For Jackson’s residential mortgage-backed and other asset-backed securities, all of which are classified as available-for-sale, the model used to analyse cash flows, begins with the current delinquency experience of the underlying collateral pool for the structure, by applying assumptions about how much of the currently delinquent loans will eventually default, and multiplying this by an assumed loss severity. Additional factors are applied to anticipate ageing effect. After applying a cash flow simulation an indication is obtained as to whether or not the security has suffered, or is anticipated to suffer, contractual principal or interest payment shortfall. If a shortfall applies an impairment charge is recorded. The difference between the fair value and book cost for unimpaired securities accounted for as available-for-sale, is accounted for as unrealised gains or losses, with the movements in the accounting period being accounted for in other comprehensive income. The Group’s review of fair value involves several criteria, including economic conditions, credit loss experience, other issuer-specific developments and future cash flows. These assessments are based on the best available information at the time. Factors such as market liquidity, the widening of bid/ask spreads and a change in cash flow assumptions can contribute to future price volatility. If actual experience differs negatively from the assumptions and other considerations used in the consolidated financial statements, unrealised losses currently in equity may be recognised in the income statement in future periods. The preceding note in this section provides explanation on how fair value is determined when the markets for the financial investments are not active. Further, additional details on the impairments of the available-for-sale securities of Jackson are described in notes D3 and G5.
Assets held at amortised cost Financial assets classified as loans and receivables under IAS 39 are carried at amortised cost using the effective interest rate method. Certain mortgage loans of the UK insurance operations have been designated at fair value through profit and loss as this loan portfolio is managed and evaluated on a fair value basis and these are included within loans in the balance sheet. The loans and receivables include loans collateralised by mortgages, deposits and loans to policyholders. In estimating future cash flows, the Group looks at the expected cash flows of the assets and applies historical loss experience of assets with similar credit risks that has been adjusted for conditions in the historical loss experience which no longer exist or for conditions that are expected to arise. The estimated future cash flows are discounted using the financial asset’s original or variable effective interest rate and exclude credit losses that have not yet been incurred. The risks inherent in reviewing the impairment of any investment include the risk that market results may differ from expectations; facts and circumstances may change in the future and differ from estimates and assumptions; or the Group may later decide to sell the asset as a result of changed circumstances.
Jackson Jackson offers individual fixed annuities, fixed index annuities, immediate annuities, variable annuities, individual and variable life insurance and institutional products. With the exception of institutional products and an incidental amount of business for annuity certain contracts, which are accounted for as investment contracts under IAS 39, all of Jackson’s contracts are accounted for under IFRS 4 as insurance contracts by applying US GAAP, the previous GAAP used before IFRS adoption. The accounting requirements under these standards and the effect of changes in valuation assumptions are considered below for fixed annuity, variable annuity and traditional life insurance contracts. Fixed annuity contracts, which are investment contracts under US GAAP terminology, are accounted for by applying in the first instance a retrospective deposit method to determine the liability for policyholder benefits. This is then augmented by potentially three additional amounts, namely deferred income, any amounts previously assessed against policyholders that are refundable on termination of the contract, and any premium deficiency, i.e., any probable future loss on the contract. These types of contracts contain considerable interest rate guarantee features. Notwithstanding the accompanying market risk exposure, except in the circumstances of interest rate scenarios where the guarantee rates included in contract terms are higher than crediting rates that can be supported from assets held to cover liabilities, the accounting measurement of Jackson’s fixed annuity products is not generally sensitive to interest rate risk. This position derives from the nature of the products and the US GAAP basis of measurement. Variable annuity contracts written by Jackson may provide for guaranteed minimum death, income, or withdrawal benefit features. In general terms, liabilities for these benefits are accounted for under US GAAP by using estimates of future benefits and fees under best estimate assumptions. For variable annuity business the key assumption is the expected long-term level of equity market returns, which for 2010 and 2009 was 8.4 per cent per annum (after deduction of external fund management fees) determined using a mean reversion methodology. Under the mean reversion methodology, projected returns over the next five years are flexed (subject to capping) so that, combined with the actual rates of return for the current and the previous two years the 8.4 per cent rate is maintained. The projected rates of return are capped at no more than 15 per cent for each of the next five years. Further details are explained in note D3(g). These returns affect the level of future expected profits through their effects on the fee income with consequential impact on the amortisation of deferred acquisition costs as described below and the required level of provision for guaranteed minimum death benefit claims. For traditional life insurance contracts, provisions for future policy benefits are determined using the net level premium method and assumptions as of the issue date as to mortality, interest, policy lapses and expenses plus provisions for adverse deviation.
Deferred acquisition costs Significant costs are incurred in connection with acquiring new insurance business. Except for acquisition costs of with-profits contracts of the UK regulated with-profits funds, which are accounted for under the realistic FSA regime as described in note A4, these costs, which vary with, and are primarily related to, the production of new business, are capitalised and amortised against margins in future revenues on the related insurance policies. The recoverability of the asset is measured and the asset is deemed impaired if the projected future margins are less than the carrying value of the asset. To the extent that the future margins differ from those anticipated, then an adjustment to the carrying value of the deferred acquisition cost asset will be necessary. The deferral and amortisation of acquisition costs is of most relevance to the Group’s results for shareholder-financed long-term business of Jackson and Asian operations. The majority of the UK shareholder-backed business is for individual and group annuity business where the incidence of acquisition costs is negligible.
Deferred tax 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 the available evidence, it can be regarded as more likely than not that there will be suitable taxable profits against which the losses can be relieved. The taxation regimes applicable across the Group apply separate rules to trading and capital profits and losses. The distinction between temporary differences that arise from items of either a capital or trading nature may affect the recognition of deferred tax assets. The judgements made, and uncertainties considered, in arriving at deferred tax balances in the financial statements are discussed in note H4.
ii Financial investments on an available-for-sale basis – this comprises assets that are designated by management and/or do not fall into any of the other categories. Available-for-sale financial assets are initially recognised at fair value plus attributable transaction costs. For available-for-sale debt securities, the difference between their cost and par value is amortised to the income statement using the effective interest rate. Available-for-sale financial assets are subsequently measured at fair value. Interest income is recognised on an effective interest basis in the income statement. Except for foreign exchange gains and losses on debt securities, not in functional currency, which are included in the income statement, unrealised gains and losses are recognised in other comprehensive income (i.e. outside of the income statement). Upon disposal or impairment, accumulated unrealised gains and losses are transferred from other comprehensive income to the income statement as realised gains or losses.
As permitted under IAS 39 the Group has designated certain financial assets as fair value through profit and loss as these assets are managed and their performance is evaluated on a fair value basis. These assets represent all of the Group’s financial assets other than the majority of loans and receivables and debt securities held by Jackson. Debt securities held by Jackson are accounted for on an available-for-sale basis. The use of the fair value option is consistent with the Group’s risk management and investment strategies. The Group uses the trade date method to account for regular purchases and sales of financial assets.
Impairments The Group assesses at each statement of financial position date, whether there is objective evidence that a financial asset or group of financial assets not held at fair value through profit and loss is impaired. A financial asset or group of financial assets is impaired and impairment losses are incurred only if there is objective evidence of impairment as a result of one or more events that have occurred after the initial recognition of the asset (a loss event) and that a loss event (or events) has an impact on the estimated future cash flows of the financial asset or group of financial assets that can be reliably estimated. Objective evidence that a financial asset or group of financial assets is impaired includes observable data that comes to the attention of the Group. For assets designated as available-for-sale, the initial impairment is the cumulative loss which is removed from the available-for-sale reserve within equity and recognised in the income statement. Any subsequent impairment loss is measured as the cumulative loss, less any impairment loss previously recognised. For loans and receivables carried at amortised cost, the impairment amount is the difference between carrying value and the present value of the expected cash flows discounted at the original effective interest rate. If, in subsequent periods, an impaired debt security held on an available-for-sale basis or an impaired loan or receivable recovers in value (in part or in full), and this recovery can be objectively related to an event occurring after the impairment, then the previously recognised impairment loss is reversed through the income statement (in part or in full).
All derivatives that do not meet the relevant hedging criteria are carried at fair value with movements in fair value being recorded in the income statement. The primary areas of the Group’s continuing operations where derivative instruments are held are the UK with-profits funds and annuity business, and Jackson.
For the Group’s continuing operations, hedge accounting under IAS 39 is not usually applied. The exceptions, where hedge accounting has been applied in 2010 and 2009, are summarised in note G3. For UK with-profits funds the derivative programme is undertaken as part of the efficient management of the portfolio as a whole. As noted in section D2 value movements on the with-profits funds investments are reflected in changes in asset-share liabilities to policyholders or the liability for unallocated surplus. Shareholders’ profit and equity are not affected directly by value movements on the derivatives held. For UK annuity business the derivatives are held to contribute to the matching as far as practical, of asset returns and duration with those of liabilities to policyholders. The carrying value of these liabilities is sensitive to the return on the matching financial assets including derivatives held. Except for the extent of minor mismatching, value movements on derivatives held for this purpose do not affect shareholders’ profit or equity. For Jackson an extensive derivative programme is maintained. Value movements on the derivatives held can be very significant in their effect on shareholder results. The Group has chosen generally not to seek to construct the Jackson derivative programme so as to facilitate hedge accounting where theoretically possible, under IAS 39. Further details on this aspect of the Group’s financial reporting are described in note A3.
UK regulated with-profits funds Prudential’s long-term business written in the UK comprises predominantly life insurance policies with discretionary participating features under which the policyholders are entitled to participate in the returns of the funds supporting these policies. Business similar to this type is also written in certain of the Group’s Asian operations subject to local market and regulatory conditions. Such policies are called with-profits policies. Prudential maintains with-profits funds within the Group’s long-term business funds, which segregate the assets and liabilities and accumulate the returns related to that with-profits business. The amounts accumulated in these with-profits funds are available to provide for future policyholder benefit provisions and for bonuses to be distributed to with-profits policyholders. The bonuses, both annual and final, reflect the right of the with-profits policyholders to participate in the financial performance of the with-profits funds. Shareholders’ profits with respect to bonuses declared on with-profits business correspond to the shareholders’ share of the cost of bonuses as declared by the Board of directors. The shareholders’ share currently represents one-ninth of the cost of bonuses declared for with-profits policies. Annual bonuses are declared and credited each year to with-profits policies. The annual bonuses increase policy benefits and, once credited, become guaranteed. Annual bonuses are charged to the profit and loss account in the year declared. Final bonuses are declared each year and accrued for all policies scheduled to mature and for death benefits expected to be paid during the next financial year. Final bonuses are not guaranteed and are only paid on policies that result from claims through the death of the policyholder or maturity of the policy within the period of declaration or by concession on surrender. No policyholder benefit provisions are recorded for future annual or final bonus declarations. The policyholders’ liabilities of the regulated with-profits funds are accounted for under FRS 27. Under FRS 27 for the UK with-profits funds: • no deferred acquisition costs and related deferred tax are recognised; and • adjusted realistic basis liabilities instead of MSB liabilities are recognised.
Other insurance contracts (i.e. contracts which contain significant insurance risk as defined under IFRS 4) For these contracts UK GAAP has been applied, which reflects the MSB. Under this basis the following approach applies: Other UK insurance contracts Other UK insurance contracts that contain significant insurance risk include unit-linked, annuity and other non-profit business. For the purposes of local regulations, segregated accounts are established for linked business for which policyholder benefits are wholly or partly determined by reference to specific investments or to an investment-related index. The interest rates used in establishing policyholder benefit provisions for pension annuities in the course of payment are adjusted each year. Mortality rates used in establishing policyholder benefit are based on published mortality tables adjusted to reflect actual experience.
Liability adequacy The Group performs liability adequacy testing on its insurance provisions to ensure that the carrying amounts of provisions (less related DAC and present value of in-force business – see policy on business acquisitions and disposals) is sufficient to cover current estimates of future cash flows. When performing the liability adequacy test, the Group discounts all contractual cash flows and compares this amount to the carrying value of the liability. Any deficiency is immediately charged to the income statement.
Share-based payments The Group offers share award and option plans for certain key employees and a Save As You Earn (SAYE) plan for all UK and certain overseas employees. The arrangements for distribution to employees of shares held in trust relating to share award plans and for entitlement to dividends depend upon the particular terms of each plan. Shares held in trust relating to these plans are conditionally gifted to employees. The compensation expense charged to the income statement is primarily based upon the fair value of the options granted, the vesting period and the vesting conditions. Vesting conditions exclude the ability of an employee to voluntarily exit a scheme and such exits are treated as an acceleration of vesting and hence a shortening of the period over which the expense is charged. The Group revises its estimate of the number of options likely to be exercised at each statement of financial position date and adjusts the charge to the income statement accordingly. Where the share-based payment depends upon vesting outcomes attaching to market-based performance conditions, additional modelling is performed to estimate the fair value of the awards. No subsequent adjustment is then made to the fair value charge for awards that do not vest on account of these performance conditions not being met. The Company has established trusts to facilitate the delivery of Prudential plc shares under employee incentive plans and savingsrelated share option schemes. None of the trusts that hold shares for employee incentive and savings plans continue to hold these shares once they are issued to employees. The cost to the Company of acquiring these treasury shares held in trusts is shown as a deduction from shareholders’ equity.
Tax The Group’s UK subsidiaries each file separate tax returns. Jackson and other foreign subsidiaries, where permitted, file consolidated income tax returns. In accordance with UK tax legislation, where one domestic UK company is a 75 per cent owned subsidiary of another UK company or both are 75 per cent owned subsidiaries of a common parent, the companies are considered to be within the same UK tax group. For companies within the same tax group, trading profits and losses arising in the same accounting period may be offset for purposes of determining current and deferred taxes. Current tax expense is charged or credited to operations based upon amounts estimated to be payable or recoverable as a result of taxable operations for the current year. To the extent that losses of an individual UK company are not offset in any one year, they can be carried back for one year or carried forward indefinitely to be offset against profits arising from the same company. Deferred taxes are provided under the liability method for all relevant temporary differences, being the difference between the carrying amount of an asset or liability in the statement of financial position and its value for tax purposes. IAS 12, ‘Income Taxes’ does not require all temporary differences to be provided for, in particular, the Group does not provide for deferred tax on undistributed earnings of subsidiaries where the Group is able to control the timing of the distribution and the temporary difference created is not expected to reverse in the foreseeable future. The tax effects of losses available for carry forward are recognised as an asset. Deferred tax assets are only recognised when it is more likely than not, that future taxable profits will be available against which these losses can be utilised. Deferred tax related to charges or credits taken to other comprehensive income is also credited or charged to other comprehensive income and is subsequently recognised in the income statement together with the deferred gain or loss. The tax charge for long-term business includes tax expense on with-profits funds attributable to both the policyholders and the shareholders. Different tax rules apply under UK law depending upon whether the business is life insurance or pension business. Tax on the life insurance business is based on investment returns less expenses attributable to that business. Tax on the pension business is based on the shareholders’ profits or losses attributable to that business. The shareholders’ portion of the long-term business is taxed at the shareholders’ rate with the remaining portion taxed at rates applicable to the policyholders.
Basis of presentation of tax charges Tax charges in the income statement reflect the aggregate of the shareholder tax on the long-term business result and on the Group’s other results. Under UK Listing Authority rules, profit before tax is required to be presented. This requirement, coupled with the fact that IFRS does not contemplate tax charges which are attributable to policyholders and unallocated surplus of with-profits funds and unit-linked policies, necessitates the reporting of total tax charges within the presented results. The result before all taxes (i.e. ‘profit before tax’ as shown in the income statement) represents income net of post-tax transfers to unallocated surplus of with-profits funds, before tax attributable to policyholders and unallocated surplus of with-profits funds, unit-linked policies and shareholders. Separately within the income statement, ‘profit before tax attributable to shareholders’ is shown after deduction of taxes attributable to policyholders and unallocated surplus of with-profits funds and unit-linked policies. Tax charges on this measure of profit reflect the tax charges attributable to shareholders. In determining the tax charges attributable to shareholders, the Group has applied a methodology consistent with that previously applied under UK GAAP reflecting the broad principles underlying the tax legislation of life assurance companies.
Rights of offset Assets and liabilities in the consolidated financial statements are only reported on a net basis when there is a legally enforceable right to offset and there is an intention to settle on a net basis.
The Group uses operating profit based on longer-term investment returns to measure the performance of its operational segments. For the purposes of measuring operating profit, investment returns on shareholder-financed business are based on the expected longer-term rates of return. This reflects the particular features of long-term insurance business where assets and liabilities are held for the long-term and for which the accounting basis for insurance liabilities under current IFRS is not generally conducive to demonstrating trends in underlying performance for life businesses exclusive of changes in market conditions. In determining profit on this basis the following key elements are applied to the results of the Group’s shareholder-financed operations. The approach to determining profit on this basis was altered in 2010 from that previously applied in 2009 in respect of the net equity hedge accounting effect for variable and fixed index annuity US life business. Comparative results have been adjusted accordingly. The approach to determining operating profit based on longer-term investment returns reflected in segment results shown in note B1 is as follows: i Debt 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 (RMR) 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. The shareholder-backed operation for which the RMR charge is most significant is Jackson National Life. For 2010 and 2009 Jackson has used the ratings resulting from the regulatory ratings detail issued by the National Association of Insurance Commissioners (NAIC) for residential mortgage-backed securities (RMBS) to determine the average annual RMR. In addition, in 2010, NAIC extended the new ratings framework to commercial mortgage-backed securities (CMBS), which Jackson has used for 2010. These were developed by external third parties; PIMCO (for RMBS) and BlackRock Solutions (for CMBS), and are considered by management more relevant information for the MBS securities concerned than using ratings by Nationally Recognised Statistical Rating Organisations (NRSRO). For other securities Jackson uses ratings by NRSRO.
