Deferred tax assets are only recognised when it is probable that future taxable profits will be available against which these losses can be utilised. Deferred tax related to charges or credits taken directly to equity is also credited or charged directly to equity and is subsequently recognised in the income statement together with the deferred gain or loss.
The Company uses the economic entity method to purchase minority interests. Under the economic entity method any difference between consideration and the share of net assets acquired is recorded directly in equity.
i Debt securities and equity securities Longer-term investment returns comprise income and longer-term capital returns. For debt securities the longer-term capital returns comprise two elements. These are a risk margin reserve based charge for expected defaults, which is determined by reference to the credit quality of the portfolio, and amortisation of interest-related realised gains and losses to operating results based on longer-term investment returns to the date when sold bonds would have otherwise matured.
— Participating business for which liabilities include policyholders’ interest in investment appreciation and other surplus.
For the participating business in Vietnam the bonuses paid in a reporting period and accrued policyholder interest in investment appreciation and other surpluses primarily reflect the level of realised investment gains above contract specific hurdle levels. For this business operating profit based on longer-term investment returns includes the aggregate of longer-term returns on the relevant investments, a credit or charge equal to movements on the liability for the policyholders’ interest in realised investment gains (net of any recovery of prior deficits on the participating pool), less amortisation over five years of current and prior movements on such credits or charges.
The overall purpose of these adjustments is to ensure that investment returns included in operating results equal longer-term returns but that in any one reporting period movements on liabilities to policyholders caused by investment returns are substantially matched in the presentation of the supplementary analysis of profit before tax attributable to policyholders.
Amendment to IFRS 4 Implementation Guidance Revised IFRS 4 implementation guidance was issued in December 2005 and is effective in conjunction with the adoption of IFRS 7 as discussed above. The revisions relate to disclosures around insurance contracts.
The Group adopted IFRS 7, Revised IFRS 4, ‘Implementation Guidance’ and the Amendment to IAS 1 in 2007. There is no impact on the profit and shareholders’ equity of the Group from the adoption of these accounting pronouncements as their provisions relate to disclosure.
IFRIC 9, ‘Reassessment of Embedded Derivatives’ IFRIC 9 requires assessment of whether embedded derivatives are required to be separated from the host contract and accounted for as derivatives when the Group first becomes a party to the contracts. Subsequent reassessment is prohibited unless there is a change in the terms of the contracts that significantly modifies the cash flows that otherwise would be required under the contracts, in which case a reassessment is required. This interpretation became effective for annual periods beginning on or after 1 June 2006.
In September 2005, the American Institute of Certified Public Accountants (AICPA) issued SOP 05-1 which affects the US GAAP insurance accounting. This SOP provides guidance on accounting by insurance enterprises for deferred acquisition costs on internal replacements of insurance and investment contracts other than those specifically described in FAS 97, ‘Accounting and Reporting by Insurance Enterprises for Certain Long-Duration and for Realised Gains and Losses from the Sale of Investments’. SOP 05-1 sets out conditions to determine whether contract modifications are considered as internal replacements and result in a replacement contract that is substantially changed from the replaced contract. SOP 05-1 then requires unamortised deferred acquisition costs, unearned revenue liabilities and deferred sales inducement assets from replaced contracts in an internal replacement transaction that results in a substantially changed contract not to be deferred in connection with the replacement contract.
Accounting pronouncements not yet effective IFRS 8, ‘Operating Segments’ IFRS 8 requires entities to adopt the ‘management approach’ to reporting the financial performance of its operating segments. The amount of each operating segment item to be reported is the measure reported to the chief operating decision maker, which in some instances will be non-GAAP. IFRS 8 will require the Group to provide an explanation of the basis on which the segment information is prepared and a reconciliation to the amount recognised in the Group’s consolidated financial statements. This standard is effective for accounting periods beginning on or after 1 January 2009.
IFRIC 14, ‘IAS19 – The Limit on a Defined Benefit Asset, Minimum Funding Requirements and their Interaction’ IFRIC 14 provides guidance on assessing the limit in IAS 19 on the amount of the surplus that can be recognised as an asset and clarifies the impact of minimum funding requirements on such assets. It also addresses when a minimum funding requirement might give rise to a liability. This interpretation is effective for accounting periods beginning on or after 1 January 2008.
The changes require information in financial statements to be aggregated on the basis of shared characteristics and introduce a statement of comprehensive income. The revisions also include changes to the titles of some of the financial statements to reflect their functions more clearly: for example the balance sheet is renamed a statement of financial position, though the new titles are not mandatory. This revised standard is effective for accounting periods beginning on or after 1 January 2009.
Revised IFRS 3, ’Business Combinations’ and Amendments to IAS 27, ‘Consolidated and Separate Financial Statements’ The revised IFRS 3 and amended IAS 27 are the outcomes of the second phase of the IASB’s and the US Financial Accounting Standards Board’s (FASB) joint business combination project. The more significant changes from the revised IFRS 3 include: — The immediate expensing of acquisition-related costs rather than inclusion in goodwill; — recognition and measurement at fair value of contingent consideration at acquisition date with subsequent changes to income; — adoption of full goodwill method to measure non-controlling interests.
B1: Supplementary analysis of profit from continuing operations before tax attributable to shareholders This information is provided as supplementary information under the Group’s accounting policies. It is not required by IFRS standards.
Asian operations Long-term businessnote ii 189 189 Asset management 72 50 Development expenses (15) (15)
Other income and expenditure Investment return and other income 86 58 Interest payable on core structural borrowings (168) (177) Corporate expenditure: Group Head Office (GHO) (117) (83) Asia Regional Head Office (38) (36)
Operating profit from continuing operations based on longer-term investment returnsnote i 1,213 1,050 Short-term fluctuations in investment returns on shareholder-backed businessnote iv (137) 155 Shareholders’ share of actuarial gains and losses on defined benefit pension schemesnote v 90 167
iii Jackson operating results based on longer-term investment returns IFRS basis operating profits for US operations include the following amounts (net of related change in amortisation of deferred acquisition costs, where applicable) so as to derive longer-term investment returns.
Debt securities: Amortisation of interest related realised gains and losses 31 38 Risk margin reserve charge for longer-term credit related losses (37) (44)
Equity type investments: Longer-term returns 47 45 152 Prudential plc Annual Report 2007
The risk margin reserve (RMR) charge for longer-term impairment losses for 2007 is based on an average annual RMR of 21 basis points (2006: 23 basis points) on a book value of US$42.7bn (2006: US$43.9bn).
iv Short-term fluctuations in investment returns on shareholder-backed business £m £m
The fluctuations for US operations for the year comprise of the following items: £m £m
Total fluctuations related to debt securities (27) (25) Derivatives (other than equity related): Market value movement (19) 34 Equity type movements: Actual less longer-term return 42 21 Other items (14) 23
The fluctuations for the UK insurance operations arise mostly in Prudential Retirement Income Limited, which writes the most significant element of the shareholder-backed annuity business in the UK. The fluctuations principally reflect the impact of widened credit spreads on the corporate bond securities backing the shareholders’ equity of the business.
Actuarial gains and losses Actual less expected return on scheme assets (8) 156 Experience losses on liabilities (14) 18 Gains on changes of assumptions for scheme liabilities 317 311
Further details on the Group’s defined benefit pension schemes are shown in note I1. vi Share-based payments
B2: Earnings per share Basic earnings per share is calculated by dividing the earnings attributable to ordinary shareholders by the weighted average number of ordinary shares outstanding during the year, excluding those held in employee share trusts, which are treated as cancelled.
B1 F5 interests interests per share per share £m £m £m £m Pence Pence
Based on operating profit based on longer-term investment returns 1,213 (383) (4) 826 33.8p 33.7p
Shareholders’ share of actuarial gains and losses on defined benefit pension schemes 90 (25) – 65 2.6p 2.7p
Notes on the Group financial statements B: Summary of results continued
Based on operating profit based on longer-term investment returns 1,050 (304) (1) 745 30.9p 30.9p
Short-term fluctuations in investment returns on shareholder-backed business 155 (38) (2) 115 4.8p 4.8p
Shareholders’ share of actuarial gains and losses on defined benefit pension schemes 167 (50) – 117 4.8p 4.8p
Adjustment for post-tax results of discontinued operations* (150) 45 2 (103) (4.3)p (4.3)p
Weighted average shares for calculation of diluted earnings per share 2,448 2,416
Parent company dividends relating to reporting period: Interim dividend (2007: 5.70p, 2006: 5.42p per share) 140 131 Final dividend (2007: 12.30p, 2006: 11.72p per share) 304 287
The movements reflect the application of year end exchange rates at balance sheet rates and average exchange rates to the income statement. The movement unallocated to a segment reflects the retranslation of currency borrowings which have been designated as a net investment hedge to hedge the currency risks related to the net investment in Jackson.
Local currency: £ 31 Dec 2007 for 2007 31 Dec 2006 for 2006 1 Jan 2006
Investment products Insurance products gross inflows gross premiums note ii Total 156 Prudential plc Annual Report 2007
Total mature life and pensions 531 654 140 126 193 191
B5: New business continued Investment products – funds under management (note ii)
Market Market gross and other 1 Jan 2006 inflows Redemptions movements 31 Dec 2006
ii Investment products referred to in the table for funds under management above are unit trust, mutual funds and similar types of retail fund management arrangements. These are unrelated to insurance products that are classified as ‘investment contracts’ under IFRS 4, as described in the preceding paragraph, although similar IFRS recognition and measurement principles apply to the acquisition costs and fees attaching to this type of business. US investment products are no longer included in the table above as they are assets under administration rather than funds under management.
iii The tables above include the transfer of 62,000 with-profits annuity policies from Equitable Life on 31 December 2007 with assets of approximately £1.7 billion. The transfer represented APE new business premium of £174 million.
iv The tables for 2006 above include a bulk annuity transaction with the Scottish Amicable Insurance Fund (SAIF) with a premium of £560 million. The transaction reflects the arrangement entered into in June 2006 for the reinsurance of non-profit immediate pension annuity liabilities of SAIF to Prudential Retirement Income Limited (PRIL), a shareholder-owned subsidiary of the Group. SAIF is a closed ring-fenced sub-fund of the PAC long-term fund established by a Court approved Scheme of Arrangement in October 1997, which is solely for the benefit of SAIF policyholders. Shareholders have no interest in the profits of this fund, although they are entitled to investment management fees on this business. The inclusion of the transaction between SAIF and PRIL as new business in the tables reflects the transfer from SAIF to Prudential shareholders’ funds of longevity risk, the requirement to set aside supporting capital, and entitlement to surpluses arising on this block of business from the reinsurance arrangement. For Group reporting purposes the amounts recorded by SAIF and PRIL for the premium are eliminated on consolidation.
B6: Group balance sheet The Group’s primary reporting segments are long-term business, asset management and, prior to disposal, banking. The Group’s secondary reporting segments are geographical, namely the UK, the US, and Asia. Details of disclosures in accordance with the requirements of IAS 14 for segment assets and liabilities are shown below.
Long-term Asset Unallocated Intra-group business management to a segment eliminations Total
Segment assets by geographical segment UK 165,103 US 39,695 Asia 15,873 Intra-group eliminations (4,151)
Assets Intangible assets attributable to shareholders: Deferred acquisition costs and other intangible assets 157 1,928 745 2,830 6 – – 2,836
Other non-investment and non-cash assetsH3-H6 4,433 1,651 762 6,846 521 4,457 (5,499) 6,325
Investment of long-term business and other operations: Investments accounted for using the equity method – – – – – 12 – 12
Asset Unallo- Intra Insurance operations Total manage- cated group Total Dis-
Intangible assets attributable to PAC with-profits fund: In respect of acquired subsidiaries for venture fund and other
Investment of long-term business and other operations: Investments accounted for using the equity method – – – – – 6 – 6 – 6
Investment contract liabilities without discretionary participation featuresG1 11,453 1,562 27 13,042 – – – 13,042 – 13,042
Unallocated surplus of with-profits funds (reflecting application of ‘realistic’ basis provisions for UK regulated with-profits fundsD2(e)(ii),H12 13,511 – 88 13,599 – – – 13,599 – 13,599
Total policyholder liabilities and unallocated surplus of with-profits funds 133,952 31,746 12,889 178,587 – – – 178,587 – 178,587
Subordinated debt (other than Egg) – – – – – 1,538 – 1,538 – 1,538
B7: Internal funds under management Internal funds under management analysed by business area at 31 December 2007 were as follows: UK US Asia Total Total
i Overview As a provider of financial services, including insurance, the Group’s business is the managed acceptance of risk. The control procedures and systems established within the Group are designed to manage, rather than eliminate, the risk of failure to meet business objectives. They can only provide reasonable and not absolute assurance against material misstatement or loss, and focus on aligning the levels of risk-taking with the achievement of business objectives.
Prudential’s risk governance framework requires that all of the Group’s businesses and functions establish processes for identifying, evaluating and managing the key risks faced by the Group. The risk governance framework is based on the concept of ‘three lines of defence’: Risk management, risk oversight and independent assurance. Primary responsibility for strategy, performance management and risk control lies with the Board, the Group Chief Executive and the chief executives of each business unit. Risk oversight is provided by Group-level risk committees, Group Finance Director and the Group Risk function, working with counterparts in the business units in addition to other Group Head Office (GHO) oversight functions. Independent assurance on the Group’s and business unit internal control and risk management systems is provided by Group-wide Internal Audit reporting to the Group and business unit audit committees.
The management of the risk attached to the Group’s financial instruments and insurance liabilities, together with the interrelationship with the management of capital may be summarised as follows: a Group risk appetite The Group risk appetite framework sets out the Group’s overall tolerance to risk exposures, approach to risk/return optimisation and management of risk. The Group risk appetite statements set out the Group’s risk tolerance, or risk appetite, to ‘shocks’ to the key financial risk exposures (market, credit and insurance risk). Aggregate risk limits are defined in terms of earnings volatility and capital requirements: i Earnings volatility: The objectives of the limits are to ensure that (a) the volatility of earnings is consistent with stakeholder expectations, (b) the Group has adequate earnings (and cash flows) to service debt and expected dividends and (c) that earnings (and cash flows) are managed properly across geographies and are consistent with the Group’s funding strategies. The two measures used currently are European Embedded Value (EEV) operating profit and International Financial Reporting Standards (IFRS) operating profit.
b Group counterparty exposure limits In addition to business unit operational limits on credit risk, counterparty risk limits are also set at the Group level. Limits on total Group-wide exposures to a single counterparty are specified for different credit rating ‘buckets’. Actual exposures are monitored against these limits on a quarterly basis.
iii Market and financial risks a Equity and interest rate risk Market risk is the risk that fair value or future cash flows of a financial instrument or, in the case of liabilities of insurance contracts, their carrying value will fluctuate because of changes in market prices. Prudential faces equity risk and interest rate risk because most of its assets are investments that are either equity type investments and subject to equity price risk, or bonds, mortgages or cash deposits, the values of which are subject to interest rate risk. The amount of risk borne by Prudential’s shareholders depends on the extent to which its customers share the investment risk through the structure of Prudential’s products.
The split of Prudential’s investments between equity investments and interest-sensitive instruments depends principally on the type of liabilities supported by those investments and the amount of capital Prudential has available. The nature of some liabilities allows Prudential to invest a substantial portion of its investment funds in equity and property investments that Prudential believes produce greater returns over the long term. On the other hand Prudential has some liabilities that contain guaranteed returns and allow instant access (for example, interest-sensitive fixed annuities and immediate annuities), which generally will be supported by fixed income investments.
b Foreign exchange risk Prudential faces foreign exchange risk, primarily because its presentation currency is pounds sterling, whereas approximately 54 per cent of Prudential’s operating profit from continuing operations based on longer-term investment returns, as described in note B1, for the year ended 31 December 2007, came from Prudential’s US and Asian operations. The exposure relating to the translation of reported earnings is not separately managed although its impact is reduced by interest payments on foreign currency borrowings and by the adoption of average exchange rates for the translation of foreign currency revenues.
In practice, most of Prudential’s invested assets are marketable securities. This, combined with the fact that a large proportion of the liabilities contain discretionary surrender values or surrender charges, reduces the liquidity risk. The Group maintains committed borrowing and securities lending facilities.
d Credit risk Credit risk is the risk that a counterparty or an issuer of securities, which Prudential holds in its asset portfolio, defaults or another party fails to perform according to the terms of the contract. Some of Prudential’s businesses, in particular Jackson, the PAC withprofits fund, Prudential’s UK pension annuity business and, prior to the sale in the first half of 2007, Egg, held large amounts of interest-sensitive investments that contain credit risk on which a certain level of defaults is expected. These expected losses are considered when Prudential determines the crediting rates, deposit rates and premium rates for the products that will be supported by these assets. The key shareholder businesses exposed to credit risks are Jackson and, prior to disposal, Egg. Certain over-the-counter derivatives contain a credit risk element that is controlled through evaluation of collateral agreements and master netting agreements on interest rate and currency swaps. Prudential is also exposed to credit-related losses in the event of non-performance by counterparties.
iv Use of derivatives In the UK and Asia, Prudential uses derivatives to reduce equity and credit risk, interest rate and currency exposures, and to facilitate efficient investment management. In the US, Prudential uses derivatives to reduce interest rate risk, to facilitate efficient portfolio management and to match liabilities under annuity policies, and for certain equity-based product management activities.
Further details of the Group’s use of derivatives are explained in note G3. It is Prudential’s policy that cash or corresponding assets cover amounts at risk through derivative transactions. Derivative financial instruments used to facilitate efficient portfolio management and for investment purposes are carried at fair value with changes in fair value included in long-term investment returns.
v Operational, compliance and fiscal risk Operational risk is the risk of direct or indirect loss resulting from inadequate or failed internal processes people or systems or from external events. Operational risk can result from a variety of factors, including failure to obtain proper internal authorisations or maintain internal controls, failure to document transactions properly, failure of operational and information security procedures or other procedural failures, computer system or software failures, other equipment failures, fraud, inadequate training or errors by employees. Compliance with internal rules and procedures designed to manage these risks is monitored by Prudential’s local management boards.
For businesses that are most sensitive to interest rate changes, such as immediate annuity business, Prudential uses cash flow analysis to create a portfolio of fixed income securities whose value changes in line with the value of liabilities when interest rates change. This type of analysis helps protect profits from changing interest rates. In the UK, the cash flow analysis is used in Prudential’s annuity business while, in the US, it is used for its interest-sensitive and fixed index annuities and stable value products such as Guaranteed Investment Contracts (GICs). Perfect matching is not possible for interest-sensitive and fixed index annuities because of the nature of the liabilities (which include guaranteed surrender values) and options for prepayment contained in the assets.
vi Asset/liability management continued For businesses that are most sensitive to equity price changes, Prudential uses stochastic modelling and scenario testing to look at the expected future returns on its investments under different scenarios that best reflect the large diversity in returns that equities can produce. This allows Prudential to devise an investment and with-profits policyholder bonus strategy that, on the model assumptions, allows it to optimise returns to its policyholders and shareholders over time, while maintaining appropriate financial strength. Prudential uses this method extensively in connection with its UK with-profits business.
vii Regulatory capital requirements Regulatory capital requirements apply at an individual company level for the Group life assurance and asset management business. These are described in sections D5 and E3 respectively. Capital requirements also applied for the Group’s discontinued banking operations, as described in note J8.
