D: Life assurance businesses

a Products and classification for IFRS reporting

The measurement basis of assets and liabilities of long-term business contracts is dependent upon the classification of the contracts under IFRS. Under IFRS 4, contracts are initially classified as being either 'insurance' contracts, if the level of insurance risk in the contracts is significant, or 'investment' contracts, if the risk is insignificant.

Insurance contracts

Insurance contracts are permitted to be accounted for under previously applied GAAP. The Group has chosen to adopt this approach. However, as an improvement to accounting policy, permitted by IFRS 4, the Group has applied the measurement principles for with‑profits contracts of UK regulated entities and disclosures of the UK Standard FRS 27 from 1 January 2005. An explanation of the provisions under FRS 27 is provided in note D2.

Under the previously applied GAAP, UK GAAP, the assets and liabilities of contracts are reported in accordance with the MSB of reporting as set out in the ABI SORP.

The insurance contracts of the Group's shareholder-backed business fall broadly into the following categories:

  • UK insurance operations
    – bulk and individual annuity business, written primarily by Prudential Retirement Income Limited and other categories of non‑participating UK business;
  • Jackson
    – fixed and variable annuity business and life insurance; and
  • Prudential Corporation Asia
    – non-participating term, whole life, and unit-linked policies, together with accident and health policies.

Investment contracts

Investment contracts are further delineated under IFRS 4 between those with and without discretionary participation features. For those contracts with discretionary participation features, IFRS 4 also permits the continued application of previously applied GAAP. The Group has adopted this approach, again subject to the FRS 27 improvement.

For investment contracts that do not contain discretionary participation features, IAS 39 and, where the contract includes an investment management element, IAS 18, apply measurement principles to assets and liabilities attaching to the contract that may diverge from those previously applied.

Contracts of the Group, which are classified as investment contracts that do not contain discretionary participation features, can be summarised as:

  • UK
    – certain unit-linked savings and similar contracts;
  • Jackson
    – GICs and funding agreements
    – minor amounts of 'annuity certain' contracts; and
  • Prudential Corporation Asia
    – minor amounts for a number of small categories of business.

The accounting for the investment 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.

Deferred income reserves

These are required to be established under IAS 18 with amortisation over the expected life of the contract. The majority of the relevant UK contracts are single premium with the initial deferred income reflecting the 'front-end load' i.e. the difference between the premium paid and the amount credited to the unit fund. Deferred income is amortised to the income statement in line with service provision. The amortisation profile is either on a straight-line basis or, if more appropriate, a further deferral of income recognition is applied.

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.

ii Jackson – GICs and funding arrangements

Under a traditional GIC, the policyholder makes a lump sum deposit. The interest rate paid is fixed and established when the contract is issued. Funding agreements are of a similar nature but the interest rate may be floating, based on a rate linked to an external index. The US GAAP accounting requirements for such contracts are very similar to those under IFRS on the amortised cost model for liability measurement.

b Concentration of risk

i Business accepted

The Group's exposure to life assurance risks is well diversified. This is achieved through the geographical spread of the Group's operations and, within those operations, through a broad mix of product types.

As part of the risk management framework, the Group regularly monitors concentration of risk using a variety of risk monitoring tools including:

  • Scenario testing and sensitivity analysis of the Group capital and profitability metrics involving IGD, Group economic capital, EEV and IFRS help identify concentrations of risks by risk types, products and business units, as well as the benefits of diversification of risks.

An example of the diversification benefits for Prudential is that adverse scenarios do not affect all business units in the same way, providing natural hedges within the Group. For example, the Group's US business is sensitive to increasing interest rates, whereas, in contrast, several business units in Asia benefit from increasing rates. Conversely, these Asian business units are sensitive towards low interest rates, whereas certain products in the US benefit from falling interest rates. The economic capital framework also takes into account situations where factors are correlated, for example the extent of correlation between UK and US economies.

  • Business units are also required to disclose to the Group risk function all material risks, along with information on their severity and likelihood, and mitigating actions taken or planned.

Credit risk remains one of the largest risk exposures. This reflects the relative size of exposure in Jackson and the UK shareholder annuities business. The Group manages concentration of credit risks by setting limits on the maximum exposure to each counterparty based on their credit ratings.

ii Ceded business

The Group cedes certain business to other insurance companies. Although the ceding of insurance does not relieve the Group of liability to its policyholders, the Group participates in such agreements for the purpose of managing its loss exposure. The Group evaluates the financial condition of its reinsurers and monitors concentration of credit risk from similar geographic regions, activities or economic characteristics of the reinsurers to minimise its exposure from reinsurer insolvencies. Reinsurance recoverable insurance assets are not a significant component of the Group's statement of financial position and accordingly, exposure to concentrations of reinsurance risk is not significant to the Group. At 31 December 2010, 97 per cent (2009: 98 per cent) of the reinsurance recoverable insurance assets were ceded by the Group's UK and US operations, of which 90 per cent (2009: 92 per cent) of the balance were from reinsurers with Standard & Poor's rating A– and above.

c Guarantees

Notes D2(e), D3(e) and D4(e) 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 2010 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 Group's exposure to guarantees was significantly reduced during 2009 as a result of the disposal of the Taiwan agency business.

d Sensitivity of EEV basis profit and equity for market and other risks

The Group prepares supplementary EEV basis financial statements for half yearly and annual publication. These statements include sensitivity disclosures which are part of the market risk information provided to key management. The 2010 EEV sensitivity disclosures are shown in note 15 of the EEV basis supplementary information in this Annual Report.

e Sensitivity of IFRS basis profit or loss and equity to market and other risks

i Overview of risks by business unit

The financial and insurance assets and liabilities attaching to the Group's life assurance business are, to varying degrees, subject to market and insurance risk and other changes of experience assumptions that may have a material effect on IFRS basis profit or loss and equity.

Market risk is the risk that the fair value or future cash flows of a financial instrument or, in the case of liabilities of insurance contracts, their carrying value will fluctuate because of changes in market prices. Market risk comprises three types of risk, namely:

  • Currency risk: due to changes in foreign exchange rates;
  • interest rate risk: due to changes in market interest rates; and
  • other price risk: due to fluctuations in market prices (other than those arising from interest rate risk or currency risk).

Policyholder liabilities relating to the Group's life assurance businesses are also sensitive to the effects of other changes in experience, or expected future experience, such as for mortality, other insurance risk and lapse risk.

In addition, the profitability of the Group's life assurance businesses and, as described in Section E, asset management business, is indirectly affected by the performance of the assets covering policyholder liabilities and related capital.

Three key points are to be noted, namely:

  • The Group's with-profits and unit-linked funds absorb most market risk attaching to the funds' investments. Except for second order effects, for example on asset management fees and shareholders' share of cost of bonuses for with-profits business, shareholder results are not directly affected by market value movements on the assets of these funds;
  • The Group's shareholder results are most sensitive to market risks for assets of shareholder-backed business; and
  • The main exposures of the Group's IFRS basis results to market risk for life assurance operations on investments of shareholder-backed business are for debt securities.

The most significant items for which the IFRS basis shareholders' profit or loss and equity for the Group's life assurance business is sensitive to these variables are shown in the following tables. The distinction between direct and indirect exposure is not intended to indicate the relative size of the sensitivity.

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Type of business Market and credit risk Insurance and lapse risk
Investments/derivatives Liabilities/unallocated surplus Other exposure
UK insurance operations (see also section D2(j))
With-profits business (including Prudential Annuities Limited) Net neutral direct exposure (Indirect exposure only) Investment performance subject to smoothing through declared bonuses Persistency risk to future shareholder transfers
SAIF sub-fund Net neutral direct exposure (Indirect exposure only) Asset management fees earned by M&G  
Unit-linked business Net neutral direct exposure (Indirect exposure only) Investment performance through asset management fees Persistency risk
  Asset/liability mismatch risk    
Shareholder-backed annuity business Credit risk

Interest rate risk for assets in excess of liabilities i.e. representing shareholder capital
  Mortality experience and assumptions for longevity
US insurance operations (see also section D3(j))
All business Currency risk     Persistency risk
Variable annuity business Net effect of market risk arising from incidence of guarantee features and variability of asset management fees offset by derivative hedging programme    
Fixed index annuity business Derivative hedge programme to the extent not fully hedged against liability and fund performance Incidence of equity participation features    
Fixed index annuities, Fixed annuities and GIC business Credit risk
Interest rate risk

These risks are reflected in volatile profit or loss and shareholders’ equity for derivative value movements and impairment losses, and, in addition, for shareholders’ equity for value movements on fixed income securities classified as ‘available fo sale’ under IAS 39
  Spread difference between earned rate and rate credited to policyholders Lapse risk but the effects of extreme events are mitigated by the use of swaption contracts
Asian insurance operations (see also section D4(j))
All business Currency risk     Mortality and morbidity risk
Persistency risk
With-profits business Net neutral direct exposure (Indirect exposure only) Investment performance subject to smoothing through declared bonuses  
Unit-linked business Net neutral direct exposure (Indirect exposure only) Investment performance through asset management fees  
Non-participating business Interest rate and price risk     Long-term interest rates   .

ii IFRS shareholder results – Exposures for market and other risk

Key Group exposures

Detailed analyses of sensitivity of IFRS basis profit or loss and equity to market and other risks are provided in notes D2(j), D3(j), D4(j) and E4. The sensitivity analyses provided show the effect on IFRS basis profit or loss and equity to changes in the relevant risk variables, all of which are reasonably possible at the relevant balance sheet date.

The IFRS operating profit based on longer-term investment returns for UK insurance operations has high potential sensitivity for changes to longevity assumptions affecting the carrying value of liabilities to policyholders for shareholder-backed annuity business. In addition, at the total IFRS profit level the result is sensitive to temporary value movements on assets backing IFRS equity.

For Jackson at the level of operating profit based on longer-term investment returns, the results are sensitive to market conditions to the extent of income earned on spread-based products not mitigated by the interest derivative programmes and second order equity-based exposure in respect of variable annuity asset management fees. Further information is given below under the US operations section of market and credit risk.

