For UK annuity business policyholder liabilities are determined by reference to current interest rates. The value movements of the assets covering liabilities are closely correlated with the related change in liabilities. Accordingly, asset value movements are recorded within the ‘operating results based on longer-term investment returns’. Policyholder liabilities include a margin for credit risk, as explained in note D2(f)(iii). Variations between actual and best estimate expected impairments are recorded as a component of short-term fluctuations in investment returns.
Examples where such bifurcation is necessary are: a Asia Vietnamese participating business For the participating business in Vietnam the liabilities include policyholders’ interest in investment appreciation and other surplus. Bonuses paid in a reporting period and accrued policyholder interest in investment appreciation and other surpluses primarily reflect the level of realised investment gains above contract specific hurdle levels. For this business, operating profit based on longer-term investment returns includes the aggregate of longer-term returns on the relevant investments, a credit or charge equal to movements on the liability for the policyholders’ interest in realised investment gains (net of any recovery of prior deficits on the participating pool), less amortisation over five years of current and prior movements on such credits or charges.
Non-participating business Liabilities are bifurcated so that the total movement in the carrying value of liabilities is split between that which is included in operating results based on longer-term investment returns, and the residual element for the effect of using year end rates is included in short-term fluctuations and in the income statement.
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 SOP 03-01, which partially reflects changes in market conditions. Under the company’s segmental basis of reporting the operating profit reflects the change in liability based on longer-term market conditions with the difference between the charge to the operating result and the movement reflected in the total result included in short-term fluctuations in investment returns.
b US operations – embedded derivatives for variable annuity guarantee features Under IFRS, the Guaranteed Minimum Withdrawal Benefit (GMWB) and Guaranteed Minimum Income Benefit (GMIB) reinsurance are required to be fair valued as embedded derivatives. The movements in carrying values are affected by changes in the level of observed implied equity volatility and changes to the discount rate applied from year to year. For these embedded derivatives, as described in note D3(i), the discount rate applied reflects AA corporate bond curve rates. For the purposes of determining operating profit based on longer-term investment returns, the charge for these features is determined using historical longer-term equity volatility levels and longterm average AA corporate bond rate curves.
Notes on the Group financial statements > A: Background and accounting policies > continued c UK shareholder-backed annuity business With one exception, the operating result based on longer-term investment returns reflects the impact of all value movements on policyholder liabilities for annuity business in PRIL and the PAC non-profit sub-fund.
iv 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 substance of the arrangements.
The following standards, interpretations and amendments have either been adopted for the first time in 2009 or have been issued but are not yet effective in 2009, 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 2009 IFRS 8, ‘Operating Segments’ IFRS 8 superseded IAS 14 ‘Segment Reporting’ for accounting periods beginning on or after 1 January 2009 and requires the Group to adopt the ‘management approach’ to reporting the financial performance of its operating segments.
The adoption of IFRS 8 has resulted in presentational and disclosure changes in the Group’s financial statements. This standard has no impact on the results or financial position of the Group.
Amendments to IAS 1, ‘Presentation of Financial Statements: A Revised Presentation’ The revised version of IAS 1, which includes non-mandatory changes to the titles of some of the financial statements, has resulted in a number of changes in presentation and disclosure.
As a result of the adoption of this revised IAS 1, the Group has changed the titles of its ‘consolidated balance sheet’ to ‘consolidated statement of financial position’ and its ‘consolidated cash flow statement’ to ‘consolidated statement of cash flows’.
As a result of this amendment, the Group has reclassified its properties under development for future use as investment properties from Property, Plant and Equipment to Investment properties. This amendment is effective on a prospective application basis from 1 January 2009 and accordingly, no adjustment to the 2008 comparatives has been made. At 1 January 2009, properties under development with a cost of £131 million were reclassified to Investment properties and revalued to a fair value of £152 million.
Amendments to IFRS 7, ‘Improving Disclosures about Financial Instruments’ In March 2009, the IASB issued amendments to IFRS 7 which require enhanced disclosures about fair value measurements and liquidity risk. The amendments include the introduction of a three-level hierarchy for fair value measurement disclosures and require additional disclosures about the relative reliability of fair value measurements. This has been included in note G1.
In addition, the Group has also adopted the following accounting pronouncements in 2009 but their adoption has had no material impact on results and financial position of the Group: • Amendment to IFRS 2, ‘Share-based Payment: Vesting Conditions and Cancellations’ • Amendment to IAS 23, ‘Borrowing costs’ • Amendments to IAS 32 and IAS 1, ‘Puttable Financial Instruments and Obligations Arising on Liquidation’ • IFRIC 16, ‘Hedges of a Net Investment in A Foreign Operation’
Accounting pronouncements endorsed by the EU but not yet effective The following accounting pronouncements potentially relevant to the Group have been issued and endorsed for use in the EU but are not mandatory for adoption for the 31 December year end.
The amendments to IAS 27 reflect changes to the accounting for non-controlling (minority) interests. The revised IFRS 3 and amended IAS 27 are effective for business combinations occurring in accounting periods beginning on or
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. This amendment is effective for EU compliant financial statements for accounting periods beginning on or after 1 July 2009. The Group is currently assessing the impact of this amendment but it is not expected to have a material impact on the financial statements of the Group.
Improvements to IFRSs (2009) In April 2009, the IASB published amendments to a number of standards as part if its annual improvements projects.
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. Financial liabilities are excluded from the scope of the standard.
The determination of the operating segments and performance measure of the operating segments of the Group are as detailed in note A4.
Shareholders' share of actuarial and other gains and losses on defined benefit pension schemesnote vii (74) (13)
Profit (loss) from continuing operations before tax attributable to shareholders 746 (450)
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.
iii Sale of Taiwan agency business: In order to facilitate comparisons of operating profit based on longer-term investment returns that reflect the Group’s retained operations, the results attributable to the Taiwan business for which the sale process was completed in June 2009 are included separately within the supplementary analysis of profit.
Average Annual Average Annual book expected losses book expected losses value RMR value RMR Moody’s rating category (or equivalent under NAIC ratings of RMBS) (US $m) % US $m £m (US $m) % US $m £m
Risk margin reserve charge to operating profit for longer-term (94) (60) (76) (41)
During 2009 the National Association of Insurance Commissioners (NAIC) changed its approach to the determination of regulatory ratings of residential mortgage-backed securities (RMBS). This recognised the complexities associated with these investments and the limitations of the credit rating previously applied. The new ratings framework has been applied by an external third party, PIMCO, and provides regulatory ratings details for more than 20,000 RMBS securities owned by US insurers at the end of 2009. Jackson has decided to use the ratings resulting from this model to determine the average annual RMR for 2009 as this is considered more relevant information for the RMBS securities concerned. If the previous approach of using ratings by Nationally Recognised Statistical Ratings Organisation (NRSROS) such as Moody’s, Standard and Poor’s or Fitch for these investments had been used this would have resulted in an annual RMR of 31 basis points for 2009, an additional £11 million of annual expected losses for the year. It should be noted that this change has no impact on the valuation applied to these securities within the IFRS statement of financial position and there is no impact to IFRS profit before tax or shareholders’ equity as a result of this change.
Consistent with the basis of measurement of insurance assets and liabilities for US GAAP investment contracts applied to Jackson’s IFRS results, the charges and credits to operating profits based on longer-term investment returns are partially offset by related changes to amortisation of deferred acquisition costs.
General overview of defaults The Group incurred defaults of £11 million in 2009 (2008: £206 million) on its debt securities portfolio. The defaults of £11 million in 2009 were experienced by the UK Shareholder-backed annuity business. Jackson experienced less than £1 million of default losses during 2009. Defaults in 2008 of £206 million (including losses on sale) arose primarily in respect of Lehman Brothers (£110 million) and Washington Mutual (£91 million), the majority of which arose in Jackson.
For 2008, the fluctuations of a charge of £138 million relate mainly to £81 million for Vietnam, reflecting a significant fall in the Vietnamese bond and equity markets.
US insurance operations The short-term fluctuations in investment returns for US insurance operations for the year comprise the following items: Short-term fluctuations related to debt securities: Charges in the year*
Defaults – (78) Losses on sales of impaired and deteriorating bonds (6) (130) Bond write downs (630) (419) Recoveries/reversals 5 3
Derivative value movements in respect of equity risk within variable annuity business are included within the operating profit based on longerterm investment returns to broadly match with the commercial effects to which the variable annuity derivative programme relates, (subject to some limitations to GMDB liabilities where US GAAP does not fully reflect the economic features being hedged.) Other derivative value movements are separately identified within short-term fluctuations in investment returns.
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.
‡ The £115 million gain (2008: charge of £85 million) for other items shown above comprises a gain of £85 million (2008: charge of £70 million) for the difference between the charge for embedded derivatives included in the operating result and the charge to the total result and a gain of £30 million (2008: charge of £15 million) of other items. For embedded derivatives the operating result reflects the application of 10 year average AA corporate bond rate curves and a static historical equity volatility assumption. The total result reflects the application of year end AA corporate bond rate curves and current equity volatility levels.
In addition, for US insurance operations, included within the statement of comprehensive income, is a reduction in net unrealised losses on debt securities classified as available-for-sale of £2,669 million (2008: increase in net unrealised losses of £2,104 million). These temporary market value movements do not reflect defaults or impairments. Additional details on the movement in the value of the Jackson portfolio are included in note D3.
UK insurance operations The short-term fluctuations gain for UK insurance operations of £108 million (2008: charge £212 million) reflected principally asset value movements, principally for shareholder-backed annuity business. The 2008 charge of £212 million also included £42 million for the effect of credit downgrades on the calculation of liabilities for shareholder-backed annuity business in PRIL and PAC non-profit sub-fund.
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 have expired and have not been renewed.
The actuarial gains and losses shown in the table above relate to the Scottish Amicable, M&G and until 2009 the small Taiwan defined benefit pension scheme. The amounts did not include actuarial gains and losses for the Prudential Staff Pension Scheme (PSPS) for which the Group has not recognised its interest in the scheme’s underlying surplus.
The losses of £147 million on change of assumptions comprise mainly the effect of a decrease in the risk discount rate combined with the effect of increase in inflation rates.
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 (£16 million) and as part of central operations (EEV non-covered business) (£7 million). (2008: £10 million and £18 million respectively).
Based on loss for the year (450) 59 (5) (396) (16.0)p (16.0)p
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 2,501 2,472
A final dividend of 13.56 pence per share was proposed by the directors on 8 March 2010. Subject to shareholders’ approval, the dividend will be paid on 27 May 2010 to shareholders on the register at the close of business on 9 April 2010. The dividend will absorb an estimated £343 million of shareholders’ funds. A scrip dividend alternative will be offered to shareholders.
Exchange movement recognised in other comprehensive income 2009 £m 2008* £m
* As a result of changes following the implementation of amendments to IAS 1, exchange losses of £240 million relating to US operations previously included within the unrealised valuation movement of Jackson’s available-for-sale debt securities have been reclassified as exchange movements within the statement of comprehensive income. This is explained further in note A5. There is no impact on shareholders’ equity or the income statement from this change.
Local currency: £ 31 Dec 2009 for 2009 31 Dec 2008 for 2008 1 Jan 2008
Total Asian operations (all retail) 842 1,340 1,177 1,082 1,261 1,216
Market translation gross and other 1 Jan 2009 inflows Redemptions movements 31 Dec 2009 2008 £m
The details shown above for insurance products include contributions for contracts that are classified under IFRS 4 ‘Insurance Contracts’ as not containing significant insurance risk. These products are described as investment contracts or other financial instruments under IFRS. Contracts included in this category are primarily certain unit-linked and similar contracts written in UK insurance operations and Guaranteed Investment Contracts and similar funding agreements written in US operations.
a Group statement of financial position by operating segment i Position at 31 December 2009 2009 £m
UnalloAsset cated manage- to a Total ment segment Intra- 31 Dec
Insurance operations insurance opera- (central group 2009 UK US Asia opera- tions opera- elimina- Group
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 method 4 – 2 6 – – – 6 Financial investments: Equity securities and portfolio holdings in unit trusts 37,051 20,984 11,182 69,217 137 – – 69,354
Properties held for saleH9 – 3 – 3 – – – 3
Insurance operations insurance manage- (central group 2009 UK US Asia opera- ment opera- elimina- Group
regulated with-profits funds)D2fii,H12 9,966 – 53 10,019 – – – 10,019
Insurance operations insurance manage- (central group 2008 UK US Asia opera- ment opera- elimina- Group
Investment of long-term business and other operations: Investments accounted for using the equity method – – – – – 10 – 10
Financial investments: Equity securities and portfolio holdings in unit trusts 38,880 15,142 8,077 62,099 23 – – 62,122
Properties held for saleH9 – – – – – – – –
Policyholder liabilities and unallocated surplus of with-profits funds: Investment contract liabilities with
Investment of long-term business and other operations: Investments accounted for using the equity method – – 6 – – – 6 10
Liabilities Policyholder liabilities and unallocated surplus of with-profits funds: Contract liabilities (including amounts in respect of contracts classified as investment contracts
Other ABS (2009: 25% AAA, 18% AA), including £nil exposure to sub-prime 877 766 *RMBS ratings refer to the rating implicit within NAIC risk-based capital valuation (see note c(i)). †Including the Group’s economic interest in Piedmont and other consolidated CDO funds. Further details on Jackson’s RMBS sub-prime and Alt-A securities are given in note D3(c).
iv Other operations Other operations’ exposure to asset-backed securities at 31 December 2009 is held by Prudential Capital and comprises: RMBS: Prime (2009: 92% AAA, 8% AA) 91 106
d 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: Total Insurance operations insurance
Shareholders’ transfers post tax (202) – (20) (222) Changes in reserving basis in Malaysia – – (63) (63) Assumption changes (shareholder-backed business) (46) – (4) (50) Investment-related items and other movements 14,118 2,986 4,242 21,346 Foreign exchange translation differences 707 (5,225) (2,069) (6,587) Disposal of Taiwan agency business – – (3,508) (3,508)
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, the Group Chief Executive and the chief executives 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 and business unit internal control and risk management systems is provided by Group-wide Internal Audit reporting to the Group and business unit audit committees.
The management of the risk attached to the Group’s financial instruments and insurance liabilities, together with the interrelationship with the management of capital may be summarised in the following sections.
The Group risk appetite framework sets out the Group’s tolerance to risk management and return optimisation. The Group defines and monitors aggregate risk limits for its earnings volatility and its capital requirements based on financial and non-financial stresses.
The Group’s risk appetite framework forms an integral part of its annual business planning cycle. Throughout the year, the Group risk function monitors the Group’s risk profile against the agreed limits. Using submissions from business units, Group risk function calculates the Group’s aggregated position (allowing for diversification effects between business units) relative to the limits determined by the risk appetite statements.
Market risk is managed such that as conditions evolve the risk profile is maintained within risk appetite in addition to business unit operational limits on credit risk, the Group sets counterparty risk limits at Group level. Limits on the total Group-wide exposures to a single counterparty are specified within different credit rating ‘categories’. Actual exposures are monitored against these limits on a monthly basis.
The Group manages its actual risk profile against its tolerance of risk. To do this, the Group maintains risk registers that include details of the identified risks and of the controls and mitigating actions employed in managing them. Any mitigation strategies involving large transactions, such as a material derivative transaction, are subject to scrutiny at Group level before implementation.
The Group uses a range of risk management and mitigation strategies. The most important of these include: adjusting asset portfolios to reduce investment risks (such as duration mismatches or overweight counterparty exposures); using derivatives to hedge market risks; implementing reinsurance programmes to limit insurance risk; implementing corporate insurance programmes to limit the impact of operational risks; and revising business plans where appropriate.
c Risk mitigation and hedging b Group risk appetite a Overview
ii Asset/liability management Prudential manages its assets and liabilities locally, in accordance with local regulatory requirements and reflecting the differing types of liabilities of each business unit. Stochastic asset/liability modelling is carried out locally by business units to perform dynamic solvency testing and assess capital requirements. Reserve adequacy testing under a range of scenarios and dynamic solvency analysis is carried out, including under certain scenarios mandated by the US, the UK and Asian regulators.