The FSA has established a structure for determining how much hybrid debt can count as capital which is similar to that used for banks. It categorises capital as Tier 1 (equity and preference shares), Upper Tier 2 and Lower Tier 2. Up to 15 per cent of Tier 1 capital can be in the form of hybrid debt and is called ‘Innovative Tier 1’. At 31 December 2007 the Group held £763 million (31 December 2006: £763 million) of Innovative Tier 1 capital in the form of perpetual securities, £nil million (£250 million) of Upper Tier 2 and £932 million (£1,103 million) of Lower Tier 2 capital. Further details on these amounts and other Group borrowings are shown in note H13.
Notes on the Group financial statements C: Group risk management continued
– fixed and variable annuity business and life insurance; and — Prudential Corporation Asia
Prudential’s internal Group economic capital requirement is defined as the minimum amount of capital that the Group needs to hold in order to remain economically solvent over a 25-year horizon, given a target probability of insolvency appropriate for AA-rated debt. The target confidence level is based on historic default rates for AA-rated debt, and varies over the time horizon of the projection. The economic capital requirement is calculated in respect of existing contractual and discretionary liabilities only, excluding the impact of future new business and dividend distribution.
The Group economic capital position is calculated using the Group Solvency Model (GSM) – an integrated stochastic asset/liability model of the Group economic solvency position. Projected economic scenarios in the GSM are generated using a stochastic economic scenario generator that captures the correlations between different asset classes and geographies.
The largest risk exposure continues to be credit risks which reflect the relative size of exposure in Jackson and the UK shareholder annuities business. However, credit risk has reduced due to the sale of Egg and Jackson’s maturing fixed annuity business.
An example of the diversification benefits for Prudential is that adverse scenarios do not affect all business units in the same way, providing natural hedges within the Group. For example, the Group’s US business is sensitive to increasing interest rates, whereas, in contrast, several business units in Asia benefit from increasing rates. Conversely, these Asian business units are sensitive towards low interest rates, whereas the US benefits from falling interest rates. The economic capital framework also takes into account situations where factors are correlated, for example the extent of correlation between Asian and US economies.
ii Ceded business The Group cedes certain business to other insurance companies. Although the ceding of insurance does not relieve the Group of liability to its policyholders, the Group participates in such agreements for the purpose of managing its loss exposure. The Group evaluates the financial condition of its reinsurers and monitors concentration of credit risk from similar geographic regions, activities or economic characteristics of the reinsurers to minimise its exposure from reinsurer insolvencies. There are no significant concentrations of reinsurance risk. At 31 December 2007, 98 per cent of the reinsurance recoverable insurance assets were ceded by the Group’s UK and US operations, of which 88 per cent of the balance were from reinsurers with Standard & Poor’s rating AA- and above. A similar position was held at 31 December 2006.
Encumbered capital is based on the Group’s internal target for economic capital subject to it meeting at least the local statutory minimum requirements. Economic capital is assessed using internal models but does not take credit for the significant diversification benefits that exist within the Group.
The present value of the future distributable earnings is calculated using a risk discount rate which reflects both the time value of money and the risks associated with the cash flows that are not otherwise allowed for. The risk allowance covers market and non-market risks.
For the UK shareholder-backed annuity business an additional margin of 100 basis points was used (2006: 100 basis points).
D1: Group overview continued Details of the key assumptions and sensitivity of the EEV value of in-force business are shown in the sections for each geographic segment that follow in this note. The sensitivity of the present value of the discounted future cash flows under the EEV methodology is of particular interest. The sensitivity provides an indication of the movement in the net value ascribable to potential variations in the amounts and timing of future cash flows to shareholders and the uncertainty attached to those cash flows.
Market risk is the risk that the fair value or future cash flows of a financial instrument or, in the case of liabilities of insurance contracts, their carrying value will fluctuate because of changes in market prices. Market risk comprises three types of risk, namely: — Currency risk: due to changes in foreign exchange rates, — interest rate risk: due to changes in market interest rates, and — other price risk: due to fluctuations in market prices (other than those arising from interest rate risk or currency risk).
Three key points are to be noted, namely: — The Group’s with-profit and unit-linked funds absorb most market risk attaching to the fund’s investments. Except for second order effects, for example on asset management fees and shareholders’ share of cost of bonuses for with-profits business, shareholder results are not directly affected by market value movements on the assets of these funds.
Type of business Investments/derivatives Liabilities/unallocated surplus Indirect exposure Insurance and lapse risk
Unit-linked business Net neutral direct exposure (Indirect exposure only) Investment performance Persistency risk through asset management fees
Variable annuity Net effect of market risk arising from incidence of Investment performance business guarantee features and variability of asset management through asset fees offset by derivative hedging programme management fees
Jackson’s derivative programme is used to substantially mitigate equity market risk attaching to its equity-based products and interest rate risk associated with its spread-based products. Combined with the spread based nature of Jackson’s other products and the US GAAP basis of measuring liabilities to policyholders, Jackson’s risk exposure at the operating profit level based on longer-term investment returns is relatively less significant than for other parts of the Group. However, movements in interest rates and credit spreads materially affect the carrying value of derivatives which are used to manage the liabilities to policyholders and backing investment assets of fixed annuity and other general account business. Combined with the use of US GAAP measurement for the asset and liabilities for the insurance contracts, which is largely insensitive to current period market movements, the Jackson total profit (i.e. including short-term fluctuations in investment returns) is very sensitive to market movements. In addition to these effects the Jackson IFRS equity is sensitive to the impact of interest rate and credit spread movements on the value of fixed income securities. Movements in unrealised appreciation on these securities are included as movement in equity (i.e. outside the income statement).
M&G profits are affected primarily by movements in the growth in funds under management and of the effect of any impairment on the loan book of Prudential Capital.
— Prudential Annuities Limited (PAL) PAL’s business is not with-profit; it writes annuity business. However, as PAL is owned by the PAC with-profits sub-fund, changes in the carrying value of PAL’s assets and liabilities are reflected in the liability for unallocated surplus which as described above, changes to which do not affect shareholder results.
— Scottish Amicable Insurance Fund (SAIF) SAIF is a ring-fenced fund in which, apart from asset management fees, shareholders have no interest. Accordingly, the Group’s IFRS profit and equity are insensitive to the direct effects of market risk attaching to SAIF’s assets and liabilities.
— Prudential Retirement Income Limited (PRIL) The assets covering PRIL’s liabilities are principally debt securities and other investments that are held to match the expected duration and payment characteristics of the policyholder liabilities. These liabilities are valued for IFRS reporting purposes by applying discount rates that reflect the market rates of return attaching to the covering assets.
Except mainly to the extent of any minor asset/liability duration mismatch and exposure to credit risk, the sensitivity of the Group’s results to market risk for movements in the carrying value of PRIL’s liabilities and covering assets is broadly neutral on a net basis.
The principal items affecting the IFRS results for PRIL are mortality experience and assumptions and credit risk.
— PAC non-profit sub-fund The PAC non-profit sub-fund principally comprises annuity business previously written by Scottish Amicable Life, credit life, unit-linked and other non-participating business.
Jackson The IFRS basis results of Jackson are highly sensitive to market risk on the assets covering liabilities for fixed annuity, term, institutional and other variable annuity business not segregated in the separate accounts.
These differences in carrying value give rise to potentially significant volatility in the IFRS income statement and shareholders’ equity. As for other shareholder-backed business the profit or loss for Jackson is presented in the Group’s supplementary basis of reporting as described in note B1, by distinguishing the result for the year between an operating result based on longer-term investment returns and short-term fluctuations in investment returns. In this way the most significant direct effect of market changes that have taken place to the Jackson result are separately identified.
In addition to these features the overriding factor that affects IFRS basis results for Asian non-participating business is the return on the assets covering the Taiwan whole of life policies. This factor directly affects the actual return in any given reporting period. In addition though, the measurement of the liabilities to policyholders and the carrying value of deferred acquisition costs for this business is dependant upon an assessment of longer-term interest rates. This key feature is described in more detail in notes D4(d) and (h)(iii).
In the UK, adverse persistency experience can effect the level of profitability from with-profits and unit-linked business. For with-profits business in any given year, the amount represented by the shareholders’ share of cost of bonus may be only marginally affected. However, altered persistency trends may affect the embedded value of the business in force reflecting an altered value of future expected shareholder transfers.
iii Impact of diversification on risk exposure The Group enjoys significant diversification benefits. This arises because not all risk scenarios will happen at the same time and across all geographic regions. The Group tests the sensitivities of results to different correlation factors such as: Correlation across geographic regions — Financial risk factors — Non-financial risk factors.
Correlation across risk factors — Longevity risk — Expenses — Persistency — Other risks.
Intangible assets attributable to PAC with-profits fund: In respect of acquired subsidiaries for venture fund and other investment purposes – 192 – 192 – – – – 192 830
Other non-investment and non-cash assets 161 2,086 289 2,375 512 660 725 1,897 4,433 4,733
Held for sale assets 30 – – – – – – – 30 463
Fund Annuities Limited Total Income Unit-linked Other 2007 2006 note ii Limited note iii note iv Limited business business Total Total Total £m £m £m £m £m £m £m £m £m £m
Operational borrowings attributable to shareholder-financed operations – – – – – 12 – 12 12 11
Notes i For the purposes of this table and subsequent explanation, references to the WPSF also include, for convenience, the amounts attaching to the
vi Included in debt securities above are £3,511 million (2006: £3,341 million) of securities which are not quoted on active markets and are valued using valuation techniques of which £3,002 million (2006: £2,945 million) related to assets held by with-profits operations and £509 million (2006: £396 million) related to assets held by shareholder-backed operations.
Derivative assets (note G3) 571 Partnerships in investment pools and other 2,820
b Information on credit risk of debt securities The following table summarises by rating the securities held by UK insurance operations as at 31 December 2007 and 2006: PAC with-profits sub-fund Other funds and subsidiaries
In the table above S&P ratings have been used where available. For securities where S&P ratings are not available those produced by Moody’s and then Fitch have been used as an alternative.
i With-profits products and PAC with-profits sub-fund Within the balance sheet of UK insurance operations at 31 December 2007, there are policyholder liabilities of £76.3 billion (2006: £74.1 billion) and unallocated surplus of £14.2 billion (2006: £13.5 billion) that relate to the WPSF. The WPSF mainly contains with-profits business but it also contains some non-profit business (unit-linked, term assurances and annuities). The WPSF’s profits are apportioned 90 per cent to its policyholders and 10 per cent to shareholders as surplus for distribution is determined via the annual actuarial valuation.
For many years, UK with-profits product providers, such as Prudential, have been required by law and regulation to consider the reasonable expectations of policyholders in setting bonus levels. This concept is established by statute but is not defined. However, it is defined within the regulatory framework, which also more recently contains an explicit requirement to treat customers fairly.
The WPSF held a provision of £45 million at 31 December 2007 (2006: £47 million) to honour guarantees on a small amount of guaranteed annuity products. SAIF’s exposure to guaranteed annuities is described below.
ii Annuity business Prudential’s conventional annuities include level, fixed increase and retail price index (RPI) annuities. They are mainly written within the subsidiaries PAL, PRIL, Prudential Pensions Limited and the PAC with-profits sub-fund, but there are some annuity liabilities in the non-profit sub-fund and SAIF.
Prudential’s fixed-increase annuities incorporate automatic increases in annuity payments by fixed amounts over the policyholder’s life. The RPI annuities that Prudential offers provide for a regular annuity payment to which an additional amount is added periodically based on the increase in the UK RPI.
D2: UK insurance operations continued iii SAIF SAIF is a ring-fenced sub-fund of the PAC long-term fund formed following the acquisition of the mutually owned Scottish Amicable Life Assurance Society in 1997. No new business may be written in SAIF, although regular premiums are still being paid on policies in force at the time of the acquisition and incremental premiums are permitted on these policies.
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.
D2: UK insurance operations continued Maintenance and, for some classes of business, termination expense assumptions are expressed as per policy amounts. They are set based on the expenses incurred during the year, including an allowance for ongoing investment expenditure and allocated between entities and product groups in accordance with the operation’s internal cost allocation model. For non-profit business a margin for adverse deviation is added to this amount. Expense inflation assumptions are set consistent with the economic basis and based on the difference between yields on nominal gilts and index-linked gilts.
The actual renewal expenses charged to SAIF continued to be based on the tariff arrangement specified in the Scottish Amicable Life Assurance Society Scheme up to 31 December 2007, when the tariff arrangement terminated. This provided an additional margin in SAIF as the unit costs derived from actual expenses (and used to derive the recommended assumptions) were generally significantly greater than the tariff costs. From 1 January 2008 the full expenses incurred are being charged to SAIF.
The FSA’s Peak 2 calculation under the realistic regime requires the value of liabilities to be calculated as: — The with-profits benefits reserve (WPBR); plus — future policy related liabilities (FPRL); plus — the realistic current liabilities of the fund.
D2: UK insurance operations continued The contract liabilities for with-profits business also require assumptions for persistency. These are set based on the results of recent experience analysis.
In payment 106% – 126% PNMA00 84% – 117% PNFA00 99% – 114% PNMA00 85% – 103% PNFA00 (C = 2000) with medium (C = 2000) with 75% (C = 2000) with medium (C = 2000) with 75% cohort improvement of medium cohort cohort improvement of medium cohort table with a minimum improvement table table with a minimum improvement table annual improvement with a minimum annual annual improvement with a minimum annual of 1.25% improvement of 0.75% of 1.25% improvement of 0.75%
In payment 93% – 100% PMA92 84% – 105% PFA92 88% – 100% PMA92 84% – 102% PFA92 (C = 2004) with medium (C = 2004) with 75% (C = 2004) with medium (C = 2004) with 75% cohort improvement of medium cohort cohort improvement of medium cohort table with a minimum improvement table table with a minimum improvement table annual improvement with a minimum annual annual improvement with a minimum annual of 1.25% improvement of 0.75% of 1.25% improvement of 0.75%
g Effect of changes in assumptions used to measure insurance assets and liabilities
PAL. The resulting assumptions for expected defaults, after allowing for the release of margins, remain appropriate given economic conditions at 31 December 2007. In addition, for PAL, there is a release of £60 million in respect of asset management fees.
The changes to the FSA rules allow insurance liabilities for this business to incorporate more realism. In particular this is achieved by: — setting technical provisions for expenses not directly attributable to one particular contract at a homogenous risk group level and not, as previously, at an individual contract level for all non-profit business; and
— recognising the economic effect of making a prudent lapse rate assumption. Previously, no lapses were assumed.
Fixed annuities 5.4 to 5.6 5.0 to 5.1 Linked annuities 5.0 to 5.2 4.8 to 5.0
Notes i The assumed long-term rate for corporate bonds for 2007 for with-profits business reflects the purchase of credit default swaps. ii The pre-tax rate of return for annuity business is based on the gross redemption yield on the backing assets net of a best estimate allowance for future defaults.
D2: UK insurance operations continued The sensitivity of the value of in-force business and net worth to changes in key assumptions is as follows: Economic assumptions: Discount rates – 1% increase (534) (480) Interest rates (including consequential changes for assumed investment returns for all asset classes, market values of debt securities, and all risk discount rates):*
Non-economic assumptions: Maintenance expenses – 10% decrease 36 33 Lapse rates – 10% decrease 87 75 Mortality and morbidity – 5% decrease in base rates (i.e. increased longevity) (103) (87)
*2006 comparatives for the sensitivity to interest rate changes have been adjusted from previously published data for the effect of revisions to the calculation of the with-profits fund.
i Sensitivity of IFRS basis profit or loss and equity to market and other risks The risks to which the IFRS basis results of the UK insurance operations are sensitive are asset/liability matching, mortality experience and payment assumptions for shareholder-backed annuity business. Further details are described below.
The 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 as detailed in note D2(e)(iii), 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 risk.
Carrying value of debt securities and derivatives 1,930 (1,634) 1,802 (1,529)
Net sensitivity of profit after tax and equity 110 (120) 91 (108)
Insurance Investment Insurance Investment contracts contracts Total PAL PRIL Total contracts contracts Total 2006 £m
Notes i The cash flow projections of expected benefit payments used in the maturity profile table above are from value of in-force business and exclude the value of future new business, including vesting of internal pension contracts. ii Benefit payments do not reflect the pattern of bonuses and shareholder transfers in respect of the with-profits business. iii Investment contracts under Other comprise certain unit-linked and similar contracts accounted for under IAS 39 and IAS 18. iv For business with no maturity term included within the contracts, for example with-profits investment bonds such as Prudence Bond, an assumption is made as to likely duration based on prior experience.
Related change in amortisation of deferred income and acquisition costs 88 75
With the exception of debt securities for US insurance operations classified as ‘available-for-sale’ under IAS 39, unrealised value movements on the Group’s investments are booked within the income statement. For with-profits operations such value movements are reflected in changes to asset share liabilities to policyholders and the liability for unallocated surplus. For shareholder-backed operations the unrealised value movements form part of the total return for the year booked in the profit before tax attributable to shareholders, which is then, in the Company’s supplementary IFRS information, analysed between operating profit based on longer-term investment return and short-term fluctuations in investment returns.
However, for debt securities classified as ‘available-for-sale’, unless impaired, fair value movements are recorded as a movement in shareholder reserves direct to equity. Impairments are recorded in the income statement as shown in note B1.
In general, the debt securities of the Group’s US insurance operations are purchased with the intention and the ability to hold them for the longer term. In 2007, there was a movement in the balance sheet value for these debt securities classified as available-for-sale from a net unrealised gain of £110 million to a net unrealised loss of £136 million. During 2007, US interest rates fell and the yield curve steepened. Offsetting this movement were market price effects resulting from increasing credit spreads and global credit concerns. As a result of these factors, the gross unrealised gain in the balance sheet decreased from £366 million at 31 December 2006 to £303 million at 31 December 2007 while the gross unrealised loss increased from £256 million at 31 December 2006 to £439 million at 31 December 2007. Details of the securities in an unrealised position are shown in D3(b) below.
D3: US insurance operations continued These features are included in the table shown below of the movements in the values of available-for-sale securities: Change in unrealised appreciation £m £m £m
Assets fair valued at below book value Book value 10,730 11,258
Assets fair valued at or above book value Book value 8,041 8,208
Reflected as part of movement in shareholders’ equity Movement in unrealised appreciation (244) Exchange movements (2)
*Debt securities for US operations as included in the balance sheet of £19,002 million comprise £18,635 million in respect of securities classified as ‘available-for-sale’ and £367 million for securities of consolidated investment funds classified as ‘fair value through profit and loss’.
Assets Intangible assets attributable to shareholders: Deferred acquisition costs and other intangible assets – 1,928 1,928 1,712
Investment contract liabilities without discretionary participation features (GIC and annuity certain) – 1,922 1,922 1,562
The loans of Jackson of £3,258 million comprise mortgage loans of £2,841 million and policy loans of £417 million. All of the mortgage loans are commercial mortgage loans which are collateralised by properties. The property types are mainly industrial, multi-family residential, suburban office, retail and hotel.
D3: US insurance operations continued Notes continued iii Other investments comprise: £m
Derivative assets (note G3) 390 Partnerships in investment pools and other 372
Partnerships in investment pools and other comprise primarily investments in limited partnerships. These include interest in the PPM America Private Equity Fund and diversified investments in 164 other partnerships by independent money managers that generally invest in various equities and fixed income loans and securities.