Jackson's derivative programme is used to substantially mitigate equity market risk attaching to its equity-based products and interest rate risk associated with its spread-based products. Movements in interest rates and credit spreads materially affect the carrying value of derivatives which are used to manage the liabilities to policyholders and backing investment assets of fixed annuity and other general account business. Combined with the use of US GAAP measurement (as grandfathered under IFRS 4) for the asset and liabilities for the insurance contract liabilities, which is largely insensitive to current period market movements, the Jackson total profit (i.e. including short-term fluctuations in investment returns) is very sensitive to market movements. In addition to these effects the Jackson IFRS equity is sensitive to the impact of interest rate and credit spread movements on the value of fixed income securities. Movements in unrealised appreciation on these securities are included as movement in equity (i.e. outside the income statement). See note D3(j) for details of the hedging.

For Asian operations, the operating profit based on longer-term investment returns is mainly affected by the impact of market levels on unit-linked business persistency, and other insurance risk.

At the total IFRS profit level the Asian result is affected by short-term value movements on the asset portfolio for non-linked shareholder-backed business.

M&G profits are affected primarily by movements in the growth in funds under management and by the effect of any impairment on the loan book and fair value movements on debt securities held by Prudential Capital.

Market and credit risk

UK insurance operations

With-profits business

  • 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.

    The shareholder results of the UK with-profits fund correspond to the shareholders' share of the cost of bonuses declared on the with-profits business. This currently corresponds to one-ninth of the cost of bonuses declared.

    Investment performance is a key driver of bonuses, and hence the shareholders' share of cost of bonuses. Due to the 'smoothed' basis of bonus declaration the sensitivity to investment performance in a single year is low. However, over multiple periods it is important.

  • Prudential Annuities Limited (PAL)

    PAL writes annuity business, but as PAL is owned by the PAC with-profits sub-fund, changes in the carrying value of PAL's assets and liabilities are reflected in the liability for unallocated surplus which as described above, do not affect shareholder results.

  • Scottish Amicable Insurance Fund (SAIF)

    SAIF is a ring-fenced fund in which, apart from asset management fees, shareholders have no interest. Accordingly, the Group's IFRS profit and equity are insensitive to the direct effects of market risk attaching to SAIF's assets and liabilities.

Shareholder-backed business

The factors that may significantly affect the IFRS results of UK shareholder-backed business are the mortality experience and assumptions and credit risk attaching to the annuity business of Prudential Retirement Income Limited and the PAC non-profit sub-fund.

  • Prudential Retirement Income Limited (PRIL)

    The assets covering PRIL's liabilities are principally debt securities and other investments that are held to match the expected duration and payment characteristics of the policyholder liabilities. These liabilities are valued for IFRS reporting purposes by applying discount rates that reflect the market rates of return attaching to the covering assets.

    Except to the extent of any asset/liability duration mismatch which is reviewed regularly, and exposure to credit risk, the sensitivity of the Group's results to market risk for movements in the carrying value of PRIL's liabilities and covering assets is broadly neutral on a net basis.

    The main market risk sensitivity for PRIL arises from interest rate risk on the debt securities which substantially represent IFRS equity. This equity comprises the net assets held within the long-term fund of the Company that cover regulatory basis liabilities that are not recognised for IFRS reporting purposes, for example contingency reserves, and shareholder capital held outside the long-term fund.

    The principal items affecting the IFRS results for PRIL are mortality experience and assumptions, and credit risk.

  • PAC non-profit sub-fund

    The PAC non-profit sub-fund principally comprises annuity business previously written by Scottish Amicable Life, credit life, unit-linked and other non-participating business.

    The financial assets covering the liabilities for those types of business are subject to market risk. However, for the annuity business the same considerations as described above for PRIL apply, whilst the liabilities of the unit-linked business change in line with the matching linked assets. Other liabilities of the PAC non-profit sub-fund are broadly insensitive to market risk.

  • Other shareholder-backed unit-linked business

    Due to the matching of policyholder liabilities to attaching asset value movements, the UK unit-linked business is not directly affected by market or credit risk. The principal factor affecting the IFRS results is investment performance through asset management fees.

US insurance operations (Jackson)

The IFRS basis results of Jackson are highly sensitive to market risk on the assets covering liabilities other than variable annuity business segregated in the separate accounts.

Invested assets covering liabilities (other than the separate accounts) and related capital comprise principally debt securities classified as available-for-sale. Value movements for these securities are reflected as movements in shareholders' equity through the statement of comprehensive income. Other invested assets and derivatives are carried at fair value with the value movements reflected in the income statement.

By contrast, the IFRS insurance liabilities for business written by Jackson, by the application of grandfathered GAAP under IFRS 4, are measured on US GAAP bases which with the exception of certain items covered by the equity hedging programme, are generally insensitive to temporary changes in market conditions or the short-term returns on the attaching asset portfolios.

These differences in carrying value of debt securities, other invested assets, derivatives and insurance liabilities give rise to potentially significant volatility in the IFRS income statement and shareholders' equity. As with other shareholder-backed business the profit or loss for Jackson is presented in the Group's segmental analysis of profit as described in note B1, by distinguishing the result for the year between an operating result based on longer-term investment returns and short-term fluctuations in investment returns. In this way the most significant direct effect of market changes that have taken place to the Jackson result are separately identified.

Excluding these short-term effects, the factors that most significantly affect the Jackson IFRS operating result based on long-term investment returns are:

  • Variable annuity business – the spread differential between the earned rate and the rate credited to policyholders on the general account funds and the effect of market movements on fees earned on separate account funds;
  • Fixed annuity business – the spread differential between the earned rate and the rate credited to policyholders; and
  • Fixed index annuity business – the spread differential between the earned rate and the rate credited to policyholders.

In addition, the total profit for Jackson is affected by the level of impairment losses on the debt securities portfolio, net effect of market risk arising from the incidence and valuation of guarantee features, guaranteed benefit payments and equity index participation features, offset by variability of benefit related fees and equity derivative hedging performance, short-term value movements on derivatives held to manage the fixed annuity and other general account business, and other temporary value movements on portfolio investments classified as fair value through profit and loss.

The Group has amended its presentation of operating profit for its US insurance operations to remove the net equity hedge accounting effect and include it in short-term fluctuations as explained further in note A4(d)(ii). Following this change the operating profit based on longer-term investment returns of the US insurance operations of £833 million for 2010 (2009: £618 million) excludes £367 million (2009: £159 million) negative net equity hedge accounting effects, net of related change to amortisation of deferred acquisition costs. The presentation of results for 2009 has been amended accordingly.

Asian insurance operations

For Asian with-profits business the same features apply as described above for UK with-profits business. Similarly, as for other parts of the Group, for unit-linked business the main factor affecting IFRS basis results is investment performance through asset management fees.

The sensitivity of the IFRS basis results of the Group's Asian operations to market risk is primarily restricted to the non-participating business.

This sensitivity is primarily reflected through the volatility of asset returns coupled with the fact that the accounting carrying value of liabilities to policyholders are only partially sensitive to changed market conditions. As for UK shareholder-backed operations and Jackson, the IFRS profit is distinguished in the Group's segmental analysis so as to distinguish operating profits based on longer-term investment returns and short-term fluctuations in investment returns.

Insurance and lapse risk

The features described above cover the main sensitivities of IFRS profit and loss and equity for market, insurance and credit risk. Lapse and longevity risk may also be a key determination of IFRS basis results with variable impacts.

In the UK, adverse persistency experience can affect the level of profitability from with-profits and unit-linked business. For with-profits business in any given year, the amount represented by the shareholders' share of cost of bonus may only be marginally affected. However, altered persistency trends may affect future expected shareholder transfers.

By contrast, Group IFRS operating profit is particularly sensitive to longevity outlook that results in changes of assumption for the UK shareholder-backed annuity business.

Jackson is sensitive to lapse risk. However, Jackson uses certain swaption derivatives to ameliorate the effect of a sharp rise in interest rates, which would be the most likely cause of a sudden change in policyholder behaviour.

In Asia, adverse persistency experience can impact the IFRS profitability of certain business written in the region. This risk is managed at a business unit level through monthly monitoring of experience and the implementation of management actions as necessary. These actions could include product enhancements, increased management focus on premium collection as well as other customer retention efforts. The potential financial impact of lapses is often mitigated through the specific features of the products, e.g. surrender charges.

iii Impact of diversification on risk exposure

The Group enjoys significant diversification benefits. This arises because not all risk scenarios will happen at the same time and across all geographic regions. The Group tests the sensitivities of results to different correlation factors such as:

Correlation across geographic regions

  • Financial risk factors
  • Non-financial risk factor

Correlation across risk factors

  • Longevity risk
  • Expenses
  • Persistency
  • Other risks

The effect of Group diversification is to significantly reduce the aggregate standalone volatility risk to IFRS operating profit based on longer-term investment returns. The effect is almost wholly explained by the correlations across risk types, in particular longevity risk.

f Duration of liabilities

Under the terms of the Group's contracts, as for life assurance contracts generally, the contractual maturity date is the earlier of the end of the contract term, death, other insurable events or surrender. The Group has therefore chosen to provide details of liability duration that reflect the actuarially determined best estimate of the likely incidence of these factors on contract duration. Details are shown in sections D2(k), D3(k) and D4(k).

In the years 2006 to 2010, claims paid on the Group's life assurance contracts including those classified as investment contracts under IFRS 4 ranged from £15 billion to £18 billion. Indicatively, it is to be expected that, of the Group's policyholder liabilities (excluding unallocated surplus) at 31 December 2010 of £214.7 billion, the amounts likely to be paid in 2011 will be of a similar magnitude.

a Summary statement of financial position

In order to reflect the different types of UK business and fund structure, the statement of financial position of the UK insurance operations may be analysed by the assets and liabilities of the Scottish Amicable Insurance Fund (SAIF), the PAC with-profits sub-fund (WPSF), unit-linked assets and liabilities and annuity (principally PRIL) and other business. The assets and liabilities of these funds and subsidiaries are shown in the table below.

£94.8 billion of the £141.4 billion of investments are held by SAIF and the PAC WPSF. Shareholders are exposed only indirectly to value movements on these assets.