(ii) Change of treatment in 2010 For previous reporting of the 2009 results, all of the above items were included in operating profit based on longer-term investment returns with the intention of broadly matching the impacts with two exceptions. The exceptions were for the effect of GMIB reinsurance and movements in carrying values of free standing derivatives and embedded derivatives arising from changes in the level of observed implied equity volatility and changes in the discount rate applied from year to year. Both of these items remain in short-term fluctuations in investment returns in 2010. Previously, for the purposes of determining operating profit based on longer-term investment returns, the charge for these features was determined using historical longer-term equity volatility levels and long-term average AA corporate bond rate curves with the movement relating to the change in difference in long-term and current rates being included in short-term fluctuations (as shown in note B1). However, despite this use of longer-term equity volatility assumption levels and AA corporate bond rate curves, accounting volatility arose within the operating profit based on longer-term investment returns that was not representative of the underlying economic result. This feature arose due to the movement in the change in the accounting values of the derivatives and Jackson’s liabilities for variable and fixed indexed annuity guarantees included in the operating profit. Under IFRS, liabilities for GMDB and ‘for life’ GMWB are not fair valued. Instead, they are accounted for under IFRS using ‘grandfathered’ US GAAP in accordance with FASB ASC Subtopic 944-80, Financial Services – Insurance – Separate Accounts (formerly SOP 03-1). This accounting basis produces a distorting accounting effect on the operating profit that is not representative of the true economics of Jackson’s hedging programme. Over the long term the impact of this accounting distortion should cumulatively net out to a broadly neutral effect, but in the short term the operating profit can be highly volatile. The recent growth in Jackson’s variable annuity business had resulted in this short-term effect having a greater impact on the Group operating profit than in prior years. Further, these accounting mismatches are magnified in periods of significant market movements. These factors have prompted a reassessment of the presentation of operating profit based on longer-term investment returns. The following items have been reclassified from operating profit to short-term fluctuations in investment returns: • The fair value movement in free standing hedging derivatives, excluding the impact of the difference between longer-term and current period implied equity volatility levels; • The movement in liabilities for those embedded derivative liabilities which are fair valued in accordance with IFRS, primarily GMWB ‘not for life’ and fixed index annuity business, excluding the impacts of the differences between longer-term and current period equity volatility and incorporating 10-year average yield curves, in lieu of current period yield curves; • Movements in IFRS basis guarantee liabilities for GMWB ‘for life’, being those policies where a minimum annual withdrawal is permitted for the duration of the policyholders’ life subject to certain conditions, and GMDB business for which, under the US GAAP rules applied under IFRS, the reserving methodology under US GAAP principles generally gives rise to a muted impact of current period market movements; • Fee assessment, and claims payments, in respect of guarantee liabilities; and • Related changes to the amortisation of deferred acquisition costs for each of the above items.
Shareholders’ share of actuarial and other gains and loss on defined benefit pension schemes (10) – (10) (74) – (74) Costs of terminated AIA transaction (377) – (377) – – – Gain on dilution of holding in PruHealth 30 – 30 – – – Loss on sale and results of Taiwan agency business – – – (621) – (621)
Guaranteed Minimum Death Benefit (GMDB) product features For unhedged GMDB liabilities accounted for under IFRS using ‘grandfathered’ US GAAP, such as in the Japanese business, the change in carrying value is determined under FASB ASC Subtopic 944-80 Financial Services – Insurance – Separate Accounts (formerly SOP 03-1), which partially reflects changes in market conditions. Under the Company’s segmental basis of reporting the operating profit reflects the change in liability based on longer-term market conditions with the difference between the charge to the operating result and the movement reflected in the total result included in short-term fluctuations in investment returns.
e Fund management and other non-insurance businesses For these businesses, the particular features applicable for life assurance noted above do not apply. For these businesses it is inappropriate to include returns in the operating result on the basis described above. Instead, it is appropriate to generally include realised gains and losses (including impairments) in the operating result with unrealised gains and losses being included in short-term fluctuations. For this purpose impairments are calculated as the credit loss determined by comparing the projected cash flows discounted at the original effective interest rate to the carrying value. In some instances it may also be appropriate to amortise realised gains and losses on derivatives and other financial instruments to operating results over a time period that reflects the underlying economic substance of the arrangements.
New accounting pronouncements The following standards, interpretations and amendments have either been adopted for the first time in 2010 or have been issued but are not yet effective in 2010, including those which have not yet been adopted in the EU. This is not intended to be a complete list as only those standards, interpretations and amendments that are anticipated to have an impact upon the Group’s financial statements have been discussed.
Accounting pronouncements adopted in 2010 Revised IFRS 3, ‘Business combinations’ and Amendments to IAS 27, ‘Consolidated and separate financial statements’ and IAS 31, ‘Interests in joint ventures’ The Group has applied the revised IFRS 3 and amended IAS 27 and IAS 31 from 1 January 2010. The revised IFRS 3 and amended IAS 27 and IAS 31 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 change in accounting policy as a result of the adoption of these standards has been applied prospectively. No restatement to 2009 comparatives is required. 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 classified as financial instruments at acquisition date with subsequent changes to income; and • additional items or adjustments to items recognised in the business combination are permitted to be applied retrospectively during the measurement period to reflect new information obtained about facts and circumstances that existed as of the acquisition date. The measurement period ends as soon as the acquirer receives the necessary information or learns that more information is not obtainable but is subject to an overall limit for one year.
Previously, no explicit guidance was provided. The adoption of revised IFRS 3 and amended IAS 27 and IAS 31 has resulted in presentational and disclosure changes in the Group’s financial statements, and affected the accounting for the acquisition of United Overseas Bank (UOB) Life Assurance Limited in Singapore. The disclosure on this acquisition is provided in note I1. As a result of the adoption of the revised IFRS 3, the Group has expensed the UOB Life acquisition-related costs incurred of £2 million which would otherwise have been included within goodwill. The Group has also recognised a gain of £30 million related to the change of treatment of PruHealth from a joint venture to an associate, in line with the revisions to IAS 31 set out above as described in note I2(a).
Amendments to IFRS 2 – Group cash-settled share-based payment transactions In June 2009, the IASB issued further amendments to IFRS 2 which sets out the accounting requirements for share-based payments. These amendments clarified existing guidance, in particular by specifying that an entity that receives goods or services in a share-based payment arrangement must account for those goods or services no matter which entity in the group settles the transaction and no matter whether the transaction is settled in shares or cash. There was no impact on the Group’s financial statements upon adoption of this standard.
Amendment to IAS 39, ‘Financial instruments: Recognition and measurement’ – Eligible Hedged Items This amendment to IAS 39 clarifies how the principles that determine whether a hedged risk or portion of cash flows is eligible for designation should be applied in particular situations. The adoption of this amendment had no impact on the Group’s designated IAS 39 hedges.
Amendments to IAS 24, ‘Related party disclosures’ The main revisions which will apply from 2011 relate to exemption for government-related entities and are therefore not applicable to the Group. The amendment also clarifies and simplifies the definition of a related party albeit the nature of the change is minor. The adoption of these revisions is not expected to have any impact on the Group’s related party disclosures.
Improvements to IFRSs (2010) The changes from this annual improvement which were issued in May 2010 and mostly effective from 2011 include clarification of financial instruments disclosures and of the statement of changes in equity. The Group is in the process of evaluating the implications of these changes.
IFRS 9, ‘Financial Instruments: Classification and measurement’ In November 2009, the IASB issued a new standard which altered the classification and measurement of financial instruments. Under the new standard only two possible classifications arise, rather than the four existing classifications currently available under IAS 39, and will result in all financial assets being valued at amortised cost or fair value through profit and loss. In October 2010, the IASB issued requirements on the accounting for financial liabilities. These requirements will be added to IFRS 9 and maintain the existing amortised cost measurement for most liabilities and will require changes in fair value due to changes in the entity’s own credit risk to be recognised in the other comprehensive income (OCI) section of the comprehensive income statement, rather than within profit or loss for liabilities measured at fair value. IFRS 9 applies to financial statements for annual periods beginning on or after 1 January 2013. Entities are permitted to apply the new requirements in earlier periods, however, if they do, they must also apply the requirements in IFRS 9 that relate to financial assets. The standard is not mandatory until 1 January 2013 and is yet to be endorsed by the European Union. The Group is still assessing the full impact of this standard.
Underlying results before exceptional credit 536 353 Exceptional credit for Malaysia operationsD4(i) – 63
Total Asian insurance operations after development expenses 532 410 Asian asset management 72 55
Operating profit based on longer-term investment returnsnote i 1,941 1,564 Short-term fluctuations in investment returns on Shareholder-backed businessnote vi (123) (123) Shareholders’ share of actuarial and other gains and losses on defined benefit pension schemesnote vii (10) (74) Costs of terminated AIA transactionnote x (377) – Gain on dilution of holding in PruHealthI2(a) 30 – Loss on sale and results for Taiwan agency businessnote iii – (621)
PROFIT FROM CONTINUING OPERATIONS BEFORE TAX ATTRIBUTABLE TO SHAREHOLDERS 1,461 746
Notes i Operating profit based on longer-term investment returns. Operating profit based on longer-term investment returns is a supplemental measure of results and is the basis on which management regularly review the performance of the Group’s segments as defined by IFRS 8. For the purposes of measuring operating profit, investment returns on shareholder-financed business are based on expected long-term rates of return as discussed in note A4. The expected long-term rates of return are intended to reflect historical real rates of return and, where appropriate, current inflation expectations adjusted for consensus economic and investment forecasts. The most significant operation that requires adjustment for the difference between actual and long-term investment returns is Jackson. The amounts included in operating results for long-term capital returns for Jackson’s debt securities comprise two
components. These are a risk margin reserve based charge for long-term 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 results to the date when sold bonds would otherwise have matured. Consistent with the policy of including longer-term investment returns in the measure of operating profit, movements in policyholder liabilities are also, where appropriate, delineated between amounts included in operating profits and movements arising from short-term market conditions, which are recorded in short-term fluctuations in investment returns. The presentation of operating profit based on longer-term investment returns has been revised in 2010 and the 2009 comparatives have been amended accordingly (see note (iv)).
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.
Risk margin reserve charge to operating profit for longer-term credit related losses (85) (55) (94) (60)
For the period ended 31 December 2010, Jackson has continued the practice commenced in the second half of 2009 in relation to RMBS and for 2010 for CMBS to determine the risk margin charge included in operating profit based on longer-term investment returns using the regulatory rating as determined by third parties; PIMCO (for RMBS) and BlackRock Solutions (for CMBS) on behalf of the National Association of Insurance Commissioners (NAIC). See note A4(d) for further information.
Interest related realised gains (losses): Arising in the year 224 125 Less: amortisation gains and losses arising in current and prior years to operating profit based on longer-term investment returns (82) (59)
† The loss of £15 million (2009: gain of £385 million) is for the value movement for non-equity freestanding derivatives held to manage the fixed annuity and other general account business. Under IAS 39, unless hedge accounting is applied, value movements on derivatives are recognised in the income statement. For the derivatives programme attaching to the fixed annuity and other general account business the Group has continued its approach of not seeking to apply hedge accounting under IAS 39. This decision reflects the inherent constraints of IAS 39 for hedge accounting investments and life assurance assets and liabilities under ‘grandfathered’ US GAAP under IFRS 4.
# Prior to the change in the presentation of operating profit of the US insurance operations as explained in note A4(d)(ii), the effect of the difference in the value movements for freestanding derivatives and embedded derivatives arising from changes between longer-term and actual levels of implied equity volatility and end of period AA corporate bond yield curves was reflected in short-term fluctuations in investment return. This normalisation reflects the use of longer-term implied equity volatility levels, and also, for embedded derivatives 10 year average AA corporate bond yield curves, in the value movement included in net equity hedge accounting effect and is unaffected by the change in the presentation of the net equity hedge accounting effect.
This volatility and interest rate normalisation of value movements for freestanding and embedded derivatives gave rise to a £2 million gain (2009: £85 million). The net equity hedge accounting effect based on longer-term equity volatility and interest rate is as described above in note ‡.
IGD hedge costs During the severe equity market conditions experienced in the first quarter of 2009 coupled with historically high equity volatility the Group entered into exceptional short-dated hedging contracts to protect against potential tail-events on the IGD capital position, in addition to the regular operational hedging programmes. The hedge contracts expired in 2009 and have not been renewed.
vii Shareholders’ share of actuarial and other gains and losses on defined benefit pension schemes
Actual less expected return on scheme assets 31 23 Experience (losses) gains on scheme liabilities (5) 17 Losses on changes of assumptions for scheme liabilities (41) (147)
Movement in the provision for deficit funding of PSPS – (48) Less: amount attributable to the PAC with-profits sub-fund – 34
Other gains and losses in 2009 related to the change in the provision for deficit funding obligation for PSPS. There was no change in 2010. Further details on the Group’s defined benefit pension schemes are shown in note I3. viii Share-based payments The charge for share-based payments for Prudential schemes is for the SAYE and Group performance-related schemes. ix Restructuring costs are incurred in the UK as part of EEV covered business (£26 million) and as part of central operations of £nil (EEV noncovered business) (2009: £16 million and £7 million respectively).
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 and consolidated unit-trusts and OEICs, which are treated as cancelled. For diluted earnings per share, the weighted average number of shares in issue is adjusted to assume conversion of all dilutive potential ordinary shares. The Group’s only class of dilutive potential ordinary shares are those share options granted to employees where the exercise price is less than the average market price of the Company’s ordinary shares during the year. No adjustment is made if the impact is anti-dilutive overall. Earnings per share are calculated based on earnings attributable to ordinary shareholders, after related tax and non-controlling interests.
Short-term fluctuations in investment returns on shareholder-backed business (123) 92 – (31) (1.2p) (1.2p)
Costs of terminated AIA transaction (377) 93 – (284) (11.3p) (11.3p) Gain on dilution of holding in PruHealth 30 – – 30 1.2p 1.2p
Based on operating profit based on longer-term investment returns 1,564 (374) (2) 1,188 47.5p 47.4p
Number of shares A reconciliation of the weighted average number of ordinary shares used for calculating basic and diluted earnings per share is set out as below: Weighted average shares for calculation of basic earnings per share 2,524 2,501 Shares under option at end of year 13 12 Number of shares that would have been issued at fair value on assumed option exercise (8) (7)
As a result of shares issued in lieu of dividends of £62 million (2009: £137 million), dividends paid in cash, as set out in the consolidated cash flow statement, were £449 million (2009: £344 million).
Parent company dividends relating to reporting period: Interim dividend (2010: 6.61p, 2009: 6.29p per share) 168 159 Final/second interim dividend (2010: 17.24p, 2009: 13.56p per share) 439 343
TOTAL ASIA OPERATIONS – EX JAPAN 1,104 785 1,391 1,131 1,501 1,209
The format of the tables shown above is consistent with the distinction between insurance and investment products as applied for previous financial reporting periods. With the exception of some US institutional business, products categorised as ‘insurance’ refer to those classified as contracts of long-term insurance business for regulatory reporting purposes, i.e. falling within one of the classes of insurance specified in Part II of Schedule 1 to the Regulated Activities Order under FSA regulations.
Loansnote d 2,302 4,201 1,340 7,843 1,418 – – 9,261 Equity securities and portfolio holdings in unit trusts 40,519 31,501 14,464 86,484 151 – – 86,635 Debt securitiesnote d 74,304 26,366 14,108 114,778 1,574 – – 116,352 Other investments 3,998 1,199 382 5,579 59 141 – 5,779 Deposits 9,022 212 638 9,872 80 – – 9,952
Properties held for saleH9 254 3 – 257 – – – 257 Cash and cash equivalentsH10 2,839 232 1,601 4,672 1,436 523 – 6,631
Note (i) Further segmental analysis: The non-current assets of the Group comprise goodwill, intangible assets other than DAC and present value of acquired in-force business and property, plant and equipment included within ‘other non-investment and non-cash assets’. Items defined as financial instruments or related to insurance contracts are excluded. Of the Group’s total non-current assets at 31 December 2010 of £2,454 million (2009: £1,965 million), £1,708 million (2009: £1,444 million) was held in the UK by the UK insurance operations, M&G and central operations, £131 million (2009: £112 million) was held in the US and £615 million (2009: £409 million) was held in Asia.
EQUITY AND LIABILITIES Equity Shareholders’ equityH11 2,148 3,815 2,149 8,112 1,787 (1,868) – 8,031 Non-controlling interests 35 – 5 40 4 – – 44
Total policyholder liabilities and unallocated surplus of with-profits fundsnote e 135,717 60,523 28,740 224,980 – – – 224,980
Borrowings attributable to with-profits operationsH13 1,522 – – 1,522 – – – 1,522 Other non-insurance liabilities:G1,H4,H14,H15 Obligations under funding, securities lending and sale and repurchase agreements 2,398 1,801 – 4,199 – – – 4,199 Net asset value attributable to unit holders of consolidated unit trusts and similar funds 1,755 33 1,126 2,914 458 – – 3,372 Deferred tax liabilities 1,738 1,776 495 4,009 5 210 – 4,224 Current tax liabilities 399 34 70 503 33 295 – 831 Accruals and deferred income 340 – 109 449 244 14 – 707 Other creditors 1,939 511 1,122 3,572 4,039 471 (5,761) 2,321 Provisions 442 19 61 522 157 50 – 729 Derivative liabilities 792 799 222 1,813 78 146 – 2,037 Other liabilities 276 355 437 1,068 21 40 – 1,129
Other non-investment and non-cash assetsH3-H6 3,074 1,404 880 5,358 718 4,393 (5,044) 5,425 Investment of long-term business and other operations: Investments accounted for using the equity
Liabilities Policyholder liabilities and unallocated surplus of with-profits funds: Investment contract liabilities with discretionary participation featuresG1 24,780 – 100 24,880 – – – 24,880 Investment contract liabilities without discretionary
Unallocated surplus of with-profits funds (reflecting application of ‘realistic’ basis provisions for UK regulated with-profits funds)D2(g)ii,H12 9,966 – 53 10,019 – – – 10,019
Total policyholder liabilities and unallocated surplus of with-profits fundsnote e 126,195 48,311 21,911 196,417 – – – 196,417
Obligations under funding, securities lending and sale and repurchase agreements 2,108 1,374 – 3,482 – – – 3,482
Intangible assets attributable to with-profits funds: In respect of acquired subsidiaries for venture fund and other investment purposes 166 – – – – – 166 124 Deferred acquisition costs and other
Other non-investment and non-cash assetsH3-H6 2,749 651 3,285 999 4,159 (5,761) 6,082 5,425 Investment of long-term business and
Properties held for saleH9 254 – 3 – – – 257 3
AT 31 DECEMBER 2009/1 JANUARY 2010 Total investments (including derivative assets) 132,690 49,576 23,390 205,656 2,890 176 208,722 Less: investments held by consolidated investment funds (1,835) – (718) (2,553) – – (2,553)
Dilution of PruHealth investment 56 – – 56 – – 56 Acquisition of UOB Life Assurance Ltd – – 1,004 1,004 – – 1,004
In the table above, with the exception of residential mortgage-backed securities within Jackson, Standard & Poor’s (S&P) ratings have been used where available. For securities where S&P ratings are not immediately available, those produced by Moody’s and then Fitch have been used as an alternative. During 2009, the National Association of Insurance Commissioners in the US revised the regulatory ratings process for more than 20,000 residential mortgage-backed securities. In addition, in 2010, NAIC applied the revised ratings process for commercial mortgage-backed securities. The table above includes these securities, held by Jackson, using the regulatory ratings levels established by an external third party (PIMCO). Notes D2(d), D3(d), D4(d) and E2 provide further details on the credit risks of debt securities by segment.
ii Group exposure to holdings in asset-backed securities The Group’s exposure to holdings in asset-backed securities which comprise residential mortgage-backed securities (RMBS), commercial mortgage backed securities (CMBS), CDO funds and other asset-backed securities (ABS), at 31 December 2010 is as follows: SHAREHOLDER-BACKED OPERATIONS: UK insurance operationsnote i 1,181 2,044 US insurance operationsnote ii 6,135 6,376 Asian insurance operationsnote iii 113 59 Other operationsnote iv 437 326
All of the £1,181 million (2009: £2,044 million) exposure of the shareholder-backed business relates to the UK market, primarily to investments held by PRIL. £3,685 million of the £5,237 million (2009: £4,695 million of the £6,451 million) exposure of the with-profits operations relates to exposure to the UK market while the remaining £1,552 million (2009: £1,756 million) relates to exposure to the US market.
iii Asian insurance operations The Asian insurance operations’ exposure to asset-backed securities is primarily held by the with-profits operations. The £435 million (2009: £378 million) asset-backed securities exposure of the Asian with-profits operations comprises: CDO funds and other ABS 184 287
CDO funds and other ABS – all without sub-prime exposure (2010: 98% AAA) 56 42 iii Loans Information on the credit quality of the portfolio of loans, which almost wholly is for amounts which are neither past due or impaired is shown in notes D2, D3, D4 and E2. Details of allowances for loans, losses and amounts past due are shown in notes G1 and G2. No additional analysis is provided of the element of loans and receivables that were neither past due nor impaired from those of the total portfolio on the grounds of the immateriality of the difference between the neither past due nor impaired element and the total portfolio.
e Reconciliation of movement in policyholder liabilities and unallocated surplus of with-profits funds A reconciliation of the total policyholder liabilities and unallocated surplus of with-profits funds of the Group from the beginning of the year to the end of the year is as follows: Insurance operations
Comprising – Policyholder liability 125,530 60,523 28,674 214,727 – Unallocated surplus of with-profits funds 10,187 – 66 10,253
* Adjusted for acquisition and disposals in the period and excluding unallocated surplus of with-profits funds.
