatile as the movements in the value of Jackson’s derivatives are refl ected within it. This volatility is refl ected in the level of short-term fl uctuations in investment returns, as shown in note B1.
Presentation of results before tax The total tax charge for the Group refl ects tax that in addition to relating to shareholders’ profi ts is also attributable to policyholders and unallocated surplus of with-profi ts funds and unit-linked policies. This is explained in more detail in note F5. Reported profi t before the total tax charge is not representative of pre-tax profi ts attributable to shareholders. Accordingly, in order to provide a measure of pre-tax profi ts attributable to shareholders the Group has chosen to adopt an income statement presentation of the tax charge and pre-tax results that distinguishes between policyholder and shareholder components.
Segmental analysis of results and earnings attributable to shareholders The Group uses operating profi t based on longer-term investment returns as the segmental measure of its results. The basis of calculation is disclosed in section 2(d) below.
For shareholder-backed business, with the exception of debt securities held by Jackson and assets classifi ed as loans and receivables at amortised cost, all fi nancial investments and investment property are designated as assets at fair value through profi t and loss. The short-term fl uctuations affect the result for the year and the Group provides additional analysis of results before and after short-term fl uctuations in investment returns, together with other items that are of a short-term volatile or one-off nature. Short-term fl uctuations in investment returns on such assets held by with-profi ts funds, do not affect directly reported shareholder results. This is because (i) the unallocated surplus of with-profi ts funds is accounted for as a liability and (ii) excess or defi cits of income and expenditure of the funds over the required surplus for distribution are transferred to or from unallocated surplus.
Insurance contracts and investment contracts with discretionary participation features (DPF) Premium and annuity considerations for conventional with-profi ts policies and other protection type insurance policies are recognised as revenue when due. Premiums and annuity considerations for linked policies, unitised with-profi ts 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.
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 notifi ed.
Investment contracts other than those with DPF For investment contracts which do not contain discretionary participating features, the accounting is carried out in accordance with IAS 39 to refl ect the deposit nature of the arrangement, with premiums and claims refl ected as deposits and withdrawals and taken directly to the statement of fi nancial position as movements in the fi nancial liability balance.
Under IFRS, investment contracts (excluding those with discretionary participation features) accounted for as fi nancial liabilities in accordance with IAS 39 which also offer investment management services, require the application of IAS 18, ‘Revenue’, for the revenue attached to these services. 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.
Annual bonuses are declared and credited each year to with-profi ts policies. The annual bonuses increase policy benefi ts and, once credited, become guaranteed. Annual bonuses are charged to the profi t and loss account in the year declared. Final bonuses are declared each year and accrued for all policies scheduled to mature and for death benefi ts expected to be paid during the next fi nancial year. Final bonuses are not guaranteed and are only paid on policies that result from claims through the death of the policyholder or maturity of the policy within the period of declaration or by concession on surrender. No policyholder benefi t provisions are recorded for future annual or fi nal bonus declarations.
157Notes on the Group fi nancial statements Prudential plc Annual Report 2012 F
The policyholders’ liabilities of the regulated with-profi ts funds are accounted for under FRS 27, under which 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: AAAAAAAAAAAAAAAAAAA A with-profi ts benefi ts reserve (WPBR); plus AAAAAAAAAAAAAAAAAAA Future policy-related liabilities (FPRL); plus AAAAAAAAAAAAAAAAAAA The realistic current liabilities of the fund.
Other insurance contracts (ie contracts which contain signifi cant insurance risk as defi ned under IFRS 4)
Jackson The future policyholder benefi t provisions for Jackson’s conventional protection-type policies are determined under US GAAP principles with the locked in assumptions as to mortality, interest, policy lapses and expenses plus provisions for adverse deviations. For non-conventional protection-type policies, the policyholder benefi t provision included within policyholder liabilities in the consolidated statement of fi nancial position is the policyholder account balance. Acquisition costs are accounted for as explained in note A4.
For the Asia operations referred to above 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 benefi t 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 benefi t 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 investment gains and other surpluses that have yet to be declared as bonuses.
Reinsurance The measurement of reinsurance assets is consistent with the measurement of the underlying direct insurance contracts.
Investment contracts (contracts which do not contain signifi cant insurance risk as defi ned under IFRS 4)
Those investment contracts without fi xed and guaranteed terms are designated at fair value through profi t and loss because the resulting liabilities are managed and their performance is evaluated on a fair value basis. Where the contract includes a surrender option its carrying value is subject to a minimum carrying value equal to its surrender value.
b Financial instruments other than fi nancial instruments classifi ed as long-term business contracts Investment classifi cation
As permitted under IAS 39 the Group has designated certain fi nancial assets as fair value through profi t and loss as these assets are managed and their performance is evaluated on a fair value basis. These assets represent all of the Group’s fi nancial assets other than those loans and receivables, carried at amortised cost, and debt securities accounted for on an available-for-sale basis by Jackson. The use of the fair value option is consistent with the Group’s risk management and investment strategies.
For fair value hedges, movements in the fair value of the hedged item attributable to the hedged risk are recognised in the income statement.
All derivatives that are not designated as hedging instruments are carried at fair value with movements in fair value being recorded in the income statement.
For shareholder-backed UK annuity business the derivatives are held to contribute to the matching as far as practical, of asset returns and duration with those of liabilities to policyholders. The carrying value of these liabilities is sensitive to the return on the matching fi nancial assets including derivatives held.
For Jackson an extensive derivative programme is maintained. Value movements on the derivatives held can be very signifi cant in their effect on shareholder results. Further details on this aspect of the Group’s fi nancial reporting are described in notes B1 and D3.
Embedded derivatives are present in host contracts issued by various Group companies, in particular Jackson. They are embedded within other non-derivative host fi nancial instruments and insurance contracts to create hybrid instruments. Embedded derivatives meeting the defi nition 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 option of IFRS 4 to not separate and fair value surrender options embedded in host contracts and with-profi ts investment contracts whose strike price is either a fi xed amount or a fi xed amount plus interest. Further details on the valuation basis for embedded derivatives attaching to Jackson’s life assurance contracts are provided in note D3(e).
Although initially recognised at fair value, net of transaction costs, borrowings, excluding liabilities of consolidated collateralised debt obligations, are subsequently accounted for on an amortised cost basis using the effective interest method. Under the effective interest method, the difference between the redemption value of the borrowing and the initial proceeds (net of related issue costs) is amortised through the income statement to the date of maturity or for hybrid debt, over the expected life of the instrument.
Financial liabilities designated at fair value through profi t and loss
Consistent with the Group’s risk management and investment strategy and the nature of the products concerned, the Group has designated under IAS 39 classifi cation certain fi nancial liabilities at fair value through profi t and loss as these instruments are managed and their performance evaluated on a fair value basis. These instruments include liabilities related to consolidated collateralised debt obligations and net assets attributable to unit holders of consolidated unit trusts and similar funds.
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 fi nancial and operating policies of an entity in order to obtain benefi ts. The results of subsidiaries are included in the fi nancial statements from the date control commences to the date control ceases. All inter-company transactions are eliminated on consolidation. Results of asset management activities include those for managing internal funds.
Investments in leasehold and freehold properties not for occupation by the Group, including properties under development for future use as investment properties, are carried at fair value, with changes in fair value included in the income statement. Properties are valued annually either by the Group’s qualifi ed surveyors or by taking into consideration the advice of professional external valuers using the Royal Institution of Chartered Surveyors guidelines. Each property is externally valued at least once every three years. Fair value is based on active market prices. If this information is not available, the Group uses alternative valuation methods such as discounted cash fl ow projections or recent prices in less active markets.
161Notes on the Group fi nancial statements Prudential plc Annual Report 2012 F
For the Group’s defi ned benefi t schemes, if the present value of the defi ned benefi t obligation exceeds the fair value of the scheme assets, then a liability is recorded in the Group’s statement of fi nancial position. By contrast, if the fair value of the assets exceeds the present value of the defi ned benefi t 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 defi cit funding, this is also recognised such that the fi nancial position recorded for the scheme refl ects the higher of any underlying IAS 19, ‘Employee Benefi ts’, defi cit and the obligation for defi cit funding.
The plan assets of the Group’s pension schemes exclude several insurance contracts that have been issued by the Group. These assets are excluded from plan assets in determining the pension obligation recognised in the consolidated statement of fi nancial position.
The Group offers share award and option plans for certain key employees and a Save As You Earn plan for all UK and certain overseas employees. Shares held in trust relating to these plans are conditionally gifted to employees.
The compensation expense charged to the income statement is primarily based upon the fair value of the options granted, the vesting period and the vesting conditions. The Company has established trusts to facilitate the delivery of Prudential plc shares under employee incentive plans and savings-related share option schemes. The cost to the Company of acquiring these treasury shares held in trusts is shown as a deduction from shareholders’ equity.
The tax charge for long-term business includes tax expense attributable to both the policyholders and the shareholders. Different tax rules apply under UK law depending upon whether the business is life insurance or pension business.
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 Group’s operating segments determined in accordance with IFRS 8, ‘Operating Segments’, are as follows: Insurance operations AAAAAAAAAAAAAAAA Asia AAAAAAAAAAAAAAAA US (Jackson) AAAAAAAAAAAAAAAA UK
Segment results that are reported to the Group Executive Committee include items directly attributable to a segment as well as those that can be allocated on a reasonable basis. Unallocated items are mainly in relation to the Group Head Offi ce and the Asia Regional Head Offi ce.
Except in the case of the assets backing the UK annuity business, unit-linked and US variable annuity separate account liabilities, operating profi t based on longer-term investment returns for shareholder-fi nanced 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 profi t based on longer-term investment returns is as follows: AAAAAAAAAAAAAAAA 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 fl uctuations in investment returns; and
i Debt, equity-type securities and loans Longer-term investment returns for both debt, equity-type securities and loans comprise longer-term actual income receivable for the period (interest/dividend income) and longer-term capital returns.
In principle, for debt securities and loans, the longer-term capital returns comprise two elements. The fi rst element is a risk margin reserve (RMR) based charge for the expected level of defaults for the period, which is determined by reference to the credit quality of the portfolio. The difference between impairment losses in the reporting period and the RMR charge to the operating result is refl ected in short-term fl uctuations in investment returns. The second element is for the amortisation of interest-related realised gains and losses to operating results based on longer-term investment returns to the date when sold bonds would have otherwise matured.
Jackson is the shareholder-backed operation for which the distinction between impairment losses and interest-related realised gains and losses is in practice relevant to a signifi cant extent. Jackson has used the ratings by Nationally Recognised Statistical Ratings Organisations (NRSRO) or ratings resulting from the regulatory ratings detail issued by the National Association of Insurance Commissioners (NAIC) developed by external third parties such as PIMCO or BlackRock Solutions to determine the average annual RMR to apply to debt securities held to back general account business. Debt securities held to back separate account and reinsurance funds withheld are not subject to RMR charge. Further details of the RMR charge, as well as the amortisation of interest-related realised gains and losses, for Jackson are shown in note B1(iv) to the consolidated fi nancial statements.
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 benefi t is economically reinsured the mark to market element of the reinsurance asset is included as a component of short-term fl uctuations 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 profi t). The principal example of non-equity based derivatives (for example interest rate swaps and swaptions) whose value movements are excluded from operating profi t 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 refl ect the economic features being hedged), and the interest rate exposure attaching to equity-based embedded derivatives.
165Notes on the Group fi nancial statements Prudential plc Annual Report 2012 F
Credit experience refl ects the impact of defaults and other similar experience, such as asset exchanges arising from debt restructuring by issuers that include effectively an element of permanent impairment of the security held. Negative experience compared to assumptions is included within short-term fl uctuations in investment returns without further adjustment. This is to be contrasted with positive experience where surpluses are retained in short-term allowances for credit risk for IFRS reporting purposes. The effects of other changes to credit risk provisioning are included in the operating result, as is the net effect of changes to the valuation rate of interest due to portfolio rebalancing to align more closely with management benchmark.
v Fund management and other non-insurance businesses For these businesses, the particular features applicable for life assurance noted above do not apply. For these businesses it is inappropriate to include returns in the operating result on the basis described above. Instead, it is appropriate to generally include realised gains and losses (including impairments) in the operating result with unrealised gains and losses being included in short-term fl uctuations in investment returns. For this purpose impairments are calculated as the credit loss determined by comparing the projected cash fl ows discounted at the original effective interest rate to the carrying value. In some instances it may also be appropriate to amortise realised gains and losses on derivatives and other fi nancial instruments to operating results over a time period that refl ects the underlying economic substance of the arrangements.
Interim dividends are recorded in the period in which they are paid. Final dividends are recorded in the period in which they are approved by shareholders.
Foreign currency transactions are translated at the spot rate prevailing at the time.
The fi nancial investments measured at fair value are classifi ed into the following three level hierarchy on the basis of the lowest level of inputs that is signifi cant to the fair value measurement of the fi nancial investment concerned: Level 1: Quoted prices (unadjusted) in active markets for identical assets and liabilities; Level 2: Inputs other than quoted prices included within level 1 that are observable either directly or indirectly
(ie derived from prices); and Level 3: Signifi cant inputs for the asset or liability that are not based on observable market data (unobservable inputs).
For Jackson’s residential mortgage-backed and other asset-backed securities, all of which are classifi ed as available-for-sale, the model used to analyse cash fl ows begins with the current delinquency experience of the underlying collateral pool for the structure, by applying assumptions about how much of the currently delinquent loans will eventually default, and multiplying this by an assumed loss severity. Additional factors are applied to anticipate ageing effects. After applying a cash fl ow simulation an indication is obtained as to whether or not the security has suffered, or is anticipated to suffer, contractual principal or interest payment shortfalls. If a shortfall applies an impairment charge is recorded. The difference between the fair value and book cost for unimpaired securities designated as available-for-sale, is accounted for as unrealised gains or losses, with the movements in the accounting period being included in other comprehensive income.
The Group’s review of fair value involves several criteria, including economic conditions, credit loss experience, other issuer-specifi c developments and future cash fl ows. These assessments are based on the best available information at the time. Factors such as market liquidity, the widening of bid/ask spreads and a change in cash fl ow assumptions can contribute to future price volatility. If actual experience differs negatively from the assumptions and other considerations used in the consolidated fi nancial statements, unrealised losses currently in equity may be recognised in the income statement in future periods. Additional details on the impairments of the available-for-sale securities of Jackson are described in notes D3 and G5.
Certain mortgage loans of the UK insurance operations and, consequent upon the purchase of REALIC in 2012, policy loans held to back funds withheld under reinsurance arrangements have been designated at fair value through profi t and loss as these loan portfolios are managed and evaluated on a fair value basis.
Insurance contracts Product classifi cation IFRS 4 requires contracts written by insurers to be classifi ed as either ‘insurance contracts’ or ‘investment contracts’ depending on the level of insurance risk transferred. Insurance risk is a pre-existing risk, other than fi nancial risk, transferred from the contract holder to the contract issuer. If signifi cant insurance risk is transferred by the contract then it is classifi ed as an insurance contract. Contracts that transfer fi nancial risk but not signifi cant insurance risk are termed investment contracts. Furthermore, some contracts, both insurance and investment, contain discretionary participating features representing the contractual right to receive additional benefi ts as a supplement to guaranteed benefi ts: a That are likely to be a signifi cant portion of the total contract benefi ts; 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.
For investment contracts that do not contain discretionary participating features, IAS 39 and, where the contract includes an investment management element, IAS 18,’Revenue’, apply measurement principles to assets and liabilities attaching to the contract.
For UK regulated with-profi ts funds, the contract liabilities are valued by reference to the UK Financial Services Authority’s (FSA) realistic basis as described in section A3(2)(a). This basis has the effect of placing a value on the liabilities of UK with-profi ts contracts, which refl ects the amounts expected to be paid based on the current value of investments held by the with-profi ts funds and current circumstances. An explanation of the basis of liability measurement is contained in section A3(2)(a).
The Group’s other with-profi ts contracts are written in with-profi ts funds that operate in some of the Group’s Asian subsidiaries. The liabilities for these contracts and those of Prudential Annuities Limited, which is a subsidiary company of the PAC with-profi ts 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.
Jackson 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 fi xed annuity, variable annuity and traditional life insurance contracts.
Variable annuity contracts written by Jackson may provide for guaranteed minimum death, income or withdrawal benefi t features. In general terms, liabilities for these benefi ts are accounted for under US GAAP by using estimates of future benefi ts and fees under best estimate assumptions.
Except to the extent of mortality experience, which primarily affects profi ts through variations in claim payments and the guaranteed minimum death benefi t reserves, the profi ts of Jackson are relatively insensitive to changes in insurance risk. This refl ects the principally spread and fee-based nature of Jackson’s business.
169Notes on the Group fi nancial statements Prudential plc Annual Report 2012 F
Deferred acquisition costs for insurance contracts Except for acquisition costs of with-profi ts contracts of the UK regulated with-profi ts funds, which are accounted for under the realistic FSA regime, costs of acquiring new insurance business are accounted for in a way that is consistent with the principles of the ABI SORP with deferral and amortisation against margins in future revenues on the related insurance policies. Costs of acquiring new insurance business, principally commissions, marketing and advertising and certain other costs associated with policy insurance and underwriting that are not reimbursed by policy charges, are specifi cally identifi ed and capitalised as part of deferred acquisition costs (DAC). In general, this deferral is presentationally shown by an explicit carrying value for DAC in the balance sheet. However, in some Asia operations the deferral is implicit through the reserving methodology. The recoverability of the explicitly and implicitly deferred acquisition costs is measured and are deemed impaired if the projected margins are less than the carrying value. To the extent that the future margins differ from those anticipated, then an adjustment to the carrying value will be necessary.