Policy reserves and liabilities on non-linked business: Reserves for future policyholder benefits and claims payable 916 935 Deposits on investment contracts (as defined under US GAAP) 16,784 17,690 Guaranteed investment contracts 1,685 1,327 Unit-linked (variable annuity) business 15,027 11,367
Corporate security and commercial loans: Publicly traded and SEC Rule 144A traded 10,345 11,569 Non-SEC Rule 144A traded 2,613 2,458
Residential mortgage-backed securities 2,939 2,827 Commercial mortgage-backed securities 1,532 1,155 Other debt securities 1,573 2,137
Credit quality For statutory reporting in the US, debt securities are classified into six quality categories specified by the Securities Valuation Office of the National Association of Insurance Commissioners (NAIC). The categories range from Class 1 (the highest) to Class 6 (the lowest). Performing securities are designated as Classes 1 to 5. Securities in or near default are designated Class 6. Securities designated as Class 3, 4, 5 and 6 are non-investment grade securities. Generally, securities rated AAA to A by nationally recognised statistical ratings organisations are reflected in Class 1, BBB in Class 2, BB in Class 3 and B and below in Classes 4 to 6. If a designation is not currently available from the NAIC, Jackson’s investment adviser, PPM America, provides the designation for the purposes of disclosure below.
The following table shows the quality of publicly traded and SEC Rule 144A traded debt securities held by the US operations as at 31 December 2007 and 2006 by NAIC classifications: Notes on the Group financial statements D: Life assurance businesses continued
Carrying value Carrying value £m % of total £m % of total
NAIC designation: The following table shows the quality of the non-SEC Rule 144A traded private placement portfolio by NAIC classifications: Carrying value Carrying value £m % of total £m % of total
Residential mortgage-backed securities (included within debt securities) Total residential mortgage-backed securities 2,939 2,827 Residential mortgage-backed securities rated AAA or equivalent by a nationally recognised statistical ratings organisation (including Standard & Poor’s, Moody’s and Fitch): Percentage of total 86.5% 61.9% Residential mortgage-backed securities rated NAIC 1: Percentage of total 99.8% 99.9% Commercial mortgage-backed securities (included within debt securities) Total commercial mortgage-backed securities 1,532 1,155 Commercial mortgage-backed securities rated AAA or equivalent by a nationally recognised statistical ratings organisation (including Standard & Poor’s, Moody’s and Fitch): Percentage of total 88.2% 94.4% Commercial mortgage-backed securities rated NAIC 1: Percentage of total 95.4% 93.2%
Moody’s – Aaa 549 Moody’s –Aa1 to Aa3 118 Moody’s –A1 to A3 47 Moody’s – Baa1 to Baa3 79 Moody’s – Other 78
Debt securities above are shown net of cumulative impairment losses on retained securities of £246 million (2006: £266 million). Included within the debt securities of Jackson at 31 December 2007 are exposures to sub-prime and Alt-A mortgages and
Sub-prime mortgages (S&P rated AAA) 237 Alt-A mortgages (77% AAA, 17% AA) 660
CDO funds* 260 *Including Group’s economic interest in Piedmont (as described in note G1) and other consolidated CDO portfolios.
Debt securities classified as available-for-sale in an unrealised loss position The unrealised losses in the US insurance operations balance sheet on unimpaired securities are (£439) million (2006: £(256) million). This reflects assets with fair market value and book value of £10,291 million and £10,730 million respectively.
The following table shows some key attributes of the debt securities that are in an unrealised loss position at 31 December
Included within the table above are amounts relating to sub-prime and Alt-A securities of: Fair value Unrealised loss Fair value of securities as a percentage of book value £m £m
Non- NonAged analysis of unrealised Not investment Investment Total Not investment Investment Total losses for the periods indicated rated grade grade rated grade grade
More than 10 years (60) (51) Mortgage-backed securities and other debt securities (160) (62)
c Products and guarantees Jackson provides long-term savings and retirement products to retail and institutional customers throughout the US. Jackson offers fixed annuities (interest-sensitive, fixed indexed and immediate annuities), variable annuities (VA), life insurance and institutional products.
i Fixed annuities Interest-sensitive annuities At 31 December 2007, interest-sensitive fixed annuities accounted for 25 per cent (2006: 31 per cent) of policy and contract liabilities of Jackson. Interest-sensitive fixed annuities are primarily deferred annuity products that are used for retirement planning and for providing income in retirement. They permit tax-deferred accumulation of funds and flexible payout options.
D3: US insurance operations continued ii Variable annuities At 31 December 2007, VAs accounted for 45 per cent (2006: 38 per cent) of Jackson’s policy and contract liabilities. VAs are deferred annuities that have the same tax advantages and payout options as interest-sensitive and fixed indexed annuities.
The primary differences between VAs and interest-sensitive or fixed indexed annuities are investment risk and return. If a policyholder chooses a VA, the rate of return depends upon the performance of the selected fund portfolio. Policyholders may allocate their investment to either the fixed or variable account. Investment risk on the variable account is borne by the policyholder, while investment risk on the fixed account is borne by Jackson through guaranteed minimum fixed rates of return. At 31 December 2007, approximately nine per cent (2006: 13 per cent) of VA funds were in fixed accounts.
iii Life insurance Jackson’s life insurance products accounted for nine per cent (2006: 10 per cent) of Jackson’s policy and contract liabilities at 31 December 2007. The products offered include variable universal life insurance, term life insurance and interest-sensitive life insurance.
D3: US insurance operations continued Jackson uses free-standing derivative instruments for hedging purposes. Additionally, certain liabilities, primarily trust instruments supported by funding agreements, fixed indexed annuities, certain GMWB variable annuity features and reinsured GMIB variable annuity features contain embedded derivatives as defined by IAS 39, ‘Financial Instruments: Recognition and Measurement’. Jackson does not account for such derivatives as either fair value or cash flow hedges as might be permitted if the specific hedge documentation requirements of IAS 39 were followed. Financial derivatives, including derivatives embedded in certain host liabilities that have been separated for accounting and financial reporting purposes are carried at fair value.
Value movements on the derivatives are reported within the income statement. Under the Group’s accounting policies supplementary analysis of the profit before taxes attributable to shareholders is provided as shown in note B1. In preparing this analysis, value movements on Jackson’s derivative contracts, other than for certain equity-based product management activities, are included within short-term fluctuations in investment returns and excluded from operating results based on longer-term investment returns. Value movements on derivative instruments used for certain equity-based product management activities are included within operating results based on longer-term investment returns, as the value movements broadly offset the economic impact of changed levels of benefit payments and reserves as equity markets fluctuate. The types of derivatives used by Jackson and their purpose are as follows: — Interest rate swaps generally involve the exchange of fixed and floating payments over the life of the agreement without an exchange of the underlying principal amount. These agreements are used for hedging purposes; — forwards consist of interest spreadlock agreements, in which Jackson locks in the forward interest rate differential between a swap and the corresponding US Treasury security. The forwards are held as a hedge of corporate spreads; — put-swaption contracts provide the purchaser with the right, but not the obligation, to require the writer to pay the present value of a long-duration interest rate swap at future exercise dates. Jackson purchases and writes put-swaptions with maturities up to 10 years. On a net basis, put-swaptions hedge against significant upward movements in interest rates; — equity index futures contracts and equity index call and put options are used to hedge Jackson’s obligations associated with its issuance of fixed indexed immediate and deferred annuities and certain VA guarantees. These annuities and guarantees contain embedded options which are fair valued for financial reporting purposes; — total return swaps in which Jackson receives equity returns or returns based on reference pools of assets in exchange for short-term floating rate payments based on notional amounts, are held for both hedging and investment purposes; — cross-currency swaps, which embody spot and forward currency swaps and additionally, in some cases, interest rate swaps and equity index swaps, are entered into for the purpose of hedging Jackson’s foreign currency denominated funding agreements supporting trust instrument obligations; — spread cap options are used as a macro-economic hedge against declining interest rates. Jackson receives quarterly settlements based on the spread between the two-year and the 10-year constant maturity swap rates in excess of a specified spread; and
e Process for setting assumptions and determining contract liabilities Under the MSB of reporting applied under IFRS 4 for insurance contracts, providing the requirements of the Companies Act, UK GAAP standards and the ABI SORP are met, it is permissible to reflect the previously applied UK GAAP basis. Accordingly, and consistent with the basis explained in note A4, in the case of Jackson the carrying values of insurance assets and liabilities are consolidated into the Group accounts based on US GAAP.
Under US GAAP, investment contracts (as defined for US GAAP purposes) are accounted for by applying in the first instance a retrospective deposit method to determine the liability for policyholder benefits. This is then augmented by potentially three additional amounts. These amounts are for: — Any amounts that have been assessed to compensate the insurer for services to be performed over future periods (i.e. deferred income); — any amounts previously assessed against policyholders that are refundable on termination of the contract; and — any probable future loss on the contract (i.e. premium deficiency).
D3: US insurance operations continued 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 profits is generally computed using the rate of interest that accrues to policyholder balances (sometimes referred to as the contract rate). Estimated gross profits 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: — Amounts expected to be assessed for mortality less benefit claims in excess of related policyholder balances; — amounts expected to be assessed for contract administration less costs incurred for contract administration; — amounts expected to be earned from the investment of policyholder balances less interest credited to policyholder balances; — amounts expected to be assessed against policyholder balances upon termination of contracts (sometimes referred to as surrender charges); and — other expected assessments and credits.
The direct GMIB liability is determined by estimating the expected value of the annuitisation benefits in excess of the projected account balance at the date of annuitisation and recognising the excess ratably over the accumulation period based on total expected assessments.
The assumptions used for calculating the direct GMIB liability at 31 December 2007 and 2006 are consistent with those used for calculating the GMDB liability.
Jackson regularly evaluates estimates used and adjusts the additional GMDB and GMIB liability balances, with a related charge or credit to benefit expense, if actual experience or other evidence suggests that earlier assumptions should be revised.
f Reinsurance The principal reinsurance ceded by Jackson outside the Group is on term life insurance, direct and assumed accident and health business and GMIB variable annuity guarantees. In 2007, the premiums for such ceded business amounted to £60 million (2006: £66 million). Net commissions received on ceded business and claims incurred ceded to external reinsurers totalled £10 million and £47 million, respectively, during 2007 (2006: £12 million and £53 million respectively). There were no deferred gains or losses on reinsurance contracts in either 2007 or 2006. The reinsurance asset for business ceded outside the Group was £436 million (2006: £427 million).
The operating profit based on longer-term investment returns of £398 million for US insurance operations for 2006 was determined after taking account of several changes of assumptions during the year. Generally, assumptions were modified in 2006 to conform to more recent experience. These changes included revisions to the assumptions regarding utilisation of free partial withdrawal options, resulting in a decrease in Deferred Acquisition Costs (DAC) of £12 million. In addition, several smaller changes relating to lapse rates, mortality rates and other assumptions resulted in an increase of £6 million in DAC. Combined with other minor modifications, the resulting net impact of all changes during the year was a decrease in pre-tax profits of £7 million.
D3: US insurance operations continued i Sensitivity of IFRS basis profit and equity to market and other risks i Currency fluctuations Consistent with the Group’s accounting policies, the profits of the Group’s US operations are translated at average exchange rates and shareholders’ equity at the closing rate for the reporting period. For 2007, the rates were US$2.00 (2006: US$1.84) and US$1.99 (2006: US$1.96) to £1 sterling, respectively. A 10 per cent increase or decrease in these rates would reduce or increase profit before tax attributable to shareholders, profit for the year and shareholders’ equity attributable to US insurance operations respectively as follows: A 10% increase in A 10% decrease in exchange rates exchange rates
Profit before tax attributable to shareholders (39) (42) 48 51 Profit for the year (29) (29) 35 35 Shareholders’ equity attributable to US insurance operations (242) (247) 296 293 ii Other sensitivities The principal determinants of variations in operating profit based on longer-term returns are: — Growth in the size of assets under management covering the liabilities for the contracts in force; — incidence of guarantees; and — spread returns for the difference between investment returns and rates credited to policyholders.
D3: US insurance operations continued iii Exposure to equity risk As noted in note D3(d), Jackson is exposed to equity risk through the options embedded in the fixed indexed liabilities and GMDB and GMWB guarantees included in certain VA benefits. This risk is managed using a comprehensive equity hedging programme to minimise the risk of a significant economic impact as a result of increases or decreases in equity market levels while taking advantage of naturally offsetting exposures in Jackson’s operations. Jackson purchases external futures and options that hedge the risks inherent in these products, while also considering the impact of rising and falling separate account fees. As a result of this hedging programme, if the equity markets were to increase, Jackson’s free-standing derivatives would decrease in value. However, over time, this movement would be broadly offset by increased separate account fees and reserve decreases, net of the related changes to amortisation of deferred acquisition costs. Due to the nature of the free-standing and embedded derivatives, this hedge, while highly effective on an economic basis, may not completely mute the immediate impact of the market movements as the free-standing derivatives reset immediately while the hedged liabilities reset more slowly (see note D3(e) for further details on the valuation of the guarantees) and fees are recognised prospectively. It is estimated that an immediate increase in the equity markets of 10 per cent would result in an accounting charge, net of related DAC amortisation, before tax of up to £30 million (2006: £20 million), excluding the impact on future separate account fees. After related deferred tax there would have been an estimated reduction in shareholders’ equity at 31 December 2007 of up to £20 million (2006: £13 million). An immediate decrease in the equity markets of 10 per cent would result in an approximately equal and opposite estimated effect on profit and shareholders’ equity. The actual impact on financial results would vary contingent upon the volume of new product sales and lapses, changes to the derivative portfolio, correlation of market returns and various other factors including volatility, interest rates and elapsed time.
iv Exposure to interest rate risk Notwithstanding the market risk exposure described in note D3(d), 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 liabilities of Jackson products is not generally sensitive to interest rate risk. This position derives from the nature of the products and the US GAAP basis of measurement described in notes D3(c) and D3(e).
D3: US insurance operations continued However, the debt securities and related derivatives are marked to market value. Value movements on derivatives, again net of related changes to amortisation of DAC and deferred tax, are recorded within profit and loss. Market value movements on debt securities, net of related changes to amortisation of DAC and deferred tax, are recorded within the statement of changes in equity. The estimated sensitivity of these items and policyholder liabilities to a one per cent decrease and increase in interest rates at 31 December 2007 and 2006 is as follows: A 1% decrease in A 1% increase in interest rates interest rates
Direct effect on carrying value of debt securities 848 858 (848) (858) Related effect on amortisation of DAC (212) (214) 212 214 Related effect on movement in deferred tax (223) (225) 223 225
Assets Intangible assets attributable to shareholders: Deferred acquisition costs and other intangible assets – – 745 745 612
Notes i The balance sheet for with-profits business comprises the with-profits assets and liabilities of the Hong Kong, Malaysia and Singapore with-profits operations. Assets and liabilities of other participating business are included in the column for ‘other business’. ii The loans of the Group’s Asian insurance operations of £1,087 million comprise mortgage loans of £132 million, policy loans of £430 million and other loans of £525 million. 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 Malaysian operation and which are all investment graded by two local rating agencies.
D4: Asian insurance operations continued Notes continued iii Credit quality of debt securities
Of the £598 million debt securities for other business which are not rated in the table above, £317 million are in respect of government bonds, £83 million corporate bonds rated as investment grade by local external ratings agencies, and £71 million structured deposits issued by banks which are themselves rated but where the specific deposits have not been.
At 31 December 2007, the policyholder liabilities (net of reinsurance) and unallocated surplus for Asian operations of £17.2 billion (2006: £12.9 billion) comprised the following: Hong Kong 3,901 3,045
D4: Asian insurance operations continued b Products and guarantees The life insurance products offered by the Group’s Asian operations include a range of with-profits and non-participating term, whole life, endowment and unit-linked policies. The Asian operations also offer health, disability, critical illness and accident coverage to supplement its core life products.
The terms and conditions of the contracts written by the Asian operations and, in particular, the products’ options and guarantees, vary from territory to territory depending upon local market circumstances.
Cash value and interest rate guarantees are of three types: — Maturity values Maturity values are guaranteed for non-participating products and on the guaranteed portion of participating products. Declared annual bonuses are also guaranteed once vested. Future bonus rates and cash dividends are not guaranteed on participating products.
— 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 reflected within the guaranteed maturity and surrender values.
On the US GAAP basis the calculations are deterministic, that is to say based on a single set of projections, and expected long-term rates of return are applied.
d Process for setting assumptions and determining liabilities The future policyholder benefit provisions for Asian businesses in the Group’s IFRS accounts and previously under the MSB, are determined in accordance with methods prescribed by local GAAP adjusted to comply, where necessary, with UK GAAP.
For Asian operations in countries where local GAAP is not well established and in which the business written is primarily non-participating and linked business, US GAAP is used as the most appropriate reporting basis. Of the more significant Asian operations, this basis is applied in Taiwan, Japan and Vietnam. The future policyholder benefit provisions for non-linked business are determined under FAS 60 using the net level premium method, with an allowance for surrenders, maintenance and claims expenses. Rates of interest used in establishing the policyholder benefit provisions vary by operation depending on the circumstances attaching to each block of business.
e Reinsurance The Asian businesses cede only minor amounts of business outside the Group with immaterial effects on reported profit. During 2007, reinsurance premiums for externally ceded business were £52 million (2006: £47 million) and the reinsurance assets were £12 million (2006: £8 million) in aggregate.
The most significant businesses in Asia are in Hong Kong, Malaysia, Singapore and Taiwan. These businesses account for 74 per cent (2006: 75 per cent) of the total value of business in-force for the Asian operations. These EEV basis in-force values have been determined after applying the principles of valuation described in section D1 and the following key assumptions for the four most significant businesses.
Expected Expected Risk discount long-term Risk discount long-term rate (in-force rate of Government rate (in-force rate of Government business)† inflation bond yield business)† inflation bond yield *Hong Kong business is predominantly US dollar denominated. † For 2007, cash rates rather than government bond yields were used in setting the risk discount rates for Malaysia, Singapore, Taiwan and for
Hong Kong dollar denominated business. For 2006, cash rates were used for these operations and for all Hong Kong business (i.e. including US dollar denominated business).
The most significant equity holdings in Asian operations are in Hong Kong, Malaysia and Singapore. The arithmetic average equity return assumptions for these three territories at 31 December 2007 were 8.1 per cent, 12.5 per cent and 9.3 per cent respectively (2006: 8.7 per cent, 12.8 per cent and 9.3 per cent respectively).
Non-economic assumptions: Maintenance expenses – 10% decrease 54 45 Lapse rates – 10% decrease 142 93 Mortality and morbidity – 5% decrease in base rates (i.e. increased longevity) 98 77
In addition to these disclosures, for Asian operations as a whole it should be noted that the cash flows of the Taiwan life business are particularly sensitive to projected rates of investment return (as described in note (h)(iii) below).
h Sensitivity of IFRS basis profit and equity to market and other risks Currency translation Consistent with the Group’s accounting policies, the profits of the Asian operations are translated at average exchange rates and shareholders’ equity at the closing rate for the reporting period. For 2007, the rates for the most significant operations are given in note B4.
Other risks i With-profits business Similar principles to those explained for UK with-profits business apply to profit emergence for the Asian with-profits business. Correspondingly, the profit emergence reflects bonus declaration and is relatively insensitive to period by period fluctuations in insurance risk or interest rate movements.
The adequacy of the insurance contract liabilities is tested by reference to best estimates of expected investment returns on policy cash flows and reinvested income. The assumed earned rates are used to discount the future cash flows. The assumed earned rates consist of a long-term best estimate determined by consideration of long-term market conditions and rates assumed to be earned in the trending period. For 2007 and 2006, it has been projected that rates of return for Taiwanese bond yields will trend from the then current levels of some 2.5 per cent (2.0 per cent) to 5.5 per cent by 31 December 2013.