As a provider of financial services, including insurance, the management of risk lies at the heart of the Group’s business. The control procedures and systems established within the Group are designed to manage, rather than eliminate, the risk of failure to meet business objectives. They can only provide reasonable and not absolute assurance against material misstatement or loss, and focus on aligning the levels of risk-taking with the achievement of business objectives. The Group’s internal control processes are detailed in the Group Governance Manual. This is supported by the Group Risk Framework, which provides an overview of the Group-wide philosophy and approach to risk management. Where appropriate, more detailed policies and procedures have been developed at Group and/or business unit levels. These include Group-wide mandatory policies on certain operational risks, including: health, safety, fraud, money laundering, bribery, business continuity, information security and operational security, and policies on certain financial risks. Additional guidelines are provided for some aspects of actuarial and financial activity. Prudential’s risk governance framework requires that all of the Group’s businesses and functions establish processes for identifying, evaluating and managing the key risks faced by the Group. The risk governance framework is based on the concept of ‘three lines of defence’: Risk management; risk oversight and independent assurance. Primary responsibility for strategy, performance management and risk control lies with the Board, which has established the Group Risk Committee to assist in providing leadership, direction and oversight, and with the Group Chief Executive and the chief executive of each business unit. Risk oversight is provided by Group-level risk committees, chaired by the Group Chief Risk Officer or the Chief Financial Officer. Independent assurance on the Group’s internal control and risk management systems is provided by the Group Audit Committee, supported by the Group-wide Internal Audit. The Group’s risk reporting framework forms an important part of the Group’s business planning process. Business units review their risks as part of the annual preparation of their business plans and review opportunities and risks against business objectives regularly with Group executive management.
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, expected dividends and to withstand unexpected shocks, and (c) earnings (and cash flows) are managed properly across geographies and are consistent with the Group’s funding strategies. The two measures applied to monitor the volatility of the Group’s earnings are International Financial Reporting Standards (IFRS) operating profit based on longerterm investment returns and European Embedded Value (EEV) operating profit based on longer-term investment returns although IFRS and EEV total profits are also considered.
i Use of derivatives In the UK business, equity exposure is incurred in the with-profits fund, and it includes a large inherited estate. The inherited estate itself is partially protected against falls in equity markets by a derivative hedging portfolio.
The Group has contingency plans in place for a range of operational risk scenarios, including incident management and business continuity plans. As a contingency plan for liquidity risk, the Group has arranged access to committed revolving credit facilities and committed securities lending facilities.
Equity and interest rate risk 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.
Foreign exchange risk Prudential faces foreign exchange risk, primarily because its presentation currency is pounds sterling, whereas approximately 73 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 2010, came from US and Asian operations. The exposure relating to the translation of reported earnings is not separately managed although its impact is reduced by interest payments on foreign currency borrowings and by the adoption of average exchange rates for the translation of foreign currency revenues. Approximately 79 per cent of the Group’s IFRS basis shareholders’ equity at 31 December 2010 arose in Prudential’s US and Asian operations (2009: approximately 77 per cent). To mitigate the exposure of the US component there are US$2.3 billion of borrowings held centrally, which are formally designated as net investment hedges at 31 December 2010. Net of the currency position arising from these borrowings some 61 per cent of the Group’s shareholders’ funds are represented by net assets in currencies other than sterling. Additional details on the market risks’ exposures of the UK, US and Asian insurance operations are provided in notes D2, D3 and D4, respectively.
iii Liquidity risk Liquidity risk is the risk that a business, though solvent on a balance sheet basis, either does not have the financial resources to meet its obligations as they fall due or can secure them only at excessive cost. The assets of insurers are in general relatively liquid, whilst liabilities to policyholders are mainly illiquid. Accordingly, for insurers, the focus of managing liquidity risk concentrates on parent capital and liquidity measures. Prudential regularly monitors and analyses its liquidity position at the Group level and performs stress tests of this position. The liquidity of the Group is monitored on a monthly basis by comparing the predicted cash needs of the Group centre, to meet corporate and financing costs (net of expected dividends from the business units), to the liquid resources available to it. These liquid resources include cash held and cash that could be raised through internal resources (for example by reporting unencumbered bonds). Base case and stress scenarios are reported monthly to the Balance Sheet and Capital Management Committee. The main stress is the assumption that the external financing markets are completely closed to Prudential, so no new external funding can be obtained, and existing funding cannot be rolled over. In addition, Group liquidity risk reports are prepared regularly. In summary, these address the sufficiency of external back-up lines, internal sources of liquidity, and monitor how external liabilities and other commitments over the next 12 months compare with internal and external sources. Currently, the parent company has significant internal resources of liquidity which are sufficient to meet all of its foreseeable future needs without having to utilise external funding. The Group maintains £2.1 billion of undrawn syndicated and bilateral committed banking facilities, maturing between 2011 and 2015.
transaction and inadmissible assets arising on the purchase of UOB’s life assurance subsidiary in Singapore.
Insurance contracts Insurance contracts are permitted to be accounted for under previously applied GAAP. The Group has chosen to adopt this approach. However, as an improvement to accounting policy, permitted by IFRS 4, the Group has applied the measurement principles for with-profits contracts of UK regulated entities and disclosures of the UK Standard FRS 27 from 1 January 2005. An explanation of the provisions under FRS 27 is provided in note D2. Under the previously applied GAAP, UK GAAP, the assets and liabilities of contracts are reported in accordance with the MSB of reporting as set out in the ABI SORP. The insurance contracts of the Group’s shareholder-backed business fall broadly into the following categories: • UK insurance operations – bulk and individual annuity business, written primarily by Prudential Retirement Income Limited and other categories of non-participating UK business; • Jackson
b Concentration of risk i Business accepted The Group’s exposure to life assurance risks is well diversified. This is achieved through the geographical spread of the Group’s operations and, within those operations, through a broad mix of product types. As part of the risk management framework, the Group regularly monitors concentration of risk using a variety of risk monitoring tools including: • Scenario testing and sensitivity analysis of the Group capital and profitability metrics involving IGD, Group economic capital, EEV and IFRS help identify concentrations of risks by risk types, products and business units, as well as the benefits of diversification of risks.
An example of the diversification benefits for Prudential is that adverse scenarios do not affect all business units in the same way, providing natural hedges within the Group. For example, the Group’s US business is sensitive to increasing interest rates, whereas, in contrast, several business units in Asia benefit from increasing rates. Conversely, these Asian business units are sensitive towards low interest rates, whereas certain products in the US benefit from falling interest rates. The economic capital framework also takes into account situations where factors are correlated, for example the extent of correlation between UK and US economies.
• Business units are also required to disclose to the Group risk function all material risks, along with information on their severity and likelihood, and mitigating actions taken or planned.
d Sensitivity of EEV basis profit and equity for market and other risks The Group prepares supplementary EEV basis financial statements for half yearly and annual publication. These statements include sensitivity disclosures which are part of the market risk information provided to key management. The 2010 EEV sensitivity disclosures are shown in note 15 of the EEV basis supplementary information in this Annual Report.
e Sensitivity of IFRS basis profit or loss and equity to market and other risks i Overview of risks by business unit The financial and insurance assets and liabilities attaching to the Group’s life assurance business are, to varying degrees, subject to market and insurance risk and other changes of experience assumptions that may have a material effect on IFRS basis profit or loss and equity. Market risk is the risk that the fair value or future cash flows of a financial instrument or, in the case of liabilities of insurance contracts, their carrying value will fluctuate because of changes in market prices. Market risk comprises three types of risk, namely: • Currency risk: due to changes in foreign exchange rates; • interest rate risk: due to changes in market interest rates; and • other price risk: due to fluctuations in market prices (other than those arising from interest rate risk or currency risk).
Interest rate risk for assets in excess of liabilities i.e. representing shareholder capital
Variable annuity business Net effect of market risk arising from incidence of guarantee features and variability of asset management fees offset by derivative hedging programme
Lapse risk but the effects of extreme events are mitigated by the use of swaption contracts
These risks are reflected in volatile profit or loss and shareholders’ equity for derivative value movements and impairment losses, and, in addition, for shareholders’ equity for value movements on fixed income securities classified as ‘available fo sale’ under IAS 39
ii IFRS shareholder results – Exposures for market and other risk Key Group exposures Detailed analyses of sensitivity of IFRS basis profit or loss and equity to market and other risks are provided in notes D2(j), D3(j), D4(j) and E4. The sensitivity analyses provided show the effect on IFRS basis profit or loss and equity to changes in the relevant risk variables, all of which are reasonably possible at the relevant balance sheet date. The IFRS operating profit based on longer-term investment returns for UK insurance operations has high potential sensitivity for changes to longevity assumptions affecting the carrying value of liabilities to policyholders for shareholder-backed annuity business. In addition, at the total IFRS profit level the result is sensitive to temporary value movements on assets backing IFRS equity. For Jackson at the level of operating profit based on longer-term investment returns, the results are sensitive to market conditions to the extent of income earned on spread-based products not mitigated by the interest derivative programmes and second order equitybased exposure in respect of variable annuity asset management fees. Further information is given below under the US operations section of market and credit risk. Jackson’s derivative programme is used to substantially mitigate equity market risk attaching to its equity-based products and interest rate risk associated with its spread-based products. Movements in interest rates and credit spreads materially affect the carrying value of derivatives which are used to manage the liabilities to policyholders and backing investment assets of fixed annuity and other general account business. Combined with the use of US GAAP measurement (as grandfathered under IFRS 4) for the asset and liabilities for the insurance contract liabilities, 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). See note D3(j) for details of the hedging. For Asian operations, the operating profit based on longer-term investment returns is mainly affected by the impact of market levels on unit-linked business persistency, and other insurance risk. At the total IFRS profit level the Asian result is affected by short-term value movements on the asset portfolio for non-linked shareholder-backed business.
• 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.
Invested assets covering liabilities (other than the separate accounts) and related capital comprise principally debt securities classified as available-for-sale. Value movements for these securities are reflected as movements in shareholders’ equity through the statement of comprehensive income. Other invested assets and derivatives are carried at fair value with the value movements reflected in the income statement. By contrast, the IFRS insurance liabilities for business written by Jackson, by the application of grandfathered GAAP under IFRS 4, are measured on US GAAP bases which with the exception of certain items covered by the equity hedging programme, are generally insensitive to temporary changes in market conditions or the short-term returns on the attaching asset portfolios. These differences in carrying value of debt securities, other invested assets, derivatives and insurance liabilities give rise to potentially significant volatility in the IFRS income statement and shareholders’ equity. As with other shareholder-backed business the profit or loss for Jackson is presented in the Group’s segmental analysis of profit 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. Excluding these short-term effects, the factors that most significantly affect the Jackson IFRS operating result based on long-term investment returns are: • Variable annuity business – the spread differential between the earned rate and the rate credited to policyholders on the general account funds and the effect of market movements on fees earned on separate account funds; • Fixed annuity business – the spread differential between the earned rate and the rate credited to policyholders; and • Fixed index annuity business – the spread differential between the earned rate and the rate credited to policyholders.
Asian insurance operations For Asian with-profits business the same features apply as described above for UK with-profits business. Similarly, as for other parts of the Group, for unit-linked business the main factor affecting IFRS basis results is investment performance through asset management fees. The sensitivity of the IFRS basis results of the Group’s Asian operations to market risk is primarily restricted to the non-participating business. This sensitivity is primarily reflected through the volatility of asset returns coupled with the fact that the accounting carrying value of liabilities to policyholders are only partially sensitive to changed market conditions. As for UK shareholder-backed operations and Jackson, the IFRS profit is distinguished in the Group’s segmental analysis so as to distinguish operating profits based on longer-term investment returns and short-term fluctuations in investment returns.
Insurance and lapse risk The features described above cover the main sensitivities of IFRS profit and loss and equity for market, insurance and credit risk. Lapse and longevity risk may also be a key determination of IFRS basis results with variable impacts. In the UK, adverse persistency experience can affect the level of profitability from with-profits and unit-linked business. For with-profits business in any given year, the amount represented by the shareholders’ share of cost of bonus may only be marginally affected. However, altered persistency trends may affect future expected shareholder transfers. By contrast, Group IFRS operating profit is particularly sensitive to longevity outlook that results in changes of assumption for the UK shareholder-backed annuity business.
Correlation across risk factors • Longevity risk • Expenses • Persistency • Other risks
f Duration of liabilities Under the terms of the Group’s contracts, as for life assurance contracts generally, the contractual maturity date is the earlier of the end of the contract term, death, other insurable events or surrender. The Group has therefore chosen to provide details of liability duration that reflect the actuarially determined best estimate of the likely incidence of these factors on contract duration. Details are shown in sections D2(k), D3(k) and D4(k). In the years 2006 to 2010, claims paid on the Group’s life assurance contracts including those classified as investment contracts under IFRS 4 ranged from £15 billion to £18 billion. Indicatively, it is to be expected that, of the Group’s policyholder liabilities (excluding unallocated surplus) at 31 December 2010 of £214.7 billion, the amounts likely to be paid in 2011 will be of a similar magnitude.
Liabilities Policyholder liabilities and unallocated surplus of with-profits funds: Contract liabilities (including amounts in respect of contracts classified as investment contracts under IFRS 4) 9,759 59,545 12,282 71,827 21,671 22,273 43,944 125,530 116,229
Unallocated surplus of with-profits funds (reflecting application of ‘realistic’ provisions for UK regulated with-
(2009: £1,106 million) and loans held by shareholder-backed business of £1,032 million (2009: £709 million). The loans held by the PAC WPSF comprise mortgage loans of £256 million, policy loans of £21 million and other loans of £993 million
(2009: £145 million, £24 million and £937 million respectively). The mortgage loans are collateralised by properties. Other loans held by the PAC with-profits fund are all commercial loans and comprise mainly syndicated loans.
† Partnerships in investment pools and other comprise mainly investments held by the PAC with-profits fund. These investments are primarily venture fund investments and investment in property funds and limited partnerships.
vii Unallocated surplus of with-profits funds Prudential’s long-term business written in the UK comprises predominantly life insurance policies under which the policyholders are entitled to participate in the returns of the funds supporting these policies. Business similar to this type is also written in certain of the Group’s Asian operations, subject to local market and regulatory conditions. Such policies are called with-profits policies. Prudential maintains with-profits funds within the Group’s long-term business funds, which segregate the assets and liabilities and accumulate the returns related to that with-profits business. The amounts accumulated in these with-profits funds are available to provide for future policyholder benefit provisions and for bonuses to be distributed to with-profits policyholders. The bonuses, both annual and final, reflect the right of the with-profits policyholders to participate in the financial performance of the with-profits funds. Shareholders’ profits with respect to bonuses declared on with-profits business correspond to the shareholders’ share of the cost of bonuses as declared by the PAC Board of directors. The shareholders’ share currently represents one-ninth of the cost of bonuses declared for with-profits policies.
Approximately 46.2 per cent (2009: 42.4 per cent) of the UK held investment property is located in London and Southeast England including
b Reconciliation of movement in investments A reconciliation of the total investments of UK insurance operations from the beginning of the year to the end of the year is as follows: PAC with-profits sub-fund Other funds and subsidiaries
Net cash inflow (outflow) from operating activities (1,226) 507 (30) 477 258 1,923 1,432 Realised gains (losses) in the year 165 554 (20) 534 (285) (306) 108 Unrealised gains and losses and exchange movements
Movement in the year of directly held investments, net of derivative liabilities (213) 6,127 560 6,687 2,559 3,261 12,294
AT 31 DECEMBER 2009/1 JANUARY 2010 Total investments (including derivative assets) 9,848 67,832 13,794 81,626 18,421 22,795 132,690 Less: Investments held by consolidated investment funds – (1,050) (19) (1,069) (729) (37) (1,835)
Directly held investments, net of derivative liabilities 9,811 66,465 13,609 80,074 17,692 22,569 130,146
AT 31 DECEMBER 2010 Total investments (including derivative assets) 9,704 70,576 14,496 85,072 20,795 25,855 141,426 Less: Investments held by consolidated investment funds – (140) (22) (162) (705) (45) (912)
Assumption changes (shareholder-backed business)note D2i, note c – – (46) (46) Investment-related items and other movementsnote b 9,365 2,849 1,904 14,118 Foreign exchange translation differences 764 (57) – 707
* Excluding the unallocated surplus of the with-profits funds and as adjusted for corporate transactions in the period.
Notes a Net flows of negative £3,192 million have improved from negative £4,343 million in 2009, principally as a result of increased premiums due to bulk annuity transaction in 2010 and improved unit-linked flows.
b Investment-related items and other movements of £13,218 million across fund types reflected the continued strong performance of UK equity markets in 2010, as well as the continued increase in value of debt securities.
d Information on credit risk of debt securities The following table summarises by rating the securities held by UK insurance operations as at 31 December 2010 and 2009: PAC with-profits sub-fund Other funds and subsidiaries UK insurance operations
Other annuity and long-term business £m 2010 Total £m 2009 Total £m
Where no external ratings are available, internal ratings produced by the Group’s asset management operation, which are prepared on the Company’s assessment of a comparable basis to external ratings, are used where possible. Of the £7,258 million total debt securities held in 2010 (2009: £6,950 million) which are not externally rated, £2,210 million were internally rated AAA to A-, £3,861 million were internally rated BBB to B- and £1,187 million were rated below B- or unrated (2009: £2,190 million, £3,445 million and £1,315 million respectively). The majority of unrated debt security investments were held in SAIF and the PAC with-profits fund and relate to convertible debt and other investments which are not covered by ratings analysts nor have an internal rating attributed to them. Of the £1,722 million PRIL and other annuity and long-term business investments which are not externally rated, £7 million were internally rated AAA, £92 million AA, £496 million A, £899 million BBB, £82 million BB and £146 million were internally rated B+ and below. As detailed in note D2(i) below, the primary sensitivity of IFRS basis profit or loss and shareholders’ equity relates to non-linked shareholder-backed business which covers ‘PRIL’ and ‘other annuity and long-term business’ in the table above.
