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 the accounting period beginning on or after 1 July 2009.
Improvements to IFRSs In May 2008, the IASB published amendments to a number of standards as part if its annual improvements projects. These amendments are effective for accounting periods beginning on or after 1 January 2009. The Group is currently assessing the impact of these improvements to its financial statements.
IFRIC 16, ‘Hedges of a net investment in a foreign operation’ This interpretation clarifies the accounting treatment in respect of net investment hedging. This includes the fact that net investment hedging relates to differences in functional currency not presentation currency, and hedging instruments may be held anywhere in the Group. This interpretation is effective for IASB compliant financial statements for accounting periods beginning on or after 1 October 2008.
These amendments are effective for accounting periods beginning on or after 1 January 2009. However, an entity will not be required to provide comparative disclosures in the first year of application. The Group is currently assessing the impact of these amendments on the financial statements of the Group.
Asian operations Insurance operationsnote ii 321 189 Asset management 52 72 Development expenses (26) (15)
(Loss) profit from continuing operations before tax attributable to shareholders (450) 1,063
B1: Supplementary analysis of profit from continuing operations before tax attributable to shareholders continued
The risk margin reserve (RMR) charge for longer-term credit related losses for 2008 is based on an average annual RMR of 23 basis points (2007: 22 basis points) on average book values for the year as shown below.
The longer-term rates of return for equity-type interests ranged from 6.3 per cent to 8.4 per cent for 2008 and 8.1 per cent to 10.1 per cent for 2007 depending on the type of investments. These rates are currently based on spreads over 10 year US treasury rates of 400 to 600 basis points. Market value movements on equity-based derivatives and embedded derivatives are also recorded within operating profits based on longer-term investment returns so as to be consistent with the market related effects on fees and reserve movements for equity-based products. Market value movements on other derivatives are excluded from operating profit, and are included in short-term fluctuations in investment returns.
Losses on sale of impaired and deteriorating bonds (130) (51) Bond writedowns (419) (35) Recoveries/reversals 3 8
Derivative value movements in respect of variable annuity business are included within the operating profit based on longer-term investment returns to broadly match with the commercial effect to which the variable annuity derivative programme relates.
In addition, for US insurance operations, included within the statement of changes in equity, is a net reduction (translated at the 2008 year-end exchange rate of 1.44) in the value of debt securities classified as available-for-sale of £2,710 million (2007: £244 million). This reduction reflects the effect of widened credit spreads and global credit concerns partially offset by the effect of reductions in US interest rates and a steepening yield curve. 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 charge for UK insurance operations of £212 million for 2008 reflects £170 million for asset value movements, principally for shareholder-backed annuity business, and £42 million for the effect of credit downgrades on the calculation of liabilities for shareholder-backed annuity business in PRIL and the PAC non-profit sub-fund, as discussed in note D2(g)(iii). The short-term fluctuation charge for 2007 arose mostly in PRIL. The fluctuation principally reflected the impact of widened credit spreads on the corporate bond securities backing the shareholders’ equity of the business.
Other The charge of £313 million for short-term fluctuations of other operations in 2008 arises from: 2008 £m
v Shareholders’ share of actuarial and other gains and losses on defined benefit pension schemes £m £m
vi Share-based payments The charge for share-based payments for Prudential schemes is for the SAYE and Group performance-related schemes.
For diluted earnings per share, the weighted average number of shares in issue is adjusted to assume conversion of all dilutive potential ordinary shares. The Group’s only class of dilutive potential ordinary shares are those share options granted to employees where the exercise price is less than the average market price of the Company’s ordinary shares during the year.
Short-term fluctuations in investment returns on shareholder-backed business (1,783) 348 (1) (1,436) (58.1)p (58.1)p
Shareholders’ share of actuarial and other gains and losses on defined benefit pension schemes (14) 3 – (11) (0.4)p (0.4)p
Short-term fluctuations in investment returns on shareholder-backed business (137) 26 1 (110) (4.5)p (4.5)p
Adjustment for post-tax results of discontinued operations* 222 19 – 241 9.9p 9.8p
Dividends declared and paid in reporting period Parent company: Interim dividend (2008: 5.99p, 2007: 5.70p per share) 149 140 Final dividend for prior period (2008: 12.30p, 2007: 11.72p per share) 304 286
Parent company dividends relating to reporting period: Interim dividend (2008: 5.99p, 2007: 5.70p per share) 149 140 Final dividend (2008: 12.91p, 2007: 12.30p per share) 322 304
Asian operations 456 16 US operations 821 (43) Unallocated to a segment (central funds) (646) 38
Insurance products – new business premiums and contributions (note i) Annual premium and
Market Market gross and other 1 Jan 2008 inflows Redemptions movements 31 Dec 2008 2007 £m
APEs are calculated as the aggregate of regular new business amounts and one-tenth of single new business amounts. 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.
iv Subsequent to 29 September 2007 following expiry of the previous management agreement CITIC–Prudential Life Insurance Company Ltd (CITIC-Prudential), the Group’s life operation in China, has been accounted for as a 50 per cent joint venture. Prior to this date CITIC–Prudential was consolidated as a subsidiary undertaking. All premiums for CITIC–Prudential are shown at 50 per cent on a like for like basis, reflecting the constant economic interest before and after the management changes in line with the original agreement with CITIC.
v Income drawdown has been reallocated from the intermediated annuities product line. The APE sales are £8 million for 2008 and £3 million for 2007. vi Sales for PruHealth are included in UK sales. Comparative figures have been restated accordingly. The APE sales are £16 million for 2008 and £13 million for 2007. vii Other operations include Thailand, the Philippines and Vietnam.
Asset management The asset management segment is comprised of both internal and third-party asset management services, inclusive of portfolio and mutual fund management, where the Group acts as an adviser, and broker-dealer activities. The nature of the products and the managing of the business differ from the risks inherent in the other business segments, and the regulatory environment of the asset management industry differs from that of the other business segments.
Segment assets by geographical segment UK 140,110 US 54,431 Asia 26,609 Intra-group eliminations (5,608)
To explain more comprehensively the assets, liabilities and capital of the Group’s businesses it is appropriate to provide an analysis of the Group’s balance sheet by a mixture of primary and secondary segments.
This analysis is shown below for the Group balance sheet by business segment at 31 December 2008.
Insurance operations insurance manage- (central group UK US Asia opera- ment opera- elimina- Group
Held for sale assetsH9 – – – – – – – –
Obligations under funding, securities lending and sale and repurchase agreements 2,251 3,321 – 5,572 – – – 5,572
Net asset value attributable to unit holders of consolidated unit trusts and similar funds 1,536 88 1,154 2,778 1,065 – – 3,843
Intangible assets attributable to PAC with-profits fund: In respect of acquired subsidiaries for venture fund and other investment purposes 192 – – 192 – – – 192 Deferred acquisition costs 19 – – 19 – – – 19
Equity securities and portfolio holdings in unit trusts 60,829 15,507 9,804 86,140 17 – – 86,157
Held for sale assetsH9 30 – – 30 – – – 30
(reflecting application of ‘realistic’ basis provisions for UK regulated with-profits funds)D2eii,H12 13,813 – 146 13,959 – – – 13,959
Total policyholder liabilities and unallocated surplus of with-profits fundsnote b 138,290 34,848 17,179 190,317 – – – 190,317
Operational borrowings attributable to shareholder-financed operationsG1,H13 12 591 – 603 1 2,477 – 3,081
Obligations under funding, securities lending and sale and repurchase agreements 1,360 2,721 – 4,081 – – – 4,081
Net asset value attributable to unit holders of consolidated unit trusts and similar funds 1,751 65 506 2,322 1,234 – – 3,556
This analysis is shown below for the Group balance sheet by business type at 31 December 2008.
Partici- and linked opera- (central group pating variable business tions opera- elimina- Group Group
Assets Intangible assets attributable to shareholders: Deferred acquisition costs and other intangible assets – – 5,343 6 – – 5,349 2,836
Other non-investment and non-cash assetsH3-H6 3,095 579 4,523 135 3,553 (5,608) 6,277 5,012 Investment of long-term business and other operations: Investments accounted for using the equity method – – – – 10 – 10 12
By business type funds annuity D4 E2 tions) tions total total
Total policyholder liabilities and unallocated surplus of with-profits fundsnote b 90,202 38,076 54,113 – – – 182,391 190,317
Operational borrowings attributable to shareholder-financed operationsG1,H13 – – 695 4 1,278 – 1,977 3,081
Net asset value attributable to unit holders of consolidated unit trusts and similar funds 1,775 877 126 1,065 – – 3,843 3,556
a Investments Reconciliation of movement in investments A reconciliation of the Group’s directly held investments from the beginning of the year to the end of the year is as follows: Total Unalloinsurance Asset cated
At 31 December 2007/1 January 2008 Total investments (including derivative assets) 143,539 38,795 18,244 200,578 3,414 58 204,050 Less: investments held by consolidated investment funds (662) – (683) (1,345) – – (1,345)
Directly held investments, net of derivative liabilities 142,188 38,637 17,559 198,384 3,228 13 201,625
Net cash inflow from operating activities 887 2,862 2,596 6,345 (615) 85 5,815 Realised gains (losses) in the year 73 (385) (273) (585) 9 (36) (612) Unrealised gains (losses) in the year (26,932) (8,825) (4,199) (39,956) (156) (19) (40,131)
Movement in the year of directly held investments, net of derivative liabilities (24,336) 6,671 3,117 (14,548) (217) 32 (14,733)
At 31 December 2008 Total investments (including derivative assets) 121,862 46,171 21,809 189,842 3,303 289 193,434 Less: investments held by consolidated investment funds (609) – (1,101) (1,710) – – (1,710)
B6: Group balance sheet continued i Information on the credit risks of debt securities
UK US Asia operations ment total total £m £m £m £m £m £m £m
With-profits operations: UK insurance operationsnote i 4,977 Asian insurance operationsnote iii 328
Shareholder-backed business (70% AAA, 19% AA) 1,075 With-profits operations (74% AAA, 10% AA) 4,977
All of the £1,075 million exposure of the shareholder-backed business relates to the UK market and primarily relate to investments held by PRIL. £2,721 million of the £4,977 million exposure of the with-profits operations relates to exposure to the UK market while the remaining £2,256 million relates to exposure to the US market.
ii US insurance operations US insurance operations’ exposure to asset-backed securities at 31 December 2008 comprises: 2008 £m
RMBS: Sub-prime (91% AAA, 3% AA) 291 Alt-A (60% AAA, 15% AA) 646 Prime (87% AAA, 5% AA) 3,572
CMBS (85% AAA, 9% AA) 1,869 CDO funds (34% AAA, 14% AA) ,* including £6 million exposure to sub-prime 320 ABS (31% AAA, 16% AA), including £51 million exposure to sub-prime 766
RMBS – all without sub-prime exposure 46 CMBS 88 CDO funds and ABS 194
The £328 million includes £259 million held by investment funds consolidated under IFRS in recognition of the control arrangements for those funds and included an amount not owned by the Group with a corresponding liability of £32 million on the balance sheet for net asset value attributable to external unit-holders in respect of these funds, which are non-recourse to the Group. Of the £328 million, 70% are investment graded by Standard & Poor’s.
iv Other operations Other operations’ exposure to asset-backed securities at 31 December 2008 is held by Prudential Capital and comprises: 2008 £m
RMBS: Prime (75% AAA, 10% AA) 106 CMBS (68% AAA, 20% AA) 230 CDO funds – all without sub-prime exposure (AAA) 38 ABS (92% AAA) 33
B6: Group balance sheet 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 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 (279) – (21) (300) Investment-related items and other movements 7,194 1,225 1,458 9,877 Foreign exchange translation differences (67) (509) 322 (254)
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. Additional guidelines are provided for some aspects of actuarial and finance activity.
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.
The Group manages its actual risk profile against our 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.
i Use of derivatives In the UK and Asia, Prudential uses derivatives to reduce equity and credit risk, interest rate and currency exposures, and to facilitate efficient investment management. In the US, Prudential uses derivatives to reduce interest rate risk, to facilitate efficient portfolio management and to match liabilities under annuity policies, and for certain equity-based product management activities.
i Market risks Market risk is the risk that arises from adverse changes in the value of, or income from, assets and changes in interest rates or exchange rates.
iii Liquidity risk Liquidity risk is the risk that Prudential, though solvent on a balance sheet basis, either does not have the financial resources to meet its obligations as they fall due or can secure the resources only at excessive cost.The parent company has significant internal resources of liquidity which are sufficient to meet all of its foreseeable future without having to utilise external funding. The Group maintains committed borrowing and securities lending facilities. In aggregate the Group has £2.1 billion of undrawn committed facilities of which it has recently renewed its £1.4 billion of the undrawn syndicated committed banking facility for a further three years as well as renewing the £500 million securities lending back-up facility.
iv Insurance risk Insurance risk is the inherent uncertainty as to the occurrence, amount and timing of insurance liabilities. This includes adverse mortality, morbidity and persistency experience.
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 rigorous 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.
Prudential’s voluntary discontinuance (persistency) assumptions reflect recent past experience for each relevant line of business, and any expectations of future persistency. Where appropriate, allowance is also made for the relationship, which is either assumed or historically observed, between persistency and investment returns and the resulting additional risk is allowed for.
Quantitative analysis of operational risk exposures material to the Group is used to inform decisions on the overall amount of capital held and the adequacy of the corporate insurance programme.
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 2008 the Group held £1,059 million (31 December 2007: £763 million) of Innovative Tier 1 capital in the form of perpetual securities, £nil (£nil) of Upper Tier 2 and £1,101 million (£932 million) of Lower Tier 2 capital. The increase in these amounts reflects exchange rate movements in 2008. Further details on these amounts and other Group borrowings are shown in note H13.
Prudential’s approach to capital allocation takes into account a range of factors, especially risk adjusted returns on capital, the impact of alternative capital measurement bases (accounting, regulatory, economic and ratings agency assessments), tax efficiency and wider strategic objectives.
Prudential’s detailed understanding of risk adjusted performance allows to manage proactively its allocation of capital to write new business to maximise risk adjusted value creation.
The accounting for the contracts of UK insurance operations and Jackson’s GICs and funding agreements are considered in turn below: i Certain UK unit-linked savings and similar contracts Deferred acquisition costs Acquisition costs are deferred to the extent that it is appropriate to recognise an asset that represents the entity’s contractual right to benefit from providing investment management services and are amortised as the entity recognises the related revenue. IAS 18 further reduces the costs potentially capable of deferral to incremental costs only. Deferred acquisition costs are amortised to the income statement in line with service provision.
Sterling reserves Prudent provisions established for possible future expenses not covered by future margins at a policy level reflecting the regulatory approach in the UK are not permitted for those contracts with insignificant insurance risk that are classified as investment contracts.
c Guarantees Notes D2(e), D3(e), D4(e) and D4(j) 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 2008 as described in section D2(g)(ii). The UK business also has products with guaranteed annuity option features, mostly within SAIF, as described in section D2(e). 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(e).
Jackson’s derivative programme seeks to manage the exposures as described in section D3(f). The most significant exposure for the Group arises on Taiwan whole of life policies as described in section D4(j)(iii).
The Group prepares and publishes supplementary information in accordance with the European Embedded Value (EEV) principles issued by the CFO Forum of European Insurance Companies in May 2004 and expanded by the addition of Additional Guidance on EEV Disclosures published in October 2005. Key elements of the EEV principles are the approach applied to allowing for risk and the use of best estimate assumptions to project future cash flows arising from the contracts.
Product specific discount rates are used in order to reflect the risk profile of each major territory and product group. No allowance is required for non-market risks where these are assumed to be fully diversifiable. The majority of non-market risks are considered to be diversifiable. Finance theory cannot be used to determine the appropriate component of beta for non-diversifiable non-market risks since there is no observable risk premium associated with it that is akin to the equity risk premium. Recognising this, a pragmatic approach has been used. A constant margin of 50 basis points (2007: 50 basis points) has been added to the risk margin derived for market risk to cover the non-diversifiable non-market risks associated with the business. For the UK shareholder-backed annuity business an additional margin of 100 basis points was used (2007: 100 basis points).
Product level betas are calculated each year. They are combined with the most recent product mix to produce appropriate betas and risk discount rates for each major product grouping.
Type of business Investments/derivatives Liabilities/unallocated Other exposure Insurance and lapse risk
Fixed indexed annuity, Credit risk Spread difference Lapse risk but the Fixed annuity and Interest rate risk between earned rate effects of extreme GIC business and rate credited to events are mitigated policyholders by the use of swaption contracts
Asian insurance operations (see also section D4(j)) Mortality and morbidity risk
D1: Group overview continued ii IFRS shareholder results – Exposures for market and other risk Key Group exposures The IFRS operating profit based on longer-term investment returns for UK insurance operations has high potential sensitivity for changes to longevity assumptions affecting the carrying value of liabilities to policyholders for shareholder-backed annuity business. In addition, at the total IFRS profit level the result is sensitive to temporary value movements on assets backing IFRS equity.
• With-profits business Shareholder results of UK with-profits business are sensitive to market risk only through the indirect effect of investment performance on declared policyholder bonuses.
The investment assets of the PAC with-profits fund are subject to market risk. However, changes in their carrying value, net of related changes to asset-share liabilities of with-profit contracts, affect the level of unallocated surplus of the fund. As unallocated surplus is accounted for as a liability under IFRS, movements in its value do not affect shareholders’ profit or equity.
• PAC non-profit sub-fund The PAC non-profit sub-fund principally comprises annuity business previously written by Scottish Amicable Life, credit life, unit-linked and other non-participating business.
By contrast, the IFRS insurance liabilities for these types of business of Jackson, by the application of grandfathered GAAP under IFRS 4, are measured on US GAAP bases which with the exception of certain items covered by the equity hedging programme, are generally insensitive to temporary changes in market conditions or the short-term returns on the attaching asset portfolios.