A stochastic approach models the inter-relationship between asset and liability movements, taking into account asset correlation and policyholder behaviour, under a large number of possible scenarios. These scenarios are projected forward over a period of time, typically 25 years, and the liabilities and solvency position of the fund are calculated in each scenario in each future year. This allows the identification of which extreme scenarios will have the most adverse effects and what the best estimate outcome may be. The fund’s policy on management actions, including bonus and investment policy, are then set in order that they are consistent with the available capital and the targeted risk of default. This differs from a deterministic model, which would only consider the results from one carefully selected scenario.
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.
Foreign exchange risk Prudential faces foreign exchange risk, primarily because its presentation currency is pounds sterling, whereas approximately 62 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 2009, 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.
Additional details on the market risks’ exposures of the UK, US and Asian insurance operations are provided in notes D2, D3 and D4, respectively.
Some of Prudential’s businesses, in particular Jackson, the PAC with-profits fund and Prudential’s UK pension annuity business hold large amounts of interest-sensitive investments that contain credit risk on which a certain level of defaults is expected. These expected losses are considered when Prudential determines the crediting rates, deposit rates and premium rates for the products that will be supported by these assets. The key shareholder business exposed to credit risks is Jackson. Certain over-the-counter derivatives contain a credit risk element that is controlled through evaluation of collateral agreements and master netting agreements on interest rate and currency swaps. Prudential is also exposed to credit-related losses in the event of non-performance by counterparties.
Further analysis of the credit quality of debt securities held by the Group is shown in note B6. Additional details on the credit quality of the debt security portfolios of UK, US and Asian insurance operations are shown in notes D2, D3 and D4, respectively.
iii Liquidity risk The assets of insurers are in general relatively liquid whilst liabilities to policyholders are mainly illiquid. Accordingly, for insurers, the focus is 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. For Prudential, liquidity risk is the risk that though solvent on a statement of financial position basis, the Group either does not have the financial resources to meet its obligations as they fall due or can secure such resources only at excessive cost. 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 repoing 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 committed facilities that include £1.4 billion of undrawn syndicated committed banking facility and two £100 million bi-lateral facilities on the same terms, maturing in 2011 and 2012 respectively, as well as a committed £500 million annually renewable securities lending back-up facility.
For example, the assumption that Prudential makes about future expected levels of mortality is particularly relevant for its UK annuity business where, in exchange for their accumulated pension fund, pension annuity policyholders receive a guaranteed payment, for as long as they live. Prudential conducts extensive research into longevity risk using data from its substantial annuitant portfolio. As part of its pension annuity pricing and reserving policy, Prudential UK assumes that current rates of mortality continuously improve over time at levels based on adjusted data from the Continuous Mortality Investigations (CMI) projections as published by the Institute and Faculty of Actuaries.
Due to the geographically diverse nature of Prudential’s operations, the application of these requirements to Prudential is complex. In particular, for many of the Group’s Asian operations the assets, liabilities and capital requirements have to be recalculated based on FSA regulations as if the companies were directly subject to FSA regulation.
The FSA has established a structure for determining how much hybrid debt can count as capital which is similar to that used for banks. It categorises capital as Tier 1 (equity and preference shares), Upper Tier 2 and Lower Tier 2. Up to 15 per cent of Tier 1 capital can be in the form of hybrid debt and is called ‘Innovative Tier 1’. At 31 December 2009 the Group held £1,422 million (2008: £1,059 million) of Innovative Tier 1 capital in the form of perpetual securities, £nil (2008: £nil) of Upper Tier 2 and £1,423 million (2008: £1,101 million) of Lower Tier 2 capital. The increase in these amounts arises from the issue in May 2009 of £400 million of subordinated debt (Lower Tier 2), the issue in July 2009 of $750 million perpetual subordinated capital securities (Innovative Tier 1) and exchange rate movements during 2009. Further details on these amounts and other Group borrowings are shown in note H13.
Prudential’s detailed understanding of risk adjusted performance allows Prudential to manage proactively its allocation of capital to write new business to maximise risk adjusted value creation.
Notes on the Group financial statements > D: Life assurance businesses a Products and classification for IFRS reporting The measurement basis of assets and liabilities of long-term business contracts is dependent upon the classification of the contracts under IFRS. Under IFRS 4, contracts are initially classified as being either ‘insurance’ contracts, if the level of insurance risk in the contracts is significant, or ‘investment’ contracts, if the risk is insignificant.
– fixed and variable annuity business and life insurance; and • Prudential Corporation Asia
Contracts of the Group, which are classified as investment contracts that do not contain discretionary participation features, can be summarised as: • UK – certain unit-linked savings and similar contracts; • Jackson – GICs and funding agreements – minor amounts of ‘annuity certain’ contracts; and
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.
Notes on the Group financial statements > D: Life assurance businesses > continued ii Ceded business The Group cedes certain business to other insurance companies. Although the ceding of insurance does not relieve the Group of liability to its policyholders, the Group participates in such agreements for the purpose of managing its loss exposure. The Group evaluates the financial condition of its reinsurers and monitors concentration of credit risk from similar geographic regions, activities or economic characteristics of the reinsurers to minimise its exposure from reinsurer insolvencies. There are no significant concentrations of reinsurance risk. At 31 December 2009, 98 per cent (2008: 98 per cent) of the reinsurance recoverable insurance assets were ceded by the Group’s UK and US operations, of which 92 per cent (2008: 93 per cent) of the balance were from reinsurers with Standard & Poor’s rating A- and above.
c Guarantees Notes D2(d), D3(d) and D4(d) provide details of guarantee features of the Group’s life assurance products. In the UK, guarantees of the with-profits products are valued for accounting purposes on a market consistent basis for 2009 as described in section D2(f)(ii). The UK business also has products with guaranteed annuity option features, mostly within SAIF, as described in section D2(d). There is little exposure to financial options and guarantees in the shareholder-backed business of the UK operations. The US business annuity products have a variety of option and guarantee features as described in Section D3(d). Jackson’s derivative programme seeks to manage the exposures as described in Section D3(e). The Group’s exposure to guarantees was significantly reduced during 2009 as a result of the disposal of the Taiwan agency business.
Market risk is the risk that the fair value or future cash flows of a financial instrument or, in the case of liabilities of insurance contracts, their carrying value will fluctuate because of changes in market prices. Market risk comprises three types of risk, namely: • Currency risk: due to changes in foreign exchange rates; • interest rate risk: due to changes in market interest rates; and • other price risk: due to fluctuations in market prices (other than those arising from interest rate risk or currency risk).
Three key points are to be noted, namely: • The Group’s with-profits and unit-linked funds absorb most market risk attaching to the funds’ investments. Except for second order effects, for example on asset management fees and shareholders’ share of cost of bonuses for with-profits business, shareholder results are not directly affected by market value movements on the assets of these funds; • the Group’s shareholder results are most sensitive to market risks for assets of shareholder-backed business; and • the main exposures of the Group’s IFRS basis results to market risk for life assurance operations on investments of shareholder-backed business are for debt securities.
UK insurance operations (see also section D2(i)) With-profits business Net neutral direct exposure Investment performance Persistency risk to
SAIF sub-fund Net neutral direct exposure Asset management fees (Indirect exposure only) earned by M&G
Fixed index Derivative hedge Incidence of equity annuity business programme to the participation features extent not fully hedged against liability and fund performance
Fixed index annuities, Credit risk Spread difference Lapse risk but the
Asian insurance operations (see also section D4(i)) Mortality and morbidity risk
With-profits business Net neutral direct exposure Investment performance (Indirect exposure only) subject to smoothing through declared bonuses
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.
Shareholder-backed business The factors that may significantly affect the IFRS results of UK shareholder-backed business are the mortality experience and assumptions and credit risk attaching to the annuity business of Prudential Retirement Income Limited and the PAC non-profit sub-fund.
• Prudential Retirement Income Limited (PRIL) The assets covering PRIL’s liabilities are principally debt securities and other investments that are held to match the expected duration and payment characteristics of the policyholder liabilities. These liabilities are valued for IFRS reporting purposes by applying discount rates that reflect the market rates of return attaching to the covering assets.
Except to the extent of any asset/liability duration mismatch which is reviewed regularly, and exposure to credit risk, the sensitivity of the Group’s results to market risk for movements in the carrying value of PRIL’s liabilities and covering assets is broadly neutral on a net basis.
The principal items affecting the IFRS results for PRIL are mortality experience and assumptions, and credit risk.
• PAC non-profit sub-fund The PAC non-profit sub-fund principally comprises annuity business previously written by Scottish Amicable Life, credit life, unitlinked and other non-participating business.
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.
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 – net effect of market risk arising from the incidence and valuation of guarantee features and variability of asset management fees offset by derivative hedging performance. The net effect of market risk in Jackson’s guarantees and derivatives included in operating result excludes the impact of changes in market implied volatility. Further movements in reserves for guarantees reflected in operating result are also based on a discount rate using a long-term average Corporate AA credit curve instead of the actual Corporate AA credit curve at the valuation date. The derivative hedging programme is designed to be economically effective and there can be some accounting mis-matches for those guarantee features which are not economically valued under grandfathered US GAAP, for example guaranteed minimum death benefits. These accounting mis-matches are magnified in periods of market dislocation; • 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 and incidence of equity index participation features, net of the related hedging performance.
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 withprofits 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.
Jackson is sensitive to lapse risk. However, Jackson uses swaption derivatives to ameliorate the effect of a sharp rise in interest rates, which would be the most likely cause of a sudden change in policyholder behaviour.
The effect of Group diversification is to significantly reduce the aggregate standalone volatility risk to IFRS operating profit based on longer-term investment returns. The effect is almost wholly explained by the correlations across risk types, in particular longevity risk.
In the years 2005 to 2009, claims paid on the Group’s life assurance contracts including those classified as investment contracts under IFRS 4 ranged from £13 billion to £19 billion. Indicatively, it is to be expected that, of the Group’s policyholder liabilities (excluding unallocated surplus) at 31 December 2009 of £186.4 billion, the amounts likely to be paid in 2010 will be of a similar magnitude.
a Summary statement of financial position In order to explain the different types of UK business and fund structure, the statement of financial position of the UK insurance operations may be analysed by the assets and liabilities of the Scottish Amicable Insurance Fund (SAIF), the PAC with-profits sub-fund (WPSF), unit-linked assets and liabilities and annuity (principally PRIL) and other business. The assets and liabilities of these funds and subsidiaries are shown in the table below.
Notes i For the purposes of this table and subsequent explanation, references to the PAC WPSF also include, for convenience, the amounts attaching to the
Defined Charges Participating Sub-fund, which includes the with-profits annuity business transferred to Prudential from the Equitable Life Assurance Society on 1 December 2007 (with assets of approximately £1.7 billion). Profits to shareholders on this with-profits annuity business emerge on a ‘charges less expenses’ basis and policyholders are entitled to 100 per cent of the investment earnings.
ii SAIF is a separate sub-fund within the PAC long-term business fund. iii Wholly-owned subsidiary of the PAC WPSF that writes annuity business. iv Excluding policyholder liabilities of the Hong Kong branch of PAC. v The loans of the Group’s UK insurance operations of £1,815 million (2008: £1,902 million) comprise loans held by the PAC WPSF of £1,106 million
The loans held by the UK shareholder-backed business comprise mortgage loans collateralised by properties of £702 million (2008: £551 million) and other loans of £7 million (2008: £6 million).
†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.
b Reconciliation of movement in policyholder liabilities and unallocated surplus of with-profits funds A reconciliation of the total policyholder liabilities and unallocated surplus of with-profits funds of UK insurance operations from the beginning of the year to the end of the year is as follows: Other funds and subsidiaries
SAIF Annuity and PAC and other UK insurance with-profits Unit-linked long-term operations sub-fund liabilities business Total £m £m £m £m
Assumption changes (shareholder-backed business)note D2h 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
Notes on the Group financial statements > D: Life assurance businesses > continued c Information on credit risk of debt securities The following table summarises by rating the securities held by UK insurance operations as at 31 December 2009 and 2008: PAC with-profits sub-fund Other funds and subsidiaries
Fund Limited Limited Total liabilities PRIL business Total Total £m £m £m £m £m £m £m £m £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 £6,950 million total debt securities held in 2009 (2008: £6,135 million) which are not externally rated, £2,190 million were internally rated AAA to A-, £3,445 million were internally rated BBB to B- and £1,315 million were rated below B- or unrated (2008: £2,325 million, £3,149 million and £661 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 £1,503 million PRIL and other annuity and long-term business investments which are not externally rated, £15 million were internally rated AAA, £88 million AA, £495 million A, £647 million BBB, £123 million BB and £135 million were internally rated B+ and below.
The WPSF held a provision of £31 million at 31 December 2009 (2008: £42 million) to honour guarantees on a small amount of guaranteed annuity products. SAIF’s exposure to guaranteed annuities is described below.
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.
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.
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
• For the SAIF and Scottish Amicable Life (SAL), the final bonus rates applicable on surrender may be adjusted to reflect expected future bonus rates.
Prudential’s approach, in applying significant judgement and discretion in relation to determining bonus rates, is consistent conceptually with the approach adopted by other firms that manage a with-profits business. It is also consistent with the requirements of UK law, which require all UK firms that carry out a with-profits business to define, and make publicly available, the Principles and Practices of Financial Management (PPFM) that are applied in the management of their with-profits funds.
(including charge for provision for asset shares and excluding policyholder bonuses) (8,118) 9,001
ii Annuity business Prudential’s conventional annuities include level, fixed-increase and retail price index (RPI) annuities. They are mainly written within the subsidiaries PAL, PRIL, Prudential Pensions Limited and the PAC with-profits sub-fund, but there are some annuity liabilities in the nonprofit sub-fund and SAIF.
iii SAIF SAIF is a ring-fenced sub-fund of the PAC long-term fund formed following the acquisition of the mutually owned Scottish Amicable Life Assurance Society in 1997. No new business may be written in SAIF, although regular premiums are still being paid on policies in force at the time of the acquisition and incremental premiums are permitted on these policies.
The Group’s main exposure to guaranteed annuities in the UK is through SAIF and a provision of £284 million was held in SAIF at 31 December 2009 (2008: £391 million) to honour the guarantees. As SAIF is a separate sub-fund solely for the benefit of policyholders of SAIF this provision has no impact on the financial position of the Group’s shareholders’ equity.
e Exposure to market risk i Non-linked life and pension business For with-profits business, the absence of guaranteed surrender values and the flexibility given by the operation of the bonus system means that a high proportion of the investments backing the with-profits business are in equities and real estate with the balance in debt securities, deposits and loans.
The investments supporting the protection business are small in value and tend to be assets of a fixed term duration reflecting the guaranteed nature of the liabilities.
The weighted components of the bond spread over swap rates for shareholder-backed fixed and linked annuity business for PRIL at 31 December 2009, 31 December 2008 and 31 December 2007 based on the asset mix at the relevant balance sheet dates are as follows: Adjustment from
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
Pillar I regulatory Regulatory to IFRS basis basis (bps) IFRS (bps) note v (bps)
Notes i Bond spread over swap rates reflect market observed data. ii Long-term expected defaults are 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 is based on external credit rating and for this purpose the credit rating assigned to each asset held is the lowest credit rating published by Moody’s, Standard and Poor’s and Fitch.
iv The short-term allowance for credit risk assumed in the Pillar 1 solvency valuations at 31 December 2007 and 31 December 2008 were determined as 25 per cent of the increase in corporate bond spreads (as estimated from the movements in published corporate bond indices) since 31 December 2006.
v The very prudent Pillar 1 regulatory basis reflects the overriding objective of ensuring sufficient provisions and capital to ensure payments to policyholders can be made. The approach for IFRS aims to establish liabilities that are closer to ‘best estimate’. In years prior to 2008 long-term IFRS default assumptions had been set mid-way between the EEV and Pillar 1 assumptions. At 31 December 2008, in light of the increased uncertainty surrounding future credit default experience, the IFRS long-term assumptions were strengthened to bring them into line with the long-term Pillar 1 default assumptions. In addition a short-term allowance for credit risk was established but at a lower level than allowed for in the Pillar 1 regulatory basis.