With-profits products provide returns to policyholders through bonuses that are ‘smoothed’. There are two types of bonuses: ‘annual’ and ‘final’. Annual bonuses are declared once a year, and once credited, are guaranteed in accordance with the terms of the particular product. Unlike annual bonuses, final bonuses are guaranteed only until the next bonus declaration. The main factors that influence the determination of bonus rates are the return on the investments of the with-profits fund, inflation, taxation, the expenses of the fund chargeable to policyholders and the degree to which investment returns are smoothed. The overall rate of return earned on investments and the expectation of future investment returns are the most important influences on bonus rates. A high proportion of the assets backing the with-profits business are invested in equities and real estate. If the financial strength of the with-profits business is affected, then a higher proportion of fixed interest or similar assets might be held by the fund. Further details on the determination of the two types of the bonuses: ‘regular’ and ‘final’, the application of significant judgement, key assumptions and the degree of smoothing of investment returns in determining the bonus rates are provided below.
Regular bonus rates For regular bonuses, the bonus rates are determined for each type of policy primarily by targeting the bonus level at a prudent proportion of the long-term expected future investment return on underlying assets. The expected future investment return is reduced as appropriate for each type of policy to allow for items such as expenses, charges, tax and shareholders’ transfers. However, the rates declared may differ by product type, or by the date of payment of the premium or date of issue of the policy or if the accumulated annual bonuses are particularly high or low relative to a prudent proportion of the achieved investment return. When target bonus levels change the PAC Board has regard to the overall strength of the long-term fund when determining the length of time over which it will seek to achieve the amended prudent target bonus level. In normal investment conditions, PAC expects changes in regular bonus rates to be gradual over time, and these are not expected to exceed one per cent per annum over any year. However, the PAC directors retain the discretion whether or not to declare a regular bonus each year, and there is no limit on the amount by which regular bonus rates can change.
The rates of final bonus usually vary by type of policy and by reference to the period, usually a year, in which the policy commences or each premium is paid. These rates are determined by reference to the asset shares for the sample policies but subject to the smoothing approach, explained below. In general, the same final bonus scale applies to maturity, death and surrender claims except that: • The total surrender value may be impacted by the application of a Market Value Reduction – MVR – (for accumulating with-profits policies) and is affected by the surrender bases (for conventional with-profits business); and
• Smoothing of investment returns: This is an important feature of with-profits products. Determining when particular circumstances, such as a significant rise or fall in market values, warrant variations in the standard bonus smoothing limits that apply in normal circumstances requires the PAC Board to exercise significant judgement.
• Determining at what level to set bonuses to ensure that they are competitive: The overall return to policyholders is an important competitive measure for attracting new business.
iv Unit-linked (non-annuity) and other non-profit business Prudential UK insurance operations also have an extensive book of unit-linked policies of varying types and provide a range of other non-profit business such as credit life and protection contracts. These contracts do not contain significant financial guarantees. There are no guaranteed maturity values or guaranteed annuity options on unit-linked policies except for minor amounts for certain policies linked to cash units within SAIF.
For with-profits business written in the WPSF or SAIF, a market consistent valuation is performed (as described in section (ii) below). Additional assumptions required are for persistency and the management actions under which the fund is managed. Assumptions used for a market consistent valuation typically do not contain margins, whereas those used for the valuation of other classes of business do. Mortality assumptions are set based on the results of the most recent experience analysis looking at the experience over recent years of the relevant business. For non-profit business, a margin for adverse deviation is added. Different assumptions are applied for different product groups. For annuitant mortality, assumptions for current mortality rates are based on recent experience investigations and expected future improvements in mortality. The expected future improvements are based on recent experience and projections of the business and industry experience generally. Maintenance and, for some classes of business, termination expense assumptions are expressed as per policy amounts. They are set based on the expenses incurred during the year, including an allowance for ongoing investment expenditure and allocated between entities and product groups in accordance with the operation’s internal cost allocation model. For non-profit business a margin for adverse deviation is added to this amount. Expense inflation assumptions are set consistent with the economic basis and based on the difference between yields on nominal gilts and index-linked gilts. The actual renewal expenses incurred on behalf of SAIF by other Group companies are recharged in full to SAIF. The assumptions for asset management expenses are based on the charges specified in agreements with the Group’s asset management operations, plus a margin for adverse deviation for non-profit business.
Tax assumptions are set equal to current rates of taxation. For non-profit business excluding unit-linked business, the valuation interest rates used to discount the liabilities are based on the yields as at the valuation date on the assets backing the technical provisions. For fixed interest securities the gross redemption yield is used except for the PAL and PRIL annuity business where the internal rate of return of the assets backing the liabilities is used. Properties are valued using the rental yield, and for equities it is the greater of the dividend yield and the average of the dividend yield and the earnings yield. An adjustment is made to the yield on non risk-free fixed interest securities and property to reflect credit risk. To calculate the non-unit reserves for linked business, assumptions have been set for the gross unit growth rate and the rate of inflation of maintenance expenses, as well as for the valuation interest rate as described above.
ii WPSF and SAIF The policyholder liabilities reported for the WPSF are primarily for two broad types of business. These are accumulating and conventional with-profits contracts. The policyholder liabilities of the WPSF are accounted for under FRS 27. The provisions have been determined on a basis consistent with the detailed methodology included in regulations contained in the FSA’s rules for the determination of reserves on the FSA’s ‘realistic’ Peak 2 basis. In aggregate, the regime has the effect of placing a value on the liabilities of UK with-profits contracts, which reflects the amounts expected to be paid based on the current value of investments held by the with-profits funds and current circumstances. These contracts are a combination of insurance and investment contracts with discretionary participation features, as defined by IFRS 4. The FSA’s Peak 2 calculation under the realistic regime requires the value of liabilities to be calculated as: • The with-profits benefits reserve (WPBR); plus • future policy related liabilities (FPRL); plus • the realistic current liabilities of the fund.
iii Annuity business Credit risk provisions For IFRS reporting, the results for UK shareholder-backed annuity business are particularly sensitive to the allowances made for credit risk. The allowance is reflected in the deduction from the valuation rate of interest for discounting projected future annuity payments to policyholders that would have otherwise applied. Since mid-2007 there has been a significant increase in the actual and perceived credit risk associated with corporate bonds as reflected in the significant widening that has occurred in corporate bond spreads. Although bond spreads over swap rates have narrowed from their peak in March 2009, they are still high compared with the levels seen in the years immediately preceding the start of the dislocated markets in 2007. The allowance that should therefore be made for credit risk remains a particular area of judgement.
Credit risk allowance Long-term expected defaultsnote ii 19 – 19 Long-term credit risk premiumnote iii 13 – 13 Short-term allowance for credit risknote iv 39 (24) 15
Notes (i) Bond spread over swap rates reflect market observed data. (ii) For the valuations prior to 31 December 2010, long-term expected defaults were derived by applying Moody’s data from 1970 to 2004 uplifted by between 100 per cent (B) and 200 per cent (AAA) according to credit rating on the annuity asset portfolio. The credit rating assigned to each asset held was based on external credit rating and for this purpose the credit rating assigned to each asset held was the lowest credit rating published by Moody’s, Standard and Poors and Fitch.
Total allowance for credit risk at 31 December 2010 26 42 68 26 16 42
Overall this has led to the credit allowance for Pillar 1 purposes to be 43 per cent (2009: 41 per cent) of the bond spread over swap rates. For IFRS purposes it represents 26 per cent (2009: 27 per cent) of the bond spread over swap rates. The reserves for credit risk allowance at 31 December 2010 for UK shareholder annuity fund were as follows: Pillar 1 Regulatory basis £bn
In deferment 92% – 98% PCMA00 with future improvements in line with Prudential’s own calibration of the CMI 2009 mortality model, with a long-term improvement rate of 2.25%
AM92 minus 4 years 87% – 98% PNFA00 (C = 2000) with 75% of medium cohort improvement table with a minimum annual improvement of 1.25% up to age 90, tapering to zero at age 120
AM92 minus 4 years 84% – 117% PNFA00 (C = 2000) with 75% of medium cohort improvement table with a minimum annual improvement of 1.25% up to age 90, tapering to zero at age 120
AF92 minus 4 years 97% – 102% PNMA00 (C = 2000) with medium cohort improvement table with a minimum annual improvement of 2.25% up to age 90, tapering to zero at age 120
h Reinsurance The Group’s UK insurance business cedes only minor amounts of business outside the Group. During 2010, reinsurance premiums for externally ceded business were £128 million (2009: £122 million) and reinsurance recoverable insurance assets were £608 million (2009: £502 million) in aggregate. The gains and losses recognised in profit and loss for the 2010 contracts were immaterial. During 2009 the Group’s UK insurance business wrote a longevity swap on certain aspects of the UK’s annuity back-book liabilities. This resulted in a one-off benefit of £34 million to IFRS profit before tax in 2009. The gains and losses recognised in profit and loss for other contracts in 2009 were immaterial.
Other operating assumptions changes Overall mortality experience was in line with expectations and no change was therefore required to the overall strength of mortality assumptions at 31 December 2009. For the shareholder-backed business, the aggregate effect of assumption changes in 2009 was a net credit to the shareholder result of £46 million, primarily related to changes to the deflation reserve, expense assumptions and modelling changes. For the with-profits sub-fund, the aggregate effect of assumption changes in 2009 was a net credit to unallocated surplus of £65 million principally for altered expense assumptions.
i With-profits business SAIF Shareholders have no interest in the profits of SAIF but are entitled to the asset management fees paid on the investment of the assets of the fund.
A decrease in assumed mortality rates of one per cent would decrease gross profits by approximately £53 million (2009: £44 million). A decrease in credit default assumptions of five basis points would increase gross profits by £119 million (2009: £91 million). A decrease in renewal expenses (excluding asset management expenses) of five per cent would increase gross profits by £23 million (2009: £17 million). The effect on profits would be approximately symmetrical for changes in assumptions that are directionally opposite to those explained above.
Carrying value of debt securities and derivatives 6,547 2,938 (2,434) (4,481) 5,372 2,422 (2,020) (3,731)
Net sensitivity of profit after tax and shareholders’ equity 416 157 (237) (403) 178 85 (83) (168)
Total unrealised valuation movements 1,221 2,669 Related change in amortisation of deferred income and acquisition costs (469) (1,069) Related tax (247) (557)
Net increase in equity 804 1,313 Shareholders’ equity at beginning of year 3,011 1,698
Included within the movements in shareholders’ equity is a net increase in value of Jackson’s debt securities classified as ‘available-forsale ’ under IAS 39 of £1,221 million (2009: £2,669 million).
With the exception of debt securities for US insurance operations classified as ‘available-for-sale’ under IAS 39, unrealised value movements on the Group’s investments are booked within the income statement. However, for debt securities classified as ‘availablefor -sale’, unless impaired, fair value movements are recognised in other comprehensive income. Realised gains and losses, including impairments, are recorded in the income statement. This classification is applied for most of the debt securities of the Group’s US operations. In 2010, Jackson recorded £124 million (2009: £630 million) of impairment losses arising from: Residential mortgage-backed securities 71 509 Public fixed income 1 91
Reflected as part of movement in other comprehensive income £m £m £m £m
Assets fair valued at or above book value Book value* 20,743 14,444
Reflected as part of movement in other comprehensive income Movement in unrealised appreciation 1,221 2,669 Exchange movements (15) 232 * Book value represents cost/amortised cost of the debt securities. † Debt securities for US operations as included in the statement of financial position of £26,366 million (2009: £22,831 million) comprise £26,325 million
(2009: £22,668 million) in respect of securities classified as ‘available-for-sale’ and £41 million (2009: £163 million) for securities of consolidated investment funds classified as fair value through profit and loss.
Included within the movement in gross unrealised losses for the debt securities of Jackson of £634 million (2009: £1,925 million) as shown above was a net increase in value of £84 million (2009: £72 million decrease) relating to the sub-prime and Alt-A securities as referred to in section B6.
Notes i Assets and liabilities attaching to variable annuity business that are not held in the separate account are shown within other business. ii Loans The loans of the Group’s US insurance operations of £4,201 million (2009: £4,319 million) comprise mortgage loans of £3,641 million
(2009: £3,774 million), policy loans of £548 million (2009: £530 million) and other loans of £12 million (2009: £15 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. The breakdown by property type is as follows: Multi-family residential 18 18
† 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 161 (2009: 159) other partnerships by independent money managers that generally invest in various equities and fixed income loans and securities.
In addition to the policyholder liabilities above, Jackson has entered into a programme of funding arrangements under contracts which, in substance, are almost identical to GICs. The liabilities under these funding arrangements totalled £1,411 million (2009: £1,444 million) and are included in ‘other non-insurance liabilities’ in the statement of financial position above.
v Equity securities and portfolio holdings in unit trusts include investments in mutual funds, the majority of which are equity based.
b Reconciliation of movement in investments A reconciliation of the total investments of US insurance operations from the beginning of the year to the end of the year is as follows: Variable annuity separate account assets and liabilities £m
Movement in the year of directly held investments, net of derivative liabilities 6,101 (2,294) 3,807
AT 31 DECEMBER 2009/1 JANUARY 2010 Total investments (including derivative assets) 20,639 28,937 49,576 Less: Derivative liabilitiesnote G3 – (461) (461)
Movement in the year of directly held investments, net of derivative liabilities 10,564 3,027 13,591
AT 31 DECEMBER 2010 Total investments (including derivative assets) 31,203 32,302 63,505 Less: Derivative liabilitiesnote G3 – (799) (799)
c Reconciliation of movement in policyholder liabilities A reconciliation of the total policyholder liabilities of US insurance operations from the beginning of the year to the end of the year is as follows: Variable annuity separate account liabilities £m
Net flowsnote b 5,758 1,610 7,368 Transfers from general to separate account 1,411 (1,411) - Investment-related items and other movementsnote c 2,875 589 3,464 Foreign exchange translation differencesnote a 520 860 1,380
Notes a Movements in the year have been translated at an average rate of 1.55 (2009: 1.57). The closing balance has been translated at closing rate of 1.57 (2009: 1.61). Differences upon retranslation are included in foreign exchange translation differences of £1,380 million (2009: £5,225 million). b Net flows for the year were £7,368 million compared with £5,189 million in 2009, driven largely by increased new business volumes for the variable annuity business.
c Positive investment-related items and other movements in variable annuity separate account liabilities of £2,875 million in 2010 and £3,368 million in 2009 represent increases in the US equity market during the respective periods. Fixed annuity, GIC and other business investment and other movements primarily reflects the movement in the valuation of the product guarantees and interest credited to policyholder accounts. In 2010, interest credited exceeded the small reduction in the guarantee valuation to give an overall increase in liabilities. In 2009, there was a more significant fall in the valuation of guarantees.
Total debt securities 26,366 22,831 i Credit quality For statutory reporting in the US, debt securities are classified into six quality categories specified by the Securities Valuation Office of the National Association of Insurance Commissioners (NAIC). The categories range from Class 1 (the highest) to Class 6 (the lowest). Performing securities are designated as Classes 1 to 5. Securities in or near default are designated Class 6. Securities designated as Class 3, 4, 5 and 6 are non-investment grade securities. Generally, securities rated AAA to A by nationally recognised statistical ratings organisations are reflected in Class 1, BBB in Class 2, BB in Class 3 and B and below in Classes 4 to 6. If a designation is not currently available from the NAIC, Jackson’s investment adviser, PPM America, provides the designation for the purposes of disclosure below.
The following table shows the quality of the publicly traded and non-SEC Rule 144A debt securities by NAIC classifications: Carrying value Carrying value £m % of total £m % of total
Included within other debt securities of £976 million (2009: £956 million) in the summary shown above are £723 million (2009: £652 million) of asset-backed securities held directly by Jackson, of which £527 million (2009: £447 million) were NAIC designation 1 and £135 million (2009: £152 million) NAIC designation 2. In addition, other debt securities includes £211 million (2009: £172 million) in respect of securities held by the Piedmont trust entity and £42 million (2009: £132 million) from the consolidation of investment funds managed by PPM America.
In addition to the ratings disclosed above, the following table summarises by rating the debt securities, as at 31 December 2010 using Standard and Poor’s (S&P), Moody’s, Fitch and implicit ratings of mortgage-backed securities (MBS) based on NAIC valuations: Carrying value
Total debt securities 26,366 22,831 * The amounts within Other which are not rated by S&P, Moody’s, Fitch nor are MBS securities using the revised regulatory ratings have the following NAIC classifications: In the table above, with the exception of some residential mortgage-backed securities and commercial mortgage-backed securities for 2010, and for residential mortgage-backed securities for 2009, commercial mortgage-backed securities S&P ratings have been used where available. For securities where S&P ratings are not immediately available, those produced by Moody’s and then Fitch have been used as an alternative. During 2009, the NAIC in the US revised the regulatory ratings process for more than 20,000 residential mortgage-backed securities. In addition, in 2010, the NAIC expanded the revised process to include commercial mortgage-backed securities. The table above includes these securities, where held by Jackson, using the regulatory rating levels established by external third parties (PIMCO for residential mortgage-backed securities and BlackRock Solutions for commercial mortgage-backed securities).
ii Determining the fair value of debt securities when the markets are not active Under IAS 39, unless categorised as ‘held to maturity’ or ‘loans and receivables’ debt securities are required to be fair valued. Where available, quoted market prices are used. However, where securities do not have an externally quoted price based on regular trades or are quoted in markets that are no longer active as a result of market conditions, IAS 39 requires that valuation techniques be applied. Note G1 sets out further details of the Group’s approach to determining fair value and classifies these fair values into a three level hierarchy as required by IFRS 7. At 31 December 2010, 0.3 per cent of Jackson’s debt securities were classified as level 3 (2009: three per cent) comprising fair values where there are significant inputs which are not based on observable market data.
iii Asset-backed securities funds exposures Included within the debt securities of Jackson at 31 December 2010 are exposures to asset-backed securities as follows: RMBS Sub-prime (31 Dec 2010: 40% AAA, 11% AA)† 224 194
a Fair value of securities as a percentage of book value The unrealised losses in Jackson’s statement of financial position on unimpaired securities are £370 million (2009: £966 million). This relates to assets with fair market value and book value of £4,002 million (2009: £7,254 million) and £4,372 million (2009: £8,220 million) respectively. The following table shows the fair value of the debt securities in a gross unrealised loss position for various percentages of book value at 31 December: Fair value of securities as a percentage of book value Fair value Unrealised loss Fair value Unrealised loss
Included within the table above are amounts relating to sub-prime and Alt–A securities of: Fair value of securities as a percentage of book value Fair value Unrealised loss Fair value Unrealised loss
At 31 December 2010, the gross unrealised losses in the statement of financial position for the sub-prime and Alt-A securities in an unrealised loss position were £40 million (2009: £119 million), as shown above in note (a). Of these losses £1 million (2009: £21 million) relate to securities that have been in an unrealised loss position for less than one year and £39 million (2009: £98 million) to securities that have been in an unrealised loss position for more than one year.
d Securities whose fair value were below 80 per cent of the book value As shown in the table (a) above, £224 million of the £370 million of gross unrealised losses at 31 December 2010 (2009: £594 million of the £966 million of gross unrealised losses) related to securities whose fair values were below 80 per cent of the book value. The analysis of the £224 million, (2009: £594 million) by category of debt securities and by age analysis indicating the length of time for which their fair value was below 80 per cent of the book value, are as follows: Category analysis Fair value Unrealised loss Fair value Unrealised loss
Fixed indexed annuities Fixed indexed annuities accounted for 9 per cent (2009: 10 per cent) of Jackson’s policy and contract liabilities at 31 December 2010. Fixed indexed annuities vary in structure, but generally are deferred annuities that enable policyholders to obtain a portion of an equity-linked return (based on participation rates and caps) but provide a guaranteed minimum return. These guaranteed minimum rates are generally set at 1.25 to 3 per cent. Jackson hedges the equity return risk on fixed indexed products using futures and options linked to the relevant index as well as through offsetting equity exposure in the VA product. The cost of these hedges is taken into account in setting the index participation rates or caps. Jackson bears the investment and surrender risk on these products.
