3 The effect of the change of assumption for VA fees represents the capitalised value of the change in the projected level of policyholder advisory fees, which vary according to the size and mix of VA funds. The charge of £(13) million for 2009 reflects a reduction in the projected level of fees paid by policyholders, according to the current fund mix. The positive effect of the change in 2008 of £29 million represents an overall reassessment of the assumed fees, reflecting recent experience at that date.
Effect of adjustments for application of EEV methodology for certain reserves and required capital: Interest Maintenance Reserve (IMR)a (10) Variable Annuity Statutory Reservesb (68) Required Capitalc 17 a The IMR is a statutory liability in respect of realised gains on the sale of bonds which, on a regulatory basis, are amortised to income over time in line with the duration of the bonds sold.
7 The credit of £68 million for other items for 2009 primarily represents favourable expense experience variance of £40 million relating to marketing expenses and positive mortality experience of £32 million primarily relating to life products.
Unwind of discount and other expected returns 588 569 Other items: Effect of asset rebalancingnote 22 118 Release of certain annuity business reserves – 56
Note For UK annuity business, the effects of rebalancing the asset portfolio backing the liabilities to policyholders are normally reflected in full in the operating result for the year. These effects arise from the altered value arising from the revised projected yield and allowances for default risk.
The charge of £(14) million, which is net of nil tax, reflects completion adjustments for a previously disposed business.
For 2008, the short-term fluctuations in investment returns for Asian operations of £(903) million arose primarily in Singapore and Hong Kong, reflecting the effect of substantial equity market falls on unit-linked and with-profits business. For unit-linked business, the short-term fluctuation in investment returns reflects the reduction in the value of the asset base and the consequent effect on the projection of future management fees. For with-profits business, the short-term fluctuation in investment returns reflects the difference between the shareholders’ 10 per cent interest in the value movements on the assets and the unwind of discount on the opening shareholders’ interest in the surplus.
Actual realised losses less default assumption and amortisation of interest-related gains and losses for fixed income securities and related swap transactions1 (367) (463)
iii UK insurance operations The short-term fluctuations in investment returns for UK insurance operations for 2009 represents: £m £m
Notes 1 For with-profits business the credit for 2009 of £430 million (2008: charge of £(2,083) million) reflects the positive variance of 8.6 per cent
iv 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 our regular operational hedging programmes. The hedge contracts have expired and have not been renewed.
v Other operations Short-term fluctuations in investment returns of Other operations, in addition to the previously discussed IGD hedge costs, arise from: £m £m
The effects of changes in economic assumptions and time value of cost of options and guarantees resulting from changes in economic factors for in-force business included within the profit (loss) from continuing operations before tax (including actual investment returns) arise as follows: Change in Change in time value time value
Notes i The effect of changes in economic assumptions in Asia for 2009 of a charge of £(165) million primarily reflects increases in risk discount rates and fund earned rates (as shown in note 16b), with the largest impact arising for Hong Kong US dollar denominated business arising from the increase in US dollar government bond yields. The £(165) million charge is net of a credit of £96 million for the effect of altered economic assumptions for Indonesia and Korea arising from a change in the application of the Group’s methodology for these operations (as discussed in note 16b).
Effect of changes in 10-year treasury rates, beta and equity risk premium:note
Note For Jackson, the charge for the effect of changes in economic assumptions represents the aggregate of the effects of changes to projected returns and the risk discount rate. The risk discount rate, as discussed in note 1b(iii), represents the aggregate of the risk-free rate and margin for market risk, credit risk and non-diversifiable non-market risk.
For VA business, changes to the risk-free rate are also reflected in determining the risk discount rate. However, the projected cash flows are also reassessed for altered investment returns on the underlying separate account assets from which fees are charged. For 2009, the effect of both of these changes resulted in an overall credit on VA business of £183 million, reflecting the increase in the risk-free rate of 1.6 per cent (as shown in note 16b). For 2008, the effect of the change in economic assumptions on VA business of a charge of £(118) million reflects the decrease in the risk-free rate of 1.8 per cent.