The liability adequacy test results are sensitive to the attainment of the trended rates during the trending period. Based on the current asset mix, margins in other contracts that are used in the assessment of the liability adequacy tests and currently assumed future rates of return, if interest rates were to remain at current levels in 2008 and 2009 and the target date for attainment of the long-term bond yield deferred to 31 December 2015, the premium reserve, net of deferred acquisition costs, would be sufficient. If interest rates were to remain at current levels beyond the end of 2009 with the date of the attainment of the long-term rate further delayed, the margin within the net GAAP reserve will reduce further.
However, the need to write off deferred acquisition costs or increase the liabilities, and by how much, would be affected by the impact of new business written between 31 December 2007 and the future reporting dates to the extent that the business is taken into account as part of the liability adequacy testing calculations for the portfolio of contracts.
At 31 December 2007, if the assumed long-term bond yield applied had been reduced by 0.5 per cent from 5.5 per cent to 5.0 per cent and continued to apply the same progression period to 31 December 2013, by assuming bond yields increase from current levels in equal annual instalments to the long-term rate, the premium reserve, net of deferred acquisition costs, would have been sufficient. The impact of reducing the long-term rate by a further 0.5 per cent to 4.5 per cent would have been such that the net GAAP reserve would have met the liability adequacy test but with no margin available to cover further deterioration. An additional 0.5 per cent reduction in the assumed long-term rate from 4.5 per cent to 4.0 per cent would lead to a charge of some £200 million.
For the Korean and Japanese life business exposures described in note (b) above, the results are comparatively unaffected by changes of assumption. The accounts basis value of liabilities for both operations are of a similar order of magnitude to those that apply for the purposes of Group solvency calculations under the Insurance Groups Directive (IGD).
Asian operations offer a range of insurance and investment products, predominantly with-profits and non-participating term, whole life endowment and unit linked.
Excluding with-profit and unit-linked business along with Taiwan, which is detailed above, 72 per cent (2006: 78 per cent) of the bond portfolio for other business of Asian operations at 31 December 2007 was held in Japan, Singapore and Vietnam with corporate bond rates varying from territory to territory and ranging from 1.5 per cent to 9.1 per cent at 31 December 2007 (1.7 per cent to 8.8 per cent at 31 December 2006) for these three countries. An analysis of movements in bond rates during previous periods and its impact on IFRS basis profit or loss and shareholders’ equity has been undertaken, with reasonably possible movements for these countries being considered to be 0.25 per cent for Japan, 0.5 per cent for Singapore and 1.0 per cent for Vietnam.
Based on these movements, plus indicative changes for bonds held in other Asian operations within the region, the impact on IFRS basis profit or loss and shareholders’ equity from a reasonably possible change in interest rates for Asian operations excluding Taiwan at 31 December 2007 has been assessed, with rate movements ranging from 0.25 per cent to 1.0 per cent (2006: 0.25 per cent to 1.0 per cent) dependent on country. Looking at the region in aggregate and noting that interest rates are unlikely to move consistently by the same degree from period to period, the range of movements considered to be reasonably possible would result in a change in IFRS profit or loss of plus or minus £30 million (2006: £32 million). These amounts, if they arose, would be recorded within the category short-term fluctuations in investment returns in the Group’s supplementary analysis of profit before tax. After adjusting for deferred tax the reasonably possible effect on shareholders’ equity is plus or minus £22 million (2006: £24 million).
The impact of a 10 per cent change in equity prices for shareholder-backed Asian other business, which would be reflected in the short-term fluctuation component of the Group’s supplementary analysis of profit before tax, would be as follows: 10% 10% 10% 10% increase decrease increase decrease
Total PAC subsidiaries equity of with- and Asian life Total life other
Deferred acquisition costs of non-participating business and goodwill not recognised for regulatory reporting purposes (4) (15) (19) (143) (1,928) (790) (2,880)
Valuation difference on PAL between IFRS basis and regulatory basis – (1,117) (1,117) – – – (1,117)
Other adjustments to restate these amounts to a regulatory basis (with SAIF and the WPSF on a Peak 2 realistic basis)note v 4 355 359 (239) 1,364 (96) 1,388
Total available capital resources of life assurance businesses on local regulatory bases 0 8,720 8,720 982 2,251 629 12,582
D5: Capital position statement for life assurance businesses continued 2007 £m
WPSF profits and funds assurance assurance 31 December 2007 SAIF note i fund note ii Jackson subsidiaries operations
D5: Capital position statement for life assurance businesses continued 2006 £m
WPSF profits and funds assurance assurance subsidiaries Group 31 December 2006 SAIF note i fund note ii Jackson subsidiaries operations M&G Egg and funds total
Group shareholders’ equity Held outside long-term funds: Held in long-term fundsnote iii – – – 700 – – 700 – – – 700
Deferred acquisition costs of non-participating business and goodwill not recognised for regulatory reporting purposes (5) (26) (31) (146) (1,712) (673) (2,562)
Jackson surplus notesnote iv – – – – 127 – 127 Part of IAS 19 basis pension deficit attributable to WPSF not recognised for regulatory purposesnote vii – (244) (244) – – – (244)
Valuation difference on PAL between IFRS basis and regulatory basis – (1,076) (1,076) – – – (1,076)
Other adjustments to restate these amounts to a regulatory basis (with SAIF and the WPSF on a Peak 2 realistic basis)note v 5 523 528 (263) 1,012 (136) 1,141
Total available capital resources of life assurance businesses on local regulatory bases 0 8,688 8,688 903 2,083 566 12,240
Other liabilities: Insurance contracts: With-profits liabilities of non-UK regulated funds – – – – – 2,658 2,658
Unit-linked, including variable annuity – 2,039 2,039 7,766 11,367 4,134 25,306
Investment contracts without discretionary participation features (principally unitlinked and similar contracts in the UK and GIC liabilities of Jackson)note vi – 12 12 11,441 1,562 27 13,042
Total policyholder liabilities shown in the consolidated balance sheet 14,130 74,149 88,279 32,162 31,746 12,801 164,988
vi Insurance business accounted for as financial instruments under IAS 39. vii In determining the IAS 19 adjustment for the purposes of this table the surplus (deficit) in the Group’s main pension scheme used for the calculation includes amounts for investments in Prudential insurance policies (see note I1).
The Prudential Sourcebook for Insurers also contains rules on Individual Capital Assessments. Under these rules and the rules of the General Prudential Sourcebook all insurers must assess for themselves the amount of capital needed to back their business. If the FSA views the results of this assessment as insufficient, it may draw up its own Individual Capital Guidance for a firm, which can be superimposed as a requirement.
Available capital of the WPSF and SAIF of £8.7 billion (2006: £8.7 billion) represents the excess of assets over liabilities on the FSA realistic basis. Unlike the previously discussed FRS 27 basis, realistic liabilities on the regulatory basis include the shareholders’ share of future bonuses. These amounts are shown before deduction of the risk capital margin (RCM) which is estimated to be £2.0 billion at 31 December 2007 (2006: £1.9 billion).
D5: Capital position statement for life assurance businesses continued As regards smoothing of maturity and death benefits, in normal circumstances PAC does not expect most pay-out 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 pay-out values between different policies. Greater flexibility may be required in certain circumstances, for example following a significant rise or fall in market values (either sudden or over a period of years) and in such situations the PAC board may decide to vary the standard bonus smoothing limits to protect the overall interests of policyholders.
The capital resources requirement for these companies broadly reflects a formula which, for active funds, equates to a percentage of regulatory reserves plus a percentage of death strains.
The available capital of Jackson shown above of £2,251 million (2006: £2,083 million) reflects US regulatory basis assets less liabilities excluding asset valuation reserves. The asset valuation reserve is designed to provide for future credit-related losses on debt securities and losses on equity investments. Available capital includes a reduction for the effect of the interest maintenance reserve, which is designed by state regulators to defer recognition of non-credit related realised capital gains and losses and to recognise them rateably in the future.
Jackson’s risk-based capital ratio is significantly in excess of regulatory requirements.
iii Asian operations The available capital shown above of £629 million (2006: £566 million) represents the excess of local regulatory basis assets over liabilities before deduction of required capital of £265 million (2006: £211 million). These amounts have been determined applying the local regulations in each of the operations.
The businesses in Asia are subject to local capital requirements in the jurisdictions in which they operate. The Hong Kong business branch of PAC and its capital requirements are subsumed within those of the PAC long-term fund. For the other material Asian operations, the details of the basis of determining regulatory capital and regulatory capital requirements are as follows: Singapore In Singapore a risk based regulatory framework applies rather than one based on a net premium approach.
Japan Mathematical reserves for traditional business are determined on a net premium basis using prescribed mortality and interest rates. Interest rates reflect the original pricing assumptions.
Malaysia Mathematical reserves for traditional business are determined on a modified net premium basis using prescribed mortality and interest rates (no higher than four per cent).
iv Group capital requirements In addition to the requirements at individual company level, FSA requirements under the IGD apply additional prudential requirements for the Group as a whole. Previously, whilst the Group owned Egg, it was required to comply with the broadly equivalent requirements of the FCD. Discussion of the Group’s estimated IGD position at 31 December 2007 is provided in the operating and financial review section of the Group’s 2007 Annual Report and in section C.
D5: Capital position statement for life assurance businesses continued c Movements in total available capital Total available capital for the Group’s life assurance operations has changed during 2007 as follows: 2007 £m
Other UK life assurance subsidiaries Asian life WPSF and funds Jackson assurance Group note i note iii note ii subsidiaries total
The increase in 2007 reflects investment return earned on the opening available capital partially offset by the £335 million effect of assumption changes and a £214 million impact from a change in the risk-free yield curve which affects the outlook for future investment returns. The £335 million effect of assumption changes on a regulatory basis compares to the £392 million effect of change in assumptions on an IFRS basis as shown in note D2(g).
The £648 million increase in available capital in 2006 for new business and other factors incorporates the effects of the strong investment returns in 2006 and the improved outlook for future investment returns at that time.
The decrease of £174 million in 2006 reflected an underlying increase of £100 million (applying the 2006 year end exchange rate of 1.96) and £274 million of exchange translation loss.
The increase in available capital in 2006 from changes in regulatory requirements of £80 million was primarily due to regulatory changes for UK regulated shareholder-backed non-participating business from the FSA’s policy statement PS06/14 confirmed in December 2006. The changes allowed liabilities for this business to incorporate more economic realism. Additional details are shown in note D2.
D5: Capital position statement for life assurance businesses continued d Transferability of available capital For PAC and all other UK long-term insurers, long-term business assets and liabilities must, by law, be maintained in funds separate from those for the assets and liabilities attributable to non-life insurance business or to shareholders. Only the ‘established surplus’ – the excess of assets over liabilities in the long-term fund determined through a formal valuation – may be transferred so as to be available for other purposes. Distributions from the with-profits sub-fund to shareholders reflect the shareholders’ one-ninth share of the cost of declared policyholders’ bonuses.
Asset management in the UK is undertaken through M&G which is made up of three distinct businesses, being Retail, Wholesale and Finance, and whose operations include retail asset management, institutional fixed income, pooled life and pension funds, property and private finance. M&G also manage the Group’s balance sheet.
Asset management 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.
E1: Income statement for asset management operations The profit included in the income statement in respect of asset management operations for the year is as follows: Asset management operations
Profit before tax for asset management operations comprise: Operating profit based on longer-term investment returns* 254 8 72 334 262 Short-term fluctuations in investment returns 4 1 – 5 – Shareholders’ share of actuarial gains and losses on defined benefit schemes 5 – – 5 21 *Operating profit based on longer-term investment returns includes £nil (2006: £2 million) of UK restructuring costs.
E2: Balance sheet for asset management operations Assets, liabilities and shareholders’ funds included in the Group consolidated balance sheet in respect of asset management operations are as follows: Asset management operations
Other non-investment and non-cash assets 304 132 85 521 415 Investment properties – – – – 1 Financial investments: Equity securities and portfolio holdings in unit trusts 11 – 6 17 13
The M&G loans of £2,334 million comprise £1,383 million of bridging loan finance assets and £951 million in respect of a structured finance arrangement, both managed by Prudential Capital. The bridging loan finance assets generally have no external credit ratings available, with internal ratings prepared by the Group’s asset management operations as part of the risk management process rating £738 million BBB+ to BBB- and £645 million BB+ to BB-. Of the loans receivable under the structured finance arrangement, £826 million of the receivable was with counterparties rated AA by Standard and Poor’s and £125 million AA-. In addition a AAA rated credit default swap was held covering £400 million of the AA rated element of the loans.
E4: Sensitivity of profit and equity to market and other financial risk i Currency translation Consistent with the Group’s accounting policies, the profits of the Asia and PPM America asset management operations are translated at average exchange rates and shareholders’ equity at the closing rate for the reporting period. For 2007, the rates for the most significant operations are given in note B4.
E5: Other operations Other operations consist of unallocated corporate activities including Group Head Office (GHO) and Asia regional head office, with net income and expenditure for the year of £248 million (2006: £248 million) for other operations detailed in note B1. An analysis of assets and liabilities relating to other operations is shown in note B6.
Notes on the Group financial statements E: Asset management (including US broker dealer) and other operations continued
F1: Segmental information The Group’s primary and secondary segments are described in detail in note B6.
Segment results – revenue less charges (continuing operations) Long-term business 1,022 2,035 Asset management 344 283 Unallocated corporate (181) (97)
Profit before tax attributable to shareholders 1,166 1,372 Tax attributable to shareholders’ profits (382) (392)
Profit for the year 1,025 875 *Profit before tax represents income net of post-tax transfers to unallocated surplus of with-profits funds, before tax attributable to policyholders and unallocated surplus of with-profits funds, unit-linked policies and shareholders’ profits.
Fee income from investment contract business and asset managementnote iii 1,039 886 Income from venture investments of the PAC with-profits funds 1,418 1,031
Notes i Acquisition costs in 2007 comprise amounts related to insurance contracts of £939 million (2006: £1,165 million), and investment contracts and asset management contracts of £91 million (2006: £73 million). These costs include amortisation of £410 million (2006: £299 million) and £3 million (2006: £6 million) respectively.
ii Acquisition costs also include fee expenses relating to financial liabilities held at amortised costs of £1 million (2006: £2 million). These expenses primarily related to fees incurred on Jackson’s investment contract liabilities (GICs and annuity certain contracts).
F5: Tax continued The total deferred tax (credit) expense arises as follows: Unrealised gains and losses on investments (225) 236 Short-term timing differences 62 156 Capital allowances (4) 2 Balances relating to investment and insurance contracts (41) 198 Unused tax losses (12) (5)
i Summary of pre-tax profit and tax charge The income statement includes the following items: Profit before tax 1,185 2,221 Tax attributable to policyholders’ returns (19) (849)
Profit from continuing operations after tax 784 980 ii Overview For the purposes of explaining the relationship between tax expense and accounting profit, it is appropriate to consider the sources of profit and tax by reference to those that are attributable to shareholders and policyholders, as follows: Attributable to Attributable to Attributable to Attributable to shareholders policyholders* Total shareholders policyholders* Total
iv Profits attributable to policyholders and related tax As noted above, it is necessary under IFRS requirements to include the total tax charge of the Company (both policyholder and shareholder elements) in the tax charge disclosed in the income statement.
In summary, for accounting purposes, in all cases and for all reporting periods, the apparent effective rate for profit attributable to policyholders and unallocated surplus is 100 per cent. However, it is to be noted that the 100 per cent rate does not reflect a rate paid on the profits attributable to policyholders. It instead reflects the basis of accounting for unallocated surplus coupled with the distinction made for performance reporting between sources of profit attributable to shareholders, policyholders and unallocated surplus and IFRS requirements in respect of reporting of all pre-tax profits and all tax charges irrespective of policyholder or shareholder economic interest.
UK Asian longinsurance term business Other operations Jackson operations operations Total
Profit before tax attributable to shareholders: Operating profit based on longer-term
Short-term fluctuations in investment returns (47) (18) (71) (1) (137) Shareholders’ share of actuarial and other gains and losses on defined benefit pension schemes – – – 90 90
Short-term fluctuations in investment returns 30% 35% 25% 28% 28% Shareholders’ share of actuarial and other gains and losses on defined benefit pension schemes 30% 35% 20% 28% 28%
Short-term fluctuations in investment returns 14 6 18 0 38 Shareholders’ share of actuarial and other gains and losses on defined benefit pension schemes – – – (25) (25)
Short-term fluctuations in investment returns (2) 1 (17) 6 (12) Shareholders’ share of actuarial and other gains and losses on defined benefit pension schemes – – – – –
Notes i Expected tax rates for profit attributable to shareholders: Expected tax rates shown in the table above reflect the corporate tax rates generally applied to taxable profits of the relevant country jurisdictions. For Asian operations the expected tax rates reflect the corporate tax rates weighted by reference to the source of profits of the operations contributing to the aggregate business result.
Expected tax rates for 2007 for Asia are lower than in 2006 due to an increased proportion of profits in low tax jurisdictions. The expected tax rate for other operations is lower than 2006. The tax rate of 28% reflects the mix of business between UK and overseas operations, which are taxed at a variety of rates. The rate will fluctuate from year to year dependent on the mix of profits between jurisdictions.
ii Variances from expected tax charge for results attributable to shareholders: For 2007, the principal variances arise from differences between the standard corporation tax rate and actual rates due to a number of factors, including: a For UK insurance operations, disallowed expenses and prior year adjustments arising from routine revisions of tax returns; b For Jackson, the benefit of a deduction from taxable income of a proportion of dividends received attributable to the variable annuity business; c For Asian long-term operations, tax losses in several jurisdictions which are not expected to be available for relief against future profits, and losses on investments in jurisdictions which do not provide corresponding tax relief; and d For other operations, the availability of capital losses brought forward on which no deferred tax had previously been recognised, which have been used against capital gains in the period.
F5: Tax continued v Reconciliation of tax charge on profits attributable to shareholders continued 2006 £m
Short-term fluctuations in investment returns (43) 53 134 11 155 Shareholders’ share of actuarial and other gains and losses on defined benefit pension schemes – – – 167 167
Operating profit based on longer-term investment returnsnote iii 30% 35% 25% 30% 31%
Short-term fluctuations in investment returns 30% 35% 25% 30% 27% Shareholders’ share of actuarial and other gains and losses on defined benefit pension schemes 30% 35% 25% 30% 30%
Expected tax charge based on expected tax rates: Operating profit based on longer-term
Short-term fluctuations in investment returns 13 (19) (33) (3) (42) Shareholders’ share of actuarial and other gains and losses on defined benefit pension schemes – – – (50) (50)
Short-term fluctuations in investment returns (4) 3 5 – 4 Shareholders’ share of actuarial and other gains and losses on defined benefit pension schemes – – – – –
Short-term fluctuations in investment returns 9 (16) (28) (3) (38) Shareholders’ share of actuarial and other gains and losses on defined benefit pension schemes – – – (50) (50)
Expected tax rates shown in the table above reflect the corporate tax rates generally applied to taxable profits of the relevant country jurisdictions. For Asian operations the expected tax rates reflect the corporate tax rate weighted by reference to the source of profits of the operations contributing to the aggregate business result. In 2006, the expected tax rate on total profits of 31 per cent is in part due to the Asian long-term business (which is subject to lower tax rates than the UK and US) being a greater proportion of Group results.
ii Variances from expected tax charge for results attributable to shareholders For 2006, the principal variances arise from differences between the standard corporation tax rate and actual rates due to a number of factors, including: a The tax credit arising from relief for excess expenses in respect of the shareholder-backed protection business. b Prior year adjustments arising from routine revisions of tax returns.