These differences in carrying value of debt securities, other invested assets, derivatives and insurance liabilities give rise to potentially significant volatility in the IFRS income statement and shareholders’ equity. As with other shareholder-backed business the profit or loss for Jackson is presented in the Group’s supplementary basis of reporting as described in note B1, by distinguishing the result for the year between an operating result based on longer-term investment returns and short-term fluctuations in investment returns. In this way the most significant direct effect of market changes that have taken place to the Jackson result are separately identified.
In addition to these features the overriding factor that affects IFRS basis results for Asian non-participating business is the return on the assets covering the Taiwan whole of life policies. This factor directly affects the actual return in any given reporting period. In addition though, the measurement of the liabilities to policyholders and the carrying value of deferred acquisition costs for this business is dependant upon an assessment of longer-term interest rates. This key feature is described in more detail in notes D4(g) and (j)(iii).
In the UK, adverse persistency experience can affect the level of profitability from with-profits and unit-linked business. For with-profits business in any given year, the amount represented by the shareholders’ share of cost of bonus may be only marginally affected. However, altered persistency trends may affect future expected shareholder transfers.
In the years 2004 to 2008, 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 2008 of £174 billion, the amounts likely to be paid in 2009 will be of a similar magnitude.
Assets Intangible assets attributable to shareholders: Deferred acquisition costs and other intangible assets 134 134 134 157
Intangible assets attributable to PAC with-profits fund: In respect of acquired subsidiaries for venture fund and other investment purposes – 174 – 174 – – – 174 192
Investments of long-term business and other operations: Financial investments: Equity securities and portfolio
Investment contract liabilities without discretionary participation features – – – – 10,277 1,307 11,584 11,584 12,073
Borrowings attributable to with-profits funds 112 1,196 – 1,196 – – – 1,308 987
Other non-insurance liabilities: Obligations under funding, securities lending and sale and repurchase agreements 260 997 313 1,310 – 681 681 2,251 1,360
Defined Charges Participating Sub-fund. 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 £1,902 million (2007: £1,245 million) comprise mortgage loans of £701 million
vi Included in debt securities above are £13,026 million (2007: £11,149 million) of securities which are not quoted on active markets and for which fair value is determined using internal valuation techniques, or is provided by brokers or pricing services, where the specific securities have been valued using valuation techniques by these third-party providers. Of this amount, £12,341 million (2007: £10,640 million) related to securities held by with-profit operations and £685 million (2007: £509 million) related to securities held by the UK shareholder-backed business. See note G1 for additional details.
Derivative assetsnote G3 1,326 571 Partnerships in investment pools and other 2,834 2,820
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.
Scottish Excluding Annuity UK Amicable Prudential Prudential Unit-linked and other insurance
Insurance Annuities Annuities assets and long-term operations Fund Limited Limited Total liabilities business Total £m £m £m £m £m £m £m
Realised gains (losses) in the year 637 3,364 73 3,437 693 (107) 4,660 Unrealised gains (losses) in the year (420) (847) (650) (1,497) (478) (394) (2,789) Foreign exchange translation
Realised gains (losses) in the year 276 84 25 109 (156) (156) 73 Unrealised gains (losses) in the year (2,560) (17,991) (1,236) (19,227) (3,568) (1,577) (26,932) Foreign exchange translation
c Reconciliation of movement in policyholder liabilities and unallocated surplus of with-profits funds A reconciliation of the total policyholder liabilities and unallocated surplus of with-profits funds of UK insurance operations from the beginning of the year to the end of the year is as follows: Other funds and subsidiaries
D2: UK insurance operations continued d Information on credit risk of debt securities The following table summarises by rating the securities held by UK insurance operations as at 31 December 2008 and 2007: Other funds and PAC with-profits sub-fund subsidiaries
Fund Limited Limited Total liabilities business Total Total £m £m £m £m £m £m £m £m
Where no external ratings are available internal ratings produced by the Group’s asset management operations, which are prepared on the Company’s assessment of a comparable basis to external ratings, are used where possible. Of the total debt securities held at 31 December 2008 which are not externally rated, £2,325 million (2007: £2,972 million) were internally rated AAA to A-, £3,149 million (2007: £2,844 million) were internally rated BBB+ to B- and £661 million (2007: £593 million) were unrated. 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.
As detailed in note D2(j) below, the primary sensitivity of IFRS basis profit or loss and shareholders’ equity relates to nonlinked shareholder-backed business which covers other funds and subsidiaries in the table above.
e Products and guarantees Prudential’s long-term products in the UK consist of life insurance, pension products and pension annuities.
These products are written primarily in: • One of three separate sub-funds of the PAC long-term fund, namely the with-profits sub-fund, SAIF, and the non-profit sub-fund; • Prudential Annuities Limited, which is owned by the PAC with-profits sub-fund; • Prudential Retirement Income Limited, a shareholder-owned subsidiary; or • Other shareholder-backed subsidiaries writing mainly non-profit unit-linked business.
i With-profits products and PAC with-profits sub-fund Within the balance sheet of UK insurance operations at 31 December 2008, as shown in note D2(a), there are policyholder liabilities and unallocated surplus of £72.1 billion (2007: £90.5 billion) that relate to the WPSF. These amounts include the liabilities and capital of Prudential Annuities Limited, a wholly owned subsidiary of the fund. The WPSF mainly contains withprofits business but it also contains some non-profit business (unit-linked, term assurances and annuities). The WPSF’s profits are apportioned 90 per cent to its policyholders and 10 per cent to shareholders as surplus for distribution is determined via the annual actuarial valuation.
With-profits products provide returns to policyholders through bonuses that are ‘smoothed’. There are two types of bonuses: ‘annual’ and ‘final’. Annual bonuses are declared once a year, and once credited, are guaranteed in accordance with the terms of the particular product. Unlike annual bonuses, final bonuses are guaranteed only until the next bonus declaration.
When determining policy payouts, including final bonuses, Prudential considers policyholders’ reasonable expectations, the need to smooth claim values and payments from year to year and competitive considerations, together with ‘asset shares’ for specimen policies. Asset shares broadly reflect the value of premiums paid plus the investment return on the assets notionally attributed to the policy, less the other items to be charged such as expenses and the cost of the life insurance cover.
The WPSF held a provision of £42 million at 31 December 2008 (2007: £45 million) to honour guarantees on a small amount of guaranteed annuity products. SAIF’s exposure to guaranteed annuities is described below.
At 31 December 2008, £29.4 billion (2007: £29.5 billion) of investments relate to annuity business of PAL and PRIL. These investments are predominantly in debt securities (including retail price index-linked bonds to match retail price index-linked annuities), loans and deposits and are duration matched with the estimated duration of the liabilities they support.
The process for determining policyholder bonuses of SAIF with-profits policies, which constitute the vast majority of obligations of the funds, is similar to that for the with-profits policies of the WPSF. However, in addition, the surplus assets in SAIF are allocated to policies in an orderly and equitable distribution over time as enhancements to policyholder benefits i.e. in excess of those based on asset share.
There are no guaranteed maturity values or guaranteed annuity options on unit-linked policies except for minor amounts for certain policies linked to cash units within SAIF.
f 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 the majority of the investments backing the with-profits business are in equities and real estate with the balance in debt securities, deposits and loans.
iii Unit-linked business Except through the second order effect on asset management fees, the unit-linked business of the UK insurance operations is not exposed to market risk. The lack of exposure arises from the contract nature whereby policyholder benefits reflect asset value movements of the unit-linked funds.
g Process for setting assumptions and determining contract liabilities i Overview The calculation of the contract liabilities involves the setting of assumptions for future experience. This is done following detailed review of the relevant experience including, in particular, mortality, expenses, tax, economic assumptions and where applicable, persistency.
Tax assumptions are set equal to current rates of taxation. For non-profit business excluding unit-linked business, the valuation interest rates used to discount the liabilities are based on the yields as at the valuation date on the assets backing the technical provisions. For fixed interest securities the gross redemption yield is used except for the PAL and PRIL annuity business where the internal rate of return of the assets backing the liabilities is used. For property it is the rental yield, and for equities it is the greater of the dividend yield and the average of the dividend yield and the earnings yield. An adjustment is made to the yield on non risk-free fixed interest securities and property to reflect credit risk. To calculate the non-unit reserves for linked business, assumptions have been set for the gross unit growth rate and the rate of inflation of maintenance expenses, as well as for the valuation interest rate as described above.
The cost of guarantees, options and smoothing is very sensitive to the bonus, market value reduction (MVR), and investment policy employed and therefore the stochastic modelling incorporates a range of management actions that would help to protect the fund in adverse investment scenarios. Substantial flexibility has been included in the modelled management actions in order to reflect the discretion that is retained in adverse investment conditions, thereby avoiding the creation of unreasonable minimum capital requirements. The management actions assumed are consistent with the Group’s management policy for with-profits funds and the Group’s disclosures in the publicly available Principles and Practices of Financial Management.
iii Annuity business Credit risk provisions For IFRS reporting, the results for UK shareholder-backed annuity business are particularly sensitive to the allowances made for credit risk. The allowance is reflected in the deduction from the valuation rate of interest for discounting projected future annuity payments to policyholders that would have otherwise applied. The valuation rate that is applied includes a liquidity premium that reflects the residual element of current bond spreads over swap rates after providing for the credit risk allowance.
The short-term allowance for credit risk assumed in the Pillar I solvency valuation has been 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.
In payment 106% – 126% PNMA00 84% – 117% PNFA00 99% – 114% PNMA00 85% – 103% PNFA00 (C = 2000) with medium (C = 2000) with 75% (C = 2000) with medium (C = 2000) with 75% cohort improvement of medium cohort cohort improvement of medium cohort table with a minimum improvement table table with a minimum improvement table annual improvement with a minimum annual annual improvement with a minimum annual of 2.25% up to age 90, improvement of 1.25% of 2.25% up to age 90, improvement of 1.25% tapering to zero at up to age 90, tapering tapering to zero at up to age 90, tapering age 120 to zero at age 120 age 120 to zero at age 120
D2: UK insurance operations continued h Reinsurance The Group’s UK insurance business cedes only minor amounts of business outside the Group. During 2008, reinsurance premiums for externally ceded business were £61 million (2007: £59 million) and reinsurance recoverable insurance assets were £416 million (2007: £335 million) in aggregate. The gains and losses recognised in profit and loss for these 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 2008. However, current mortality assumptions have been rebalanced across different categories of business so that they are more closely aligned to the actual experience of each product category. The overall effect of rebalancing the assumptions between different product groups is financially neutral.
Credit risk In total, for 2008, the effect of changes to the allowance for credit risk and the effect of portfolio rebalancing gives rise to a charge of £23 million. For shareholder-backed annuity and lifetime mortgage business, the operating profit based on longerterm investment returns includes a charge of £413 million for the additional credit risk allowance in line with the assumptions shown above in D2(g), for the annuity portfolio as a whole. Partially offsetting this is a credit of £390 million for the effect of £2.8 billion of portfolio rebalancing to more closely align with management benchmark. The credit reflects the additional yield expected after allowing for additional credit risk arising from the rebalancing.
Aggregate effect of assumptions changes For UK insurance operations, the effects of assumptions changes were as follows: ShareholderWith -profits backed sub-fund business
Effect of (strengthening) weakening of mortality assumptions (60) (4) Modelling of management actionsnote a 421 – (Strengthening) weakening of other assumptions 75 –
Effect of strengthening of mortality assumptionsnote a (435) (276) Modelling of management actionsnote b (167) – Strengthening of other assumptionsnote c (62) –
Release of other margins: Projected benefit relatednote d 13 104 Investment related:note e
Notes a The mortality assumptions have been strengthened by increasing the minimum level of future improvement rate. b Given the continuing strong financial position of the fund, the assumed management actions relating to with-profits business have been revised in order to better reflect the benefits to policyholders that can be supported by the fund.
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 2008 and 2007 are demonstrated in note D5.
A decrease in assumed mortality rates of one per cent would decrease gross profits by approximately £35 million (2007: £35 million). A decrease in credit default assumptions of five basis points would increase gross profits by £71 million (2007: £72 million). A decrease in renewal expenses (excluding asset management expenses) of five per cent would increase gross profits by £15 million (2007: £13 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(e) and (g), 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.
A decrease A decrease An increase An increase A decrease An increase of 2% of 1% of 1% of 2% of 1% of 1%
Carrying value of debt securities and derivatives 4,362 1,983 (1,676) (3,108) 1,930 (1,634)
In addition the shareholder-backed portfolio of UK non-linked insurance operations covering liabilities and shareholders’ equity includes equity securities and investment property. Similar to the sensitivity analysis to interest rate movement above, the Group has also extended the range of reasonably possible movements in the value of equity securities and investment property at 31 December 2008. In addition to the movement of 10 per cent as applied at 31 December 2007, for 2008, the Group has also estimated the sensitivity to movements of 20 and 40 per cent. Excluding any second order effects on the measurement of the liabilities for future cash flow to the policyholder, a 10 per cent fall in their value at 31 December 2008 and 2007 and a 20 and 40 per cent fall in their value at 31 December 2008 would have given rise to the following effects on pre-tax profit, profit after tax, and shareholders’ equity.
A decrease A decrease A decrease A decrease of 40% of 20% of 10% of 10%
Net sensitivity of profit after tax and shareholders’ equity (366) (183) (92) (62)
A 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 supplementary analysis of profits, be included within the short-term fluctuations in investment returns.
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 2008 and 2007 for that purpose for insurance contracts, as defined by IFRS, i.e. those containing significant insurance risk, and investment contracts, which do not.
v The maturity tables shown above have been prepared on a discounted basis. Details of undiscounted cash flow for investment contracts are shown in note G2.
Operating profit based on longer-term investment returns 406 444 Short-term fluctuations in investment returns (1,058) (18)
Total income and expense for the year (866) 156 Transfers to Central companies (126) (122)
Net (decrease) increase in equity (992) 34 Shareholders’ equity at beginning of year 2,690 2,656
Included within the movements in shareholders’ equity is a net reduction in value of Jackson’s debt securities classified as ‘available-for-sale’ under IAS 39 of £2,710 million (2007: £244 million). This reduction reflects the effects of widening of global credit spreads partially offset by the effect of reduced risk-free interest rates and a steepening yield curve.These temporary market movements do not reflect defaults or impairments.
With the exception of debt securities for US insurance operations classified as ‘available-for-sale’ under IAS 39, unrealised value movements on the Group’s investments are booked within the income statement. For debt securities classified as ‘available–for-sale’, unless impaired, fair value movements are recorded as a movement in shareholder reserves direct to equity. Realised gains and losses, including impairments, are recorded in the income statement. In 2008, Jackson recorded £497 million (2007: £35 million) of impairment losses arising from: Residential mortgage-backed securities 167 – Public fixed income 311 21
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. Impairment charges are generally recorded on structured securities when the Company forecasts a contractual payment shortfall. The impairment loss reflects the difference between the fair value and book value.
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 £m £m £m £m
Assets fair valued at below book value Book value 20,600 10,730
Assets fair valued at or above book value Book value 6,296 8,041
Reflected as part of movement in shareholders’ equity Movement in unrealised appreciation (2,710) (244) Exchange movements (51) (2)
*Debt securities for US operations as included in the balance sheet of £24,249 million (2007: £19,002 million) comprise £23,999 million (2007: £18,635 million) in respect of securities classified as ‘available-for-sale’ and £250 million (2007: £367 million) for securities of consolidated investment funds classified as ‘fair value through profit and loss’.
Included within the movement in unrealised losses for the debt securities of Jackson of £2,572 million (2007: £183 million) as shown above was a value reduction of £134 million (2007: £55 million) relating to the sub-prime and Alt-A securities as referred to in section B6.
Deferred tax assets – 1,969 1,969 657 Other non-investment and non-cash assets – 1,819 1,819 994 Investments of long-term business and other operations: Financial investments: Equity securities and portfolio holdings in unit trusts 14,538 604 15,142 15,507
Investment contract liabilities without discretionary participation features (GIC and annuity certain) – 2,885 2,885 1,922
The loans of Jackson of £5,121 million (2007: £3,258 million) comprise mortgage loans of £4,534 million (2007: £2,841 million) and policy loans of £587 million (2007: £417 million). All of the mortgage loans are commercial mortgage loans which are collateralised by properties. The property types are mainly industrial, multi-family residential, suburban office, retail and hotel.
iv Summary policyholder liabilities (net of reinsurance) and reserves at 31 December 2008 The policyholder liabilities, net of reinsurers’ share of £800 million (2007: £436 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 2,518 916 Deposits on investment contracts (as defined under US GAAP) 24,962 16,784 Guaranteed investment contracts 2,543 1,685 Unit-linked (variable annuity) business 14,538 15,027
b Reconciliation of movement in investments A reconciliation of the total investments of US insurance operations from the beginning of the year to the end of the year is as follows: Variable annuity separate account Fixed annuity, US insurance assets and GIC and other operations liabilities business Total £m £m £m
Movement in the year of directly held investments, net of derivative liabilities 3,660 (1,060) 2,600
Investment-related items and other movements (6,288) 1,736 (4,552) Foreign exchange translation differences 4,376 8,377 12,753
Residential mortgage-backed securities 4,509 3,177 Commercial mortgage-backed securities 1,869 1,532 Other debt securities 1,400 1,335
Included within other debt securities of £1,400 million (2007: £1,335 million) in the summary shown above are £893 million (2007: £706 million) of asset-backed securities held directly by Jackson, of which £663 million (2007: £579 million) were NAIC designation 1 and £159 million (2007: £127 million) NAIC designation 2. In addition, other debt securities includes £257 million (2007: £316 million) in respect of securities held by the Piedmont trust entity and £250 million (2007: £313 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 held by US insurance operations as at 31 December 2008 using Standard and Poor’s (S&P), Moody’s and Fitch ratings: Carrying Carrying value value
See note G1 for further details on the fair value measurement using valuation techniques when the markets are not active.
Sub-prime mortgages (91% S&P rated AAA, 3% AA (2007: 100% S&P rated AAA)) 291 237 Alt-A mortgages (60% AAA, 15% AA (2007: 77% AAA, 17% AA)) 646 660
CDO funds* 320 260 *Including Group’s economic interest in Piedmont and other consolidated CDO portfolios.