In 2009, the Group has included an additional allowance for credit risk. In determining this allowance a number of factors were considered. These factors, in particular, include: a How much of the credit spread on debt securities represents an increased credit risk not reflected in the RMR long-term default assumptions, and how much is liquidity premium. In assessing this effect consideration has been given to a number of approaches to estimating the liquidity premium by considering statistical data over the four years from 2006 to 2009, and b Policyholder benefits for Jackson fixed annuity business are not fixed. It is possible in adverse economic scenarios to pass on a component of credit loss to policyholders (subject to guarantee features) through lower crediting rates. Consequently, it is only necessary to allow for the balance of the credit risk in the risk discount rate.
After taking these and other more detailed factors into account and, based on market conditions in late 2009, the risk discount rate for spread business has been increased by 150 basis points as an additional allowance for credit risk. For VA business, the additional allowance increase has been set at 20 per cent of the non-VA business increase to reflect the fact that a proportion of the VA business is allocated to general account holdings of debt securities.
(Decrease) increase in expected long-term rates of return (284) 191 (93) 83 (1,082) (999)
Decrease (increase) in risk discount rates 240 (311) (71) (394) 668 274
2 In 2009, the charge of £(251) million for with-profits and other business reflects the fact that the risk discount rate has increased significantly more than the earned rate as a result of the revised correlation assumptions, lower equity backing ratio and very low cash return. In 2008, the charge of £(466) million for the effects of the decrease in expected long-term rates of return and risk discount rates primarily reflect the reduction in gilt rates of (0.85) per cent.
iv The effect of changes in time value of cost of options and guarantees of a credit of £52 million for UK insurance operations primarily relates to withprofits business reflecting the effect of the improved investment return achieved in 2009, combined with an overall beneficial impact arising from changes in economic assumptions. In 2008, the charge of £(50) million primarily related to with-profits business reflecting the effect of the reduction in the expected long-term rates of return as described in note (2) above.
6 Effect of changes in economic assumptions and time value of cost of options and guarantees continued
US operations Jackson – EEV basis shareholders’ funds (net of surplus note borrowings of £158m (2008: £154m)) 4,122 4,339
UK operations Insurance operations: Long-term business operations: Smoothed shareholders’ funds 5,547 5,437
Other operations Holding company net borrowings at market value9 (1,780) (818)
‘Other operations’ net liabilities, these amounts have been determined on the statutory IFRS basis. The overall pension scheme deficit, net of tax, attributable to shareholders relating to PSPS is determined as shown below: £m £m
*For 2008, the EEV basis deficit of £(37) million for other operations includes the shareholders’ share of the deficit on the Scottish Amicable Pension Scheme, which for 2009 is included within the shareholders’ funds of UK long-term business operations.
Asset Free surplus of management long-term and UK business, asset general management
Underlying movement: New business (675) – (675) Business in force: Expected in-force cash flows (including expected return on net assets) 1,657 257 1,914 Effects of changes in operating assumptions, operating experience variances and other operating items 175 – 175
Net cash flows to parent companynote iv (506) (182) (688) Exchange movements, timing differences and other itemsnote v 219 (62) 157
Representing: UK insurance operations13 186 147 333 8 Analysis of movement in free surplus 7 Shareholders’ funds – segmental analysis continued
Short-term fluctuations in investment returns primarily reflect temporary market movements on the portfolio of investments held by the Group’s shareholder-backed operations together with the shareholders’ 10 per cent interest in the value movements on the assets in the with-profits funds.
The effect of changes in economic assumptions on free surplus includes the impact of an increase in required capital for Jackson of £168 million driven by impairments and credit downgrades. Separately, short-term fluctuations in investment returns include the effect of impairments and credit downgrades in excess of the expected longer-term level reflected within operating profit.
iv Net cash flows to parent company reflect the flows for long-term business operations as included in the holding company cash flow at transaction rates.
Mark to market value movements on Jackson assets backing surplus and required capital13 133 – 133 a Balance sheet
Mark to Mark to market market value EEV basis value EEV basis adjustment at market adjustment at market
Holding company* cash and short-term investments (1,486) – (1,486) (1,165) – (1,165)
Core structural borrowings – central fundsnote 3,240 26 3,266 2,785 (802) 1,983 *Including central finance subsidiaries.
The loss (profit) recorded in the consolidated income statement represents a charge of £774 million (2008: credit of £(619) million) in respect of central funds and a charge of £21 million (2008: credit of £(37) million) in respect of Jackson.