G1: Financial instruments – designation and fair values The Group designates all financial assets as either fair value through profit and loss, available-for-sale, or as loans and receivables. Financial liabilities are designated as either fair value through profit and loss or amortised cost, or for investment contracts with discretionary participating features accounted for under IFRS 4 as described in note A4.
Operational borrowings attributable to shareholder-financed operationsH13 – 3,081 – 3,081 3,081 Borrowings attributable to with-profits fundsH13 204 783 – 987 1,006 Obligations under funding, securities lending and sale and repurchase agreements – 4,081 – 4,081 4,100 Net asset value attributable to unit holders of consolidated unit trust and similar funds 3,556 – – 3,556 3,556 Investment contracts with discretionary participating featuresnote iv – – 29,550 29,550 – Investment contracts without discretionary
Financial liabilities Banking customer accounts – 5,554 – 5,554 5,554 Core structural borrowings of shareholder-financed
Operational borrowings attributable to shareholder-financed operationsH13 – 5,609 – 5,609 5,609 Borrowings attributable to with-profits fundsH13 553 1,223 – 1,776 1,798 Obligations under funding, securities lending and sale and repurchase agreements – 4,232 – 4,232 4,229 Net asset value attributable to unit holders of consolidated unit trust and similar funds 2,476 – – 2,476 2,476 Investment contracts with discretionary participating featuresnote iv – – 28,733 28,733 – Investment contracts without discretionary
Notes on the Group financial statements G: Financial assets and liabilities continued
G1: Financial instruments – designation and fair values continued Analysed by: 2006 £m
Notes i As at 31 December 2007, £722 million (2006: £624 million) of convertible bonds were included in debt securities and £278 million (2006: £279 million)
were included in borrowings. ii Loans and receivables are reported net of allowance for loan losses of £13 million (2006:£14 million). iii See note G3 for details of the derivative assets included. The balance also contains the PAC with-profits fund’s participation in various investment funds and limited liability property partnerships.
v For financial liabilities designated as fair value through profit and loss there was no impact on profit from movements in credit risk during 2007 (2006: £nil).
Determination of fair value The fair values of the financial assets and liabilities as shown on the table above have been determined on the following bases.
G1: Financial instruments – designation and fair values continued Use of valuation techniques The carrying value of investments on the balance sheet of the Group which are not on active markets and therefore valued using valuation techniques as described above are as follows: 2007 £m
The majority of the financial investments valued using valuation techniques were debt securities. Of the debt securities valued using valuation techniques of £6,374 million (2006: £6,200 million) at 31 December 2007, debt securities with a fair value of £3,511 million (2006: £3,341 million) were held by UK operations. £3,002 million (2006: £2,945 million) of this amount related to securities held by with-profits operations and £509 million (2006: £396 million) related to securities held by the shareholderbacked UK annuity subsidiary Prudential Retirement Income Limited (PRIL). Debt securities valued using valuation techniques held by the US operations were £2,863 million (2006: £2,859 million).
In addition to private debt securities, debt securities of US operations valued using valuation techniques also included securities held by the Piedmont trust entity, an 80 per cent Jackson held static trust formed as a result of a securitisation of asset-backed securities in 2003 that are accounted for on an available-for-sale basis. As at 31 December 2007, the fair value of these Piedmont assets valued using valuation techniques was £316 million (2006: £405 million). Significant estimates and judgements are also employed in valuing certain asset-backed and mortgage-backed securities held by the Piedmont trust entity. These valuations may impact reported shareholder profit and loss amounts through the determination of impairment and recovery amounts.
Management has obtained broker bids on these Piedmont trust assets that represent the value at which the Group could sell the investments, if forced. These bids are not based on full knowledge and hence analysis of the investments, but represent the best estimate of the worst case decline in market value of these securities. The broker bids for these securities at 31 December 2007 totalled £260 million, a difference of £56 million (2006: £372 million, a difference of £33 million), from the fair value applied.
G1: Financial instruments – designation and fair values continued The equity securities and other investments which included property and other partnerships in investment pools, venture investments and derivative assets as shown on the table above are valued using valuation techniques which apply less readily observable market factors and more non-observable factors than the matrix pricing technique as used for the majority of the debt securities. In addition to the investments shown above, there are some minor amounts valued using valuation techniques in the Group’s Asian operations.
Interest income and expense The interest income on financial assets not at fair value through profit and loss for the year ended 31 December 2007 from continuing operations was £2,016 million (2006: £2,006 million).
Interest rate risk The following table shows an analysis of the classes of financial assets and liabilities and their direct exposure to interest rate risk. Each applicable class of the Group’s financial assets or liabilities is analysed between those exposed to fair value interest rate risk, cash flow interest rate risk and those with no direct interest rate risk exposure: 2007 £m
Financial liabilities Core structural borrowings of shareholder-financed operations 2,492 – – 2,492 Operational borrowings attributable to shareholder-financed operations 2,743 331 7 3,081 Borrowings attributable to with-profits funds 451 441 95 987 Obligations under funding, securities lending and sale and
Not directly Fair value Cash flow exposed to Total Discontinued interest interest interest continuing banking rate risk rate risk rate risk operations operations Total
Financial assets Cash and cash equivalents – – 5,065 5,065 6 5,071
Financial liabilities Banking customer accounts – – – – 5,554 5,554 Core structural borrowings of
After After After After Total 1 year 1 year to 5 years to 10 years to 15 years to Over No stated carrying or less 5 years 10 years 15 years 20 years 20 years maturity value
G2: Market risk continued This table has been prepared on an undiscounted basis and accordingly the amounts shown for life assurance investment contracts differ from those disclosed on the balance sheet. Durations of long-term business contracts, covering insurance and investment contracts, on a discounted basis are included in section D.
The fair value of collateral held against loans that are past due and impaired at 31 December 2007 was £nil (2006: £1 million). The fair value of collateral held against loans that are past due but not impaired at 31 December 2007 was £nil (2006: £3 million). Collateral would predominately consist of policy loans that are secured by the cash values of the underlying policy.
UK insurance operations – Sub-prime (AAA) 129 – Alt-A (96% AAA) 100
G2: Market risk continued iii Holdings in debt securities with a wrap guarantee from a monoline insurer 2007 £m
With-profits operations: Asian insurance operations 9 UK insurance operations (73% held by PAL) 1,168
Currency risk As at 31 December 2007, the Group held 19 per cent (2006: 16 per cent) and 13 per cent (2006: 15 per cent) of its financial assets and financial liabilities respectively, in currencies, mainly US dollar and Euro, other than the functional currency of the relevant business unit.
See also note J3 for details of the market risks faced by the discontinued banking operations.
All over-the-counter derivative transactions are conducted under standardised ISDA (International Swaps and Derivatives Association Inc) master agreements and the Group has collateral agreements between the individual Group entities and relevant counterparties in place under each of these market master agreements.
UK Other Total Discontinued insurance US continuing continuing banking operations operations operations operations operations Total
UK insurance operations US Notional amount on which Notional amount on which future payments are based future payments are based
UK insurance operations US Discontinued banking operations Notional amount on which Notional amount on which Notional amount on which future payments are based future payments are based future payments are based
Inflation swaps 1,109 1,109 – – – – Credit default swaps – – – – 1,787 – Single stock options – 6 – – – – Credit derivatives – – – 18 – – Put options – – 2,708 – – – FTSE swap – – – – 49 49 *In addition, the other operations, including the Group Treasury function and the Asian operations, have cross-currency swap assets and liabilities with notional amounts of £730 million (2006: £754 million) and £1,401 million (2006: £1,743 million) respectively, forward currency contracts assets and liabilities with notional amounts of £983 million (2006: £443 million) and £773 million (2006: £63 million) respectively, interest rate swaps of £2,799 million (2006: £1,856 million) and inflation swap liabilities with notional amounts of £150 million (2006: £150 million).
The Group uses various interest rate derivative instruments such as interest rate swaps to reduce exposure to interest rate volatility.
The UK insurance operations use various currency derivatives in order to limit volatility due to foreign currency exchange rate fluctuations arising on securities denominated in currencies other than sterling. See also note G2 above. In addition, total return swaps and interest rate swaps are held for efficient portfolio management.
For the purpose of reducing interest rate risk, Egg used a number of derivative instruments, including interest rate swaps and forward agreements. Additionally, swaps were used to provide caps to the funding cost of the credit card product.
Egg also made general use of credit default swaps to manage credit risk without changing the underlying product or investment portfolios.
The fair value of the derivatives designated as fair value hedges above at 31 December 2007, were an asset of £5 million and liabilities of £25 million (2006: asset of £5 million and liabilities of £29 million). Movements in the fair value of the hedging instruments of a net gain of £6 million (2006: net gain of £4 million) and the hedged items of a net loss of £4 million (2006: net loss of £4 million) are recorded in the income statement in respect of the fair value hedges above.
Net investment hedges The Group has entered into a series of three-month period forward currency transactions which together form a US$2 billion net investment hedge of the currency exposure of the net investments in the US operations. The forward currency contracts were renewed throughout 2007 and 2006. The forward currency contracts in place at 31 December 2007 expire in March 2008. The fair value of the forward currency contracts at 31 December 2007 was a liability of £44 million (2006: a liability of £4 million).
In addition, the Group has designated perpetual subordinated capital securities totalling US$1.55 billion as a net investment hedge to hedge the currency risks related to the net investment in Jackson. The carrying value of the subordinated capital securities was £763 million (2006: £763 million) as at 31 December 2007. The foreign exchange gain of £13 million (2006: gain of £110 million) on translation of the borrowings to pounds sterling at the balance sheet date is recognised in the translation reserve in shareholders’ equity.
At 31 December 2007, the Group had entered into reverse repurchase transactions under which it purchased securities and had taken on the obligation to resell the securities for the purchase price of £1,361 million (2006: £1,435 million), together with accrued interest.
Collateral and pledges under derivative transactions At 31 December 2007, the Group had pledged £260 million (2006: £263 million) for liabilities and held collateral of £292 million (2006: £212 million) in respect of over-the-counter derivative transactions.
G5: Impairment of financial assets In accordance with the Group’s accounting policy set out in note A4, impairment reviews were performed for available-for-sale securities and loans and receivables. In addition, impairment reviews were undertaken for the reinsurers’ share of policyholder liability provisions.
During the year ended 31 December 2007, impairment losses of £184 million (2006: £416 million) were recognised. These were £149 million (2006: £384 million) for loans and advances to customers in discontinued banking operations and £35 million (2006: £ 32 million) for continuing operations, mainly being in respect of available-for-sale securities held by Jackson.
The effect of those reasonably likely changes in the key assumptions underlying the estimates that underpin the assessment of whether impairment has taken place depends on the factors described in note A3. A key indicator of whether such impairment may arise in future, and the potential amounts at risk, is the profile of gross unrealised losses for fixed maturity and equity securities accounted for on an available-for-sale basis by reference to the time periods by which the securities have been held continuously in an unrealised loss position and by reference to the maturity date of the securities concerned.
Assessment of whether goodwill may be impaired With the exception of M&G, the goodwill attributable to shareholders in the balance sheet relates to acquired life businesses. The Company routinely compares the aggregate of net asset value and acquired goodwill on an IFRS basis of acquired life business with the value of the business as determined using the EEV methodology, as described in note D1. Any excess of IFRS over EEV carrying value is then compared with EEV basis value of current and projected future new business to determine whether there is any indication that the goodwill in the IFRS balance sheet may be impaired.
ii The risk discount rate. Differing discount rates have been applied in accordance with the nature of the individual component businesses. For retail and institutional business a risk discount rate of 12 per cent has been applied. This represents an average implied discount rate for comparable UK listed asset managers calculated by reference to risk-free rates, equity risk premiums of five per cent and an average ‘beta’ factor for relative market risk of comparable UK listed asset managers. A similar approach has been applied for the other component businesses of M&G.
Present value of acquired in-force policies for insurance contracts as classified under IFRS 4 59 66 Present value of future profits of acquired investment management contracts, including life assurance contracts classified as financial instruments and investment management contracts under IFRS 4 4 6 Distribution rights* 16 –
Total of deferred acquisition costs and acquired in-force value of long-term business contracts 2,836 2,497 *Distribution rights relate to facilitation fees paid in 2007 of £16 million which are amortised over 8 years. The amortisation charge for the year to 31 December 2007 was £0.3 million.
At 1 January Gross amount 130 118 Accumulated amortisation (20) (14)
H1: Intangible assets attributable to shareholders continued Present value of acquired in-force business of long-term business contracts attributable to shareholders Prior to the adoption of IFRS 4, the present value of acquired in-force business (PVAIF) was accounted for under UK GAAP. On 1 January 2005, following the adoption of IFRS 4, PVAIF relating to investment contracts without discretionary participation features, which was previously included within long-term business, is removed and replaced by an asset representing the present value of the future profits of the asset management component of these contracts, where applicable. These contracts are accounted for under the provisions of IAS 18. The remainder of the PVAIF balance relates to insurance contracts and is accounted for under UK GAAP as permitted by IFRS 4.
Amortisation charge – (35) (35) Deconsolidated venture fund investments (708) (208) (916)
The recoverable amount for the venture fund investments previously controlled by the Group through PPM Capital was determined on a portfolio CGU basis by aggregating fair values calculated for each entity less costs to sell these entities.
Unrealised losses on investments 129 83 Balances relating to investment and insurance contracts 2 439 Short-term timing differences 744 446 Capital allowances 20 12 Unused deferred tax losses 30 –
H4: Tax assets and liabilities continued Deferred tax assets are recognised to the extent that they are regarded as recoverable, that is to the extent that, on the basis of all available evidence, it can be regarded as more likely than not that there will be suitable taxable profits from which the future reversal of the underlying temporary differences can be deducted. The UK taxation regime applies separate rules to trading and capital profits and losses. The distinction between temporary differences that arise from items of either a trading or capital nature may affect the recognition of deferred tax assets. Accordingly, for the 2007 results and balance sheet position at 31 December 2007, the possible tax benefit of approximately £280 million (2006: £333 million), which may arise from capital losses valued at approximately £1.4 billion (2006: £1.7 billion), is sufficiently uncertain that it has not been recognised. In addition, a potential deferred tax asset of £112 million (2006: £71 million), which may arise from trading losses of approximately £350 million (2006: £245 million), is sufficiently uncertain that it has not been recognised.
Liabilities Of the £1,237 million (2006: £1,303 million) current tax liability, it is not practicable to estimate how much is expected to be settled in one year or less due to the uncertainty over when outstanding issues will be agreed with HM Revenue & Customs.
Unrealised gains on investments 2,098 2,346 Balances relating to investment and insurance contracts 599 613 Short-term timing differences 766 916 Capital allowances 12 7
Surplus, gross of deferred tax, based on scheme assets held, including investments in Prudential insurance policies: Attributable to PAC with-profits fund (i.e. absorbed by the liability for unallocated surplus) 365 – Attributable to shareholder-financed operations (i.e. to shareholders’ equity) 163 –
Premiums receivable: From policyholders 154 200 From intermediaries 13 12 From reinsurers 104 22
Total accrued investment income and other debtors 3,320 2,952 *The 2007 pension surplus amounts relate to the PSPS defined benefit scheme. The 2006 amounts are included in H14 Provisions note.
H6: Property, plant and equipment Property, plant and equipment comprise Group occupied properties, development property and tangible assets. A reconciliation of the carrying amount of these items from the beginning of the year to the end of the year is as follows: Group occupied Development Tangible Continuing Discontinued property property assets operations operations Total £m £m £m £m £m £m
Arising on acquisition of subsidiaries – – 40 40 – 40
Arising on acquisition of subsidiaries 5 – 33 38 – 38 Disposal of subsidiaries – – – – (57) (57) Deconsolidated venture fund investments I6 (69) – (261) (330) – (330)
Long-term business 206 153 Asset management 11 6 Unallocated corporate 11 3
H7: Investment properties Investment properties principally relate to the PAC with-profits fund and are carried at fair value. A reconciliation of the carrying amount of investment properties at the beginning and end of the year is set out below: Additions: Resulting from acquisitions 1,707 1,185 Resulting from expenditure capitalised 128 51 Resulting from acquisitions through business combinations – 2
The income statement includes the following items in respect of investment properties: Rental income from investment properties 670 744 Direct operating expenses (including repairs and maintenance expenses)
Contingent rent is that portion of the lease payments that is not fixed in amount but is based on the future value of a factor that changes other than with the passage of time. Contingent rent recognised as an expense in 2007 amounted to £14 million (2006: £11 million). Contingent rents recognised as income in the year amounted to £26 million (2006: £33 million).
The total minimum future rentals to be received on non-cancellable sub-leases for land and buildings for the year ended 31 December 2007 are £2,746 million (2006: £2,651 million).
Investments in associates The Group had four associates at 31 December 2007 (2006: three) that are accounted for using the equity method. The Group acquired one new associate in 2007, a 30 per cent interest in The Nam Khang, a Vietnamese property developer. The Group’s other associates, a 30 per cent interest in Apollo Education and Training Organisation Vietnam, a 25 per cent interest in OYO Developments Limited, and a 38.6 per cent interest in IFonline Group Limited (IFonline), were held by the Group in both
Associates accounted for using the equity method Equity accounting is applied to IFonline based on its reporting period of the year to 30 November and is adjusted for material changes up to 31 December. Accordingly, the information is deemed to cover the same period as that of the Group.
Share of profit for the year after tax – 1 1 – 1
The Group’s share of the assets, liabilities, revenues and profit and loss of associates accounted for using the equity method at 31 December 2007 and 2006 is as follows: Financial position Total assets (excluding goodwill) 7 4 Total liabilities (3) (5)
The aggregate assets of these associates are approximately £9 billion (2006: £7 billion). Aggregate liabilities, excluding liabilities to unit holders and shareholders for unit trusts and OEICs, are approximately £2 billion (2006: £3 billion). Fund revenues, with revenue arising in unit trusts and OEICs deemed to constitute the investment return for these vehicles, were approximately £0.5 billion (2006: £0.4 billion) and net profit in the year, excluding unit trusts and OEICs where all investment returns accrue to unit holders or shareholders respectively, was approximately £0.2 billion (2006: £0.2 billion).
Prudential BSN Takaful Berhad was a new joint venture in 2006. In January 2006, the Group sold its 50 per cent interest in Marlborough Stirling Mortgage Services Limited for £2.9 million.
Management Company Limited. Although this investment has a reporting period of 31 March, 12 months of financial information up to 31 December is recorded. Accordingly, the information is deemed to cover the same period as that of the Group.
Issued shares of 5p each fully paid: At the beginning of the year 2,386,784,266 119 1,564 Shares issued under share option schemes 2,953,552 – 15 Shares issued in lieu of cash dividends 12,940,993 1 75 Shares issued in respect of acquisition of Egg minority interests 41,633,614 2 243 Transfer to retained earnings in respect of shares issued in lieu of cash dividends – – (75)
Issued shares of 5p each fully paid: At the beginning of the year 2,444,312,425 122 1,822 Shares issued under share option schemes 803,818 – 6 Shares issued in lieu of cash dividends 24,900,997 1 175 Transfer to retained earnings in respect of shares issued in lieu of cash dividends – – (175)
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.