As shown in the table above, £1,938 million of the £3,178 million of gross unrealised losses at 31 December 2008 related to securities whose fair value were below 80 per cent of the book value. The analysis of the £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: Notes on the Group financial statements D: Life assurance businesses continued
Commercial mortgage-backed securities 198 (86) 4 (1) Other asset-backed securities 811 (375) 4 (1)
D3: US insurance operations continued e Products and guarantees Jackson provides long-term savings and retirement products to retail and institutional customers throughout the US. Jackson offers fixed annuities (interest-sensitive, fixed indexed and immediate annuities), variable annuities (VA), life insurance and institutional products.
i Fixed annuities Interest-sensitive annuities At 31 December 2008, interest-sensitive fixed annuities accounted for 29 per cent (2007: 25 per cent) of policy and contract liabilities of Jackson. Interest-sensitive fixed annuities are primarily deferred annuity products that are used for retirement planning and for providing income in retirement. They permit tax-deferred accumulation of funds and flexible payout options.
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 (2007: 1.5 per cent to 5.5 per cent) depending on the jurisdiction of issue and the date of issue, with 83 per cent (2007: 80 per cent) of the fund at three per cent or less. The average guarantee rate is 3.1 per cent (2007: 3.1 per cent).
Approximately 34 per cent (2007: 30 per cent) of the interest-sensitive fixed annuities Jackson wrote in 2008 provide for a market value adjustment, that could be positive or negative, on surrenders in the surrender period of the policy. This formulabased adjustment approximates the change in value that assets supporting the product would realise as interest rates move up or down. The minimum guaranteed rate is not affected by this adjustment.
Immediate annuities At 31 December 2008, immediate annuities accounted for two per cent (2007: 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.
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 2008, approximately 18 per cent (2007: approximately nine per cent) of VA funds were in fixed accounts.
iii Life insurance Jackson’s life insurance products accounted for 10 per cent (2007: nine per cent) of Jackson’s policy and contract liabilities at 31 December 2008. The products offered include variable universal life insurance, term life insurance and interest-sensitive life insurance.
iv Institutional products Jackson’s institutional products consist of GICs, funding agreements (including agreements issued in conjunction with Jackson’s participation in the US Federal Home Loan Bank programme) and medium-term note funding agreements. At 31 December 2008, institutional products accounted for 12 per cent of policy and contract liabilities (2007: 12 per cent). Under a traditional GIC, the policyholder makes a lump sum deposit. The interest rate paid is fixed and established when the contract is issued. If deposited funds are withdrawn earlier than the specified term of the contract, an adjustment is made that approximates a market value adjustment.
Under a funding agreement, the policyholder either makes a lump sum deposit or makes specified periodic deposits. Jackson agrees to pay a rate of interest, which may be fixed but which is usually a floating short-term interest rate linked to an external index. The average term of the funding arrangements is one to two years. Funding agreements terminable by the policyholder with less than 90 days’ notice account for one per cent (2007: less than one per cent) of total policyholder reserves.
f Exposure to market risk and risk management Jackson’s main exposures are to market risk through its exposure to interest rate risk and equity risk. Approximately 90 per cent (2007: 90 per cent) of its general account investments support interest-sensitive and fixed indexed annuities, life business and surplus and 10 per cent (2007: 10 per cent) support institutional business. All of these types of business contain considerable interest rate guarantee features and, consequently, require that the assets that support them are primarily fixed income or fixed maturity.
Prudential is exposed primarily to the following risks in the US arising from fluctuations in interest rates: • The risk of loss related to meeting guaranteed rates of accumulation following a sharp and sustained fall in interest rates; • the risk of loss related to policyholder withdrawals following a sharp and sustained increase in interest rates; and • the risk of mismatch between the expected duration of certain annuity liabilities and prepayment risk and extension risk inherent in mortgage-backed securities.
Prudential is also exposed to the following risks in the US arising from equity market movements: • The risk of loss related to the incidence of benefits related to guarantees issued in conjunction with its VA contracts; • the risk of loss related to meeting contractual accumulation requirements in FIA contracts; and • the risk that the hedge programme is not effective in mitigation of periodic accounting risk.
Capitalised acquisition costs and deferred income for these contracts are amortised over the life of the book of contracts. The present value of the estimated gross profits is generally computed using the rate of interest that accrues to policyholder balances (sometimes referred to as the contract rate). Estimated gross profits include estimates of the following elements, each of which will be determined based on the best estimate of amounts of the following individual elements over the life of the book of contracts without provision for adverse deviation for: • Amounts expected to be assessed for mortality less benefit claims in excess of related policyholder balances; • amounts expected to be assessed for contract administration less costs incurred for contract administration; • amounts expected to be earned from the investment of policyholder balances less interest credited to policyholder balances; • amounts expected to be assessed against policyholder balances upon termination of contracts (sometimes referred to as surrender charges); and • other expected assessments and credits.
The assumptions used for calculating the direct GMIB liability at 31 December 2008 and 2007 are consistent with those used for calculating the GMDB liability.
Most GMWB features are considered to be embedded derivatives under IAS 39. Therefore, provisions for these benefits are recognised at fair value, with the change in fair value included in operating profit based on longer-term investment returns. Certain GMWB features guarantee payments over a lifetime and, therefore, include mortality risk. Provisions for these GMWB amounts are valued consistent with the GMDB valuation method discussed above.
With the exception of the GMDB, GMIB, GMWB and GMAB features of VA contracts, the financial guarantee features of Jackson’s contracts are in most circumstances not explicitly valued, but the impact of any interest guarantees would be reflected as they are earned in the current account value (i.e. the US GAAP liability).
For traditional life insurance contracts, provisions for future policy benefits are determined under US GAAP standards SFAS 60, ‘Accounting and Reporting by Insurance Enterprises’ using the net level premium method and assumptions as of the issue date as to mortality, interest, policy lapses and expenses plus provisions for adverse deviation.
b Deferred acquisition costs Income statement – amortisation for variable annuity business Under IFRS 4, the Group applies US GAAP to the insurance assets and liabilities of Jackson. Under the US GAAP standard FAS 97, acquisition costs for Jackson’s fixed and variable annuity business are deferred and then amortised in line with the expected emergence of margins. The amortisation profile is dependant on assumptions which, for variable annuity business, the key assumption is the expected level of equity market returns. For 2008 and recent previous years a rate of 8.4 per cent has been applied using, as is industry practice, a mean reversion methodology.
However, as noted above, the mean reversion methodology allows for a substantial, but not complete, recovery of the lost fund value. As a result, DAC amortisation, reflected in the 2008 results after incorporating the mean reversion has instead increased by some £140 million, of which £40 million arises due to the capping feature.
(Loss) profit before tax attributable to shareholders* 59 (39) (72) 48 (Loss) profit for the year 51 (29) (62) 35 Shareholders’ equity attributable to US insurance operations (158) (242) 193 296 *Sensitivity on (loss) profit before tax i.e. aggregate of the operating profit based on longer-term investment returns and short-term fluctuations, as discussed in note B1.
The opposite effect of a 10 per cent increase and decrease of exchange rates on (loss) profit for 2008 compared to 2007 is due to a loss before and after tax for 2008 compared to a profit before and after tax for 2007.
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 2008 and 2007 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 DAC amortisation than would have been recognised had the cap not been met.
• Variations in fees and other income, offset by variations in market value adjustment payments and, where necessary, strengthening of liabilities.
D3: US insurance operations continued iii Exposure to equity risk As noted in note D3(f), Jackson is exposed to equity risk through the options embedded in the fixed indexed liabilities and GMDB and GMWB guarantees included in certain VA benefits. This risk is managed using a comprehensive equity hedging programme to minimise the risk of a significant economic impact as a result of increases or decreases in equity market levels while taking advantage of naturally offsetting exposures in Jackson’s operations. Jackson purchases external futures and options that hedge the risks inherent in these products, while also considering the impact of rising and falling separate account fees.
At 31 December 2008 based on the hedges in place at that time, it is estimated that an immediate decrease in the equity markets of 10 per cent would result in an accounting charge, net of related DAC amortisation, before tax of up to £20 million, excluding the impact on future separate account fees. After related deferred tax there would have been an estimated reduction in shareholders’ equity at 31 December 2008 of up to £15 million. An immediate decrease in the equity markets of 20 and 40 per cent would result in an accounting charge, net of related DAC amortisation, before tax of up to £40 million and £ 90 million respectively, excluding the impact on future separate account fees. After related deferred tax there would have been an estimated reduction in shareholders’ equity at 31 December 2008 of up to £30 million and £60 million respectively. Since the year-end we have implemented additional equity hedging to reduce the exposure to further falls in the level of the S&P index.
An immediate increase in the equity markets of the percentages above would result in an approximately equal and opposite estimated effect on profit and shareholders’ equity. At 31 December 2007, it was estimated that an immediate decrease in the equity markets at 10 per cent would result in an accounting benefit, net of related DAC amortisation, before tax of up to £30 million, excluding the impact on future separate account fees. After related deferred tax, it was estimated that there would have been an increase in shareholders’ equity of up to £20 million. The difference in the effects of a decrease in the equity markets at 31 December 2008 and 2007 was due to an increased number of GMDB and GMWB guarantees being ‘in the money’. As a result of this changed position, the adverse effects from a decreasing equity market at 31 December 2008 more than offsets the benefits from the hedging instruments.
The actual impact on financial results would vary contingent upon the volume of new product sales and lapses, changes to the derivative portfolio, correlation of market returns and various other factors including volatility, interest rates and elapsed time.
In addition, Jackson is also exposed to equity risk from its holding of equity securities, partnerships in investment pools and other financial derivatives.
Jackson has extended the range of reasonably possible movements in the value of equity securities, partnerships in investment pools and other financial derivatives at 31 December 2008. Consequently, in addition to the movement of 10 per cent as applied at 31 December 2007, for 2008, Jackson has also estimated the sensitivity to movements of 20 and 40 per cent. A 10 per cent fall in their value at 31 December 2008 and 2007 and a 20 and 40 per cent fall in their value at 31 December 2008 would have given rise to the following effects on pre-tax profit, net of related changes in amortisation of DAC, profit after tax and shareholders’ equity.
Related effect on amortisation of DAC 498 215 (193) (395) 52 (58)
Short-term fluctuations in investment returns (466) (212) 208 448 (87) 123
Total net effect on IFRS equity 819 426 (426) (820) 347 (326)
k Duration of liabilities 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 maturity profile of the cash flows used for that purpose for 2008 and 2007 is as follows: Fixed Fixed annuity annuity and other and other business business
Assets Intangible assets attributable to shareholders: Deferred acquisition costs and other intangible assets – – 1,247 1,247 745
Intangible assets attributable to with-profit funds: Deferred acquisition costs and other intangible assets 113 – – 113 –
Deferred tax assets – – 101 101 73 Other non-investment and non-cash assets 225 136 1,055 1,416 689 Investments of long-term business and other operations: Financial investments: Equity securities and portfolio holdings in unit trusts 2,800 4,846 431 8,077 9,804
Less: Investments held by consolidated investment funds (242) 0 (305) (547)
Movement in the year of directly held investments, net of derivative liabilities 1,497 2,724 164 4,385
Directly held investments, net of derivative liabilities 7,200 6,790 3,569 17,559
Net cash inflow from operating activities 342 1,786 468 2,596 Realised gains (losses) in the year (236) (99) 62 (273) Unrealised gains (losses) in the year (1,362) (2,685) (152) (4,199) Foreign exchange translation differences 2,217 1,385 1,391 4,993
Directly held investments, net of derivative liabilities 8,161 7,177 5,338 20,676
Shareholders transfer post tax (21) – – (21) Investment-related items and other movements 441 914 103 1,458 Foreign exchange translation differences 96 207 19 322
Shareholders’ transfers post tax (23) – – (23) Investment-related items and other movements (1,320) (3,158) 185 (4,293) Foreign exchange translation differences 2,387 1,774 1,428 5,589
d Information on credit risks of debt securities The following table summarises the credit quality of the debt securities of the Asian insurance operations as at 31 December 2008 by rating agency rating: With- Unitprofits linked Other business business business Total Total
e 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.
In general terms, the Asian participating products provide savings and protection where the basic sum assured can be enhanced by a profit share (or bonus) from the underlying fund as determined at the discretion of the insurers. The Asian operations’ non-participating term, whole life and endowment products offer savings and/or protection where the benefits are guaranteed or determined by a set of defined market-related parameters. Unit-linked products combine savings with protection, the cash value of the policy depends on the value of the underlying unitised funds. Accident and Health (A&H) policies provide mortality or morbidity benefits and include health, disability, critical illness and accident coverage. A&H products are commonly offered as supplements to main life policies but can be sold separately.
Subject to local market circumstances and regulatory requirements, the guarantee features described in note D2(e) in respect of UK business broadly apply to similar types of participating contracts written in the Hong Kong branch, Singapore and Malaysia. Participating products have both guaranteed and non-guaranteed elements.
• Interest rate guarantees It is common in Asia for regulations or market-driven demand and competition to provide some form of capital value protection and minimum crediting interest rate guarantees. This would be reflected within the guaranteed maturity and surrender values.
Under these contracts, the cost of premiums are also fixed at inception based on a number of assumptions at that time, including long-term interest rates, mortality assumptions and expenses. The guaranteed maturity and surrender values reflect the pricing basis. The main variable that determines the amounts payable under the contracts is the duration of the contracts, which is determined by death or surrender. The sensitivity of the IFRS result for these contracts is shown in note (j) below.
f Exposure to market risk The Asian operations sell with-profits and unit-linked policies and, although the with-profits business generally has a lower terminal bonus element than in the UK, the investment portfolio still contains a proportion of equities and, to a lesser extent, property. Non-participating business is largely backed by debt securities or deposits. With the principal exception of Taiwan’s whole of life policy book, as described in note (j) below, the exposure to market risk of the Group arising from its Asian operations is at modest levels. This arises from the fact that the Asian operations have a balanced portfolio of with-profits, unit-linked and other types of business.
For the Taiwanese life operation the profits attaching to legacy interest rate guaranteed products are particularly affected by the rates of return earned, and estimated to be earned on the assets held to cover liabilities and on future investment income and contract cash flows. Under IFRS, the insurance contract liabilities of the Taiwan business are determined on the US GAAP basis previously applied under UK GAAP. Under this basis, the policy liabilities are calculated on sets of assumptions, which are locked in at the point of policy inceptions, and a deferred acquisition cost is held in the balance sheet.
The liability adequacy test is more sensitive to changes in the expected long-term rate, further delays in the assumed progression period, or a combination thereof. However, as explained in note I10, on 20 February 2009 the Company announced the intended sale of the legacy agency book and agency force in Taiwan to China Life Insurance of Taiwan.
D4: Asian insurance operations continued b Deferral and amortisation of acquisition costs Under IFRS, the basis of accounting for insurance assets and liabilities reflects ‘grandfathered’ GAAP under the Modified Statutory Basis. In general, this requires the deferral and amortisation of acquisition costs in line with the emergence of margins. In 2008, the basis of deferral and amortisation has been adjusted for a number of territories to better reflect the MSB requirement as follows: For the India life operation, reflecting the initial development stage of the business, acquisition costs had previously not been deferred. In 2008, £19 million of deferred acquisition costs, net of amortisation in the year, has been established.
For the Korea life business, the deferral of acquisition costs had previously followed the local regulatory basis as being an appropriate proxy for the MSB basis. The regulatory basis is subject to constraints in respect of assumptions for expense loadings, the amortisation period, and the DAC balance not being higher than the cash surrender value. This basis is no longer appropriate and on adjusting the basis £9 million of DAC has been established that reflects a revised estimate of the 1 January 2008 balance and a charge of £26 million for current year acquisition costs (net of amortisation) for applying the more appropriate basis.
For Singapore, refinements have been made with a £21 million benefit (of which £7 million relates to the 1 January 2008 position) where the local risk based capital approach does not provide an appropriate basis of implicit allowance for acquisition costs for certain products.
Profit before tax attributable to shareholders* (14) (16) 18 20 Profit for the year (6) (10) 8 13 Shareholders’ equity, excluding goodwill, attributable to Asian operations (202) (124) 246 151 *Sensitivity on profit before tax i.e. aggregate of the operating profit based on longer-term investment returns, short-term fluctuations in investment returns, and actuarial gains and losses on defined benefit pension schemes, as discussed in note B1.
ii Unit-linked business As for the UK insurance operations, the profits and shareholders’ equity related to the Asian operations is primarily driven by charges related to invested funds. For the Asian operations, substantially all of the contracts are classified as insurance contracts under IFRS 4, i.e. containing significant insurance risk. The sensitivity of profits and equity to changes in insurance risk is minor and, to interest rate risk, not material.
iii Other business Taiwan whole of life business – interest rate risk on deferred acquisition costs and policyholders’ liabilities The principal other business of Asian operations which is most sensitive to interest rates is the traditional whole of life business written in Taiwan.
The in-force business of the Taiwan life operation includes traditional whole of life policies where the premium rates have been set by the regulator at different points for the industry as a whole. Premium rates were set to give a guaranteed minimum sum assured on death and a guaranteed surrender value on early surrender based on prevailing interest rates at the time of policy issue. Premium rates also included allowance for mortality and expenses. The required rates of guarantee have fallen over time as interest rates have reduced from a high of eight per cent to current levels of around 1.4 per cent. The current low level of bond rates in Taiwan gives rise to a negative spread for the majority of these policies. The current cash cost of funding in-force negative spread in Taiwan is around £50 million a year.
The adequacy of the liability is also sensitive to the level of the projected long-term rate on bonds. The current long-term assumption of 5.5 per cent has been determined on a best estimate basis by reference to detailed assessments of the financial dynamics of the Taiwanese economy. In the event that the rate applied was altered, the carrying value of the deferred acquisition costs and policyholder liabilities would potentially be affected.