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    PAC with-profits sub-fundnote i Other funds and subsidiaries UK insurance operations
  Scottish Amicable Insurance Fund
note ii
£m
Excluding Prudential Annuities Limited
£m
Prudential Annuities Limited
note iii
£m
Total
note iv
£m
Unit– linked assets and liabilities
£m
Annuity and other long-term business
£m
Total
£m
2010 Total
£m
2009 Total
£m
Assets    
Intangible assets attributable to shareholders:    
Deferred acquisition costs and other intangible assets 118 118 118 127
  118 118 118 127
Intangible assets attributable to PAC with-profits fund:    
In respect of acquired subsidiaries for venture fund and other investment purposes 166 166 166 124
Deferred acquisition costs 13 13 13 9
  179 179 179 133
Total 179 179 118 118 297 260
Deferred tax assets 2 93 14 107 105 105 214 292
Other non-investment and non-cash assets 412 1,810 322 2,132 557 1,532 2,089 4,633 3,074
Investments of long-term business and other operations:    
Investment propertiesnote viii 673 7,589 731 8,320 745 1,474 2,219 11,212 10,861
Investments accounted for using the equity method 69 69 69 4
Financial investments:    
Loansnote v 153 979 138 1,117 1,032 1,032 2,302 1,815
Equity securities and portfolio holdings in unit trusts 3,105 23,716 229 23,945 13,434 35 13,469 40,519 37,051
Debt securitiesnote D2c 4,704 29,013 12,785 41,798 6,045 21,757 27,802 74,304 67,772
Other investmentsnote vi 276 3,241 178 3,419 73 230 303 3,998 3,630
Deposits 793 6,038 435 6,473 498 1,258 1,756 9,022 11,557
Total investmentsnote b 9,704 70,576 14,496 85,072 20,795 25,855 46,650 141,426 132,690
Properties held for sale 254 254 254
Cash and cash equivalents 170 1,127 82 1,209 1,153 307 1,460 2,839 2,265
Total assets 10,288 74,039 14,914 88,953 22,505 27,917 50,422 149,663 138,581

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    PAC with-profits sub-fundnote i Other funds and subsidiaries UK insurance operations
  Scottish Amicable Insurance Fund
note ii
£m
Excluding Prudential Annuities Limited
£m
Prudential Annuities Limited
note iii
£m
Total
note iv
£m
Unit– linked assets and liabilities
£m
Annuity and other long-term business
£m
Total
£m
2010 Total
£m
2009 Total
£m
Equity and liabilities    
Equity    
Shareholders’ equity 2,148 2,148 2,148 1,939
Non-controlling interests 35 35 35 28
Total equity 35 35 2,148 2,148 2,183 1,967
Liabilities    
Policyholder liabilities and unallocated surplus of with-profits funds:    
Contract liabilities (including amounts in respect of contracts classified as investment contracts under IFRS 4) 9,759 59,545 12,282 71,827 21,671 22,273 43,944 125,530 116,229
Unallocated surplus of with-profits funds (reflecting application of ‘realistic’ provisions for UK regulated with-profits funds)note vii 8,363 1,824 10,187 10,187 9,966
Total 9,759 67,908 14,106 82,014 21,671 22,273 43,944 135,717 126,195
Operational borrowings attributable to shareholder-financed operations 162 162 162 158
Borrowings attributable to with-profits funds 118 1,404 1,404 1,522 1,284
Deferred tax liabilities 80 903 252 1,155 503 503 1,738 1,606
Other non-insurance liabilities 331 3,789 556 4,345 834 2,831 3,665 8,341 7,371
Total liabilities 10,288 74,004 14,914 88,918 22,505 25,769 48,274 147,480 136,614
Total equity and liabilities 10,288 74,039 14,914 88,953 22,505 27,917 50,422 149,663 138,581
Notes
  1. For the purposes of this table and subsequent explanation, references to the PAC WPSF also include, for convenience, the amounts attaching to the Defined Charges Participating Sub-fund, which comprises 3.5 per cent of the total assets of WPSF and includes the with-profits annuity business transferred to Prudential from the Equitable Life Assurance Society on 1 December 2007 (with assets of approximately £1.7 billion). Profits to shareholders on this with-profits annuity business emerge on a 'charges less expenses' basis and policyholders are entitled to 100 per cent of the investment earnings.
  2. SAIF is a separate sub-fund within the PAC long-term business fund.
  3. Wholly-owned subsidiary of the PAC WPSF that writes annuity business.
  4. Excluding policyholder liabilities of the Hong Kong branch of PAC.
  5. The loans of the Group's UK insurance operations of £2,302 million (2009: £1,815 million) comprise loans held by the PAC WPSF of £1,270 million (2009: £1,106 million) and loans held by shareholder-backed business of £1,032 million (2009: £709 million).

    The loans held by the PAC WPSF comprise mortgage loans of £256 million, policy loans of £21 million and other loans of £993 million (2009: £145 million, £24 million and £937 million respectively). The mortgage loans are collateralised by properties. Other loans held by the PAC with-profits fund are all commercial loans and comprise mainly syndicated loans.

    The loans held by the UK shareholder-backed business comprise mortgage loans collateralised by properties of £1,027 million (2009: £702 million) and other loans of £5 million (2009: £7 million).

  6. Other investments comprise:

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      2010 £m 2009 £m
    Derivative assets*(note G3) 926 910
    Partnerships in investment pools and other 3,072 2,720
      3,998 3,630
    • *In the UK, Prudential uses derivatives to reduce equity and credit risk, interest rate and currency exposures, and to facilitate efficient portfolio management. After derivative liabilities of £792 million (2009: £709 million), which are also included in the statement of financial position, the overall derivative position was a net asset of £134 million (2009: £201 million).
    • Partnerships in investment pools and other comprise mainly investments held by the PAC with-profits fund. These investments are primarily venture fund investments and investment in property funds and limited partnerships.
  7. Unallocated surplus of with-profits funds

    Prudential's long-term business written in the UK comprises predominantly life insurance policies under which the policyholders are entitled to participate in the returns of the funds supporting these policies. Business similar to this type is also written in certain of the Group's Asian operations, subject to local market and regulatory conditions. Such policies are called with-profits policies. Prudential maintains with-profits funds within the Group's long-term business funds, which segregate the assets and liabilities and accumulate the returns related to that with-profits business. The amounts accumulated in these with-profits funds are available to provide for future policyholder benefit provisions and for bonuses to be distributed to with-profits policyholders. The bonuses, both annual and final, reflect the right of the with-profits policyholders to participate in the financial performance of the with-profits funds. Shareholders' profits with respect to bonuses declared on with-profits business correspond to the shareholders' share of the cost of bonuses as declared by the PAC Board of directors. The shareholders' share currently represents one-ninth of the cost of bonuses declared for with-profits policies.

    The unallocated surplus represents the excess of assets over policyholder liabilities for the Group's with-profits funds. As allowed under IFRS 4, the Group has opted to continue to record unallocated surplus of with-profits funds wholly as a liability. The annual excess (shortfall) of income over expenditure of the with-profits funds, after declaration and attribution of the cost of bonuses to policyholders and shareholders, is transferred to (from) the unallocated surplus each year through a charge (credit) to the income statement. The balance retained in the unallocated surplus represents cumulative income arising on the with-profits business that has not been allocated to policyholders or shareholders. The balance of the unallocated surplus is determined after full provision for deferred tax on unrealised appreciation on investments.

  8. Investment properties

    At 31 December 2010, the Group's UK insurance operations had £11,212 million (2009: £10,861 million) of investment properties. The following table shows the property portfolio by type of investment. The properties are shown at market value below in accordance with the policies described in note A4.

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      2010 2009
    £m % £m %
    Office buildings 4,617 41.2 4,820 44.4
    Shopping centres/commercial 3,777 33.7 3,699 34.0
    Retail warehouses/industrial 2,184 19.5 1,780 16.4
    Development 402 3.6 20 0.2
    Other 232 2.0 542 5.0
    Total 11,212 100.0 10,861 100.0

    Approximately 46.2 per cent (2009: 42.4 per cent) of the UK held investment property is located in London and Southeast England including Buckinghamshire, Berkshire, East and West Sussex, Hampshire, Isle of Wight, Kent, Oxfordshire and Surrey, with 36.7 per cent (2009: 39.8 per cent) located throughout the rest of the UK and the remaining 17.1 per cent (2009: 17.8 per cent) located overseas.

b Reconciliation of movement in investments

A reconciliation of the total investments of UK insurance operations from the beginning of the year to the end of the year is as follows:

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    PAC with-profits sub-fund Other funds and subsidiaries  
  Scottish Amicable Insurance Fund
£m
Excluding Prudential Annuities Limited
£m
Prudential Annuities Limited
£m
Total
£m
Unit– linked assets and liabilities
£m
Annuity and other long-term business
£m
UK insurance operations
£m
At 1 January 2009              
Total investments (including derivative assets) 10,438 62,814 13,329 76,143 15,571 19,710 121,862
Less: Investments held by consolidated investment funds (145) (145) (424) (40) (609)
Less: Derivative liabilities (414) (2,331) (280) (2,611) (14) (362) (3,401)
Directly held investments, net of derivative liabilities 10,024 60,338 13,049 73,387 15,133 19,308 117,852
Net cash inflow (outflow) from operating activities (1,226) 507 (30) 477 258 1,923 1,432
Realised gains (losses) in the year 165 554 (20) 534 (285) (306) 108
Unrealised gains and losses and exchange movements in the year 848 4,935 610 5,545 2,586 1,644 10,623
Reclassification of property under development 131 131 131
Movement in the year of directly held investments, net of derivative liabilities (213) 6,127 560 6,687 2,559 3,261 12,294
At 31 December 2009/
1 January 2010
 
Total investments (including derivative assets) 9,848 67,832 13,794 81,626 18,421 22,795 132,690
Less: Investments held by consolidated investment funds (1,050) (19) (1,069) (729) (37) (1,835)
Less: Derivative liabilitiesnote G3 (37) (317) (166) (483) (189) (709)
Directly held investments, net of derivative liabilities 9,811 66,465 13,609 80,074 17,692 22,569 130,146
Net cash inflow (outflow) from operating activities (762) (838) (21) (859) 1,000 1,950 1,329
Realised gains in the year 368 1,502 73 1,575 267 23 2,233
Unrealised gains and losses and exchange movements in the year 249 2,963 608 3,571 1,131 1,007 5,958
Dilution of PruHealth investment 56 56
Movement in the year of directly held investments, net of derivative liabilities (145) 3,627 660 4,287 2,398 3,036 9,576
At 31 December 2010  
Total investments (including derivative assets) 9,704 70,576 14,496 85,072 20,795 25,855 141,426
Less: Investments held by consolidated investment funds (140) (22) (162) (705) (45) (912)
Less: Derivative liabilitiesnote G3 (38) (344) (205) (549) (205) (792)
Directly held investments, net of derivative liabilities 9,666 70,092 14,269 84,361 20,090 25,605 139,722