The Group has consolidated a number of authorised investment funds where it is deemed to control these funds under IFRS. Certain of these funds hold shares in Prudential plc. The total number of shares held by these funds at 31 December 2007 was 4.1 million (2006: 4.9 million) and the cost of acquiring these shares of £22 million (2006: £26 million) is included in cost of own shares. The market value of these shares as at 31 December 2007 was £29 million (2006: £34 million).
H13: Borrowings continued Notes i The ¤500 million 5.75 per cent borrowings have been swapped into borrowings of £333 million with interest payable at six month £Libor plus 0.962 per cent.
Less than 1 year – 150 3 to 4 years – – 4 to 5 years – –
Borrowings in respect of short-term fixed income securities programmes Commercial paper 2,422 2,017 Floating Rate Notes 2007 – 5 Medium-Term Notes 2008 48 – Medium-Term Notes 2010 7 10
Jacksonnote ii 126 – Investment subsidiariesnote iii 9 76 Piedmont and CDO fundsnote iv 456 667
Other borrowings Bank loans and overdrafts 6 9 Obligations under finance leases 7 6
v The borrowings in respect of banking operations comprise deposits by banks of £nil (2006: £2,220 million) and unsubordinated debt securities issued by Egg of £nil (2006: £599 million). The deposits by banks mainly relate to securitisation of credit card receivables. See also note G4.
The following table sets out the maturity analysis of the Group’s operational borrowings attributable to shareholder-financed operations: £m £m
Non-recourse borrowings of venture fund investment subsidiariesnote i – 926 Non-recourse borrowings of consolidated investment fundsnote i 789 681 £100m 8.5% Undated Subordinated Guaranteed Bonds of Scottish Amicable Finance plcnote ii 100 100 Other borrowings (predominantly obligations under finance leases) 98 69
ii The interests of the holders of the bonds issued by Scottish Amicable Finance plc, a subsidiary of the Scottish Amicable Insurance Fund, are subordinate to the entitlements of the policyholders of that fund. iii Maturity analysis
The pension deficit does not include amounts relating to the PSPS pension scheme for 2007. These amounts are included in the accrued investment income and the other debtors note on H5.
Analysis of other provisions: Charged to income statement: Additional provisions 116 161 Unused amounts reversed (23) (13)
Comprising: Legal provisions 19 11 Restructuring provisions 35 72 Other provisions 166 155
Of the other provisions balance, £77 million (2006: £55 million) is expected to be settled within one year. Employer contributions expected to be paid into defined benefit pension schemes within one year are shown in note I1.
Legal provisions The legal provisions of £19 million (2006: £11 million) relate predominantly to Jackson. Jackson has been named in civil proceedings, which appear to be substantially similar to other class action litigation brought against many life insurers in the US, alleging misconduct in the sale of insurance products. During 2007, an additional provision of £12 million was made and £4 million was paid.
At 1 January 2006, a provision of £30 million was brought forward, and during 2006 an additional £75 million was provided, £4 million of unused provision was released, and £29 million was paid.
Discontinued banking operations restructuring Following the disposal of Egg in 2007 there was no provision held at 31 December 2007. In 2006, as a result of the UK and Egg initiative described above, a provision of £1 million was brought forward relating to Egg’s withdrawal from the French market, and during 2006 an additional £11 million was provided, of which £8 million was used.
Other provisions Other provisions of £166 million (2006: £155 million) include provisions of £155 million (2006: £134 million) relating to staff benefit schemes. During 2007, another £78 million was provided, £3 million of unused provision was released and £54 million was paid. In 2006, a provision of £94 million was brought forward, an additional £78 million was provided, £7 million of unused provision was released and £31 million was paid. Other provisions also include £11 million (2006: £18 million) relating to various onerous contracts where, in 2007, an additional £2 million was provided, £1 million of unused provision was released and £8 million was used. In 2006, £19 million was brought forward, £1 million was provided and £2 million was used. The remaining provisions of £3 million in 2006 include VAT provisions.
Contingencies and related obligations Litigation In addition to the legal proceedings relating to Jackson mentioned above, the Group is involved in other litigation and regulatory issues arising in the ordinary course of business. Whilst the outcome of such matters cannot be predicted with certainty, the directors believe that the ultimate outcome of such litigation and regulatory issues will not have a material adverse effect on the Group’s financial condition, results of operations, or cash flows.
Balance at beginning of year 401 331 Changes to actuarial assumptions and method of calculation 71 108 Discount unwind 22 15 Redress to policyholders (41) (48) Payment of administrative costs (5) (5)
The pension mis-selling provision is included within the liabilities in respect of investment contracts with discretionary participation features under IFRS 4.
The pension mis-selling provision at 31 December 2007 set out above of £448 million is stochastically determined on a discounted basis. The average discount rate implied in the movement in the year is 4.6 per cent. The undiscounted amounts at 31 December 2007 expected to be paid in each of the years ending 31 December are as follows: 2007 £m
The FSA periodically updates the actuarial assumptions to be used in calculating the provision, including interest rates and mortality assumptions. The pension mis-selling provision represents the discounted value of future expected payments, including benefit payments and all internal and external legal and administrative costs of adjudicating, processing and settling those claims. To the extent that amounts have not been paid, the provision increases each year reflecting the shorter period of discount.
The costs associated with the pension mis-selling review have been met from the inherited estate. 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.
The bonus and investment policy for each type of with-profits policy is the same irrespective of whether or not the assurance applies. Hence removal of the assurance for new business has had no impact on policyholder returns and this is expected to continue for the foreseeable future.
Guaranteed annuities Prudential Assurance used to sell guaranteed annuity products in the UK and at 31 December 2007 held a provision of £45 million (2006: £47 million) within the main with-profits fund to honour guarantees on these products. The Group’s main exposure to guaranteed annuities in the UK is through SAIF and at 31 December 2007 a provision of £563 million (2006: £561 million) was held in SAIF to honour the guarantees. As SAIF is a separate sub-fund of the Prudential Assurance long-term business fund, the movement in this provision has no impact on shareholders.
In 1997, the business of SALAS, a mutual society, was transferred to Prudential Assurance. In effecting the transfer, a separate sub-fund, SAIF, was established within Prudential Assurance’s long-term business fund. This sub-fund contains all the with-profits business and all other pension business that was transferred. No new business has been or will be written in the sub-fund and the sub-fund is managed to ensure that all the invested assets are distributed to SAIF policyholders over the lifetime of SAIF policies. With the exception of certain amounts in respect of the unitised with-profits life business, all future earnings arising in SAIF are retained for SAIF policyholders. Any excess (deficiency) of revenue over expense within SAIF during a period is offset by a transfer to (from) the SAIF unallocated surplus. Shareholders have no interest in the profits of SAIF but are entitled to the asset management fees paid on this business. With the exception of certain guaranteed annuity products mentioned earlier in this note, and certain products which include a minimum guaranteed rate of accumulation, the majority of SAIF with-profits policies do not guarantee minimum rates of return to policyholders.
Guarantees and commitments Guarantee funds in both the UK and the US provide for payments to be made to policyholders on behalf of insolvent life insurance companies. These guarantee funds are financed by payments assessed on solvent insurance companies based on location, volume and types of business. The Group estimated its reserve for future guarantee fund assessments for Jackson to be £9 million at 31 December 2007 (2006: £9 million). Similar assessments for the UK businesses were not significant. The directors believe that the reserve is adequate for all anticipated payments for known insolvencies.
The costs of employment for continuing operations were: Business operations: Wages and salaries 819 761 Social security costs 62 58 Other pension costs (see below) 62 67 Pension actuarial gains credited to income statement (296) (469)
Venture fund investment subsidiaries of the PAC with-profits fund (see below) 423 230
Other pension costs comprises £34 million (2006: £45 million) relating to defined benefit schemes and £28 million (2006: £22 million) relating to defined contribution schemes of continuing operations. Of the defined contribution scheme costs, £19 million (2006: £14 million) related to overseas defined contribution schemes. The £34 million (2006: £45 million) comprises a £14 million (2006: £29 million) charge on an economic basis, reflecting the total assets of the schemes, and a further £20 million (2006: £16 million) charge to adjust for amounts invested in Prudential insurance policies to arrive at the IAS 19 basis charge. The £296 million (2006: £469 million) of actuarial gains comprises £295 million (2006: £485 million) of actuarial gains on an economic basis and £1 million actuarial gain (2006: £16 million actuarial losses) for amounts invested in Prudential insurance policies. The derivation of these amounts is shown in note (b)(i)7 below.
As at 31 December 2007, the shareholders’ share of the surplus for PSPS and the deficits of the other schemes amounted to a £76 million surplus net of related tax relief (2006: £8 million deficit). These amounts are determined after including amounts invested by PSPS and the M&G scheme in Prudential policies as explained later in this note.
In addition, also on the economic basis, the PAC with-profits sub-fund was credited £9 million (2006: charge of £1 million) for the aggregate of service cost and net finance income and benefited by £205 million (2006: £318 million) for its share of net actuarial gains on the scheme assets and liabilities. As shareholder profits for the PAC with-profits sub-fund reflects the surplus for distribution, these amounts are effectively absorbed by an increased charge in the income statement for the transfer to the liability for unallocated surplus.
The actuarial gains primarily represent the difference between actual and expected investment returns for the schemes and the reduction in liabilities primarily caused by an increase in the discount rate caused by increases in corporate bond returns, which more than offsets the effects of strengthened mortality assumptions for the UK pension schemes.
Surpluses and deficits on the Group’s defined benefit schemes are apportioned to the PAC life fund and shareholders’ funds based on estimates of employees’ service between them. At 31 December 2005, the deficit of PSPS was apportioned in the ratio 70/30 between the life-fund and shareholder-backed operations following detailed consideration of the sourcing of previous contributions. This ratio was applied to the base deficit position at 1 January 2006 and for the purpose of determining the allocation of the movements in that position up to 31 December 2007. The IAS 19 service charge and ongoing employer contributions are allocated by reference to the cost allocation for current activity. The deficit of the Scottish Amicable Pension Scheme of £54 million has been allocated 50 per cent to the PAC with-profits fund and 50 per cent to the PAC shareholder fund.
Reflecting these two elements, at 31 December 2007, the total share of the surplus on PSPS and the deficit on the smaller Scottish Amicable scheme attributable to the PAC with-profits fund amounted to a net surplus of £304 million (2006: £66 million) net of related tax relief.
3 Assumptions The actuarial assumptions used in determining benefit obligations and the net periodic benefit costs for the years ended 31 December were as follows: Discount rate 5.9 5.2 Rate of increase in salaries 5.3 5.0 Rate of increase of pensions in payment for inflation: Expected returns on plan assets 6.2 5.9 *The rates of 2.5 per cent shown are those for PSPS. Assumed rates of increase of pensions in payment for inflation for all other schemes are 3.3 per cent in 2007 (2006: 3.0 per cent).
The mean term of the current PSPS liabilities is around 20 years. Using external actuarial advice provided by Watson Wyatt Partners for the valuation of PSPS and by Aon Limited for the
I1: Staff and pension plans continued 4 Summary financial position The Group liability in respect of defined benefit pension schemes is as follows: Economic position: Surplus (deficit), gross of deferred tax, based on scheme assets held, including investments in Prudential insurance policies: Attributable to the PAC with-profits fund (i.e. absorbed by the liability for unallocated surplus) 338 73 Attributable to shareholder-financed operations (i.e. to shareholders’ equity) 109 (8)
Economic surplus – as explained in note 5 below 447 65 Add back: investments in Prudential insurance policies (offset on consolidation in the Group financial statements against insurance liabilities) (312) (287)
Surplus (deficit) included in balance sheet under IAS 19 – as explained in note 7 below 135 (222)
The following disclosures explain the economic position and IAS 19 basis of accounting after eliminating investment in Prudential insurance policies on consolidation.
Present value of benefit obligations (4,361) (654) (5,015) (4,607) (603) (5,210)
Notes i The PSPS has entered into a derivatives based strategy to match the duration and inflation profile of its liabilities. This involved a reallocation from other investments to cash-like investments with an interest and inflation swap overlay. In broad terms, the scheme is committed to making a series of payments related to LIBOR on a nominal amount and in return the scheme receives a series of fixed and inflation-linked payments which match a proportion of its liabilities. As at 31 December 2007, the nominal value of the interest and inflation swaps amounted to £1.2 billion and £0.7 billion respectively.
ii The resulting scheme surplus or deficit arising from the excess of assets over liabilities or vice versa at 31 December 2007 comprised surplus of £338 million (2006: surplus of £73 million) attributable to the PAC with-profits fund and surplus of £109 million (2006: deficit of £8 million) attributable to shareholder operations.
Estimated pension scheme surplus (deficit) attributable to shareholder operations – economic basis Movements on the pension scheme surplus (deficit) (determined on the ‘economic basis’), to the extent attributable to shareholder operations are as follows: 2007 £m
Net of tax surplus (deficit) (8) (17) 65 36 76 2006 £m
Current service cost (58) (69) Finance income (expense): Interest on pension scheme liabilities (265) (255) Expected return on pension scheme assets 309 295
Charge to operating results, based on longer-term investment returns, attributable to shareholders (23) (28)
Total actuarial gains 295 485 Less: amount attributable to PAC with-profits fund (205) (318)
Service cost less Actuarial Contributions net finance gains paid by PAC At beginning income (losses) with-profits At end of year note i above note ii above fund of year 2006 £m
Service cost less Actuarial Contributions net finance gains paid by PAC At beginning income (losses) with-profits At end of year note i above note ii above fund of year
I1: Staff and pension plans continued 6 Movement in IAS 19 basis financial position The change in the present value of the benefit obligation and the change in fair value of the assets for the total of the PSPS, Scottish Amicable, M&G and Taiwan schemes over the period were as follows: 2007 £m
IAS 19 basis: Investments present Economic change in in Prudential Economic value basis: fair value of insurance basis: of benefit net plan assets policies total assets obligation obligation
Fair value of plan assets, end of year 5,150 312 5,462 5,462 Present value of benefit obligation, end of year (5,015) (5,015)
Fair value of plan assets, beginning of year 4,622 253 4,875 4,875 Present value of benefit obligation, beginning of year (5,418) (5,418)
I1: Staff and pension plans continued 7 IAS 19 basis financial position as consolidated The IAS 19 basis net pensions deficit can be summarised as follows: Fair value of plan assets, end of year 5,150 4,988 4,622 4,092 Present value of funded benefit obligation (4,826) (5,023) (5,228) (4,777)
Surplus (provision) recognised in the balance sheet 135 (222) (796) (825)
Net periodic pension credit (included within acquisition and other operating expenditure in the income statement) 262 424
The actual return on plan assets was £282 million (2006: £419 million) on an IAS 19 basis.
Plan assets in surplus (deficit) of benefit obligation 135 (222) (796) (825)
Experience adjustments on plan liabilities (14) 18 1 (17) Percentage of plan liabilities at 31 December 0.28% (0.35)% (0.02)% 0.35% Experience adjustments on plan assets (IAS 19 basis) (7) 140 527 112 Percentage of plan assets at 31 December (0.14)% 2.81% 11.42% 2.74%
Discount rate Decrease by 0.2% from 5.9% to 5.7% Increase scheme liabilities by 3.5% Discount rate Increase by 0.2% from 5.9% to 6.1% Decrease scheme liabilities by 3.4% Rate of inflation Decrease by 0.2% from 3.3% to 3.1% Decrease scheme liabilities by 1.3%
with consequent reduction in salary increases Mortality rates Reduce rates from 100% of table to 95% Increase liabilities by 1.2%
No rights were granted in the RSP if the Company’s TSR performance as ranked against the comparator group is below 50th percentile. An option of 25 per cent of the maximum award is made. The maximum grant is made only if the TSR ranking of the Company is 20th percentile or above. Between these points, the size of the grant of option made is calculated on a straight line sliding scale.
The BUPP is an incentive plan created to provide a common framework under which awards would be made to senior employees and in the UK, Jackson and Asia include the Chief Executive Officers. Awards under this plan in 2006 and 2007 were based on growth in Shareholder Capital Value on the European Embedded Value (EEV) basis with performance measured over three years. Upon vesting, half of the vested award is released as shares and the other half released in cash. Participants are entitled to receive the value of reinvested dividends over the performance period for those shares that vest. The growth parameters for the awards are relevant to each region and vesting of the awards between each performance point is on a straight line sliding scale basis.
I2: Share-based payments continued In addition, there are other share awards which included the 1,000 Day Long Term Incentive Plan (LTIP) and other arrangements.
The 1,000 Day LTIP plan was a UK insurance operations performance-based plan in which the UK Remuneration Committee could, at any time up to 5 October 2005, select employees at its absolute discretion, for participation in the plan. The performance period was 1,000 days and, based on the final performance level being at, or above, the threshold level, the committee shall grant participants 10 per cent of the allocated award in 2005, 20 per cent in 2006 and the remaining 70 per cent in 2007. There are no beneficial interests, or any rights to dividends until such time as the awards are released, at nil cost, to participants.
I2: Share-based payments continued The following table provides a summary of the range of exercise prices for Prudential plc options (including conditional options) outstanding at 31 December 2007.
The following table provides a summary of the range of exercise prices for Prudential plc options (including conditional options) outstanding at 31 December 2006.
The weighted average fair values of Prudential plc options and awards granted during the period are as follows: Weighted average fair value Weighted average fair value Other RSP and Other
When options are granted or awards made to employees, an estimate is made of what percentage is more than likely to vest, be forfeited, lapse or cancelled based on historical information. Based on these estimates, compensation expense to be accrued at that date is calculated and amortised over the vesting period. For early exercises of options or release of awards due to redundancy, death or resignation, the compensation expense is immediately recognised and for forfeitures due to employees leaving the Group, any previously recognised expense is reversed. However, if an employee loses their award because of the Group’s failure to meet the performance criteria, previously recognised expense is not reversed.
On 1 May 2007, Egg Banking plc was sold to Citi and, at 31 December 2007, there were no outstanding SAYE options to acquire Egg shares.
I2: Share-based payments continued c Total share-based payment expense Total expense recognised in the year in the consolidated financial statements related to share-based compensation is as follows: Share-based compensation expense 28 22 Amount accounted for as equity-settled 19 14 Carrying value at 31 December of liabilities arising from share-based payment transactions 18 18 Intrinsic value of above liabilities for which rights had vested at 31 December 4 3
Post-employment benefits comprise the change in the transfer value of the accrued benefit relating to directors’ defined benefit pension schemes in the year and the total contributions made to directors’ other pension arrangements.
Total key management remuneration includes total directors’ emoluments of £11,959,000 (2006: £11,084,000) as shown in the directors’ remuneration report on pages 102 to 123, and additional amounts in respect of pensions and share-based payments. Further information on directors’ remuneration is given in the directors’ remuneration report.
The Audit Committee annually reviews the auditor’s objectivity and independence. More information on these issues is given in the corporate governance report on page 95.
I5: Related party transactions Transactions between the Company and its subsidiaries are eliminated on consolidation.
In 2007, prior to disposal, three (2006: three) directors had credit cards with the discontinued banking operations. In 2007 and 2006, other transactions with directors were de-minimis both by virtue of their size and in the context of the directors’ financial positions. As indicated above, all of the above noted transactions are on terms equivalent to those that prevail in arm’s length transactions.