For UK regulated with-profi ts funds where the realistic FSA regime is applied, the basis of setting liabilities is such that it would be inappropriate for acquisition costs to be deferred, therefore these costs are expensed as incurred. The majority of the UK shareholder-backed business is individual and group annuity business where the incidence of acquisition costs is negligible.
As explained in note A5, the Group has adopted the US Financial Accounting Standards Board measurement and recognition requirements in Accounting Standards update No 2010-26 on ‘Accounting for Costs Associated with Acquiring or Renewing Insurance Contracts’ (the ‘Update’) from 1 January 2012 into its IFRS reporting for the results of Jackson and those Asia operations whose IFRS insurance assets and liabilities are measured principally by reference to US GAAP principles. Under the Update insurers are required to capitalise only those incremental costs directly relating to acquiring a contract from 1 January 2012. For Group IFRS reporting Prudential has chosen to apply this new basis retrospectively for the results of these operations.
On adoption of the new DAC policy for Jackson the deferred costs balance for business in force at 31 December 2011 was retrospectively reduced from £3,880 million to £3,095 million (31 December 2010: DAC balance reduced from £3,543 million to £2,829 million).
Asia 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 territories in Asia, 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.
The following standards, interpretations and amendments have either been adopted for the fi rst time in 2012 or have been issued but are not yet effective in 2012, including those which have not yet been adopted in the EU. This is not intended to be a complete list as only those standards, interpretations and amendments that could have an impact upon the Group’s fi nancial statements have been discussed.
a Accounting pronouncements adopted in 2012 Amendments to IFRS 7, ‘Financial instruments: Disclosures – Transfers of fi nancial assets’ The amendments introduce new disclosure requirements about transfers of fi nancial assets which include disclosures for fi nancial assets that are not derecognised in their entirety and fi nancial assets that are derecognised in their entirety but for which the entity retains continuing involvement. The adoption of these amendments did not have a signifi cant impact on the Group’s disclosures.
Amendments to IAS 12, ‘Income taxes’ These 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. The adoption of these amendments did not have a material effect on the Group’s fi nancial statements.
b Adoption of updated US GAAP reporting requirements for Group IFRS reporting in 2012 Background 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’). The Update was issued to address perceived diversity in practices by companies preparing fi nancial 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 relating to acquiring a contract for fi nancial statements for reporting periods beginning after 15 December 2011. All other indirect acquisition expenses are required to be charged to the income statements 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.
The Group’s IFRS accounting policies include that under IFRS 4, ‘Insurance Contracts’, insurance assets and liabilities other than those for UK regulated with-profi ts funds, are measured using the GAAP basis applied prior to IFRS adoption in 2005. On this basis insurance assets and liabilities are measured under the UK Modifi ed Statutory Basis (MSB) which was codifi ed by the Statement of Recommended Practice (SORP) on accounting for insurance business issued by the Association of British Insurers (ABI) in 2003. The SORP also permits the use of local GAAP subject to the requirement for adjustments to be made to ensure suffi cient consistency of measurement under the UK GAAP framework under which the SORP was developed.
The 2011 comparatives in these consolidated fi nancial statements have been adjusted accordingly for the retrospective application of this Update.
* Separately from the DAC change noted above, in Vietnam, the Company has improved its estimation basis for liabilities in 2012 from one determined substantially by reference to US GAAP requirements. Aft er making this change, the estimation basis for Vietnam is aligned substantially with that used in Singapore, Malaysia and some other Asia operations.
171Notes on the Group fi nancial statements Prudential plc Annual Report 2012 F
Eff ect of the change in accounting policy (a) The effect of the change in accounting policy for deferred acquisition costs (DAC) on the income statement, earnings per share, comprehensive income, changes in equity and statement of fi nancial position is shown in the tables below: Consolidated income statement
Total revenue, net of reinsurance 55,476 – 55,476 36,506 – 36,506 Acquisition costs and other expenditure (5,908) (147) (6,055) (5,005) (115) (5,120) Total other charges, net of reinsurance (46,233) – (46,233) (29,575) – (29,575)
Profi t before tax attributable to shareholders 2,957 (147) 2,810 1,943 (115) 1,828 Total tax charge attributable to policyholders
Profi t for the year attributable to equity holders of the Company 2,296 (99) 2,197 1,490 (75) 1,415
Earnings per share (in pence) Based on profi t attributable to the equity holders of the Company:
Consolidated statement of comprehensive income and statement of changes in equity
Related change in amortisation of deferred income and acquisition costs (314) 44 (270) (331) 56 (275)
Shareholders’ equity: Net increase in shareholders’ equity 1,845 (50) 1,795 1,086 (43) 1,043 At beginning of year 9,117 (553) 8,564 8,031 (510) 7,521
Liabilities Deferred tax liabilities 4,273 (303) 3,970 4,211 (282) 3,929 Total other liabilities 295,919 – 295,919 260,209 – 260,209
173Notes on the Group fi nancial statements Prudential plc Annual Report 2012 F
Asia insurance operationsnote (i) 922 (9) 913 704 – 704 US insurance operationsnote (ii) 1,081 (117) 964 694 (43) 651 Other operations 656 – 656 672 – 672
Shareholders’ share of actuarial and other gains and losses on defi ned benefi t pension schemes 50 – 50 21 – 21
Profi t before tax attributable to shareholders 2,957 (147) 2,810 1,943 (115) 1,828
Notes on the eff ect of the change in the accounting policy on operating profi t based on longer-term investment returns (i) Asia insurance operations
New business Acquisition costs on new contracts not deferred under the new policy (14) (16) Business in force at beginning of period Reduction in amortisation on reduced DAC balance under the new policy 5 16
New business Acquisition costs on new contracts not deferred under the new policy (174) (156) Business in force at beginning of period Reduction in amortisation on reduced DAC balance under the new policy 57 113
Amendments to IAS 19, ‘Employee benefi ts’ In June 2011, the IASB published amendments to IAS 19 on accounting for pensions and other post-employment benefi ts effective from annual periods beginning on or after 1 January 2013. The key revisions to the standard are: AAAAAAAAAAAAAAAA The removal of the corridor option for actuarial gains and losses The Group does not apply the corridor option, therefore, its removal has no impact to the Group; AAAAAAAAAAAAAAAA Presentation of actuarial gains and losses The Group currently presents actuarial gains and losses in the income statement. Under the revised standard actuarial gains and losses will be presented in ‘other comprehensive income’. Details of the 2012 and 2011 actuarial gains and losses on the current basis are shown in note I3; AAAAAAAAAAAAAAAA The replacement of the expected return on plan assets with an amount based on the liability discount rate in the determination of pension costs This revision alters the pension costs included in the Group’s income statement with a corresponding equal and opposite effect on the actuarial gains and losses included in other comprehensive income. The effect of this change for Prudential is not expected to be signifi cant; and
AAAAAAAAAAAAAAAA Enhanced disclosures, specifi cally on risks arising from defi ned benefi t plans.
Standards on joint arrangements and disclosures: IFRS 11, ‘Joint arrangements’, IFRS 12, ‘Disclosures of interest in other entities’ and IAS 28, ‘Investments in associates and joint ventures’ In May 2011, the IASB issued IFRS 11, ‘Joint arrangements’ to replace IAS 31, ‘Interests in Joint Ventures’. The standard also incorporates the guidance contained in related interpretation in SIC 13, Jointly Controlled Entities – Non-Monetary Contributions by Venturers. The standard requires a joint venture to be recognised as an investment and be accounted for using the equity method in accordance with IAS 28. The attaching changes to disclosure requirements for parties to joint arrangements are specifi ed in IFRS 12, ‘Disclosures of interest in other entities’, which replaces the disclosure requirements of IAS 28, ‘Investments in associates and joint ventures’ and IAS 31, ‘Interests in Joint Ventures’.
The standards are effective from annual periods beginning on or after 1 January 2013 for IFRS as issued by the IASB and 1 January 2014 for IFRS as endorsed by the EU but with early adoption permitted. The Group’s investments in joint ventures are currently accounted for using proportionate consolidation. At 31 December 2012, this approach gave rise to consolidated gross assets and liabilities for the joint ventures of £3,946 million and £ 3,595 million respectively. With the application of IFRS 11, the Group’s investments in joint ventures will be accounted for on a single line equity method thus giving rise at 31 December 2012 to a net interest of £351 million included within gross assets.
Similarly, the 2012 gross revenue and charges of £1,040 million and £942 million respectively, which are currently included on a line-by-line basis within the income statement will, after adoption of the standard, be presented as a single net contribution of £98 million. As a consequence, the standard will also have a small impact on profi t before tax as the tax on the profi ts of the joint ventures will no longer be presented in the tax line, instead the tax charges will be required to be netted against the Group’s share of joint ventures’ income included in profi t before tax. The tax charges for 2012 for the Group’s share of joint ventures’ income was £19 million. Adoption of the standard will have no impact on net of tax profi ts or shareholders’ equity.
Standards on consolidation and disclosures: IFRS 10, ‘Consolidated fi nancial statements’, IFRS 12, ‘Disclosures of interest in other entities’ and IAS 27, ‘Separate fi nancial statements’ In May 2011, the IASB issued these three standards to replace IAS 27, ‘Consolidated and separate fi nancial statements’ and SIC 12, ‘Consolidation – Special Purpose Entities’.
The grossing up effect on the 2012 statement of fi nancial position is not expected to exceed £1 billion. Adoption of the standard is expected to have an insignifi cant effect on the retrospectively adjusted comparative 2012 profi t and shareholders’ equity in the 2013 results.
The standard is effective from annual periods beginning on or after 1 January 2013, with no adjustment to comparative results. The Group is currently assessing the impact of the standard but it is not expected to have a material impact on the fair value measurement of the Group’s assets and liabilities. Disclosures will be enhanced in providing detail of the methodology and underlying assumptions used to determine fair value of the Group’s assets and liabilities, in line with the new requirements.
Amendments to IAS 1, ‘Presentation of fi nancial statements’ These amendments, effective on or after 1 January 2013, change the requirement for the disclosure of items presented in other comprehensive income, requiring items to be presented separately based on whether or not they may be recycled to profi t or loss in the future. The Group is expecting the amendments to be purely presentational with no signifi cant impact on the Group’s results and fi nancial position.
Off setting Financial Assets and Financial Liabilities (Amendments to IAS 32, ‘Financial instruments: Presentation’ and IFRS 7, ‘Financial instruments: Disclosures’) The two amendments, effective on or after 1 January 2013 and 2014, respectively clarifi es the offsetting criteria for fi nancial assets and fi nancial liabilities in the statement of fi nancial position. The Group is currently assessing the impact of these amendments.
Long-term business 703 683 General insurance commission note (v) 33 40
RPI to CPI infl ation measure change on defi ned benefi t pension schemes note (vi) – 42 Solvency II implementation costs (48) (55) Restructuring costs note (vii) (19) (16)
Operating profi t based on longer-term investment returns 2,533 2,027 Short-term fl uctuations in investment returns on shareholder-backed business note (viii) 204 (220) Shareholders' share of actuarial and other gains and losses on defi ned benefi t pension schemes note (ix) 50 21 Gain on dilution of Group's holdings I2 42 – Amortisation of acquisition accounting adjustments arising on the purchase of REALIC I1 (19) –
Notes (i) Operating profi t based on longer-term investment returns The Group provides supplementary analysis of IFRS profi t before tax attributable to shareholders so as to distinguish operating profi t based on longer-term investment returns from other elements of total profi t. Operating profi t based on longer-term investment returns is the basis on which management regularly reviews the performance of Prudential’s segments as defi ned by IFRS 8. Further discussion on the determination of operating profi t based on longer-term investment returns is provided in note A3(2)(d).
Related change to amortisation of deferred acquisition costs (see below) 21 13 22 14
Risk margin reserve charge to operating profi t for longer-term credit-related losses (104) (66) (90) (56)
(v) General insurance commission UK operations transferred its general insurance business to Churchill in 2002, with general insurance commission representing the commission received net of expenses for Prudential-branded general insurance products as part of this arrangement. (vi) RPI to CPI infl ation measure change During 2011, the Group altered its infl ation measure basis for future statutory increases to pension payments for certain tranches of its UK defi ned benefi t pension schemes. This refl ected the UK Government’s decision to replace the basis of indexation from Retail Prices Index with Consumer Prices Index. This resulted in a credit to the operating profi t before tax in 2011 of £42 million.
(vii) Restructuring costs are incurred in the UK and represent one-off expenses incurred in securing expense savings. (viii) Short-term fl uctuations in investment returns on shareholder-backed business.
Short-term fl uctuations relating to debt securities: Charges in the year: Defaults – – Losses on sales of impaired and deteriorating bonds (23) (32) Bond write downs (37) (62)
Total charges in the year note (a) (47) (52) Less: Risk margin charge included in operating profi t based on longer-term investment returns note (iii) 79 70
Interest-related realised gains: Arising in the year 94 158 Less: amortisation of gains and losses arising in current and prior years to operating profi t based on longer-term investment returns (91) (84)
Total short-term fl uctuations related to debt securities 32 89 Derivatives (other than equity-related): market value movements (net of related change to amortisation of deferred acquisition costs) note (b) 135 554 Net equity hedge results (principally guarantees and derivatives, net of related change to amortisation of deferred acquisition costs) note (c) (302) (788) Equity-type investments: actual less longer-term return (net of related change to amortisation of deferred acquisition costs) A3(d)(i) 23 – Other items (net of related change to amortisation of deferred acquisition costs) 22 (22)
Total residential mortgage-backed securities (8) (26) Corporate debt securities (14) (14)
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 general account business, the Group has continued its approach of not seeking to apply hedge accounting under IAS 39.
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 classifi ed as available-for-sale of £862 million (2011: increase in net unrealised gains of £811 million). Temporary market value movements do not refl ect defaults or impairments. Additional details on the movement in the value of the Jackson portfolio are included in note D3.
UK Insurance operations The gain on short-term fl uctuations in investment returns for UK insurance operations of £136 million (2011: £159 million) principally refl ect net investment gains arising in the year on fi xed income assets backing the capital of the shareholder-backed annuity business.
Prudential Capital’s bond portfolio. Short-term fl uctuations in investment returns for Other operations in 2011 of £(120) million represent unrealised value movements on investments, including centrally held swaps to manage foreign exchange and certain macroeconomic exposures of the Group.
(14) 40 Less: amount attributable to the PAC with-profi ts sub-fund 15 (18)
Other gains and losses One-off uplift to recognise a portion of PSPS surplus 164 – Movement in the provision for defi cit funding of PSPS – (4) Less: amount attributable to the PAC with-profi ts sub-fund (115) 3
Short-term fl uctuations in investment returns on shareholder-backed business B1 204 (26) – 178 7.0p 7.0p
Gain on dilution of Group's holdings I2 42 – – 42 1.7p 1.7p Amortisation of acquisition accounting adjustments arising on the purchase of REALIC I1 (19) 7 – (12) (0.5)p (0.5)p
Based on profi t for the year 2,810 (613) – 2,197 86.5p 86.4p
Short-term fl uctuations in investment returns on shareholder-backed business B1 (220) 29 – (191) (7.6)p (7.6)p
Shareholders’ share of actuarial and other gains and losses on defi ned benefi t pension schemes B1 21 (5) – 16 0.6p 0.6p
Weighted average shares for calculation of basic earnings per share 2,541 2,533 Shares under option at end of year 9 13 Number of shares that would have been issued at fair value on assumed option exercise (6) (8)
Dividends declared and paid in reporting year Parent company: Interim dividend (2012: 8.40p; 2011: 7.95p) 215 203 Final dividend for prior period (2012: 17.24p; 2011: 17.24p) 440 439
181Notes on the Group fi nancial statements Prudential plc Annual Report 2012 F
The movements for Asia and US operations refl ect 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 refl ects 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.
Hong Kong 12.60 12.29 12.07 12.48 Indonesia 15,665.76 14,842.01 14,091.80 14,049.41 Malaysia 4.97 4.89 4.93 4.90 Singapore 1.99 1.98 2.02 2.02 India 89.06 84.70 82.53 74.80 Vietnam 33,875.42 33,083.59 33,688.16 33,139.22 US 1.63 1.58 1.55 1.60
The tables below aggregate the three asset management segments for ease of presentation and hence should be read in conjunction with the associated tables on asset management in note E2.