Immediate annuities At 31 December 2010, immediate annuities accounted for two per cent (2009: two per cent) of Jackson’s policy and contract liabilities. Immediate annuities guarantee a series of payments beginning within a year of purchase and continuing over either a fixed period of years and/or the life of the policyholder. If the term is for the life of the policyholder, then Jackson’s primary risk is mortality risk. The implicit interest rate on these products is based on the market conditions that exist at the time the policy is issued and is guaranteed for the term of the annuity.
Jackson issues VA contracts where it contractually guarantees to the contractholder either a) return of no less than total deposits made to the contract adjusted for any partial withdrawals, b) total deposits made to the contract adjusted for any partial withdrawals plus a minimum return, or c) the highest contract value on a specified anniversary date adjusted for any withdrawals following the contract anniversary. These guarantees include benefits that are payable in the event of death (guaranteed minimum death benefit (GMDB)), annuitisation (guaranteed minimum income benefit (GMIB)), or at specified dates during the accumulation period (guaranteed minimum withdrawal benefit (GMWB)) and guaranteed minimum accumulation benefit (GMAB). Jackson hedges these risks using equity options and futures contracts as described in note D3(f). The GMIB is no longer offered, with existing coverage being reinsured.
iii Life insurance Jackson’s life insurance products accounted for seven per cent (2009: nine per cent) of Jackson’s policy and contract liabilities at 31 December 2010. The products offered include variable universal life insurance, term life insurance and interest-sensitive life insurance.
f Exposure to market risk and risk management Jackson’s main exposures are to market risk through its exposure to interest rate risk and equity risk. Approximately 91 per cent (2009: 90 per cent) of its general account investments support interest-sensitive and fixed indexed annuities, life business and surplus and nine per cent (2009: ten per cent) support institutional business. All of these types of business contain considerable interest rate guarantee features and, consequently, require that the assets that support them are primarily fixed income or fixed maturity.
g Process for setting assumptions and determining contract liabilities Under the MSB of reporting applied under IFRS 4 for insurance contracts, providing the requirements of the Companies Act, UK GAAP standards and the ABI SORP are met, it is permissible to reflect the previously applied UK GAAP basis. Accordingly, and consistent with the basis explained in note A4, in the case of Jackson the carrying values of insurance assets and liabilities are consolidated into the Group accounts based on US GAAP. Under US GAAP, investment contracts (as defined for US GAAP purposes) are accounted for by applying in the first instance a retrospective deposit method to determine the liability for policyholder benefits. This is then augmented by potentially three additional amounts. These amounts are for: • any amounts that have been assessed to compensate the insurer for services to be performed over future periods (i.e. deferred income); • any amounts previously assessed against policyholders that are refundable on termination of the contract; and • any probable future loss on the contract (i.e. premium deficiency).
Under US GAAP (as grandfathered under IFRS 4) the projected gross profits reflect an assumed long-term level of equity return which, for Jackson, is 8.4 per cent after deduction of net external fund management fees. This is applied to the period end level of separate account equity assets after application of a mean reversion technique that removes a portion of the effect of levels of short-term variability in current market returns. Under the mean reversion technique applied by Jackson, the projected level of return for each of the next five years is adjusted from period to period so that in combination with the actual rates of return for the preceding two years and the current year, the 8.4 per cent annual return is realized on average over the entire eight year period. Projected returns after the mean reversion period revert back to the 8.4 per cent target. A capping feature, which currently applies due to the very sharp market falls in 2008, is that the projected rates of return for the next five years can be no more than 15 per cent (gross of asset management fee) per annum. If Jackson had not applied the mean reversion methodology and had instead applied a constant 8.4 per cent annual return from today’s asset values, the Jackson DAC balance of £3,543 million would fall approximately £80 million to £3,463 million at 31 December 2010. The amortisation charge to the income statement is reflected in operating profit and short-term fluctuations in investment returns. The amortisation charge to the operating profit in a reporting period will incorporate an element of acceleration or deceleration that reflects the variance between the actual level of return attained and the assumed level in the mean reversion calculation. In 2010, the element of DAC amortisation charge included in operating profit includes £11 million of accelerated amortisation. This amount reflects actual separate account return shortfalls in the periods compared with the assumed level of 15 per cent for the year. For 2009, reflecting the excess of actual separate account returns over the 15 per cent assumed level, the operating profit incorporates a credit for decelerated amortisation of £39 million. For 2010, the separate account return (gross of asset management fees) was approximately 13 per cent. In 2011, while the capping feature is in effect, each one per cent divergence of the actual separate account return below or above the assumed return of 15 per cent is estimated to give rise to accelerated or decelerated amortisation, respectively, of approximately £6 million (£3 million if the projected rate falls below the 15 per cent cap). In the absence of significant market declines between now and the end of 2011, Jackson would expect to see higher amortisation levels than normal in 2011. This would essentially represent a reversal of the mean reversion benefits to date, as at that point highly negative returns from 2008 will no longer be included in the mean reverting return calculation.
Statement of changes in equity – ‘shadow DAC adjustments’ Consequent upon the positive unrealised valuation movement in 2010 of £1,221 million (2009: positive £2,669 million) there is a debit of £496 million (2009: £1,069 million debit) for altered ‘shadow’ amortisation booked within other comprehensive income. These adjustments reflect movement from period to period, in the changes to the pattern of reported gross profits that would have happened if the assets reflected in the statement of financial position had been sold, crystallising the unrealised gains or losses, and the proceeds reinvested at the yields currently available in the market. At 31 December 2010 the cumulative ‘shadow DAC balance’ was negative £520 million (2009: negative £10 million).
h Reinsurance The principal reinsurance ceded by Jackson outside the Group is on term life insurance, direct and assumed accident and health business and GMIB variable annuity guarantees. In 2010, the premiums for such ceded business amounted to £83 million (2009: £82 million). Net commissions received on ceded business and claims incurred ceded to external reinsurers totalled £12 million and £72 million respectively, during 2010 (2009: £12 million and £66 million respectively). There were no deferred gains or losses on reinsurance contracts in either 2010 or 2009. The reinsurance asset for business ceded outside the Group was £694 million (2009: £667 million).
There are no changes of assumptions that had a material impact on the 2010 results of US insurance operations. Separately, in 2010, the Group amended its presentation of operating profit for its US insurance operations to exclude the net equity hedge accounting effect of negative £367 million (2009: negative £159 million) relating to its variable and fixed index annuity business and reclassified it as a short-term fluctuation within the Group’s supplementary analysis of profit. This is explained further in note A4(d)(ii). This change had no effect on the measurement of insurance assets and liabilities and therefore on total profit or shareholders’ equity.
Measurement basis for embedded derivatives of variable annuity business and other policyholder liability Certain variable annuity products sold by Jackson include Guaranteed Minimum Withdrawal Benefits (GMWB) with lifetime benefits which, in accordance with the Group’s accounting policies, are measured within the IFRS balance sheet at fair value. This requires a number of assumptions related to projected future cash flows, including those driven by policyholder behaviours such as lapses, fund selections and withdrawals utilisation.
During 2009 the GMWB utilisation assumptions were revised to take account of the more recent experience of policyholder behaviour. Previously policyholder behaviour for the utilisation of GMWB was assumed to be largely driven by the extent to which benefits were ‘in the money’. For 2009, the assumption has been altered to take account of recent experience which shows that the attained age of the policyholder is the key factor in determining utilisation levels. This has led to a release in policyholder liabilities of £96 million which is offset by a corresponding DAC amortisation charge of £68 million to give an overall impact on profit before tax of £28 million. This assumption change has been offset by sundry other assumption changes such that the overall impact on operating profit of policyholder liability assumption changes, after taking into account DAC amortisation offsets, is a charge of £4 million. 2010 has been prepared on a consistent basis to 2009.
j 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 2010, the rates were US$1.55 (2009: US$1.57) and US$1.57 (2009: US$1.61) to £1 sterling, respectively. A 10 per cent increase or decrease in these rates would reduce or increase profit (loss) before tax attributable to shareholders, profit (loss) for the year and shareholders’ equity attributable to US insurance operations respectively as follows: A 10% increase in exchange rates
iii Exposure to equity risk Variable annuity contracts related Jackson issues variable annuity contracts through its separate accounts for which investment income and investment gains and losses accrue to, and investment risk is borne by, the contract holder (traditional variable annuities). It also issues variable annuity and life contracts through separate accounts where it contractually guarantees to the contract holder (variable contracts with guarantees) either a) return of no less than deposits made to the contract adjusted for any partial withdrawals, b) total deposits made to the contract adjusted for any partial withdrawals plus a minimum return, or c) the highest contract value on a specified anniversary date adjusted for any withdrawals following the contract anniversary. These guarantees include benefits that are payable in the event of death (GMDB), annuitisation (GMIB), at specified dates during the accumulation period (GMWB) or at the end of a specified period (GMAB). At 31 December 2010 and 2009, Jackson had variable annuity contracts with guarantees, for which the net amount at risk (‘NAR’) is generally the amount of guaranteed benefit in excess of current account value, as follows: Minimum return
Return of net deposits plus a minimum return GMDB 0-6% 16,915 2,834 63.8 years GMWB – Premium only 0% 2,505 277 GMWB – For life 0-5%* 1,240 471†
Combination net deposits plus minimum return, highest specified anniversary account value minus withdrawals post-anniversary GMDB 0-6% 1,307 384 65.1 years GMIB 0-6% 1,815 488 5.9 years GMWB – For life 0-7%* 6,934 568†
* Ranges shown based on simple interest. The upper limits of five per cent, seven per cent and eight per cent simple interest are approximately equal to 4.1 per cent, 5.5 per cent and six per cent respectively, on a compound interest basis over a typical 10-year bonus period.
Account balances of contracts with guarantees were invested in variable separate accounts as follows: Mutual fund type Equity 23,841 15,477 Bond 3,417 2,340 Balanced 3,345 2,186 Money market 451 522
iv Exposure to interest rate risk Notwithstanding the market risk exposure described in note D3(f), except in the circumstances of interest rate scenarios where the guarantee rates included in contract terms are higher than crediting rates that can be supported from assets held to cover liabilities, the accounting measurement of fixed annuity liabilities of Jackson products is not generally sensitive to interest rate risk. This position derives from the nature of the products and the US GAAP basis of measurement described in notes D3(e) and D3(g). The GMWB features attaching to variable annuity business (other than ‘for-life’) represents embedded derivatives which are fair valued and so will be sensitive to changes in interest rate. Debt securities and related derivatives are marked to fair value. Value movements on derivatives, net of related changes to amortisation of DAC and deferred tax, are recorded within profit and loss. Fair value movements on debt securities, net of related changes to amortisation of DAC and deferred tax, are recorded within other comprehensive income. The estimated sensitivity of these items and policyholder liabilities to a one per cent and two per cent decrease and increase in interest rates at 31 December 2010 and 2009 is as follows: A 2% decrease
Short-term fluctuations in investment returns (237) (102) 89 169 (229) (109) 117 267
Related effect on charge for deferred tax (120) (50) 32 62 131 60 (60) (131)
Other comprehensive income Direct effect on carrying value of debt securities 2,663 1,454 (1,454) (2,663) 2,183 1,179 (1,179) (2,183) Related effect on amortisation of DAC (1,174) (641) 641 1,174 (764) (413) 413 764 Related effect on movement in deferred tax (521) (285) 285 521 (497) (268) 268 497
Total net effect on IFRS equity 1,190 621 (588) (1,082) 680 387 (385) (677)
k Duration of liabilities The table below shows the carrying value of policyholder liabilities. Separately, the Group uses cash flow projections of expected benefit payments as part of the determination of the value of in-force business when preparing EEV basis results. The table below also shows the maturity profile of the cash flows used for that purpose for 2010 and 2009: Fixed annuity and other business (including
The maturity tables shown above have been prepared on a discounted basis. Details of undiscounted cash flows for investment contracts are shown in note G2.
Liabilities Policyholder liabilities and unallocated surplus of with-profits funds: Contract liabilities (including amounts in respect of contracts classified as investment contracts under IFRS 4) 10,958 12,724 4,992 28,674 21,858 Unallocated surplus of with-profits funds 66 – – 66 53
Notes i The statement of financial position 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 £1,340 million (2009: £1,207 million) comprise mortgage loans of £25 million
Net cash inflow from operating activities 565 1,243 1,220 3,028 Disposal of Taiwan agency business – (734) (2,527) (3,261) Realised gains (losses) in the year (183) 1 (61) (243) Unrealised gains and losses and exchange movements in the year 671 2,048 (393) 2,326
AT 31 DECEMBER 2009/1 JANUARY 2010 Total investments (including derivative assets) 9,547 9,953 3,890 23,390 Less: Investments held by consolidated investment funds (270) (218) (230) (718) Less: Derivative liabilitiesnote G3 (63) – (83) (146)
Net cash inflow from operating activities 278 838 1,051 2,167 Realised gains in the year 638 327 19 984 Unrealised gains and losses and exchange movements in the year 993 1,786 522 3,301 Acquisition of UOB Life Assurance Limited 527 3 474 1,004
AT 31 DECEMBER 2010 Total investments (including derivative assets) 12,152 12,955 5,836 30,943 Less: Investments held by consolidated investment funds (382) (266) (91) (739) Less: Derivative liabilitiesnote G3 (120) – (102) (222)
c Reconciliation of movement in policyholder liabilities and unallocated surplus of with-profits funds A reconciliation of the total policyholder liabilities and unallocated surplus of with-profits funds of Asian insurance operations from the beginning of the year to the end of the year is as follows: With-profits business £m
Premiums New businessnote ii 141 1,072 452 1,665 In-force 897 1,130 616 2,643
Comprising: – Policyholder liabilities 10,958 12,724 4,992 28,674 – Unallocated surplus of with-profits funds 66 – – 66
Notes i Movements in the year have been translated at the average exchange rate for the year ended 31 December 2010. The closing balance has been translated at the closing spot rates as at 31 December 2010. Differences upon retranslation are included in foreign exchange translation differences of positive £2,081 million in 2010 (2009: negative £2,069 million).
The depressed state of the investment markets in late 2008 and 2009 resulted in both the number of, and average value of, withdrawals of investment related products decreasing.
vi The disposal of Taiwan agency business reflects the liabilities transferred at the date of disposal. vii The acquisition of UOB Life Assurance Limited reflects the liabilities acquired at the date of acquisition.
Whole of life contracts with floor levels of policyholder benefits that accrue at rates set at inception and do not vary subsequently with market conditions are written in the Korean life operations. This is to a much lesser extent than the policies written by the Taiwan agency business which was sold in the first half of 2009, as Korea has a much higher proportion of linked and health business. The Korean business has non-linked liabilities and linked liabilities at 31 December 2010 of £408 million and £1,491 million respectively (2009: £349 million and £1,173 million respectively). The other area of note in respect of guarantees is the Japanese business where pricing rates are higher than current bond yields. Lapse risk is a feature in that policyholders could potentially surrender their policies on guaranteed terms if interest rates significantly increased leaving the potential for losses if bond values had depreciated significantly. However, the business is matched to a relatively short realistic liability duration. The method for determining liabilities of insurance contracts for UK GAAP and IFRS purposes for some Asian operations is based on US GAAP principles and this method applies to contracts with cash value and interest rate guarantees. Following standard US GAAP procedure, premium deficiency reserve calculations are performed each year to establish whether the carrying values of the liabilities are sufficient. On the US GAAP basis the calculations are deterministic, that is to say based on a single set of projections, and expected long-term rates of return are applied.
A 10% decrease in exchange rates 2010 £m 2009 £m 2010 £m 2009 £m
(Loss) profit before tax attributable to shareholdersnote i (65) (40) 80 49 (Loss) profit for the year (58) (35) 71 43 Shareholders’ equity, excluding goodwill, attributable to Asian operations (193) (129) 236 158
iii Other business a Interest rate risk Asian operations offer a range of insurance and investment products, predominately with-profits and non-participating term, whole life endowment and unit-linked. Excluding with-profit and unit-linked business, the results of the Asian business are sensitive to the vagaries of routine movements in interest rates.