Factors affecting the credit risk allowance at 31 December 2009 The main factors influencing the credit risk allowance at 31 December 2009 are as follows: a Credit downgrades and default experience As highlighted above, the short-term allowance at 31 December 2008 was intended to cover both short-term credit downgrades and losses in excess of the longer-term expectations. Downgrades in 2009 have been within the opening Pillar 1 assumptions and hence the increase in the long-term allowance as a result of credit downgrades has been offset by an equal decrease in the short-term allowance. Defaults for the UK shareholder-backed annuity business totalled £11 million during 2009, below the amount allowed for within the short-term allowance. The allowance (in bps terms) has been adjusted to eliminate any experience profits that would have otherwise arisen.
On a Pillar 1 basis this transaction had no overall impact on the solvency surplus of PRIL, the PAC non-participating sub-fund and PAL. On an IFRS basis, a lower short-term default reserve was held at 31 December 2008 and the release of the reserves in respect of the subordinated debt is therefore lower. Overall the reduction in subordinated financial debt holdings generated a pre-tax IFRS operating loss of £51 million.
c Asset purchases in respect of new business The assets purchased during 2009 to back new business have been of better average credit quality than the assets held at 31 December 2008, in particular no subordinated bank debt or sub-investment grade assets have been bought to back new business. As a result of the lower credit risk of the new business assets, the overall allowance for credit risk required at 31 December 2009 is reduced when the new business assets and in-force assets are aggregated together.
d Overall impact on the PRIL credit risk allowance After taking account of the factors noted above the movement on the average basis points allowances for PRIL on the Pillar 1 regulatory and IFRS bases are as follows: Pillar 1 Regulatory basis IFRS (bps) (bps)
Mortality The mortality assumptions are set in light of recent population and internal experience. The assumptions used are percentages of standard actuarial mortality tables with an allowance for future mortality improvements. Where annuities have been sold on an enhanced basis to impaired lives an additional age adjustment is made. The percentages of the standard table used are selected according to the source of business. The range of percentages used is set out in the following tables: PAL PRIL
In payment 102% – 126% PNMA00 84% – 117% PNFA00 97% – 102% PNMA00 88% – 98% PNFA00
In deferment AM92 minus 4 years AF92 minus 4 years AM92 minus 4 years AF92 minus 4 years
In payment 106% – 126% PNMA00 84% – 117% PNFA00 99% – 114% PNMA00 85% – 103% PNFA00
(C = 2000) with medium (C = 2000) with 75% (C = 2000) with medium (C = 2000) with 75%
g Reinsurance The Group’s UK insurance business cedes only minor amounts of business outside the Group. During 2009, reinsurance premiums for externally ceded business were £122 million (2008: £61 million) and reinsurance recoverable insurance assets were £502 million (2008: £416 million) in aggregate. During the year 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. The gains and losses recognised in profit and loss for other contracts were immaterial.
Mortality Recent mortality experience has been in line with expectations and no change is therefore required to the overall strength of mortality assumptions at 31 December 2009.
Credit risk The approach to reserving for credit risk is set out in note (f)(iii).
Effect of changing expense assumptions 51 (9) Release of investment-related margins: Deflation risk margins 32 Asset management fees 14
b The assumption changes in 2009 for the shareholder-backed business primarily relate to changes to the deflation reserve, expense assumptions and modelling changes.
Mortality Overall mortality experience was in line with expectations and no change was therefore required to the overall strength of mortality assumptions at 31 December 2008. However, mortality assumptions were rebalanced across different categories of business so as to more closely align to the actual experience of each product category. The overall effect of rebalancing the assumptions between different product groups was financially neutral.
The level of unallocated surplus is particularly sensitive to the level of investment returns on the portion of the life fund assets that represents the surplus. The effects for 2009 and 2008 are demonstrated in note D5.
A decrease in assumed mortality rates of one per cent would decrease gross profits by approximately £44 million (2008: £35 million). A decrease in credit default assumptions of five basis points would increase gross profits by £91 million (2008: £71 million). A decrease in renewal expenses (excluding asset management expenses) of five per cent would increase gross profits by £17 million (2008: £15 million). The effect on profits would be approximately symmetrical for changes in assumptions that are directionally opposite to those explained above.
iv Shareholder exposure to interest rate risk and other market risk By virtue of the fund structure, product features and basis of accounting described in note D2(d) and (f), the policyholder liabilities of the UK insurance operations are, except for pension annuity business, not generally exposed to interest rate risk. For pension annuity business, liabilities are exposed to fair value interest rate risk. However, the net exposure to the PAC WPSF (for PAL) and shareholders (for liabilities of PRIL and the non-profit sub-fund) is very substantially ameliorated by virtue of the close matching of assets with appropriate duration. The level of matching from period to period can vary depending on management actions and economic factors so it is possible for a degree of mis-matching profits or losses to arise.
The close matching by the Group of assets of appropriate duration to annuity liabilities is based on maintaining economic and regulatory capital. The measurement of liabilities under capital reporting requirements and IFRS is not the same, with contingency reserves and some other margins for prudence within the assumptions required under the FSA regulatory solvency basis not included for IFRS reporting purposes. As a result IFRS equity is higher than regulatory capital and therefore more sensitive to interest rate risk.
The estimated sensitivity of the UK non-linked shareholder-backed business (principally pension annuities business) to a movement in interest rates is as follows.
A 10 or 20 per cent (2008: 10, 20 or 40 per cent) increase in their value would have an approximately equal and opposite effect on profit and shareholders’ equity to the sensitivities shown above. The market risk sensitivities shown above reflect the impact of temporary market movements and, therefore, the primary effect of such movements would, in the Group’s segmental analysis of profits, be included within the short-term fluctuations in investment returns. The disclosure of the effect of a 40 per cent fall for the 2008 year end was included because of the exceptional market conditions at that time. These conditions have now abated and the disclosure is no longer appropriate.
In the equity risk sensitivity analysis given above, the Group has, for 2009, considered the impact of an instantaneous 20 per cent fall in equity markets. If equity markets were to fall by more than 20 per cent, the Group believes that this would not be an instantaneous fall but rather this would be expected to occur over a period of time during which the Group would be able to put in place mitigating management actions.
Notes on the Group financial statements > D: Life assurance businesses > continued j Duration of liabilities With the exception of most unitised with-profits bonds and other whole of life contracts the majority of the contracts of the UK insurance operations have a contract term. However, in effect, the maturity term of contracts reflects the earlier of death, maturity, or lapsation. In addition, with-profits contract liabilities as noted in note D2(f) include projected future bonuses based on current investment values. The actual amounts payable will vary with future investment performance of SAIF and the WPSF.
The tables below show the carrying value of the policyholder liabilities. Separately, the Group uses cash flow projections of expected benefit payments as part of the determination of the value of in-force business when preparing EEV basis results. The tables below also show the maturity profile of the cash flows used for 2009 and 2008 for that purpose for insurance contracts, as defined by IFRS, i.e. those containing significant insurance risk, and investment contracts, which do not.
Insurance Investment Insurance Investment contracts contracts Total PAL PRIL Total contracts contracts Total Total
Unrealised valuation movements on securities classified as available-for-sale: Unrealised holding gains (losses) arising during the year 2,249 (2,482)
Related change in amortisation of deferred income and acquisition costs (1,069) 831
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 £2,669 million (2008: net reduction of £2,104 million).
Further details on the impairment losses recognised in the year are shown in note B1. Jackson’s portfolio of debt securities is managed proactively with credit analysts closely monitoring and reporting on the credit quality of its holdings. Jackson continues to review its investments on a case-by-case basis to determine whether any decline in fair value represents an impairment. In addition, investment in structured securities where market prices are depressed are subject to a rigorous review of their future estimated cash flows, including expected and stress case scenarios, to identify potential shortfalls in contractual payments (both interest and principal). Impairment charges are recorded on structured securities when the Company forecasts a contractual payment shortfall. Situations where such a shortfall would not lead to a recognition of a loss are rare. However, some structured securities do not have a single determined set of future cash flows and instead, there can be a reasonable range of estimates that could potentially emerge. With this variability, there could be instances where the projected cash flow shortfall under management’s base case set of assumptions is so minor that relatively small and justifiable changes to the base case assumptions would eliminate the need for an impairment loss to be recognised. The impairment loss reflects the difference between the fair value and book value.
In 2009, there was a movement in the statement of financial position value for debt securities classified as available-for-sale from a net unrealised loss of £2,897 million to a net unrealised gain of £4 million (2008: net unrealised loss of £136 million to a net unrealised loss of £2,897 million), principally as a result of improving credit spreads more than offsetting the negative effect on the bond values from the increase in the US treasury yields. During 2009, the gross unrealised gain in the statement of financial position increased from £281 million at 31 December 2008 to £970 million at 31 December 2009 while the gross unrealised loss decreased from £3,178 million at 31 December 2008 to £966 million at 31 December 2009. Details of the securities in an unrealised loss position are shown in D3(c) below.
These features are included in the table shown below of the movements in the values of available-for-sale securities: Changes in Foreign unrealised exchange appreciation‡ translation
Fair value (as included in statement of financial position) 7,254 17,422
Fair value (as included in statement of financial position)† 22,668 23,999
*Book value represents cost/amortised cost of the debt securities. † Debt securities for US operations as included in the statement of financial position of £22,831 million (2008: £24,249 million) comprise £22,668 million
(2008: £23,999 million) in respect of securities classified as ‘available-for-sale’ and £163 million (2008: £250 million) for securities of consolidated investment funds classified as fair value through profit and loss.
Assets Intangible assets attributable to shareholders: Deferred acquisition costs and other intangible assets – 3,092 3,092 3,962
iv Summary policyholder liabilities (net of reinsurance) and reserves at 31 December 2009 The policyholder liabilities, net of reinsurers’ share of £667 million (2008: £800 million), reflect balances in respect of the following: £m £m
Policy reserves and liabilities on non-linked business: Reserves for future policyholder benefits and claims payable 1,645 2,518 Deposits on investment contracts (as defined under US GAAP) 23,706 24,962 Guaranteed investment contracts 1,654 2,543
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 £1,444 million (2008: £3,233 million) and are included in ‘other non-insurance liabilities’ in the statement of financial position above.
Notes on the Group financial statements > D: Life assurance businesses > continued 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.
NAIC designation: Included within other debt securities of £956 million (2008: £1,400 million) in the summary shown above are £652 million (2008: £893 million) of asset-backed securities held directly by Jackson, of which £447 million (2008: £663 million) were NAIC designation 1 and £152 million (2008: £159 million) NAIC designation 2. In addition, other debt securities includes £172 million (2008: £257 million) in respect of securities held by the Piedmont trust entity and £131 million (2008: £250 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 2009 using Standard and Poor’s (S&P), Moody’s, Fitch and implicit ratings of RMBS based on NAIC valuations: Carrying Carrying value value
Total debt securities 22,831 24,249 * The amounts within Other which are not rated by S&P, Moody’s, Fitch nor are RMBS securities using the revised regulatory ratings have the following NAIC classifications: £m £m
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 are in inactive markets, 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 2009, three per cent of Jackson’s debt securities were classified as level 3 (2008: 15 per cent) being fair values where there are significant inputs which are not based on observable market data. The higher proportion at 31 December 2008 arises from the illiquidity of the market at that time and hence a greater use of internal valuation techniques.
iii Asset-backed securities funds exposures Included within the debt securities of Jackson at 31 December 2009 are exposures to asset-backed securities as follows: RMBS Sub-prime (31 Dec 2009: 76% AAA, 1% AA)† 194 291
ABS (31 Dec 2009: 25% AAA, 18% AA), including nil exposure to sub-prime 877 766 *Including Group’s economic interest in Piedmont and other consolidated CDO funds. † RMBS ratings refer to the rating implicit within NAIC risk-based capital valuation (see D3(i) previous page).
c Age analysis of unrealised losses for the years indicated The following table shows the aged analysis for all the unrealised losses in the portfolio by reference to the length of time the securities have been in an unrealised loss position: Non- Noninvestment Investment investment Investment grade grade Total grade grade Total
At 31 December 2009, the gross unrealised losses in the statement of financial position for the sub-prime and Alt-A securities in an unrealised loss position were £119 million (2008: £212 million), as shown above in note (a). Of these losses £21 million (2008: £91 million) relate to securities that have been in an unrealised loss position for less than one year and £98 million (2008: £121 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, £594 million of the £966 million of gross unrealised losses at 31 December 2009 (2008: £1,938 million of the £3,178 million of gross unrealised losses) related to securities whose fair values were below 80 per cent of the book value. The analysis of the £594 million, (2008: £1,938 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: Fair Unrealised Fair Unrealised Category analysis value loss value loss
Age analysis of fair value being below 80 per cent for the period indicated: Fair Unrealised Fair Unrealised Age analysis value loss value loss d Products and guarantees Jackson provides long-term savings and retirement products to retail and institutional customers throughout the US. Jackson offers fixed annuities (interest-sensitive, fixed indexed and immediate annuities), variable annuities (VA), life insurance and institutional products.
The policy provides that at Jackson’s discretion it may reset the interest rate, subject to a guaranteed minimum. The minimum guarantee varies from 1.5 per cent to 5.5 per cent (2008: 1.5 per cent to 5.5 per cent) depending on the jurisdiction of issue and the date of issue, with 82 per cent (2008: 83 per cent) of the fund at three per cent or less. The average guarantee rate is 3.1 per cent (2008: 3.1 per cent).
Fixed indexed annuities Fixed indexed annuities accounted for 10 per cent (2008: eight per cent) of Jackson’s policy and contract liabilities at 31 December 2009. Fixed indexed annuities vary in structure, but generally are deferred annuities that enable policyholders to obtain a portion of an equitylinked return (based on participation rates and caps) but provide a guaranteed minimum return. These guaranteed minimum rates are generally set at 1.25 to 3.0 per cent.
Immediate annuities At 31 December 2009, immediate annuities accounted for two per cent (2008: 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.
ii Variable annuities At 31 December 2009, VAs accounted for 49 per cent (2008: 39 per cent) of Jackson’s policy and contract liabilities. VAs are deferred annuities that have the same tax advantages and payout options as interest-sensitive and fixed indexed annuities.
The primary differences between VAs and interest-sensitive or fixed indexed annuities are investment risk and return. If a policyholder chooses a VA, the rate of return depends upon the performance of the selected fund portfolio. Policyholders may allocate their investment to either the fixed or variable account. Investment risk on the variable account is borne by the policyholder, while investment risk on the fixed account is borne by Jackson through guaranteed minimum fixed rates of return. At 31 December 2009, approximately 14 per cent (2008: approximately 18 per cent) of VA funds were in fixed accounts.
Jackson issues VA contracts where it contractually guarantees to the contractholder either a) return of no less than total deposits made to the contract adjusted for any partial withdrawals, b) total deposits made to the contract adjusted for any partial withdrawals plus a minimum return, or c) the highest contract value on a specified anniversary date adjusted for any withdrawals following the contract anniversary. These guarantees include benefits that are payable in the event of death (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(e). The GMIB is no longer offered, with existing coverage being reinsured.
Jackson enters into financial derivative transactions, including those noted below to reduce and manage business risks. These transactions manage the risk of a change in the value, yield, price, cash flows, or quantity of, or a degree of exposure with respect to assets, liabilities or future cash flows, which Jackson has acquired or incurred.
• credit default swaps, represent agreements under which Jackson has purchased default protection on certain underlying corporate bonds held in its portfolio. These contracts allow Jackson to sell the protected bonds at par value to the counterparty in the event of their default in exchange for periodic payments made by Jackson for the life of the agreement.
f 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).
In accordance with SOP03-01 (Accounting and Reporting by Insurance Enterprises for Certain Non-traditional Long Duration Contracts and for Separate Accounts) which specifies how certain guarantee features should be accounted for under US GAAP, the GMDB liability is not fair valued but is instead determined each period end by estimating the expected value of death benefits in excess of the projected account balance and recognising the excess ratably over the life of the contract based on total expected assessments. At 31 December 2009, the GMDB liability was valued using a series of deterministic investment performance scenarios, a mean investment return of 8.4 per cent (2008: 8.4 per cent) and assumptions for lapse, mortality and expense that are the same as those used in amortising the capitalised acquisition costs.
The assumptions used for calculating the direct GMIB liability at 31 December 2009 and 2008 are consistent with those used for calculating the GMDB liability.