Intangible assets attributable to with-profi ts funds: In respect of acquired subsidiaries for venture fund and other investment purposes 178 – – 178 – – – 178 Deferred acquisition costs and other intangible assets 6 – 72 78 – – – 78
Deferred tax assets H4 183 1,889 83 2,155 107 52 – 2,314 Other non-investment and non-cash assets H3,H6 5,424 6,792 1,117 13,333 1,051 3,766 (6,113) 12,037 Investments of long-term business and other operations: Investment properties 10,852 24 4 10,880 – – – 10,880 Investments accounted for using the equity method 72 – – 72 41 – – 113
Financial investments: Loans 3,373 6,235 1,014 10,622 1,199 – – 11,821 Equity securities and portfolio holdings in unit trusts 36,027 49,551 14,310 99,888 70 – – 99,958 Debt securities B5(c) 83,862 32,993 21,402 138,257 1,846 – – 140,103 Other investments 4,576 2,296 957 7,829 44 27 – 7,900 Deposits 11,131 211 1,227 12,569 84 – – 12,653
Liabilities Policyholder liabilities and unallocated surplus of with-profi ts funds: Insurance contract liabilities H12 84,266 90,192 34,126 208,584 – – – 208,584 Investment contract liabilities with discretionary participation features G1 33,464 – 348 33,812 – – – 33,812 Investment contract liabilities without discretionary participation features G1 16,182 2,069 127 18,378 – – – 18,378 Unallocated surplus of with-profi ts funds (refl ecting application of ‘realistic’ basis provisions for UK regulated with-profi ts funds) D2, H12 10,526 – 63 10,589 – – – 10,589
Borrowings attributable to with-profi ts operations 1,033 – – 1,033 – – – 1,033
Financial investments: Loans 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 B5(c) 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
: Su m m ary o f resu lts 2011* £m
Liabilities Policyholder liabilities and unallocated surplus of with-profi ts funds: Insurance contract liabilities H12 82,732 67,278 30,353 180,363 – – – 180,363 Investment contract liabilities with discretionary participation features G1 29,348 – 397 29,745 – – – 29,745 Investment contract liabilities without discretionary participation features G1 14,944 1,911 112 16,967 – – – 16,967 Unallocated surplus of with-profi ts funds (refl ecting application of ‘realistic’ basis provisions for UK regulated with-profi ts funds) D2, H12 9,165 – 50 9,215 – – – 9,215
Intangible assets attributable to with-profi ts funds: In respect of acquired subsidiaries for venture fund and other investment purposes 178 – – – – – 178 178 Deferred acquisition costs and other intangible assets 78 – – – – – 78 89
Deferred tax assets 114 – 2,041 107 52 – 2,314 2,276 Other non-investment and non-cash assets 3,133 508 9,692 1,051 3,766 (6,113) 12,037 6,638 Investments of long-term business and other operations: Investment properties 8,659 622 1,599 – – – 10,880 10,757 Investments accounted for using the equity method – – 72 41 – – 113 70
Financial investments: Loans 2,709 – 7,913 1,199 – – 11,821 9,714 Equity securities and portfolio holdings in unit trusts 25,105 73,860 923 70 – – 99,958 87,349 Debt securities 62,002 9,504 66,751 1,846 – – 140,103 124,498 Other investments 4,745 57 3,027 44 27 – 7,900 7,509 Deposits 9,470 1,396 1,703 84 – – 12,653 10,708
Properties held for sale 98 – – – – – 98 3 Cash and cash equivalents 1,721 1,310 1,788 1,083 482 – 6,384 7,257 * The 2011 comparative results have been adjusted from those previously published for the retrospective application of the change in accounting policy described in note A5.
Liabilities Policyholder liabilities and unallocated surplus of with-profi ts funds: Contract liabilities (including amounts in respect of contracts classifi ed as investment contracts under IFRS 4) 97,795 85,523 77,456 – – – 260,774 227,075 Unallocated surplus of with-profi ts funds 10,589 – – – – – 10,589 9,215
Deferred tax liabilities 1,086 46 2,809 13 16 – 3,970 3,929 Other non-insurance liabilities 7,508 1,687 9,497 4,543 602 (6,113) 17,724 15,996 * The 2011 comparative results have been adjusted from those previously published for the retrospective application of the change in accounting policy described in note A5.
Policyholder liabilities 125,530 60,523 28,674 214,727 Unallocated surplus of with-profi ts funds 10,187 – 66 10,253 Premiums 6,988 12,914 5,079 24,981 Surrenders (4,255) (4,270) (2,237) (10,762)
Net fl ows (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-profi ts funds 9,165 – 50 9,215 At 1 January 2012 136,189 69,189 30,912 236,290 Premiums 8,340 14,907 5,620 28,867 Surrenders (4,785) (4,356) (2,541) (11,682)
: Su m m ary o f resu lts c Debt securities and loans i Information on the credit risks of debt securities
In the table above, with the exception of some mortgage-backed securities within Jackson, Standard & Poor’s (S&P) ratings have been used where available. For securities where S&P ratings are not immediately available, those produced by Moody’s and then Fitch have been used as an alternative. For some mortgage-backed securities within Jackson, the table above includes these securities using the regulatory ratings detail issued by the National Association of Insurance Commissioners (NAIC). These regulatory ratings levels were established by external third parties (PIMCO for residential mortgage-backed securities and BlackRock Solutions for commercial mortgage-backed securities). Notes D2(c), D3(c), D4(c) and E2 provide further details on the credit risks of debt securities by segment.
Notes (i) UK insurance operations All of the exposure of the shareholder-backed business relates to the UK market and primarily relates to investments held by PRIL. Of the £5,850 million
(2011: £5,351 million) relating to with-profi ts business, £1,697 million (2011: £1,314 million) relates to exposure to the US and with the remaining exposure being primarily to the UK market.
(ii) Asia insurance operations The Asia insurance operations’ exposure to asset-backed securities is primarily held by the with-profi ts operations. Of the £241 million, 63 per cent
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.
: G ro u p risk m an agem en t
D1: Group overview a Products and classifi cation for IFRS reporting The measurement basis of assets and liabilities of long-term business contracts is dependent upon the classifi cation of the contracts under IFRS. Under IFRS 4, contracts are initially classifi ed as being either ‘insurance’ contracts, if the level of insurance risk in the contracts is signifi cant, or ‘investment’ contracts, if the risk is insignifi cant.
An example of the diversifi cation benefi ts 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 benefi t from increasing rates. Conversely, these Asian business units are sensitive towards low interest rates, whereas certain products in the US benefi t 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 refl ects 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.
193Notes on the Group fi nancial statements Prudential plc Annual Report 2012 F
: L ife assu ran ce b u sin ess ii Ceded business The Group cedes certain business to other insurance companies. Although the ceding of insurance does not relieve the Group of liability to its policyholders, the Group participates in such agreements for the purpose of managing its loss exposure. The Group evaluates the fi nancial condition of its reinsurers and monitors concentration of credit risk from similar geographic regions, activities or economic characteristics of the reinsurers to minimise its exposure from reinsurer insolvencies. At 31 December 2012 the reinsurers’ share of insurance contract liabilities was £6,859 million (2011: £1,344 million). The increase arises from the acquisition of REALIC. Further details are shown in note D3(f) and I1. At 31 December 2012, 97 per cent (2011: 91 per cent) of the reinsurance recoverable insurance assets were ceded by the Group’s UK and US operations, of which 92 per cent (2011: 94 per cent) of the balance were from reinsurers with Standard & Poor’s rating A- and above.
c Guarantees Notes D2(d), D3(d) and D4(d) provide details of guarantee features of the Group’s life assurance products. In the UK, guarantees of the with-profi ts products are valued for accounting purposes on a market consistent basis for 2012 as described in section D2(e)(ii). The UK business also has products with guaranteed annuity option features, mostly within Scottish Amicable Insurance Fund (SAIF), as described in section D2(d). There is little exposure to fi nancial 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(d). Jackson’s derivative programme seeks to manage the exposures as described in section D3(h).
Net neutral direct exposure (Indirect exposure only) Investment performance subject to smoothing through declared bonuses
Profi t and loss and shareholders’ equity are volatile for these risks as they affect the values of derivatives and embedded derivatives and impairment losses. In addition, shareholders’ equity is volatile for the incidence of these risks on unrealised appreciation of fi xed income securities classifi ed as available-for-sale under IAS 39
ii IFRS shareholder results – Exposures for market and other risk Key Group exposures
US For Jackson, at the level of operating profi t based on longer-term investment returns, the results are sensitive to market conditions to the extent of income earned on spread-based products and second order equity-based exposure in respect of variable annuity asset management fees. Further information is given below in note D3h(iv).
At the total IFRS profi t level the Asia result is affected by short-term value movements on the asset portfolio for non-linked shareholder-backed business.
Correlation across risk factors AAAAAAAAAAAAAAAAA Longevity risk AAAAAAAAAAAAAAAAA Expenses AAAAAAAAAAAAAAAAA Persistency AAAAAAAAAAAAAAAAA Other risks
The effect of Group diversifi cation across the Group’s life businesses is to signifi cantly reduce the aggregate standalone volatility risk to IFRS operating profi t based on longer-term investment returns. The effect is almost wholly explained by the correlations across risk types, in particular longevity risk.
In the years 2008 to 2012, claims paid on the Group’s life assurance contracts, including those classifi ed as investment contracts under IFRS 4, ranged from £17 billion to £21 billion. Indicatively, it is to be expected that, of the Group’s policyholder liabilities (excluding unallocated surplus) at 31 December 2012 of £260.8 billion, the amounts likely to be paid in 2013 will be of a similar magnitude.
£97 billion of the £150 billion of investments are held by SAIF and the PAC WPSF. Shareholders are exposed only indirectly to value movements on these assets.
Intangible assets attributable to with-profi ts funds: In respect of acquired subsidiaries for venture fund and other investment purposes – 178 – – – 178 178 Deferred acquisition costs – 6 – – – 6 6
Properties held for sale – 98 – – – 98 – Cash and cash equivalents 120 1,077 889 552 1,441 2,638 2,965
Equity and liabilities Equity Shareholders’ equity – – – 3,033 3,033 3,033 2,581 Non-controlling interests – 1 – – – 1 33
Borrowings attributable to with-profi ts funds 17 1,016 – – – 1,033 972 Deferred tax liabilities 39 663 – 483 483 1,185 1,349 Other non-insurance liabilities 299 4,200 911 3,298 4,209 8,708 9,464
Charges Participating Sub-fund which comprises 3.3 per cent of the total assets of the WPSF and includes the with-profi ts annuity business transferred to Prudential from the Equitable Life Assurance Society on 1 December 2007 (with assets of approximately £1.7 billion). Profi ts to shareholders on this with-profi ts annuity business emerge on a ‘charges less expenses’ basis and policyholders are entitled to 100 per cent of the investment earnings.
(v) Loans The loans of the Group’s UK insurance operations comprise: SAIF and PAC WPSF: Mortgage loans* 1,311 1,036 Policy loans 16 20 Other loans† 782 917
Policyholder liabilities 81,586 21,671 22,273 125,530 Unallocated surplus of with-profi ts funds 10,187 – – 10,187 Premiums 3,413 1,854 1,721 6,988 Surrenders (2,285) (1,851) (119) (4,255)
Comprising: Policyholder liabilities 80,976 21,281 24,767 127,024 Unallocated surplus of with-profi ts funds 9,165 – – 9,165 Premiums 4,539 1,775 2,026 8,340 Surrenders (2,200) (2,378) (207) (4,785)
Shareholders’ transfers post tax (205) – – (205) Switches (236) 236 – – Investment-related items and other movementsnote (b) 8,656 1,941 2,409 13,006 Foreign exchange translation differences (98) – – (98)
Comprising: Policyholder liabilities 84,407 22,197 27,308 133,912 Unallocated surplus of with-profi ts funds 10,526 – – 10,526 Average policyholder liability balances*
(b) Investment-related items and other movements of £13,006 million across fund types refl ected the continued strong performance of UK equity markets in 2012, as well as investment gains from debt securities following falling bond yields, and other asset classes.
201Notes on the Group fi nancial statements Prudential plc Annual Report 2012 F
The majority of unrated debt security investments were held in SAIF and the PAC with-profi ts sub-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 £2,296 million PRIL and other annuity and long-term business investments which are not externally rated, £6 million were internally rated AAA, £429 million AA, £737 million A, £895 million BBB, £115 million BB and £114 million were internally rated B+ and below or unrated.
When target bonus levels change the PAC board of directors (PAC Board) has regard to the overall strength of the long-term fund when determining the length of time over which it will seek to achieve the amended prudent target bonus level.
A fi nal 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 fi nal 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 as explained below.
203Notes on the Group fi nancial statements Prudential plc Annual Report 2012 F
The application of the above method for determining bonuses requires the PAC Board to apply signifi cant judgement in many respects, including in particular the following: AAAAAAAAAAAAAAAAA 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 defi ned; AAAAAAAAAAAAAAAAA Smoothing of investment returns: This is an important feature of with-profi ts products. Determining when particular circumstances, such as a signifi cant 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 signifi cant judgement; and
As noted above, the overall rate of return on investments and the expectation of future investment returns are the most important infl uences 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-profi ts business as described above. As such, it is not possible to specifi cally quantify the effects of each of these assumptions, or of reasonably likely changes in these assumptions.
Prudential’s approach, in applying signifi cant judgement and discretion in relation to determining bonus rates, is consistent conceptually with the approach adopted by other fi rms that manage a with-profi ts business. It is also consistent with the requirements of UK law, which require all UK fi rms that carry out a with-profi ts business to defi ne, and make publicly available, the Principles and Practices of Financial Management (PPFM) that are applied in the management of their with-profi ts funds.
Accordingly, Prudential’s PPFM contains an explanation of how it determines regular and fi nal bonus rates within the discretionary framework that applies to all with-profi ts policies, subject to the general legislative requirements applicable. The purpose of Prudential’s PPFM is therefore to: AAAAAAAAAAAAAAAAA Explain the nature and extent of the discretion available; AAAAAAAAAAAAAAAAA Show how competing or confl icting 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 AAAAAAAAAAAAAAAAA Provide a knowledgeable observer (eg a fi nancial adviser) with an understanding of the material risks and rewards from starting and continuing to invest in a with-profi ts policy with Prudential.
AAAAAAAAAAAAAAAAA A With-Profi ts Committee of independent individuals, which assesses the degree of compliance with the PPFM and the manner in which confl icting rights have been addressed.
In determining bonus rates for the UK with-profi ts policies, smoothing is applied to the allocation of the overall earnings of the UK with-profi ts fund of which the investment return is a signifi cant element. The smoothing approach differs between accumulating and conventional with-profi ts policies to refl ect the different contract features. In normal circumstances, Prudential does not expect most payout values on policies of the same duration to change by more than 10 per cent up or down from one year to the next, although some larger changes may occur to balance payout values between different policies. Greater fl exibility may be required in certain circumstances, for example, following a signifi cant rise or fall in market values, and in such situations the PAC Board may decide to vary the standard bonus smoothing limits in order to protect the overall interests of policyholders.
The degree of smoothing is illustrated numerically by comparing in the following table the relatively ‘smoothed’ level of policyholder bonuses declared as part of the surplus for distribution, with the more volatile movement in investment return and other items of income and expenditure of the UK component of the PAC with-profi ts fund for each year presented.
Net income of the fund: Investment return 8,350 4,094 Claims incurred (6,857) (6,411) Movement in policyholder liabilities (3,989) (614) Add back policyholder bonuses for the year (as shown below) 1,865 1,945 Claims incurred and movement in policyholder liabilities
The fund is solely for the benefi t of policyholders of SAIF. Shareholders have no interest in the profi ts of this fund although they are entitled to asset management fees on this business.
205Notes on the Group fi nancial statements Prudential plc Annual Report 2012 F
e Process for setting assumptions and determining contract liabilities i Overview The calculation of the contract liabilities involves the setting of assumptions for future experience. This is done following detailed review of the relevant experience including in particular mortality, expenses, tax, economic assumptions and, where applicable, persistency.
Mortality assumptions are set based on the results of the most recent experience analysis looking at the experience over recent years of the relevant business. For non-profi t business, a margin for adverse deviation is added. Different assumptions are applied for different product groups. For annuitant mortality, assumptions for current mortality rates are based on recent experience investigations and expected future improvements in mortality. The expected future improvements are based on recent experience and projections of the business and industry experience generally.
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-profi t business a margin for adverse deviation is added to this amount. Expense infl ation assumptions are set consistent with the economic basis and based on the difference between yields on nominal gilts and index-linked gilts.
The contract liabilities for with-profi ts business also require assumptions for persistency. These are set based on the results of recent experience analysis.
For IFRS reporting, the results for UK shareholder-backed annuity business are particularly sensitive to the allowances made for credit risk. The allowance is refl ected in the deduction from the valuation rate of interest for discounting projected future annuity payments to policyholders that would have otherwise applied. Since mid-2007 there has been a signifi cant increase in the actual and perceived credit risk associated with corporate bonds as refl ected in the signifi cant widening that has occurred in corporate bond spreads. Although bond spreads over swap rates have narrowed from their peak in March 2009, they are still high compared with the levels seen in the years immediately preceding the start of the dislocated markets in 2007. The allowance that should therefore be made for credit risk remains a particular area of judgement.
PRIL at 31 December 2012 and 31 December 2011, based on the asset mix at the relevant balance sheet date are shown below.
Credit risk allowance Long-term expected defaultsnote (ii) 15 – 15 Additional provisionsnote (iii) 50 (23) 27
Credit risk allowance Long-term expected defaultsnote (ii) 15 – 15 Additional provisionsnote (iii) 51 (24) 27
Movement in the credit risk allowance for PRIL for the year ended 31 December 2012 The movement during 2012 of the average basis points allowance for PRIL on Pillar 1 regulatory and IFRS bases are as follows: Pillar 1 regulatory basis (bps)
Overall the movement has led to the credit allowance for Pillar 1 purposes to be 40 per cent (2011: 33 per cent) of the bond spread over swap rates. For IFRS purposes it represents 26 per cent (2011: 20 per cent) of the bond spread over swap rates.