At 31 December 2010, an increase in the rates of one per cent (Japan and Taiwan (0.5 per cent)) (2009: one per cent except Japan and Taiwan 0.5 per cent) is estimated to have the effect of decreasing pre-tax profit by £112 million (2009: £109 million). After adjusting these results for deferred tax the reasonable possible effect on shareholders’ equity is a decrease of £82 million (2009: £83 million).
k Duration of liabilities The table below shows the carrying value of policyholder liabilities. Separately the Group uses cash flow projections of expected benefit payments as part of the determination of the value of in-force business when preparing EEV basis results. The table below also shows the maturity profile of the cash flows, taking account of expected future premiums and investment returns used for that purpose for 2010 and 2009: Policyholder liabilities 28,674 21,858
Unallocated surplus of with-profits fundsnote v – 10,187 10,187 – – 66 10,253 Shareholders’ share of realistic
Other adjustments to restate these amounts to a regulatory basis (with SAIF and the WPSF on a Peak 2 realistic basis)note v – 706 706 (292) 576 156 1,146
TOTAL AVAILABLE CAPITAL RESOURCES OF LIFE ASSURANCE BUSINESSES ON LOCAL REGULATORY BASES – 6,800 6,800 1,707 2,907 1,378 12,792
Held outside long-term funds: Held in long-term fundsnote iii – – – 1,114 – – 1,114 – – 1,114
Jackson surplus notesnote iv – – – – 154 – 154 Investment and policyholder liabilities valuation differences between IFRS basis and regulatory basis for Jacksonnote viii – – – – 2,221 – 2,221
regulated with-profits funds: Investment contracts (with discretionary participation features) 396 24,384 24,780 – – 100 24,880
Other liabilities: Insurance contracts: With-profits liabilities of non-UK regulated funds – – – – – 3,942 3,942 Unit-linked, including variable annuity – 1,998 1,998 6,793 20,639 9,717 39,147
Investment contracts without discretionary participation features (principally unit-linked and similar contracts in the UK and GIC liabilities of Jackson)note vi – – – 13,794 1,965 46 15,805
TOTAL POLICYHOLDER LIABILITIES SHOWN IN THE CONSOLIDATED STATEMENT OF FINANCIAL POSITION 9,972 67,557 77,529 38,700 48,311 21,858 186,398
vi Insurance business accounted for as financial instruments under IAS 39. vii In determining the IAS 19 adjustment for the purposes of this table the deficit in the Group’s main pension scheme used for the calculation includes amounts for investments in Prudential insurance policies (see note I3).
viii The investment and policyholder liabilities valuation difference between IFRS and regulatory bases for Jackson is mainly due to not all investments being carried at fair value under the regulatory basis and also due to the valuation difference on annuity reserves.
PAC WPSF and SAIF Under FSA rules, insurers with with-profits liabilities of more than £500 million must hold capital equal to the higher of the MCR and the Enhanced Capital Requirement (ECR). The ECR is intended to provide a more risk responsive and ‘realistic’ measure of a with-profit insurer’s capital requirements, whereas the MCR is broadly speaking equivalent to the previous required minimum margin under the Interim Prudential Sourcebook and satisfies the minimum EU Standards. Determination of the ECR involves the comparison of two separate measurements of the firm’s resources requirement, which the FSA refers to as the ‘twin peaks’ approach.
In normal investment conditions, PAC expects changes to regular bonus rates to be gradual over time and changes are not expected to exceed one per cent per annum over any year. However, discretion is retained as to whether or not a regular bonus is declared each year, and there is no limit on the amount by which regular bonus rates can be changed. As regards smoothing of maturity and death benefits, in normal circumstances PAC does not expect most 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. For surrender benefits, any substantial fall in the market value of the assets of the with-profits sub-fund would lead to changes in the application of MVRs for accumulating with-profits policies, firstly to increase the size of MVRs already being applied and, secondly, to extend the range of policies for which an MVR is applied.
ii Jackson The regulatory framework for Jackson is governed by the requirements of the US NAIC approved risk-based capital standards. Under these requirements life insurance companies report for the most part on a formula-based capital standard that they calculate by applying factors to various asset, premium and reserve items and separate model based calculations of risk associated primarily with variable annuity products. The risk-based capital formula takes into account the risk characteristics of a company, including asset risk, insurance risk, interest rate risk, market risk and business risk. The available capital of Jackson shown above of £2,907 million (2009: £2,488 million) reflects US regulatory basis assets less liabilities including asset valuation reserves. The asset valuation reserve is designed to provide for future credit-related losses on debt securities and losses on equity investments. Available capital includes a reduction for the effect of the interest maintenance reserve, which is designed by state regulators to defer recognition of non-credit related realised capital gains and losses and to recognise them rateably in the future. Jackson’s risk-based capital ratio is significantly in excess of regulatory requirements. At 31 December 2010, Jackson had a permitted practice in effect as granted by the local regulator allowing Jackson to carry certain interest rate swaps at book value, as if statutory hedge accounting were in place, instead of at fair value as would have been otherwise required. Jackson was also required to demonstrate the effectiveness of its interest rate swap programme pursuant to the Michigan Insurance Code. The total effect of this permitted practice, which expires on 1 October 2011 was to increase statutory surplus by £83 million at 31 December 2010.
iii Asian operations The available capital shown above of £1,378 million (2009: £1,129 million) represents the excess of local regulatory basis assets over liabilities before deduction of required capital of £572 million (2009: £438 million). These amounts have been determined applying the local regulations in each of the operations. The businesses in Asia are subject to local capital requirements in the jurisdictions in which they operate. The Hong Kong business branch of PAC and its capital requirements are subsumed within those of the PAC long-term fund. For the other material Asian operations, the details of the basis of determining regulatory capital and regulatory capital requirements are as follows: Singapore In Singapore a risk-based regulatory framework applies rather than one based on a net premium approach.
For participating business, a gross premium reserve, determined using prudent best estimate assumptions and which makes allowance for future bonus, is held. The amount held is subject to a minimum of the higher of the assets attributed to participating business and a gross premium reserve calculated on specified assumptions, but without allowance for future bonus, that include prescribed provisions for adverse deviations (PADs). For non-participating business, gross premium reserves are held. For linked business the value of units is held together with a non-unit reserve calculated in accordance with standard actuarial methodology.
Indonesia Policy reserves for traditional business are determined on a modified net premium basis. The valuation interest rates are capped at nine per cent for local currency products and five per cent for foreign currency products. For linked business the value of units is held together with a non-unit reserve calculated in accordance with standard actuarial methodology. Solvency capital is determined using a risk-based capital approach. Insurance companies in Indonesia are expected to maintain the level of net assets above 120 per cent of solvency capital. Due to the 2008 financial crisis, the local regulator provided relief in solvency capital and the measure continues until further notice.
Vietnam Mathematical reserves are calculated using a modified net premium approach, using a stable set of assumptions agreed with the regulator. The capital requirement is determined as four per cent of reserves plus a specified percentage of 0.1 per cent of sums at risk for policies with original term less than or equal to five years or 0.3 per cent of sums at risk for policies with original term of more than five years. An additional capital requirement of Vietnamese Dong 200 billion is also required for companies transacting unit-linked business.
iv Group capital requirements In addition to the requirements at individual company level, FSA requirements under the IGD apply additional prudential requirements for the Group as a whole. Discussion of the Group’s estimated IGD position at 31 December 2010, together with market risk sensitivity disclosure provided to key management, is provided in the business review section of the Group’s 2010 Annual Report and in section C.
c Movements in total available capital Total available capital for the Group’s life assurance operations has changed during 2010 as follows: 2010 £m
Changes in management policy 364 – – – 364 Changes in regulatory requirements – – (60) – (60) New business and other factors (note v) 87 70 479 251 887
Detail on the movement for 2009 is as follows: 2009 £m
Changes in management policy – 26 – (101) (75) Changes in regulatory requirements – – 128 178 306 New business and other factors (note v) 1,052 505 (398) (360) 799
The decrease of £270 million in 2009 reflected an underlying increase of £33 million (applying the 2009 year end exchange rate of $1.61:£1)
v New business and other factors comprise the effect of changes in new business, valuation interest rate, investment return, foreign exchange and other factors.
d Transferability of available capital For PAC and all other UK long-term insurers, long-term business assets and liabilities must, by law, be maintained in funds separate from those for the assets and liabilities attributable to non-life insurance business or to shareholders. Only the ‘established surplus’, the excess of assets over liabilities in the long-term fund determined through a formal valuation, may be transferred so as to be available for other purposes. Distributions from the with-profits sub-fund to shareholders reflect the shareholders’ one-ninth share of the cost of declared policyholders’ bonuses. Accordingly, the excess of assets over liabilities of the PAC long-term fund is retained within that company. The retention of the capital enables it to support with-profits and other business of the fund by, for example, providing the benefits associated with smoothing and guarantees. It also provides investment flexibility for the fund’s assets by meeting the regulatory capital requirements that demonstrate solvency and by absorbing the costs of significant events or fundamental changes in its long-term business without affecting the bonus and investment policies. For other UK long-term business subsidiaries, the amounts retained within the companies are at levels which provide an appropriate level of capital strength in excess of the regulatory minimum.
Revenue of consolidated investment funds* 11 – – 11 102 NPH broker-dealer fees† – 369 – 369 317
Charges (excluding revenue of consolidated investment funds and NPH broker-dealer fees) (617) (207) (179) (1,003) (744)
† NPH broker-dealer fees represents commissions received and then paid to the writing broker on sales of investment products. ‡ Short-term fluctuations for M&G are primarily in respect of unrealised value movements on Prudential Capital’s bond portfolio. § Included within Asian asset management charges of £179 million are £60 million of commissions (2009: £57 million).
b M&G operating profit based on longer-term investment returns: Asset management fee income 612 457 Other income 3 13 Staff costs (263) (205) Other costs (123) (100)
Underlying profit before performance-related fees 229 165 Performance-related fees 17 12
Operating profit from asset management operations 246 177 Operating profit from Prudential Capital 38 61
LIABILITIES Core structural borrowing of shareholder-financed operations 250 – – 250 – Intra Group debt represented by operational borrowings at
Group levelnote iv 2,560 – – 2,560 2,038 Net asset value attributable to external holders of consolidated unit trusts and similar fundsnote v 458 – – 458 410
The M&G loans of £1,418 million (2009: £1,413 million) relate to loans and receivables managed by Prudential Capital. These assets are generally secured but have no external credit ratings. Internal ratings prepared by the Group’s asset management operations as part of the risk management process, are £213 million A+ to A– (2009: £92 million), £873 million BBB+ to BBB– (2009: £835 million), £219 million BB+ to BB– (2009: £330 million) and £113 million B+ to B– (2009: £156 million).
iii M&G includes those assets and liabilities in respect of Prudential Capital. iv Intra Group debt represented by operational borrowings at Group level
E2: STATEMENT OF FINANCIAL POSITION FOR ASSET MANAGEMENT OPERATIONS > CONTINUED
Net cash outflow from operating activities (124) (21) (3) (148) Realised gains in the year 34 – – 34 Unrealised gains and losses and exchange movements in the year (48) (4) (4) (56)
AT 31 DECEMBER 2010 Total investments (including derivative assets) 3,203 23 56 3,282 Less: Derivative liabilitiesnote G3 (78) – – (78)
E4: SENSITIVITY OF PROFIT AND EQUITY TO MARKET AND OTHER FINANCIAL RISK
ii Other sensitivities to other financial risks for asset management operations The principal sensitivities to other financial risk of asset management operations are credit risk on the bridging loan portfolio (as described in note E2) of the Prudential Capital operation and the indirect effect of changes to market values of funds under management. Due to the nature of the asset management operations there is limited direct sensitivity to movements in interest rates. Total debt securities held at 31 December 2010 by asset management operations were £1,574 million (2009: £1,164 million), the majority of which are held by the Prudential Capital operation. Debt securities held by M&G and Prudential Capital are in general variable rate bonds and so market value is limited in sensitivity to interest rate movements and consequently any change in interest rates would not have a material impact on profit or shareholder’s equity. Asset management operations do not hold significant investments in property or equities.
Other operations consist of unallocated corporate activities relating to Group Head Office and the Asia regional head office, with net income and expenditure for the year of negative £450 million (2009: negative £395 million) as detailed in note B1. An analysis of the assets and liabilities of other operations is shown in note B6.
Earned premiums, net of reinsurance 6,243 11,734 6,234 – – – 24,211 – 24,211
Total revenue, net of reinsurance 20,850 16,286 9,117 954 598 251 48,056 (410) 47,646
Movement in unallocated surplus of with-profits fundsnote iv 70 – (315) – – – (245) – (245)
Acquisition costs and other operating expenditurenote F3 (1,093) (395) (1,662) (628) (576) (179) (4,533) (266) (4,799)
Operating profit based on longer-term investment returnsnote iii 719 833 532 284 22 72 2,462 (521) 1,941
Costs of terminated AIA transaction – – – – – – – (377) (377) Gain on dilution of holding in PruHealth
Acquisition costs and other operating expenditurenote F3 (1,508) (383) (1,536) (505) (496) (162) (4,590) 18 (4,572)
Finance costs: interest on core structural borrowings of shareholder-financed operations – (13) – – – – (13) (196) (209)
Tax charge attributable to policyholders’ returns (750) – (68) – – – (818) – (818)
Operating profit based on longer-term investment returnsnote iii 657 618 410 238 4 55 1,982 (418) 1,564
Short-term fluctuations in investment returns on shareholder-backed business 108 (132) 31 70 – – 77 (200) (123)
Shareholders’ share of actuarial and other gains and losses on defined benefit pension schemes (46) – – (14) – – (60) (14) (74)
(incorporating related amortisation of deferred acquisition costs) and include it in short-term fluctuations. The 2009 comparatives have been amended accordingly. Note A4d(ii) explains the effect of the change.
INVESTMENT RETURN Realised and unrealised gains and losses on securities at fair value through profit and loss 14,728 18,175 Realised and unrealised losses and gains on derivatives at fair value through profit and loss (891) 1,164 Realised losses on available-for-sale securities, previously recognised in other comprehensive income (51) (420) Realised losses on loans (12) (115) Interestnotes i,ii 5,976 5,575
Notes i The segmental analysis of interest income is as follows: Insurance operations: Asset management operations: US – 2
Unallocated corporate 50 10 ii Interest income includes £21 million (2009: £17 million) accrued in respect of impaired securities. iii Fee income includes £11 million (2009: £1 million) relating to financial instruments that are not held at fair value through profit and loss. These fees primarily related to prepayment fees, late fees and syndication fees.
Revenue from external customers: Unallocated corporate – – 29 – 29 Intragroup revenue eliminated on consolidation (77) (72) (175) 324 –
Total revenue from external customers 6,544 12,235 7,098 – 25,877 2009 £m
Revenue from external customers: Unallocated corporate – – 12 – 12 Intragroup revenue eliminated on consolidation (70) (67) (145) 282 –
Acquisition costs incurrednotes i,ii 2,024 1,796 Acquisition costs deferred less amortisation of acquisition costs (918) (763) Administration costs and other expenditure 3,496 2,924 Movements in amounts attributable to external unit holdersnote v 197 615
ii There were no fee expenses relating to financial liabilities held at amortised cost included in acquisition costs in 2010 and 2009. iii The total depreciation and amortisation expense is £309 million (2009: £377 million). Of this amount, £226 million (2009: £305 million) relates to amortisation of deferred acquisition costs of insurance contracts and asset management contracts, which is primarily borne by the insurance operations. The segmental analysis of total depreciation and amortisation expense is as follows: Insurance operations: Asset management operations: TOTAL SEGMENT 301 367
Unallocated corporate 8 10 iv Interest expense, excluding interest on core structural borrowings of shareholder-financed operations, amounted to £113 million (2009: £89 million) and is included within total acquisition costs and other operating expenditure as part of investment management expenses. The segmental analysis of this interest expense is as follows: Insurance operations: Asset management operations: M&G 19 – US – – Asia – –
vi The total amounts for acquisition costs and other expenditure shown above includes Corporate Expenditure shown in note B1 (Segment disclosure – income statement). The charge for Corporate Expenditure comprises: Group head office: Regular and project costs (147) (140) Provision for property leases and other non-recurrent items (25) (6)
Asia regional office: Gross costs (90) (95) Recharges to Asia operations 42 38
F4: FINANCE COSTS: INTEREST ON CORE STRUCTURAL BORROWINGS OF SHAREHOLDER-FINANCED OPERATIONS
Finance costs consist of £244 million (2009: £196 million) interest on core debt of the parent company and £13 million (2009: £13 million) on US insurance operations’ surplus notes.
The current tax charge of £91 million includes £13 million for 2010 (2009: charge of £6 million) in respect of the tax charge for Hong Kong. The Hong Kong current tax charge is calculated as 16.5 per cent for all periods on either (i) five per cent of the net insurance premium or (ii) the estimated assessable profits, depending on the nature of the business written. The total tax charge of £636 million for 2010 (2009: charge of £873 million) comprises a charge of £313 million (2009: charge of £895 million) for UK tax and a charge of £323 million (2009: credit of £22 million) for overseas tax. This tax charge comprises tax attributable to policyholders and unallocated surplus of with-profits funds, unit-linked policies and shareholders. The tax charge attributable to shareholders of £25 million for 2010 (2009: charge of £55 million) comprises a credit of £187 million (2009: charge of £176 million) for UK tax and a charge of £212 million (2009: credit of £121 million) for overseas tax. The tax charge attributable to shareholders’ returns includes an exceptional tax credit of £158 million which primarily relates to the impact of a settlement agreed with the UK Tax authorities. This exceptional tax credit is recorded within ‘Adjustments in respect of prior years’. In addition, adjustments in respect of prior years also includes other changes that arose as a result of routine revision of tax returns.
ii Overview For the purposes of explaining the relationship between tax expense and accounting profit, it is appropriate to consider the sources of profit and tax by reference to those that are attributable to shareholders and policyholders, as follows: Attributable to shareholders
Due to the requirements of the financial reporting standards IAS 1 and IAS 12, the profit (loss) before tax and tax charge reflect the aggregate of amounts that are attributable to shareholders and policyholders. Profit (loss) before tax comprises profit attributable to shareholders and pre-tax profit attributable to policyholders of linked and with-profits funds and unallocated surplus of with-profits funds. The total tax charge for linked and with-profits business includes tax expense on unit-linked and with-profits funds attributable to policyholders, the unallocated surplus of with-profits funds and the shareholders’ profits. This feature arises from the basis of taxation applied to life and pension business, principally in the UK, but with similar bases applying in certain Asian operations, and is explained in note (iii) below. Furthermore, the basis of preparation of Prudential’s financial statements incorporates the additional feature that, as permitted under IFRS 4, the residual equity of the Group’s with-profits funds, i.e. unallocated surplus, is recorded as a liability with transfers to and from that liability reflected in pre-tax profits. This gives rise to anomalous effective tax rates for profits attributable to policyholders (as described in note (iv) below). In meeting the reconciliation requirements set out in paragraph 81(c) of IAS 12, the presentation shown in this disclosure note seeks to ensure that the explanation of the relationship between tax expense and accounting profit draw properly the distinction between the elements of the profit and tax charge that are attributable to policyholders and shareholders as explained below in notes (iv) and (v) respectively. Due to the nature of the basis of taxation of UK life and pension business (as described in note (iii) below), and the significance of the results of the business to the Group, it is inappropriate to seek to explain the effective tax rate on profit before tax by the traditional approach that would apply for other industries. The shareholder elements are the components of the profit and tax charge that are of most direct relevance to investors, and it is this aspect that the IAS 12 reconciliation requirement is seeking to explain for companies that do not need to account for both with-profits and unit-linked funds, where tax is borne by the Company on the policyholders’ behalf and which is not contemplated by the IFRS requirement.
v Reconciliation of tax charge on profit attributable to shareholders for continuing operations: 2010 £m (except for tax rates)
Operating profit based on longer-term investment returnsnote iii 22% 35% 28% 28% 29% Short-term fluctuations in investment returns 25% 35% 28% 28% 52% Shareholders’ share of actuarial and other gains and losses on defined benefit pension schemes – – 28% 28% 20% Cost of terminated AIA transaction – – – 28% 28% Gain on dilution of holding in PruHealth – – 28% – 28%
Expected tax (charge) credit based on expected tax rates: Operating profit based on longer-term investment returnsnote iii (117) (292) (201) 40 (570) Short-term fluctuations in investment returns (29) 132 (32) (7) 64 Shareholders’ share of actuarial and other gains and losses on defined benefit pension schemes – – 1 1 2 Cost of terminated AIA transaction – – – 106 106 Gain on dilution of holding in PruHealth – – (8) – (8)
Operating profit based on longer-term investment returns (58) (249) (183) 277 (213) Short-term fluctuations in investment returns (8) 132 (32) – 92 Shareholders’ share of actuarial and other gains and losses on defined benefit pension schemes – – 1 2 3 Cost of terminated AIA transaction – – – 93 93 Gain on dilution of holding in PruHealth – – – – –
* The tax charge attributable to shareholders’ return includes an exceptional tax credit of £158 million which primarily relates to the impact of a settlement agreed with the UK tax authorities.