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:

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  Other shareholder-backed funds and subsidiaries  
  SAIF and PAC with-profits sub-fund
£m
Unit– linked liabilities
£m
Annuity and other long-term business
£m
UK insurance operations
Total

£m
At 1 January 2009 82,108 16,318 17,535 115,961
Premiums 3,271 1,860 1,736 6,867
Surrenders (2,394) (1,535) (42) (3,971)
Maturities/Deaths (5,147) (670) (1,422) (7,239)
Net flowsnote a (4,270) (345) 272 (4,343)
Shareholders transfers post-tax (202) (202)
Switches (270) 270
Assumption changes (shareholder-backed business)note D2i, note c (46) (46)
Investment-related items and other movementsnote b 9,365 2,849 1,904 14,118
Foreign exchange translation differences 764 (57) 707
At 31 December 2009/1 January 2010 87,495 19,035 19,665 126,195
Comprising:        
– Policyholder liabilities 77,529 19,035 19,665 116,229
– Unallocated surplus of with-profits funds 9,966 9,966
Premiums 3,311 2,301 2,278 7,890
Surrenders (2,453) (1,272) (54) (3,779)
Maturities/Deaths (5,079) (726) (1,498) (7,303)
Net flowsnote a (4,221) 303 726 (3,192)
Shareholders transfers post-tax (223) (223)
Switches (236) 236
Assumption changes (shareholder-backed business)note D2i, note c (46) (46)
Investment-related items and other movementsnote b 9,165 2,097 1,956 13,218
Dilution of holding in PruHealth (27) (27)
Foreign exchange translation differences (207) (1) (208)
At 31 December 2010 91,773 21,671 22,273 135,717
Comprising:        
– Policyholder liabilities 81,586 21,671 22,273 125,530
– Unallocated surplus of with-profits funds 10,187 10,187
Average policyholder liabilities balances*        
2010 79,558 20,353 20,969 120,880
2009 75,692 17,677 18,600 111,969
  • *Excluding the unallocated surplus of the with-profits funds and as adjusted for corporate transactions in the period.

Notes

  1. Net flows of negative £3,192 million have improved from negative £4,343 million in 2009, principally as a result of increased premiums due to bulk annuity transaction in 2010 and improved unit-linked flows.
  2. Investment-related items and other movements of £13,218 million across fund types reflected the continued strong performance of UK equity markets in 2010, as well as the continued increase in value of debt securities.
  3. Assumption changes principally represent the net impact of changes to the mortality assumptions and expense assumptions.

d Information on credit risk of debt securities

The following table summarises by rating the securities held by UK insurance operations as at 31 December 2010 and 2009:

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    PAC with-profits sub-fund Other funds and subsidiaries UK insurance operations
Scottish Amicable Insurance Fund
£m
Excluding Prudential Annuities Limited
£m
Prudential Annuities Limited
£m
Total
£m
Unit– linked assets and liabilities
£m
PRIL
£m
Other annuity and long-term business
£m
2010
Total

£m
2009
Total

£m
S&P – AAA 1,128 5,741 3,315 9,056 2,459 5,224 966 18,833 16,091
S&P – AA+ to AA– 346 2,045 1,334 3,379 608 2,299 253 6,885 6,472
S&P – A+ to A– 1,211 7,568 3,778 11,346 1,672 6,467 812 21,508 19,693
S&P – BBB+ to BBB– 1,011 6,960 1,153 8,113 836 2,464 424 12,848 12,183
S&P – Other 359 2,662 178 2,840 34 149 21 3,403 2,667
  4,055 24,976 9,758 34,734 5,609 16,603 2,476 63,477 57,106
Moody’s – Aaa 78 428 56 484 80 93 30 765 463
Moody’s – Aa1 to Aa 9 81 51 132 52 141 26 360 276
Moody’s – A1 to A3 27 169 214 383 33 169 20 632 801
Moody’s – Baa1 to Baa3 63 358 248 606 92 155 33 949 815
Moody’s – Other 16 116 31 147 10 57 3 233 339
  193 1,152 600 1,752 267 615 112 2,939 2,694
Fitch 28 207 118 325 48 208 21 630 1,022
Other 428 2,678 2,309 4,987 121 1,622 100 7,258 6,950
Total debt securities 4,704 29,013 12,785 41,798 6,045 19,048 2,709 74,304 67,772

Where no external ratings are available, internal ratings produced by the Group's asset management operation, which are prepared on the Company's assessment of a comparable basis to external ratings, are used where possible. Of the £7,258 million total debt securities held in 2010 (2009: £6,950 million) which are not externally rated, £2,210 million were internally rated AAA to A–, £3,861 million were internally rated BBB to B– and £1,187 million were rated below B– or unrated (2009: £2,190 million, £3,445 million and £1,315 million respectively). The majority of unrated debt security investments were held in SAIF and the PAC with-profits fund and relate to convertible debt and other investments which are not covered by ratings analysts nor have an internal rating attributed to them. Of the £1,722 million PRIL and other annuity and long-term business investments which are not externally rated, £7 million were internally rated AAA, £92 million AA, £496 million A, £899 million BBB, £82 million BB and £146 million were internally rated B+ and below.

As detailed in note D2(i) below, the primary sensitivity of IFRS basis profit or loss and shareholders' equity relates to non-linked shareholder-backed business which covers 'PRIL' and 'other annuity and long-term business' in the table above.

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 statement of financial position of UK insurance operations at 31 December 2010, as shown in note D2(a), there are policyholder liabilities and unallocated surplus of £82.0 billion (2009: £77.5 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 with-profits business but it also contains some non-profit business (unit-linked, term assurances and annuities). The WPSF's profits are apportioned 90 per cent to its policyholders and 10 per cent to shareholders as surplus for distribution is determined via the annual actuarial valuation.

The WPSF held a provision of £24 million at 31 December 2010 (2009: £31 million) to honour guarantees on a small amount of guaranteed annuity products. SAIF's exposure to guaranteed annuities is described below.

Beyond the generic guarantees described above, there are very few explicit options or guarantees such as minimum investment returns, surrender values or annuities at retirement and any granted have generally been at very low levels.

With-profits products provide returns to policyholders through bonuses that are 'smoothed'. There are two types of bonuses:'annual' and 'final'. Annual bonuses are declared once a year, and once credited, are guaranteed in accordance with the terms of the particular product. Unlike annual bonuses, final bonuses are guaranteed only until the next bonus declaration.

The main factors that influence the determination of bonus rates are the return on the investments of the with-profits fund, inflation, taxation, the expenses of the fund chargeable to policyholders and the degree to which investment returns are smoothed. The overall rate of return earned on investments and the expectation of future investment returns are the most important influences on bonus rates.

A high proportion of the assets backing the with-profits business are invested in equities and real estate. If the financial strength of the with-profits business is affected, then a higher proportion of fixed interest or similar assets might be held by the fund.

Further details on the determination of the two types of the bonuses: 'regular' and 'final', the application of significant judgement, key assumptions and the degree of smoothing of investment returns in determining the bonus rates are provided below.

Regular bonus rates

For regular bonuses, the bonus rates are determined for each type of policy primarily by targeting the bonus level at a prudent proportion of the long-term expected future investment return on underlying assets. The expected future investment return is reduced as appropriate for each type of policy to allow for items such as expenses, charges, tax and shareholders' transfers. However, the rates declared may differ by product type, or by the date of payment of the premium or date of issue of the policy or if the accumulated annual bonuses are particularly high or low relative to a prudent proportion of the achieved investment return.

When target bonus levels change the PAC Board has regard to the overall strength of the long-term fund when determining the length of time over which it will seek to achieve the amended prudent target bonus level.

In normal investment conditions, PAC expects changes in regular bonus rates to be gradual over time, and these are not expected to exceed one per cent per annum over any year. However, the PAC directors retain the discretion whether or not to declare a regular bonus each year, and there is no limit on the amount by which regular bonus rates can change.

Final bonus rates

A final bonus which is normally declared yearly, may be added when a claim is paid or when units of a unitised product are realised.

The rates of final bonus usually vary by type of policy and by reference to the period, usually a year, in which the policy commences or each premium is paid. These rates are determined by reference to the asset shares for the sample policies but subject to the smoothing approach, explained below.

In general, the same final bonus scale applies to maturity, death and surrender claims except that:

  • The total surrender value may be impacted by the application of a Market Value Reduction – MVR – (for accumulating with-profits policies) and is affected by the surrender bases (for conventional with-profits business); and
  • For the SAIF and Scottish Amicable Life (SAL), the final bonus rates applicable on surrender may be adjusted to reflect expected future bonus rates.

Application of significant judgement

The application of the above method for determining bonuses requires the PAC Board of directors to apply significant judgement in many respects, including in particular the following:

  • Determining what constitutes fair treatment of customers: Prudential is required by UK law and regulation to consider the fair treatment of its customers in setting bonus levels. The concept of determining what constitutes fair treatment, while established by statute, is not defined.
  • Smoothing of investment returns: This is an important feature of with-profits products. Determining when particular circumstances, such as a significant rise or fall in market values, warrant variations in the standard bonus smoothing limits that apply in normal circumstances requires the PAC Board to exercise significant judgement.
  • Determining at what level to set bonuses to ensure that they are competitive: The overall return to policyholders is an important competitive measure for attracting new business.

Key assumptions

As noted above, the overall rate of return on investments and the expectation of future investment returns are the most important influences in bonus rates, subject to the smoothing described below. Prudential determines the assumptions to apply in respect of these factors, including the effects of reasonably likely changes in key assumptions, in the context of the overarching discretionary and smoothing framework that applies to its with-profits business as described above. As such, it is not possible to specifically quantify the effects of each of these assumptions or of reasonably likely changes in these assumptions.