The reserves for credit risk allowance at 31 December 2012 for the UK shareholder annuity fund were as follows: Pillar 1 regulatory basis £bn
In 2009, Prudential’s annuity business liabilities were determined using the Continuous Mortality Investigation (CMI) medium cohort projections with a fl oor. Since 2009, new mortality projection models have been released annually by the CMI. The CMI 2009 model was used to produce the 2010 and 2011 results, with calibration to refl ect an appropriate view of future mortality improvements. The CMI 2011 model was used to produce the 2012 results, again with calibration to refl ect an appropriate view of future mortality improvements.
AF92 minus 4 years 92% – 96% PCMA00 with future improvements in line with Prudential’s own calibration of the CMI 2011 mortality model, with a long-term improvement rate of 2.25%.
AM92 minus 4 years 84% – 97% PCFA00 with future improvements in line with Prudential’s own calibration of the CMI 2011 mortality model, with a long-term improvement rate of 1.50%.
AF92 minus 4 years 93% – 94% PCMA00 with future improvements in line with Prudential’s own calibration of the CMI 2009 mortality model, with a long-term improvement rate of 2.25%.
AF92 minus 4 years 94% – 95% PCMA00 with future improvements in line with Prudential’s own calibration of the CMI 2009 mortality model, with a long-term improvement rate of 2.25%.
AM92 minus 4 years 86% – 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%.
209Notes on the Group fi nancial statements Prudential plc Annual Report 2012 F
g Eff ect of changes in assumptions used to measure insurance assets and liabilities Credit risk
The investment assets of PAC with-profi ts funds are subject to market risk. Changes in their carrying value, net of related changes to asset-share liabilities of with-profi t contracts, affect the level of unallocated surplus of the fund. Therefore, the level of unallocated surplus is particularly sensitive to the level of investment returns on the portion of the assets that represents surplus. The effects for 2012 and 2011 are demonstrated in note D5. However, as unallocated surplus is accounted for as a liability under IFRS, movements in its value do not affect shareholders’ profi t and equity.
The shareholder results of the UK with-profi ts fund correspond to the shareholders’ share of the cost of bonuses declared on the with-profi ts business which is currently one-ninth of the cost of bonuses declared. Investment performance is a key driver of bonuses, and hence the shareholders’ share of the cost of bonuses. Due to the ‘smoothed’ basis of bonus declaration, the sensitivity to investment performance in a single year is low relative to movements in the period to period performance. However, over multiple periods, it is important.
In summary, profi ts from shareholder-backed annuity business are most sensitive to: AAAAAAAAAAAAAAAAA The extent to which the duration of the assets held closely matches the expected duration of the liabilities under the contracts; AAAAAAAAAAAAAAAAA Actual versus expected default rates on assets held; AAAAAAAAAAAAAAAAA The difference between long-term rates of return on corporate bonds and risk-free rates; AAAAAAAAAAAAAAAAA The variance between actual and expected mortality experience; AAAAAAAAAAAAAAAAA The extent to which changes to the assumed rate of improvements in mortality give rise to changes in the measurement of liabilities; and AAAAAAAAAAAAAAAAA Changes in renewal expense levels.
iii Unit-linked and other business Unit-linked and other business represents a comparatively small proportion of the in-force business of the UK insurance operations.
Due to the matching of policyholder liabilities to attaching asset value movements, the UK unit-linked business is not directly affected by market or credit risk liabilities of other business and are also broadly insensitive to market risk. Profi ts from unit-linked and similar contracts primarily arise from the excess of charges to policyholders for management of assets under the Company’s stewardship, over expenses incurred. The former is most sensitive to the net accretion of funds under management as a function of new business and lapse and timing of death. The accounting impact of the latter is dependent upon the amortisation of acquisition costs in line with the emergence of margins (for insurance contracts) and amortisation in line with service provision (for the investment management component of investment contracts). By virtue of the design features of most of the contracts which provide low levels of mortality cover, the profi ts are relatively insensitive to changes in mortality experience.
211Notes on the Group fi nancial statements Prudential plc Annual Report 2012 F
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.
Carrying value of debt securities and derivatives 9,006 3,993 (3,265) (5,983) 7,676 3,426 (2,820) (5,178)
Policyholder liabilities (7,878) (3,513) 2,867 5,235 (6,842) (3,060) 2,510 4,593 Related deferred tax effects (259) (110) 91 172 (208) (91) 77 146
Net sensitivity of profi t after tax and shareholders’ equity 869 370 (307) (576) 626 275 (233) (439)
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 fl ows to the policyholder, a fall in their value would have given rise to the following effects on pre-tax profi t, profi t after tax and shareholders’ equity.
Net sensitivity of profi t after tax and shareholders’ equity (243) (122) (239) (120)
Expected maturity: 0 to 5 years 45 39 42 30 26 27 35 28 31 36 5 to 10 years 24 25 24 24 22 22 25 23 24 24 10 to 15 years 13 17 15 18 17 18 17 17 17 16 15 to 20 years 8 11 10 12 13 13 10 12 11 11 20 to 25 years 5 6 5 8 9 9 6 9 8 7 over 25 years 5 2 4 8 13 11 7 11 9 6 2011 £m
(ii) Benefi t payments do not refl ect the pattern of bonuses and shareholder transfers in respect of the with-profi ts 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-profi ts investment bonds such as Prudence Bonds, an assumption is made as to likely duration based on prior experience.
(v) The maturity tables shown above have been prepared on a discounted basis. Details of undiscounted cash fl ow for investment contracts are shown in note G2.
Total unrealised valuation movements 862 811 Related change in amortisation of deferred acquisition costs (270) (275) Related tax (205) (187)
Included within the movements in shareholders’ equity is a net increase in value of Jackson’s debt securities classifi ed as ‘available-for-sale’ under IAS 39 of £862 million (2011: £811 million).
With the exception of debt securities for US insurance operations classifi ed as ‘available-for-sale’ under IAS 39, unrealised value movements on the Group’s investments are booked within the income statement. However, for debt securities classifi ed as ‘available-for-sale’, unless impaired, fair value movements are recognised in other comprehensive income. Realised gains and losses, including impairments, are recorded in the income statement. This classifi cation is applied for most of the debt securities of the Group’s US operations. In 2012, Jackson recorded £37 million (2011: £62 million) of impairment losses arising from: Residential mortgage-backed securities 8 21 Public fi xed income 2 – Other 27 41
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 fl ows, 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 fl ows 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 fl ow shortfall under management’s base case set of assumptions is so minor that relatively small and justifi able changes to the base case assumptions would eliminate the need for an impairment loss to be recognised. The impairment loss refl ects the difference between the fair value and book value.
Assets fair valued at or above book value Book value* 25,467 22,504 Unrealised gain (loss) 2,985 803 (121) 2,303
Total Book value* 30,018 24,959 Net unrealised gain (loss) 2,807 862 (112) 2,057
Included within the movement in gross unrealised losses for the debt securities of Jackson of £59 million (2011: £122 million) as shown above was a net decrease in value of £33 million (2011: £12 million increase) relating to the sub-prime and Alt-A securities as referred to in section B5.
215Notes on the Group fi nancial statements Prudential plc Annual Report 2012 F
Deferred tax assets – 1,889 1,889 1,392 Other non-investment and non-cash assetsnote (vi) – 6,792 6,792 1,542 Investments of long-term business and other operations: Investment properties – 24 24 35 Financial investments: Loansnote (ii) – 6,235 6,235 4,110 Equity securities and portfolio holdings in unit trustsnote (v) 49,298 253 49,551 38,036 Debt securities – 32,993 32,993 27,022 Other investmentsnote (iii) – 2,296 2,296 2,376 Deposits – 211 211 167
(iii) Other investments comprise: Derivative assets*G3 1,546 1,677 Partnerships in investment pools and other† 750 699 * In the US, Prudential uses derivatives: – To reduce interest rate risk; – To facilitate effi cient portfolio management to match liabilities under annuity policies; and – For certain equity-based product management activities.
(iv) Summary policyholder liabilities (net of reinsurance) and reserves at 31 December 2012 The policyholder liabilities, net of reinsurers’ share of £6,076 million (2011: £907 million), refl ect balances in respect of the following: Policy reserves and liabilities on non-linked business: Reserves for future policyholder benefi ts and claims payable 7,663 518 Deposits on investment contracts (as defi ned under IFRS ‘grandfathered’ US GAAP) 27,425 28,314 Guaranteed investment contracts 1,799 1,617
: L ife assu ran ce b u sin ess b Reconciliation of movement in policyholder liabilities A reconciliation of the total policyholder liabilities of US insurance operations from the beginning of the year to the end of the year is as follows: US insurance operations
US equity market during the year with the S&P index increasing by 13.4 per cent. Fixed annuity, GIC and other business investment and other movements primarily refl ects the interest credited to policyholder account in the year, net of falls in the technical provisions held for the guarantees issued with variable annuity business.
Residential mortgage-backed securities 2,400 2,591 Commercial mortgage-backed securities 2,639 2,169 Other debt securities 587 620
i Credit quality The following table summarises by rating the debt securities, as at 31 December 2012 and 2011 using Standard & Poor’s (S&P), Moody’s, Fitch and implicit ratings of mortgage-backed securities (MBS) based on NAIC* valuations.
S&P – AAA 187 133 S&P – AA+ to AA- 6,343 4,476 S&P – A+ to A- 7,728 6,382 S&P – BBB+ to BBB- 10,230 8,446 S&P – Other 1,173 999
Moody’s – Aaa 55 62 Moody’s – Aa1 to Aa3 18 15 Moody’s – A1 to A3 21 29 Moody’s – Baa1 to Baa3 56 67 Moody’s – Other 13 17
: L ife assu ran ce b u sin ess 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 classifi cation 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 classifi es these fair values into a three level hierarchy as required by IFRS 7. At 31 December 2012, 0.1 per cent of Jackson’s debt securities were classifi ed as level 3 (31 December 2011: 0.1 per cent) comprising of fair values where there are signifi cant inputs which are not based on observable market data.
Jackson defi nes its exposure to sub-prime mortgages as investments in residential mortgage-backed securities in which the underlying borrowers have a US Fair Isaac Credit Organisation (FICO) credit score of 680 or lower.
D3: US insurance operations continued d Products and guarantees Jackson provides long-term savings and retirement products to retail and institutional customers throughout the US. Jackson offers fi xed annuities (interest-sensitive, fi xed indexed and immediate annuities), variable annuities (VA), life insurance and institutional products.
At 31 December 2012, interest-sensitive fi xed annuities accounted for 13 per cent (2011: 16 per cent) of policy and contract liabilities of Jackson. Interest-sensitive fi xed annuities are primarily deferred annuity products that are used for asset accumulation in retirement planning and for providing income in retirement. They permit tax-deferred accumulation of funds and fl exible payout options.
Approximately 50 per cent (2011: 48 per cent) of the interest-sensitive fi xed annuities Jackson wrote in 2012 provide for a market value adjustment that could be positive or negative, on surrenders in the surrender period of the policy. This formula-based adjustment approximates the change in value that assets supporting the product would realise as interest rates move up or down. The minimum guaranteed rate is not affected by this adjustment.
Jackson hedges the equity return risk on fi xed indexed products using futures and options linked to the relevant index as well as through offsetting equity exposure in the VA product. The cost of these hedges is taken into account in setting the index participation rates or caps. Jackson bears the investment and surrender risk on these products.
At 31 December 2012, immediate annuities accounted for 1 per cent (2011: 1 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 fi xed 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.
221Notes on the Group fi nancial statements Prudential plc Annual Report 2012 F
Jackson issues VA contracts where it contractually guarantees to the contractholder either a) return of no less than total deposits made to the contract adjusted for any partial withdrawals, b) total deposits made to the contract adjusted for any partial withdrawals plus a minimum return, or c) the highest contract value on a specifi ed anniversary date adjusted for any withdrawals following the contract anniversary. These guarantees include benefi ts that are payable in the event of death (guaranteed minimum death benefi t (GMDB)), annuitisation (guaranteed minimum income benefi t (GMIB)), or at specifi ed dates during the accumulation period (guaranteed minimum withdrawal benefi t (GMWB) and guaranteed minimum accumulation benefi t (GMAB)). Jackson hedges these risks using equity options and futures contracts as described in note D3(h). The GMAB was eliminated from Jackson’s product offerings in 2011. The GMIB is no longer offered, with existing coverage being reinsured.
In March 2012, Jackson launched a new variable annuity product, Elite Access, which has no guaranteed benefi ts and provides tax effi cient access to alternative investments. Single premium sales in the period since launch were £849 million.
At 31 December 2012, Jackson (including the newly acquired REALIC) had interest sensitive life business in force with total account value of £6.0 billion (US$9.7 billion) (2011: £3.3 billion (US$5.1 billion)), with minimum guaranteed interest rates ranging from 2.5 per cent to 6.0 per cent with a 4.67 per cent average guaranteed rate (2011: 3.0 per cent to 6.0 per cent with a 4.88 per cent average guaranteed rate). The table below shows the distribution of the interest-sensitive life business’ account values within this range of minimum guaranteed interest rates as at 31 December 2012 and 2011: Account value
Medium-term note funding agreements are generally issued to support trust instruments issued on non-US exchanges or to qualifi ed investors (as defi ned by SEC Rule 144A). Through the funding agreements, Jackson agrees to pay a rate of interest, which may be fi xed or fl oating, to the holders of the trust instruments.
Capitalised acquisition costs and deferred income for these contracts are amortised over the life of the book of contracts. The present value of the estimated gross profi ts is generally computed using the rate of interest that accrues to policyholder balances (sometimes referred to as the contract rate). Estimated gross profi ts include estimates of the following elements, each of which will be determined based on the best estimate of amounts of the following individual elements over the life of the book of contracts without provision for adverse deviation for: AAAAAAAAAAAAAAAA Amounts expected to be assessed for mortality less benefi t claims in excess of related policyholder balances; AAAAAAAAAAAAAAAA Amounts expected to be assessed for contract administration less costs incurred for contract administration; AAAAAAAAAAAAAAAA Amounts expected to be earned from the investment of policyholder balances less interest credited to policyholder balances; AAAAAAAAAAAAAAAA Amounts expected to be assessed against policyholder balances upon termination of contracts (sometimes referred to as surrender charges); and AAAAAAAAAAAAAAAA Other expected assessments and credits.
VA contracts written by Jackson may, as described above, provide for GMDB, GMIB, GMWB and GMAB features. In general terms, liabilities for these benefi ts are accounted for under US GAAP by using estimates of future benefi ts and fees under best estimate persistency assumptions.
The assumptions used for calculating the direct GMIB liability at 31 December 2012 and 2011, are consistent with those used for calculating the GMDB and ‘for life’ GMWB liabilities. The change in these reserves, along with claim payments and associated fees included in reserves, are included along with the hedge results in short-term fl uctuations, resulting in removal of the market impact from the operating profi t based on longer-term investment returns.
GMWB ‘not for life’ features are considered to be embedded derivatives under IAS 39. Therefore, provisions for these benefi ts are recognised at fair value, with the change in fair value included in short-term fl uctuations.
Institutional products are accounted for as investment contracts under IFRS with the liability classifi ed as being in respect of fi nancial instruments rather than insurance contracts, as defi ned by IFRS 4. In practice, there is no material difference between the IFRS and US GAAP basis of recognition and measurement for these contracts.
For variable annuity products, under US GAAP (as ‘grandfathered’ under IFRS 4) the projected gross profi ts, against which acquisition costs are amortised, refl ect an assumed long-term level of equity return 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.
The amortisation charge to the income statement is refl ected in operating profi t and short-term fl uctuations in investment returns. The amortisation charge to the operating profi t in a reporting period comprises: (i) A core amount that refl ects a relatively stable proportion of underlying profi t; and (ii) An element of acceleration or deceleration arising from market movements differing from expectations.
In periods where the cap and fl oor feature of the mean reversion technique are not relevant, the technique operates to dampen the second element above. Nevertheless, extreme market movements can cause material acceleration or deceleration of amortisation in spite of this dampening effect.
g Eff ect of changes in assumptions used to measure insurance assets and liabilities In 2012 and 2011, there were no changes of assumptions that had a material impact on the results of US insurance operations.
h Exposure and sensitivity of IFRS basis profi t and shareholders’ equity to market and other risks Jackson’s main exposures are to market risk through its exposure to interest rate risk and equity risk. Approximately 94 per cent (2011: 92 per cent) of its general account investments support interest-sensitive and fi xed indexed annuities, life business and surplus and 6 per cent (2011: 8 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 fi xed income or fi xed maturity. Jackson is exposed primarily to the following risks in the US arising from fl uctuations in interest rates: AAAAAAAAAAAAAAAAAAA The risk of loss related to meeting guaranteed rates of accumulation following a sharp and sustained fall in interest rates; AAAAAAAAAAAAAAAAAAA The risk of loss related to policyholder withdrawals following a sharp and sustained increase in interest rates; and AAAAAAAAAAAAAAAAAAA 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: AAAAAAAAAAAAAAAAAAA The risk of loss related to the incidence of benefi ts related to guarantees issued in connection with its VA contracts; and AAAAAAAAAAAAAAAAAAA The risk of loss related to meeting contractual accumulation requirements in FIA contracts.