Tax on short-term fluctuations in investment returns (76) 165 (124) (35) 61 26 Tax on shareholders’ share of actuarial and other gains and losses on defined benefit pension schemes – – 14 14 9 23 Tax on effect of changes in economic assumptions and time value of cost of options and guarantees 94 181 61 336 – 336
Profit (loss) for the year 1,289 223 731 2,243 (998) 1,245
Related tax – – – – 11 11 Intra group dividends (including statutory transfer) (553) (39) (206) (798) 798 – External dividends – – – – (481) (481) Reserve movements in respect of share-based payments – – – – 29 29 Investment in operationsnote ii 219 – 27 246 (246) –
Shareholders’ equity at 31 December 2009note iii, 7 5,781 4,122 5,439 15,342 (69) 15,273 10 Reconciliation of movement in shareholders’ funds
Asian US insurance business operations operations operations operations £m £m £m £m
The tax charge (credit) comprises: Tax charge on operating profit based on longer-term investment returns: Long-term business:note i
Total tax charge on operating profit based on longer-term investment returns 866 758
Tax credit on items not included in operating profit: Tax credit on short-term fluctuations in investment returns (26) (1,432)
Tax credit on shareholders’ share of actuarial and other gains and losses on defined benefit pension schemes (23) (2)
Profit after tax and minority interests from long-term business 1,905 (855) 1,050 1,193 2,243 Exchange movements on foreign operations and
Mark to market value movements on Jackson assets backing surplus and required capital 133 – 133 – 133 Other transfers from net worth (86) – (86) – (86)
Changes in operating assumptions and experience variancesnote vi (98) 85 (13) (73) (86)
Profit on sale and results for Taiwan agency business 987 (1,232) (245) 393 148
Existing business – transfer to net worth 706 (359) 347 (347) –
Intra-group dividends (including statutory transfer) and investment in operations (39) – (39) – (39)
Mark to market value movements on Jackson assets backing surplus and required capital 133 – 133 – 133
Changes in operating assumptions and experience variances 158 (23) 135 (121) 14
Profit after tax and minority interests from long-term business 430 76 506 225 731
ii The movements arising from new business contribution are as follows: Pre-tax new Pre-tax new business Post-tax new business Post-tax new contribution business contribution business note 2 Tax contribution note 2 Tax contribution 13 Reconciliation of net worth and value of in-force businessnote i continued
vii The change in the cost of capital for Asian operations from £(869) million in 2008 to £(198) million in 2009 primarily reflects the effect of the disposal of the Taiwan agency business.
The discounted value of in-force business and required capital can be reconciled to the analysis of free surplus crystallisation as follows: Required capital13 2,994 4,117
Note Other items includes the deduction of the value of the shareholders’ interest in the estate, the value of which is derived by increasing final bonus rates so as to exhaust the estate over the lifetime of the in-force with-profits business. This is an assumption to give an appropriate valuation. To be conservative this item is excluded from the expected free surplus generation profile below. Also included in ‘Other items’ are amounts which are deducted in full against VIF, as they represent the Group’s best estimate of amounts that will be paid in the future, but for which there is no definitive timeframe for when the payments will actually be made.
14 Expected transfer of value of in-force business to free surplus
Cash flows are projected on a deterministic basis and are discounted at the appropriate risk discount rate. The modelled cash flows use the same methodology underpinning the Group’s embedded value reporting and so is subject to the same assumptions and sensitivities.