Prudential's approach, in applying significant judgement and discretion in relation to determining bonus rates, is consistent conceptually with the approach adopted by other firms that manage a with-profits business. It is also consistent with the requirements of UK law, which require all UK firms that carry out a with-profits business to define, and make publicly available, the Principles and Practices of Financial Management (PPFM) that are applied in the management of their with-profits funds.

Accordingly, Prudential's PPFM contains an explanation of how it determines regular and final bonus rates within the discretionary framework that applies to all with-profits policies, subject to the general legislative requirements applicable. The purpose of Prudential's PPFM is therefore to:

  • explain the nature and extent of the discretion available;
  • show how competing or conflicting interests or expectations of:
    – different groups and generations of policyholders; and
    – policyholders and shareholders are managed so that all policyholders and shareholders are treated fairly; and
  • provide a knowledgeable observer (e.g. a financial adviser) with an understanding of the material risks and rewards from starting and continuing to invest in a with-profits policy with Prudential.

Furthermore, in accordance with industry-wide regulatory requirements, the PAC Board has appointed:

  • an Actuarial Function Holder who provides the PAC Board with all actuarial advice;
  • a With-Profits Actuary whose specific duty is to advise the PAC Board on the reasonableness and proportionality of the manner in which its discretion has been exercised in applying the PPFM and the manner in which any conflicting interests have been addressed; and
  • a With-Profits Committee of independent individuals, which assesses the degree of compliance with the PPFM and the manner in which conflicting rights have been addressed.

Smoothing of investment return

In determining bonus rates for the UK with-profits policies, smoothing is applied to the allocation of the overall earnings of the UK with-profits fund of which the investment return is a significant element. The smoothing approach differs between accumulating and conventional with-profits policies to reflect the different contract features. In normal circumstances, Prudential does not expect most payout values on policies of the same duration to change by more than 10 per cent up or down from one year to the next, although some larger changes may occur to balance payout values between different policies. Greater flexibility may be required in certain circumstances, for example following a significant rise or fall in market values, and in such situations the PAC Board may decide to vary the standard bonus smoothing limits in order to protect the overall interests of policyholders.

The degree of smoothing is illustrated numerically by comparing in the following table the relatively 'smoothed' level of policyholder bonuses declared as part of the surplus for distribution with the more volatile movement in investment return and other items of income and expenditure of the UK component of the PAC with-profits fund for each year presented.

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  2010 £m 2009 £m
Net income of the fund:    
Investment return 8,815 10,461
Claims incurred (6,390) (6,253)
Movement in policyholder liabilities (4,301) (3,692)
Add back policyholder bonuses for the year (as shown below) 2,019 1,827
Claims incurred and movement in policyholder liabilities (including charge for provision for asset shares and excluding policyholder bonuses) (8,672) (8,118)
Earned premiums, net of reinsurance 3,148 3,063
Other income 9 (2)
Acquisition costs and other expenditure (600) (842)
Tax (charge) (528) (640)
Net income of the fund before movement in unallocated surplus 2,172 3,922
Movement in unallocated surplus 70 (1,893)
Surplus for distribution 2,242 2,029
Surplus for distribution allocated as follows:    
– 90% policyholders bonus (as shown above) 2,019 1,827
– 10% shareholders’ transfers 223 202
  2,242 2,029

ii Annuity business

Prudential's conventional annuities include level, fixed-increase and retail price index (RPI) annuities. They are mainly written within the subsidiaries PAL, PRIL, Prudential Pensions Limited and the PAC with-profits sub-fund, but there are some annuity liabilities in the non-profit sub-fund and SAIF.

Prudential's fixed-increase annuities incorporate automatic increases in annuity payments by fixed amounts over the policyholder's life. The RPI annuities that Prudential offers provide for a regular annuity payment to which an additional amount is added periodically based on the increase in the UK RPI.

Prudential's with-profits annuities, which are written in the WPSF, combine the income features of annuity products with the investment smoothing features of with-profits products and enable policyholders to obtain exposure to investment return on the WPSF's equity shares, property and other investment categories over time. Policyholders select a 'required smoothed return bonus' from the specific range Prudential offers for the particular product. The amount of the annuity payment each year depends upon the relationship between the required smoothed return bonus rate selected by the policyholder when the product is purchased and the smoothed return bonus rates Prudential subsequently declares each year during the term of the product. If the total bonus rates fall below the anticipated rate, then the annuity income falls.

At 31 December 2010, £35.6 billion (2009: £32.3 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.

iii SAIF

SAIF is a ring-fenced sub-fund of the PAC long-term fund formed following the acquisition of the mutually owned Scottish Amicable Life Assurance Society in 1997. No new business may be written in SAIF, although regular premiums are still being paid on policies in force at the time of the acquisition and incremental premiums are permitted on these policies.

The fund is solely for the benefit of policyholders of SAIF. Shareholders have no interest in the profits of this fund although they are entitled to asset management fees on this business.

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.

Provision is made for the risks attaching to some SAIF unitised with-profits policies that have MVR-free dates and for those SAIF products which have a guaranteed minimum benefit on death or maturity of premiums accumulated at four per cent per annum.

The Group's main exposure to guaranteed annuities in the UK is through SAIF and a provision of £336 million was held in SAIF at 31 December 2010 (2009: £284 million) to honour the guarantees. As SAIF is a separate sub-fund solely for the benefit of policyholders of SAIF this provision has no impact on the financial position of the Group's shareholders' equity.

iv Unit-linked (non-annuity) and other non-profit business

Prudential UK insurance operations also have an extensive book of unit-linked policies of varying types and provide a range of other non-profit business such as credit life and protection contracts. These contracts do not contain significant financial guarantees.

There are no guaranteed maturity values or guaranteed annuity options on unit-linked policies except for minor amounts for certain policies linked to cash units within SAIF.

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 a high proportion of the investments backing the with-profits business are in equities and real estate with the balance in debt securities, deposits and loans.

The investments supporting the protection business are small in value and tend to be assets of a fixed term duration reflecting the guaranteed nature of the liabilities.

ii Pension annuity business

Prudential's UK annuity business mainly employs fixed income investments (including UK retail price index-linked assets) because the liabilities consist of guaranteed payments for as long as each annuitant or surviving partner is alive. Retail price index-linked assets are used to back pension annuities where the payments are linked to the RPI.

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.

For with-profits business written in the WPSF or SAIF, a market consistent valuation is performed (as described in section (ii) below). Additional assumptions required are for persistency and the management actions under which the fund is managed. Assumptions used for a market consistent valuation typically do not contain margins, whereas those used for the valuation of other classes of business do.

Mortality assumptions are set based on the results of the most recent experience analysis looking at the experience over recent years of the relevant business. For non-profit business, a margin for adverse deviation is added. Different assumptions are applied for different product groups. For annuitant mortality, assumptions for current mortality rates are based on recent experience investigations and expected future improvements in mortality. The expected future improvements are based on recent experience and projections of the business and industry experience generally.

Maintenance and, for some classes of business, termination expense assumptions are expressed as per policy amounts. They are set based on the expenses incurred during the year, including an allowance for ongoing investment expenditure and allocated between entities and product groups in accordance with the operation's internal cost allocation model. For non-profit business a margin for adverse deviation is added to this amount. Expense inflation assumptions are set consistent with the economic basis and based on the difference between yields on nominal gilts and index-linked gilts.

The actual renewal expenses incurred on behalf of SAIF by other Group companies are recharged in full to SAIF.

The assumptions for asset management expenses are based on the charges specified in agreements with the Group's asset management operations, plus a margin for adverse deviation for non-profit business.

Tax assumptions are set equal to current rates of taxation.

For non-profit business excluding unit-linked business, the valuation interest rates used to discount the liabilities are based on the yields as at the valuation date on the assets backing the technical provisions. For fixed interest securities the gross redemption yield is used except for the PAL and PRIL annuity business where the internal rate of return of the assets backing the liabilities is used. Properties are valued using the rental yield, and for equities it is the greater of the dividend yield and the average of the dividend yield and the earnings yield. An adjustment is made to the yield on non risk-free fixed interest securities and property to reflect credit risk. To calculate the non-unit reserves for linked business, assumptions have been set for the gross unit growth rate and the rate of inflation of maintenance expenses, as well as for the valuation interest rate as described above.

ii WPSF and SAIF

The policyholder liabilities reported for the WPSF are primarily for two broad types of business. These are accumulating and conventional with-profits contracts. The policyholder liabilities of the WPSF are accounted for under FRS 27.

The provisions have been determined on a basis consistent with the detailed methodology included in regulations contained in the FSA's rules for the determination of reserves on the FSA's 'realistic' Peak 2 basis. In aggregate, the regime has the effect of placing a value on the liabilities of UK with-profits contracts, which reflects the amounts expected to be paid based on the current value of investments held by the with-profits funds and current circumstances. These contracts are a combination of insurance and investment contracts with discretionary participation features, as defined by IFRS 4.

The FSA's Peak 2 calculation under the realistic regime requires the value of liabilities to be calculated as:

  • The with-profits benefits reserve (WPBR); plus
  • future policy related liabilities (FPRL); plus
  • the realistic current liabilities of the fund.

The WPBR is primarily based on the retrospective calculation of accumulated asset shares but is adjusted to reflect future expected policyholder benefits and other outgoings. Asset shares are calculated as the accumulation of all items of income and outgo that are relevant to each policy type. Income comprises credits for premiums, investment returns (including unrealised gains), and miscellaneous profits. Outgo comprises charges for tax (including an allowance for tax on unrealised gains), guarantees and smoothing, mortality and morbidity, shareholders' profit transfers, miscellaneous losses, and expenses and commission (net of any tax relief).

The FPRL must include a market consistent valuation of costs of guarantees, options and smoothing, less any related charges, and this amount must be determined using either a stochastic approach, hedging costs or a series of deterministic projections with attributed probabilities.

The assumptions used in the stochastic models are calibrated to produce risk-free returns on each asset class. Volatilities of, and correlations between, investment returns from different asset classes are as determined by the Group's Portfolio Management Group and aim to be market consistent.

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 PPFM.