Jackson enters into fi nancial 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 fl ows or quantity of, or a degree of exposure with respect to assets, liabilities or future cash fl ows, 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, fi xed indexed annuities, certain GMWB variable annuity features and reinsured GMIB variable annuity features, contain embedded derivatives as defi ned by IAS 39, ‘Financial Instruments: Recognition and Measurement’. Jackson does not account for such derivatives as either fair value or cash fl ow hedges as might be permitted if the specifi c hedge documentation requirements of IAS 39 were followed. Financial derivatives, including derivatives embedded in certain host liabilities that have been separated for accounting and fi nancial reporting purposes, are carried at fair value.
Value movements on the derivatives are reported within the income statement. In preparing Jackson’s segment profi t as shown in note B1, value movements on Jackson’s derivative contracts, are included within short-term fl uctuations in investment returns and excluded from operating results based on longer-term investment returns. The types of derivatives used by Jackson and their purpose are as follows: AAAAAAAAAAAAAAAAAAA Interest rate swaps generally involve the exchange of fi xed and fl oating payments over the period for which Jackson holds the instrument without an exchange of the underlying principal amount. These agreements are used for hedging purposes; AAAAAAAAAAAAAAAAAAA Put-swaption contracts provide the purchaser with the right, but not the obligation, to require the writer to pay the present value of a long-duration interest rate swap at future exercise dates. Jackson purchases and writes put-swaptions with maturities up to 10 years. Put-swaptions hedge against signifi cant movements in interest rates; AAAAAAAAAAAAAAAAAAA Equity index futures contracts and equity index options (including various call, put options and put spreads) are used to hedge Jackson’s obligations associated with its issuance of fi xed indexed immediate and deferred annuities and certain VA guarantees. These annuities and guarantees contain embedded options which are fair valued for fi nancial reporting purposes; AAAAAAAAAAAAAAAAAAA Total return swaps in which Jackson receives equity returns or returns based on reference pools of assets in exchange for short-term fl oating rate payments based on notional amounts, are held for both hedging and investment purposes; AAAAAAAAAAAAAAAAAAA Cross-currency swaps, which embody spot and forward currency swaps and additionally, in some cases, interest rate swaps and equity index swaps, are entered into for the purpose of hedging Jackson’s foreign currency denominated funding agreements supporting trust instrument obligations; and
The estimated sensitivity of Jackson’s profi t and shareholders’ equity to equity and interest rate risks provided below is net of the related changes in amortisation of DAC. The effect on the related changes in amortisation of DAC provided is based on the current ‘grandfathered’ US GAAP DAC basis but does not include any effect from an acceleration or deceleration of amortisation of DAC. Note A5 provides explanation of the new US GAAP DAC basis adopted by the Company from 1 January 2012. Note D3(e) above provides an explanation of the dynamics that affect the amortisation charge.
At 31 December 2012 and 2011, Jackson had variable annuity contracts with guarantees, for which the net amount at risk (NAR) is generally the amount of guaranteed benefi t in excess of current account value, as follows: Minimum return
GMWB – Highest anniversary only 1,880 245 GMWB* 697 137* Combination net deposits plus minimum return, highest specifi ed anniversary account value minus withdrawals post-anniversary
GMAB – Premium only 0% 54 2 Highest specifi ed anniversary account value minus withdrawals post-anniversary
Account balances of contracts with guarantees were invested in variable separate accounts as follows: Mutual fund type: Equity 38,092 28,902 Bond 5,673 4,251 Balanced 4,601 3,846 Money market 766 677
The above table provides sensitivity movements as at a point in time, while the actual impact on fi nancial results would vary contingent upon the volume of new product sales and lapses, changes to the derivative portfolio, correlation of market returns and various other factors including volatility, interest rates and elapsed time.
A range of reasonably possible movements in the value of equity securities, partnerships in investment pools and other fi nancial derivatives have been applied to Jackson’s holdings at 31 December 2012 and 2011. The table below shows the sensitivity to a 10 per cent and 20 per cent fall in value, and the impact that this would have on pre-tax profi t, net of related changes in amortisation of DAC, profi t after tax and shareholders’ equity.
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.
ii Sensitivity to interest rate risk Notwithstanding the market risk exposure previously described, except in the circumstances of interest rate scenarios where the guarantee rates included in contract terms are higher than crediting rates that can be supported from assets held to cover liabilities, the accounting measurement of fi xed annuity liabilities of Jackson products is not generally sensitive to interest rate risk. This position derives from the nature of the products and the US GAAP basis of measurement. The GMWB features attaching to variable annuity business (other than ‘for-life’) are accounted for as embedded derivatives which are fair valued and so will be sensitive to changes in interest rate.
Policyholder liabilities (2,021) (871) 610 970 (925) (446) 395 753 Related effect on amortisation of DAC 309 93 (39) (14) (132) (61) 33 46
Related effect on amortisation of DAC (1,332) (748) 748 1,332 (954) (539) 539 954 Related effect on movement in deferred
229Notes on the Group fi nancial statements Prudential plc Annual Report 2012 F
Note Sensitivity on profi t before tax ie aggregate of the operating profi t based on longer-term investment returns and short-term fl uctuations in investment returns.
In addition, the total profi t 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 benefi t payments and equity index participation features, offset by variability of benefi t related fees and equity derivative hedging performance, short-term value movements on derivatives held to manage the fi xed annuity and other general account business, and other temporary value movements on portfolio investments classifi ed as fair value through profi t and loss.
As with other shareholder-backed business the profi t or loss for Jackson is presented by distinguishing the result for the year between an operating result based on longer-term investment returns and short-term fl uctuations in investment returns. In this way, the most signifi cant direct effect of market changes that have taken place to the Jackson result are separately identifi ed. The principal determinants of variations in operating profi t based on longer-term returns are: AAAAAAAAAAAAAAAAA Growth in the size of assets under management covering the liabilities for the contracts in force; AAAAAAAAAAAAAAAAA Variations in fees and other income, offset by variations in market value adjustment payments and, where necessary, strengthening of liabilities; AAAAAAAAAAAAAAAAA Spread returns for the difference between investment returns and rates credited to policyholders; and AAAAAAAAAAAAAAAAA Amortisation of deferred acquisition costs.
For variable annuity business, the key assumption is the expected long-term level of separate account returns, which for 2012 and 2011 was 8.4 per cent. The impact of using this return is refl ected in two principal ways, namely: AAAAAAAAAAAAAAAAA Through the projected expected gross profi ts 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(e) above; and
AAAAAAAAAAAAAAAAA The required level of provision for guaranteed minimum death benefi t claims.
D3: US insurance operations continued i Duration of liabilities The table below shows the carrying value of policyholder liabilities. The table below also shows the maturity profi le of the cash fl ows for 2012 and 2011: Fixed annuity and other business (including
Expected maturity: 0 to 5 years 45 46 46 47 47 47 5 to 10 years 27 31 29 27 30 29 10 to 15 years 12 13 13 11 13 12 15 to 20 years 7 6 6 6 6 6 20 to 25 years 5 2 3 5 2 3 Over 25 years 4 2 3 4 2 3
The maturity tables shown above have been prepared on a discounted basis. Details of undiscounted cash fl ows for investment contracts are shown in note G2.
231Notes on the Group fi nancial statements Prudential plc Annual Report 2012 F
Intangible assets attributable to with-profi ts funds: Deferred acquisition costs and other intangible assets 72 – – 72 83
Deferred tax liabilities 384 46 158 588 506 Other non-insurance liabilities 3,009 776 1,424 5,209 3,097 * The 2011 comparative results have been adjusted from those previously published for the retrospective application of the change in accounting policy described in note A5.
Notes (i) The statement of fi nancial position for with-profi ts business comprises the with-profi ts assets and liabilities of the Hong Kong, Malaysia and Singapore with-profi ts 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-profi ts within the statement of fi nancial position, the Hong Kong branch balance is reported within the unallocated surplus of the PAC with-profi ts sub-fund of the UK insurance operations.
(iii) Asia insurance operations The loans of the Group’s Asia insurance operations comprise: Mortgage loans* 43 31 Policy loans* 610 572 Other loans† 361 630
Total Asia insurance operations loans 1,014 1,233 * The mortgage and policy loans are secured by properties and life insurance policies respectively. † The majority of the other loans are commercial loans held by the Malaysia operation and which are all investment graded by two local rating agencies.
: L ife assu ran ce b u sin ess b Reconciliation of movement in policyholder liabilities and unallocated surplus of with-profi ts funds A reconciliation of the total policyholder liabilities and unallocated surplus of with-profi ts funds of Asia insurance operations from the beginning of the year to the end of the year is as follows: With-profi ts business £m
Premiums: New business 162 1,136 723 2,021 In-force 1,110 1,163 785 3,058
Comprising: Policyholder liabilities 12,593 12,015 6,254 30,862 Unallocated surplus of with-profi ts funds 50 – – 50
Premiums: New business 216 1,336 636 2,188 In-force 1,263 1,292 877 3,432
* Averages have been based on opening and closing balances and exclude unallocated surplus of with-profi ts funds.
Excluding India where the market has been going through a signifi cant period of change following regulatory changes in 2010, the surrender rate in 2012 was at 9.7 per cent (2011: 9.6 per cent). For with-profi ts business, surrenders have increased from £502 million in 2011 to £608 million in 2012, primarily as a result of certain products in Hong Kong reaching their fi ve year anniversary, the point at which some product features trigger.
(d) Positive investment-related items and other movements of £2,178 million in 2012 primarily refl ects improvements in the Asia equity market.
Moody’s – Aaa 700 215 474 1,389 1,489 Moody’s – Aa1 to Aa3 139 34 98 271 128 Moody’s – A1 to A3 93 14 62 169 304 Moody’s – Baa1 to Baa3 196 122 57 375 131 Moody’s – Other 98 12 2 112 59
The following table analyses debt securities of ‘Other business’ which are not externally rated: Government bonds 287 244 Corporate bonds rated as investment grade by local external ratings agencies 1,069 776 Other 123 45 d Products and guarantees The life insurance products offered by the Group’s Asia operations include a range of with-profi ts and non-participating term, whole life, endowment and unit-linked policies. The Asia operations also offer health, disability, critical illness and accident coverage to supplement its core life products.
Non-participating long-term products are the only ones where the Group is contractually obliged to provide guarantees on all benefi ts. Unit-linked products have the lowest level of guarantee.
Product guarantees in Asia can be broadly classifi ed into four main categories, namely premium rate, cash value and interest rate guarantees, policy renewability and convertibility options.
The risks on death coverage through premium rate guarantees are low due to appropriate product pricing.
235Notes on the Group fi nancial statements Prudential plc Annual Report 2012 F
Cash value and interest rate guarantees are of three types: AAAAAAAAAAAAAAAAAAA Maturity values Maturity values are guaranteed for non-participating products and on the guaranteed portion of participating products. Declared annual bonuses are also guaranteed once vested. Future bonus rates and cash dividends are not guaranteed on participating products; AAAAAAAAAAAAAAAAAAA Surrender values Surrender values are guaranteed for non-participating products and on the guaranteed portion of participating products. The surrender value of declared reversionary bonuses are also guaranteed once vested. Market value adjustments and surrender penalties are used where the law permits such adjustments in cash values; and
AAAAAAAAAAAAAAAAAAA Interest rate guarantees It is common in Asia for regulations or market-driven demand and competition to provide some form of capital value protection and minimum crediting interest rate guarantees. This would be refl ected within the guaranteed maturity and surrender values.
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 signifi cantly increased leaving the potential for losses if bond values had depreciated signifi cantly. However, the business is matched to a relatively short realistic liability duration.
e Process for setting assumptions and determining liabilities The future policyholder benefi t provisions for Asia 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.
g Eff ect of changes in bases, estimates and assumptions used to measure insurance assets and liabilities In 2012, the IFRS operating profi t based on longer-term investment returns for Asia insurance operations included a net £48 million credit (2011: £38 million) representing a small number of non-recurring items that are not anticipated to re-occur in subsequent periods.
Separately, the IFRS policyholder liabilities of the shareholder-backed non-linked business of the Group’s Hong Kong operation are measured on a prospective net premium valuation approach with zero allowance for lapses. In 2012, the basis of determining the valuation rate of interest has been altered to align with a permitted practice of the Hong Kong authorities for regulatory reporting. The main change is to apply a valuation rate of interest that incorporates a reinvestment yield that is weighted by reference to current and the historical three year average, rather than the year end rate. The change reduced the carrying value of policyholder liabilities at 31 December 2012 by £95 million. This benefi t is included within the short-term fl uctuations in investment returns in the Group’s supplementary analysis of profi t.
In Asia, adverse persistency experience can impact the IFRS profi tability of certain business written in the region. This risk is managed at a business unit level through regular 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 fi nancial impact of lapses is often mitigated through the specifi c features of the products, eg surrender charges.
(i) Sensitivity of profi t and shareholders’ equity to risks other than currency translation risk With-profi ts business
For the sensitivity analysis as at 31 December 2011, as shown in the table below, for the majority of the territories, a movement of 1 per cent in the 10-year government bond rate has been used. Exceptions to this approach are for Japan and Taiwan, where a movement of 0.5 per cent has been used. Following falls in interest rates in many of the territories during 2012, the approach was altered such that the reasonably possible interest rate movement used is 1 per cent for all territories but subject to a fl oor of zero where the bond rates are currently below 1 per cent. This revised approach was applied in estimating the sensitivity at 31 December 2012.
The estimated sensitivity to the decrease and increase in interest rates at 31 December 2012 and 2011 is as follows: Decrease of 1%
Net effect on profi t and shareholders’ equity 160 (216) 51 (125)
* Except for Japan and Taiwan using 0.5 per cent sensitivity.
The degree of sensitivity of the results of the non-linked shareholder-backed business of the Asia operations to movements in interest rates depends upon the degree to which the liabilities under the ‘grandfathered’ IFRS 4 measurement basis refl ects market interest rates from period to period. For example, for those countries, such as those applying US GAAP, the results can be more sensitive as the effect of interest rate movements on the backing investments may not be offset by liability movements.
237Notes on the Group fi nancial statements Prudential plc Annual Report 2012 F
A 10 per cent or 20 per cent increase in their value would have an approximately equal and opposite effect on profi t and shareholders’ equity to the sensitivities shown above. The market risk sensitivities shown above refl ect the impact of temporary market movements and therefore, the primary effect of such movements would, in the Group’s segmental analysis of profi ts, be included within the short-term fl uctuations in investment returns.
(ii) Sensitivity of IFRS basis profi t and shareholders’ equity to currency translation risk Consistent with the Group’s accounting policies, the profi ts of the Asia insurance operations are translated at average exchange rates and shareholders’ equity at the closing rate for the reporting period. For 2012, the rates for the most signifi cant operations are given in note B4.
Profi t before tax attributable to shareholders note (90) (57) 110 70 Profi t for the year (75) (46) 92 56 Shareholders’ equity, excluding goodwill, attributable to Asia operations (243) (228) 297 278
Note Sensitivity on profi t (loss) before tax ie aggregate of the operating profi t based on longer-term investment returns and short-term fl uctuations in investment returns.
i Duration of liabilities The table below shows the carrying value of policyholder liabilities. The table below also shows the maturity profi le of the cash fl ows, taking account of expected future premiums and investment returns for 2012 and 2011: Expected maturity: 0 to 5 years 23 22 5 to 10 years 19 19 10 to 15 years 17 15 15 to 20 years 13 13 20 to 25 years 9 10 Over 25 years 19 21
Group shareholders’ equity Held outside long-term funds: Total – – – 920 4,343 2,529 7,792 1,546 (1,066) 8,272 Held in long-term fundsnote (iii) – – – 2,087 – – 2,087 – – 2,087
Unallocated surplus of with-profi ts funds note (v) – 10,526 10,526 – – 63 10,589
Jackson surplus notes note (iv) – – – – 153 – 153 Investment and policyholder liabilities valuation differences between IFRS and regulatory basis for Jackson note (vii) – – – – 696 – 696
Valuation difference on PAL between IFRS basis and regulatory basis – (215) (215) – – – (215)
Other adjustments to restate these amounts to a regulatory basis (with SAIF and the WPSF on a Peak 2 realistic basis)note (v) – (729) (729) (534) 906 (78) (435)
Total available capital resources of life assurance businesses on local regulatory bases – 7,000 7,000 2,370 2,899 1,621 13,890
: L ife assu ran ce b u sin ess 2012 £m
Shareholders’ share of realistic liabilities – (2,394) (2,394) – – – (2,394)
Deferred acquisition costs of non-participating business not recognised for regulatory reporting purposes and goodwill – (6) (6) (111) (3,095) (929) (4,141)
Adjustment from IAS 19 basis pension defi cit attributable to WPSF to pension liability for regulatory purposes – 16 16 – – – 16
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) 699 66 259
241Notes on the Group fi nancial statements Prudential plc Annual Report 2012 F
Other liabilities: Insurance contracts: With-profi ts liabilities of non-UK regulated funds – – – – – 5,419 5,419 Unit-linked, including variable annuitynote (viii) 26 26 6,387 37,833 12,015 56,261 Other life assurance business 209 13,365 13,574 24,734 29,445 6,142 73,895
(iv) For regulatory purposes the Jackson surplus notes are accounted for as capital. (v) Other adjustments to shareholders’ equity and unallocated surplus include amounts for the value of non-participating business for UK regulated with-profi ts funds, deferred tax, admissibility and other items measured diff erently on the regulatory basis. For Jackson, the principal reconciling item is deferred tax related to the diff erences between IFRS and regulatory basis, as shown in the table above, and other methodology diff erences.