Long-term expected defaults – 5 bps increase – – (76) (76) Liquidity premium – 10 bps increase – – 152 152 2008 £m
Equity/property market values – 10% fall (94) (117) (381) (592) (35) (627)
Asian Total operations long-term (excluding Total business sold Taiwan UK long-term Taiwan operations agency US insurance business agency (as previously business) operations operations operations business published)
The tables below summarise the principal financial assumptions: China Hong Kong India Indonesia Japan Korea China Hong Kong India Indonesia Japan Korea Asian operations note iv notes ii,iii note iv note iv notes ii,iii
Risk discount rate: Expected long-term rate of inflation 4.0 2.25 5.0 6.0 0.0 2.75 4.0 2.25 5.0 6.0 0.7 2.75
Notes i The weighted risk discount rates for Asian operations shown above have been determined by weighting each country’s risk discount rates by reference to the EEV basis new business result and the closing value of in-force business. ii The assumptions shown are for US dollar denominated business which comprises the largest proportion of the in-force Hong Kong business. iii The mean equity return assumptions for the most significant equity holdings in the Asian operations were: Hong Kong 7.9 6.2
Assumed long-term spread between earned rate and rate credited to policyholders see note i for new tranches of Fixed Annuity businessnote i below 1.75
Pre-tax expected long-term nominal rate of return for US equities 7.9 6.3
Notes i The expected spread for new tranches in 2009 of fixed annuity business (including the proportion of variable annuity new business invested in the general account) and fixed index annuity business are as follows: Fixed Annuity business* Fixed Index
ii The risk discount rates at 31 December 2009 for new business and business in force for US operations reflect weighted rates based on underlying rates of 8.2 per cent (2008: 6.2 per cent) for Variable Annuity (VA) business and 6.2 per cent (2008: 3.0 per cent) for other business. The increase in the weighted discount rates reflects the increase in the US 10 year treasury bond rate of 160 bps, the additional credit risk allowance of 30 bps for VA business and 150 bps for other business, as explained in notes 1b(iii) and 6, and a change in the product mix reflecting the increased proportion of VA business.
The results for Jackson reflect the application of the discount rates shown above, which for 2009 reflect the inclusion of an additional allowance for a combination of credit risk premium and short-term default allowance as described in note 1b(iii) and note 6. In the event that US 10-year treasury rates increase, the altered embedded value results would reflect a lower contribution from fixed annuity business and a partially offsetting increase for variable annuity business as the projected earned rate, as well as the discount rate, would increase for this type of business.
At 31 December 2008, the book value yields, net of RMR allowance, were in excess of the risk discount rate. To correct for the anomalous effect that would otherwise occur no credit was taken in the financial statements for full year 2008 for the cost of capital benefit that this feature would have given rise to for fixed annuity business. As interest rates have subsequently risen such that the risk discount rate exceeds book value yield at 31 December 2009 no such adjustment is needed for the year.
Notes i The risk discount rate applied to new shareholder-backed annuity business for 2009 has been determined after allowing for credit risk on the backing assets. ii The risk discount rates for new business and business in force for UK insurance operations other than shareholder-backed annuities reflect weighted rates based on the type of business.
For with-profits business, the embedded value reflects the discounted value of future shareholder transfers. These transfers are directly affected by the level of projected rates of return on investments, including debt securities. For 2008, the Company considered that in light of the current market conditions, it would be appropriate to assume an unchanged level of default allowance and an unchanged discount rate methodology relative to those at 31 December 2007.
For 2009, the approach for with-profit holdings has been refined. For equities and properties the projected earned rate is defined as the risk-free rate plus a long-term risk premium. Under the revised methodology a similar approach is adopted for corporate bonds i.e. the assumed earned rate is defined as the risk-free rate plus an assessment of the long-term spread over gilts, net of best estimate defaults.
Stochastic assumptions The economic assumptions used for the stochastic calculations are consistent with those used for the deterministic calculations described above. Assumptions specific to the stochastic calculations, such as the volatilities of asset returns, reflect local market conditions and are based on a combination of actual market data, historic market data and an assessment of longer-term economic conditions. Common principles have been adopted across the Group for the stochastic asset models, for example, separate modelling of individual asset classes but with allowance for correlation between the various asset classes.
Mean returns have been derived as the annualised arithmetic average return across all simulations and durations. For each projection year, standard deviations have been calculated by taking the square root of the annualised variance of the returns over all the simulations. These have been averaged over all durations in the projection. For equity and property, the standard deviations relate to the total return on these assets. The standard deviations applied to 2009 and 2008 are as follows: Equities: c Demographic assumptions Persistency, mortality and morbidity assumptions are based on an analysis of recent experience but also reflect expected future experience. Where relevant, when calculating the time value of financial options and guarantees, policyholder withdrawal rates vary in line with the emerging investment conditions according to management’s expectations.
e Taxation and other legislation Current taxation and other legislation have been assumed to continue unaltered except where changes have been announced and the relevant legislation passed.