For GMWB and GMIB reinsurance embedded derivatives that are fair valued under IAS 39, Jackson bases its volatility assumptions solely on implied market volatility with no reference to historical volatility levels and explicitly incorporates Jackson’s own credit risk in determining discount rates.
Volatility assumptions are now based on a weighting of available market data on implied volatility for durations up to ten years, at which point the projected volatility is held constant. Non-performance risk is incorporated into the calculation through the use of discount interest rates sourced from a AA corporate credit curve. Other risk margins, particularly for market illiquidity and policyholder behaviour are also incorporated into the model through the use of explicitly conservative assumptions. On a periodic basis, Jackson rationalises the resulting fair values based on comparisons to other models and market movements.
Institutional products are accounted for as investment contracts under IFRS with the liability classified as being in respect of financial instruments rather than insurance contracts, as defined by IFRS 4. In practice, there is no material difference between the IFRS and US GAAP basis of recognition and measurement for these contracts.
h Effect of changes in assumptions used to measure insurance assets and liabilities a 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) 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.
i Sensitivity of IFRS basis profit and equity to market and other risks i Currency fluctuations Consistent with the Group’s accounting policies, the profits of the Group’s US operations are translated at average exchange rates and shareholders’ equity at the closing rate for the reporting period. For 2009, the rates were US$1.57 (2008: US$1.85) and US$1.61 (2008: US$1.44) 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 A 10% decrease in exchange rates exchange rates
Shareholders’ equity attributable to US insurance operations (274) (158) 335 193
Note i Sensitivity on profit (loss) before tax i.e. aggregate of the operating profit based on longer-term investment returns and short-term fluctuations, as discussed in note B1.
A detailed analysis of actual experience is measured by internally developed mortality and persistency studies. For variable annuity business, the key assumption is the expected long-term level of equity market returns, which for 2009 and 2008 was 8.4 per cent per annum implemented using a mean reversion methodology. These returns affect the level of future expected profits through their effects on the fee income and the required level of provision for guaranteed minimum death benefit claims. The mean reversion methodology dampens the impact of equity market movements during a particular year, but does not fully eliminate the effects of movements in the equity markets.
In addition, the mean reversion methodology includes both a cap and a floor that determine the maximum impact that the methodology may have. Due to the significant market movements during 2008, Jackson exceeded the cap on future equity market returns, resulting in a higher level of sensitivity to market movements than would have been recognised had the cap not been met at the end of 2008. Given the low market return in 2008 this cap remained in place at 31 December 2009 and so the higher level of sensitivity remains.
As a result of this hedging programme, if the equity markets were to increase further in the future, Jackson’s free-standing derivatives would decrease in value. However, over time, this movement would be broadly offset by increased separate account fees and reserve decreases, net of the related changes to amortisation of deferred acquisition costs. Due to the nature of the free-standing and embedded derivatives, this hedge, while highly effective on an economic basis, may not completely mute the immediate impact of the market movements as the free-standing derivatives reset immediately while the hedged liabilities reset more slowly and fees are recognised prospectively. The opposite impacts would be observed if the equity markets were to decrease.
Net sensitivity of profit after tax and shareholders’ equity (76) (38) (166) (92) (64)
iv Exposure to interest rate risk Notwithstanding the market risk exposure described in note D3(e), 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(d) and D3(f). The GMWB features attaching to variable annuity business represents embedded derivatives which are fair valued and so will be sensitive to changes in interest rate.
Short-term fluctuations in investment returns (229) (109) 117 267 (466) (212) 208 448
Related effect on charge for deferred tax 131 60 (60) (131) 206 94 (95) (207)
Related effect on movement in deferred tax (497) (268) 268 497 (650) (325) 325 650
Total net effect on IFRS equity 680 387 (385) (677) 819 426 (426) (820)
Expected maturity: 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.
Notes on the Group financial statements > D: Life assurance businesses > continued a Summary statement of financial position
Assets Intangible assets attributable to shareholders: Deferred acquisition costs and other intangible assets – – 822 822 1,247
Other non-investment and non-cash assetsnote iii 234 83 563 880 1,416
Investments of long-term business and other operations: Investments accounted for using the equity method – – 2 2 –
Financial investments: Equity securities and portfolio holdings in unit trusts 3,691 7,224 267 11,182 8,077
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 £1,207 million (2008: £1,705 million) comprise mortgage loans of £13 million (2008: £238 million), policy loans of £437 million (2008: £675 million) and other loans of £757 million (2008: £792 million). The mortgage and policy loans are secured by properties and life insurance policies respectively. The majority of the other loans are commercial loans held by the Malaysian operation and which are all investment graded by two local rating agencies.
Notes on the Group financial statements > D: Life assurance businesses > continued b 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: Asian Unit-linked insurance
Notes i Movements in the year have been translated at the average exchange rate for the year ended 31 December 2009. The closing balance has been translated at the closing spot rates as at 31 December 2009. Differences upon retranslation are included in foreign exchange differences of negative £2,069 million.
iv The positive investment related items and other movements for with-profits (£1,431 million) and unit-linked business (£2,661 million) were mainly driven from Asian equity market gains in the period.
d Products and guarantees The life insurance products offered by the Group’s Asian operations include a range of with-profits and non-participating term, whole life, endowment and unit-linked policies. The Asian operations also offer health, disability, critical illness and accident coverage to supplement its core life products.
Non-participating long-term products are the only ones where the insurer is contractually obliged to provide guarantees on all benefits. Investment-linked products have the lowest level of guarantee, if any.
Product guarantees in Asia can be broadly classified into four main categories, namely premium rate, cash value and interest rate guarantees, policy renewability and convertibility options.
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 2009 of £349 million and £1,173 million respectively (2008: £312 million and £742 million respectively).
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.
f Process for setting assumptions and determining liabilities The future policyholder benefit provisions for Asian businesses in the Group’s IFRS accounts and previously under the MSB, are determined in accordance with methods prescribed by local GAAP adjusted to comply, where necessary, with UK GAAP.
For the Korea life business, refinements were made to move to a more appropriate basis which resulted in a credit of £35 million (£9 million of which related to the 1 January 2008 balance).
Profit (loss) before tax attributable to shareholdersnote i (40) (14) 49 18
Shareholders’ equity, excluding goodwill, attributable to Asian operations (129) (202) 158 246
For the purposes of analysing sensitivity to variations in interest rates, it has been determined for the majority of territories that a movement of one per cent in the 10 year government bond rate can be considered reasonably possible. At 31 December 2009, 10 year government bond rates vary from territory to territory and range from 1.3 per cent to 11.45 per cent (2008: 1.17 per cent to 10.18 per cent). An exception to this arises in Japan where reasonably possible interest rate movements have been determined as 0.5 per cent respectively. (2008: Japan 0.5 per cent, Vietnam 1.5 per cent). These reasonably possible changes would have the following impact: A decrease A decrease of 1% of 1%
c Equity price risk The non-linked shareholder business has limited exposure to equity and property investment (£278 million at 31 December 2009). Generally changes in equity and property investment values are not automatically matched by investments in policyholder liabilities. However for the Vietnam business, to the extent that equity investment appreciation is realised through sales of securities then policyholders’ liabilities are adjusted to the extent that policyholders participate.
A 10 or 20 per cent, (2008: 10, 20 or 40 per cent) increase in their value is estimated to have an approximately equal and opposite effect on profit and shareholders’ equity to the sensitivities shown above. The low tax rate effect, which is particularly evident in 2008 relates to the availability of losses in some of the territories.
Notes on the Group financial statements > D: Life assurance businesses > continued a Summary statement The Group’s estimated capital position for life assurance businesses with reconciliations to shareholders’ equity is shown below. Available capital for each fund or group of companies is determined by reference to local regulation at 31 December 2009 and 2008.
Total available capital resources of life assurance businesses on local regulatory bases – 6,432 6,432 1,607 2,488 1,129 11,656
Total subsidiaries Asian life Total life WPSF PAC with- and funds assurance assurance 31 December 2009 SAIF note i profits fund note ii Jackson subsidiaries operations
WPSF profits funds subsidi- opera- Prudential aries and Group 31 December 2008 SAIF note i fund note ii Jackson aries tions Capital) funds total
Adjustments to regulatory basis Unallocated surplus of with-profits fundsnote v – 8,254 8,254 – – 160 8,414
IFRS and regulatory basis for Jacksonnote viii – – – – 4,819 – 4,819
IFRS basis and regulatory basis – (1,350) (1,350) – – – (1,350)
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 I2).
Notes on the Group financial statements > D: Life assurance businesses > continued b Basis of preparation, capital requirements and management Each of the Group’s long-term business operations is capitalised to a sufficiently strong level for its individual circumstances. Details by the Group’s major operations are shown below.
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.
Available capital of the WPSF and SAIF of £6.4 billion (2008: £5.4 billion) represents the excess of assets over liabilities on the FSA realistic basis. Unlike the previously discussed FRS 27 basis, realistic liabilities on the regulatory basis include the shareholders’ share of future bonuses. These amounts are shown before deduction of the risk capital margin (RCM) which is estimated to be £1.4 billion at
The FSA’s basis of setting the RCM is to target a level broadly equivalent to a Standard & Poor’s credit rating of BBB and to judge this by ensuring there are sufficient assets to absorb a one in 200 year event. The RCM calculation achieves this by setting rules for the determination of margins to cover defined stress changes in asset values and yields for market risk, credit risk and termination risk for with-profits policies.
Other UK life assurance subsidiaries and funds The available capital of £1,607 million (2008: £1,053 million) reflects the excess of regulatory basis assets over liabilities of the subsidiaries and funds, before deduction of the capital resources requirement of £952 million (2008: £884 million).
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 on a formula-based capital standard that they calculate by applying factors to various asset, premium and reserve items. The formula takes into account the risk characteristics of a company, including asset risk, insurance risk, interest rate risk and business risk.
The available capital of Jackson shown above of £2,488 million (2008: £2,758 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.
iii Asian operations The available capital shown above of £1,129 million (2008: £1,410 million) represents the excess of local regulatory basis assets over liabilities before deduction of required capital of £438 million (2008: £407 million). These amounts have been determined applying the local regulations in each of the operations.
For non-participating business, gross premium reserves determined using best estimate assumptions along with provisions of risk margin for adverse deviations (PRADs) discounted at the risk-free rate are held. For linked business the value of units is held together with a non-unit reserve calculated in accordance with standard actuarial methodology.
The capital requirement in Korea has moved to a risk-based regulatory framework in April 2009 with a two-year transition period where insurers can choose between the prior and new framework. A risk-based regulatory framework is adopted immediately by the Company. Under the new framework, insurance companies in Korea are expected to maintain a level of free surplus in excess of the capital requirements with the general target level of solvency margin being in excess of 150 per cent of the risk-based capital.
c Movements in total available capital Total available capital for the Group’s life assurance operations has changed during 2009 as follows: 2009 £m
Other UK life assurance Asian life subsidiaries assurance WPSF and funds Jackson subsidiaries Group note i note iii note ii note iv total
The increase of £507 million in 2008 reflected an underlying decrease of £358 million (applying the 2008 year end exchange rate of $1.44:£1) and £865 million of exchange translation gain.
The underlying increase/decrease of the available capital of Jackson in 2009 and 2008 includes the effects of capital contributions, dividends paid to the parent company, impairment losses and also the effects of hedging transactions.
iv Asian life assurance subsidiaries The decrease of £281 million in 2009 reflects an underlying decrease of £152 million (applying the relevant 2009 year end exchange rates) and £129 million of exchange translation loss. This underlying decrease of available capital includes the effects of the change to a risk-based capital framework in Malaysia from 1 January 2009 as explained in section b above and also the sale of the Taiwan agency business in June 2009 as described in note I1.
f Intra-group arrangements in respect of SAIF Should the assets of SAIF be inadequate to meet the guaranteed benefit obligations to the policyholders of SAIF, the PAC long-term fund would be liable to cover any such deficiency.
Notes on the Group financial statements > E: Asset management (including US broker-dealer) and other operations a The profit included in the income statement in respect of asset management operations for the year is as follows: Asset management operations
Comprising: Operating profit based on longer-term investment returns† 238 4 55 297 345
*Included within revenue for M&G of £799 million (2008: £53 million) are realised and unrealised net gains of £176 million (2008: losses of £673 million) in respect of consolidated investment funds and Prudential Capital. The investment funds are managed on behalf of third-parties and are consolidated under IFRS in recognition of the control arrangements for the funds. The investment losses in respect of the investment funds are non-recourse to M&G and the Group and are added back through charges and consequently there is no impact on the profit before tax. Excluding the anomaly in respect of the consolidated investment funds the revenue for M&G would be £697 million (2008: £494 million) and the charges, £403 million (2008: £413 million.)
Notes on the Group financial statements > E: Asset management (including US broker-dealer) and other operations > continued
Financial investments: Equity securities and portfolio holdings in unit trusts 129 – 8 137 23
Cash and cash equivalents note v 820 40 110 970 1,472
Liabilities Intra Group debt represented by operational borrowings at Group levelnote iv 2,038 – – 2,038 1,278
Net asset value attributable to external holders of consolidated unit trusts and similar funds note v 410 – – 410 1,065
v Consolidated unit trusts and similar funds The M&G statement of financial position shown above includes investment funds which are managed on behalf of third-parties. In respect of these funds, the statement of financial position includes cash and cash equivalents of £269 million, £158 million of other investments, £(17) million of other net assets and liabilities and the net asset value attributable to external unit holders of £410 million which are non-recourse to M&G and the Group.
A 10 per cent increase in the relevant Asian exchange rates would have reduced reported profit before tax attributable to shareholders and shareholders’ equity, excluding goodwill attributable to Asia and PPM America asset management operations, by £5 million (2008: £5 million) and £23 million (2008: £26 million) respectively.
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 2009 by asset management operations were £1,164 million (2008: £991 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.
Notes on the Group financial statements > F: Income statement notes
Total revenue, net of reinsurance note iii (12,426) 517 1,121 52 409 202 (10,125) (142) (10,267)
Total charges, net of reinsurance note iii 11,224 (1,169) (1,074) 29 (402) (150) 8,458 (265) 8,193
Notes on the Group financial statements > F: Income statement notes > continued
Notes i The segmental analysis of interest income is as follows: £m £m
Unallocated corporate 10 55 ii Interest income includes £17 million (2008: £11 million) accrued in respect of impaired securities. iii Fee income includes £1 million (2008: £7 million) relating to financial instruments that are not held at fair value through profit and loss.
In Asia, revenue from external customers from no individual country exceeds 10 per cent of the Group total. The largest country is Hong Kong with a total revenue from external customers of £1,013 million (2008: £1,170 million).
ii Acquisition costs also include fee expenses relating to financial liabilities held at amortised cost of £nil (2008: £nil). iii Administrative and operating costs include the movement in amounts attributable to external unit holders of the consolidated investment funds of the
Notes on the Group financial statements > F: Income statement notes > continued v Interest expense, excluding interest on core structural borrowings of shareholder-financed operations, amounted to £89 million (2008: £278 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: £m £m
Finance costs consist of £196 million (2008: £161 million) interest on core debt of the parent company and £13 million (2008: £11 million) on US insurance operations’ surplus notes.
a Total tax (charge) credit by nature of expense An analysis of the total tax benefit (expense) of continuing operations recognised in the income statement by nature of benefit (expense) is as follows: Current tax (expense) benefit: Corporation tax (500) (225)
Deferred tax arising from: Origination and reversal of temporary differences (340) 1,629
Expense in respect of a previously unrecognised tax loss, tax credit or temporary difference from a prior period (4) (77)
The total tax (expense) benefit arises as follows: Current tax (expense) benefit: Deferred tax (charge) credit: The total tax charge of £873 million for 2009 (2008: credit of £1,683 million) comprises a charge of £895 million (2008: credit of £1,758 million) for UK tax and a credit of £22 million (2008: charge of £75 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 £55 million for 2009 (2008: credit of £59 million) comprises a charge of £176 million (2008: credit of £95 million) for UK tax and a credit of £121 million (2008: charge of £36 million) for overseas tax.