At 31 December 2008, if the assumed long-term bond yield applied had been reduced by both 0.5 and 1.0 per cent from 5.5 per cent to 4.5 per cent and continued to apply the same progression period to 31 December 2018, by assuming bond yields increase from current levels in equal annual instalments to the long-term rate, the premium reserve, net of deferred acquisition costs, would have been sufficient. An additional 0.5 per cent reduction in the assumed long-term rate from 4.5 per cent to 4.0 per cent would lead to a charge of some £150 million.
The adequacy of the Taiwan insurance contract liabilities is also sensitive to movements in short-term movements in market interest rates. This is because a reduction in the current interest rates would alter the progression rate to the long-term rate and the assumed timing of attainment of the rate may be insufficient and they would have been deferred. Based on the in-force business at 31 December 2008, a delay of one to two years in the attainment of the long-term rate of 5.5 per cent would not give rise to an additional charge. Based on the in-force business at 31 December 2008, a delay of three to four years in the attainment of the long-term rate of 5.5 per cent would not give rise to a significant charge. A delay of five years would give rise to a charge of some £60 million.
For the Korean and Japanese life business exposures described in note (e) above, the results are comparatively unaffected by changes of assumption.
Valuation difference on PAL between IFRS basis and regulatory basis (1,350) (1,350) – – (1,350)
Total subsidiaries Asian life Total life WPSF PAC with- and funds assurance assurance 31 December 2008 SAIF note i profits fund note ii Jackson subsidiaries operations
Other liabilities: Insurance contracts: With-profits liabilities of non-UK regulated funds 3,407 3,407
Unit-linked, including variable annuity – 1,872 1,872 6,041 14,538 7,220 29,671
Total policyholder liabilities shown in the consolidated balance sheet 10,018 63,836 73,854 33,853 45,361 20,909 173,977
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.
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 1 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 £1,053 million (2007: £982 million) reflects the excess of regulatory basis assets over liabilities of the subsidiaries and funds, before deduction of the capital resources requirement of £884 million (2007: £841 million).
Jackson’s risk-based capital ratio is significantly in excess of regulatory requirements. Effective for 2008 reporting, the local regulator granted Jackson three permitted practices, which expire 1 October 2009, unless extended by the local regulator. One permitted practice allows Jackson to carry interest rate swaps at book value, as if statutory hedge accounting were in place, instead of at fair value as would have been otherwise required. Jackson must also demonstrate the effectiveness of its interest rate swap programme pursuant to the Michigan Insurance Code. The local regulator also granted a permitted practice to allow Jackson to recognise book to tax differences that will reverse within the next three years (instead of one year as required by the NAIC) in determining the admissible tax asset (subject to a limitation of 15 per cent of capital and surplus versus the 10 per cent limitation imposed by the NAIC guidance). Finally, the local regulator granted a permitted practice to allow Jackson to use an average interest rate in calculating certain regulatory requirements. The permitted practice requires that Jackson maintain certain minimum capital levels excluding the effect of the permitted practices. The total effect of these permitted practices was to increase statutory surplus by £588 million and reduce authorised control level required capital by £57 million at 31 December 2008.
Solvency capital is determined using a risk-based capital approach. In 2008, due to the financial crisis, the local regulator provided relief to ease certain of the requirements in determining the risk-based capital surplus. This relief applies to 2008 and 2009.
Malaysia is adopting a risk-based capital framework from 2009, which has not been reflected in the tables presented.
Detail on the movement for 2007 is as follows: 2007 £m
The decrease in 2008 reflects primarily the negative investment returns earned on the opening available capital and £149 million negative effect of changes in assumptions on a regulatory basis compares to the £83 million effect of change in assumptions on an IFRS basis as shown in note D2(i). The increase in 2007 reflects investment return earned on the opening available capital partially offset by the £335 million effect of assumption changes and a £214 million impact from a change in the risk-free yield curve which affects the outlook for future investment returns. The £335 million effect of assumption changes on a regulatory basis compares to the £392 million effect of change in assumptions on an IFRS basis as shown in note D2(i).
ii Jackson The increase of £507 million reflects an underlying decrease of £358 million (applying the 2008 year end exchange rate of 1.44) and £865 million of exchange translation gain. The increase of £168 million in 2007 reflects an underlying increase of £203 million (applying the 2007 year end exchange rate of 1.99) and £35 million of exchange translation loss.
For example, for businesses that are most sensitive to interest rate changes, such as immediate annuity business, Prudential uses cash flow analysis to create a portfolio of debt securities whose value changes in line with the value of liabilities when interest rates change. This type of analysis helps protect profits from changing interest rates. This type of analysis is used in the UK for annuity business and by Jackson for its interest-sensitive and fixed indexed annuities and stable value products.
For businesses that are most sensitive to equity price changes, Prudential uses stochastic modelling and scenario testing to look at the future returns on its investments under different scenarios which best reflect the large diversity in returns that equities can produce. This allows Prudential to devise an investment and with-profits policyholder bonus strategy that, on the model assumptions, allows it to optimise returns to its policyholders and shareholders over time while maintaining appropriate financial strength. Prudential uses this methodology extensively in connection with its UK with-profits business.
Asset management in Asia serves both the life companies in Asia by managing the life funds and funds underlying the investment linked products and third-party customers through mutual fund business. Asia offers mutual fund investment products in a number of countries within the region, allowing customers to participate in debt, equity and money market investments.
Profit before tax for asset management operations comprise: Operating profit based on longer-term investment returns† 286 7 52 345 334 Short-term fluctuations in investment returns‡ (195) – – (195) 5 Shareholders’ share of actuarial gains and losses on defined benefit schemes (10) – – (10) 5 *Included within revenue for M&G are realised and unrealised net 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 £494 million and the charges, £413 million.
† Operating profit based on longer-term investment returns includes a £28 million charge for an impairment loss on a holding in Lehman Brothers. ‡ Short-term fluctuations for M&G are primarily in respect of unrealised value movements, on Prudential Capital’s bond portfolio.
Assets, liabilities and shareholders’ funds included in the Group consolidated balance sheet in respect of asset management operations are as follows: Asset management operations
Other non-investment and non-cash assets 27 169 99 295 521 Financial investments: Equity securities and portfolio holdings in unit trusts 11 – 12 23 17
iii M&G shareholder funds include those in respect of Prudential Capital, with the net reduction in the year primarily due to unrealised value movements of £190 million, on Prudential Capital’s bond portfolio.
v Consolidated investment funds The M&G balance sheet shown above includes Prudential Capital together with investment funds which are managed on behalf of third-parties. In respect of the consolidated investment funds, the balance sheet includes cash and cash equivalents of £835 million, £345 million of other investments, £(115) million of other net assets and liabilities and the net asset value attributable to external unit holders of £1,065 million in respect of these funds, which are non-recourse to M&G and the Group.
Reconciliation of movement in investments A reconciliation of the total investments of asset management operations from the beginning of the year to the end of the year is as follows: Asset management operations
Net cash inflow from operating activities 296 – 21 317 Realised gains in the year 8 – – 8 Unrealised (losses) in the year (22) – – (22) Foreign exchange translation differences 105 (1) – 104
Movement in the year of directly held investments, net of derivative liabilities 387 (1) 21 407
Directly held investments, net of derivative liabilities 3,148 34 46 3,228
Directly held investments, net of derivative liabilities 2,924 40 47 3,011
Asset management operations in the UK, Hong Kong, Singapore, Vietnam and China are subject to regulatory requirements based on fixed operating expenses and other operating considerations. The movement in the year of the surplus regulatory capital position of these operations, combined with the movement in the IFRS basis shareholders’ funds for other asset management operations, is as follows: Asset management operations
E4: Sensitivity of profit and equity to market and other financial risk i Currency translation Consistent with the Group’s accounting policies, the profits of the Asia and PPM America asset management operations are translated at average exchange rates and shareholders’ equity at the closing rate for the reporting period. For 2008, the rates for the most significant operations are given in note B4.
Other operations consist of unallocated corporate activities relating to Group Head Office and the Asia regional head office, with net income and expenditure for the year of negative £260 million (2007: negative £260 million) as detailed in note B1. An analysis of the assets and liabilities of other operations is shown in note B6.
Analysed as: Investment returnsnote iii (30,202) 12,225 Other items 19,935 20,645
Charges (before income tax attributable to policyholders and unallocated surplus of long-term insurance funds)
(Loss) profit before tax attributable to shareholdersB1 (450) 1,063 Tax attributable to shareholders’ (loss) profit 59 (354)
Notes i Total revenue for 2008 is negative £10,267 million whilst charges are a credit of £8,193 million. These abnormal effects arise from the basis of preparation whereby revenue includes investment appreciation, which is negative in 2008, and charges reflect the allocation, where appropriate, of investment return to policyholder benefits.
ii The measure is the formal (loss) profit before tax measure under IFRS but is not the result attributable to shareholders. iii Investment return principally comprises
– Interest and dividends; – Realised and unrealised gains and losses on securities and derivatives classified as fair value through profit and loss under IAS 39; and – Realised gains and losses, including impairment losses, on securities classified as available-for-sale under IAS 39.
Long-term business premiums Insurance contract premiums 17,573 17,308 Investment contracts with discretionary participation feature premiums 964 874 Inwards reinsurance premiums 454 177 Less: reinsurance premiums ceded (202) (171)
Realised and unrealised gains and losses on securities at fair value through profit and loss (34,157) 2,634 Realised and unrealised gains and losses on derivatives at fair value through profit and loss (5,261) 270 Realised gains and losses on available-for-sale securities, previously recognised directly in equity (487) 13 Realised gains and losses on loans 210 47
Notes i Interest income includes £11 million (2007: £2 million) accrued in respect of impaired securities. ii Fee income includes £7 million (2007: £31 million) relating to financial instruments that are not held at fair value through profit and loss.
These fees primarily related to prepayment fees, late fees and syndication fees. iii In November 2007 the Group sold PPM Capital and as a result the Group no longer controls venture fund investments managed by the sold entity and consequently has ceased to consolidate these operations from that date.
Notes i Acquisition costs in 2008 comprise amounts related to insurance contracts of £1,048 million (2007: £939 million), and investment contracts and asset management contracts of £137 million (2007: £91 million). These costs include amortisation of £520 million (2007: £410 million) and £15 million (2007: £3 million) respectively.
iv In November 2007, the Group sold PPM Capital and as a result, the Group no longer controls venture fund investments managed by the sold entity and consequently has ceased to consolidate these operations from that date with this resulting in a reduction of associated operating expenditure.
Finance costs consist of £161 million (2007: £158 million) interest on core debt of central companies and £11 million (2007: £10 million) on US operations’ surplus notes.
F5: Tax a Total tax credit (charge) 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 benefit (expense): Corporation tax (225) (806) Adjustments in respect of prior years 359 185
The total tax benefit (expense) arises as follows: Current tax benefit (expense): Deferred tax credit: Notes on the Group financial statements F: Income statement notes continued
The total deferred tax credit (charge) arises as follows: Unrealised gains and losses on investments 1,521 225 Short-term timing differences (29) (10) Capital allowances 2 4 Balances relating to investment and insurance contracts (239) 41 Unused tax losses 294 12
In April 2008 the standard corporation tax rate for the UK changed from 30% to 28%. Deferred tax at the end of 2007 for UK operations had been provided at the new rate of 28 per cent on the basis that materially all of the temporary differences are expected to reverse once the new rate took effect. The effect on the deferred tax assets and liabilities at 31 December 2007 was £20 million.
(Loss) profit before tax attributable to shareholders (450) 1,063 Tax attributable to shareholders’ (losses) profits: Tax credit (charge) 1,683 (349) Less: tax attributable to policyholders’ returns (1,624) (5)
*For the column entitled ‘Attributable to policyholders’, the profit before tax represents income, net of post-tax transfers to unallocated surplus of with-profits funds, before tax attributable to policyholders and unallocated surplus of with-profits funds and unit-linked policies.
Due to the requirements of the financial reporting standards IAS 1 and IAS 12, the profit before tax and tax charge reflect the aggregate of amounts that are attributable to shareholders and policyholders.
The total tax charge for linked and with-profits business includes tax expense on unit-linked and with-profits funds attributable to policyholders, the unallocated surplus of with-profits funds and the shareholders’ profits. This feature arises from the basis of taxation applied to life and pension business, principally in the UK, but with similar bases applying in certain Asian operations, and is explained in note (iii) below.
Furthermore, the basis of preparation of Prudential’s financial statements incorporates the additional feature that, as permitted under IFRS 4, the residual equity of the Group’s with-profits funds, i.e. unallocated surplus, is recorded as a liability with transfers to and from that liability reflected in pre-tax profits. This gives rise to anomalous effective tax rates for profits attributable to policyholders (as described in note (iv) below).
The shareholder elements are the components of the profit and tax charge that are of most direct relevance to investors, and it is this aspect that the IAS 12 requirement is seeking to explain for companies that do not need to account for both with-profits and unit-linked funds, where tax is borne by the Company on the policyholders’ behalf and which is not contemplated by IFRS requirement.
If the shareholder profit is higher than the I-E amount, extra income is attributable to the I-E calculation until the I-E profit equals the shareholder profit. If on the other hand, the I-E profit is the greater, then an amount equal to the shareholder profit is taxed at the corporate rate of tax, with the remainder of the I-E profit being taxed at the lower policyholder rate of tax.
For unit-linked business, pre-tax profits also reflect the aggregate of profits attributable to policyholders and shareholders. The pre-tax profits attributable to policyholders represent fees earned that are used to pay tax borne by the Company on policyholders’ behalf. The net of tax profit attributable to policyholders for unit-linked business is thus zero.
F5: Tax continued v Reconciliation of tax charge on profits attributable to shareholders 2008 £m
Short-term fluctuations in investment returns (200) (1,058) (212) (313) (1,783) Shareholders’ share of actuarial gains and losses on defined benefit pension schemes (3) – – (11) (14)
Operating profit based on longer-term investment returnsnote iii 24% 35% 28% 23% 29%
Short-term fluctuations in investment returns 27% 35% 28% 28% 32% Shareholders’ share of actuarial gains and losses on defined benefit pension schemes 25% – – 28% 27%
Short-term fluctuations in investment returns 31 197 51 69 348 Shareholders’ share of actuarial gains and losses on defined benefit pension schemes 1 – – 2 3
Actual tax rate: Operating profit based on longer-term investment returns 36% 31% 17% (28%) 22%
Notes i Expected tax rates for profit attributable to shareholders: The expected tax rate for Other operations is lower than 2007. The tax rate of 23% reflects the mix of business between UK and overseas operations, which are taxed at a variety of rates. The rate will fluctuate from year to year dependent on the mix of profits between jurisdictions.
ii For 2008, the principal variances arise from differences between the standard corporation tax rate and actual rates due to a number of factors, including: a For Asian long-term operations, tax losses in several jurisdictions which are not expected to be available for relief against future profits, and losses on investments in jurisdictions which do not provide corresponding tax relief; b For Jackson, the inability to fully recognise deferred tax assets on losses being carried forward which has partially been offset by the benefit of a deduction from taxable income of a proportion of dividends received attributable to the variable annuity business; c For UK insurance operations, prior year adjustments arising from the routine revisions of tax returns, the settlement of outstanding issues with
Operating profit based on longer-term investment returnsnote iii 21% 35% 30% 28% 30% Short-term fluctuations in investment returns 25% 35% 30% 28% 28% Shareholders’ share of actuarial and other gains and losses on defined benefit pension schemes 20% 35% 30% 28% 28%
Actual tax charge: Operating profit based on longer-term investment returnsnote iii (49) (133) (181) (18) (381) Short-term fluctuations in investment returns 1 7 12 6 26 Shareholders’ share of actuarial and other gains and losses on defined benefit pension schemes – – – 1 1
Expected rates for 2007 for Asia are lower than 2006 due to an increased proportion of profits in low tax jurisdictions. The expected rate for other operations is lower than 2006.The tax rate of 28 per cent reflects the mix of business between UK and overseas operations which are taxed at a variety of rates. The rates will fluctuate year on year dependent on the mix of profits between jurisdictions.
Equity securities and portfolio holdings in unit trusts 62,122 – – 62,122 62,122
Equity securities and portfolio holdings in unit trusts 86,157 – – 86,157 86,157
Notes i As at 31 December 2008, £620 million (2007: £722 million) of convertible bonds were included in debt securities and £363 million (2007: £278 million) were included in borrowings.
ii Loans and receivables are reported net of allowance for loan losses of £27 million (2007: £13 million). iii See note G3 for details of the derivative assets included. The balance also contains the PAC with-profits fund’s participation in various investment funds and limited liability property partnerships.
v For financial liabilities designated as fair value through profit and loss there was no impact on profit from movements in credit risk during 2008
Changes in assumptions relating to these variables could positively or negatively impact the reported fair value of these
The estimated fair value of derivative financial instruments reflects the estimated amount the Group would receive or pay in an arm’s length transaction. This amount is determined using quotations from independent third-parties or valued internally using standard market practices. In accordance with the Group’s risk management framework, all internally generated valuations are subject to independent assessment against external counterparties’ valuations.
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 UK unit-linked policies). For investment contracts in the US with fixed and guaranteed terms the fair value is determined based on the present value of future cash flows discounted at current interest rates.
Other investments (including derivative assets) 2,189 257 1,215 324 3,985 2007 £m
Other investments (including derivative assets) 2,425 103 744 73 3,345 *Including SAIF
For the UK operations, in accordance with the Group’s Risk Management Framework, all internally generated calculations are subject to independent assessment by the Group’s Fair Value Committees which comprise members who are independent of the fund managers involved in the day-to-day trading in these assets.
The equity securities and other investments which included property and other partnerships in investment pools, venture investments and derivative assets and derivative liabilities as shown on the table above are valued using valuation techniques which apply less readily observable market factors and more non-observable factors than the matrix pricing technique as used for the majority of the debt securities.
The total amount of the change in fair value estimation using valuation techniques, including valuation techniques based on assumptions not wholly supported by observable market prices or rates, recognised in the income statement in 2008 was a gain of £355 million (2007: gain of £288 million) for the with-profits fund investments. The gain in 2008 reflects an underlying loss which is more than offset by the exchange gains of the foreign currency denominated investments of the with-profits fund.