Expected tax (charge) credit based on expected tax rates: Operating profit based on longer-term investment returnsnote iii (98) (216) (184) 34 (464) Short-term fluctuations in investment returns (8) 46 (30) 47 55 Shareholders’ share of actuarial and other gains and losses on defined benefit pension schemes – – 13 8 21 Loss on sale and results for Taiwan agency business 155 – – – 155
Operating profit based on longer-term investment returnsnote iii 35 76 (29) 8 90 Short-term fluctuations in investment returns 15 196 – 14 225 Shareholders’ share of actuarial and other gains and losses on defined benefit pension schemes – – – – – Loss on sale and results for Taiwan agency business (137) – – – (137)
Actual tax rate: Operating profit based on longer-term investment returns 15% 23% 32% 35% 24%
* The Group has amended the presentation of operating profit for its US insurance operations to remove the net equity hedge accounting effect (incorporating related amortisation of deferred acquisition costs) and include it in short-term fluctuations. The 2009 comparatives have been amended accordingly. Note A4d(ii) explains the effect of the change.
• The expected tax rate for Other operations reflects the mix of business between UK and overseas operations, which are taxed at a variety of rates. The rates will fluctuate from year to year dependent on the mix of profits.
(c) UK insurance operations For 2010, routine revisions to prior period tax returns. For 2009, adjustments in respect of prior year tax charge and different tax bases of
ASIAN OPERATIONS Policyholder returns Assets backing unit-linked liabilities 1,279 2,539 With-profits business 1,039 1,519
US OPERATIONS Policyholder returns Assets held to back (separate account) unit-linked liabilities 3,520 3,760
Shareholder returns Prudential Retirement Income Limited (PRIL) 1,717 1,827 Other business 834 1,113
Changes in shareholder investment returns for US operations reflect primarily movements in the investment income, movements in the value of the derivative instruments held to manage the general account assets and liability portfolio, and realised gains and losses. However, separately reflecting Jackson’s types of business an allocation is made to policyholders through the application of crediting rates. The shareholder investment return for US operations also includes the fair value movement of the derivatives and the movement on the related liabilities of the variable annuity guarantees under Jackson’s dynamic hedging programme. The majority of the investments held to back the US non-participating business are debt securities for which the available-for-sale designation is applied for IFRS basis reporting. Under this designation the return included in the income statement reflects the aggregate of investment income and realised gains and losses (including impairment losses). However, movements in unrealised appreciation or depreciation are recognised in other comprehensive income. The return on these assets is attributable to shareholders.
F7: BENEFITS AND CLAIMS AND MOVEMENTS IN UNALLOCATED SURPLUS OF WITH-PROFITS FUNDS,
Increase in policyholder liabilities (6,230) (9,193) (8,432) (23,855) Movement in unallocated surplus of with-profits funds 334 – (1,893) (1,559)
Equity securities and portfolio holdings in unit trusts 86,635 – – 86,635 86,635
FINANCIAL ASSETS Cash and cash equivalents – – 5,307 5,307 5,307
Other investmentsnote iii 5,132 – – 5,132 5,132 Accrued investment income – – 2,473 2,473 2,473 2009 £m
FINANCIAL LIABILITIES Core structural borrowings of shareholder-financed operationsnotes i,H13 – 3,394 – 3,394 3,424 Operational borrowings attributable to shareholder-financed operationsH13 – 2,751 – 2,751 2,751 Borrowings attributable to with-profits fundsH13 105 1,179 – 1,284 1,281 Obligations under funding, securities lending and sale and repurchase agreements – 3,482 – 3,482 3,540 Net asset value attributable to unit holders of consolidated unit trust and similar funds 3,809 – – 3,809 3,809 Investment contracts with discretionary participation featuresnote iv – – 24,880 24,880 – Investment contracts without discretionary participation features 13,840 1,965 – 15,805 15,866
Notes i As at 31 December 2010, £685 million (2009: £659 million) of convertible bonds were included in debt securities and £352 million
(2009: £347 million) were included in borrowings. ii Loans and receivables are reported net of allowance for loan losses of £52 million (2009: £44 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 2010 and 2009.
Determination of fair value The fair values of the financial assets and liabilities as shown in the table above have been determined on the following bases. The fair values of the financial instruments for which fair valuation is required under IFRS are determined by the use of current market bid prices for exchange-quoted investments, or by using quotations from independent third-parties, such as brokers and pricing services or by using appropriate valuation techniques. Investments valued using valuation techniques include financial investments which by their nature do not have an externally quoted price based on regular trades and financial investments for which markets are no longer active as a result of market conditions, e.g. market illiquidity. The valuation techniques used include comparison to recent arm’s length transactions, reference to other instruments that are substantially the same, discounted cash flow analysis, option adjusted spread models and, if applicable, enterprise valuation. These techniques may include a number of assumptions relating to variables such as credit risk and interest rates. Changes in assumptions relating to these variables could positively or negatively impact the reported fair value of these instruments. When determining the inputs into the valuation techniques used priority is given to publicly available prices from independent sources, when available, but overall the source of pricing is chosen with the objective of arriving at a fair value measurement which reflects the price at which an orderly transaction would take place between market participants on the measurement date. The fair value estimates are made at a specific point in time, based upon available market information and judgements about the financial instruments, including estimates of the timing and amount of expected future cash flows and the credit standing of counterparties. Such estimates do not reflect any premium or discount that could result from offering for sale at one time the Group’s entire holdings of a particular financial instrument, nor do they consider the tax impact of the realisation of unrealised gains or losses from selling the financial instrument being fair valued. In some cases the disclosed value cannot be realised in immediate settlement of the financial instrument. The loans and receivables have been shown net of provisions for impairment. The fair value of loans has been estimated from discounted cash flows expected to be received. The rate of discount used was the market rate of interest. The estimated fair value of derivative financial instruments reflects the estimated amount the Group would receive or pay in an arm’s length transaction. This amount is determined using quoted prices if exchange listed, quotations from independent third-parties or valued internally using standard market practices. In accordance with the Group’s risk management framework, all internally generated valuations are subject to assessment against external counterparties’ valuations.
Level 2: Inputs other than quoted prices included within level 1 that are observable either directly (i.e. as prices) or indirectly (i.e. derived from prices) Level 2 principally includes corporate bonds and other non-national government debt securities which are valued using observable inputs, together with over-the-counter derivatives such as forward exchange contracts and non-quoted investment funds valued with observable inputs. It also includes net assets attributable to unit-holders of consolidated unit trusts and similar funds and investment contract liabilities that are valued using observable inputs. The nature of Prudential’s operations in the US and the UK mean that a significant proportion of the assets backing non-linked shareholder-backed business are held in corporate bonds, structured securities and other non-national government debt securities. These assets, in line with market practice, are generally valued using independent pricing providers in the US and third-party broker quotes in the UK and Asia either directly or via third-parties, such as IDC or Bloomberg. Such assets are generally classified as level 2 as the nature of these quotations means that they do not strictly meet the definition of level 1 assets. These valuations are determined using independent external quotations from multiple sources and are subject to a number of monitoring controls, such as monthly price variances, stale price reviews and variance analysis on prices achieved on subsequent trades. Pricing services, where available, are used to obtain the third-party broker quotes. Where pricing services providers are used, a single valuation is obtained and applied.
UNIT-LINKED AND VARIABLE ANNUITY SEPARATE ACCOUNT Equity securities and portfolio holdings in unit trusts 54,272 2 – 54,274 Debt securities 3,784 5,268 2 9,054 Other investments (including derivative assets) 43 88 – 131 Derivative liabilities – – – –
Total financial investments, net of derivative liabilities 58,099 5,358 2 63,459 Investment contracts without discretionary participation features held at fair value – (13,841) – (13,841) Net asset value attributable to unit holders of consolidated unit trusts and similar funds (1,360) – – (1,360)
NON-LINKED SHAREHOLDER-BACKED Loans – 227 – 227 Equity securities and portfolio holdings in unit trusts 808 21 161 990 Debt securities 10,389 43,305 343 54,037 Other investments (including derivative assets) 52 1,146 563 1,761 Derivative liabilities (80) (1,049) (201) (1,330)
Total financial investments, net of derivative liabilities 11,169 43,650 866 55,685 Investment contracts without discretionary participation features held at fair value – (1,981) – (1,981) Net asset value attributable to unit holders of consolidated unit trusts and
Total financial investments, net of derivative liabilities 110,138 92,245 4,573 206,956 Borrowings attributable to the with-profits fund held at fair value – (82) – (82) Investment contracts without discretionary participation features held at fair value – (15,822) – (15,822) Net asset value attributable to unit holders of consolidated unit trusts and
WITH-PROFITS Equity securities and portfolio holdings in unit trusts 28,688 799 475 29,962
Total financial investments, net of derivative liabilities 35,776 40,545 3,833 80,154 Borrowings attributable to the with-profits fund held at fair value – (105) – (105) Net asset value attributable to unit holders of consolidated unit trusts and
NON-LINKED SHAREHOLDER-BACKED Equity securities and portfolio holdings in unit trusts 557 36 179 772
GROUP TOTAL Equity securities and portfolio holdings in unit trusts 67,861 839 654 69,354
Total financial investments, net of derivative liabilities 84,180 84,999 5,557 174,736 Borrowings attributable to the with-profits fund held at fair value – (105) – (105) Investment contracts without discretionary participation features held at fair value – (13,840) – (13,840) Net asset value attributable to unit holders of consolidated unit trusts and
Reconciliation of movements in level 3 financial instruments measured at fair value The following tables reconcile the value of level 3 financial instruments at 1 January 2010 to that presented at 31 December 2010 and at 1 January 2009 to that presented at 31 December 2009. Total gains and losses recorded in the income statement in the year represents realised gains and losses, including interest and dividend income unrealised gains and losses on financial instruments classified at fair value through profit and loss and foreign exchange movements on an individual entity’s overseas investments. All these amounts are included within ‘investment return’ within the income statement. Total gains and losses recorded in other comprehensive income includes unrealised gains and losses on debt securities held as available-for-sale within Jackson and foreign exchange movements arising from the retranslation of the Group’s overseas subsidiaries and branches. The transfers out from level 3 during 2010 comprise mainly transfers within the Jackson’s portfolio. Certain broker-priced assets of Jackson were previously classified as level 3 holdings as a result of illiquidity in the market and the resultant lack of observability into the assumptions used to produce those fair values. During 2010, as a result of ongoing consideration regarding the use of assumptions by pricing sources and the changes in the level of observability of these inputs over recent periods, Jackson determined that these assets would be more appropriately categorised as level 2. As a result, Jackson transferred debt securities of £606 million and derivative assets of £101 million from level 3 to level 2. The remaining transfers out of level 3 of the Group are primarily debt securities reclassifications from level 3 to level 2 which reflect improving liquidity during the period. The transfers out from level 3 during 2009 included a transfer of £2,072 million from level 3 to level 2 in respect of structured securities of Jackson. At 31 December 2008, Jackson had utilised internal valuations for certain structured securities given the illiquidity of the market at that time. These assets had therefore been classified as level 3 given the unobservable nature of assumptions within the internal valuation models used. During the first half of 2009, improvements were observed in the level of liquidity for these structured securities such that external prices based on observable inputs from pricing services or brokers were used to value nearly all of the structured securities at 31 December 2009. The remaining transfers in and out of level 3 in 2009 represented sundry individual asset reclassifications, none of which are materially significant as highlighted in the table below.
Total financial investments, net of derivative liabilities 3,833 190 23 435 (529) (34) 11 (224) 3,705
Net asset value attributable to unit holders of consolidated unit trusts and similar funds (323) (32) – 9 – – – – (346)
Net asset value attributable to unit holders of consolidated unit trusts and similar funds (2) – – – – – – 2 –
Total financial investments, net of derivative liabilities 1,684 102 108 205 (452) (27) 63 (817) 866
Total financial investments, net of derivative liabilities 5,557 292 134 642 (985) (79) 74 (1,062) 4,573
Net asset value attributable to unit holders of consolidated unit trusts and similar funds (367) (49) (1) (7) 43 – – 2 (379)
Other investments (including derivative assets) 2,122 (211) (89) 403 (55) – – – 2,170
Other investments (including derivative assets) 692 130 (76) 153 (308) – 43 (2) 632
Total financial investments, net of derivative liabilities 4,760 161 (675) 214 (813) (2) 242 (2,203) 1,684 Net asset value attributable to unit holders of consolidated unit trusts and similar funds (65) 17 6 – – – – – (42)
GROUP TOTAL Equity securities and portfolio holdings in unit trusts 827 (50) (35) 47 (111) – – (24) 654
Total financial investments, net of derivative liabilities 8,766 (67) (775) 709 (1,172) (27) 384 (2,261) 5,557 Net asset value attributable to unit holders of consolidated unit trusts and similar funds (446) 26 6 48 – – (1) – (367)
Of the total gains and losses in the income statement in 2010 of £243 million gains, £315 million relates to financial instruments still held at the end of the year, which can be analysed as £18 million for equity securities, £110 million for debt securities, £243 million for other investments, £(6) million for derivative liabilities and £(50) million for net asset value attributable to unit holders of consolidated unit trusts and similar funds. Of the total gains and losses in the income statement in 2009 of £41 million losses, £(205) million relates to financial instruments still held at the end of the year, which can be analysed as £41 million losses for equity securities, £44 million losses for debt securities, £221 million losses for other investments, £76 million gains for derivative liabilities and £25 million gains for net asset value attributable to unit holders of consolidated unit trusts and similar funds.
Interest income and expense The interest income on financial assets not at fair value through profit and loss for the year ended 31 December 2010 from continuing operations was £1,994 million (2009: £1,998 million). The interest expense on financial liabilities not at fair value through profit and loss for the year ended 31 December 2010 from continuing operations was £427 million (2009: £366 million).
FINANCIAL LIABILITIES Core structural borrowings of shareholder-financed operations 3,676 – – 3,676 Operational borrowings attributable to shareholder-financed operations 2,624 377 3 3,004 Borrowings attributable to with-profits funds 679 710 133 1,522 Obligations under funding, securities lending and sale and repurchase agreements 631 3,568 – 4,199 Investment contracts without discretionary participation features 988 894 15,822 17,704
Liquidity analysis i) Contractual maturities of financial liabilities The following table sets out the contractual maturities for applicable classes of financial liabilities, excluding derivative liabilities and investment contracts that are separately presented. The financial liabilities are included in the column relating to the contractual maturities at the undiscounted cash flows (including contractual interest payments) due to be paid assuming conditions are consistent with those of year end.
FINANCIAL LIABILITIES Core structural borrowings of shareholder-financed operationsH13 3,676 164 861 731 1,314 835 1,244 1,469 6,618 Operational borrowings attributable to shareholder-financed operationsH13 3,004 2,510 561 3 3 3 10 – 3,090 Borrowings attributable to with-profits fundsH13 1,522 155 1,051 161 2 2 121 182 1,674 Obligations under funding, securities lending and sale and repurchase agreements 4,199 4,199 – – – – – – 4,199
Net asset value attributable to unit holders of consolidated unit-trusts and similar funds 3,372 3,372 – – – – – – 3,372
The net derivative positions as shown in the table above comprise the following derivative assets and liabilities: Derivative assets 2,039 1,780 Derivative liabilities (2,037) (1,501)
The majority of derivative assets and liabilities have been included at fair value within the one year or less column representing the basis on which they are managed (i.e. to manage principally asset or liability value exposures). Contractual maturities are not considered essential for an understanding of the timing of the cash flows for these instruments and in particular the Group has no cash flow hedges. The only exception is certain identified interest rate swaps which are fully expected to be held until maturity solely for the purposes of matching cash flows on separately held assets and liabilities. For these instruments the undiscounted cash flows (including contractual interest amounts) due to be paid under the swap contract assuming conditions are consistent with those at year end are included in the column relating to the contractual maturity of the derivative. The table below shows the maturity profile for investment contracts on an undiscounted basis to the nearest billion. This maturity profile has been based on the cash flow projections of expected benefit payments as part of the determination of the value of in-force business when preparing EEV basis results.
Most investment contracts have options to surrender early, albeit these are often subject to surrender or other penalties. It is therefore the case that most contracts could be said to have a contractual maturity of less than one year, but in reality the additional charges and term of the contracts means these are unlikely to be exercised in practice and the more useful information is to present information on expected payment. The maturity profile above excludes certain corporate unit-linked business with gross policyholder liabilities of £11 billion (2009: £9 billion) which has no stated maturity but which is repayable on demand. 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 statement of financial position. Durations of long-term business contracts, covering insurance and investment contracts, on a discounted basis are included in section D. The vast majority of the Group’s financial assets are held to back the Group’s policyholder liabilities. Although asset/liability matching is an important component of managing policyholder liabilities (both those classified as insurance and those classified as investments), this profile is mainly relevant for managing market risk rather than liquidity risk. Within each business unit this asset/ liability matching is performed on a portfolio by portfolio basis.
Currency risk As at 31 December 2010, the Group held 18 per cent (2009: 19 per cent) and 14 per cent (2009: 13 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. The financial assets, of which 70 per cent (2009: 74 per cent) are held by the PAC with-profits fund, allow the PAC with-profits fund to obtain exposure to foreign equity markets. The financial liabilities, of which 28 per cent (2009: 34 per cent) are held by the PAC with-profits fund, mainly relate to foreign currency borrowings.