F4: Finance costs: Interest on core structural borrowings of shareholder-financed operations
The prior year adjustments primarily relate to a change in assumptions regarding available foreign tax credits on overseas dividends and other changes that arose as a result of routine revision of tax returns.
b Reconciliation of effective tax rate The total tax charge is attributable to shareholders and policyholders as summarised in the income statement.
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.
The purpose of this approach is to ensure that the Company is always at a minimum taxed on the profit, as defined for taxation purposes by reference to the Company’s regulatory returns (rather than IFRS basis results), that it has earned. The shareholders’ portion of the long-term business is taxed at the shareholders’ rate, with the remaining portion taxed at rates applicable to the policyholders.
For SAIF, similar transfers are made. However, in the case of SAIF, a net nil balance is derived, reflecting the lack of shareholder interest in the financial performance of the fund (other than through asset management arrangements).
Asian US UK insurance insurance insurance Other operations operations operations operations Total
Short-term fluctuations in investment returns 31 27 108 (130) 36 Shareholders’ share of actuarial and other gains and losses on defined benefit pension schemes – – (46) (28) (74) Loss on sale and results for Taiwan agency business (621) – – – (621)
Expected tax (charge) credit based on expected tax rates: Operating profit based on longer-term
Short-term fluctuations in investment returns (8) (9) (30) 47 – 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
Short-term fluctuations in investment returns 15 195 – 14 224 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)
Notes on the Group financial statements > F: Income statement notes > continued 2008 £m
Results for sold Taiwan agency business 1 – – – 1
Shareholders’ share of actuarial and other gains and losses on defined benefit pension schemes 25% – – 28% 27%
Results for sold Taiwan agency business 25% – – – 25%
Results for sold Taiwan agency business – – – – –
Shareholders’ share of actuarial and other gains and losses on defined benefit pension schemes – – – (1) (1)
Shareholders’ share of actuarial and other gains and losses on defined benefit pension schemes 1 – – 2 3
IFRS basis profits, is restricted to a share of the actuarially determined surplus for distribution (in the UK 10 per cent)). Except for this surplus the investment return of the with-profit funds is attributable to policyholders (through the asset-share liabilities) or the unallocated surplus, which is accounted for as a liability under IFRS 4.
The investment return related to the types of business above does not impact shareholders’ profits directly. However there is an indirect impact, for example, investment-related fees or the effect of investment return on the shareholders’ share of the cost of bonuses of withprofits funds.
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.
Benefits and claims represent payments, including final bonuses, to policyholders in respect of maturities, surrenders and deaths plus the change in technical provisions (which primarily represents the movement in amounts owed to policyholders). Benefits and claims are amounts attributable to policyholders. The movement in unallocated surplus of with-profits funds represents the transfer to (from) the unallocated surplus each year through a charge (credit) to the income statement of the annual excess (shortfall) of income over expenditure of the with-profits funds, after declaration and attribution of the cost of bonuses to policyholders and shareholders.
F7: Benefits and claims and movements in unallocated surplus of with-profits funds, net of reinsurance
Notes on the Group financial statements > G: Financial assets and liabilities
Financial assets Cash and cash equivalents – – 5,307 5,307 5,307
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 –
Financial assets Cash and cash equivalents – – 5,955 5,955 5,955
Obligations under funding, securities lending and sale and repurchase agreements – 5,572 – 5,572 5,676
Notes i As at 31 December 2009, £659 million (2008: £620 million) of convertible bonds were included in debt securities and £347 million
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 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 fair value estimates cannot be substantiated by comparison to independent markets, nor can the disclosed value be realised in immediate settlement of the financial instrument.
The fair value of borrowings is based on quoted market prices, where available. Section A4 provides details of the determination of fair value for investment contracts without fixed and guaranteed terms (notably
Level 1, 2 and 3 fair value measurement hierarchy of Group financial instruments In March 2009 IFRS 7 ‘Financial Instruments: Disclosures’ was amended by the IASB to require certain additional disclosures to be included in IFRS financial statements. This includes, as is presented below, a table of financial instruments carried at fair value analysed by level of the IFRS 7 defined fair value hierarchy. This hierarchy is based on the inputs of the fair value measurement and reflects the lowest level input that is significant to that measurement. IFRS 7 does not require comparatives to be provided in the year of adoption but we have chosen to provide the table at both 31 December 2009 and 31 December 2008.
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 fund valued with observable inputs. It also includes net assets attributable to unitholders 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 have generally been classified as level 2 as the nature of broker quotations means that it does not strictly meet the definition of a level 1 asset. However 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.
Level 3: Significant inputs for the asset or liability that are not based on observable market data (unobservable inputs) Level 3 principally includes investments in private equity funds, investments in property funds which are exposed to bespoke properties or risks, investments which are internally valued or subject to a significant number of unobservable assumptions and certain derivatives which are bespoke or long dated. It also includes debt securities which are rarely traded or traded only in privately negotiated transactions and hence where it is difficult to assert that these have been based on observable market data. The inherent nature of the vast majority of these assets means that, in normal market conditions, there is unlikely to be significant change in the specific underlying assets classified as level 3.
Group total Equity securities and portfolio holdings in unit trusts 67,861 839 654 69,354
With-profits Equity securities and portfolio holdings in unit trusts 30,427 885 509 31,821
Total financial investments, net of derivative liabilities 37,103 34,451 3,973 75,527
Investment contracts without discretionary participation features held at fair value – – – –
Unit-linked and variable annuity Equity securities and portfolio holdings in unit trusts 29,097 114 – 29,211
Investment contracts without discretionary participation features held at fair value – (10,309) – (10,309)
Net asset value attributable to unit holders of consolidated unit trusts and similar funds (877) – – (877)
Non-linked shareholder-backed Equity securities and portfolio holdings in unit trusts 745 27 318 1,090
Total financial investments, net of derivative liabilities 7,648 35,167 4,760 47,575
Reconciliation of movements in level 3 financial instruments measured at fair value The following table reconciles the value of level 3 financial instruments 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 recorded gains/ in other losses in compre- Transfers Transfers At At 1 Jan income hensive into out of 31 Dec 2009 statement income Purchases Sales Settled level 3 level 3 2009 £m £m £m £m £m £m £m £m £m
Total financial investments, net of derivative liabilities 3,973 (230) (101) 479 (359) (17) 142 (54) 3,833
Net asset value attributable to unit holders of consolidated unit trusts and similar funds (381) 9 – 49 – – – – (323)
(including derivative assets) – – – – – – – – – Derivative liabilities – – – – – – – – –
Total financial investments, net of derivative liabilities 33 2 1 16 – (8) – (4) 40
Net asset value attributable to unit holders of consolidated unit trusts and similar funds (65) 17 6 – – – – – (42)
Total financial investments, net of derivative liabilities 8,766 (67) (775) 709 (1,172) (27) 384 (2,261) 5,557
Transfers between level 1 and level 2 There have been no significant transfers between level 1 and level 2 during the year.
The interest expense on financial liabilities not at fair value through profit and loss for the year ended 31 December 2009 from continuing operations was £366 million (2008: £645 million).
Obligations under funding, securities lending and sale and repurchase agreements 889 4,683 – 5,572
Total After 1 After 5 After 10 After 15 carrying 1 year year to years to years to years to Over No stated value or less 5 years 10 years 15 years 20 years 20 years maturity Total
Obligations under funding, securities lending and sale and repurchase agreements 5,572 5,572 – – – – – – 5,572
Total After 1 After 3 carrying 1 year year to years to After value or less 3 years 5 years 5 years Total
The net derivative positions as shown in the table above comprise the following derivative assets and liabilities: Derivative assets 1,780 2,370
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.
Notes on the Group financial statements > G: Financial assets and liabilities > continued 2009 £bn
Total After 1 After 5 After 10 After 15 undis1 year year to years to years to years to Over counted Carrying or less 5 years 10 years 15 years 20 years 20 years value value
The maturity profile above excludes certain corporate unit-linked business with gross policyholder liabilities of £9 billion (2008: £8 billion) which has no stated maturity but which is repayable on demand.
For the reasons above an analysis of the Group’s assets by contractual maturity is not considered necessary to evaluate the nature and extent of the Group’s liquidity risk.
Of the total loans and receivables held £64 million (2008: £21 million) are past their due date but have not been impaired. Of the total past due but not impaired, £53 million are less than one year past their due date and £11 million is more than six months but less than one year past their due date (2008: £21 million and nil respectively). The Group expects full recovery of these loans and receivables. No further analysis has been provided of the age of financial assets that are past due at the end of the reporting period but not impaired as the amounts are immaterial.
Financial assets that would have been past due or impaired had the terms not been renegotiated amounted to £55 million (2008: £1 million).
Currency risk As at 31 December 2009, the Group held 19 per cent (2008: 20 per cent) and 13 per cent (2008: 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 liabilities, of which 34 per cent (2008: 38 per cent) are held by the PAC with-profits fund, mainly relate to foreign currency borrowings.
UK US Asian insurance insurance insurance Asset Unallocated Group operations operations operations management to a segment total 2008 £m
UK US Asian insurance insurance insurance Asset Unallocated Group operations operations operations management to a segment total
Notes on the Group financial statements > G: Financial assets and liabilities > continued
These derivatives are used for efficient portfolio management to obtain cost effective and efficient exposure to various markets in accordance with the Group’s investment strategies and to manage exposure to interest rate, currency, credit and other business risks. See also note D3 for use of derivatives by the Group’s US operations.
The US operations and some of the UK operations hold large amounts of interest-rate sensitive investments that contain credit risks on which a certain level of defaults is expected. These entities have purchased some swaptions in order to manage the default risk on certain underlying assets and hence reduce the amount of regulatory capital held to support the assets.
Cash flow hedges The Group has no cash flow hedges in place.
In addition, the Group has designated perpetual subordinated capital securities totalling US$1.55 billion as a net investment hedge to edge the currency risks related to the net investment in Jackson. The carrying value of the subordinated capital securities was £963 million (2008: £1,059 million) as at 31 December 2009. The foreign exchange gain of £118 million (2008: loss of £299 million) on translation of the borrowings to pounds sterling at the statement of financial position date is recognised in the translation reserve in shareholders’ equity.
At 31 December 2009, 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 £1,587 million (2008: £588 million), together with accrued interest.
Collateral and pledges under derivative transactions At 31 December 2009, the Group had pledged £644 million (2008: £1,154 million) for liabilities and held collateral of £586 million (2008: £829 million) in respect of over-the-counter derivative transactions.
During the year ended 31 December 2009, impairment losses of £647 million (2008: £525 million) were recognised for available-forsale securities and loans and receivables. These were £630 million (2008: £497 million) in respect of available-for-sale securities held by Jackson and £17 million (2008: £28 million) in respect of loans and receivables. The 2009 impairment charge for loans and receivables of £17 million relates to loans held by the UK with-profits fund and mortgage loans held by Jackson. The 2008 impairment charge for loans and receivables of £28 million related primarily to loans held by the UK with-profits fund.
Impairment losses recognised on available-for-sale securities amounted to £630 million (2008: £497 million). Of this amount, 86 per cent (2008: 29 per cent) has been recorded on structured asset-backed securities, primarily due to reduced cash flow expectations on such securities that are collateralised by diversified pools of primarily below investment grade securities. Of the losses related to the impairment of fixed maturity securities, the top five individual corporate issuers made up 11 per cent (2008: 27 per cent), reflecting a deteriorating business outlook of the companies concerned.
(2008: 55 per cent) of these losses related to the disposal of fixed maturity securities of five (2008: six) individual issuers, which were disposed of to rebalance the portfolio in the US operations in response to the unstable mortgage lending.
For 2009 the amounts of gross unrealised losses for fixed maturity securities classified as available-for-sale under IFRS in an unrealised loss position was £966 million (2008: £3,178 million). Notes B1 and D3 provide further details on the impairment charges and unrealised losses of Jackson’s available-for-sale securities.
iii The risk discount rate. Differing discount rates have been applied in accordance with the nature of the individual component businesses. For retail and institutional business a risk discount rate of 12 per cent (2008: 12 per cent) has been applied to post-tax cash flows. The pre-tax risk discount rate was 16 per cent (2008: 16 per cent). Management have determined the risk discount rate by reference to an average implied discount rate for comparable UK listed asset managers calculated by reference to risk-free rates, equity risk premiums of five per cent and an average ‘beta’ factor for relative market risk of comparable UK listed asset managers. A similar approach has been applied for the other component businesses of M&G.
b Deferred acquisition costs and other intangible assets Deferred acquisition costs and other intangible assets in the Group consolidated statement of financial position attributable to shareholders consist of: Deferred acquisition costs (DAC) related to insurance contracts as classified under IFRS 4 3,823 5,097
Present value of acquired in-force policies for insurance contracts as classified under IFRS 4 52 64
Present value of future profits of acquired investment management contracts, including life assurance contracts classified as financial instruments and investment management contracts under IFRS 4 1 1
Total of deferred acquisition costs and other intangible assets 4,049 5,349
Note i The amount in respect of US insurance operations comprises entirely of DAC and includes £1,938 million (2008: £1,676 million) in respect of variable annuity business, £1,164 million (2008: £1,134 million) in respect of other business and £(10) million (2008: £1,152 million) in respect of cumulative shadow DAC.
Balance at 31 December 4,049 5,349 * As a result of changes following the implementation of amendments to IAS 1, exchange losses of £239 million relating to US operations charge in shadow DAC have been reclassified as exchange movement within exchange differences in the table above. This is explained further in note A5. There is no impact on shareholders’ equity or the income statement from this change.
Amortisation is included in the ‘acquisition costs and other operating expenditures’ line in the income statement.
Distribution rights attributable to the Asian insurance operations Distribution rights relate to facilitation fees paid in respect of the bancassurance partnership arrangements in Asia for the bank distribution of Prudential’s insurance products for a fixed period of time. The distribution rights amounts are amortised over the term of the distribution contracts.
All the goodwill relates to the UK insurance operations segment. The only venture fund investment consolidated by the Group relates to an investment by PAC with-profits fund managed by M&G.
The goodwill shown in the table above relates to this venture fund investment. Goodwill is tested for impairment for this investment by comparing the investment’s carrying value including goodwill with its recoverable amount. The recoverable amount of the investment was determined by calculating its fair value less costs to sell. The fair value has been determined by using the discounted cash flow valuation. The valuation is 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 calculation is the risk discount rate of 14 per cent which has been derived by reference to risk-free rates and an equity premium risk. In 2009, following the impairment testing carried out, £50 million (2008: £18 million) of the goodwill was deemed to be impaired and written off accordingly.
Deferred acquisition costs related to insurance contracts attributable to the PAC with-profit fund The movement in deferred acquisition costs relating to insurance contracts attributable to the PAC with-profits fund is as follows: Additions – –
Liabilities The current tax liability increased to £1,215 million (2008: £842 million) primarily due to the increase in policyholder tax payable in the UK. The Group considers that whilst the UK tax provision established within the current tax liability represents an appropriate provision for matters under discussion with HM Revenue & Customs in the UK, it is not possible to estimate the amount of the tax liability expected to be settled in one year or less due to the uncertainty over when these issues will be agreed.
Discounting Deferred tax asset and liability balances have not been discounted.
Of the £3,235 million (2008: £3,745 million) of accrued investment income and other debtors, £134 million (2008: £114 million) is expected to be settled after one year or more.
Net book amount 153 – 214 367 * In line with changes issued by the IASB as part of its Annual Improvement Project in May 2008 as shown in note A5, all development properties have been reclassified as investment properties (see note H7).
Notes on the Group financial statements > H: Other information on statement of financial position items > continued
Disposals (including amounts disposed of with the Taiwan agency business) (1,220) (1,010)
arising from investment properties: That generated rental income during the year 131 109
The present values of these minimum lease payments are: Less than 1 year 8 5
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.
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 662 742
Investments in associates The Group had three associates at 31 December 2009 (2008: four) that are accounted for using the equity method. The Group’s associates are a 30 per cent interest in The Nam Khang, a Vietnamese property developer, a 30 per cent interest in Apollo Education and Training Organisation Vietnam and a 25 per cent interest in OYO Developments Limited. IFonline Group Limited (IFonline) is no longer an associate of the Group following a restructuring of that entity in April 2009.