Changes in values of assets of the with-profits funds are reflected in policyholder liabilities and unallocated surplus. Due to the liability accounting treatment of unallocated surplus, changes in values of securities held by with-profits funds have no direct effect on the profit or loss attributable to shareholders or shareholders’ equity.
The total amount of the change in fair value estimation using valuation techniques, including those based on assumptions not wholly supported by observable market prices or rates, recognised in the income statement in 2008 and which was attributable to shareholders, was a loss of £685 million (2007: gain of £116 million).
The 2007 comparatives shown above differ from the previously published information for the inclusion of the financial investments for which prices have been provided by independent third-parties, such as pricing services and brokers, and for which the prices have been derived using valuation techniques by these providers. The previously published 2007 information included only the financial investments valued internally using valuation techniques.
Interest income and expense The interest income on financial assets not at fair value through profit and loss for the year ended 31 December 2008 from continuing operations was £2,532 million (2007: £2,016 million).
The interest expense on financial liabilities not at fair value through profit and loss for the year ended 31 December 2008 from continuing operations was £645 million (2007: £699 million).
Interest rate risk The following table shows an analysis of the classes of financial assets and liabilities and their direct exposure to interest rate risk. Each applicable class of the Group’s financial assets or liabilities is analysed between those exposed to fair value interest rate risk, cash flow interest rate risk and those with no direct interest rate risk exposure: 2008 £m
Not directly Fair value Cash flow exposed to interest interest interest rate risk rate risk rate risk Total
After 1 After 5 After 10 After 15 Total 1 year year to years to years to years to Over No stated carrying or less 5 years 10 years 15 years 20 years 20 years maturity value
Obligations under funding, securities lending and sale and repurchase agreements 4,081 – – – – – – 4,081
Total After 1 After 5 After 10 After 15 undis1 year year to years to years to years to Over counted or less 5 years 10 years 15 years 20 years 20 years value 2007 £bn
This table has been prepared on an undiscounted basis and accordingly the amounts shown for life assurance investment contracts differ from those disclosed on the balance sheet. Durations of long-term business contracts, covering insurance and investment contracts, on a discounted basis are included in section D.
There was no collateral held against loans that are past due and impaired or that are past due but not impaired at 31 December 2008 (2007: £nil).
In addition, during the year the Group took possession of £66 million (2007: £7 million) of other collateral held as security, which mainly consists of assets that could be readily convertible into cash.
Currency risk As at 31 December 2008, the Group held 20 per cent (2007: 19 per cent) and 13 per cent (2007: 13 per cent) of its financial assets and financial liabilities respectively, in currencies, mainly US dollar and Euro, other than the functional currency of the relevant business unit.
The financial assets, of which 77 per cent (2007: 86 per cent) are held by the PAC with-profits fund, allow the PAC with-profits fund to obtain exposure to foreign equity markets.
The amount of exchange gains recognised in the income statement in 2008, except for those arising on financial instruments measured at fair value through profit and loss, is £638 million (2007: £102 million). This constitutes £32 million (2007: £109 million) gains on Medium Term Notes (MTN) liabilities and £606 million of net gains (2007: £7 million net losses), mainly arising on investments of the PAC with-profits fund. The gains on MTN liabilities are fully offset by value movements on cross-currency swaps, which are measured at fair value through profit and loss.
The total fair value balances of derivative assets and liabilities as at 31 December 2008 were as follows: 2008 £m
Inflation swaps 2,559 2,482 – – Credit default swaps 123 14 – – Single stock options 1 1 – – Credit derivatives – – 31 177 Put options – – 6,573 –
Total return swaps 479 514 – 313 *In addition, the other operations, including the Group Treasury function and the Asian operations, have cross-currency swap assets and liabilities with notional amounts of £1,503 million (2007: £730 million) and £605 million (2007: £1,401 million) respectively, forward currency contracts assets and liabilities with notional amounts of £1,419 million (2007: £983 million) and £2,310 million (2007: £773 million) respectively, interest rate swaps assets and liabilities of £1,407 million (2007: £2,799 million) and of £2,316 million (2007: £1,563 million), respectively, and cliquet options assets of £1,525 million (2007: £nil).
Inflation swaps 1,758 1,319 – – Credit default swaps 4,181 59 – – Single stock options – – – – Credit derivatives – – 3 20 Put options – – 3,642 – Equity options – – 5,545 11 Total return swaps 956 955 226 –
As part of the efficient portfolio management of the PAC with-profits fund, the fund may, from time to time, invest in cashsettled forward contracts over Prudential plc shares, which are accounted for consistently with other derivatives. This is in order to avoid a mismatch of the with-profits investment portfolio with the investment benchmarks set for its equity-based investment funds. The contracts will form part of the long-term investments of the with-profits fund. These contracts are subject to a number of limitations for legal and regulatory reasons.
Fair value hedges The Group uses interest rate derivatives to hedge the interest exposures on its US$1 billion, 6.5 per cent perpetual subordinated capital securities and US$300 million, 6.5 per cent perpetual subordinated capital securities. Where the hedge relationship is de-designated and re-designated, the fair value adjustment to the hedged item up to the point of de-designation continues to be reported as part of the basis of the hedged item and is amortised to the income statement based on a recalculated effective interest rate over the residual period to the first break clause date of the perpetual subordinated capital securities.
The fair value of the derivatives designated as fair value hedges above at 31 December 2008, were an asset of £17 million and liabilities of £nil (2007: asset of £5 million and liabilities of £25 million). Movements in the fair value of the hedging instruments of a net loss of £4 million (2007: net gain of £6 million) and the hedged items of a net gain of £7 million (2007: net loss of £4 million) are recorded in the income statement in respect of the fair value hedges above.
Net investment hedges The Group has entered into a series of one to three-month period forward currency transactions which together form a US$2 billion net investment hedge of the currency exposure of the net investments in the US operations. The forward currency contracts were renewed throughout 2008 and 2007. The forward currency contracts in place at 31 December 2008 expire in January 2009. In December 2008, the Group de-designated the US$2 billion forward currency contract and re-designated only US$600 million of the forward currency contract as a partial net investment hedge of the currency exposure of the net investments in the US operations. The change reflected consideration of the direct US dollar exposure for accounting purposes, and the indirect offsetting exposure within the Group’s IGD solvency reporting. The fair value of the forward currency contracts at 31 December 2008 was a liability of £56 million (2007: a liability of £44 million), of which £17 million (2007: a liability of £44 million) was designated as a net investment hedge of the currency exposure of the net investments in the US operations.
In addition, the Group has designated perpetual subordinated capital securities totalling US$1.55 billion as a net investment hedge to hedge the currency risks related to the net investment in Jackson. The carrying value of the subordinated capital securities was £1,059 million (2007: £763 million) as at 31 December 2008. The foreign exchange loss of £299 million (2007: gain of £13 million) on translation of the borrowings to pounds sterling at the balance sheet date is recognised in the translation reserve in shareholders’ equity.
Securities lending and reverse repurchase agreements The Group has entered into securities lending (including repurchase agreements) whereby blocks of securities are loaned to third-parties, primarily major brokerage firms. The amounts above the fair value of the loaned securities required to be held as collateral by the agreements depend on the quality of the collateral, calculated on a daily basis. The loaned securities are not removed from the Group’s consolidated balance sheet, rather they are retained within the appropriate investment classification. Collateral typically consists of cash, debt securities, equity securities and letters of credit. At 31 December 2008, the Group had lent £12,617 million (2007: £17,172 million) (of which £9,701 million (2007: £11,461 million) was lent by the PAC with-profits fund) of securities and held collateral under such agreements of £13,497 million (2007: £18,125 million) (of which £9,924 million (2007: £12,105 million) was held by the PAC with-profits fund).
During the year ended 31 December 2008, impairment losses of £525 million (2007: £184 million) were recognised for available-for-sale securities and loans and receivables. These were £497 million (2007: £35 million) in respect of available-for-sale securities held by Jackson and £28 million (2007: £149 million) in respect of loans and receivables. The 2008 impairment charge for loans and receivables of £28 million relates primarily to loans held by the UK with-profits fund. The 2007 impairment charge of £149 million related to loans and advances to customers in the discontinued banking operations during the period of ownership.
Impairment losses recognised on available-for-sale securities amounted to £497 million (2007: £35 million). Of this amount, 8 per cent (2007: 14 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 27 per cent (2007: 57 per cent), reflecting a deteriorating business outlook of the companies concerned.
Impairment testing Goodwill does not generate cash flows independently of other groups of assets and thus is assigned to cash generating units (CGUs) for the purposes of impairment testing. These CGUs are based upon how management monitors the business and represent the lowest level to which goodwill can be allocated on a reasonable basis. An allocation to CGUs of the Group’s goodwill attributable to shareholders is shown below: ‘Other’ represents goodwill amounts allocated across CGUs in Asia and US operations. These goodwill amounts are not individually material.
M&G The recoverable amount for the M&G CGU has been determined by calculating its value in use. This has been calculated by aggregating the present value of future cash flows expected to be derived from the component businesses of M&G (based upon management projections).
ii The assumed growth rate on forecast cash flows beyond the terminal year of the budget. A growth rate of 2.5 per cent has been used to extrapolate beyond the plan period.
Japanese life company The aggregate goodwill impairment of £120 million at 31 December 2008 and 2007 relates to the goodwill held in relation to the Japanese life operation which was impaired in 2005.
b Deferred acquisition costs and other intangible assets Deferred acquisition costs and other intangible assets in the Group consolidated balance sheet attributable to shareholders consist of: Deferred acquisition costs (DAC) related to insurance contracts as classified under IFRS 4 5,097 2,644 Deferred acquisition costs related to investment management contracts, including life assurance contracts classified as financial instruments and investment management contracts under IFRS 4 108 113
Total of deferred acquisition costs and other intangible assets 5,349 2,836
Arising in: UK insurance operations 134 157 US insurance operations 3,962 1,928 Asian insurance operations 1,247 745 Asset management operations 6 6
Amortisation to income statement (551) (424) Exchange differences 1,035 (42) Change in shadow DAC (note D3 (i)) 1,070 88
Notes on the Group financial statements H: Other information on balance sheet items continued
At 1 January Gross amount 136 130 Accumulated amortisation (23) (20)
Present value of acquired in-force business of long-term business contracts attributable to shareholders Prior to the adoption of IFRS 4, the present value of acquired in-force business (PVAIF) was accounted for under UK GAAP. On 1 January 2005, following the adoption of IFRS 4, PVAIF relating to investment contracts without discretionary participation features, which was previously included within long-term business, is removed and replaced by an asset representing the present value of the future profits of the asset management component of these contracts, where applicable. These contracts are accounted for under the provisions of IAS 18. The remainder of the PVAIF balance relates to insurance contracts and is accounted for under UK GAAP as permitted by IFRS 4.
At 1 January Gross amount 16 – Accumulated amortisation 0 –
H2: Intangible assets attributable to with-profits funds a Goodwill in respect of acquired investment subsidiaries for venture fund and other investment purposes 2008 £m
Goodwill Carrying value at 1 January 2008 192 Amortisation charge – Impairment (18)
All the goodwill relates to the UK and the insurance operations segments. Following the sale by the Group of PPM Capital in November 2007, 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 with its recoverable amount. The recoverable amount of the investment was determined by calculating its fair value less costs to sell. At 31 December 2008, following the impairment testing carried out, £18 million of the goodwill was deemed to be impaired and written off accordingly.
The impairment charge of £18 million is recorded under ‘acquisition costs and other operating expenditure’ but is also taken account of in determining the charge/credit in the income statement for the transfer to the liability for unallocated surplus of with-profits funds.
The movement on reinsurers’ share of insurance contract liabilities is as follows: Movement in the year 243 (147) Foreign exchange translation differences 209 (7)
Unrealised losses on investments 1,267 129 Balances relating to investment and insurance contracts 12 2 Short-term timing differences 1,282 770 Capital allowances 16 20 Unused deferred tax losses 309 30
The deferred tax asset at 31 December 2008 and 2007 arises in the following parts of the Group.
Liabilities Of the £842 million (2007: £1,237 million) current tax liability, it is not practicable to estimate how much is expected to be settled in one year or less due to the uncertainty over when outstanding issues will be agreed with HM Revenue & Customs.
Of the £3,745 million (2007: £2,932 million) of accrued investment income and other debtors, £114 million (2007: £64 million) is expected to be settled after one year or more.
Reclassification from (to) held for investment 68 (676) – (608) (608)
All additions arising on acquisition of subsidiaries in 2007 related to acquisitions of venture investment subsidiaries of the PAC with-profits fund.
Insurance operations 212 206 Asset management 13 11 Unallocated corporate 16 11
Net loss from fair value adjustments (3,784) (1,128) Net foreign exchange differences 395 14 Transfers to held for sale assets – (25) Transfers from (to) development properties 676 (121) Transfers to owner occupied properties (68) –
Contingent rent is that portion of the lease payments that is not fixed in amount but is based on the future value of a factor that changes other than with the passage of time. Contingent rent recognised as an expense in 2008 amounted to £nil (2007: £14 million). Contingent rents recognised as income in the year amounted to £nil (2007: £26 million).
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 742 679
The total minimum future rentals to be received on non-cancellable sub-leases for land and buildings at 31 December 2008 are £3,730 million (2007: £2,746 million).
Investments in associates The Group had four associates at 31 December 2008 (2007: 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, a 25 per cent interest in OYO Developments Limited, and a 26.8 per cent interest in IFonline Group Limited (IFonline).
The Group also has investments in associates which meet the IAS 28 criteria for measurement at fair value through profit and loss in accordance with IAS 39.
A summary of the movements in investments in associates accounted for using the equity method in 2008 and 2007 is set out below: Total Share of Share of Share of carrying capital reserves net assets Goodwill value £m £m £m £m £m
The Group’s share of the assets, liabilities, revenues and profit and loss of associates accounted for using the equity method at 31 December 2008 and 2007 is as follows: Financial position Total assets (excluding goodwill) 12 7 Total liabilities (4) (3)
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 non-coterminous with that of the Group. In these instances, the investments are recorded at fair value at 31 December 2008 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 £4 billion (2007: £2 billion) at 31 December 2008.
ICICI Prudential Life Insurance Company Limited 26 Life assurance India BOCI – Prudential Asset Management Limited 36 Pensions China PruHealth 50 Private medical insurance UK CITIC – Prudential Life Insurance Company Limited 50 Life assurance China CITIC Prudential Fund Management Company Limited 49 Asset management China Prudential ICICI Asset Management Company Limited 49 Asset management India Prudential BSN Takaful Berhad 49 General and life insurance Malaysia
In August 2007, the Group increased its stake in CITIC Prudential Fund Management Company Limited from 33 per cent to 49 per cent.
The investments noted in the table above have the same accounting year end as the Group, except for ICICI Prudential Life Insurance Company Limited and Prudential ICICI Asset Management Company Limited. Although these investments have reporting periods ending 31 March, 12 months of financial information up to 31 December is recorded. Accordingly, the information is deemed to cover the same period as that of the Group.
There are several minor service agreements in place between the joint ventures and the Group. During 2008, the aggregate amount of the transactions was £15.9 million (2007: £5.4 million) and the balance outstanding as at 31 December 2008 was £22.5 million (2007: £4.7 million).
Assets held for sale in 2007 of £30 million comprised investment property of the PAC with-profits fund. Investment properties are classified as held for sale when contracts have been exchanged but the sale has not been completed at the period end. There were no assets held for sale at 31 December 2008. Gains on disposal of held for sale assets are recorded in ‘investment income’ within the income statement.
Share capital and share premium Share capital 125 123 Share premium 1,840 1,828 Reserves Retained earnings 3,604 4,301 Translation reserve 638 (112) Available-for-sale reserve (1,149) (78)
Issued shares of 5p each fully paid: At the beginning of the year 2,470,017,240 123 1,828 Shares issued under share option schemes 2,307,469 – 12 Shares issued in lieu of cash dividends 24,622,979 2 156 Transfer to retained earnings in respect of shares issued in lieu of cash dividends – – (156)
The cost of own shares of £75 million as at 31 December 2008 (2007: £60 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 2008, 6.4 million (2007: 6.6 million) Prudential plc shares with a market value of £27 million (2007: £47 million) were held in such trusts. Of this total, 6.0 million (2007: 5.1 million) shares were held in trusts under employee incentive plans. In 2008, the Company purchased 5.4 million (2007: 1.2 million) shares in respect of employee incentive plans at a cost of £27 million (2007: £9 million). The maximum number of shares held in the year was 6.6 million which was at the beginning of the year.
Income and expense included in the income statement (12,760) (5,815) Foreign exchange translation differences 16,014 270
Note B6 provides further analysis of the movement in the year of the Group’s policyholder liabilities and unallocated surplus of the with-profits funds.
Jackson US$250m 8.15% Surplus Notes 2027note vi 173 173 125 *These debt classifications are consistent with the treatment of capital for regulatory purposes, as defined in the FSA Handbook. † Including central finance subsidiaries. ‡ The senior debt ranks above subordinated debt in the event of liquidation.
ii The ¤20 million Medium-Term Subordinated Notes 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.
The following table sets out the maturity analysis of the Group’s core structural borrowings: £m £m
2 to 3 years – – 3 to 4 years – – 4 to 5 years – –
Jacksonnote ii 104 126 Investment subsidiaries 23 9 Piedmont and CDO fundsnote iii 384 456
The interest rate on this debt is variable based on a market rate and was 0.47 per cent at 31 December 2008. 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.
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.
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) 67 98 Attributable to shareholder-financed operations (i.e. to shareholders’ equity) 82 85
Analysis of other provisions: Charged to income statement: Additional provisions 48 116 Unused amounts released (24) (23)
Of the other provisions balance of £155 million (2007: £220 million), £90 million (2007: £77 million) is expected to be settled within one year. Employer contributions expected to be paid into defined benefit pension schemes within one year are shown in note I1.