(vi) Insurance business accounted for as fi nancial instruments under IAS 39. (vii) The investment and policyholder liabilities valuation diff erence 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 diff erence on annuity reserves. (viii) The allocation between the with-profi ts liabilities and unit-linked liabilities within the WPSF column have been adjusted for those previously published to align with the basis of presentation applied in 2012.
D5: Capital position statement for life assurance businesses continued b Basis of preparation, capital requirements and management Each of the Group’s long-term business operations is capitalised to a suffi ciently strong level for its individual circumstances. Details by the Group’s major operations are shown below.
i UK insurance operations The FSA rules which govern the Prudential regulation of insurance form part of the Prudential Sourcebook for Insurers, the General Prudential Sourcebook and Interim Prudential Sourcebook for Insurers. Overall, the net requirements of the General Prudential Sourcebook are intended to align the capital adequacy requirements for insurance business more closely with those of banking and investment fi rms and building societies, for example, by addressing tiers of capital, rather than looking at net admissible assets. An insurer must hold capital resources equal at least to the Minimum Capital Requirement (MCR).
The Prudential Sourcebook for Insurers also contains rules on Individual Capital Assessments. Under these rules, and the rules of the General Prudential Sourcebook, all insurers must assess for themselves the amount of capital needed to back their business. If the FSA views the results of this assessment as insuffi cient, it may draw up its own Individual Capital Guidance for a fi rm, which can be superimposed as a requirement.
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 suffi cient assets to absorb a one in 200 year event. The RCM calculation achieves this by setting rules for the determination of margins to cover defi ned stress changes in asset values and yields for market risk, credit risk and termination risk for with-profi ts policies.
PAC has discretion in its management actions in the case of adverse investment conditions. Management actions encompass, but are not confi ned to, investment allocation decisions, levels of reversionary bonuses, crediting rates and total claim values.
The capital resources requirement for these companies broadly refl ects a formula which, for active funds, equates to a percentage of regulatory reserves plus a percentage of death strains. Death strains represent the payments made to policyholders upon death in excess of amounts explicitly allocated to fund the provisions for policyholder’s claims and maturities.
243Notes on the Group fi nancial statements Prudential plc Annual Report 2012 F
: L ife assu ran ce b u sin ess 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.
Michigan insurance law specifi cally allows value of business acquired (VOBA) as an admitted asset as long as certain criteria are met. US NAIC standards limit the admitted amount of goodwill/VOBA generally to 10 per cent of capital and surplus. At 31 December 2012, Jackson reported £289 million of statutory basis VOBA as a result of the REALIC acquisition, which is fully admissible under Michigan insurance law.
iii Asia operations The available capital shown above of £1,621 million (2011: £1,493 million) represents the excess of local regulatory basis assets over liabilities before deduction of required capital of £661 million (2011: £608 million). These amounts have been determined applying the local regulations in each of the operations.
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 fi nancial 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 signifi cant impact on the Group’s Indonesia business; Japan
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. The adjusted solvency capital assets of the Company must exceed 200 per cent of the risk related capital requirement value at risk. A number of changes to the risk-based capital rules in Japan were effective in April 2012, but the changes did not have a signifi cant impact on the Group’s Japan business;
Policy reserves for traditional business are determined on net premium reserve basis using pricing mortality and prescribed standard interest rates.
A risk-based capital framework applies in Korea. Under this 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.
c Movements in total available capital Total available capital for the Group’s life assurance operations has changed as follows: 2012 £m
245Notes on the Group fi nancial statements Prudential plc Annual Report 2012 F
Available capital at 31 December 2010 6,800 1,707 2,907 1,378 12,792 Changes in assumptions (60) 38 – (32) (54) Changes in management policy (15) – – – (15) Changes in regulatory requirements – – – 17 17 New business and other factorsnote (v) (586) 192 (380) 130 (644)
The increase in 2012 of £861 million refl ects primarily the positive impact of investment returns earned on the opening available capital. The decrease in 2011 of £661 million refl ects primarily the negative eff ect of the lower interest rate used to value projected policyholder benefi t payments, partially off set by the positive impact of investment returns earned on the opening available capital. (ii) Jackson
The increase of £372 million in 2012 refl ects an underlying increase of £483 million (applying the 2012 year end exchange rate of US$1.63:£1.00) and £111 million of exchange translation loss.
The decrease of £380 million in 2011 refl ects an underlying decrease of £402 million (applying the 2011 year end exchange rate of US$1.55:£1.00) and £22 million of exchange translation gains.
(iii) Other UK life assurance subsidiaries and funds The eff ect from the changes in assumptions of valuation interest rates on insurance liabilities is broadly matched by the corresponding eff ect on assets leaving no signifi cant impact on the available capital.
(iv) Asia life assurance subsidiaries The increase of £128 million in 2012 refl ects an underlying increase of £177 million (applying the relevant 2012 year end exchange rates) and £49 million of exchange translation loss.
(v) New business and other factors comprise the eff ect of changes in new business, valuation interest rate, investment return, foreign exchange and other factors.
Accordingly, the excess of assets over liabilities of the PAC long-term fund is retained within that company. The retention of the capital enables it to support with-profi ts and other business of the fund by, for example, providing the benefi ts associated with smoothing and guarantees. It also provides investment fl exibility for the fund’s assets by meeting the regulatory capital requirements that demonstrate solvency and by absorbing the costs of signifi cant events or fundamental changes in its long-term business without affecting the bonus and investment policies.
D5: Capital position statement for life assurance businesses continued e Sensitivity of liabilities and total capital to changed market conditions and capital management policies Prudential manages its assets, liabilities and capital locally, in accordance with local regulatory requirements and refl ecting the different types of liabilities Prudential has in each business. As a result of the diversity of products offered by Prudential, and the different regulatory requirements in which it operates, Prudential employs differing methods of asset/liability and capital management, depending on the business concerned.
For example, for businesses that are most sensitive to interest rate changes, such as immediate annuity business, Prudential uses cash fl ow analysis to create a portfolio of debt securities whose value changes in line with the value of liabilities when interest rates change. This type of analysis helps protect profi ts from changing interest rates. This type of analysis is used in the UK for annuity business and by Jackson for its interest-sensitive and fi xed indexed annuities and stable value products.
For businesses that are most sensitive to equity price changes, Prudential uses stochastic modelling and scenario testing to look at the future returns on its investments under different scenarios which best refl ect the large diversity in returns that equities can produce. This allows Prudential to devise an investment and with-profi ts policyholder bonus strategy that, on the model assumptions, allows it to optimise returns to its policyholders and shareholders over time, while maintaining appropriate fi nancial strength. Prudential uses this methodology extensively in connection with its UK with-profi ts business.
f Intragroup arrangements in respect of SAIF Should the assets of SAIF be inadequate to meet the guaranteed benefi t obligations of the policyholders of SAIF, the PAC long-term fund would be liable to cover any such defi ciency in the fi rst instance. The directors believe that the probability of either the PAC long-term fund or the Group’s shareholders’ funds having to contribute to SAIF is remote.
247Notes on the Group fi nancial statements Prudential plc Annual Report 2012 F
Asset management in the UK and Europe is undertaken through M&G which is made up of three distinct businesses being Retail, Institutional and Finance. M&G’s investment expertise covers all key asset classes, equities, fi xed interest and commercial real estate, and includes a number of specialist fi xed income and real estate strategies. M&G manages its own retail fund operations, funds for pensions, insurance companies and third-party entities.
Asset management in the US is undertaken through PPM America which manages assets for the Group’s UK, Asia and US affi liates plus also provides investment services to other affi liated and unaffi liated institutional clients including collateralised debt obligations (CDOs), private investment funds, institutional accounts and mutual funds. In addition, broker-dealer activities are undertaken in the US where trades in securities are carried out for both third-party customers and for its own account.
Eastspring Investments in Asia serves both the life companies in Asia by managing the life funds and funds underlying the investment linked products and third-party customers through mutual fund business. Asia offers mutual fund investment products in a number of countries within the region, allowing customers to participate in debt, equity and money market investments.
Revenue (excluding revenue of consolidated investment funds and NPH broker-dealer fees) 1,234 296 282 1,812 1,583
Revenue of consolidated investment fundsnote (i) (11) – – (11) 9 NPH broker-dealer feesnote (i) – 435 – 435 405
Charges (excluding charges of consolidated investment funds and NPH broker-dealer fees) (713) (257) (207) (1,177) (1,147)
Comprising: Operating profi t based on longer-term investment returns 371 39 75 485 461 Short-term fl uctuations in investment returnsnote (ii) 93 – – 93 (29) Shareholder’s share of actuarial gains and losses on defi ned benefi t pension schemes 15 – – 15 4 Gain on dilution of Group's holdings 42 – – 42 –
* For 2012, gross revenue includes the Group’s share of results from the associate PPM South Africa. In prior years, PPM South Africa was treated as a subsidiary and accounted for accordingly.
E1: Income statement for asset management operations continued b M&G operating profi t based on longer-term investment returns: 2012 £m 2011* £m
Underlying profi t before performance-related fees 298 262 Share of associate results 13 26 Performance-related fees 9 13
Total M&G operating profi t based on longer-term investment returns 371 357 * Following the divestment in the fi rst half of 2012 of M&G’s holding in PPM South Africa from 75 per cent to 49.99 per cent and its treatment from 2012 as an associate, M&G’s operating income and expense no longer include any element from PPM South Africa, with the share of associates’ results being presented in a separate line. The table above refl ects the retrospective application of this basis of presentation for the 2011 results. Total profi t remains the same.
Other non-investment and non-cash assets 901 174 83 1,158 1,129 Associate investments accounted for using the equity method 41 – – 41 – Financial investments: Loansnote (i) 1,199 – – 1,199 1,256 Equity securities and portfolio holdings in unit trusts 50 – 20 70 594 Debt securitiesnote (ii) 1,839 – 7 1,846 1,842 Other investments 38 6 – 44 78 Deposits 3 33 48 84 89
Group levelnote (iv) 2,084 – – 2,084 2,956 Net asset value attributable to external holders of consolidated unit trusts and similar funds 162 – – 162 678 Other non-insurance liabilitiesnote (v) 2,077 155 79 2,311 2,297
E2: Statement of fi nancial position for asset management operations continued
(ii) Debt securities Of the £1,846 million total debt securities at 31 December 2012 (2011: £1,842 million) for asset management operations, the following amounts were held by M&G.
(v) Other non-insurance liabilities consists primarily of intra-group balances, derivative liabilities and other creditors.
Certain asset management operations are subject to regulatory requirements. The movement in the year of the surplus regulatory capital position of these operations, combined with the movement in the IFRS basis shareholders’ funds for unregulated asset management operations, is as follows: Asset management operations
Regulatory and other surplus Beginning of year 156 129 127 412 432 Gains during the year 356 8 52 416 326 Movement in capital requirement (3) – 6 3 (14)
The movement in the year refl ects gains driven by profi ts generated during the year and also changes in regulatory requirements. Distributions consist of dividends paid up to the parent company.
251Notes on the Group fi nancial statements Prudential plc Annual Report 2012 F
: A sset m an agem en t (in clu d in g U
S b ro ker-d ealer) an d o th er o p eratio n s
A 10 per cent increase in the relevant exchange rates would have reduced reported profi t before tax attributable to shareholders and shareholders’ equity, excluding goodwill attributable to Eastspring Investments and US asset management operations, by £10 million (2011: £9 million) and £29 million (2011: £30 million) respectively.
The Group holds certain derivatives that are used to manage foreign currency movements and macroeconomic exposures. The fair value of these derivatives is sensitive to the combined effect of movements in exchange rates, interest rates and infl ation rates. The possible permutations cover a wide range of scenarios. For indicative purposes, a reasonably possible range of fair value movements could be plus or minus £17 million.
Earned premiums, net of reinsurance 6,885 14,467 8,052 – – – 29,404 – 29,404 Investment return note (ii) 14,495 6,193 3,112 251 6 8 24,065 (14) 24,051 Other income 213 (2) 153 972 725 274 2,335 (314) 2,021
Benefi ts and claims and movements in unallocated surplus of with-profi ts funds, net of reinsurance (18,957) (18,711) (8,285) – – – (45,953) – (45,953)
Finance costs: interest on core structural borrowings of shareholder-fi nanced operations – (13) – (16) – – (29) (251) (280)
Total charges, net of reinsurance (20,435) (19,803) (10,250) (702) (692) (207) (52,089) (199) (52,288)
Tax charge attributable to policyholders’ returns (300) – (78) – – – (378) – (378)
This is represented in the segmental analysis of profi t from continuing operations before tax attributable to shareholders in note B1 as follows: Year ended 31 December 2012 £m
Operating profi t based on longer-term investment returns 736 964 913 371 39 75 3,098 (565) 2,533
Gross premiums earned 5,678 12,650 7,378 – – – 25,706 – 25,706 Outward reinsurance premiums (131) (72) (226) – – – (429) (429)
Earned premiums, net of reinsurance 5,547 12,578 7,152 – – – 25,277 – 25,277 Investment return note (ii) 7,604 1,447 283 128 1 2 9,465 (105) 9,360 Other income 193 (62) 155 923 653 290 2,152 (283) 1,869
Finance costs: interest on core structural borrowings of shareholder-fi nanced operations – (13) – (15) – – (28) (258) (286)
Profi t (loss) before tax (being tax attributable to shareholders’ and policyholders’ returns) note (i) 832 484 663 332 24 80 2,415 (604) 1,811
This is represented in the segmental analysis of profi t from continuing operations before tax attributable to shareholders in note B1 as follows: Year ended 31 December 2011* £m
Operating profi t based on longer-term investment returns 723 651 704 357 24 80 2,539 (512) 2,027
Shareholders’ share of actuarial and other gains and losses on defi ned benefi t pension schemes 18 – – 4 – – 22 (1) 21
(iv) The increase in the credit for outwards reinsurers’ share of benefi ts and claims for Jackson from 2010 to 2011 arises from the fair value movements 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.
Long-term business premiums Insurance contract premiums 27,447 23,705 Investment contracts with discretionary participation feature premiums 2,243 1,861 Inwards reinsurance premiums 220 140 Less: reinsurance premiums ceded (506) (429)
Investment return Realised and unrealised gains and losses on securities at fair value through profi t and loss 15,338 866 Realised and unrealised losses and gains on derivatives at fair value through profi t and loss 75 86 Realised losses on available-for-sale securities, previously recognised in other comprehensive income 68 101 Realised losses on loans (51) (43) Interest notes (i),(ii) 6,600 6,440 Dividends 1,462 1,304 Other investment return 559 606
Fee income from investment contract business and asset management notes (iii),(iv) 2,021 1,869
Notes (i) The segmental analysis of interest income is as follows: Insurance operations: Asset management operations: Unallocated corporate (9) (16)
255Notes on the Group fi nancial statements Prudential plc Annual Report 2012 F
(iv) The following table provides additional segmental analysis of revenue from external customers: 2012 £m
Total revenue from external customers 8,395 15,113 7,917 – 31,425 2011 £m
Revenue from external customers of Asia, US and UK insurance operations shown above are net of outwards reinsurance premiums of £178 million, £193 million, and £135 million respectively (2011: £226 million, £72 million and £131 million respectively).
In Asia, revenue from external customers from no individual country exceeds 10 per cent of the Group total. The largest country is Hong Kong with a total revenue from external customers of £1,745 million (2011: Singapore £1,383 million).
Notes (i) Acquisition costs in 2012 comprise amounts related to insurance contracts of £(1,949) million (2011: £(1,679) million), and investment contracts and asset management contracts of £(220) million (2011: £(65) million). (ii) There were no fee expenses relating to fi nancial liabilities held at amortised cost included in acquisition costs in 2012 and 2011. (iii) The total depreciation and amortisation expense of £(731) million (2011: £(584) million) relates to amortisation of deferred acquisition costs of insurance contracts and asset management contracts. The segmental analysis of total depreciation and amortisation expense is as follows: 2012 £m 2011* £m
(iv) Interest expense, excluding interest on core structural borrowings of shareholder-fi nanced operations, amounted to £(140) million (2011: £(123) 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: Asset management operations: Total segment (115) (101)
in an cial statem en ts F: In co m e statem en t n o tes
Current tax expense: Deferred tax (charge) credit: * The 2011 comparative results have been adjusted from those previously published for the retrospective application of the change in the accounting policy described in note A5.
In the UK, life insurance companies are taxed on both their shareholders’ profi ts and on their policyholders’ investment returns on certain insurance and investment products. Tax on shareholders’ profi ts is calculated at the standard corporation tax rate, and tax on policyholders’ investment returns is calculated at the basic rate of income tax. Although both types of tax are included in the total tax charge in the Group’s consolidated income statement, they are presented separately in the income statement to provide the most relevant information about tax that the Group pays on its profi ts.