The notional amount of the derivatives, distinguishing between UK insurance and US operations, was as follows: 2010 £m
US insurance operations Notional amount on which future payments are based
Inflation swaps 2,337 2,205 – – Credit default swaps 90 12 – – Credit derivatives – – – 189 Put options – – 9,072 –
Securities lending and reverse repurchase agreements The Group has entered into securities lending (including repurchase agreements) whereby blocks of securities are loaned to thirdparties, primarily major brokerage firms. The amounts above the fair value of the loaned securities required to be held as collateral by the agreements depend on the quality of the collateral, calculated on a daily basis. The loaned securities are not removed from the Group’s consolidated statement of financial position, rather they are retained within the appropriate investment classification. Collateral typically consists of cash, debt securities, equity securities and letters of credit. At 31 December 2010, the Group had lent £8,708 million (2009: £10,501 million) of which £6,488 million (2009: £7,910 million) was lent by the PAC with-profits fund of securities and held collateral under such agreements of £9,334 million (2009: £10,669 million) of which £6,910 million (2009: £8,086 million) was held by the PAC with-profits fund. At 31 December 2010, 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 £1,208 million (2009: £1,587 million), together with accrued interest.
Collateral and pledges under derivative transactions At 31 December 2010, the Group had pledged £800 million (2009: £644 million) for liabilities and held collateral of £804 million (2009: £586 million) in respect of over-the-counter derivative transactions.
b Deferred acquisition costs and other intangible assets attributable to shareholders The deferred acquisition costs and other intangible assets in the Group consolidated statement of financial position attributable to shareholders comprise: Deferred acquisition costs (DAC) related to insurance contracts as classified under IFRS 4 4,316 3,823 Deferred acquisition costs related to investment management contracts, including life assurance contracts classified as financial instruments and investment management contracts under IFRS 4 110 107
Dilution of holding in PruHealth (7) – – – – (7) – DAC movement on sale of Taiwan agency business – – – – – – (436)
Deferred acquisition costs related to insurance contracts attributable to shareholders The movement in deferred acquisition costs relating to insurance contracts attributable to shareholders is as follows: DEFERRED ACQUISITION COSTS AT 1 JANUARY 3,823 5,097
Present value of acquired in-force business of long-term business contracts attributable to shareholders The present value of acquired in-force business (PVAIF) relating to investment contracts without discretionary participation features represents the contractual right to benefit from providing these investment management services in the future. The fair value is measured as the present value of the future profits of the investment management component of these contracts. These contracts are accounted for under the provisions of IAS 18. The PVAIF balance relating to insurance contracts is accounted for under UK GAAP as permitted by IFRS 4. The present value of future profits of acquired investment management contracts which was fully amortised during the year related to unit-linked contracts acquired as part of the M&G acquisition in 1999. Amortisation is charged to the ‘acquisition costs and other operating expenditure’ line in the income statement over the period of provision of asset management services as those profits emerge.
Acquisition of UOB Life Assurance Ltd(note I1) 12 – – – Exchange differences 10 – (6) –
All the goodwill relates to the UK insurance operations segment. The venture fund investments consolidated by the Group relates to investments by PAC with-profits fund managed by M&G. The goodwill shown in the table above relates to these venture fund investments. Goodwill is tested for impairment for these investments by comparing the investment’s carrying value including goodwill with its recoverable amount. The recoverable amount of the investments is determined by calculating their fair value less costs to sell. The fair value is determined by using a discounted cash flow valuation. The valuations are based on cash flow projections to 2015 prepared by management after considering the historical experience and future growth rates of the business. The key assumption applied in the calculations is the risk discount rate ranging from 10 to 14 per cent derived by reference to risk-free rates and an equity premium risk. In 2010, no goodwill was deemed to be impaired following the impairment testing carried out. In 2009, following the impairment testing carried out, £50 million of the goodwill was deemed to be impaired. In 2009, the impairment charge was recorded under ‘acquisition costs and other expenditure’ but was also taken account of in determining the charge/credit in the income statement for the transfer to the liability for unallocated surplus of with-profits funds. Accordingly, the charge did not affect shareholders’ profits or equity.
b Deferred acquisition costs and other intangible assets Other intangible assets in the Group consolidated statement of financial position attributable to with-profits funds consist of: Deferred acquisition costs related to insurance contracts attributable to the PAC with-profits fund 13 9 Distribution rights attributable to with-profits funds of the Asian insurance operations 97 97
Deferred acquisition costs related to insurance contracts attributable to the PAC with-profits fund The movement in deferred acquisition costs relating to insurance contracts attributable to the PAC with-profits fund is as follows: Additions 9 – Amortisation charge (5) (4)
The above costs relate to non-participating business written by the PAC with-profits sub-fund. No deferred acquisition costs are established for the participating business.
The deferred tax asset at 31 December 2010 and 2009 arises in the following parts of the Group: UK insurance operations: PAC with-profits fund (including PAL) 108 141
Unrealised gains on investments 1,678 1,744 Balances relating to investment and insurance contracts 1,057 961 Short-term timing differences 1,477 1,159 Capital allowances 12 8
Of the £3,571 million (2009: £3,235 million) of accrued investment income and other debtors, £151 million (2009: £134 million) is expected to be settled after one year or more.
Property, plant and equipment comprise Group occupied properties, development property (until 2009) 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 property £m
YEAR ENDED 31 DECEMBER 2009 Opening net book amount 263 131 241 635
NET BOOK AMOUNT 173 – 439 612 * In line with the 2008 IASB Annual Improvements Project, all development properties were reclassified as investment properties with effect from
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: Reclassification of development property* – 131 Additions: Resulting from acquisitions 267 184 Resulting from expenditure capitalised 44 133 Resulting from acquisitions through business combinations – 1 Disposals (including amounts disposed of with the Taiwan agency business) (390) (1,220) Net gain (loss) from fair value adjustments 636 (203) Net foreign exchange differences 38 (113) Transfers to held for sale assets (254) – Transfers to owner occupied properties 1 –
* In line with changes issued by the IASB as part of its Annual Improvement Project in May 2008 (as shown in note H6) all development properties with a total cost of £131 million have been reclassified as investment properties at 1 January 2009. At this date these investments had a fair value of £152 million. The initial gain of £21 million is included as part of ‘net loss from fair value adjustments’.
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. There was no contingent rent recognised as income or expense in 2010 and 2009. The Group’s policy is to rent investment properties to tenants through operating leases. Minimum future rentals to be received on non-cancellable operating leases are receivable in the following periods: Less than 1 year 601 662
The total minimum future rentals to be received on non-cancellable sub-leases for land and buildings at 31 December 2010 are £3,366 million (2009: £3,684 million).
Associates accounted for using the equity method A summary of the movements in investments in associates accounted for using the equity method in 2010 and 2009 is set out below: Share of capital £m
Exchange translations and other movements (7) 4 (3) (1) (4) Share of loss for the year after tax – – – – –
Transfer of PruHealth to associates (note I2) 1 65 66 – 66 Acquisition/capital injection in PruHealth 9 – 9 – 9 Exchange translation and other movements (3) (1) (4) – (4) Share of loss for the year after tax – (6) (6) – (6)
There have been no changes recognised in the other comprehensive income of associates that would also be recognised in the other comprehensive income by the Group. The Group’s share of the assets, liabilities, revenues and profit and loss of associates accounted for using the equity method at 31 December 2010 and 2009 is as follows: FINANCIAL POSITION Total assets (excluding goodwill) 70 5 Total liabilities – –
CITIC Prudential Life Insurance Company Limited 50 Life assurance China CITIC Prudential Fund Management Company Limited 49 Asset management China Prudential ICICI Asset Management Company Limited 49 Asset management India Prudential BSN Takaful Berhad 49 General and life insurance Malaysia BOCI Prudential Asset Management Limited 36 Asset management China ICICI Prudential Life Insurance Company Limited 26 Life assurance India
Net profit (loss) 60 29 * The 2010 amounts include the Group’s share of PruHealth’s results for the seven months ended 31 July 2010. On 1 August 2010 the Group’s interest in PruHealth was diluted and the Group’s investment was reclassified as an associate (see note I2 and the note above).
There are several minor service agreements in place between the joint ventures and the Group. During 2010, the aggregate amount of the transactions was £29.7 million (2009: £14.1 million) and the balance outstanding as at 31 December 2010 was £69.5 million (2009: £54.6 million). The joint ventures have no significant contingent liabilities to which the Group is exposed nor does the Group have any significant contingent liabilities in relation to its interest in the joint ventures.
Investment properties are classified as held for sale when contracts have been exchanged but the sale has not been completed at the period end. At 31 December 2010 the value of assets held for sale was £257 million (2009: £3 million). Gains on disposal of held for sale assets are recorded in ‘investment return’ within the income statement.
Cash and cash equivalents held centrally are considered to be available for general use by the Group. These funds amount to £523 million and £895 million at 31 December 2010 and 2009, respectively. The remaining funds are considered not to be available for general use by the Group, and include funds held for the benefit of policyholders.
Issued shares of 5p each fully paid: Shares issued under share option schemes 2,455,227 – 13 Shares issued in lieu of cash dividends 10,911,808 – 62 Reserve movements in respect of shares issued in lieu of cash dividends – – (62)
H11: SHAREHOLDERS’ EQUITY: SHARE CAPITAL, SHARE PREMIUM AND RESERVES > CONTINUED
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. Shares issued in lieu of cash dividends are considered to take the legal form of bonus issue shares and have been accounted for as such. At 31 December 2010, there were options outstanding under Save As You Earn schemes to subscribe for 12,802,482 (2009: 12,230,833) shares at prices ranging from 288 pence to 572 pence (2009: 266 pence to 572 pence) and exercisable by the year 2016 (2009: 2016). The cost of own shares of £75 million as at 31 December 2010 (2009: £75 million) is deducted from retained earnings. The Company has established trusts to facilitate the delivery of shares under employee incentive plans and savings-related share option schemes. At 31 December 2010, 4.5 million (2009: 5.3 million) Prudential plc shares with a market value of £30 million (2009: £34 million) were held in such trusts. Of this total, 4.4 million (2009: 4.8 million) shares were held in trusts under employee incentive plans. In 2010, the Company purchased 5.7 million (2009: 3.4 million) shares in respect of employee incentive plans at a cost of £32 million (2009: £17 million). The maximum number of shares held in the year was 5.3 million which was at the beginning of the year. Of the total shares held in trust, 0.1 million (2009: 0.5 million) shares were held by a qualifying employee share ownership trust. These shares are expected to be fully distributed in the future on maturity of savings-related share option schemes. The shares purchased each month are as follows: Share Price
January 19,852 3.83 3.94 76,575 February 19,926 3.52 3.52 70,140 March 1,112,209 2.02 3.50 3,837,968 April 22,164 3.38 3.38 74,859 May 32,416 4.45 6.59 173,242 June 26,594 4.44 7.31 145,230 July 342,062 3.86 4.30 1,374,929 August 14,059 4.85 4.85 68,144 September 12,435 5.50 5.50 68,393 October 10,332 6.34 6.34 65,453 November 10,576 6.04 6.04 63,879 December 1,739,591 6.06 6.35 10,941,847
The Group has consolidated a number of authorised investment funds where it is deemed to control these funds under IFRS. Some of these funds hold shares in Prudential plc. The total number of shares held by these funds at 31 December 2010 was 9.8 million (2009: 10.6 million) and the cost of acquiring these shares of £47 million (2009: £50 million) is included in the cost of own shares. The market value of these shares as at 31 December 2010 was £65 million (2009: £67 million).
During 2010 and 2009 respectively, these funds made 833,618 net disposals and 1,414,263 net acquisitions of Prudential shares for a net decrease of £3 million and a net increase of £3 million to book cost.
Income and expense included in the income statement 19,765 1,559 Foreign exchange translation differences (6,574) 46 Disposal of Taiwan agency business (3,508) –
US$1,000m 6.5% Perpetual Subordinated Capital Securities 639 639 619 US$250m 6.75% Perpetual Subordinated Capital Securitiesnote iii 160 160 155 US$300m 6.5% Perpetual Subordinated Capital Securitiesnote iii 192 192 192 US$750m 11.75% Perpetual Subordinated Capital Securities 472 472 456
Senior debt: PRUCAP £250m bank loan note iv 250 250 – JACKSON
ii The €20 million borrowings were issued at 20-year Euro Constant Maturity Swap (capped at 6.5 per cent). These have been swapped into borrowings of £14 million with interest payable at three month £LIBOR plus 1.2 per cent. iii The US$250 million 6.75 per cent borrowings and the US$300 million 6.5 per cent borrowings can be converted, in whole or in part, at the
iv The £250 million PruCap bank loan was made in two tranches: £135 million maturing in June 2014, currently drawn at a cost of six month £LIBOR plus 1.2 per cent and £115 million maturing in August 2012, currently drawn at a cost of twelve month £LIBOR plus 1.41 per cent.
v The Jackson borrowings are unsecured and subordinated to all present and future indebtedness, policy claims and other creditor claims of Jackson. vi Maturity analysis The following table sets out the contractual maturity analysis of the Group’s core structural borrowings: Less than 1 year – –
vi Maturity analysis The following table sets out the contractual maturity analysis of the Group’s operational borrowings attributable to shareholder-financed operations: Less than 1 year 2,496 2,183
Notes i In all instances the holders of the debt instruments issued by these funds do not have recourse beyond the assets of those funds. 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 following table sets out the contractual maturity analysis of the Group’s borrowings attributable to with-profits operations: Less than 1 year 96 33
Contingencies and related obligations Litigation regarding the Prudential Staff Pension Scheme (PSPS) and other matters The Company is currently awaiting the decision of the English High Court in a case that was heard in early 2011 involving PSPS. This case relates to the defined benefit section of PSPS and was heard at the request of the trustees of the scheme who are seeking to clarify the Company’s obligations relating to discretionary pension increases. In the event that the English High Court decides that the obligations relating to discretionary pension increases are greater than the Company currently believes, the assumptions applied for IAS 19 reporting purposes, and therefore the level of surplus of the Scheme may be affected. The Court decision might also affect the level of future deficit funding agreed concurrently with the next actuarial valuation as at 5 April 2011.
The impact of such changes on the deficit funding obligations of the shareholders’ funds of the Group would be determined in the context of the pre-existing features applicable to the PSPS scheme described below: (i) Although underlying surpluses of the scheme are not recognised for IAS 19 Group accounting purposes under IFRIC 14, the surplus determined on the actuarial valuation basis would be considered in the context of setting altered levels of future deficit funding, and
Pension mis-selling review The pensions review by the UK insurance regulator of past sales of personal pension policies required all UK life insurance companies to review their cases of potential mis-selling and record a provision for the estimated costs. The Group met the requirement of the FSA to issue offers to all cases by 30 June 2002. The table below summarises the change in the pension mis-selling provision for the years ended 31 December 2010 and 2009. The change in the provision is included in benefits and claims in the income statement and the movement in unallocated surplus of with-profits funds has been determined accordingly.
Balance at beginning of year 322 345 Changes to actuarial assumptions and method of calculation 37 20 Discount unwind 2 3 Redress to policyholders (46) (44) Payment of administrative costs (1) (2)
The pension mis-selling provision at 31 December 2010 set out above of £314 million is stochastically determined on a discounted basis. The average discount rate implied in the movement in the year is four per cent. The undiscounted amounts at 31 December 2010 expected to be paid in each of the years ending 31 December are as follows: 2010 £m
Mortgage endowment products review In common with several other UK insurance companies, the Group used to sell low-cost endowment products related to repayment of residential mortgages. At sale, the initial sum assured is set at a level such that the projected benefits, including an estimate of the annual bonus receivable over the life of the policy, will equal or exceed the mortgage debt. Because of a decrease in expected future investment returns since these products were sold, the FSA is concerned that the maturity value of some of these products will be less than the mortgage debt. The FSA has worked with insurance companies to devise a programme whereby the companies write to customers indicating whether they may have a possible shortfall and outline the actions that the customers can take to prevent this possibility. The Group is exposed to mortgage endowment products in respect of policies issued by Scottish Amicable Life plc (SAL) and the Scottish Amicable Life Assurance Society (SALAS) which were transferred into SAIF. At 31 December 2010, provisions of £2 million (2009: £4 million) in respect of the SAL policies and £20 million (2009: £35 million) in SAIF were held within policyholder liabilities to cover potential compensation in respect of mortgage endowment product mis-selling claims. As SAIF is a separate sub-fund of the Prudential Assurance long-term business fund, wholly attributable to the policyholders of the fund, this provision has no impact on shareholders. In addition, in the year ended 31 December 2010 Prudential Assurance’s main with-profits fund paid compensation of £2 million (2009: £2 million) in respect of mortgage endowment products mis-selling claims and at 31 December 2010 held a provision of £32 million (2009: £47 million) in respect of further compensation. The movement in this provision has no impact on the Group’s profit before tax. In May 2006, the Group introduced a deadline for both Prudential and Scottish Amicable mortgage endowment complaints. Impacted customers have three years to lodge a mis-selling complaint in line with the time limit prescribed by the FSA and the ABI.
Guaranteed annuities Prudential Assurance used to sell guaranteed annuity products in the UK and at 31 December 2010 held a provision of £24 million (2009: £31 million) within the main with-profits fund within policyholder liabilities to honour guarantees on these products. The Group’s main exposure to guaranteed annuities in the UK is through SAIF and at 31 December 2010 a provision of £336 million (2009: £284 million) was held in SAIF to honour the guarantees. As SAIF is a separate sub-fund of the Prudential Assurance long-term business fund, wholly attributable to the policyholders of the fund, the movement in this provision has no impact on shareholders.
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, included within other liabilities to be £16 million at 31 December 2010 (2009: £15 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. At 31 December 2010, Jackson has unfunded commitments of £363 million (2009: £339 million) related to its investments in limited partnerships and of £88 million (2009: £89 million) related to commercial mortgage loans. These commitments were entered into in the normal course of business and the directors do not expect a material adverse impact on the operations to arise from them. Jackson owns debt instruments issued by securitisation trusts managed by PPM America. At 31 December 2010, the support provided by certain forbearance agreements Jackson entered into with the counterparty to certain of these trusts could potentially expose Jackson to maximum losses of £332 million, if circumstances allowed the forbearance period to cease. Jackson believes that, so long as the forbearance period continues, the risk of loss under the agreements is remote. The Group has provided other guarantees and commitments to third-parties entered into in the normal course of business but the Company does not consider that the amounts involved are significant.
Creditors arising from direct insurance and reinsurance operations 821 615 Interest payable 66 83 Other items 242 179
On 1 February 2010, the Group acquired from United Overseas Bank (UOB) its 100 per cent interest in UOB Life Assurance Limited in Singapore for total cash consideration, after post-completion adjustments of SGD67 million (£32 million), of SGD495 million (£220 million). As part of the transaction the Group also entered into a long-term strategic partnership to develop a major regional bancassurance business with UOB. In addition to the amounts above, the Group incurred £2 million of acquisition-related costs (excluding integration costs). These have been excluded from the consideration transferred and have been recognised as an expense in the period, in the consolidated income statement.
Cash consideration 220 Less: fair value of identifiable net assets acquired (79)