Total Asian operations (all retail) 842 1,340 1,177 1,082 1,261 1,216 6,245 6,508
Total mature life and pensions 317 512 122 137 154 188 725 1,025
Annual premiums and contribution equivalents are calculated as the aggregate of regular new business amounts and one-tenth of single new business amounts. PVNBPs are calculated as equalling single premiums plus the present value of expected premiums of new regular premium business, allowing for lapses and other assumptions made in determining the EEV new business contribution. New business premiums reflect those premiums attaching to covered business, including premiums for contracts classified as investment products for IFRS basis reporting. New business premiums for regular premium products are shown on an annualised basis. Department of Work and Pensions (DWP) rebate business is classified as single recurrent business. Internal vesting business is classified as new business where the contracts include an open market option.
ii The table above includes new business for the Taiwan bank distribution operation. New business of the Taiwan agency business, which was sold in June 2009 (as explained in note 18) is excluded from the table. Comparative figures have been adjusted accordingly.
Profit on sale and results for Taiwan agency business 91 (248)
a 2009 On 20 February 2009, the Group announced that it had entered into an agreement to sell the assets and liabilities of its agency business and its agency force in Taiwan to China Life Insurance Company Ltd of Taiwan for the nominal sum of NT$1. The economic transfer date for the purpose of determining the net assets transferred was 28 February 2009. The sale was completed, following regulatory approval, on 19 June 2009.
The profit on sale and results for the period of ownership comprise: £m
Net asset value attributable to equity holders of Company at 1 January 2009 and provision for restructuring costs 134 Goodwill written off (44)
Representing: Profit arising on sale and result for long-term business operations10 148 Goodwill written off (44) Adjustments in respect of restructuring costs borne by non-covered business (13)
In order to facilitate comparisons of the Group’s retained businesses, the presentation of the EEV basis results has been adjusted to show separately the results for the sold Taiwan agency business, as explained below: 18 Sale of legacy agency book and agency force in Taiwan to China Life Insurance of Taiwan
Notes on the EEV basis supplementary information > continued 2008 £m
Mark to market value movements on core borrowings 656 – 656
Shareholders’ share of actuarial and other gains and losses on defined benefit pension schemes (15) 1 (14)
Effect of changes in economic assumptions and the time value of cost of options and guarantees (581) 183 (398)
This decision does not affect the Group’s asset management operations in Japan, which ranks among the largest foreign asset managers.
The Transaction will be effected through the acquisition of both Prudential (by a scheme of arrangement, the ‘Scheme’) and AIA by a new company (‘New Prudential’). The new company will assume the name Prudential plc, be headquartered and incorporated in the UK, and traded on the main market of the London Stock Exchange with ADRs traded on the New York Stock Exchange. The existing Board of Prudential will become the Board of New Prudential.
The rights issue and the Scheme will be subject to shareholder approval at a General meeting. The Transaction is also subject to certain regulatory and anti-trust approvals including various regulatory approvals required on a change of control of Prudential as a result of the Scheme.
On 8 March 2010 the Company confirmed that the Prudential Group had entered into foreign exchange hedging arrangements in respect of its requirement to convert the pounds sterling proceeds of the rights issue into US dollars, which is the currency in which Prudential must pay the cash element of the consideration.
In preparing the EEV supplementary information, the directors have: • prepared the supplementary information in accordance with the EEV Principles; • identified and described the business covered by the EVM; • applied the EVM consistently to the covered business; • determined assumptions on a realistic basis, having regard to past, current and expected future experience and to any relevant external data, and then applied them consistently; • made estimates that are reasonable and consistent; and • described the basis on which business that is not covered business has been included in the supplementary information, including any material departures from the accounting framework applicable to the Group’s financial statements.
We have audited the EEV basis supplementary information (‘the supplementary information’) of Prudential Plc for the year ended 31 December 2009 set out on pages 304 to 340. The financial reporting framework that has been applied in the supplementary information is the European Embedded Value Principles issued in May 2004 by the European CFO Forum as supplemented by the Additional Guidance on European Embedded Value Disclosures issued in October 2005 (together ‘the EEV Principles’) using the methodology and assumptions set out on pages 308 to 312 and 333 to 337 respectively. The supplementary information should be read in conjunction with the group financial statements which are on pages 119 to 301.
Our responsibility is to audit the supplementary information in accordance with the terms of our engagement and having regard to 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.