The contract liabilities for with-profits business also require assumptions for persistency. These are set based on the results of recent experience analysis.

iii Annuity business

Credit risk provisions

For IFRS reporting, the results for UK shareholder-backed annuity business are particularly sensitive to the allowances made for credit risk. The allowance is reflected in the deduction from the valuation rate of interest for discounting projected future annuity payments to policyholders that would have otherwise applied. Since mid-2007 there has been a significant increase in the actual and perceived credit risk associated with corporate bonds as reflected in the significant widening that has occurred in corporate bond spreads. Although bond spreads over swap rates have narrowed from their peak in March 2009, they are still high compared with the levels seen in the years immediately preceding the start of the dislocated markets in 2007. The allowance that should therefore be made for credit risk remains a particular area of judgement.

The additional yield received on corporate bonds relative to swaps can be broken into the following constituent parts:

  1. the expected level of future defaults;
  2. the credit risk premium that is required to compensate for the potential volatility in default levels;
  3. the liquidity premium that is required to compensate for the lower liquidity of corporate bonds relative to swaps; and
  4. the mark to market risk premium that is required to compensate for the potential volatility in corporate bond spreads (and hence market values) at the time of sale.

The sum of (c) and (d) is often referred to as 'liquidity premium'.

The credit risk allowance is a function of the asset mix and the credit quality of the underlying portfolio. At 31 December 2010, 84 per cent (2009: 80 per cent) of the assets backing the UK shareholder annuity and other business were debt securities as shown in D2 (a). This comprises both government and corporate bonds. Government bonds are generally given a credit default allowance of zero. For corporate bonds the credit allowance varies by credit rating. An analysis of the credit ratings of debt securities is included in note D2 (d).

Given that the normal business model for Prudential's annuity business is to hold bonds to match long-term liabilities, the valuation rate that is applied to discount the future annuity payments includes a liquidity premium that reflects the residual element of current bond spreads over swap rates after providing for the credit risk.

Historically, until the second half of 2007, when corporate bond spreads widened significantly, the allowance for credit risk was calculated as the long-term expected defaults and a long-term credit risk premium. This long-term credit risk was supplemented by a short-term allowance from 31 December 2007 to allow for the concern that credit ratings applied by the rating agencies may be downgraded and defaults in the short-term might be higher than the long-term assumptions.

The weighted components of the bond spread over swap rates for shareholder-backed fixed and linked annuity business for PRIL at 31 December 2010, 2009 and 2008, based on the asset mix at the relevant balance sheet date are shown below.

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31 December 2010 2010
Pillar I Regulatory basis
(bps)
Adjustment from regulatory to IFRS basis
(bps)
note v
IFRS
(bps)
Bond spread over swap ratesnote i 160 160
Credit risk allowance      
Long-term expected defaultsnote ii 16 16
Long-term credit risk premiumnote iii 10 10
Short-term allowance for credit risknote iv 42 (26) 16
Total credit risk allowance 68 (26) 42
Liquidity premium 92 26 118

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31 December 2009 2009
Pillar I Regulatory basis
(bps)
Adjustment from regulatory to IFRS basis
(bps)
note v
IFRS
(bps)
Bond spread over swap ratesnote i 175 175
Credit risk allowance      
Long-term expected defaultsnote ii 19 19
Long-term credit risk premiumnote iii 13 13
Short-term allowance for credit risknote iv 39 (24) 15
Total credit risk allowance 71 (24) 47
Liquidity premium 104 24 128

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31 December 2008 2008
Pillar I Regulatory basis
(bps)
Adjustment from regulatory to IFRS basis
(bps)
note v
IFRS
(bps)
Bond spread over swap ratesnote i 323 323
Credit risk allowance      
Long-term expected defaultsnote ii 15 15
Long-term credit risk premiumnote iii 11 11
Short-term allowance for credit risknote iv 54 (25) 29
Total credit risk allowance 80 (25) 55
Liquidity premium 243 25 268
Notes
  1. Bond spread over swap rates reflect market observed data.
  2. For the valuations prior to 31 December 2010, long-term expected defaults were derived by applying Moody's data from 1970 to 2004 uplifted by between 100 per cent (B) and 200 per cent (AAA) according to credit rating on the annuity asset portfolio. The credit rating assigned to each asset held was based on external credit rating and for this purpose the credit rating assigned to each asset held was the lowest credit rating published by Moody's, Standard and Poors and Fitch.

    For the 31 December 2010 valuation, long-term expected defaults are derived by applying Moody's data from 1970 to 2009 and the definition of the credit rating used has been revised from the lowest credit rating to the second highest credit rating published by Moody's, Standard and Poors and Fitch.

  3. For the valuations prior to 31 December 2010, the long-term credit risk premium provides compensation against the risk of potential volatility in the level of defaults and is derived by applying the 95th percentile from Moody's data from 1970 to 2004 to the annuity asset portfolio. For the 31 December 2010 valuation, the long-term credit risk premium is derived from Moody's data from 1970 to 2009.

    The combined effect of this change and the changes described in (ii) above is neutral on the long-term credit risk allowance for PRIL.

  4. The short-term allowance for credit risk assumed in the Pillar 1 solvency valuations at 31 December 2008 was 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. Subsequent to this date movements have reflected events in the period, namely the impact of credit migration, the decision not to release favourable default experience, new business and asset trading amongst other items. This is demonstrated by the analyses below.
  5. The very prudent Pillar 1 regulatory basis reflects the overriding objective of ensuring sufficient provisions and capital to ensure payments to policyholders can be made. The approach for IFRS aims to establish liabilities that are closer to 'best estimate'. IFRS default assumptions are therefore set between the EEV and Pillar I assumptions.

Factors affecting the credit risk allowance at 31 December 2010

The main factors influencing the credit risk allowance at 31 December 2010 are as follows:

a Credit downgrades and default experience

The credit risk allowances have been adjusted during 2010 to take account of emerging downgrade and default experience. Experience in relation to changes in credit rating has improved in 2010 and no assets defaulted for the PRIL business during the year. The allowance for short-term downgrades has been reduced to offset the impact of credit downgrades on the long-term assumptions. In addition, the allowance for short-term defaults has been updated to eliminate any experience profits that would otherwise have arisen due to default experience being better than allowed for in the opening reserves.

b Asset trading

Since the second half of 2009, the Group started trading out of subordinated financial debt into higher quality assets. The continuation of the reduction in the subordinated financial debt holdings in 2010 improved the overall credit quality of the corporate bond portfolio and so allowed for a release of long-term credit reserves.

On a Pillar 1 basis this transaction had no overall impact on the solvency surplus of PRIL, the PAC non-participating sub-fund and PAL. On an IFRS basis, the reduction in subordinated financial debt holdings generated a pre-tax IFRS operating loss of £4 million (2009: loss of £51 million).

c Asset purchases in respect of new business

Similar to 2009, the assets purchased during 2010 to back new business have been of better average credit quality than the assets held at 31 December 2008, in particular no subordinated bank debt or sub-investment grade assets have been bought to back new business. As a result of the lower credit risk of the new business assets the overall allowance for credit risk required at 31 December 2010 is reduced when the new business assets and in-force assets are aggregated together.

d Overall impact on the PRIL credit risk allowance

After taking account of the factors noted above the movement on the average basis points allowances for PRIL on the Pillar 1 regulatory and IFRS bases are as follows:

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  Pillar 1 Regulatory basis
(bps)
IFRS
(bps)
Long-term Short-term Total Long-term Short-term Total
Total allowance for credit risk at 31 December 2009 32 39 71 32 15 47
Credit downgrades 1 (1) 1 (1)
Retention of surplus from favourable default experience 7 7 3 3
Asset trading (5) (5) (5) (5)
New business (2) (2) (1) (1)
Other (2) (1) (3) (2) (2)
Total allowance for credit risk at 31 December 2010 26 42 68 26 16 42

Overall this has led to the credit allowance for Pillar 1 purposes to be 43 per cent (2009: 41 per cent) of the bond spread over swap rates. For IFRS purposes it represents 26 per cent (2009: 27 per cent) of the bond spread over swap rates.

The reserves for credit risk allowance at 31 December 2010 for UK shareholder annuity fund were as follows:

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  Pillar 1 Regulatory basis
£bn
IFRS
£bn
Long-term Short-term Total Long-term Short-term Total
PRIL 0.6 1.0 1.6 0.6 0.4 1.0
PAC non-profit sub-fund 0.1 0.1 0.2 0.1 0.1
Total 0.7 1.1 1.8 0.7 0.4 1.1

Mortality

The mortality assumptions are set in light of recent population and internal experience. The assumptions used are percentages of standard actuarial mortality tables with an allowance for future mortality improvements. Where annuities have been sold on an enhanced basis to impaired lives an additional age adjustment is made. The percentages of the standard table used are selected according to the source of business.

In 2009, Prudential's annuity business liabilities were determined using the Continuous Mortality Investigation ('CMI') medium cohort projections with a floor. In November 2009 a new mortality projection model was released by the CMI. This model is expected to become the new industry standard. The new model has been applied in determining the 2010 results with calibration to reflect an appropriate view of future mortality improvement. In recognition of the trend in assumed mortality improvements the Company has in previous years included margins in its annuity liabilities. In determining the 2010 results the appropriate level of these margins has been reassessed. See note D2 (i) below for the net effect of applying the new model, releases of margin, and changes to other related mortality assumptions.