I6: Subsidiary undertakings i Principal subsidiaries The principal subsidiary undertakings of the Company at 31 December 2007, all wholly owned except PCA Life Assurance Company Limited, were: Country of Main activity incorporation
PAC and Jackson are the two principal insurance subsidiaries of the Group, which together comprise approximately 78 per cent (2006: 76 per cent) of total Group assets. At 31 December 2007, the PAC long-term fund’s excess of available capital resources over its regulatory requirement (as per line 42 of Form 2 of the PAC FSA regulatory returns) was estimated to be £10.5 billion (2006: £9.7 billion) and the statutory capital and surplus of Jackson was US$4.0 billion (£2.0 billion) (2006: US$3.7 billion (£1.9 billion)). The Group capital position statement for life assurance businesses is set out in note D5.
On 9 November 2007, the Company announced that it had completed the sale of PPM Capital, its direct private equity business.
Orizon AG was managed by PPM Capital while Red Funnel is managed by M&G.
— 53 per cent of the voting equity interests of Histoire D’or, a jewellery retail company, in April 2006; — 51 per cent of the voting equity interests of Azzuri Communications, a business IT service company, in June 2006; and — 60 per cent of the voting equity interests of Paramount plc, a restaurant company, in September 2006.
The results of the aggregated ventures acquisitions in 2007 and 2006 have been included in the consolidated financial statements of the Group commencing on the respective dates of acquisition and contributed a loss of £8.3 million (2006: loss of £7.7 million) to earnings within the income statement, which is also reflected as part of the change in unallocated surplus of the with-profits fund. The results of Orizon AG included in the loss of £8.3 million above was from the date of its acquisition to November 2007 when it ceased to be consolidated.
I6: Subsidiary undertakings continued The table below identifies the net assets of these acquisitions and minor business purchases by existing venture holdings. This reconciles the net assets to the consideration paid in 2007 and 2006: Fair value on Fair value on acquisition acquisition
Aggregate goodwill of £313 million (2006: £336 million) has been recognised for the excess of the cost over the Group’s interest in the net fair value of the entities’ assets, liabilities, and contingent liabilities acquired in 2007.
In November 2007, the Group disposed of PPM Capital, following which the Group no longer has a controlling interest in venture fund investment subsidiaries managed by PPM Capital and consequently has ceased to consolidate these investments. The cessation of control arises from the Group’s interest in venture fund investments being held either through partnership agreements, with the Group a limited partner, or, where there is a direct holding, an asset management agreement being in place, both of which result in the Group only being able to exert control under exceptional circumstances.
Goodwill and other intangible assets, net of amortisation, relating to these investments of £916 million at the date of disposal of PPM Capital, were derecognised accordingly.
In 2006, Upperpoint Distribution Limited, Taverner Hotel Group Pty Ltd, Orefi, Aperio Group Pty Ltd and BST Safety Textiles Luxembourg S.a.r.l., all venture subsidiaries of the PAC with-profits fund, were disposed of for cash consideration of £133 million. Goodwill of £46 million and cash and cash equivalents of £19 million were disposed of. Note that, in addition, one venture subsidiary was classified as held for sale at 31 December 2006 (see note H9).
Structural borrowings of with-profits operations relate solely to the £100 million 8.5 per cent undated subordinated guaranteed bonds which contribute to the solvency base of SAIF. Cash flows in respect of other borrowings of with-profits funds, which principally relate to consolidated investment funds and, prior to deconsolidation, venture fund investment subsidiaries, are also included within cash flows from operating activities.
The Group has presented the income statement and balance sheet for discontinued banking operations in a format that demonstrates the characteristics and principal operations specific to a bank. The format is different from that of the Group consolidated income statement and balance sheet; however, total profit (loss) for the year and net assets remain the same. To understand how the amounts presented from discontinued banking operations are consolidated in the Group financial statements, refer to the primary segmental information for the income statement in note F1 and the primary segmental information for the balance sheet in note B6.
J1: Income statement for discontinued banking operations The profit (loss) included in the income statement in respect of discontinued banking operations for the period of ownership is as follows: Interest income 261 783 Interest expense (148) (453)
Fee and commission income 41 153 Fee and commission expense (8) (23) Other operating income – 8
General administrative expenses (56) (192) Impairment losses on loans and cash advances to customers J5 (149) (384) Other operating expenses (9) (49)
The interest income on financial assets not at fair value through profit and loss for the period of ownership in 2007 was £241 million (2006: £769 million).
Fee and commission expense includes fee expenses relating to financial liabilities held at amortised cost of £4 million (2006: £13 million) which related to treasury fees.
Of the profit (loss) for the period of ownership in 2007 and 2006, a loss of £nil million and a loss of £2 million, respectively, are attributable to minority interests in Egg.
Assets Cash and balances with central banks 6 Loans and advances to banks 903 Loans and advances to customers 6,193 Investment securities 1,976 Derivative financial instruments 78 Other assets 342
Debt securities issued – – 553 46 – 599 Derivative financial instruments 56 – – 98 – 154
J5: Losses on loans and advances The following table details the movements in the allowance for losses on loans and advances to customers held by Egg for the period of ownership in 2007 and 2006. The aggregate loss on loans at the end of the year and the charge during the period of ownership have been included in the consolidated financial statements.
Impairment losses on loans and advances to customers Where financial assets are carried at amortised cost, the Group measures the amount of the impairment loss by comparing the carrying amount of the asset with the present value of its estimated cash flows.
Interest rate risk The primary market risk to which Egg was exposed was interest rate risk. Interest rate risk arose in Egg as a result of fixed rate, variable rate and non-interest bearing assets and liabilities. Exposure to interest rate movements arose when there was a mismatch between interest rate sensitive assets and liabilities.
Currency risk The risks arising from assets and liabilities denominated in foreign currencies were managed by a separate treasury function within Egg and within agreed limits set by the ALCO. During the year, cash flows generated by the foreign currency assets and liabilities were hedged by using derivative contracts to manage exposure to exchange rate fluctuations.
The following table identifies the geographical concentrations of credit risk, stated in terms of total assets and off-balance sheet items, held by Egg at 31 December 2006: 2006 £m
Loans and advances to banks 903 Investment securities 1,970 Loans and advances to customers 6,711 Allowances for impairment losses on loans and advances to customers (518) Fair value of derivative assets 78 Off-balance sheet items (including unutilised credit limits on credit cards) 9,475
At 31 December 2006, Egg had certain credit-related commitments in the form of unused credit limits on credit cards of £9,458 million and pre-approved but unused borrowing limits on mortgages and personal loans of £8 million and £9 million respectively which are included in off-balance sheet items above. Egg was potentially exposed to a loss totalling these amounts, but it was unlikely that such a loss would arise as these credit facilities were granted only on the basis of the customers having achieved certain credit standards. Additionally, it was unlikely, should all these customers have utilised their credit or borrowing limits, that all of them would default on their debt entirely.
Assets pledged as collateral and securitisation Egg entered into securities lending arrangements, including repurchase agreements and over-the-counter derivative transactions, as part of normal operating activities. Assets were pledged as collateral to support these activities. Collateral in respect of repurchase agreements was £nil at 31 December 2006. Collateral in respect of over-the-counter derivative transactions was £29.3 million at 31 December 2006. See note G4 where amounts relating to Egg have been included in the disclosure of these transactions on a Group basis.
J8: Capital position At 31 December 2006 Egg had a capital surplus of £210 million over required regulatory capital levels.
Current assets Debtors: Amounts owed by subsidiary undertakings 3,291 2,057 Other debtors 25 42
Amounts owed to subsidiary undertakings (2,455) (667) Tax payable (332) (290) Sundry creditors (6) (26) Accruals and deferred income (44) (42)
Total net assets (excluding pension) 3,000 3,278 Pension asset (net of related deferred tax) 8 117 34
2 Basis of preparation The financial statements of the Company, which comprise the balance sheet and related notes, are prepared in accordance with Section 226 of, and Schedule 4 to, the Companies Act 1985, which apply to companies generally. The Company has taken advantage of the exemption under Section 230 of the Companies Act 1985 from presenting its own profit and loss account.
FRS 29, ‘Financial Instruments: Disclosures’ which replaces the disclosure requirements of FRS 25, ‘Financial Instruments: Disclosure and Presentation’ became effective in 2007. Similar to the treatment adopted for FRS 25, the Company has taken advantage of the exemption within FRS 29, from the requirements of this standard on the basis that the Company is included in the publicly available consolidated financial statements of the Group that include disclosures that comply with IFRS 7, ‘Financial Instruments: Disclosures’, which is equivalent to FRS 29.
An amendment to FRS 26, ‘Financial Instruments: Recognition and Measurement’ which brings recognition and derecognition requirements of IAS 39, ‘Financial Instruments: Recognition and Measurement’ into FRS 26 became effective in 2007. The amendment applies only to financial assets and liabilities. The relevant requirements of FRS 5, ‘Reporting the Substance of Transactions’ continue to apply to the recognition and derecognition of non-financial assets. The adoption of this amendment to FRS 26 did not have an impact on the balance sheet or profit and loss account of the Company.
The aggregate of the actuarially determined service costs of the currently employed personnel and the unwind of the discount on liabilities at the start of the period, less the expected investment return on the scheme assets at the start of the period, is recognised in the profit and loss account.
vii These borrowings support a short-term fixed income securities programme. viii The interests of the holders of the Subordinated Notes and the Subordinated Capital Securities are subordinate to the entitlements of other creditors of the Company.
Parent com pany 7 Derivative financial instruments The table below analyses the fair value of derivatives of the Company at 31 December: Fair value Fair value Fair value Fair value assets liabilities assets liabilities
Derivative financial instruments held to manage interest rate and currency profile: Inflation-linked swap – 82 – 67 Forward foreign currency contracts – 44 – 4
The change in fair value of the derivative financial instruments of the Company was a gain before tax of £13 million (2006: £131 million).
The valuation as at 5 April 2005 was accompanied by changes to the basis of funding for the scheme from 2006 onwards. Deficit funding amounts designed to eliminate the actuarial deficit over a 10-year period are being made. Based on this valuation, total contributions to the scheme for deficit funding and employer contributions for ongoing service for current employees were expected to be of the order of £70 to 75 million per annum over a 10-year period. In 2007, total contributions for the year, including expenses and augmentations, were £82 million (2006: £137 million). The 2006 amount reflected the increased level of contributions for ongoing service and deficit funding backdated to 6 April 2005.
The key assumptions adopted were: Price inflation 3.3 3.0 Rate of increase in salaries 5.3 5.0 Rate of increase in pension payments for inflation: Rate used to discount scheme liabilities 5.9 5.2
Allocated as: Attributable to the PAC with-profits fund 365 93 (265) Attributable to the Company 163 48 (114)
After deducting deferred tax, the amounts reflected in the balance sheet of the Company are: 117 34 (80)
Parent com pany 8 Pension scheme financial position continued The change in the present value of the scheme liabilities and the change in the fair value of the assets is as follows: Present value of scheme liabilities, beginning of year 4,607 4,776 Service costs 39 47
Pension credit (charge) Operating charge: Service costs (39) (47) Finance income (expense): Interest on scheme liabilities (234) (226) Expected return on scheme assets 276 266
The total actual return on scheme assets for PSPS was £264 million (2006: £407 million). The actuarial gains before tax of £91 million (2006: £118 million) attributable to the Company are recorded in the statement of total recognised gains and losses. Cumulative actuarial gains as at 31 December 2007 amount to £234 million (2006: £143 million). The additional loss of £59 million in 2005 reflected the changed estimate of allocation in the deficit of PSPS from a ratio of 20/80 between the Company and the PAC with-profits fund prior to 2005 to a ratio of 30/70 from 2005 onwards. Total employer contributions expected to be paid into the PSPS defined benefit scheme for the year ending 31 December 2008 amount to £75 million.
At 31 December 2007, there were options subsisting under share option schemes to subscribe for 9,017,442 (2006: 10,722,274) shares at prices ranging from 266 pence to 695 pence (2006: 266 pence to 715 pence) and exercisable by the year 2014 (2006: 2013). In addition, there were 2,037,220 (2006: 4,113,481) conditional options outstanding under the Restricted Share Plan exercisable at nil cost within a 10-year period. No further options will be issued under the Restricted Share Plan which has been replaced by the Group Performance Share Plan. There were 3,485,617 (2006: 1,623,637) conditional options outstanding under the Group Performance Share Plan exercisable at nil cost within a 10-year period. Further information on the Group’s employee share options is given in note I2 ‘Share-based payments’ of the notes on the financial statements of the Group.
Parent com pany 10 Profit of the Company and reconciliation of movement in shareholders’ funds The loss after tax of the Company for the year was £17 million (2006: profit of £834 million). After dividends of £426 million (2006: £398 million), actuarial gains net of tax in respect of the pension scheme of £66 million (2006: £83 million) and a transfer from the share premium account of £175 million (2006: £75 million) in respect of shares issued in lieu of cash dividends, retained profit at 31 December 2007 amounted to £1,166 million (2006: £1,368 million).
A reconciliation of the movement in shareholders’ funds of the Company for the years ended 31 December 2007 and 2006 is given below: (Loss) profit for the year (17) 834
Actuarial gains recognised in respect of the pension scheme net of related tax (note 8) 66 83 New share capital subscribed (note 9) 182 336
Shareholders’ funds at end of year 3,117 3,312 11 Other information a Information on directors’ remuneration is given in the directors’ remuneration report section of this Annual Report and note I3
In addition, the Company paid fees for other services of £0.2 million (2006: £0.6 million), which were wholly for services relating to corporate finance transactions.
12 Post balance sheet events A final dividend of 12.30 pence per share was proposed by the directors on 13 March 2008. Subject to shareholders’ approval, the dividend will be paid on 20 May 2008 to shareholders on the register at the close of business on 11 April 2008. The dividend will absorb an estimated £304 million of shareholders’ funds. A scrip dividend alternative will be offered to shareholders. There have been no other significant events affecting the Company since the balance sheet date.
— prepare the financial statements on the going concern basis unless it is inappropriate to presume that the Group and the parent company will continue in business.
Statement of directors’ responsibilities in respect of the Annual Report and the financial statements 300 Prudential plc Annual Report 2007
We have audited the Group and parent company financial statements (the financial statements) of Prudential plc for the year ended 31 December 2007 which comprise the consolidated Group income statement, the consolidated Group and parent company balance sheets, the consolidated Group cash flow statement, the consolidated Group statement of change in shareholders’ equity and the related notes on pages 127 to 299. These financial statements have been prepared under the accounting policies set out therein. We have also audited the information in the directors’ remuneration report on pages 102 to 123 that is described as having been audited.
Basis of audit opinion We conducted our audit in accordance with International Standards on Auditing (UK and Ireland) issued by the Auditing Practices Board. An audit includes examination, on a test basis, of evidence relevant to the amounts and disclosures in the financial statements and the part of the directors’ remuneration report to be audited. It also includes an assessment of the significant estimates and judgements made by the directors in the preparation of the financial statements, and of whether the accounting policies are appropriate to the Group’s and Company’s circumstances, consistently applied and adequately disclosed.
Opinion In our opinion: — The Group financial statements give a true and fair view, in accordance with IFRS as adopted by the European Union, of the state of the Group’s affairs as at 31 December 2007 and of its profit for the year then ended; — the Group financial statements have been properly prepared in accordance with the Companies Act 1985 and Article 4 of the IAS Regulation; — the parent company financial statements give a true and fair view, in accordance with United Kingdom Generally Accepted Accounting Practice, of the state of the parent company’s affairs as at 31 December 2007; — the parent company financial statements and the part of the directors’ remuneration report to be audited have been properly prepared in accordance with the Companies Act 1985; and
Operating profit from continuing operations based on longer-term investment returns* Results analysis by business area
Asian operations New business 5(b) 653 514 Business in force 6 393 315
Long-term business 2,532 2,223 Asset management 334 264 Other results (324) (354)
*EEV basis operating profit from continuing operations based on longer-term investment returns excludes short-term fluctuations in investment returns, the mark to market value movements on core borrowings, the shareholders’ share of actuarial gains and losses on defined benefit pension schemes, the effect of changes in economic assumptions and changes in the time value of cost of options and guarantees arising from changes in economic factors. The amounts for these items are included in total EEV profit. The directors believe that operating profit, as adjusted for these items, better reflects underlying performance. Profit before tax and basic earnings per share include these items together with actual investment returns. This basis of presentation has been adopted consistently throughout this supplementary information.
The results for continuing operations shown above exclude those in respect of discontinued banking operations. On 1 May 2007, the Company sold Egg. Accordingly, the presentation of the comparative results for 2006 has been adjusted from those previously published.
Operating profit from continuing operations based on longer-term investment returns Asian operations 1,103 864 US operations 635 718 UK operations: UK insurance operations 859 686
Attributable to: Equity holders of the Company 3,062 2,212 Minority interests 21 1
Based on profit from continuing operations after tax and minority interests
Total – based on profit for the year after minority interests of £3,062m (2006: £2,212m) 125.2p 91.7p
Dividends relating to the reporting period: Dividends declared and paid in the reporting period: Current year interim dividend 5.70p 5.42p Final dividend for prior year 11.72p 11.02p
Movement in shareholders’ equity (excluding minority interests) – EEV basis Year ended 31 December 2007
Acquisition of Egg minority interests – (167) New share capital subscribed 182 336 Reserve movements in respect of share-based payments 18 15 Treasury shares: Movement in own shares in respect of share-based payment plans 7 6 Movement on Prudential plc shares purchased by unit trusts consolidated under IFRS 4 0
Comprising: Asian operations: Net assets 3,837 2,637 Acquired goodwill 172 172
UK operations: Long-term business 6,497 5,813 M&G: Net assets 271 230 Acquired goodwill 1,153 1,153
Total assets less liabilities, excluding insurance funds 195,987 183,130 Less insurance funds:*
Share capital 123 122 Share premium 1,828 1,822 IFRS basis shareholders’ reserves 4,250 3,544
Total IFRS basis shareholders’ equity 6,201 5,488 Additional EEV basis retained profit 8,578 6,395
The supplementary information on pages 302 to 332 was approved by the Board of directors on 13 March 2008.
1 Basis of preparation The EEV basis results have been prepared in accordance with the EEV Principles issued by the CFO Forum of European Insurance Companies in May 2004 and expanded by the Additional Guidance on EEV Disclosures published in October 2005. Where appropriate the EEV basis results include the effects of adoption of International Financial Reporting Standards (IFRS).
The EEV results for the Group are prepared for ‘covered business’ as defined by the EEV Principles. Covered business represents the Group’s long-term insurance business for which the value of new and in-force contracts is attributable to shareholders. The EEV basis results for the Group’s covered business are then combined with the IFRS basis results of the Group’s other operations. These other operations include the results of discontinued banking operations, following the sale of Egg on 1 May 2007.
The definition of long-term business operations is consistent with previous practice and comprises those contracts falling under the definition of long-term insurance business for regulatory purposes together with, for US operations, contracts that are in substance the same as guaranteed investment contracts (GICs) but do not fall within the technical definition. Under the EEV Principles, the results for covered business incorporate the projected margins of attaching internal asset management.
With two principal exceptions, covered business comprises the Group’s long-term business operations. The principal exceptions are for the closed Scottish Amicable Insurance Fund (SAIF) and for the presentational treatment of the financial position of two of the Group’s defined benefit pension schemes. A very small amount of UK group pensions business is also not modelled for EEV reporting purposes.
The value of future new business is excluded from the embedded value. Notwithstanding the basis of presentation of results (as explained in notes 4 and 6) no smoothing of market or account balance values, unrealised gains or investment returns is applied in determining the embedded value or the profit before tax.