Risks relating to Prudential’s business Prudential’s businesses are inherently subject to market fluctuations and general economic conditions.
Estimates of financial instruments’ value are difficult because a significant part of Prudential’s shareholders’ profit is related to bonuses for policyholders declared on its with-profits products, which are broadly based on historic and current rates of return on equity, real estate and fixed income securities, as well as Prudential’s expectations of future investment returns. During 2008 and for the first half of 2009, Prudential has had to operate in the UK against a challenging background of unprecedented volatility in capital and equity markets, interest rates and widespread economic uncertainty. This has led, among other things, to reduced consumer spending, an increase in unemployment, and consequently reduced liquidity, requiring the intervention of the Bank of England via a quantitative easing programme to restore credit liquidity in the market.
In the US fluctuations in prevailing interest rates can affect results from Jackson National Life Insurance Company (‘Jackson’), which has a significant spread-based business, with the majority of its assets invested in fixed income securities. In particular, fixed annuities and stable value products written by Jackson expose the Prudential Group to the risk that changes in interest rates, which are not fully reflected in the interest rates credited to customers, will reduce spread. The spread is the difference between the rate of return Jackson is able to earn on the assets backing the policyholders’ liabilities and the amounts that are credited to policyholders in the form of benefit increases, subject to minimum crediting rates. During 2008, the US financial services industry faced an unprecedented array of challenges: the S&P 500 index fell by 38.5 per cent, government interest rates fell to historic lows, and global markets experienced a significant increase in volatility. In addition, credit markets seized up and global credit spreads widened to historic levels. These factors contributed to substantial increases in Jackson’s unrealised losses. Although global markets have begun to stabilise beginning in 2009, interest rates remain low, many of the challenges of 2008 persist in the credit markets and new challenges such as potential sovereign credit deterioration and defaults continue to emerge. Declines in spread from these products or other spread businesses that Jackson conducts could have a material impact on its businesses or results of operations. Jackson also writes a significant amount of variable annuities that offer capital or income protection guarantees. There could be unforeseen market circumstances where the derivatives that it enters into to hedge its market risks may not fully offset its losses, and any cost of the guarantees that remain unhedged will also affect the Company’s results.
For some non unit-linked investment products, in particular those written in some of the Group’s Asian operations, it may not be possible to hold assets which will provide cash flows to exactly match those relating to policyholder liabilities. This is particularly true in those countries where bond markets are not developed and in certain markets where regulated surrender values are set with reference to the interest rate environment prevailing at the time of policy issue. This results in a mismatch due to the duration and uncertainty of the liability cash flows and the lack of sufficient assets of a suitable duration. This residual asset/liability mismatch risk can be managed but not eliminated. Where interest rates in these markets remain lower than interest rates used to calculate surrender values over a sustained period, this could have an adverse impact on the Group’s reported profit.
Consequently, this could impact on the Group’s gearing ratios (defined as debt over debt plus shareholders’ funds). The impact of gains or losses on currency translations is recorded as a component of shareholders’ funds within the statement of changes in equity.
Prudential conducts its businesses subject to regulation and associated regulatory risks, including the effects of changes in the laws, regulations, policies and interpretations and any accounting standards in the markets in which it operates. Changes in government policy, legislation (including tax) or regulatory interpretation applying to companies in the financial services and insurance industries in any of the markets in which Prudential operates, which in some circumstances may be applied retrospectively, may adversely affect Prudential’s product range, distribution channels, capital requirements and, consequently, reported results and financing requirements. For instance, regulators in jurisdictions in which Prudential operates may change the level of capital required to be held by individual businesses. Also these changes could include possible changes in the regulatory framework for pension arrangements and policies, the regulation of selling practices and solvency requirements. Furthermore, as a result of the recent interventions by governments in response to global economic conditions, it is widely expected that there will be a substantial increase in government regulation and supervision of the financial services industry, including the possibility of higher capital requirements, restrictions on certain types of transaction structure, and enhanced supervisory powers.
Various jurisdictions in which Prudential operates have created investor compensation schemes that require mandatory contributions from market participants in some instances in the event of a failure of a market participant. As a major participant in the majority of its chosen markets, circumstances could arise where Prudential, along with other companies, may be required to make such contributions.