Tax (charge) credit to policyholders’ returns (488) 110 (378) 17 Tax charge attributable to shareholders (319) (294) (613) (409)
Deferred tax (charge)/credit (184) 350 * The 2011 comparative results have been adjusted from those previously published for the retrospective application of the change in accounting policy described in note A5.
in an cial statem en ts F: In co m e statem en t n o tes b Reconciliation of eff ective tax rate The total tax charge is attributable to shareholders and policyholders as summarised in the income statement.
i Summary of pre-tax profi t and tax (charge) The income statement includes the following items: 2012 £m 2011* £m
Reconciliation of tax charge on profi t attributable to shareholders for continuing operations: 2012 £m (except for tax rates)
Analysed into: Tax on operating profi t based on longer-term investment returns 142 272 126 42 582 Tax on non-operating profi t 16 (38) 35 18 31
Actual tax rate: Operating profi t based on longer-term investment returns 16% 28% 17% (53)% 23%
261Notes on the Group fi nancial statements Prudential plc Annual Report 2012 F
Tax at the expected tax rate 151 170 243 (45) 519 Effects of: Adjustment to tax charge in relation to prior years (7) – 33 (19) 7 Movements in provisions for open tax matters – – – (44) (44) Income not taxable or taxable at concessionary rates (36) – (1) – (37) Deductions not allowable for tax purposes 12 – – 4 16 Different local basis of tax on overseas profi ts – (37) – – (37) Impact of changes in local statutory tax rates – – (32) 1 (31) Deferred tax adjustments 7 – – – 7 Irrecoverable withholding taxes – – – 13 13 Other (3) (6) (14) 19 (4)
c Taxes paid In 2012 Prudential remitted £2.2 billion (2011: £1.6 billion) of tax to Revenue authorities, this includes £925 million (2011: £561 million) of corporation tax, £184 million of other taxes and £1,078 million collected on behalf of employees, customers and third parties.
The geographical split of taxes remitted by Prudential is as follows: Corporation taxes* v Other taxes†
Taxes collected‡ Total * In certain countries such as the UK, the corporation tax payments for the Group’s life insurance businesses are based on taxable profi ts which include policyholder investment returns on certain life insurance products.
The Group designates all fi nancial assets as at fair value, either through profi t and loss or on an available-for-sale, or as loans and receivables on an amortised cost basis, net of impairment basis. Financial liabilities are designated as either fair value through profi t and loss, amortised cost, or as investment contracts with discretionary participation features accounted for under IFRS 4 as described in note A3.
Financial assets Cash and cash equivalents – – 6,384 6,384 6,384 Deposits – – 12,653 12,653 12,653 Equity securities and portfolio holdings in unit trusts 99,958 – – 99,958 99,958 Debt securities note (i) 107,278 32,825 – 140,103 140,103 Loans note (ii) 2,068 – 9,753 11,821 12,333 Other investments note (iii) 7,900 – – 7,900 7,900 Accrued investment income – – 2,798 2,798 2,798 Other debtors – – 1,361 1,361 1,361 2012 £m
Financial liabilities Core structural borrowings of shareholder-fi nanced operations notes (i), H13 – 3,554 – 3,554 4,133 Operational borrowings attributable to shareholder-fi nanced operations H13 – 2,245 – 2,245 2,245 Borrowings attributable to with-profi ts funds H13 40 993 – 1,033 1,042 Obligations under funding, securities lending and sale and repurchase agreements – 2,436 – 2,436 2,455 Net asset value attributable to unit holders of consolidated unit trust and similar funds 4,345 – – 4,345 4,345 Investment contracts with discretionary participation features note (iv) – – 33,812 33,812 – Investment contracts without discretionary participation features 16,309 2,069 – 18,378 18,419 Other creditors 259 2,522 – 2,781 2,781 Derivative liabilities 2,829 – – 2,829 2,829 Other liabilities 2,021 1,433 – 3,454 3,453
263Notes on the Group fi nancial statements Prudential plc Annual Report 2012 F
Financial liabilities Core structural borrowings of shareholder-fi nanced operations notes (i), H13 – 3,611 – 3,611 3,815 Operational borrowings attributable to shareholder-fi nanced operations H13 – 3,340 – 3,340 3,340 Borrowings attributable to with-profi ts funds H13 39 933 – 972 978 Obligations under funding, securities lending and sale and repurchase agreements – 3,114 – 3,114 3,144 Net asset value attributable to unit holders of consolidated unit trust and similar funds 3,840 – – 3,840 3,840 Investment contracts with discretionary participation features note (iv) – – 29,745 29,745 – Investment contracts without discretionary participation features 15,056 1,911 – 16,967 17,008 Other creditors 281 2,263 – 2,544 2,544 Derivative liabilities 3,054 – – 3,054 3,054 Other liabilities – 1,249 – 1,249 1,249
Notes (i) As at 31 December 2012 £525 million (2011: £523 million) of convertible bonds were included in debt securities and £673 million (2011: £702 million) were included in borrowings.
(ii) Loans and receivables are reported net of allowance for loan losses of £83 million (2011: £89 million). (iii) See note G3 for details of the derivative assets included. The balance also contains the PAC with-profi ts fund’s participation in various investment funds and limited liability property partnerships.
(iv) It is impractical to determine the fair value of investment contracts with discretionary participation features due to the lack of a reliable basis to measure such features.
(v) For fi nancial liabilities designated as fair value through profi t and loss, the impact on profi t from movements in credit risk during 2012 and 2011 was negligible.
Determination of fair value The fair values of the fi nancial instruments for which fair valuation is required under IFRS are determined by the use of current market bid prices for exchange-quoted investments, or by using quotations from independent third parties, such as brokers and pricing services or by using appropriate valuation techniques. Investments valued using valuation techniques include fi nancial investments which by their nature do not have an externally quoted price based on regular trades and fi nancial investments for which markets are no longer active as a result of market conditions eg market illiquidity. The valuation techniques used include comparison to recent arm’s length transactions, reference to other instruments that are substantially the same, discounted cash fl ow analysis, option adjusted spread models and, if applicable, enterprise valuation. These techniques may include a number of assumptions relating to variables such as credit risk and interest rates. Changes in assumptions relating to these variables could positively or negatively impact the reported fair value of these instruments. When determining the inputs into the valuation techniques used priority is given to publicly available prices from independent sources when available, but overall the source of pricing is chosen with the objective of arriving at a fair value measurement which refl ects the price at which an orderly transaction would take place between market participants on the measurement date.
The loans and receivables have been shown net of provisions for impairment. The fair value of loans has been estimated from discounted cash fl ows expected to be received. The rate of discount used was the market rate of interest.
Level 1, 2 and 3 fair value measurement hierarchy of Group fi nancial instruments The table below includes fi nancial instruments carried at fair value analysed by level of the IFRS 7 ‘Financial Instruments: Disclosures’ defi ned fair value hierarchy. This hierarchy is based on the inputs to the fair value measurement and refl ects the lowest level input that is signifi cant to that measurement.
Level 2 – inputs other than quoted prices included within level 1 that are observable either directly (ie as prices) or indirectly (ie derived from prices) Level 2 includes investments where a direct link to an actively traded price is not readily apparent, but which are valued using inputs which are largely observable either directly (ie as prices) or indirectly (ie derived from prices). A signifi cant proportion of the Group’s Level 2 assets are corporate bonds, structured securities and other non-national government debt securities. These assets, in line with market practice, are generally valued using independent pricing services or third-party broker quotes. These valuations are determined using independent external quotations from multiple sources and are subject to a number of monitoring controls, such as monthly price variances and analysis on prices achieved on subsequent trades.
At 31 December 2012, the Group held £6,660 million (2011: £4,565 million), 3 per cent of the fair valued fi nancial investments, net of derivative liabilities (2011: 2 per cent), within Level 3.
Excluding the fi nancial investments of £1,842 million held to back the funds withheld liability under REALIC’s reinsurance arrangement, the Level 3 fair valued fi nancial investments, net of derivative liabilities, supporting non-linked shareholder-backed business at 31 December 2012 were £861 million (2011: £800 million) (representing 1.2 per cent of the total fair valued fi nancial investments net of derivative liabilities backing this business (2011: 1.3 per cent)). Of this amount, £837 million of net assets are externally valued and £24 million of net liabilities are internally valued (2011: net assets of £757 million and £43 million respectively). Internal valuations, which represent 0.03 per cent of the total fair valued fi nancial investments net of derivative liabilities supporting non-linked shareholder-backed business at 31 December 2012 (2011: 0.1 per cent), are inherently more subjective than external valuations.
Analysis of fi nancial investments, net of derivative liabilities by business type
With-profi ts Equity securities and portfolio holdings in unit trusts 22,129 2,496 480 25,105 Debt securities 15,910 45,550 542 62,002 Other investments (including derivative assets) 108 1,743 2,894 4,745 Derivative liabilities (61) (1,072) – (1,133)
Total fi nancial investments, net of derivative liabilities 38,086 48,717 3,916 90,719 Percentage of total 42% 54% 4% 100%
Unit-linked and variable annuity separate account Equity securities and portfolio holdings in unit trusts 73,632 189 39 73,860 Debt securities 3,843 5,659 2 9,504 Other investments (including derivative assets) 47 10 – 57 Derivative liabilities – (1) – (1)
Total fi nancial investments, net of derivative liabilities 130,281 110,259 6,660 247,200 Borrowings attributable to the with-profi ts fund held at fair value – (40) – (40) Investment contracts liabilities without discretionary participation features held at fair value – (16,309) – (16,309) Net asset value attributable to unit holders of consolidated unit trusts
Total fi nancial instruments at fair value 126,972 93,221 4,033 224,226 Percentage of total 57% 41% 2% 100%
With-profi ts Equity securities and portfolio holdings in unit trusts 24,001 1,762 284 26,047 Debt securities 13,298 43,279 655 57,232 Other investments (including derivative assets) 252 1,378 2,793 4,423 Derivative liabilities (214) (1,127) – (1,341)
Total fi nancial investments, net of derivative liabilities 114,055 97,961 4,565 216,581 Borrowings attributable to the with-profi ts fund held at fair value – (39) – (39) Investment contracts liabilities without discretionary participation features held at fair value – (15,056) – (15,056) Net asset value attributable to unit holders of consolidated unit trusts
Total investment return recorded in the income statement represents interest and dividend income, realised gains and losses, unrealised gains and losses on fi nancial instruments classifi ed at fair value through profi t and loss and foreign exchange movements on an individual entity’s overseas investments.
The transfers in and out of Level 3 during 2012 represent sundry individual fi nancial investments, none of which are materially signifi cant as highlighted in the table below: £m
Debt securities 909 65 (3) – 260 (217) (73) – 18 (169) 790 Other investments (including
Net asset value attributable to unit holders of consolidated unit trusts and similar funds (449) (20) (47) – 2 1 – (93) – – (606)
2011 Equity securities and portfolio holdings in unit trusts 576 50 (1) – 62 (278) – – – (34) 375
Net asset value attributable to unit holders of consolidated unit trusts and similar funds (379) (78) – – (10) 18 – – – – (449)
269Notes on the Group fi nancial statements Prudential plc Annual Report 2012 F
Interest income and expense The interest income on fi nancial assets not at fair value through profi t and loss for the year ended 31 December 2012 from continuing operations was £1,886 million (2011: £1,814 million).
The interest expense on fi nancial liabilities not at fair value through profi t and loss for the year ended 31 December 2012 from continuing operations was £420 million (2011: £456 million).
Interest rate risk The following table shows an analysis of the classes of fi nancial assets and liabilities except for cash and cash equivalents and their direct exposure to interest rate risk. Each applicable class of the Group’s fi nancial assets or liabilities is analysed between those exposed to fair value interest rate risk, cash fl ow interest rate risk and those with no direct interest rate risk exposure: 2012 £m
Financial liabilities Core structural borrowings of shareholder-fi nanced operations 3,279 275 – 3,554 Operational borrowings attributable to shareholder-fi nanced operations 574 1,670 1 2,245 Borrowings attributable to with-profi ts funds 379 562 92 1,033 Obligations under funding, securities lending and sale and repurchase agreements 403 2,033 – 2,436 Investment contracts without discretionary participation features 1,179 894 16,305 18,378 Derivative liabilities 974 576 1,279 2,829 Other liabilities 165 116 3,173 3,454 2011 £m
Financial liabilities Core structural borrowings of shareholder-fi nanced operations H13 3,554 140 791 603 958 1,038 691 1,753 5,974 Operational borrowings attributable to shareholder-fi nanced operations H13 2,245 1,708 558 – – – – – 2,266 Borrowings attributable to with-profi ts funds H13 1,033 115 542 199 71 12 73 194 1,206 Obligations under funding, securities lending and sale and repurchase agreements 2,436 2,436 – – – – – – 2,436 Other liabilities 3,453 945 45 5 – – – 2,458 3,453 Net asset value attributable to unit holders of consolidated unit-trusts and similar funds 4,345 4,345 – – – – – – 4,345 Other creditors 2,781 2,515 23 36 73 70 406 – 3,123 2011 £m
Aft er 3 years to 5 years Aft er 5 years Total
The majority of derivative assets and liabilities have been included at fair value within the one year or less column, representing the basis on which they are managed (ie to manage principally asset or liability value exposures). Contractual maturities are not considered essential for an understanding of the timing of the cash fl ows for these instruments and, in particular, the Group has no cash fl ow hedges. The only exception is certain identifi ed interest rate swaps which are fully expected to be held until maturity solely for the purposes of matching cash fl ows on separately held assets and liabilities. For these instruments the undiscounted cash fl ows (including contractual interest amounts) due to be paid under the swap contract assuming conditions are consistent with those at year end are included in the column relating to the contractual maturity of the derivative.
The table below shows the maturity profi le for investment contracts on an undiscounted basis to the nearest £ billion. This maturity profi le has been based on the cash fl ow projections of expected benefi t payments as part of the determination of the value of in-force business when preparing EEV basis results.
The vast majority of the Group’s fi nancial assets are held to back the Group’s policyholder liabilities. Although asset/liability matching is an important component of managing policyholder liabilities (both those classifi ed as insurance and those classifi ed as investments), this profi le is mainly relevant for managing market risk rather than liquidity risk. Within each business unit this asset/liability matching is performed on a portfolio by portfolio basis.
Financial assets that would have been past due or impaired had the terms not been renegotiated amounted to £86 million (2011: £90 million).
Financial assets, of which 56 per cent (2011: 55 per cent) are held by the PAC with-profi ts fund, allow the PAC with-profi ts fund to obtain exposure to foreign equity markets.
The exchange risks inherent in these exposures are mitigated through the use of derivatives, mainly forward currency contracts (note G3).
273Notes on the Group fi nancial statements Prudential plc Annual Report 2012 F
The total fair value balances of derivative assets and liabilities as at 31 December 2012 were as follows: 2012 £m
The Group uses various interest rate derivative instruments such as interest rate swaps to reduce exposure to interest rate volatility. The UK with-profi ts funds use derivatives for the purposes of effi cient portfolio management or reduction in investment risks. For UK
annuity business derivatives are used to assist with asset and liability cash fl ow matching. Some of the Group’s products, especially those sold in the US, have certain guarantee features linked to equity indexes. A mismatch between guaranteed product liabilities and the performance of the underlying assets backing them, exposes the Group to equity index risk. In order to mitigate this risk, the relevant business units purchase swaptions, equity options and futures to match asset performance with liabilities under equity-indexed products.
Net investment hedges The Group has designated perpetual subordinated capital securities totalling US$2.85 billion (2011: US$2.85 billion) as a net investment hedge to hedge the currency risks related to the net investment in Jackson. The carrying value of the subordinated capital securities was £1,746 million as at 31 December 2012 (2011: £1,823 million). The foreign exchange loss of £81 million (2011: loss of £18 million) on translation of the borrowings to pounds sterling at the statement of fi nancial position date is recognised in the translation reserve in shareholders’ equity.
Collateral and pledges under derivative transactions At 31 December 2012, the Group had pledged £754 million (2011: £840 million) for liabilities and held collateral of £1,964 million (2011: £1,953 million) in respect of over-the-counter derivative transactions.
These transactions are conducted under terms that are usual and customary to collateralised transactions including, where relevant, standard securities lending and repurchase agreement.
In accordance with the Group’s accounting policy set out in note A3, impairment reviews were performed for available-for-sale securities and loans and receivables. In addition, impairment reviews were undertaken for the reinsurers’ share of insurance contract liabilities.
Available-for-sale securities held by Jackson 37 62 Loans and receivables* 13 64 * Relates to loans held by the UK with-profi ts fund and mortgage loans held by Jackson
In 2012, the Group realised gross losses on sales of available-for-sale securities of £44 million (2011: £43 million) with 64 per cent (2011: 64 per cent) of these losses related to the disposal of fi xed maturity securities of 10 (2011: 10) individual issuers, which were disposed of as part of risk reduction programmes intended to limit future credit loss exposure. Of the £44 million (2011: £43 million), £23 million (2011: £32 million) relates to losses on sales of impaired and deteriorating securities.
Cost At beginning of year 1,585 1,586 Additional consideration paid on previously acquired business 2 – Exchange differences 2 (1)
Goodwill attributable to shareholders comprises: ‘Other’ represents goodwill amounts across cash generating units (CGUs) in Asia and US operations. Other goodwill amounts are not individually material.
Impairment testing Goodwill does not generate cash fl ows independently of other groups of assets and thus is assigned to CGUs for the purposes of impairment testing. These CGUs are based upon how management monitors the business and represent the lowest level to which goodwill can be allocated on a reasonable basis.