The tables and range of percentages used are set out in the following tables:

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2010 PAL PRIL
Males Females Males Females
In payment 92% – 98% PCMA00 with future improvements in line with Prudential’s own calibration of the CMI 2009 mortality model, with a long-term improvement rate of 2.25% 88% – 100% PCFA00 with future improvements in line with Prudential’s own calibration of the CMI 2009 mortality model, with a long-term improvement rate of 1.25% 94% – 95% PCMA00 with future improvements in line with Prudential’s own calibration of the CMI 2009 mortality model, with a long-term improvement rate of 2.25% 86% – 97% PCFA00 with future improvements in line with Prudential’s own calibration of the CMI 2009 mortality model, with a long-term improvement rate of 1.25%
In deferment AM92 minus 4 years AF92 minus 4 years AM92 minus 4 years AF92 minus 4 years

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2009 PAL PRIL
Males Females Males Females
In payment 102% – 126% PNMA00 (C = 2000) with medium cohort improvement table with a minimum annual improvement of 2.25% up to age 90, tapering to zero at age 120 84% – 117% PNFA00 (C = 2000) with 75% of medium cohort improvement table with a minimum annual improvement of 1.25% up to age 90, tapering to zero at age 120 96% – 102% PNMA00 (C = 2000) with medium cohort improvement table with a minimum annual improvement of 2.25% up to age 90, tapering to zero at age 120 87% – 98% PNFA00 (C = 2000) with 75% of medium cohort improvement table with a minimum annual improvement of 1.25% up to age 90, tapering to zero at age 120
In deferment AM92 minus 4 years AF92 minus 4 years AM92 minus 4 years AF92 minus 4 years

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2008 PAL PRIL
Males Females Males Females
In payment 102% – 126% PNMA00 (C = 2000) with medium cohort improvement table with a minimum annual improvement of 2.25% up to age 90, tapering to zero at age 120 84% – 117% PNFA00 (C = 2000) with 75% of medium cohort improvement table with a minimum annual improvement of 1.25% up to age 90, tapering to zero at age 120 97% – 102% PNMA00 (C = 2000) with medium cohort improvement table with a minimum annual improvement of 2.25% up to age 90, tapering to zero at age 120 88% – 98% PNFA00 (C = 2000) with 75% of medium cohort improvement table with a minimum annual improvement of 1.25% up to age 90, tapering to zero at age 120
In deferment AM92 minus 4 years AF92 minus 4 years AM92 minus 4 years AF92 minus 4 years

iv Unit-linked (non-annuity) and other non-profit business

The majority of other long-term business written in the UK insurance operations is unit-linked business or other business with similar features. For these contracts the attaching liability reflects the unit value obligation and provision for expenses and mortality risk. The latter component is determined by applying mortality assumptions on a basis that is appropriate for the policyholder profile.

For unit-linked business, the assets covering unit liabilities are exposed to market risk, but the residual risk when considering the unit-linked liabilities and assets together is limited to the effect on fund-based charges.

For those contracts where the level of insurance risk is insignificant the assets and liabilities arising under the contracts are distinguished between those that relate to the financial instrument liability and acquisition costs and deferred income that relate to the component of the contract that relates to investment management. Acquisition costs and deferred income are recognised consistent with the level of service provision in line with the requirements of IAS 18.

h Reinsurance

The Group's UK insurance business cedes only minor amounts of business outside the Group. During 2010, reinsurance premiums for externally ceded business were £128 million (2009: £122 million) and reinsurance recoverable insurance assets were £608 million (2009: £502 million) in aggregate. The gains and losses recognised in profit and loss for the 2010 contracts were immaterial. During 2009 the Group's UK insurance business wrote a longevity swap on certain aspects of the UK's annuity back-book liabilities. This resulted in a one-off benefit of £34 million to IFRS profit before tax in 2009. The gains and losses recognised in profit and loss for other contracts in 2009 were immaterial.

i Effect of changes in assumptions used to measure insurance assets and liabilities

2010

Credit risk

The approach to reserving for credit risk is set out in note D2(g)(iii).

Other operating assumption changes

Note D2(g)(iii) above explains the application of a new mortality projection model in 2010 to determine the Prudential's annuity business.

The net effect of applying the new model, releases of margins and changes to other related mortality assumptions for shareholder‑backed business is a credit of £8 million. With a £38 million benefit from altered expense assumptions the overall credit for shareholder-backed business is £46 million.

For the with-profits sub-fund, the aggregate effect of assumption changes in 2010 was a net charge to unallocated surplus of £62 million, relating to changes in mortality, expense, persistency and economic assumptions.

2009

Credit risk

The approach to reserving for credit risk is set out in note D2(g)(iii).

Other operating assumptions changes

Overall mortality experience was in line with expectations and no change was therefore required to the overall strength of mortality assumptions at 31 December 2009.

For the shareholder-backed business, the aggregate effect of assumption changes in 2009 was a net credit to the shareholder result of £46 million, primarily related to changes to the deflation reserve, expense assumptions and modelling changes.

For the with-profits sub-fund, the aggregate effect of assumption changes in 2009 was a net credit to unallocated surplus of £65 million principally for altered expense assumptions.

j Sensitivity of IFRS basis profit or loss and equity to market and other risks

The risks to which the IFRS basis results of the UK insurance operations are sensitive are asset/liability matching, mortality experience and payment assumptions for shareholder-backed annuity business. Further details are described below.

i With-profits business

SAIF

Shareholders have no interest in the profits of SAIF but are entitled to the asset management fees paid on the investment of the assets of the fund.

With-profits sub-fund business

For with-profits business (including non-participating business of PAL which is owned by the WPSF) adjustments to liabilities and any related tax effects are recognised in the income statement. However, except for any impact on the annual declaration of bonuses, shareholders' profit for with-profits business is unaffected. This is because IFRS basis profits for with-profits business, which are determined on the same basis as on preceding UK GAAP, solely reflect one-ninth of the cost of bonuses declared for the year.

The main factors that influence the determination of bonus rates are the return on the investments of the fund, the effect of inflation, taxation, the expenses of the fund chargeable to policyholders and the degree to which investment returns are smoothed. Mortality and other insurance risk are relatively minor factors.

Unallocated surplus represents the excess of assets over policyholder liabilities of the fund. As unallocated surplus of the WPSF is recorded as a liability, movements in its value do not affect shareholders' profits or equity.

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 2010 and 2009 are demonstrated in note D5.

ii Shareholder-backed annuity business

Profits from shareholder-backed annuity business are most sensitive to:

  • The extent to which the duration of the assets held closely matches the expected duration of the liabilities under the contracts. Assuming close matching, the impact of short-term asset value movements as a result of interest rate movements will broadly offset changes in the value of liabilities caused by movements in valuation rates of interest;
  • actual versus expected default rates on assets held;
  • the difference between long-term rates of return on corporate bonds and risk-free rates;
  • the variance between actual and expected mortality experience;
  • the extent to which expected future mortality experience gives rise to changes in the measurement of liabilities; and
  • changes in renewal expense levels.

A decrease in assumed mortality rates of one per cent would decrease gross profits by approximately £53 million (2009: £44 million). A decrease in credit default assumptions of five basis points would increase gross profits by £119 million (2009: £91 million). A decrease in renewal expenses (excluding asset management expenses) of five per cent would increase gross profits by £23 million (2009: £17 million). The effect on profits would be approximately symmetrical for changes in assumptions that are directionally opposite to those explained above.

iii Unit-linked and other business

Unit-linked and other business represents a comparatively small proportion of the in-force business of the UK insurance operations.

Profits from unit-linked and similar contracts primarily arise from the excess of charges to policyholders, for management of assets under the Company's stewardship, over expenses incurred. The former is most sensitive to the net accretion of funds under management as a function of new business and lapse and timing of death. The accounting impact of the latter is dependent upon the amortisation of acquisition costs in line with the emergence of margins (for insurance contracts) and amortisation in line with service provision (for the investment management component of investment contracts). By virtue of the design features of most of the contracts which provide low levels of mortality cover, the profits are relatively insensitive to changes in mortality experience.

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. The level of matching from period to period can vary depending on management actions and economic factors so it is possible for a degree of mis-matching profits or losses to arise.

The close matching by the Group of assets of appropriate duration to annuity liabilities is based on maintaining economic and regulatory capital. The measurement of liabilities under capital reporting requirements and IFRS is not the same, with contingency reserves and some other margins for prudence within the assumptions required under the FSA regulatory solvency basis not included for IFRS reporting purposes. As a result IFRS equity is higher than regulatory capital and therefore more sensitive to interest rate risk.

The estimated sensitivity of the UK non-linked shareholder-backed business (principally pension annuities business) to a movement in interest rates is as follows.

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  2010 £m 2009 £m
A decrease of 2% A decrease of 1% An increase of 1% An increase of 2% A decrease of 2% A decrease of 1% An increase of 1% An increase of 2%
Carrying value of debt securities and derivatives 6,547 2,938 (2,434) (4,481) 5,372 2,422 (2,020) (3,731)
Policyholder liabilities (5,977) (2,723) 2,109 3,929 (5,125) (2,304) 1,905 3,498
Related deferred tax effects (154) (58) 88 149 (69) (33) 32 65
Net sensitivity of profit after tax and shareholders’ equity 416 157 (237) (403) 178 85 (83) (168)

In addition the shareholder-backed portfolio of UK non-linked insurance operations covering liabilities and shareholders' equity includes equity securities and investment property. Excluding any second order effects on the measurement of the liabilities for future cash flows to the policyholder, a fall in their value would have given rise to the following effects on pre-tax profit, profit after tax, and shareholders' equity.

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  2010 £m 2009 £m
A decrease of 20% A decrease of 10% A decrease of 20% A decrease of 10%
Pre-tax profit (302) (151) (292) (146)
Related deferred tax effects 82 41 82 41
Net sensitivity of profit after tax and shareholders’ equity (220) (110) (210) (105)

A 10 or 20 per cent increase in their value would have an approximately equal and opposite effect on profit and shareholders' equity to the sensitivities shown above. The market risk sensitivities shown above reflect the impact of temporary market movements and, therefore, the primary effect of such movements would, in the Group's segmental analysis of profits, be included within the short-term fluctuations in investment returns.

In the equity risk sensitivity analysis given above, the Group has considered the impact of an instantaneous 20 per cent fall in equity markets. If equity markets were to fall by more than 20 per cent, the Group believes that this would not be an instantaneous fall but rather this would be expected to occur over a period of time during which the Group would be able to put in place mitigating management actions.

k Duration of liabilities

With the exception of most unitised with-profits bonds and other whole of life contracts the majority of the contracts of the UK insurance operations have a contract term. However, in effect, the maturity term of contracts reflects the earlier of death, maturity, or lapsation. In addition, with-profits contract liabilities as noted in note D2(g) include projected future bonuses based on current investment values. The actual amounts payable will vary with future investment performance of SAIF and the WPSF.

The tables below show the carrying value of the policyholder liabilities. Separately, the Group uses cash flow projections of expected benefit payments as part of the determination of the value of in-force business when preparing EEV basis results. The tables below also show the maturity profile of the cash flows used for 2010 and 2009 for that purpose for insurance contracts, as defined by IFRS, i.e. those containing significant insurance risk, and investment contracts, which do not.