The Group’s accounts are prepared in accordance with current International Financial Reporting Standards (‘IFRS’) applicable to the insurance industry. The International Accounting Standards Board (‘IASB’) introduced a framework that it described as Phase I, which permitted insurers to continue to use the statutory basis of accounting for insurance assets and liabilities that existed in their jurisdictions prior to January 2005. The IASB has published proposals in its Phase II discussion paper, which would introduce significant changes to the statutory reporting of insurance entities that prepare accounts according to IFRS and has stated its intention to publish an Exposure Draft in 2010. It is uncertain whether and how the proposals in the discussion paper will become definitive IFRS and when such changes might take effect.
Any changes or modification of IFRS accounting policies may require a change in the future results or a restatement of reported results.
European Embedded Value (‘EEV’) basis results are published as supplementary information by Prudential using principles issued by the European CFO (Chief Financial Officers) Forum. The EEV basis is a value based reporting method for Prudential’s long-term business which is used by market analysts and which underpins a significant part of the key performance indicators used by Prudential’s management for both internal and external reporting purposes. In June 2008, in an effort to improve the consistency and transparency of embedded value reporting, the CFO Forum published the Market Consistent Embedded Value (‘MCEV’) Principles. Following a review of the impact of turbulent market conditions on the MCEV Principles, the CFO Forum announced in May 2009 the postponement of the mandatory reporting on MCEV basis until 2011 and subsequently, in October 2009, changes in the principles to allow for the inclusion of a liquidity premium, which is the additional return investors require for investing in less liquid assets and is a key component in the calculation of the profitability of UK annuity business. It also announced that it was performing further work to develop more detailed application guidance to increase consistency going forward. When the work has been completed, Prudential will consider its approach to the new Principles. The adoption of the new Principles would give rise to different embedded value results from those prepared under the application of European Embedded Value Principles.
The resolution of several issues affecting the financial services industry could have a negative impact on Prudential’s reported results or on its relations with current and potential customers. Prudential is, and in the future may be, subject to legal and regulatory actions in the ordinary course of its business, both in the UK and internationally. This could be a review of business sold in the past under previously acceptable market practices at the time, such as the requirement in the UK to provide redress to certain past purchasers of pension and mortgage endowment policies, changes to the tax regime affecting products, and regulatory reviews on products sold and industry practices, including, in the latter case, businesses it has closed.
Regulators particularly, but not exclusively, in the US and the UK are moving towards a regime based on principles-based regulation which brings an element of uncertainty. These regulators are increasingly interested in the approach that product providers use to select third-party distributors and to monitor the appropriateness of sales made by them. In some cases product providers can be held responsible for the deficiencies of thirdparty distributors.
In the US, federal and state regulators have focused on, and continue to devote substantial attention to, the mutual fund, fixed index variable annuity and insurance product industries. This includes new regulations in respect of the suitability of broker-dealers’ sales of certain products. As a result of publicity relating to widespread perceptions of industry abuses, there have been numerous regulatory inquiries and proposals for legislative and regulatory reforms.
Prudential’s financial strength and credit ratings, which are used by the market to measure its ability to meet policyholder obligations, are an important factor affecting public confidence in most of Prudential’s products, and as a result its competitiveness. Changes in methodologies and criteria used by rating agencies could result in downgrades that do not reflect changes in the general economic conditions or Prudential’s financial condition. Downgrades in Prudential’s ratings could have an adverse effect on its ability to market products and retain current policyholders. In addition, the interest rates Prudential pays on its borrowings are affected by its debt credit ratings, which are in place to measure Prudential’s ability to meet its contractual obligations.
Jackson’s financial strength is rated AA (negative outlook) by Standard & Poor’s and Fitch, A1 (negative outlook) by Moody’s, and A+ (negative outlook) by AM Best.
Operational risks are present in all of Prudential’s businesses, including the risk of direct or indirect loss resulting from inadequate or failed internal and external processes, systems and human error or from external events. Prudential’s business is dependent on processing a large number of complex transactions across numerous and diverse products, and is subject to a number of different legal and regulatory regimes. In addition, Prudential outsources several operations, including in the UK a significant part of its back office and customer-facing functions as well as a number of IT functions. In turn, Prudential is reliant upon the operational processing performance of its outsourcing partners.