Assessment of whether goodwill may be impaired Goodwill is tested for impairment by comparing the CGUs’ carrying amount, including any goodwill, with its recoverable amount. With the exception of M&G, the goodwill attributable to shareholders in the statement of fi nancial position mainly relates to acquired life businesses. The Company routinely compares the aggregate of net asset value and acquired goodwill on an IFRS basis of acquired life business with the value of the business as determined using the EEV methodology, as described in note D1. Any excess of IFRS over EEV carrying value is then compared with EEV basis value of current and projected future new business to determine whether there is any indication that the goodwill in the IFRS statement of fi nancial position may be impaired. The assumptions underpinning the Group’s EEV basis of reporting are included in the EEV basis supplementary information in this Annual Report.
b Deferred acquisition costs and other intangible assets attributable to shareholders The deferred acquisition costs (DAC) and other intangible assets in the Group consolidated statement of fi nancial position attributable to shareholders comprise: 2012 £m 2011* £m 2010* £m
Deferred acquisition costs related to insurance contracts as classifi ed under IFRS 4 3,866 3,805 3,550 Deferred acquisition costs related to investment management contracts, including life assurance contracts classifi ed as fi nancial instruments and investment management contracts under IFRS 4 100 107 110
Aft er eff ect of change 111 3,095 694 12 322 4,234 3,901 3,446 Additions 12 798 249 3 31 1,093 1,117 968 Acquisition of REALIC in 2012 and UOB Life
Assurance Ltd in 2010 – – – – 5 5 – 12 Amortisation to the income statement: Amortisation related to short-term fl uctuations in
Dilution of Group's holdings – – – – – – – (7)
US operations DAC Summary balances The DAC amount in respect of US insurance operations comprises amounts in respect of: 2012 £m 2011* £m 2010* £m
Total DAC for US operations 3,199 3,095 2,829 * The 2011 and 2010 comparative results have been adjusted from those previously published for the retrospective application of the change in accounting policy described in note A5.
DAC at 1 January 3,805 105 3,550 110 3,172 107 Additions 1,048 12 982 17 710 21 Amortisation (563) (17) (450) (20) (19) (18) Exchange differences (154) – – – 104 – Change in shadow DAC related to movement in unrealised appreciation of Jackson’s securities classifi ed as available-for-sale (270) – (275) – (410) –
* The 2011 and 2010 comparative results have been adjusted from those previously published for the retrospective application of the change in accounting policy described in note A5.
Additions (including amounts arising on acquisition of subsidiaries) 5 – 31 36 – 96 24 120
(ii) Other intangibles comprise distribution and soft ware rights. Distribution rights relate to facilitation fees paid in respect of the bancassurance partnership arrangements in Asia for the bank distribution of Prudential’s insurance products for a fi xed period of time. The distribution rights amounts are amortised over the term of the distribution contracts. Soft ware is amortised over its useful economic life, which generally represents the licence period of the soft ware acquired. Amortisation is charged to the ‘acquisition costs and other expenditure’ line in the income statement.
b Deferred acquisition costs and other intangible assets Other intangible assets in the Group consolidated statement of fi nancial position attributable to with-profi ts funds consist of: Deferred acquisition costs related to insurance contracts attributable to the PAC with-profi ts fund 6 6 Distribution rights attributable to with-profi ts funds of the Asia insurance operations 70 83 Computer software attributable to with-profi ts funds of the Asia insurance operations 2 –
The movement on reinsurers’ share of insurance contract liabilities is as follows: At 1 January 1,486 1,167 Acquisition of REALIC 4,810 – Other movements in the year (55) 303 Foreign exchange translation differences (162) 16
281Notes on the Group fi nancial statements Prudential plc Annual Report 2012 F
Assets Of the £254 million (2011: £546 million) current tax recoverable, the majority is expected to be recovered in one year or less.
Unrealised losses on investments 102 297 Balances relating to investment and insurance contracts 1 13 Short-term timing differences 2,097 1,513 Capital allowances 15 15 Unused deferred tax losses 99 438
US insurance operations 1,889 1,392 Asia insurance operations 83 114 Other operations 159 538
Asia 36 3 to 5 years UK long-term business 18 1 to 3 years Other 45 1 to 3 years
Liabilities The current tax liability decreased to £445 million (2011: £930 million) refl ecting the settlement of prior year balances in the UK and Asia following the agreement of tax positions.
Unrealised gains on investments 1,814 1,566 1,678 Balances relating to investment and insurance contracts 432 667 801 Short-term timing differences 1,715 1,687 1,477 Capital allowances 9 9 12 * The 2011 and 2010 comparative results have been adjusted from those previously published for the retrospective application of the change in accounting policy described in note A5.
The UK government’s tax rate change to 23 per cent (from the 24 per cent effective from 1 April 2012) has had the effect of reducing the UK with-profi ts and shareholder-backed business element of the net deferred tax balances as at 31 December 2012 by £52 million. The tax change to 23 per cent is effective from 1 April 2013 but has been enacted at 31 December 2012.
The subsequent proposed phased rate changes to 21 per cent are expected to have the effect of reducing the UK with-profi ts and shareholder-backed business elements of the net deferred tax balances at 31 December 2012 by £52 million.
283Notes on the Group fi nancial statements Prudential plc Annual Report 2012 F
Year ended 31 December Opening net book amount 233 515 748 173 381 554 Exchange differences (9) (8) (17) (2) (7) (9)
Net (loss) gain from fair value adjustments (175) 522 Net foreign exchange differences (53) (41) Transfers (to)/from held for sale assets (97) 25 Transfers from owner occupied properties – 5
The income statement includes the following items in respect of investment properties: Rental income from investment properties 559 606 Direct operating expenses (including repairs and maintenance expenses) arising from investment properties that generated rental income during the year 64 128
Further information on the investment property held by the UK insurance operations further information is included in note D2(a). Investment properties of £3,845 million (2011: £3,439 million) are held under fi nance leases. A reconciliation between the total of future minimum lease payments at the statement of fi nancial position date, and their present value is shown below: Future minimum lease payments at 31 December 988 1,071 Future fi nance charges on fi nance leases (877) (944)
Future minimum lease payments are due as follows: Less than 1 year 6 7 1 to 5 years 23 26 Over 5 years 959 1,038
The present values of these minimum lease payments are: Less than 1 year 6 6 1 to 5 years 19 23 Over 5 years 86 98
Contingent rent is that portion of the lease payments that is not fi xed in amount but is based on the future value of a factor that changes other than with the passage of time. There was no contingent rent recognised as income or expense in 2012 and 2011. The Group’s policy is to rent investment properties to tenants through operating leases. Minimum future rentals to be received on non-cancellable operating leases of the Group’s freehold investment properties are receivable in the following periods: Less than 1 year 451 430 1 to 5 years 1,541 1,407 Over 5 years 3,785 3,304
285Notes on the Group fi nancial statements Prudential plc Annual Report 2012 F
Investments in associates The Group had two associates at 31 December 2012 (31 December 2011: one) that were accounted for under the equity method. The Group’s associates at 31 December 2012 are a 25 per cent interest in PruHealth Holdings Limited and a 49.99 per cent interest in PPM South Africa, following the dilution of the Group’s holding in the period (see note I2). The Group’s share of the profi t during the year was a profi t of £8 million (full year 2011: a loss of £3 million). The total carrying value of these associates are £113 million (2011: £70 million). This is refl ected in the Group’s profi t after tax attributable to equity holders during the year.
Balance at 31 December 2011 104 (34) 70 – 70 Transfer of PPMSA as an associate I2 – 39 39 – 39 Exchange translation and other movements – (6) (6) – (6) Share of profi t for the year after tax – 10 10 – 10
Results of operations Revenue 96 81 Profi t (loss) in the year 10 (3)
287Notes on the Group fi nancial statements Prudential plc Annual Report 2012 F
Cash and cash equivalents held centrally are considered to be available for general use by the Group. These funds amount to £482 million and £309 million at 31 December 2012 and 2011, respectively. The remaining funds are considered not to be available for general use by the Group, and include funds held for the benefi t of policyholders.
At 31 December 2011 2,548,039,330 127 1,873 Shares issued under share option schemes 9,203,022 1 16
Amounts recorded in share capital represent the nominal value of the shares issued. The difference between the proceeds received on issue of shares, net of issue costs, and the nominal value of shares issued is credited to the share premium account. At 31 December 2012, there were options outstanding under Save As You Earn schemes to subscribe for shares as follows: Number of shares to subscribe for
H: Other information on statement of fi nancial position items continued
January 15,573 6.40 6.40 99,589 12,723 6.83 6.83 86,834 February 12,678 7.33 7.33 92,930 11,688 7.13 7.13 83,376 March 4,022,002 7.10 8.03 32,058,297 2,106,702 7.04 7.14 15,253,240 April 368,901 7.27 7.67 2,712,460 263,361 7.40 7.49 1,960,300 May 939,541 6.80 7.26 6,407,556 174,614 7.46 7.53 1,307,410 June 482,377 6.61 6.84 3,208,338 1,418,209 7.07 7.18 10,141,069 July 15,047 7.26 7.26 109,166 98,334 6.89 7.34 683,084 August 28,488 7.88 8.12 228,176 1,520,620 5.77 6.32 9,051,804 September 712,649 8.16 8.25 5,829,154 19,273 5.85 6.00 115,022 October 12,549 8.39 8.39 105,329 15,385 6.07 6.07 93,310 November 492,993 8.55 9.15 4,502,129 110,951 6.15 6.33 692,501 December 2,277,012 8.86 9.27 20,706,597 2,456,692 6.07 6.55 15,226,106
The Group has consolidated a number of authorised investment funds where it is deemed to control these funds under IFRS. Some of these funds hold shares in Prudential plc. The total number of shares held by these funds at 31 December 2012 was 4.5 million (2011: 8.6 million) and the cost of acquiring these shares of £27 million (2011: £52 million) is included in the cost of own shares. The market value of these shares as at 31 December 2012 was £39 million (2011: £54 million). During 2012, these funds made net disposals of 4,143,340 Prudential shares (2011: net disposals of 1,171,635) for a net decrease of £25.1 million to book cost (2011: net increase of £4.8 million). All share transactions were made on an exchange other than the Stock Exchange of Hong Kong. Other than set out above the Group did not purchase, sell or redeem any Prudential plc listed securities during 2012 or 2011.
H12: Insurance contract liabilities and unallocated surplus of with-profi ts funds
At 1 January 2012 180,363 9,215 Income and expense included in the income statement 32,760 1,381 Foreign exchange translation differences (4,539) (7)
Notes B5, D2b, D3b and D4b provide further analysis of the movement in the year of the Group’s policyholder liabilities and unallocated surplus of the with-profi ts funds.
Central operations Subordinated debt: ¤20m Medium Term Subordinated Notes 2023 note (i) 16 16 17 £435m 6.125% Subordinated Notes 2031 429 429 428 £400m 11.375% Subordinated Notes 2039 386 386 384 US$1,000m 6.5% Perpetual Subordinated Capital
Total central operations 1,746 831 549 3,126 3,201 £275m bank loan note (iii) 275 275 250 US$250m 8.15% Surplus Notes 2027 note (iv) 153 153 160 * These debt classifi cations are consistent with the treatment of capital for regulatory purposes, as defi ned in the FSA handbook. In January 2011, the Company issued US$550 million 7.75 per cent Tier 1 subordinated debt, primarily to retail investors. The proceeds, net of costs, were US$539 million (£340 million) and were used to fi nance the repayments of the €500 million Tier 2 subordinated debt in December 2011.
The Group has designated US$2.85 billion (2011: US$2.85 billion) of its Tier 1 subordinated debt as a net investment hedge under IAS 39 to hedge the currency risks related to the net investment in Jackson.
† The senior debt ranks above subordinated debt in the event of liquidation.
Notes (i) The €20 million borrowings were issued at 20-year Euro Constant Maturity Swap (capped at 6.5 per cent). These have been swapped into borrowings of £14 million with interest payable at three month £LIBOR plus 1.2 per cent.
(vi) Management analyses the net core structural borrowings position as follows: Total core structural borrowings (as above) 3,554 3,611 Less: Holding company cash and short-term investments (recorded within the consolidated statement of fi nancial position) (1,380) (1,200)
Borrowings of US operations Investment subsidiaries (non-recourse) note (i) 19 20 Piedmont and CDO funds (non-recourse) notes (i), (ii) 1 1
(iii) Other borrowings mainly include amounts whose repayment to the lender is contingent upon future surplus emerging from certain contracts specifi ed under the arrangement. If insuffi cient surplus emerges on those contracts, there is no recourse to other assets of the Group and the liability is not payable to the degree of shortfall.
The Group has chosen to designate as a fair value hedge under IAS 39 certain fi xed to fl oating rate swaps which hedge the fair value exposures to interest rate movements of these borrowings.
(iv) In addition to the debt listed above, £200 million Floating Rate Notes were issued by Prudential plc in October 2012 which will mature in April 2013. These Notes have been wholly subscribed by a Group subsidiary and accordingly have been eliminated on consolidation in the Group fi nancial statements. These notes were originally issued in October 2008 and have been reissued upon their maturity.
: O th er in fo rm atio n o n statem en t o f fi n an cial p o sitio n item s
(vi) In January 2013 the Company repaid on maturity, £250 million Medium-Term Notes included within borrowings in respect of short-term fi xed income securities in the table above.
(Surplus) defi cit gross of deferred tax, based on scheme assets held, including investments in Prudential insurance policies: Attributable to PAC with-profi ts fund 37 41 Attributable to shareholder-fi nanced operations (1) 23 36 64 Add back investments in Prudential insurance policies 169 165
Provision after elimination of investments in Prudential insurance policies and matching policyholder liabilities from Group statement of fi nancial position 205 229
Analysis of other provisions: At 1 January I3 300 282 Charged to income statement: Additional provisions 237 144 Unused amounts released (12) (29)
Comprising: Legal provisions 20 14 Restructuring provisions 27 23 Other provisions 349 263
At 1 January 14 23 263 20 26 236 Charged to income statement: Additional provisions 10 14 213 – 5 139 Unused amounts released (1) (4) (7) – (5) (24)
Contingencies and related obligations In addition to the legal proceedings relating to Jackson mentioned under the legal provisions section above, the Group is involved in other litigation and regulatory issues. Whilst the outcome of such litigation and regulatory issues cannot be predicted with certainty, the Company believes that their ultimate outcome will not have a material adverse effect on the Group’s fi nancial condition, results of operations, or cash fl ows.
Pension mis-selling review The pensions review by the UK insurance regulator of past sales of personal pension policies required all UK life insurance companies to review their cases of potential mis-selling and record a provision for the estimated costs. The Group met the requirement of the FSA to issue offers to all cases by 30 June 2002.
The costs associated with the pension mis-selling review have been met from the inherited estate (see below). Accordingly, these costs have not been charged to the asset shares used in the determination of policyholder bonus rates. Hence policyholders’ pay-out values have been unaffected by pension mis-selling.
This review was completed on 30 June 2002. The assurance will continue to apply to any policy in force at 31 December 2003, both for premiums paid before 1 January 2004, and for subsequent regular premiums (including future fi xed, retail prices index or salary related increases and Department for Work and Pensions rebate business). The assurance has not applied to new business since 1 January 2004. New business in this context consists of new policies, new members to existing pension schemes plus regular and single premium top-ups, transfers and switches to existing arrangements. The maximum amount of capital support available under the terms of the assurance will reduce over time.
Guaranteed annuities Prudential Assurance used to sell guaranteed annuity products in the UK and at 31 December 2012 held a provision of £47 million (2011: £90 million) within the main with-profi ts fund within policyholder liabilities to honour guarantees on these products. The Group’s main exposure to guaranteed annuities in the UK is through SAIF and at 31 December 2012 a provision of £371 million (2011: £370 million) was held in SAIF to honour the guarantees. As SAIF is a separate sub-fund of the Prudential Assurance long-term business fund, wholly attributable to the policyholders of the fund, the movement in this provision has no impact on shareholders.
The assets of the with-profi ts sub-fund (WPSF) within the long-term insurance fund of The Prudential Assurance Company Limited (PAC) comprise the amounts that it expects to pay out to meet its obligations to existing policyholders and an additional amount used as working capital. The amount payable over time to policyholders from the WPSF is equal to the policyholders’ accumulated asset shares plus any additional payments that may be required by way of smoothing or to meet guarantees. The balance of the assets of the WPSF is called the ‘inherited estate’ and has accumulated over many years from various sources.
As a proprietary insurance company, PAC is liable to meet its obligations to policyholders even if the assets of the long-term funds are insuffi cient to do so. The assets, represented by the unallocated surplus of with-profi ts funds, in excess of amounts expected to be paid for future terminal bonuses and related shareholder transfers (‘the excess assets’) in the long-term funds could be materially depleted over time by, for example, a signifi cant or sustained equity market downturn, costs of signifi cant fundamental strategic change or a material increase in the pension mis-selling provision. In the unlikely circumstance that the depletion of the excess assets within the long-term fund was such that the Group’s ability to satisfy policyholders’ reasonable expectations was adversely affected, it might become necessary to restrict the annual distribution to shareholders or to contribute shareholders’ funds to the long-term funds to provide fi nancial support.