Associates accounted for using the equity method A summary of the movements in investments in associates accounted for using the equity method in 2009 and 2008 is set out below: Total Share of Share of Share of carrying capital reserves net assets Goodwill value £m £m £m £m £m
Share of loss for the year after tax – – – – –
The Group’s share of the assets, liabilities, revenues and profit and loss of associates accounted for using the equity method at 31 December 2009 and 2008 is as follows: Financial position Total assets (excluding goodwill) 5 12
Associates carried at fair value through profit and loss The Group’s associates that are carried at fair value through profit and loss comprise investments in OEICs, unit trusts, funds holding collateralised debt obligations, property unit trusts, and venture capital investments of the PAC with-profits fund where the Group has significant influence. These investments are incorporated both in the UK and overseas, and some have year ends which are noncoterminous with that of the Group. In these instances, the investments are recorded at fair value at 31 December 2009 based on valuations or pricing information at that specific date. The aggregate fair value of associates carried at fair value through profit and loss where there are published price quotations is approximately £6 billion (2008: £4 billion) at 31 December 2009.
CITIC – Prudential Life Insurance Company Limited 50 Life assurance China
The summarised financial data for the Group’s share of investments in joint ventures is as follows: Financial position Current assets 386 250
There are several minor service agreements in place between the joint ventures and the Group. During 2009, the aggregate amount of the transactions was £14.1 million (2008: £15.9 million) and the balance outstanding as at 31 December 2009 was £54.6 million (2008: £22.5 million).
Gains on disposal of held for sale assets are recorded in ‘investment income’ within the income statement.
Cash and cash equivalents consist of cash at bank and in hand, deposits held at call with banks, treasury bills and other short-term highly liquid investments with less than 90 days maturity from the date of acquisition. Cash and cash equivalents included in the cash flow statement comprise the following statement of financial position amounts: Cash equivalents 236 593
Cash and cash equivalents held centrally are considered to be available for general use by the Group. These funds amount to £895 million and £165 million at 31 December 2009 and 2008, 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.
Total shareholders’ equity 6,271 5,058 * As a result of changes following the implementation of amendments to IAS 1, losses of £240 million relating to US operations previously included within the unrealised valuation movement of Jackson’s available-for-sale debt securities have been reclassified as exchange movements within the statement of comprehensive income. This is explained further in note A5. There is no impact on shareholders’ equity or the income statement from this change.
Number of Share Share ordinary capital premium shares £m £m Issued shares of 5p each fully paid: At the beginning of the year 2,470,017,240 123 1,828
The cost of own shares of £75 million as at 31 December 2009 (2008: £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 2009, 5.3 million (2008: 6.4 million) Prudential plc shares with a market value of £34 million (2008: £27 million) were held in such trusts. Of this total, 4.8 million (2008: 6.0 million) shares were held in trusts under employee incentive plans. In 2009, the Company purchased 3.4 million (2008: 5.4 million) shares in respect of employee incentive plans at a cost of £17 million (2008: £27 million). The maximum number of shares held in the year was 6.4 million which was at the beginning of the year.
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 2009 was 10.6 million (2008: 9.2 million) and the cost of acquiring these shares of £51 million (2008: £47 million) is included in the cost of own shares. The market value of these shares as at 31 December 2009 was £67 million (2008: £37 million).
Movement in year Insurance Unallocated contract surplus of withliabilities profits funds £m £m
Notes B6, D2b, D3b and D4b provide further analysis of the movement in the year of the Group’s policyholder liabilities and unallocated surplus of the with-profits funds.
US$300m 6.5% Perpetual Subordinated Capital Securities notes iv 192 192 190
Senior debt: Jackson US$250m 8.15% Surplus Notes 2027 note vi 154 154 173 * These debt classifications are consistent with the treatment of capital for regulatory purposes, as defined in the FSA Handbook. † The senior debt ranks above subordinated debt in the event of liquidation.
Notes i The ¤500 million 5.75 per cent borrowings have been swapped into borrowings of £333 million with interest payable at six month £Libor plus 0.962 per cent.
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 Interest on the US$1,000 million 6.5 per cent borrowings was swapped into floating rate payments at three month US$Libor plus 0.80 per cent.
v The £249 million 5.5 per cent borrowings were repaid on maturity in May 2009. In the same month, the Company issued £400 million subordinated debt in part to replace the maturing debt.
vi The Jackson borrowings are unsecured and subordinated to all present and future indebtedness, policy claims and other creditor claims of Jackson. vii Maturity analysis The following table sets out the contractual maturity analysis of the Group’s core structural borrowings: £m £m
Less than 1 year – 249 1 to 2 years – – 2 to 3 years – – 3 to 4 years – – 4 to 5 years – –
Borrowings in respect of short-term fixed income securities programmes Commercial paper 2,031 1,269
ii This represents senior debt issued through the Federal Home Loan Bank of Indianapolis and was secured on collateral posted with FHLB by Jackson. iii Piedmont is an investment trust investing in certain asset-backed and mortgage-backed securities in the US. These borrowings pertain to debt instruments issued to external parties.
iv Bank loans and overdrafts include a short-term loan of £130 million in respect of Asian operations (2008: £130 million). v Other borrowings represents amounts whose repayment to the lender is contingent on future surpluses emerging from certain contracts specified under the arrangement. If insufficient surplus emerges on the contracts, there is no recourse to other assets of the Group and the liability is not payable to the degree of shortfall.
vi In addition to the operational borrowings shown in the table above, Prudential plc has issued £200 million Floating Rate Notes 2010, which were wholly subscribed to by a Group subsidiary. These borrowings have been eliminated on consolidation.
vii Maturity analysis The following table sets out the contractual maturity analysis of the Group’s operational borrowings attributable to shareholder-financed operations: £m £m
Non-recourse borrowings of consolidated investment funds note i 1,016 1,161 £100m 8.5% Undated Subordinated Guaranteed Bonds of Scottish Amicable Finance plc note ii 100 100
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: £m £m
Deficit, gross of deferred tax, based on scheme assets held, including investments in
Prudential insurance policies: Attributable to PAC with-profits fund (i.e. absorbed by the liability for unallocated surplus) 122 67
Attributable to shareholder-financed operations (i.e. to shareholders’ equity) 128 82 250 149
Add back: Investments in Prudential insurance policies 187 157 Provision after elimination of investments in Prudential insurance policies and matching policyholder liability from Group statement of financial position 437 306
Analysis of other provisions: Charged to income statement: Additional provisions 148 48
Legal provisions Of the legal provisions of £15 million (2008: £23 million) £11 million (2008:£23 million) relates to Jackson. Jackson has been named in civil proceedings, which appear to be substantially similar to other class action litigation brought against many life insurers in the US, alleging misconduct in the sale of insurance products. During 2009, £9 million was paid.
Other provisions Other provisions of £174 million (2008: £111 million) include provisions of £143 million (2008: £95 million) relating to staff benefit schemes. During 2009, another £112 million was provided (including exchange movements of £6 million), £10 million of unused provision was released and £54 million was paid. In 2008, a provision of £155 million was brought forward, an additional £37 million was provided, £15 million of unused provision was released and £82 million was paid. Other provisions also include £27 million (2008: £16 million) relating to various onerous contracts where, in 2009, an additional £15 million was provided and £4 million was used. In 2008, £11 million was brought forward, £10 million was provided and £5 million was paid. Other provisions also include £4 million of regulatory provisions, where £9 million was provided, £2 million of unused provision was released and £3 million was paid.
Contingencies and related obligations Litigation In addition to the legal proceedings relating to Jackson mentioned under the legal provisions section above, the Group is involved in other litigation and regulatory issues. Whilst the outcome of such matters cannot be predicted with certainty, the Company believes that the ultimate outcome of such litigation and regulatory issues will not have a material adverse effect on the Group’s financial condition, results of operations, or cash flows.
The pension mis-selling provision at 31 December 2009 set out above of £322 million is stochastically determined on a discounted basis. The average discount rate implied in the movement in the year is 4.6 per cent. The undiscounted amounts at 31 December 2009 expected to be paid in each of the years ending 31 December are as follows: F IN
Notes on the Group financial statements > H: Other information on statement of financial position items > continued 2009 £m
The Financial Ombudsman Service periodically updates the actuarial assumptions to be used in calculating the compensation payments, including interest rates and mortality assumptions. The pension mis-selling provision represents the discounted value of future expected payments, including benefit payments and all internal and external legal and administrative costs of adjudicating, processing and settling those claims. To the extent that amounts have not been paid, the provision increases each year reflecting the shorter period of discount.
The bonus and investment policy for each type of with-profits policy is the same irrespective of whether or not the assurance applies and this is expected to continue for the foreseeable future. Hence removal of the assurance for new business has had no impact on policyholder returns.
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.
In addition, in the year ended 31 December 2009 Prudential Assurance’s main with-profits fund paid compensation of £2 million (2008: £1 million) in respect of mortgage endowment products mis-selling claims and at 31 December 2009 held a provision of £47 million (2008: £54 million) in respect of further compensation. The movement in this provision has no impact on the Group’s profit before tax.
Guaranteed annuities Prudential Assurance used to sell guaranteed annuity products in the UK and at 31 December 2009 held a provision of £31 million (2008: £42 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 2009 a provision of £284 million (2008: £391 million) was held in SAIF to honour the guarantees. As SAIF is a separate sub-fund of the Prudential Assurance long-term business fund, the movement in this provision has no impact on shareholders.
The inherited estate, as working capital, enables PAC to support with-profits business by providing the benefits associated with smoothing and guarantees, by providing investment flexibility for the fund’s assets, by meeting the regulatory capital requirements that demonstrate solvency and by absorbing the costs of certain significant events or fundamental changes in its long-term business without affecting the bonus and investment policies. The size of the inherited estate fluctuates from year to year depending on the investment return and the extent to which it has been required to meet smoothing costs, guarantees and other events.
Should the assets of SAIF be inadequate to meet the guaranteed benefit obligations to the policyholders of SAIF, the PAC long-term fund would be liable to cover any such deficiency. Due to the quality and diversity of the assets in SAIF and the ability of SAIF to revise guaranteed benefits in the event of an asset shortfall, the directors believe that the probability of either the PAC long-term fund or the Group’s shareholders’ funds having to contribute to SAIF is remote.
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 £15 million at 31 December 2009 (2008: £18 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 2009, Jackson has unfunded commitments of £339 million (2008: £400 million) related to its investments in limited partnerships and of £89 million (2008: £24 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.
The Company retains its interest in life insurance business in Taiwan through its retained bank distribution partnerships and its direct investment of 9.99 per cent in China Life.
Loss on sale and trading results of the Taiwan agency business: Gross of tax (621) 1
Loss on sale and results of the Taiwan agency business, net of tax (603) (3)
I1: Sale of legacy agency book and agency force in Taiwan to China Life Insurance Company of Taiwan
Cash and cash equivalents disposed of were £388 million and restructuring and other costs incurred in cash in the year were £64 million. In addition, the Company invested £45 million in China Life as described above. Accordingly, the cash outflow for the Group arising from the sale of the Taiwan agency business, as shown in the consolidated statement of cash flows, was £497 million.
a Staff and employment costs The average number of staff employed by the Group during the year was: Business operations: UK operations 4,516 6,231
The costs of employment were: Business operations: Wages and salaries 878 791
Pension actuarial and other losses (gains) charged to income statement 138 (10)
Other pension costs comprises £57 million (2008: £47 million) relating to defined benefit schemes and £38 million (2008: £31 million) relating to defined contribution schemes of continuing operations. Of the defined contribution scheme costs, £27 million (2008: £21 million) related to overseas defined contribution schemes. The £57 million (2008: £47 million) relating to defined benefit schemes comprises a charge of £29 million (2008: £29 million) relating to PSPS and a charge of £28 million (2008: £18 million) for other schemes.
Consistent with the derecognition of the Company’s interest in the underlying IAS 19 surplus of PSPS as described in note (b)(i)1 below, the £29 million (2008: £29 million) for PSPS represents the cash cost of contributions for ongoing service of active members and the unwind of discount on the opening provision for deficit funding for PSPS. The charge of £28 million (2008: £18 million) for other schemes comprises a £19 million (2008: £7 million) charge on an economic basis, reflecting the total assets of the schemes, and a further £9 million (2008: £11 million) charge to adjust for amounts invested in Prudential insurance policies to arrive at the IAS 19 basis charge.
The loss of £138 million (2008: gains of £10 million) for actuarial and other gains comprises a loss of £155 million (2008: £21 million) for actuarial and other losses on an economic basis and £17 million actuarial gains (2008: £31 million) to adjust for amounts invested in Prudential insurance policies. The derivation of these amounts is shown in note (b)(i)7 on pages 282 and 283.
The Group also operates two smaller defined benefit schemes for UK employees in respect of Scottish Amicable and M&G. For all three schemes the projected unit method was used for the most recent full actuarial valuations. There is also a small defined benefit scheme in Taiwan but as part of the sale of the Taiwan agency business completed in June 2009, the Group settled the majority of the obligations under the scheme as a significant number of employees transferred out.
Under the IAS 19 valuation basis, the Group adopted IFRIC 14, ‘IAS 19 – The Limit on a Defined Benefit Asset, Minimum Funding Requirements and their Interaction’ in 2008. Under IFRIC 14, on an economic basis the Group has not recognised the underlying PSPS surplus of £513 million gross of deferred tax (2008: £728 million) due to the Group not having an unconditional right of refund to any surplus in the scheme. Additionally, under IFRIC 14, the Group has also recognised a liability for committed deficit funding obligation to PSPS. Although the contributions would increase the surplus in the scheme, the corresponding asset will not be recognised in the Group accounts. At 31 December 2009, based on the new funding arrangement as described above, the Group has recognised a liability for deficit funding to 30 June 2012 for PSPS of £75 million, gross of deferred tax (2008: £65 million gross of deferred tax based on the previous deficit funding commitment to 5 April 2010).
As at 31 December 2009, after the effect of the application of IFRIC 14, the shareholders’ share of the pension liability for PSPS deficit funding obligation and the deficits of the defined benefit pension schemes amounted to a £92 million liability net of related tax relief (2008: £61 million). These amounts are determined after including amounts invested by the M&G scheme in Prudential policies as explained later in this note.
2 Corporate governance The rules of the Group’s largest pension arrangement, the defined benefit section of PSPS, a final salary scheme, specify that, in exercising its investment powers, the Trustee’s objective is to achieve the best overall investment return consistent with the security of the assets of the scheme. In doing this, consideration is given to the nature and duration of the scheme’s liabilities. The Trustee sets the benchmark for the asset mix, following analysis of the liabilities by the Scheme’s Actuary and, having taken advice from the Investment Managers, then selects benchmark indices for each asset type in order to measure investment performance against a benchmark return.
The calculations are based on current actuarially calculated mortality estimates with a specific allowance made for future improvements in mortality, which is broadly based on adjusted versions of the medium cohort projections prepared by the Continuous Mortality Investigation Bureau of the Institute and Faculty of Actuaries.
The mean term of the current PSPS liabilities is around 18 years. Using external actuarial advice provided by the scheme actuaries being Towers Watson (previously known as Watson Wyatt) for the valuation of PSPS and by Aon Limited for the M&G scheme, and Xafinity for the Scottish Amicable scheme, the most recent full valuations have been updated to 31 December 2009, applying the principles prescribed by IAS 19.
Exclude: investments in Prudential insurance policies (offset on consolidation in the
Estimated pension scheme deficit – economic basis Movements on the pension scheme deficit (determined on the ‘economic basis’) are as follows, with the effect of the application of IFRIC 14 being shown separately: 2009 £m
Surplus (based on other (deficit) (deficit) in longer-term gains Disposal of in scheme scheme at investment and Taiwan at 31 Dec 1 January returns) losses Contributions agency 2009 2009 note b note c paid business* note a
Shareholders’ share: Gross of tax surplus (deficit) (82) (32) (74) 43 17 (128)
Shareholders’ share: Gross of tax (deficit) surplus (194) (24) (25) – – (243)
Present value of benefit obligations (4,436) (738) (5,174) (4,075) (598) (4,673)
Set up obligation for deficit funding for PSPS (75) – (75) (65) – (65)
Notes i The PSPS has entered into a derivatives based strategy to match the duration and inflation profile of its liabilities. This involved a reallocation from other investments to cash-like investments with an interest and inflation swap overlay. In broad terms, the scheme is committed to making a series of payments related to LIBOR on a nominal amount and in return the scheme receives a series of fixed and inflation-linked payments which match a proportion of its liabilities. As at 31 December 2009, the nominal value of the interest and inflation-linked swaps amounted to £1.1 billion (2008: £1.2 billion) and £1.9 billion (2008: £0.3 billion) respectively.
iii In addition to PSPS, there are two smaller schemes in the UK, the Scottish Amicable Pension Scheme, and the M&G Pension Scheme, with a combined deficit at 31 December 2009 of £175 million (2008: £67 million), gross of tax. There is also a small scheme in Taiwan, which at 31 December 2009 had a deficit of nil (2008: £17 million), gross of tax. As part of the sale of the Taiwan agency business in June 2009 the Group has settled the majority of the obligations under the Taiwan scheme relating to the employees who were transferred out.