Legal provisions The legal provisions of £23 million (2007: £19 million) relate predominantly to Jackson. Jackson has been named in civil proceedings, which appear to be substantially similar to other class action litigation brought against many life insurers in the US, alleging misconduct in the sale of insurance products. During 2008, £2 million was paid.
During 2008, an additional provision of £4 million was provided, £7 million of unused provision was released, and £11 million was paid.
Other provisions Other provisions of £111 million (2007: £166 million) include provisions of £95 million (2007: £155 million) relating to staff benefit schemes. During 2008, another £37 million was provided (including exchange movements of £6 million), £15 million of unused provision was released and £82 million was paid. In 2007, a provision of £134 million was brought forward, an additional £78 million was provided, £3 million of unused provision was released and £54 million was paid. Other provisions also include £16 million (2007: £11 million) relating to various onerous contracts where, in 2008, an additional £10 million was provided and £5 million was used. In 2007, £18 million was brought forward, £2 million was provided and £1 million was released and £8 million was paid.
Contingencies and related obligations Litigation In addition to the legal proceedings relating to Jackson mentioned above, the Group is involved in other litigation and regulatory issues. Whilst the outcome of such matters cannot be predicted with certainty, the directors believe that the ultimate outcome of such litigation and regulatory issues will not have a material adverse effect on the Group’s financial condition, results of operations, or cash flows.
This review was completed on 30 June 2002. The assurance will continue to apply to any policy in force at 31 December 2003, both for premiums paid before 1 January 2004, and for subsequent regular premiums (including future fixed, RPI or salary related increases and Department of Work and Pensions rebate business). The assurance has not applied to new business since 1 January 2004. New business in this context consists of new policies, new members to existing pension schemes plus regular and single premium top-ups, transfers and switches to existing arrangements. The maximum amount of capital support available under the terms of the assurance will reduce over time.
The Group is exposed to mortgage endowment products in respect of policies issued by Scottish Amicable Life plc (SAL) and policies issued by Scottish Amicable Life Assurance Society (SALAS) which were transferred into SAIF. At 31 December 2008, provisions of £5 million (2007: £5 million) in SAL and £40 million (2007: £43 million) in SAIF were held to cover potential compensation in respect of mortgage endowment product mis-selling claims. As SAIF is a separate sub-fund of the Prudential Assurance long-term business fund, this provision has no impact on shareholders.
Prudential announced in March 2006 that it had begun a process to determine whether it could achieve greater clarity as to the status of the inherited estate through reattribution. In June 2008 Prudential announced that it did not believe that it was in the interests of current or future policyholders or shareholders to continue the reattribution process. This announcement reflects Prudential’s overriding priority which is to maintain the long-term financial security of the WPSF and to continue delivering strong performance for the benefit of its policyholders.
Guarantees and commitments Guarantee funds in both the UK and the US provide for payments to be made to policyholders on behalf of insolvent life insurance companies. These guarantee funds are financed by payments assessed on solvent insurance companies based on location, volume and types of business. The Group estimated its reserve for future guarantee fund assessments for Jackson to be £18 million at 31 December 2008 (2007: £9 million). Similar assessments for the UK businesses were not significant. The directors believe that the reserve is adequate for all anticipated payments for known insolvencies.
Jackson owns debt instruments issued by two separate securitisation trusts managed by PPM America which are consolidated into the Group accounts, SERVES 2001-6 (SERVES 2) and SERVES 2004-1 (SERVES 3). Jackson has a £50 million debt interest in SERVES 2 and a £33 million debt interest in SERVES 3. The creditors of the entities have no recourse to the general credit of Jackson. During 2008, Jackson entered into ‘Option Put and Forbearance Agreements’ with the counterparty to these two entities in exchange for the counterparty forbearing its right to initiate forced liquidations of the entities under certain market value triggers. The support provided by the agreements could potentially expose Jackson to maximum losses of £118 million and £103 million for SERVES 2 and SERVES 3, respectively, if circumstances allowed the forbearance period to cease. Jackson believes that, so long as the forbearance period continues, the risk of loss under the agreements is remote.
I1: Staff and pension plans a Staff and employment costs The average number of staff employed by the Group during the year were: Business operations: UK operations 6,231 7,732 US operations 3,298 3,123 Asian operations 20,154 16,807
The costs of employment for continuing operations were: Business operations: Wages and salaries 791 819 Social security costs 54 62 Other pension costs (see below) 78 96 Pension actuarial and other (gains) losses charged to income statement (10) 2
Other pension costs comprises £47 million (2007: £68 million) relating to defined benefit schemes and £31 million (2007: £28 million) relating to defined contribution schemes of continuing operations. Of the defined contribution scheme costs, £21 million (2007: £19 million) related to overseas defined contribution schemes. The £47 million (2007: £68 million) comprises a charge of £29 million (2007: £41 million) relating to PSPS and a charge of £18 million (2007: £27 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 (2007: £41 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 £18 million (2007: £27 million) for other schemes comprises a £7 million (2007: £17 million) charge on an economic basis, reflecting the total assets of the schemes, and a further £11 million (2007: £10 million) charge to adjust for amounts invested in Prudential insurance policies to arrive at the IAS 19 basis charge.
The gains of £10 million (2007: loss of £2 million) for actuarial and other gains comprises a loss of £21 million (2007: loss of £7 million) for actuarial and other losses on an economic basis and £31 million actuarial gains (2007: gain of £5 million) to adjust for amounts invested in Prudential insurance policies. The derivation of these amounts is shown in note (b)(i)7 below.
Of the £423 million costs of employment for venture fund investment subsidiaries in 2007, £349 million related to wages and salaries, £70 million related to social security costs and £4 million related to pension costs. Following the change of control arrangements put in place at the same time as the sale by the Group of PPM Capital in November 2007, the Group no longer controls those venture fund investment subsidiaries managed by the sold entity and consequently ceased to consolidate these operations subsequent to this, with the average number of staff employed and costs of employment for 2007 detailed above reflecting the period prior to disposal.
Of the £21 million costs of employment for discontinued banking operations in 2007, £18 million related to wages and salaries, £2 million related to social security costs and £1 million related to pension costs.
b Pension plans i Defined benefit plans 1 Summary and the effects of the adoption of IFRIC 14 The Group business operations operate a number of pension schemes. The specific features of these plans vary in accordance with the regulations of the country in which the employees are located, although they are, in general, funded wholly by the Group and based either on a cash balance formula or on years of service and salary earned in the last year or years of employment. The largest defined benefit scheme is the principal UK scheme, namely the Prudential Staff Pension Scheme (PSPS), 87 per cent (2007: 87 per cent) of the underlying scheme liabilities of the Group defined benefit schemes are accounted for within PSPS.
The Group also operates two smaller defined benefit schemes for UK employees in respect of Scottish Amicable and M&G activities. 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.
Defined benefit schemes in the UK are generally required to be subject to full actuarial valuation every three years in order to assess the appropriate level of funding for schemes in relation 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 2005. This valuation demonstrated the scheme to be 94 per cent funded, with a shortfall of actuarially determined assets to liabilities of six per cent, representing a deficit of £243 million.
The adoption of IFRIC 14 As mentioned in notes A2 and A5, the Group has adopted IFRIC 14 for pension schemes in 2008. The adoption of IFRIC 14, which gives 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 thereby providing reliable and more relevant information. The recognition of an asset is restricted to those that are demonstrably recoverable, either by refund or reduction in future contributions. It also addresses when a minimum funding requirement might give rise to a liability. The assessment of recoverability and any additional liability is made by reference to the terms of the Trust Deed of pension schemes and, unless substantively enacted or contractually agreed, with no account taken of potential changes to current funding arrangements.
The summary effect of the adoption of IFRIC 14 In respect of the position at 31 December 2008, the Group has not recognised the underlying PSPS pension surplus of £728 million (£615 million net of deferred tax), reflecting the difference between the market value of the scheme assets and the discounted value of the liabilities, which would have otherwise been recognised as an asset on its balance sheet under the previous policy. In addition, the Group has recognised a liability for deficit funding to 5 April 2010 of £65 million (£55 million net of deferred tax) in respect of PSPS. Of these, the amounts attributable to shareholders are £223 million (£160 million net of deferred tax) for the surplus not recognised as an asset and £20 million (£15 million net of deferred tax) for the additional liability for deficit funding. In total the impact on shareholders’ equity at 31 December 2008 is a reduction of £175 million as shown below.
The 2007 comparative figures in these consolidated financial statements have been adjusted accordingly for the adoption of IFRIC 14.
Profit (loss) from continuing operations after tax/profit (loss) for the year (36) (75)
Effect on the Group’s supplementary analysis of profit and movements in shareholders’ equity
Short-term fluctuations in investment returns on shareholder-backed business (1,783) – (1,783) (137) – (137)
As at 31 December 2008, after the effect of the adoption 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 £61 million liability net of related tax relief (2007: £63 million). These amounts are determined after including amounts invested by the M&G scheme in Prudential policies as explained later in this note.
On the economic basis (including investments of the M&G scheme in Prudential policies as assets) for 2008, a £26 million (2007: £35 million) pre-tax shareholder charge to operating results based on longer-term returns arises. In addition, outside the operating result but included in total profits is a pre-tax shareholder loss of £14 million (2007: £1 million).
At 31 December 2008, after the effect of the adoption of IFRIC 14, the total share of the liability for deficit funding on PSPS and the deficit on the smaller Scottish Amicable Scheme attributable to the PAC with-profits fund amounted to a liability of £60 million (2007: £88 million) net of related tax relief.
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, regard is had 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.
However, the Investment Managers will not invest in any new class of investment asset without prior consultation with the Trustee.
3 Assumptions The actuarial assumptions used in determining benefit obligations and the net periodic benefit costs for the years ended 31 December were as follows: Discount rate* 6.1 5.9 Rate of increase in salaries 5.0 5.3 Rate of inflation 3.0 3.3 Rate of increase of pensions in payment for inflation: Expected returns on plan assets 6.2 5.9 *The discount rate of 6.1% has been determined by reference to an ‘AA’ corporate bond index adjusted to allow for the difference in duration between the index and the pension liabilities.
The tables used for PSPS at 31 December 2008 were: Male: 100 per cent PMA92 with CMIR17 improvements to the valuation date and medium cohort improvements subject to a floor of 1.75 per cent up to the age of 90, decreasing linearly to zero by age of 120; and Female: 100 per cent PFA92 with CMIR17 improvements to the valuation date and 75 per cent medium cohort improvements subject to a floor of one per cent up to the age of 90 and decreasing linearly to zero by age of 120.
Economic deficit – as explained in note 5 below (149) (183) Add back: investments in Prudential insurance policies (offset on consolidation in the Group financial statements against insurance liabilities) (157) (172)
Deficit included in balance sheet under IAS 19 – as explained in note 7 below (306) (355)
The M&G pension scheme has invested £157 million at 31 December 2008 (2007: £172 million) in Prudential insurance policies. As required by IFRS, this amount of scheme asset is eliminated against the policyholder liability and hence, for the purposes of preparing the consolidated balance sheet, the IAS 19 basis net pension liability is £157 million (2007: £172 million) lower than the ‘economic basis’ deficit of £149 million (2007: ‘economic basis’ deficit of £183 million). Additionally, the PSPS scheme has invested £103 million at 31 December 2008 (2007: £140 million) in Prudential insurance policies. However, these assets are not recognised due to the effects of the change in accounting policy for the adoption of IFRIC 14 as described in note 1 above.
Present value of benefit obligations (4,075) (598) (4,673) (4,361) (654) (5,015)
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 2008, the nominal value of the interest and inflation-linked swaps amounted to £1.2 billion (2007: £1.2 billion) and £0.3 billion (2007: £0.7 billion) respectively.
ii The resulting scheme deficit arising from the excess of liabilities over assets at 31 December 2008 of £149 million comprised a deficit of £67 million (2007: deficit of £98 million) attributable to the PAC with-profits fund and deficit of £82 million (2007: deficit of £85 million) attributable to shareholder operations.
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 2008 of £67 million (2007: £71 million), gross of tax. There is also a small scheme in Taiwan, which at 31 December 2008 had a deficit of £17 million (2007: £10 million), gross of tax.
Actuarial and other gains and losses (21) (7) Exchange translation difference (4) –
Charge to operating results Actuarial (based on and other longer-term gains (losses) Contributions investment attributable to paid by Exchange
At beginning returns) shareholders shareholder At end of year note i note ii operations of year
Current service cost (19) (19) Curtailment credit 14 – Finance income (expense): Interest on pension scheme liabilities (39) (31) Expected return on pension scheme assets 37 33
*Consistent with the derecognition of the Company’s interest in the underlying IAS 19 surplus of PSPS, the effect of the accounting policy change on the operating results, based on longer-term investment returns, is to replace the usual IAS 19 pension charges and credits with the cash cost of contributions for ongoing service of active members. In addition, the charge to the operating results also includes a charge for the unwind of discount on the opening provision for deficit funding for PSPS.
Actuarial gains and losses: Actual less expected return on pension scheme assets (97) 4 Experience gains (losses) on scheme liabilities 18 (4) Changes in assumptions underlying the present value of scheme liabilitiesa 71 (7)
Total actuarial losses (8) (7) Less: amount attributable to PAC with-profits fund (2) 6
Actuarial gains and losses attributable to shareholders, excluded from operating results based on longer-term investment returns, but included in profit before tax attributable to shareholdersb (14) (1)
b The amounts of actuarial gains and losses shown in the table above relate to Scottish Amicable, M&G and a small Taiwan defined benefit pension scheme. Consistent with the derecognition of the underlying IAS 19 surplus of PSPS, the amounts do not include actuarial gains and losses for PSPS. In addition, as a result of the adoption of IFRIC 14, the Group has recognised a provision for deficit funding to 5 April 2010 in respect of PSPS. The change in the period in relation to this provision is recognised above as other gains and losses on defined benefit pension schemes.
Estimated pension scheme deficit attributable to PAC with-profits fund – economic basis Movements on the pension scheme deficit determined on the ‘economic basis’ are as follows: 2008 £m
At beginning (credit) gains (losses) with-profits At end of year note i above note ii above fund of year 2007 £m
Cash costs and unwind of discount on the opening provision for deficit funding for PSPS (29) (29)
Fair value of plan assets, end of year 357 157 514 514 Present value of benefit obligation, end of year (598) (598) Provision for deficit funding of PSPS (65) (65)
Service cost – current charge only (19) (19) Interest cost (31) (31) Expected return on plan assets 23 10 33 33
Fair value of plan assets, end of year 401 172 573 573 Present value of benefit obligation, end of year (654) (654) Provision for deficit funding for PSPS (102) (102)
Actuarial gains and losses – economic basis 60 295 Less: actuarial losses on investments of scheme assets in Prudential insurance policies 79 1
*Consistent with the derecognition of the Company’s interest in the underlying IAS 19 surplus of PSPS, the effect on the net periodic pension cost for PSPS was to replace the usual IAS 19 pension charges and credits with the cash cost of contribution for ongoing services of active members and also not to report the actuarial gains and losses.
†In determining the expected return on scheme assets for 2008, the 5.9 per cent rate shown below has been applied to the opening assets.
The long-term expected rate of return has been taken to be the weighted average (by market value) of the long-term expected rates of return on each major asset class shown below: Scheme assets (IAS 19 basis before effect of adoption of IFRIC 14)
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 balance sheet date.
Fair value of scheme assets, end of year (IAS 19 basis) 5,057 5,150 4,988 4,622 4,092 Present value of the benefit obligation, end of year (4,673) (5,015) (5,210) (5,418) (4,917)
Underlying scheme assets in surplus (deficit) of benefit obligation, before the effect of the adoption of IFRIC 14 384 135 (222) (796) (825)
The experience adjustments on scheme liabilities in 2008 of a gain of £145 million relate mainly to the ‘true up’ reflecting improvements in data consequent upon the ongoing triennial valuation of PSPS.
Total employer contributions expected to be paid into the Group defined benefit schemes for the year ending 31 December 2009 amounts to £98 million (2008: £90 million), subject to a reassessment when the valuation at 5 April 2008 is completed.
Discount rate Decrease by 0.2% from 6.1% to 5.9% Increase in scheme liabilities by: PSPS 3.3% Scottish Amicable 4.9% M&G 4.5%
Rate of inflation Decrease by 0.2% from 3.0% to 2.8% Decrease in scheme liabilities by: with consequent reduction in PSPS 0.8% salary increases Scottish Amicable 4.5%
Discount rate Decrease by 0.2% from 5.9% to 5.7% Increase in scheme liabilities by: PSPS 3.5% Scottish Amicable 5.3% M&G 4.8%
Discount rate Increase by 0.2% from 5.9% to 6.1% Decrease in scheme liabilities by: PSPS 3.4% Scottish Amicable 5.1% M&G 4.5%
Rate of inflation Decrease by 0.2% from 3.3% to 3.1% Decrease in scheme liabilities by: with consequent reduction in PSPS 1.3% salary increases Scottish Amicable 5.0%
9 Transfer value of PSPS scheme At 31 December 2008, 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 2008 was £31 million (2007: £28 million).
The RSP was, until March 2006, the Group’s long-term incentive plan for executive directors and other senior executives designed to provide rewards linked to shareholder return. Each year participants were granted a conditional option to receive a number of shares. There was a deferment period of three years at the end of which the award vested to an extent that depended on the performance of the Group’s shares including notional reinvested dividends and on the Group’s underlying financial performance. After vesting, the option may be exercised at zero cost at any time, subject to closed period rules, in the balance of a 10-year period. Shares are purchased in the open market by a trust for the benefit of qualifying employees. The RSP replaced the Executive Share Option Scheme in 1995 and all options under this plan had been exercised at 31 December 2005.
No rights were granted in the RSP if the Company’s TSR performance as ranked against the comparator group is below 50th percentile. For performance at 50th percentile, an option of 25 per cent of the maximum award is made. The maximum grant is made only if the TSR ranking of the Company is 20th percentile or above. Between these points, the size of the grant of option made is calculated on a straight line sliding scale.