Notes on the EEV basis supplementary information 306 Prudential plc Annual Report 2007
2 Methodology continued Cost of capital A charge is deducted from the embedded value for the cost of capital supporting the Group’s long-term business. This capital is referred to as encumbered capital. The cost is the difference between the nominal value of the capital and the discounted value of the projected releases of this capital allowing for investment earnings (net of tax) on the capital.
Where capital is held within a with-profits long-term fund, the value placed on surplus assets in this fund is already discounted to reflect their release over time and no further adjustment is necessary in respect of encumbered capital. However, where business is funded directly by shareholders, the capital requires adjustment to reflect the cost of that capital to shareholders.
Non-participating long-term products are the only ones where the insurer is contractually obliged to provide guarantees on all benefits. The most significant book of non-participating business in the Group’s Asian operations is Taiwan’s whole of life contracts. For these contracts there are floor levels of policyholder benefits that accrue at rates set at inception by reference to minimum returns established by local regulation. These rates do not vary subsequently with market conditions. Under these contracts the cost of premiums are also fixed at inception based on a number of assumptions at that time, including long-term interest rates, mortality assumptions and expenses. The guaranteed maturity and surrender values reflect the pricing basis.
Fixed annuities provide that, at Jackson’s discretion, it may reset the interest rate credited to policyholders’ accounts, subject to a guaranteed minimum. The guaranteed minimum return varies from 1.5 per cent to 5.5 per cent (2006: 1.5 per cent to 5.5 per cent), depending on the particular product, jurisdiction where issued, and date of issue. At 31 December 2007, 80 per cent (2006: 70 per cent) of the fund relates to policies with guarantees of three per cent or less. The average guarantee rate is 3.1 per cent (2006: 3.2 per cent).
The Group’s main exposure to guaranteed annuity options in the UK is through SAIF and a provision on the Pillar I Peak 2 basis of £563 million (2006: £561 million) was held in SAIF at 31 December 2007 to honour the guarantees.
b Level of encumbered capital In adopting the EEV Principles, Prudential has based encumbered capital on its internal targets for economic capital subject to it being at least the local statutory minimum requirements. Economic capital is assessed using internal models but, when applying the EEV Principles, Prudential does not take credit for the significant diversification benefits that exist within the Group. For with-profits business written in a segregated life fund, as is the case in Asia and the UK, the capital available in the fund is sufficient to meet the encumbered capital requirements.
— Asian operations: the economic capital requirement is substantially higher than local statutory requirements in total. Economic capital requirements vary by territory, but in aggregate, the encumbered capital is equivalent to the amount required under the Insurance Groups Directive (IGD).
2 Methodology continued Product level betas are calculated each year. They are combined with the most recent product mix to produce appropriate betas and risk discount rates for each major product grouping.
Non-diversifiable, non-market risks Finance theory cannot be used to determine the appropriate component of beta for non-diversifiable non-market risks since there is no observable risk premium associated with it that is akin to the equity risk premium. Recognising this, a pragmatic approach has been used.
Except for UK shareholder-backed annuity business, a constant margin of 50 basis points (2006: 50 basis points) has been added to the risk margin derived for market risk to cover the non-diversifiable non-market risks associated with the business. For UK shareholder-backed annuity business, a margin of 100 basis points was used (2006: 100 basis points).
In all instances, the modelled actions are in accordance with approved local practice and therefore reflect the options actually available to management. For the PAC with-profits fund, the actions assumed are consistent with those set out in the Principles and Practices of Financial Management.
f Pension costs The Group operates three defined benefit schemes in the UK. The principal scheme is the Prudential Staff Pension Scheme (PSPS). The other two, much smaller, schemes are the Scottish Amicable and M&G schemes. There is also a small scheme in Taiwan.
Under the EEV basis the IAS 19 basis surplus or deficit is initially allocated in the same manner. The shareholders’ 10 per cent interest in the PAC with-profits fund estate is determined after inclusion of the portion of the IAS 19 basis surplus or deficit attributable to the fund. Adjustments under EEV in respect of accounting for surpluses or deficits on defined benefit schemes are reflected as part of ‘Other operations’, as shown in note 15.
g Debt capital Core structural debt liabilities are carried at market value.
3 Assumptions a Best estimate assumptions Best estimate assumptions are used for the cash flow projections, where best estimate is defined as the mean of the distribution of future possible outcomes. The assumptions are reviewed actively and changes are made when evidence exists that material changes in future experience are reasonably certain.
b Principal economic assumptions Deterministic In most countries, the long-term expected rates of return on investments and risk discount rates are set by reference to period end rates of return on cash or fixed interest securities. This ‘active’ basis of assumption setting has been applied in preparing the results of all the Group’s US and UK long-term business operations. For the Group’s Asian operations, the active basis is appropriate for business written in Japan, Korea and US dollar denominated business written in Hong Kong.
An exception to this general rule is that for countries where long-term fixed interest markets are less established, investment return assumptions and risk discount rates are based on an assessment of longer-term economic conditions. Except for the countries listed above, this basis is appropriate for the Group’s Asian operations.
The tables below summarise the principal financial assumptions: China Hong Kong India Indonesia Japan Korea China Hong Kong India Indonesia Japan Korea Asian operations notes iii,iv,v notes iii,iv,v
In projecting forward the Fund Earned Rate, allowance is made for the mix of assets in the fund, future investment strategy, and further market value depreciation of bonds held as a result of assumed future yield increases. These factors, together with the assumption of the phased progression in bond yields, give rise to an average assumed Fund Earned Rate that trends from 0.5 per cent for 2007 to 6.4 per cent for 2014. The assumed Fund Earned Rate increases to 2.5 per cent in 2008 and then increases to 3.3 per cent by 2013. Thereafter, the assumed Fund Earned Rate fluctuates around a target of 6.4 per cent. This projection compares with that applied for the 2006 results of a grading from an assumed rate of 2.1 per cent for 2006 to 5.7 per cent for 2014.
Risk discount rate:* New business 7.0 7.6 In force 6.0 6.7
US 10-year treasury bond rate at end of period 4.1 4.8 Pre-tax expected long-term nominal rate of return for US equities 8.1 8.8 Expected long-term rate of inflation 2.4 2.5 *The risk discount rates at 31 December 2007 for new business and business in force for US operations reflect weighted rates based on underlying rates of 8.1 per cent for variable annuity business and 4.8 per cent for other business. The decrease in the weighted discount rates reflects the decrease in the US 10-year treasury bond rate.
Pre-tax expected long-term nominal rates of investment return: UK equities 8.55 8.6 Overseas equities 8.1to10.2 8.6 to 9.3
Pre-tax expected long-term nominal rate of return for annuity business:note iii
Stochastic The economic assumptions used for the stochastic calculations are consistent with those used for the deterministic calculations described above. Assumptions specific to the stochastic calculations, such as the volatilities of asset returns, reflect local market conditions and are based on a combination of actual market data, historic market data and an assessment of longer-term economic conditions. Common principles have been adopted across the Group for the stochastic asset models, for example, separate modelling of individual asset classes but with allowance for correlation between the various asset classes.
The stochastic cost of guarantees is primarily only of significance for the Hong Kong, Malaysia, Singapore and Taiwan operations. The mean stochastic returns are consistent with the mean deterministic returns for each country. The expected volatility of equity returns for both 2007 and 2006 ranges from 18 per cent to 25 per cent and the volatility of government bond yields ranges from 1.3 per cent to 2.5 per cent (2006: 1.4 per cent to 2.5 per cent).
Mean returns have been derived as the annualised arithmetic average return across all simulations and durations. For each projection year, standard deviations have been calculated by taking the square root of the annualised variance of the returns over all the simulations. These have been averaged over all durations in the projection. For equity and property, the standard deviations relate to the total return on these assets. The standard deviations applied to both years are as follows: %
Property 15.0 c Demographic assumptions Persistency, mortality and morbidity assumptions are based on an analysis of recent experience but also reflect expected future experience. Where relevant, when calculating the time value of financial options and guarantees, policyholder withdrawal rates vary in line with the emerging investment conditions according to management’s expectations.
e Inter-company arrangements The EEV results for covered business incorporate the effect of the reinsurance arrangement of non-profit immediate pension annuity liabilities of SAIF to PRIL, as described in note 5a. In addition, the analysis of free surplus and value of in-force business takes account of the impact of contingent loan arrangements between Group companies.
b Investment return Profit before tax With the exception of debt securities held by Jackson, investment gains and losses during the year (to the extent that changes in capital values do not directly match changes in liabilities) are included directly in the profit for the year and shareholders’ funds as they arise.
However, in determining the movements on the additional shareholders’ interest the basis for calculating the Jackson EEV result acknowledges that for debt securities backing liabilities the aggregate EEV results reflect the fact that the value of in-force business instead incorporates the discounted value of future spread earnings. This value is not affected generally by short-term market movements on securities that are broadly speaking held with the intent and ability to be retained for the longer term.
Operating profit Investment returns, including investment gains, in respect of long-term insurance business are recognised in operating results at the expected long-term rate of return. For the purpose of calculating the longer-term investment return to be included in the operating results of UK operations, where equity holdings are a significant proportion of investment portfolios, values of assets at the beginning of the reporting period are adjusted to remove the effects of short-term market volatility.
For the purposes of determining the long-term returns for debt securities of shareholder-backed operations, a risk margin charge is included which reflects the expected long-term rate of default based on the credit quality of the portfolio. For Jackson, interest-related realised gains and losses are amortised to the operating results over the maturity period of the sold bonds and for equity-related investments, a long-term rate of return is assumed, which reflects the aggregation of risk-free rates and equity risk premium.
Actuarial gains and losses Actuarial gains and losses comprise: — the difference between actual and expected return on the scheme assets; — experience gains and losses on scheme liabilities; and — the impact of altered economic and other assumptions on the discounted value of scheme liabilities.
4 Accounting presentation continued f Capital held centrally for Asian operations In adopting the EEV Principles, Prudential has decided to set encumbered capital at its internal targets for economic capital. In Asia, the economic capital target is substantially higher than the local statutory requirements in total. Accordingly, capital is held centrally for Asian operations. For the purpose of the presentation of the Group’s operating results, it is assumed that the centrally held capital is lent interest free to the Asian operations. In turn, the results of the Asian operations include the return on that capital and Group shareholders’ other income for EEV basis reporting is consequently reduced.
h Foreign currency translation Foreign currency profits and losses have been translated at average exchange rates for the year. Foreign currency assets and liabilities have been translated at year end rates of exchange. The purpose of translating the profits and losses at average exchange rates, notwithstanding the fact that EEV profit represents the incremental value added on a discounted cash flow basis, is to maintain consistency with the methodology applied for IFRS basis reporting.
5. Premiums, operating profit and margins from new business Annual Premium and Present Value of New a Premiums and contributionsnote i Contribution Equivalents Business Premiums Single Regular (APE) (PVNBP)
APEs are calculated as the aggregate of regular new business amounts and one-tenth of single new business amounts. PVNBPs are calculated as equalling single premiums plus the present value of expected premiums of new regular premium business, allowing for lapses and other assumptions made in determining the EEV new business contribution. New business premiums reflect those premiums attaching to covered business, including premiums for contracts classified as investment products for IFRS basis reporting. New business premiums for regular premium products are shown on an annualised basis. Department of Work and Pensions (DWP) rebate business is classified as single recurrent business. Internal vesting business is classified as new business where the contracts include an open market option.
iii The tables for 2006 include a bulk annuity transaction with the Scottish Amicable Insurance Fund (SAIF) with a premium of £560 million. The transaction reflects the arrangement entered into in June 2006, for the reinsurance of non-profit immediate pension annuity liabilities of SAIF to Prudential Retirement Income Limited (PRIL) a shareholder owned subsidiary of the Group. SAIF is a closed ring-fenced sub-fund of the PAC long-term fund established by a Court approved Scheme of Arrangement in October 1997, which is solely for the benefit of SAIF policyholders. Shareholders have no interest in the profits of this fund and, accordingly, it is not part of covered business for EEV reporting purposes. Consistent with this treatment, and the transfer of longevity risk, requirement for capital support and entitlement to profits on this block of business from SAIF to Prudential shareholders, the transaction has been accounted for as new business for EEV basis reporting purposes.
In determining the EEV basis value of new business written in the year the policies incept, premiums are included in projected cash flows on the same basis of distinguishing annual and single premium business as set out for statutory basis reporting. Included within pre-tax new business profits shown in the table above are profits arising from asset management business falling within the scope of covered business of: Asian operations 44 23 US operations 1 2 UK insurance operations 11 9
Annual Present value premium and of new contribution business Pre-tax newNew business premiums equivalent premiums business New business margin
Spread experience variance 99 118 Amortisation of interest-related realised gains and losses 37 45 Changes in operating assumptions (24) (7) Othernote iii (10) 42
Unwind of discount and other expected returnsnote i 592 530 Effect of change in the UK corporate tax ratenote iva 67 – Annuity business:note ivb
5 This amount reflects the release of other additional margins in the liabilities that are no longer appropriate in light of the explicit strengthening of the mortality assumptions.
Cost of development of new products and distribution capabilities (and costs associated with regulatory requirements for 2006) (36) (32)
1 The licence fee payments are made by shareholder-backed subsidiaries of UK insurance operations, via a service company, to the PAC withprofits fund for the right to use trademarks and for the goodwill associated with the purchase of the business of the Scottish Amicable Life Assurance Society in 1997. The licence fee arrangements run to 2017.
2 The charge of £14 million (2006: £16 million) in respect of SAIF, which is not covered business, is borne by a service company and arises from a tariff arrangement which ran to the end of 2007 and was onerous to shareholders.
On 29 January 2007 the Company announced the sale of Egg to Citi and on 15 March 2007 the Company announced the actions necessary to implement the reassessed plans in light of this transaction and additional initiatives. In preparing the 2006 results, account was taken of the effect of expense savings that were expected to arise with some certainty. Without this factor the effect on the 2006 results would have been a charge of £44 million for the net effect of revised assumptions in line with 2006 unit costs. For the 2007 results the unit costs are in line with assumptions and no anticipation of savings has been incorporated.
EEV basis 45 8 8 Restructuring costs Restructuring costs have been incurred as follows: UK insurance operations 8 34
Share of investment return of funds managed by PPM America that are consolidated into Group results but attributable to external investors 1 1
Notes i The short-term fluctuations for Asian operations of £226 million (2006: £286 million) arose mainly from favourable equity investment performance in most territories, principally in Hong Kong of £102 million (2006: £73 million), Vietnam £66 million (2006: £108 million) and Singapore £38 million (2006: £41 million) offset by a negative fluctuation in Taiwan of £26 million principally due to a £30 million value reduction for an investment in a CDO fund (2006: favourable variance of £46 million).
9 Short-term fluctuations in investment returns continued Notes continued ii Short-term fluctuations for Jackson comprise: £m £m
Actual investment return on investments less long-term returns included within operating profit: Actual realised (losses) gains less default assumption and amortisation of interest-related realised gains and losses for fixed maturity securities and related swap transactions (44) 20 Actual less long-term return on equity-based investments and other items 51 26
iii The charge for UK insurance operations for 2007 of £43 million primarily reflects value movements on the bond holdings of PRIL’s shareholders’ funds due to the net effect of widened credit spreads and reduced interest rates together with the difference between the actual investment return for the with-profits life fund of 7.2 per cent and the gross long-term assumed rate of 7.85 per cent. For 2006, the credit of £378 million reflects the PAC life fund investment return of 12.4 per cent.
iv Comparative figures for 2006 have been adjusted from those previously published to exclude discontinued banking operations.
Core borrowings of the Group are marked to market value under EEV. The figures in the table above reflect the movement in the difference between market and IFRS carrying values. As the liabilities are generally held to maturity or for the long term, no deferred tax asset or liability has been established on the difference (compared to IFRS) in carrying value. Accordingly, no deferred tax charge is recorded in the results in respect of the 2007 credit of £223 million (2006: £85 million).
11 Actuarial gains and losses on defined benefit pension schemes The gain of £116 million (2006: gain of £207 million) included within profit before tax reflects the shareholders’ share of actuarial gains and losses on the Group’s defined benefit pension schemes. On the EEV basis, this gain includes a 10 per cent share of the actuarial gains and losses on the share attributable to the PAC with-profits fund for the Prudential Staff and Scottish Amicable Pension Schemes. The 2007 gains mainly reflect gains due to changes in economic assumptions, partly offset by the effect of strengthened mortality assumptions. The very high level of shareholders’ actuarial gains in 2006 reflected the excess of market returns over the long-term assumption and the increase in discount rate applied in determining the present value of projected pension payments from 4.8 per cent at 31 December 2005 to 5.2 per cent at 31 December 2006.
12 Effect of changes in economic assumptions and time value of cost of options and guarantees continued Notes i The principal components of the effect of changes in economic assumptions in 2007 of £201 million for Asian operations are credits of £110 million in Taiwan and £80 million in Hong Kong. The increase for Taiwan reflects the combined effect of changes to the projected fund earned rate (as explained in note 3), and to economic capital (versus projected), offset by the effect of an increase in the risk discount rate. The increase for Hong Kong reflects a reduction in the risk discount rate for all product lines and an increase in the projected fund earned rate for participating and linked business. The charge of £132 million for 2006 mainly relates to Taiwan where there was a charge of £101 million arising from the delay in the assumed long-term yield projection and the associated effect of this delay on the economic capital requirement.
iii The effect of changes in economic assumptions in 2007 of £466 million for UK insurance operations reflects a 0.35 per cent increase in the fund earned rate arising from the increase in assumed returns on non-UK equities and corporate bond rates which more than offsets the slight reduction in gilt rates (as shown in note 3), a partial offset from the cost of credit default swaps of £41 million and the effect of the risk discount rate for business in force reducing slightly by 0.15 per cent in a similar way to the fall in gilt rates as also shown in note 3.
13 Tax attributable to shareholders’ profit The tax charge comprises: Tax charge (credit) on operating profit from continuing operations based on longer-term investment returns Long-term business:note i
Asian operationsnotes ii,iii 252 222 US operationsnote v 197 251 UK insurance operationsnotes ii,iii 236 178
Total tax charge on items not included in operating profit from continuing operations 267 270
Tax charge on profit from continuing operations (including tax on actual investment returns)note vi 961 904
Notes i The profit for the year for covered business is in most cases calculated initially at the post-tax level. The post-tax profit for covered business is then grossed up for presentation purposes at the effective rates of tax applicable to the countries and periods concerned. For Asia, this is subject to the availability of taxable profits. For Jackson, the US federal tax rate of 35 per cent is applied to gross up movements on the value of in-force business. Effects on statutory tax for the period affect the overall tax rate. In the UK, the effective rate is the UK corporation tax rate of 28 per cent which will take effect from 1 April 2008 (2006: 30 per cent).
Operating profit after tax and minority interests from continuing operations 1,831 1,498 Operating EPS from continuing operations 74.9p 62.1p
Total EPS from continuing operations: Total profit before tax 3,803 3,222
Net assets of operations – EEV basis shareholders’ funds 3,726 2,548 Acquired goodwillnote ii 111 111
Net assets of operations 111 89 Acquired goodwillnote ii 61 61
Net assets of operations 271 230 Acquired goodwillnote ii 1,153 1,153
iii With the exception of the share of pension scheme surplus attributable to the PAC with-profits fund which is included in Other operations’ net assets (liabilities), and the borrowings as described in note iv, the amounts shown for the items in the table above that are referenced to this note have been determined on the statutory IFRS basis. The overall pension scheme surplus, net of tax, attributable to shareholders relating to the Prudential Staff Pension and Scottish Amicable Pension Schemes are determined as shown below: £m £m