Cash costs and unwind of discount on opening provision for deficit funding for PSPS (29) (29)
Movement due to the sold Taiwan agency business and exchange translation difference 17 (5)
Net decrease in deficit (101) 34 b The components of the (charge) credit to operating results (gross of allocation of the share attributable to the PAC with-profits fund) are as follows: Service cost (34) (45)
Unwind of discount on opening provision for deficit funding for PSPS (4) (4)
c The components of the credit (charge) for actuarial and other gains and losses (gross of allocation of the share attributable to the PAC with-profits fund but excluding the charge relating to the sold Taiwan agency business) are as follows: Actual less expected return on assets 108 (356)
Actuarial and other gains and losses after the effect of IFRIC 14 (155) (20)
The net charge for actuarial and other gains and losses is recorded within the income statement but, within the segmental analysis of profit, the shareholders’ share of actuarial and other gains and losses (i.e. net of allocation of the share to the PAC with-profits funds) is excluded from operating profit based on longer-term investment returns.
The 2009 actuarial losses of £337 million primarily reflects the effect of increases in inflation rates and decrease in risk discount rates partially offset by the excess of market returns over long-term assumptions and experience gains on liabilities.
6 Movement in IAS 19 basis financial position The change in the present value of the benefit obligation and the change in fair value of the assets for the total of the PSPS, Scottish Amicable, M&G and Taiwan schemes over the period were as follows: 2009 £m
Fair value of plan assets, beginning of year 357 157 514 514 Present value of benefit obligation, beginning of year (598) (598) Provision for deficit funding for PSPS (65) (65)
Fair value of plan assets, end of year 376 187 563 563 Present value of benefit obligation, end of year (738) (738) Provision for deficit funding of PSPS (75) (75)
Movement in the provision for deficit funding for PSPS (13) (13)
Fair value of plan assets, end of year 357 157 514 514
Adjustment in respect of investment of PSPS in Prudential policies 101 103 140 126 –
Components of net periodic pension cost Current service cost (34) (45)
Less: expected return on investments of scheme assets in Prudential insurance policies (16) (22)
Actuarial gains and losses – IAS 19 basis* (as referred to in noteI2a) (138) 10
Net periodic pension cost (included within acquisition and other operating expenditure in the income statement) (195) (37)
†In determining the expected return on scheme assets for 2009, the 4.5 per cent rate shown below has been applied to the opening assets.
The expected rates of return have been determined by reference to long-term expectations, the carrying value of the assets and equity and other market conditions at the statement of financial position date.
Present value of the benefit obligation, end of year (5,174) (4,673) (5,015) (5,210) (5,418)
Experience adjustments on scheme assets (IAS 19 basis) 100 (277) (7) 140 527
Percentage of scheme assets at 31 December 1.91% (5.48)% (0.14)% 2.81% 11.42%
Total employer contributions expected to be paid into the Group defined benefit schemes for the year ending 31 December 2010 amounts to £88 million (2009: £98 million).
8 Sensitivity of the pension scheme liabilities of the PSPS, Scottish Amicable and M&G pension schemes to key variables The table below shows the sensitivity of the underlying PSPS, Scottish Amicable and M&G pension scheme liabilities at 31 December 2009 of £4,436 million, £515 million and £223 million respectively (2008: £4,075 million, £398 million and £180 million) to changes in discount rates and inflation rates.
Discount rate Decrease by 0.2% from 5.8% to 5.6% Increase in scheme liabilities by: PSPS 3.5%
The sensitivity of the underlying pension scheme liabilities to changes in discount rates and inflation rates as shown above does not directly equate to an impact on the profit or loss attributable to shareholders or shareholders’ equity due to the effect of the application of IFRIC 14 on PSPS and the allocation of a share of the interest in financial position of the PSPS and Scottish Amicable schemes to the PAC with-profits fund as described in note (b)(i)(1) above.
For PSPS, the underlying surplus of the scheme of £513 million (2008: £728 million) has not been recognised under IFRIC 14. Any change in the underlying scheme liabilities to the extent that it is not sufficient to alter PSPS into a liability in excess of the deficit funding provision will not have an impact on the Group’s results and financial position.
In the event that a change in the PSPS scheme liabilities results in a deficit position for the scheme which is recognisable, the deficit recognised affects the Group’s results and financial position only to the extent of the amounts attributable to shareholder operations. The amounts attributable to the PAC with-profits fund are absorbed by the liability for unallocated surplus and have no direct effect on the profit or loss attributable to shareholders or shareholders’ equity. This applies similarly to the Scottish Amicable scheme, whose deficit has been allocated 50 per cent to the PAC with-profits fund and 50 per cent to the PAC shareholders fund.
9 Transfer value of PSPS scheme At 31 December 2009, it is estimated that the assets of the scheme are broadly sufficient to cover the liabilities of PSPS on a ‘buyout’ basis including an allowance for expenses. The ‘buyout’ basis refers to a basis that might apply in the circumstance of a transfer to another appropriate financial institution. In making this assessment it has been assumed that a more conservative investment strategy applies together with a more prudent allowance for future mortality improvements and no allowance for discretionary pension increases.
ii Other pension plans The Group operates various defined contribution pension schemes including schemes in Jackson and Asia. As noted earlier, the cost of the Group’s contributions for continuing operations to these schemes in 2009 was £38 million (2008: £31 million).
The Business Unit Performance Plan (BUPP) is an incentive plan created to provide a common framework under which awards would be made to senior employees in the UK, Jackson and Asia including the Chief Executive Officers. Awards under this plan are based on growth in Shareholder Capital Value on the European Embedded Value (EEV) basis with performance measured over three years. Upon vesting of awards made up to 2008, half of the awards will be released as shares and the other half released in cash. In the year ending 31 December, 2009 all awards made will be settled in shares after vesting. Participants are entitled to receive the value of reinvested dividends over the performance period for those shares that vest. The growth parameters for the awards are relevant to each region and vesting of the awards between each performance point is on a straight line sliding scale basis.
UK-based executive directors are also eligible to participate in the Company’s HMRC approved Share Incentive Plan which allows all UK-based employees to purchase shares of Prudential plc (partnership shares) on a monthly basis out of gross salary. For every four partnership shares bought, an additional matching share is awarded, purchased on the open market. Dividend shares accumulate while the employee participates in the plan. Partnership shares may be withdrawn from the scheme at any time. If the employee withdraws from the plan within five years, the matching shares are forfeit and if within three years, dividend shares are forfeit.
Jackson operates a performance-related share award which, subject to the prior approval of the Jackson Remuneration Committee, may grant share awards to eligible Jackson employees in the form of a contingent right to receive shares or a conditional allocation of shares. These share awards have vesting periods of four years and are at nil cost to the employee. Award holders do not have any right to dividends or voting rights attaching to the shares. The shares are held in the employee share trust in the form of American Depository Receipts which are tradable on the New York Stock Exchange.
In addition, there are other share awards including the Prudential Corporation Asia Deferred Bonus Plan (PCA DBP), Prudential Capital Deferred Bonus Plan (PruCap DBP) and other arrangements. There are no performance conditions attaching to these deferred bonus plans and awards vest in full subject to the individual being employed by Prudential at the end of the vesting period. The other arrangements relate to various awards that have been made without performance conditions to individual employees, typically in order to secure their appointment or ensure retention.
The weighted average share price of Prudential plc for the year ended 31 December 2009 was £4.17 compared to £5.46 for the year ended 31 December 2008.
Weighted average Weighted Weighted remaining average average Number contractual exercise Number exercise outstanding life prices exercisable prices Range of exercise prices millions years £ millions £
The fair value amounts relating to all options including conditional nil cost options above were determined using the Black-Scholes and the Monte Carlo option-pricing models using the following assumptions: Other Other GPSP options GPSP options
The expected volatility is measured as the standard deviation of expected share price returns based on statistical analysis of daily share prices over a period up to the grant date equal to the expected life of options. Risk-free interest rates are UK gilt rates with projections for three, five and seven year terms to match corresponding vesting periods. Dividend yield is determined as the average yield over the year of grant and expected dividends are not incorporated into the measurement of fair value. For the GPSP, volatility and correlation between Prudential and an index constructed from a simple average of the TSR growth of 11 companies is required. For grants in 2009, an average index volatility and correlation of 40 per cent and 83 per cent respectively, were used. Changes to the subjective input assumptions could materially affect the fair value estimate.
c Total share-based payment expense Total expense recognised in the year in the consolidated financial statements related to share-based compensation is as follows: Share-based compensation expense 37 23
Carrying value at 31 December of liabilities arising from share-based payment transactions 13 12
Total key management remuneration amounts to £20,989,000 (2008: £18,122,000). This comprises salaries and short-term benefits of £11,570,000 (2008: £10,425,000), post-employment benefits of £1,132,000 (2008: £1,003,000), leaving benefits of £915,000 (2008: £507,000) and share-based payments of £7,372,000 (2008: £6,187,000).
Total key management remuneration includes total directors’ emoluments of £15,090,000 (2008: £12,683,000) as shown in the directors’ remuneration table and related footnotes in the directors’ remuneration report, and additional amounts in respect of pensions and share-based payments. Further information on directors’ remuneration is given in the directors’ remuneration report.
Fees payable to the Company’s auditor for the audit of the Company’s annual accounts 1.8 1.6
Fees payable to the Company’s auditor and its associates for other services: Audit of subsidiaries and associates pursuant to legislation 5.5 5.0
Auditor Independence Policy which sets out the types of services that the auditor may provide, consistent with the guidance in Sir Robert Smith’s report ‘Audit Committees – Combined Code Guidance’ and with the provisions of the US Sarbanes-Oxley Act.
i Principal subsidiaries The principal subsidiary undertakings of the Company at 31 December 2009 were: Country of Main activity incorporation
iii Acquisition and disposal of subsidiaries There were no material acquisitions or disposals of subsidiaries during the year in 2009 and 2008.
iv PAC with-profits fund acquisitions and disposals There were no new acquisitions or disposals by the PAC with-profits fund in 2009 and 2008. However, during 2009, the holding in the voting equity interest of Red Funnel increased from 90 per cent to 100 per cent. In 2008, this holding increased from 78 per cent to 90 per cent. Red Funnel is a venture capital holding owned by the PAC with-profits fund managed by M&G.
Later than 1 year and not later than 5 years 178 199
The total minimum future sublease rentals to be received on non-cancellable operating leases for land and buildings for the year ended 31 December 2009 were nil (2008: £0.2 million).
ii Capital commitments The Group has provided, from time to time, certain guarantees and commitments to third-parties including funding the purchase or development of land and buildings and other related matters. At 31 December 2009, there were no contractual obligations to purchase or develop investment properties (2008: £1 million).
Structural borrowings of shareholder-financed operations comprise core debt of the parent company and Jackson surplus notes. Core debt excludes borrowings to support short-term fixed income securities programmes, non-recourse borrowings of investment subsidiaries of shareholder-financed operations and other borrowings of shareholder-financed operations. Cash flows in respect of these borrowings are included within cash flows from operating activities.
iii Agreement to acquire AIA Group Limited On 1 March 2010, Prudential plc announced that it had reached agreement with American International Group Inc. (‘AIG’), on terms for the combination of Prudential and AIA Group Limited (‘AIA’), a wholly-owned subsidiary of AIG (the ‘Transaction’). AIA is a leading life insurance organisation in Asia which provides individuals and businesses with products and services for their insurance, protection, savings, investment and retirement needs in 15 geographical markets in the region. The combined group will be the leading life insurer in Hong Kong, Singapore, Malaysia, Indonesia, Vietnam, Thailand and the Philippines with the leading foreign life insurance business in China and India, a significantly enhanced presence in the high growth South East Asian life markets and strong operations in the US and UK.
The Company has not prepared a cash flow statement on the basis that its cash flow is included within the cash flow statement in the consolidated financial statements. The Company has also taken advantage of the exemption within FRS 29, ‘Financial Instruments: Disclosures’, from the requirements of this standard on the basis that the Company’s results are included in the publicly available consolidated financial statements of the Group that include disclosures that comply with IFRS 7, ‘Financial Instruments: Disclosures’, which is equivalent to FRS 29. This included exemption from the requirements for enhanced disclosures about fair value measurements and liquidity risk of the ‘Amendments to FRS 29 – Improving disclosures about financial instruments’ approved by the Accounting Standards Board (ASB) in May 2009 and effective from 1 January 2009. The enhanced disclosures as required by the equivalent Amendments to IFRS 7 have been included in note G ‘Financial assets and liabilities’ of the consolidated financial statements.
Dividends Dividends are recognised in the period in which they are declared. Dividends declared after the balance sheet date in respect of the prior reporting period are treated as a non-adjusting event.
Transfer of investment in subsidiary undertaking (1,021) 889 Additional investment in subsidiary undertakings 3,899 (3,889) Net advance of loans – 687
The additional investment in subsidiary undertakings during the year of £3,899 million (2008: £35 million) includes £3,889 million in a central finance subsidiary following an internal restructuring, for which the consideration was the assignment of loans to other central finance subsidiaries, and £10 million (2008: £9 million) for share-based payments reflecting the value of payments granted by the Company to employees of its subsidiary undertakings in 2009.
The principal subsidiary undertakings of the Company at 31 December 2009, all wholly-owned, were: Main activity Country of incorporation
Each subsidiary has one class of ordinary shares and operates mainly in its country of incorporation, except for PRIL which operates mainly in England and Wales. In 2009, the Company transferred the assets and liabilities of its agency distribution business and its agency force in Taiwan to China Life Insurance Company Ltd of Taiwan.
Core structural borrowings: ¤20m Medium-Term Subordinated £400m 11.375% Subordinated Notes 2039note iv 380 – – – 380 –
ii The ¤500 million 5.75 per cent borrowings have been swapped into borrowings of £333 million with interest payable at six month £LIBOR plus 0.962 per cent.
In March 2009, this swap was cancelled. vi 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
vii Interest on the US$300 million 6.5 per cent borrowings was swapped into floating rate payments but, in 2008, swapped back into fixed rate payments of 6.5 per cent.
viii Hedge accounting is applied at both the Group consolidated level and Company level. Due to different dates of commencement of this accounting treatment, the hedge values differ between these two levels.
xi The interests of the holders of the Subordinated Notes and the Subordinated Capital Securities are subordinate to the entitlements of other creditors of the Company.
Fair value Fair value Fair value Fair value assets liabilities assets liabilities
Derivative financial instruments held to manage interest rate and currency profile: Cross-currency swaps 118 – 182 –
The change in fair value of the derivative financial instruments of the Company was a gain before tax of £83 million (2008: loss before tax of £343 million).
For the purpose of preparing consolidated financial statements, the Group applies IFRS basis accounting including IAS 19, ‘Employee Benefits’. However, the individual accounts of the Company continue to follow UK GAAP including FRS 17. The FRS 17 disclosures are aligned with IAS 19. In 2008, the Group adopted IFRIC 14, interpretation guidance to IAS 19 with the effect of derecognising the Group’s interest in PSPS surplus and recognising an additional liability for the deficit funding obligation for PSPS in the Group financial statements. Further details are described in note I2 ‘Staff and pension plans’ of the notes on the financial statements of the Group.