UK-based executive directors are eligible to participate in the Prudential HM Revenue & Customs (HMRC) approved UK Savings Related Share Option Scheme (SAYE scheme) and the Asia-based executive directors can participate in the equivalent International SAYE scheme. The schemes allow employees to save towards the exercise of options over Prudential plc shares, at an option price set at the beginning of the savings period at a discount of up to 20 per cent to the market price. Savings contracts may be up to £250 per month for three or five years, or additionally in the UK scheme seven years. On maturity at the end of the set term, participants may exercise their options within six months of the end of the savings period and purchase Prudential plc shares. If an option is not exercised within six months, participants are entitled to a refund of their cash contributions plus interest if applicable under the rules. Shares are issued to satisfy options that are exercised. No options may be granted under the schemes if the grant would cause the number of shares which have been issued, or which remain issuable pursuant to options granted in the preceding 10 years under the scheme and other share option schemes operated by the Company, or which have been issued under any other share incentive scheme of the Company, to exceed 10 per cent of the Company’s ordinary share capital at the proposed date of grant.
Movements in share options outstanding under the Group’s share-based compensation plans relating to Prudential plc shares during 2008 and 2007 were as follows: Weighted Weighted average average
The weighted average share price of Prudential plc for the year ended 31 December 2008 was £5.46 compared to £7.15 for the year ended 31 December 2007.
Movements in share awards outstanding under the Group’s share-based compensation plans relating to Prudential plc shares at 31 December 2008 and 2007 were as follows: Number of Number of awards awards
The following table provides a summary of the range of exercise prices for Prudential plc options (including conditional options) outstanding at 31 December 2007.
During the year, the Group granted share options to certain non-employee independent financial advisors. Those options were measured using the Black-Scholes option pricing model with assumptions consistent with those of other share options. These transactions were measured using an option model because the Group does not receive a separate and measurable benefit from those non-employees in exchange for the options granted. As such, the fair value of the options themselves is more readily determinable than the services received in return.
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 23 28 Amount accounted for as equity-settled 27 19 Carrying value at 31 December of liabilities arising from share-based payment transactions 12 18 Intrinsic value of above liabilities for which rights had vested at 31 December 4 4
In addition, there were fees incurred of £0.2 million (2007: £0.2 million) for the audit of pension schemes. The Audit Committee regularly monitors the non-audit services provided to the Group by its auditor and has developed a formal 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.
Apart from the transactions with directors referred to below, no director had interests in shares, transactions or arrangements that require disclosure, other than those given in the directors’ remuneration report. Key management remuneration is disclosed in note I3.
ii Dividend restrictions and minimum capital requirements Certain Group subsidiaries are subject to restrictions on the amount of funds they may transfer in the form of cash dividends or otherwise to the parent company. UK insurance companies are required to maintain solvency margins which must be supported by capital reserves and other resources, including unrealised gains on investments. Jackson can pay dividends on its capital stock only out of earned surplus unless prior regulatory approval is obtained. Furthermore, without the prior regulatory approval, dividends cannot be distributed if all dividends made within the preceding 12 months exceed the greater of Jackson’s statutory net gain from operations or 10 per cent of Jackson’s statutory surplus for the prior year. In 2009, the maximum amount of dividends that can be paid by Jackson without prior regulatory approval is US$290 million (£202 million) (in 2008: US$490 million (£246 million)). The Group’s Asian subsidiaries, mainly the Singapore and Malaysia businesses, may remit dividends to the Group, in general, provided the statutory insurance fund meets the capital adequacy standard required under local statutory regulations.
PAC and Jackson are the two principal insurance subsidiaries of the Group, which together comprise approximately 77 per cent (2007: 78 per cent) of total Group assets. At 31 December 2008, the PAC long-term fund’s excess of available capital resources over its regulatory requirement (as per line 42 of Form 2 of the PAC FSA regulatory returns) was estimated to be £4.7 billion (2007: £10.5 billion) and the statutory capital and surplus of Jackson was US$3 billion (£2 billion) (2007: US$4.0 billion (£2.0 billion)). The Group capital position statement for life assurance businesses is set out in note D5.
iv PAC with-profits fund acquisitions and disposals The PAC with-profits fund acquired a number of venture capital holdings through PPM Capital and M&G. Prior to November 2007, the Group was deemed to have a controlling interest in these venture capital holdings, in aggregate with, if applicable, other holdings held by, for example, the Prudential Staff Pension Scheme. In November 2007, the Group disposed of PPM Capital following which the Group no longer had a controlling interest in venture fund investment subsidiaries that it managed and consequently ceased to consolidate these investments from that date. The Group continues to consolidate, where applicable, the venture capital holdings managed by M&G.
The acquisitions made in 2007 were as follows: • 71 per cent of the voting equity interest of Orizon AG, an employment hiring agency, which was managed by PPM Capital; and • 78 per cent of the voting equity interest of Red Funnel, a ferry company, which was managed by M&G.
These acquisitions are considered individually immaterial and therefore all information relating to the acquisitions has been presented in aggregate in this note.
The results of the acquisitions have been included in the consolidated financial statements of the Group and contributed a loss of £8.3 million to earnings within the income statement.
2008 There were no new acquisitions or disposals of venture capital investments in 2008. However, during the year, the holding in the voting equity interest of Red Funnel increased from 78 per cent to 90 per cent.
I7: Commitments i Operating leases The Group leases various offices to conduct its business. Leases in which a significant portion of the risks and rewards of ownership are retained by the lessor are classified as operating leases. Payments made under operating leases (net of any incentives received from the lessor) are charged to the income statement on a straight-line basis over the period of the lease.
Future minimum lease payments for non-cancellable operating leases fall due during the following periods: Not later than 1 year 86 38 Later than 1 year and not later than 5 years 199 126 Later than 5 years 140 111
Minimum lease rental payments for the year ended 31 December 2008 of £84 million (2007: £50 million) are included in the consolidated income statement.
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 and non-recourse borrowings of investment subsidiaries and consolidated investment funds of shareholder-financed operations and other borrowings. Cash flows in respect of these borrowings are included within cash flows from operating activities.
Cash flows relating to discontinued operations in 2007, as detailed in note I9, are inflows of £157 million for the period of ownership in 2007. All of these related to cash flows from operating activities.
Discontinued banking operations in 2007 related entirely to UK banking operations following the sale on 1 May 2007 of Egg Banking plc to Citi. Consideration paid to the Company was, net of expenses, £527 million cash. Cash and cash equivalents disposed of in 2007 were £1,065 million. Accordingly, the cash outflow for the Group in 2007 arising from the disposal of Egg, as shown in the consolidated cash flow statement, was £538 million.
The profit included in the 2007 income statement in respect of discontinued banking operations for the period of ownership was as follows: 2007 £m
Operating income 146 General administrative expenses (56) Impairment losses on loans and cash advances to customers (149) Other operating expenses (9)
The interest income on financial assets not at fair value through profit and loss for the period of ownership in 2007 was £241 million. The interest expense on financial liabilities not at fair value through profit and loss for the period of ownership in 2007 was £148 million.
Of the loss for the period of ownership in 2007, no loss was attributable to minority interests in Egg.
In addition, the Company will invest £45 million to purchase a 9.95 per cent stake in China Life through a share placement. The business to be transferred represents 94 per cent of Prudential’s in-force liabilities in Taiwan and includes its legacy interest rate guaranteed products with IFRS basis gross assets at 31 December 2008 of £4.5 billion. After taking account of IFRS shareholders’ funds of the business at 31 December 2008 and restructuring and other costs, the Group’s IFRS shareholders’ funds are expected to decrease by approximately £595 million. In addition, on completion there will be a net increase in the Company’s Insurance Groups Directive surplus of approximately £800 million.
The movement in shareholders’ IFRS equity of the total Taiwan life business for 2008 comprised: £m
Operating profit based on longer-term investment returns 60 Short-term fluctuations in investment returns (65) Shareholders share of actuarial and other gains and losses on defined benefit pension schemes (3)
Loss for the financial year (16) Minority interests – Investments by Parent Company* 93 Exchange and other reserve movements 111
The carrying value of the IFRS equity reflects the application of ‘grandfathered’ US GAAP under IFRS. This does not, and is not designed to include the cost of holding economic capital, to support the legacy interest rate guaranteed products as recognised under the Company’s supplementary reporting basis under European Embedded Value principles.
ii Insurance Groups Directive – Group solvency position The IGD group solvency position as at 31 December 2008 will be submitted to the FSA by 30 April 2009. At the time of preparation of these financial statements the surplus capital, under the IGD test of capital adequacy, was estimated to be around £1.7 billion before allowing for the 2008 final dividend, giving a solvency ratio of 160 per cent. This is composed of the Group’s IGD surplus at 31 December 2008 which is estimated at £1.4 billion and of an additional £0.3 billion which the FSA has, after the year end, allowed the Group to include in the Group’s IGD surplus going forward as a result of an innovative structure the Group has developed. The £0.3 billion additional capital reflects the ability to realise a portion of the shareholders’ economic interest in the future transfers from the PAC with-profits fund.
Less liabilities: amounts falling due within one year Debenture loans 6 (249) –
Profit and loss account 10 1,280 1,185 *The Company has adopted the principles of UITF 44 in accounting for share-based payments, with consequential changes to the 2007 comparative figures. Note 2 explains the effect of the change.
Prudential plc (the Company) is a parent holding company. The Company together with its subsidiaries (collectively, the Group) is an international financial services group with its principal operations in the UK, the US and Asia. The Group operates in the UK through its subsidiaries, primarily The Prudential Assurance Company Limited, Prudential Annuities Limited, Prudential Retirement Income Limited and M&G Investment Management Limited. In the US, the Group’s principal subsidiary is Jackson National Life Insurance Company. In Asia, the Group’s main operations are in Hong Kong, Malaysia, Singapore and Taiwan.
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 is also exempt under the terms of FRS 8 from disclosing related party transactions with entities that are part of the Group or investees of the Group. In addition, the Company has 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.
UITF 44, ’Group and Treasury Share Transactions’ which is an interpretation of FRS 20, ’Share-based Payment’ became effective in 2008. Where a parent company grants the options or awards of its equity instruments to employees of its subsidiary, and such share-based compensation is accounted for as equity-settled in the consolidated financial statements, UITF 44 requires the subsidiary to record a compensation expense with a corresponding increase in equity as a capital contribution equal to the value of the share-based payment in accordance with FRS 20. Consequently, in the financial statements of the parent company, an increase in the investment in the subsidiary is recorded for the value of the share options and awards granted to the employees of the subsidiary. As a result of the adoption of UITF 44, the Company has recognised an addition to investment in subsidiary undertakings of the aggregate amount of the contributions for equity instruments it granted, primarily under the Save As You Earn (SAYE) plan, subsequent to 7 November 2002. As at 31 December 2008, the addition to investment in subsidiary undertakings of the Company was £28 million with a corresponding credit to equity for the same amount. The 2007 comparatives have also been adjusted accordingly for the adoption of UITF 44 with an addition to investment in subsidiary undertakings of £19 million and a corresponding credit to equity. There is no impact on the profit or loss of the Company.
In October 2008, the Accounting Standards Board (ASB) approved the ‘Amendments to FRS 26 (IAS 39) and FRS 29 (IFRS 7): Reclassification of Financial Assets’ that permit the reclassification of certain ‘held for trading’ and ‘available-for-sale’ financial assets into the ‘loans and receivables’ category carried at amortised cost if specific conditions are met and additional disclosures are made regarding any assets so reclassified. The adoption of these amendments to FRS 26 and FRS 29 did not have an impact on the balance sheet or profit and loss account of the Company as the Company has not made any such reclassification of financial assets as permitted by the amendments.
A pension surplus or deficit is recorded as the difference between the present value of the scheme liabilities and the fair value of the scheme assets. The Company’s share of pension surplus is recognised to the extent that the Company was able to recover a surplus either through reduced contributions in the future or through refunds from the scheme.
Following the adoption of UITF 44, where the Company, as the parent company, grants the options or awards of its equity instruments to employees of its subsidiary, and such share-based payment is accounted for as equity-settled in the Group financial statements, the Company records an increase in the investment in the subsidiary undertakings for the value of the share options and awards granted with a corresponding credit entry recognised directly in equity. The value of the share options and awards granted is based upon the fair value of the options and awards at the grant date, the vesting period and the vesting conditions.
At beginning of year 7,170 2,809 Additional investment in subsidiary undertakings 35 – Writedown of investment in subsidiary undertaking (12) – Net advance of loans – 403
The investments of the Company in shares in subsidiary undertakings at the beginning of the year increased by £19 million from the previously published £7,151 million to £7,170 million following the adoption of UITF 44. This reflects the value of the sharebased payments granted by the Company to employees of its subsidiary undertakings up to 31 December 2007. The additional investment in subsidiary undertakings during 2008 of £35 million as shown in the table above includes £9 million in respect of the further amount of share-based payments recognised in 2008.
vi Hedge accounting is applied at both the Group consolidated level and Company level. Due to different dates for commencement of this accounting treatment, the hedge values differ between these two levels.
vii These borrowings support a short-term fixed income securities programme. viii In October 2008, the Company issued £200 million Floating Rate Notes, maturing in April 2009. These were wholly subscribed to by a Group subsidiary and accordingly have been eliminated on consolidation in the Group financial statements. ix 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.
Derivative financial instruments held to manage interest rate and currency profile: Cross-currency swaps 182 – 2 1 Inflation-linked swap – 162 – 82 Forward foreign currency contracts 66 56 – 44
The change in fair value of the derivative financial instruments of the Company was a loss before tax of £343 million (2007: gain before tax of £13 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 2008 applying the principles prescribed by FRS 17.
The key assumptions adopted were: Rate of inflation 3.0 3.3 Rate of increase in salaries 5.0 5.3 Rate of increase in pension payments for inflation: Rate used to discount scheme liabilities 6.1 5.9
Surplus in the scheme recognised by the Company 50 163 48
After deducting deferred tax, the amounts reflected in the balance sheet of the Company are 36 117 34
Underlying scheme assets and liabilities of PSPS The change in the present value of the underlying scheme liabilities and the change in the fair value of the underlying assets of PSPS are as follows: Present value of scheme liabilities, beginning of year 4,361 4,607 Service costs 26 39 Interest costs 250 234 Curtailment credit (30) – Employee contributions 1 2 Actuarial losses (327) (314) Benefit payments (206) (207)
The pension charge attributable to the Company is net of the apportionment to the PAC with-profits funds and corresponds to the surplus recognised on the balance sheet of the Company. In 2008, an amount of £9 million was applied to extinguish the curtailment credit attributable to the Company from the unrecognised portion of the pension surplus at 31 December 2008.
Changes in assumptions underlying the present value of scheme liabilities 200 324 232 (405) (128)
Actuarial (losses) gains attributable to the Company (143) 91 118 (30) (10)
The total actual return on scheme assets for PSPS was a loss of £40 million (2007: a gain of £264 million). The experience gains on scheme liabilities in 2008 of a gain of £127 million relate mainly to the ‘true-up’ reflecting improvements in data consequent upon the ongoing triennial valuation of PSPS.
At beginning of year 2,470,017,240 123 1,828 Shares issued under share option schemes 2,307,469 – 12 Shares issued in lieu of cash dividends 24,622,979 2 156 Transfer to retained profit in respect of shares issued in lieu of cash dividends – – (156)
At 31 December 2008, there were options subsisting under share option schemes to subscribe for 6,825,343 (2007: 9,017,442) shares at prices ranging from 266 pence to 617 pence (2007: 266 pence to 695 pence) and exercisable by the year 2015 (2007: 2014). In addition, there were 967,652 (2007: 2,037,220) conditional options outstanding under the Restricted Share Plan exercisable at nil cost within a 10-year period. No further options will be issued under the Restricted Share Plan which has been replaced by the Group Performance Share Plan. There were 4,906,234 (2007: 3,485,617) conditional options outstanding under the Group Performance Share Plan exercisable at nil cost within a 10-year period. Further information on the Group’s employee share options is given in note I2 ‘Share-based payments’ of the notes on the financial statements of the Group.
10 Profit of the Company and reconciliation of movement in shareholders’ funds
A reconciliation of the movement in shareholders’ funds of the Company for the years ended 31 December 2008 and 2007 is given below: Profit (loss) for the year 486 (17)
Actuarial (losses) gains recognised in respect of the pension scheme net of related taxnote 8 (103) 66 New share capital subscribednote 9 170 182 Reserve movements in respect of share-based paymentsnote 4 9 5
Shareholders’ funds at beginning of year, as previously published 3,117 3,312 Effect of the adoption of UITF 44 on share-based paymentsnote 4 19 14
Shareholders’ funds at beginning of year, after change of accounting policies 3,136 3,326
11 Other information a Information on directors’ remuneration is given in the directors’ remuneration report section of this Annual Report and note I3 ‘Key management remuneration’ of the notes on the financial statements of the Group.
b Information on transactions of the directors with the Group is given in note I5 ‘Related party transactions’ of the notes on the financial statements of the Group.
c The Company employs no staff. d Fees payable to the Company’s auditor for the audit of the Company’s annual accounts were £0.1 million (2007: £0.1 million).
On 20 February 2009, the Company announced that it had entered into an agreement to transfer the assets and liabilities of its agency distribution business and its agency force in Taiwan to China Life Insurance Company Ltd of Taiwan. The business being transferred represents 94 per cent of the in-force liabilities in Taiwan. Further details are set out in note I10 of the Group financial statements.
Under applicable law and regulations, the directors are also responsible for preparing a directors’ report, directors’ remuneration report and corporate governance statement that comply with that law and those regulations.
• the directors’ report includes a fair review of the development and performance of the business and the position of the Company and the undertakings included in the consolidation taken as a whole, together with a description of the principal risks and uncertainties that they face.
We have audited the Group and parent company financial statements (the financial statements) of Prudential plc for the year ended 31 December 2008 which comprise the consolidated Group income statement, the consolidated Group and parent company balance sheets, the consolidated Group cash flow statement, the consolidated Group statement of change in shareholders’ equity and the related notes on pages 131 to 315. These financial statements have been prepared under the accounting policies set out therein.