Further, because of the long-term nature of much of Prudential’s business, accurate records have to be maintained for significant periods. Prudential’s systems and processes incorporate controls which are designed to manage and mitigate the operational risks associated with its activities. For example, any weakness in the administration systems or actuarial reserving processes could have an impact on its results of operations during the effective period. Prudential has not experienced or identified any operational risks in its systems or processes during 2009, which have subsequently caused, or are expected to cause, a significant negative impact on its results of operations.
Adverse experience against the assumptions used in pricing products and reporting business results could significantly affect Prudential’s results of operations. Prudential needs to make assumptions about a number of factors in determining the pricing of its products, and for reporting the capital levels and the results of its long-term business operations. For example, the assumption that Prudential makes about future expected levels of mortality is particularly relevant for its UK annuity business. In exchange for a premium equal to the capital value of their accumulated pension fund, pension annuity policyholders receive a guaranteed payment, usually monthly, for as long as they are alive. Prudential conducts rigorous research into longevity risk, using data from its substantial annuitant portfolio. As part of its pension annuity pricing and reserving policy, Prudential assumes that current rates of mortality continuously improve over time at levels based on adjusted data from the Continuous Mortality Investigations (CMI) as published by the Institute and Faculty of Actuaries. If mortality improvement rates significantly exceed the improvement assumed, Prudential’s results of operations could be adversely affected.
Prudential operates in a number of markets through joint ventures and other arrangements with third parties (including in China and India). These arrangements involve certain risks that Prudential does not face with respect to its consolidated subsidiaries.
Prudential operates, and in certain markets is required by local regulation to operate, through joint ventures (including in China and India). Prudential’s ability to exercise management control over its joint venture operations and its investment in them depends on the terms of the joint venture agreements, in particular, the allocation of control among, and continued cooperation between, the joint venture participants. Prudential may also face financial or other exposure in the event that any of its joint venture partners fails to meet its obligations under the joint venture or encounters financial difficulty. In addition, a significant proportion of the Group’s product distribution is carried out through arrangements with third-parties not controlled by Prudential and is dependent upon continuation of these relationships. A temporary or permanent disruption to these distribution arrangements could adversely affect Prudential’s results of operations.
Under Prudential’s Articles of Association, certain legal proceedings may only be brought in the courts of England and Wales. This applies to legal proceedings between a shareholder (in its capacity as such) against Prudential and/or its directors and/or its professional service providers. It also applies to legal proceedings between Prudential and its directors and/or Prudential and Prudential’s professional service providers that arise in connection with legal proceedings between the shareholder and such professional service provider. This provision could make it difficult for US and other non-UK shareholders to enforce their shareholder rights.
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Form 20-F The Company is subject to the reporting requirements of the Securities and Exchange Commission (SEC) in the USA as such requirements apply to foreign companies and files its Form 20-F with the SEC. Copies of Form 20-F can be found on the Company's website at www.prudential.co.uk or on the SEC's website at www.sec.gov
Forward-looking statement This report may contain certain ‘forward-looking statements’ with respect to certain of Prudential's plans and its current goals and expectations relating to its future financial condition, performance, results, strategy and objectives. Statements containing the words ‘believes’, ‘intends’, ‘expects’, ‘plans’, ‘seeks’ and ‘anticipates’, and words of similar meaning, are forward-looking. By their nature, all forward-looking statements involve risk and uncertainty because they relate to future events and circumstances which are beyond Prudential's control including among other things, UK domestic and global economic and business conditions, market related risks such as fluctuations in interest rates and exchange rates, and the performance of financial markets generally; the policies and actions of regulatory authorities, the impact of competition, inflation, and deflation; experience in particular with regard to mortality and morbidity trends, lapse rates and policy renewal rates; the timing, impact and other uncertainties of future acquisitions or combinations within relevant industries; and the impact of changes in capital, solvency or accounting standards, and tax and other legislation and regulations in the jurisdictions in which Prudential and its affiliates operate. This may for example result in changes to assumptions used for determining results of operations or re-estimations of reserves for future policy benefits. As a result, Prudential's actual future financial condition, performance and results may differ materially from the plans, goals, and expectations set forth in Prudential's forward-looking statements. Prudential undertakes no obligation to update the forward-looking statements contained in this report or any other forward-looking statements it may make.