At 31 December 2005, the allocation of surpluses and deficits attaching to PSPS between the Company and the unallocated surplus of the Prudential Assurance Company’s (PAC) with-profits funds was apportioned in the ratio 30/70 between the Company and the PAC with-profits fund following detailed consideration of the sourcing of previous contributions. This ratio was applied to the base deficit position at 1 January 2006 and for the purpose of determining the allocation of the movements in that position up to 31 December 2009. The FRS 17 service charge and ongoing employer contributions are allocated by reference to the cost allocation for current activity.
Defined benefit schemes are generally required to be subject to full actuarial valuation every three years to assess the appropriate level of funding for schemes having regard to their commitments. These valuations include assessments of the likely rate of return on the assets held within the separate trustee administered funds. PSPS was last actuarially valued as at 5 April 2008 using the projected unit method.
This valuation demonstrated the Scheme to be 106 per cent funded by reference to the Scheme Solvency Target that forms the basis of the Scheme’s statutory funding objective. Accordingly, the total contributions to be made by the Group to the Scheme were reduced from the previous arrangement of £70-£75 million per annum to £50 million per annum effective from 1 July 2009. As PSPS was in a surplus position at the valuation date, no formal recovery plan was required. However, recognising that there had been a significant deterioration in the value of the Scheme’s assets from 5 April 2008 to the date of the finalisation of the valuation, contributions to the Scheme for additional funding of £25 million per annum as well as a £25 million per annum employer’s contribution for ongoing service of current employees, were agreed with the PSPS Trustees subject to a reassessment when the next valuation is completed. The additional funding is akin to deficit funding. In 2009, total contributions for the year, including expenses and augmentations, were £67 million (2008: £79 million).
Using external actuarial advice provided by the professionally qualified actuaries, Watson Wyatt Partners, for the valuation of PSPS, the most recent full valuations have been updated to 31 December 2009 applying the principles prescribed by FRS 17.
Further details on the PSPS scheme, including mortality assumptions, are shown in note I2 ‘Staff and pension plans’ of the notes on the financial statements of the Group.
The surplus in the scheme recognised in the balance sheet of the Company represents the element of the amount which is recoverable through reduced future contributions and is net of the apportionment to the PAC with-profits fund.
Fair value of scheme assets, at 31 December 4,949 4,803 * The contributions include deficit funding, ongoing service contributions, expenses and augmentations.
the present value of the scheme liabilities) (230) 68 302 390 95
Actuarial (losses) gains attributable to the Company (3) (143) 91 118 (30)
The actuarial gains (losses) attributable to the Company are net of the apportionment to the PAC with-profits fund and are related to the surplus recognised on the balance sheet of the Company. In 2009, the actuarial losses attributable to the Company included an amount of £66 million (2008: £164 million) for the unrecognised portion of surplus which has not been deducted from the pension charge.
The actuarial losses before tax of £3 million (2008: £143 million) attributable to the Company are recorded in the statement of total recognised gains and losses. Cumulative actuarial gains as at 31 December 2009 amount to £88 million (2008: £91 million).
Total employer contributions expected to be paid into the PSPS defined benefit scheme for the year ending 31 December 2010 amount to £54 million, reflecting the new funding arrangement agreed in 2009, following the completion of the 2008 actuarial valuation, and expenses.
A summary of the ordinary shares in issue is set out below: Share Share Number of capital premium
Issued shares of 5 pence each fully paid shares £m £m
8 Pension scheme financial position continued 9 Share capital and share premium
Actuarial losses recognised in respect of the pension scheme net of related taxnote 8 (2) (103)
Shareholders’ funds at end of year 3,826 3,245 a Information on directors’ remuneration is given in the directors’ remuneration report section of this Annual Report and note I4 ‘Key management remuneration’ of the notes on the financial statements of the Group.
10 Profit of the Company and reconciliation of the movement in shareholders’ funds 12 Post balance sheet events 11 Other information
The directors of Prudential plc, whose names and positions are set out on pages 76 to 78 confirm that to the best of their knowledge: • The financial statements, prepared in accordance with the applicable set of accounting standards, give a true and fair view of the assets, liabilities, financial position and profit or loss of the Company and the undertakings included in the consolidation taken as a whole; and
We have audited the financial statements of Prudential plc for the year ended 31 December 2009 set out on pages 119 to 301. The financial reporting framework that has been applied in the preparation of the Group financial statements is applicable law and International Financial Reporting Standards (IFRSs) as adopted by the EU. The financial reporting framework that has been applied in the preparation of the parent company financial statements is applicable law and UK Accounting Standards (UK Generally Accepted Accounting Practice).
Respective responsibilities of directors and auditors As explained more fully in the Directors’ Responsibilities Statement set out on page 302, the directors are responsible for the preparation of the financial statements and for being satisfied that they give a true and fair view. Our responsibility is to audit the financial statements in accordance with applicable law and International Standards on Auditing (UK and Ireland). Those standards require us to comply with the Auditing Practices Board’s (APB’s) Ethical Standards for Auditors.
Scope of the audit of the financial statements A description of the scope of an audit of financial statements is provided on the APB’s web-site at www.frc.org.uk/apb/scope/UKP.
• the parent company financial statements and the part of the Directors’ Remuneration Report to be audited are not in agreement with the accounting records and returns; or
• the part of the Corporate Governance Statement set out in the Governance report relating to the Company’s compliance with the nine provisions of the June 2008 Combined Code specified for our review.
Long-term business 1,105 1,213 Asset management 55 52 Development expenses (6) (26)
Notes i EEV basis operating profit based on longer-term investment returns excludes short-term fluctuations in investment returns, the mark to market value movements on core borrowings, the shareholders’ share of actuarial and other gains and losses on defined benefit pension schemes, and the effect of changes in economic assumptions and changes in the time value of cost of options and guarantees arising from changes in economic factors. In addition, 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 Group IGD capital position. These contracts were in addition to the Group’s regular operational hedging programmes. It also disposed of its Taiwan agency business. The effect of these items has been shown separately from operating profit based on longer-term investment returns. The treatment of the Taiwan agency business within the comparatives is discussed below. The amounts for these items are included in total EEV profit attributable to shareholders. The Company believes that operating profit, as adjusted for these items, better reflects underlying performance. Profit before tax and basic earnings per share include these items together with actual investment returns. This basis of presentation has been adopted consistently throughout this supplementary information.
iv Restructuring costs comprise the charge of £23 million recognised on an IFRS basis and an additional £4 million recognised on the EEV basis for the shareholders’ share of restructuring costs incurred by the PAC with-profits fund.
vi Exchange translation The comparative results have been prepared using previously reported exchange rates.
Operating profit based on longer-term investment returns Asian operations 1,154 1,239
Profit (loss) from continuing operations after tax before minority interests 1,262 (1,335)
Based on profit (loss) after tax and minority interests of £1,245m (2008: £(1,338)m) 12 49.8p (54.1)p
Profit (loss) for the year attributable to equity shareholders 1,245 (1,338)
Mark to market value movements on Jackson assets backing surplus and required capital (gross movement) 205 (228)
Shareholders’ equity at beginning of year (excluding minority interests) 10 14,956 14,600
Shareholders’ equity at end of year (excluding minority interests) 7,10 15,273 14,956
Asset Asset Long-term management Long-term management business and other business and other operations operations Total operations operations Total
Shareholders’ equity (excluding minority interests) 7,10 15,273 14,956 *Including liabilities in respect of insurance products classified as investment contracts under IFRS 4.
With two principal exceptions, covered business comprises the Group’s long-term business operations. The principal exceptions are for the closed Scottish Amicable Insurance Fund (SAIF) and for the presentational treatment of the financial position of the Group’s principal defined benefit pension scheme, the Prudential Staff Pension Scheme (PSPS). A small amount of UK group pensions business is also not modelled for EEV reporting purposes.
b Methodology i Embedded value Overview The embedded value is the present value of the shareholders’ interest in the earnings distributable from assets allocated to covered business after sufficient allowance has been made for the aggregate risks in that business. The shareholders’ interest in the Group’s long-term business comprises: • present value of future shareholder cash flows from in-force covered business (value of in-force business), less a deduction for the cost of locked-in (encumbered) capital; • locked-in (encumbered) capital; and • shareholders’ net worth in excess of encumbered capital (free surplus).
However, in determining the movements on the additional shareholders’ interest, the basis for calculating the Jackson EEV result acknowledges that for debt securities backing liabilities the aggregate EEV results reflect the fact that the value of in-force business instead incorporates the discounted value of future spread earnings. This value is not affected generally by short-term market movements on securities that are broadly speaking held for the longer term.
Non-participating long-term products are the only ones where the insurer is contractually obliged to provide guarantees on all benefits. Whole of life contracts with floor levels of policyholder benefits that accrue at rates set at inception and do not vary subsequent with market conditions are written in the Korean life operations. This is to a much lesser extent than the policies written by the Taiwan Life business which was sold in the first half of 2009, as detailed in note 18.
Fixed annuities also present a risk that policyholders will exercise their option to surrender their contracts in periods of rapidly rising interest rates, possibly requiring Jackson to liquidate assets at an inopportune time.
UK insurance operations The only significant financial options and guarantees in the UK insurance operations arise in the with-profits fund and SAIF.
The Group’s main exposure to guaranteed annuity options in the UK is through SAIF and a provision on the Pillar I Peak 2 basis of £284 million (2008: £391 million) was held in SAIF at 31 December 2009 to honour the guarantees.
Time value The value of financial options and guarantees comprises two parts. One is given by a deterministic valuation on best estimate assumptions (the intrinsic value). The other part arises from the variability of economic outcomes in the future (the time value).
Where appropriate, a full stochastic valuation has been undertaken to determine the value of the in-force business including the cost of capital. A deterministic valuation of the in-force business is also derived using consistent assumptions and the time value of the financial options and guarantees is derived as the difference between the two.
• UK insurance operations: the capital requirements are set at the higher of Pillar I and Pillar II requirements for shareholder-backed business of UK insurance operations as a whole, which for 2009 and 2008 was Pillar I.
iii Allowance for risk and risk discount rates Overview Under the EEV Principles, discount rates used to determine the present value of future cash flows are set equal to risk-free rates plus a risk margin. The risk margin should reflect any non-diversifiable risk associated with the emergence of distributable earnings that is not allowed for elsewhere in the valuation. Prudential has selected a granular approach to better reflect differences in market risk inherent in each product group. The risk discount rate so derived does not reflect an overall Group market beta but instead reflects the expected volatility associated with the cash flows for each product category in the embedded value model.
These allowances are initially reflected in determining best-estimate returns and through the market risk allowance described above. However, for those businesses which are largely backed by holdings of debt securities these allowances in the projected returns and market risk allowances may not be sufficient and an additional allowance may be appropriate.
The level of allowance differs from that for UK annuity business for investment portfolio differences and to take account of the management actions available in adverse economic scenarios to reduce crediting rates to policyholders, subject to guarantee features of the products. For 2008 and previously, allowance for these elements of credit risk was recognised only in the risk margin reserve charge and to the extent implicit within the market risk allowance.
Notes on the EEV basis supplementary information > continued v With-profits business and the treatment of the estate The proportion of surplus allocated to shareholders from the PAC with-profits fund has been based on the present level of 10 per cent.
vi Pension costs The Group operates three defined benefit schemes in the UK. The principal scheme is the Prudential Staff Pension Scheme (PSPS). The other two, much smaller, schemes are the Scottish Amicable and M&G schemes. There is also a small scheme in Taiwan, but as part of the sale of the Taiwan agency business completed in June 2009, the Group settled the majority of the obligations under the scheme as a significant number of employees were transferred out.
Under IFRS the surpluses or deficits attaching to these schemes are accounted for in accordance with the provisions of IAS 19 that apply the principles of IFRIC 14, which was adopted in 2008 providing guidance on assessing the limit in IAS 19 on the amount of surplus in a defined benefit pension scheme that can be recognised as an asset.
Separately, the projected cash flows of in-force covered business include the cost of contributions to the defined benefit schemes for future service based on the contribution basis applying to the schemes at the time of the preparation of the results.
vii Debt capital Core structural debt liabilities are carried at market value. As the liabilities are generally held to maturity or for the long-term, no deferred tax asset or liability has been established on the difference, compared to the IFRS carrying value. Accordingly, no deferred tax credit or charge is recorded in the results for the reporting period in respect of the mark to market value adjustment.
viii Foreign currency translation Foreign currency profits and losses have been translated at average exchange rates for the year. Foreign currency assets and liabilities have been translated at year end rates of exchange. The purpose of translating the profits and losses at average exchange rates, notwithstanding the fact that EEV profit represents the incremental value added on a discounted cash flow basis, is to maintain consistency with the methodology applied for IFRS basis reporting.
iv Unwind of discount and other expected returns The unwind of discount and other expected returns is determined by reference to the value of in-force business, required capital and surplus assets at the start of the period as adjusted for the effect of changes in economic and operating assumptions reflected in the current period. For UK insurance operations the amount included within operating results based on longer-term returns represents the unwind of discount on the value of in-force business at the beginning of the period (adjusted for the effect of current period assumption changes), the unwind of discount on additional value representing the shareholders’ share of smoothed surplus assets retained within the PAC with-profits fund (as explained in note 1b(v) above), and the expected return on shareholders’ assets held in other UK long-term business operations. Surplus assets retained within the PAC with-profits fund are smoothed for this purpose to remove the effects of short-term investment volatility from operating results. In the summary statement of financial position and for total profit reporting, asset values and investment returns are not smoothed.
vi Effect of changes in economic assumptions and time value of cost of options and guarantees Movements in the value of in-force business at the beginning of the period caused by changes in economic assumptions and the time value of cost of options and guarantees resulting from changes in economic factors are recorded in non-operating results.
2 Analysis of new business contribution 1 Basis of preparation, methodology and accounting presentation continued
iii New business contributions represent profits determined by applying non-economic assumptions as at the end of the year. In general, the use of point of sale or end of period economic assumptions is not significant in determining the new business contribution for different types of business and across financial reporting periods. However, to obtain proper measurement of the new business contribution for business which is interest rate sensitive, it is appropriate to use assumptions reflecting point of sale market conditions, consistent with how the business was priced. In practice, the only area within the Group where this has a material effect is for UK shareholder-backed annuity and lifetime mortgage business. For other business within the Group end of period economic assumptions are used.
iv The tables above include new business for the Taiwan bank distribution operation. New business of the Taiwan agency business, which was sold in June 2009 is excluded from the tables but included in the result for the sold Taiwan agency business, shown separately in the analysis of profit, as shown in note 18. Comparative figures have been adjusted accordingly.
Unwind of discount and other expected returnsnote i 489 344 588 1,421 Effect of change in operating assumptionsnote ii (12) 101 – 89 Experience variances and other itemsnote iii (85) 124 52 91
The increase in unwind of discount and other expected returns from £1,211 million for 2008 to £1,421 million for 2009 mainly arises in the US, primarily reflecting an increase in the discount rate applied to the value of in-force business (as adjusted for the effects of changes in operating and non-operating assumptions) and in Asian operations as a result of higher start of year value of in-force business, reflecting the increasing growth of this business.
The credit of £101 million for US operations in 2009 primarily reflects the positive impact of altered assumptions arising from beneficial policyholder behaviour for Guaranteed Minimum Withdrawal Benefits on Variable Annuity business, as explained in note v(1) below.
The credit of £52 million for UK insurance operations is detailed in note vi below.
Unwind of discount and other expected returns 489 409 Effect of change in operating assumptions: Mortality and morbidity 11 26 41
Experience variances and other items: Mortality and morbidity 5 52 34
The favourable effect of the change in persistency assumptions of £79 million in 2008 predominately arose in Singapore (£90 million), Hong Kong (£28 million) (principally for health and protection products) and in Malaysia (£21 million) which reflected improved lapse rates, based on recent experience, offset by a charge in Korea (£(44) million) mainly relating to premium holidays.
Experience variances and other items: Spread experience variance6 (3) 54 Amortisation of interest-related realised gains and losses66 59 28 3 Operating profit from business in force continued
Notes 1 The positive impact of the change in GMWB policyholder behaviour assumptions of £156 million reflects the altered assumptions relating to the utilisation of withdrawal features available to policyholders on VA contracts which have been modified to take account of the more recent experience of policyholder behaviour when benefits are ‘in the money’. 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.