We report to you our opinion as to whether the financial statements give a true and fair view and whether the financial statements and the part of the directors’ remuneration report to be audited have been properly prepared in accordance with the Companies Act 1985 and, as regards the Group financial statements, Article 4 of the International Auditing Standards Regulation (IAS Regulation). We also report to you whether in our opinion the information given in the directors’ report is consistent with the financial statements. In addition, we report to you if, in our opinion, the Company has not kept proper accounting records, if we have not received all the information and explanations we require for our audit, or if information specified by law regarding directors’ remuneration and other transactions is not disclosed.
Opinion In our opinion: • The Group financial statements give a true and fair view, in accordance with IFRS as adopted by the European Union, of the state of the Group’s affairs as at 31 December 2008 and of its loss for the year then ended; • the Group financial statements have been properly prepared in accordance with the Companies Act 1985 and Article 4 of the IAS Regulation; • the parent company financial statements give a true and fair view, in accordance with United Kingdom Generally Accepted Accounting Practice, of the state of the parent company’s affairs as at 31 December 2008; • the parent company financial statements and the part of the directors’ remuneration report to be audited have been properly prepared in accordance with the Companies Act 1985; and
Asian operations New business 5(b) 741 643 Business in force 6 568 399
Long-term business 2,932 2,524 Asset management 345 334 Other results (316) (328)
*EEV basis operating profit from continuing operations based on longer-term investment returns excludes short-term fluctuations in investment returns, the mark to market value movements on core borrowings, the shareholders’ share of actuarial 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. The amounts for these items are included in total EEV profit attributable to shareholders. The directors believe that operating profit, as adjusted for these items, better reflects underlying performance. Profit before tax and basic earnings per share include these items together with actual investment returns. This basis of presentation has been adopted consistently throughout this supplementary information.
Operating profit from continuing operations based on longer-term investment returns Asian operations 1,335 1,099 US operations 593 635 UK operations: UK insurance operations 1,081 859
Attributable to: Equity holders of the Company (1,338) 2,963 Minority interests 3 21
Continuing operations From operating profit based on longer-term investment returns, after related tax
Dividends relating to the reporting period: Dividends declared and paid in the reporting period: Current year interim dividend 5.99p 5.70p Final dividend for prior year 12.30p 11.72p
(Loss) profit for the year attributable to equity shareholders (1,338) 2,963 Items taken directly to equity: Exchange movements 4(h) 2,010 64 Unrealised valuation movements on securities classified as available-for-sale of discontinued banking operations – (2) Movement on cash flow hedges – (3) Related tax 119 3
New share capital subscribed 170 182 Reserve movements in respect of share-based payments 18 18 Treasury shares: Movement in own shares in respect of share-based payment plans 3 7 Movement on Prudential plc shares purchased by unit trusts consolidated under IFRS (25) 4
Mark to market value movements on Jackson assets backing surplus and required capital (148) (13)
Shareholders’ equity at beginning of year (excluding minority interests) As previously reported 14,779 11,883 Effect of adoption of principles of IFRIC 14 for accounting for pension schemes 20 (179) (80)
UK operations: Insurance business 4,919 6,497 M&G: Net assets 147 271 Acquired goodwill 1,153 1,153
Net asset value per share Based on EEV basis shareholders’ equity of £14,956m (2007: £14,600m) (in pence) 599p 591p Number of issued shares at year end (millions) 2,497 2,470
European Embedded Value (EEV) basis supplementary information Year ended 31 December 2008 continued
Total assets less liabilities, excluding insurance funds 186,209 195,596 Less insurance funds:*
Policyholder liabilities (net of reinsurers’ share) and unallocated surplus of with-profits funds (181,151) (189,534) Less shareholders’ accrued interest in the long-term business 9,898 8,538
Shareholders’ equity (excluding minority interests) 16 14,956 14,600 *Including liabilities in respect of insurance products classified as investment contracts under IFRS 4.
The supplementary information on pages 318 to 356 was approved by the Board of directors on 18 March 2009.
Harvey McGrath Mark Tucker Tidjane Thiam Chairman Group Chief Executive Chief Financial Officer F
The EEV basis results have been prepared in accordance with the EEV Principles issued by the CFO Forum of European Insurance Companies in May 2004 and expanded by the Additional Guidance on EEV Disclosures published in October 2005. Where appropriate the EEV basis results include the effects of adoption of International Financial Reporting Standards (IFRS).
2 Methodology a 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).
Valuation movements on investments With the exception of debt securities held by Jackson, investment gains and losses during the period (to the extent that changes in capital values do not directly match changes in liabilities) are included directly in the profit for the period and shareholders’ funds as they arise.
However, in determining the movements on the additional shareholders’ interest, the basis for calculating the Jackson EEV result acknowledges that for debt securities backing liabilities the aggregate EEV results reflect the fact that the value of in-force business instead incorporates the discounted value of future spread earnings. This value is not affected generally by short-term market movements on securities that are broadly speaking held with the intent and ability to be retained for the longer term.
Fixed annuities provide that, at Jackson’s discretion, it may reset the interest rate credited to policyholders’ accounts, subject to a guaranteed minimum. The guaranteed minimum return varies from 1.5 per cent to 5.5 per cent (2007: 1.5 per cent to 5.5 per cent), depending on the particular product, jurisdiction where issued, and date of issue. At 31 December 2008, 83 per cent (2007: 80 per cent) of the fund relates to policies with guarantees of three per cent or less. The average guarantee rate is 3.0 per cent (2007: 3.1 per cent).
CAPM does not include any allowance for non-market risks since these are assumed to be fully diversifiable. For EEV
purposes, however, a risk margin is added for non-diversifiable non-market risks and to cover Group level risks.
Under IFRS the surpluses or deficits attaching to these schemes are accounted for in accordance with the provisions of IAS 19 that effectively 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.
Under the EEV basis the IAS 19 basis surpluses (to the extent not restricted under IFRIC 14) or deficits are initially allocated in the same manner. The shareholders’ 10 per cent interest in the PAC with-profits fund estate is determined after inclusion of the portion of the IAS 19 basis surpluses or deficits attributable to the fund. Adjustments under EEV in respect of accounting for surpluses or deficits on defined benefit schemes are reflected as part of ‘Other operations’, as shown in note 15.
Expected returns on equity and property asset classes in respect of each territory are derived by adding a risk premium, also based on the long-term view of Prudential’s economists, to the risk-free rate. In Asia, equity risk premiums range from 3.0 per cent to 7.0 per cent (2007: 3.0 per cent to 6.0 per cent). In the US and the UK, the equity risk premium is 4.0 per cent above risk-free rates for both 2008 and 2007.
Malaysia Philippines Singapore Taiwan Thailand Vietnam Malaysia Philippines Singapore Taiwan Thailand Vietnam Asian operations notes iv,v notes iv,v notes ii,v notes iv, v notes iv, v notes ii, v
The expected long-term rate is a function of expectation of inflation and real rates of interest, on which the Company has taken external expert advice. It is considered that the outlook for long-term interest rates in Asia will be strongly influenced by the trend in the projection of comparable US long-term real interest rates. Consequently, assessment of the expected rates for Taiwan has taken into account the structural factors of government borrowing, savings rates, short-term interest rates, government intervention and non-market influences that could affect Taiwanese real interest rates over the projection period. Together with a central inflation projection for Taiwan, the Company considers that the long-term rate of 5.5 per cent is appropriate in the longer-term.
In projecting forward the Fund Earned Rate, allowance is made for the mix of assets in the fund, future investment strategy, and further market value depreciation of bonds held as a result of assumed future yield increases. These factors, together with the assumption of the phased progression in bond yields, give rise to an average assumed Fund Earned Rate that changes from 6.6 per cent for 2008 to 6.7 per cent for 2019. The assumed Fund Earned Rate falls to 3.35 per cent in 2009 and subsequently to 1.2 per cent in 2010, then increases to 5.15 per cent by 2018. Thereafter, the assumed Fund Earned Rate fluctuates around a target of 6.7 per cent. This projection compares with that applied for the 2007 results of a grading from an assumed rate of 0.5 per cent for 2007 to 6.4 per cent for 2014.
Consistent with the EEV methodology applied, a constant discount rate has been applied to the projected cash flows. On 20 February 2009, the Company announced that it had agreed to transfer the agency business of the Taiwan Life business to China Life.
US operations (Jackson)note ii 31 Dec 2008 % 31 Dec 2007 %
Notes i The risk discount rates at 31 December 2008 for new business and business in-force for US operations reflect weighted rates based on underlying rates of 6.2 per cent for variable annuity (VA) business and 3.0 per cent for other business. The decrease in the weighted discount rates reflects the decrease in the US 10-year treasury bond rate of 180 bps and a change in the product mix with the 2008 results seeing an increase in the proportion of new and in-force business arising from other than VA business.
In the event that longer-term default levels are higher then, unlike for UK annuity business where policyholder benefits are not changeable, Jackson has some discretion to adjust crediting rates, subject to contract guarantee levels and general market competition considerations.
UK insurance operationsnote iv 31 Dec 2008 % 31 Dec 2007 %
Notes i The new business risk discount rate for shareholder-backed annuity business for 2008 reflects the assets allocated to back new business with an allowance for credit risk based on point of sale market conditions, consistent with how the business was priced. The allowance for credit risk for new business at point of sale is determined using the same methodology for in-force business described in note (iv) below.
On a weighted basis for fixed annuities and inflation-linked annuities the allowance is 15 bps for long-term expected defaults, 11 bps for long-term credit risk premium, and 54 bps for short-term credit risk.
Pillar I reserves are calculated using a similar allowance for credit risk. For EEV reporting the allowance for short-term credit risk is assumed to be released gradually over the five year period following the valuation date.
v The assumed long-term rate for corporate bonds for 2007 for with-profits business was determined after taking account of the purchase of credit default swaps.
The stochastic cost of guarantees is primarily only of significance for the Hong Kong, Malaysia, Singapore and Taiwan operations.
US operations (Jackson) • Interest rates are projected using a log-normal generator calibrated to actual market data; • Corporate bond returns are based on Treasury securities plus a spread that has been calibrated to current market conditions and varies by credit quality; and • Variable annuity equity and bond returns have been stochastically generated using a log-normal model with parameters determined by reference to historical data. The volatility of equity fund returns for both 2008 and 2007 ranges from 18.6 per cent to 28.1 per cent, depending on risk class, and the standard deviation of bond returns ranges from 1.5 per cent to 1.6 per cent (2007: 1.4 per cent to 1.7 per cent).
Mean returns have been derived as the annualised arithmetic average return across all simulations and durations. For each projection year, standard deviations have been calculated by taking the square root of the annualised variance of the returns over all the simulations. These have been averaged over all durations in the projection. For equity and property, the standard deviations relate to the total return on these assets. The standard deviations applied to both 2008 and 2007 are as follows: %
g Asset management and service companies The value of future profits or losses from asset management and service companies that support the Group’s covered businesses are included in the profits for new business and the in-force value of the Group’s long-term business.
4 Accounting presentation a Analysis of profit before tax To the extent applicable, presentation of the EEV profit for the year is consistent with the basis that the Group applies for analysis of IFRS basis profits before shareholder taxes between operating and non-operating results. Operating results reflect the underlying results of the Group’s continuing operations including longer-term investment returns. Operating results include the impact of routine changes of estimates and non-economic assumptions. Non operating results comprise short-term fluctuations in investment returns, the shareholders’ share of actuarial and other gains and losses on defined benefit pension schemes, the mark to market value movements on core borrowings and the effect of changes in economic assumptions and changes in the time value of cost of options and guarantees.
Actuarial gains and losses Actuarial gains and losses comprise: • The difference between actual and expected return on the scheme assets; • experience gains and losses on scheme liabilities; • the impact of altered economic and other assumptions on the discounted value of scheme liabilities; and • the movement in estimates of deficit funding requirements.
g Taxation The EEV profit for the year for covered business is in most cases calculated initially at the post-tax level. The post-tax profit is then grossed up for presentation purposes at the effective rate of tax. In general, the effective rate corresponds to the corporation tax rate on shareholder profits of the business concerned.
4 Accounting presentation continued h Foreign currency translation Foreign currency profits and losses have been translated at average exchange rates for the year. Foreign currency assets and liabilities have been translated at year end rates of exchange. The purpose of translating the profits and losses at average exchange rates, notwithstanding the fact that EEV profit represents the incremental value added on a discounted cash flow basis, is to maintain consistency with the methodology applied for IFRS basis reporting.
The principal exchange rates applied are: Closing rate at Average Closing rate at Average Opening rate Local currency: £ 31 Dec 2008 for 2008 31 Dec 2007 for 2007 at 1 Jan 2007
iii Subsequent to 29 September 2007 following expiry of the previous management agreement CITIC–Prudential Life Insurance Company Ltd (CITIC-Prudential), the Group’s life operation in China, has been accounted for as a 50 per cent joint venture. Prior to this date CITIC–Prudential was consolidated as a subsidiary undertaking. All premiums for CITIC–Prudential are shown at 50 per cent on a like for like basis, reflecting the constant economic interest before and after the management changes in line with the original agreement with CITIC.
Post-tax Post-tax Pre-tax Tax Note 17(a) ii Pre-tax Tax Note 17(a) ii
Included within pre-tax new business profits shown in the table above are profits arising from asset management business falling within the scope of covered business of: Asian operations 35 44 US operations 4 1 UK insurance operations 13 11
China Life on 20 February 2009. Details are included in note 21. ii The tables for Asian operations above reflect the inclusion of CITIC-Prudential Life Insurance Company Ltd, the Group’s life operation in China as a 50 per cent held joint venture for 2008 and 2007 reflecting the economic interest throughout both years described in note (a)iii above. Previously, for presentational purposes, the 2007 results reflected the inclusion of CITIC-Prudential as a subsidiary undertaking up to 29 September 2007 and 50 per cent thereafter following the change of management arrangement after this date, with appropriate minority interest accounting to reflect the 50 per cent economic interest. The presentation of the operating profit for 2007 has been adjusted to allocate £10 million of profit from the result for new business to business in-force to prevent distortion of the published new business margin.
New business contributions for all business represent profits determined by applying non-economic assumptions as at the end of the year.
On value of in-force business and required capital 176 187 On surplus assets 57 53
Effect of change in corporate tax ratesnote 4 15 32 Other – 5 1 The favourable effect of £58 million relating to mortality and morbidity assumption changes mainly relates to Singapore of £34 million, Taiwan of £18 million and Hong Kong of £15 million, which reflect actual experience across most products, offset by a charge in Malaysia of £(19) million which reflects negative morbidity experience on A&H products.
b Experience variances and other items Experience variances and other items of a charge of £(1) million (2007: credit of £5 million) include a credit of £36 million (2007: £47 million) for favourable mortality and morbidity experience variance relating to better than expected experience across most territories, offset by a charge of £(34) million (2007: £(27) million) for expense experience variances and £(3) million (2007: £(4) million) of other charges. Also for 2007 there is a charge of £(11) million in respect of Vietnam for higher than expected investment fees payable on asset managers’ performance.
The negative expense experience variance of £(34) million for 2008 includes £(11) million arising in Korea, reflecting lower sales, and includes a charge of £(9) million for expense overruns for China which is at a relatively early stage of development, for which the expenses for new business are in excess of the target levels factored into the valuation of new business. On the basis of current plans the target level for expenses for this operation is planned to be attained in 2012. The negative experience variance in 2007 of £(27) million arose in China of £(12) million and India of £(15) million.
The 2007 comparative result has been increased by £10 million for the adjustment in respect of China (as explained in note 5c) and reduced by £(4) million for the discontinuance of the allocation of notional return on centrally held economic capital in respect of Taiwan from shareholders’ other income to the result for Asian operations as explained in note 4f. Other income is increased by an equivalent amount. Total profits are unaffected by these adjustments.
Effect of adjustments for certain reserves, surplus note borrowings and required capital
Notes continued 1 The effect of changes in mortality assumptions reflect lower mortality rates for life products consistent with recent experience. 2 The effect of change in assumption in respect of VA fees represents an overall increase in the level of projected advisory fees for variable annuity business.
iv UK insurance operations a Effect of change in UK corporate tax rate
b Annuity business For UK insurance operations there is a net nil charge or credit for the 2008 and 2007 results. However, the 2007 results for annuity business have been determined after a strengthening of explicit mortality assumptions and the release of excess margins in the aggregate liabilities that had previously been set aside as an indirect extra allowance for longevity related risks.
The overall impact of the assumption changes and release of margins for 2007 is as follows: 2007 £m
The annual licence fee payments are made by shareholder-backed subsidiaries of UK insurance operations, via a service company, to the PAC with-profits sub-fund for the right to use trademarks and for the goodwill associated with the purchase of the business of the Scottish Amicable Life Assurance Society in 1997. The licence fee arrangements run to 2017.
For 2007, the expense over-runs arising from the tariff arrangement in respect of SAIF of £14 million were borne by a service company. The arrangement was in place until the end of 2007 and was onerous to shareholders.
For Singapore and Hong Kong, the short-term fluctuations in investment returns primarily reflects 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.
The short-term fluctuations in investment returns for Taiwan principally reflect the equity market fall and a £(40) million value reduction for an investment in a CDO fund.
Loss due to changed expectation of profits from fees on in-force variable annuity business in future periods based on current period equity returns, net of related hedging activity* (733) (16)
Actual less longer-term return on equity-type securities (148) 51 *This adjustment arises due to the market returns being lower than the assumed longer-term rate of return. This gives rise to lower than expected year end values of variable annuity assets under management with a resulting effect on the projected value of future account values and hence future profitability from altered fees. For 2008, the US equity market returns were approximately negative 38.5 per cent compared to the assumed longer-term rate of return of 5.8 per cent.
iii UK insurance operations The short-term fluctuations in investment returns for UK insurance operations for 2008 arise on the following types of business: £m