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  2010 £m
With-profits business Annuity business (Insurance contracts) Other
Insurance contracts Investment contracts Total PAL PRIL Total Insurance contracts Investment contracts Total Total
Policyholder liabilities 43,691 25,613 69,304 12,282 16,442 28,724 11,737 15,765 27,502 125,530
  2010%
Expected maturity:  
0 to 5 years 46 31 40 32 29 30 35 29 32 36
5 to 10 years 25 25 25 25 23 24 26 21 23 24
10 to 15 years 13 19 16 18 17 18 18 20 19 17
15 to 20 years 7 14 10 12 13 12 10 11 11 11
20 to 25 years 4 8 6 7 8 8 6 8 7 7
Over 25 years 5 3 3 6 10 8 5 11 8 5

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  2009 £m
With-profits business Annuity business (Insurance contracts) Other
Insurance contracts Investment contracts Total PAL PRIL Total Insurance contracts Investment contracts Total Total
Policyholder liabilities 40,780 24,780 65,560 11,969 14,292 26,261 10,614 13,794 24,408 116,229
  2009%
Expected maturity:  
0 to 5 years 50 29 41 32 31 32 34 35 35 38
5 to 10 years 26 25 26 25 23 24 25 22 23 25
10 to 15 years 13 19 15 18 17 17 18 19 18 16
15 to 20 years 6 14 9 11 12 12 11 11 11 10
20 to 25 years 3 9 6 7 8 7 7 6 6 6
Over 25 years 2 4 3 7 9 8 5 7 7 5
Notes
  1. The cash flow projections of expected benefit payments used in the maturity profile table above are from value of in-force business and exclude the value of future new business, including vesting of internal pension contracts.
  2. Benefit payments do not reflect the pattern of bonuses and shareholder transfers in respect of the with-profits business.
  3. Investment contracts under Other comprise certain unit-linked and similar contracts accounted for under IAS 39 and IAS 18.
  4. For business with no maturity term included within the contracts, for example with-profits investment bonds such as Prudence Bond, an assumption is made as to likely duration based on prior experience.
  5. 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.

a Summary results and statement of financial position

i Results and movements in shareholders' equity

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  2010 £m 2009(1) £m
Operating profit based on longer-term investment returns 833 618
Short-term fluctuations in investment returns (378) (132)
Profit before shareholder tax 455 486
Tax (117) 102
Profit for the year 338 588

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  2010 £m 2009 £m
Profit for the year (as above) 338 588
Items recognised in other comprehensive income:    
Exchange movements 85 (231)
Unrealised valuation movements on securities classified as available-for-sale:    
Unrealised holding gains arising during the year 1,170 2,249
Less losses included in the income statement 51 420
Total unrealised valuation movements 1,221 2,669
Related change in amortisation of deferred income and acquisition costs (469) (1,069)
Related tax (247) (557)
Total other comprehensive income 563 812
Total comprehensive income for the year 901 1,400
Dividends, interest payments to central companies and other movements (97) (87)
Net increase in equity 804 1,313
Shareholders’ equity at beginning of year 3,011 1,698
Shareholders’ equity at end of year 3,815 3,011

Note

  1. The Group has amended the presentation of operating profit for its US insurance operations to remove the net equity hedge accounting effect (incorporating related amortisation of deferred acquisition costs) and include it in short-term fluctuations. The 2009 comparatives have been amended accordingly. Note A4(d)(ii) explains the effect of the change.

Included within the movements in shareholders' equity is a net increase in value of Jackson's debt securities classified as 'available-for-sale' under IAS 39 of £1,221 million (2009: £2,669 million).

With the exception of debt securities for US insurance operations classified as 'available-for-sale' under IAS 39, unrealised value movements on the Group's investments are booked within the income statement. However, for debt securities classified as 'available-for-sale', unless impaired, fair value movements are recognised in other comprehensive income. Realised gains and losses, including impairments, are recorded in the income statement. This classification is applied for most of the debt securities of the Group's US operations. In 2010, Jackson recorded £124 million (2009: £630 million) of impairment losses arising from:

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  2010 £m 2009 £m
Residential mortgage-backed securities 71 509
Public fixed income 1 91
Other 52 30
  124 630

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, investments in structured securities are subject to a rigorous review of their future estimated cash flows, including expected and stress case scenarios, to identify potential shortfalls in contractual payments (both interest and principal). Impairment charges are recorded on structured securities when the Company forecasts a contractual payment shortfall. Situations where such a shortfall would not lead to a recognition of a loss are rare. However, some structured securities do not have a single determined set of future cash flows and instead, there can be a reasonable range of estimates that could potentially emerge. With this variability, there could be instances where the projected cash flow shortfall under management's base case set of assumptions is so minor that relatively small and justifiable changes to the base case assumptions would eliminate the need for an impairment loss to be recognised. The impairment loss reflects the difference between the fair value and book value.

In 2010, there was a movement in the statement of financial position value for debt securities classified as available-for-sale from a net unrealised gain of £4 million to a net unrealised gain of £1,210 million (2009: net unrealised loss of £2,897 million to a net unrealised gain of £4 million).This increase reflects the effects of tightening credit spreads in the US bond market and lower interest rates. During 2010, the gross unrealised gain in the statement of financial position increased from £970 million at 31 December 2009 to £1,580 million at 31 December 2010 while the gross unrealised loss decreased from £966 million at 31 December 2009 to £370 million at 31 December 2010. Details of the securities in an unrealised loss position are shown in D3(d) below.

These features are included in the table shown below of the movements in the values of available-for-sale securities:

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  2010     2009
  Changes in unrealised appreciation Foreign exchange translation  
Reflected as part of movement in other comprehensive income
£m £m £m £m
  • *Book value represents cost/amortised cost of the debt securities.
  • Debt securities for US operations as included in the statement of financial position of £26,366 million (2009: £22,831 million) comprise £26,325 million (2009: £22,668 million) in respect of securities classified as 'available-for-sale' and £41 million (2009: £163 million) for securities of consolidated investment funds classified as fair value through profit and loss.
  • Translated at the average rate of US$1.55: £1.
Assets fair valued at below book value        
Book value* 4,372     8,220
Unrealised loss (370) 634 (38) (966)
Fair value (as included in statement of financial position) 4,002     7,254
Assets fair valued at or above book value        
Book value* 20,743     14,444
Unrealised gain 1,580 587 23 970
Fair value (as included in statement of financial position) 22,323     15,414
Total        
Book value* 25,115     22,664
Net unrealised gain (loss) 1,210 1,221 (15) 4
Fair value (as included in statement of financial position) 26,325     22,668
Reflected as part of movement in other comprehensive income        
Movement in unrealised appreciation 1,221     2,669
Exchange movements (15)     232
  1,206     2,901

Included within the movement in gross unrealised losses for the debt securities of Jackson of £634 million (2009: £1,925 million) as shown above was a net increase in value of £84 million (2009: £72 million decrease) relating to the sub-prime and Alt-A securities as referred to in section B6.

ii Statement of financial position

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    US insurance operations
Variable annuity separate account assets and liabilities
note i
£m
Fixed annuity, GIC and other business
note i
£m
2010
Total
£m
2009
Total
£m
Assets    
Intangible assets attributable to shareholders:    
Deferred acquisition costs and other intangible assets 3,543 3,543 3,092
Total 3,543 3,543 3,092
Deferred tax assets 1,391 1,391 1,944
Other non-investment and non-cash assets 1,241 1,241 1,404
Investments of long-term business and other operations:    
Investment properties 26 26 33
Financial investments:    
Loansnote ii 4,201 4,201 4,319
Equity securities and portfolio holdings in unit trustsnote v 31,203 298 31,501 20,984
Debt securitiesnote D3d 26,366 26,366 22,831
Other investmentsnote iii 1,199 1,199 955
Deposits 212 212 454
Total investmentsnote G 31,203 32,302 63,505 49,576
Properties held for sale 3 3 3
Cash and cash equivalents 232 232 340
Total assets 31,203 38,712 69,915 56,359
Equity and liabilities    
Equity    
Shareholders’ equity 3,815 3,815 3,011
Total equity 3,815 3,815 3,011
Liabilities    
Policyholder liabilities:note iv    
Contract liabilities (including amounts in respect of contracts classified as investment contracts under IFRS 4) 31,203 29,320 60,523 48,311
Total 31,203 29,320 60,523 48,311
Core structural borrowings of shareholder-financed operations 159 159 154
Operational borrowings attributable to shareholder-financed operations 90 90 203
Deferred tax liabilities 1,776 1,776 1,858
Other non-insurance liabilities 3,552 3,552 2,822
Total liabilities 31,203 34,897 66,100 53,348
Total equity and liabilities 31,203 38,712 69,915 56,359
Notes
  1. Assets and liabilities attaching to variable annuity business that are not held in the separate account are shown within other business.
  2. Loans

    The loans of the Group's US insurance operations of £4,201 million (2009: £4,319 million) comprise mortgage loans of £3,641 million (2009: £3,774 million), policy loans of £548 million (2009: £530 million) and other loans of £12 million (2009: £15 million). All of the mortgage loans are commercial mortgage loans which are collateralised by properties. The property types are mainly industrial, multi-family residential, suburban office, retail and hotel. The breakdown by property type is as follows:

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      2010 % 2009 %
    Industrial 31 32
    Multi-family residential 18 18
    Office 19 20
    Retail 21 19
    Hotels 10 10
    Other 1 1
      100 100

    The US insurance operations' commercial mortgage loan portfolio does not include any single-family residential mortgage loans and is therefore not exposed to the risk of defaults associated with residential sub-prime mortgage loans. The average loan size is £6.6 million (2009: £6.3 million). The portfolio has a current estimated average loan to value of 73 per cent (2009: 74 per cent) which provides significant cushion to withstand substantial declines in value.

    The policy loans are fully secured by individual life insurance policies or annuity policies. These loans are accounted for at amortised cost, less any impairment.

  3. Other investments comprise:

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      2010 £m 2009 £m
    • *In the US, Prudential uses derivatives to reduce interest rate risk, to facilitate efficient portfolio management to match liabilities under annuity policies, and for certain equity-based product management activities. After taking account of the derivative liability of £799 million (2009: £461 million), which is also included in the statement of financial position, the derivative position for US operations is a net liability of £154 million (2009: net asset of £58 million).
    • Partnerships in investment pools and other comprise primarily investments in limited partnerships. These include interest in the PPM America Private Equity Fund and diversified investments in 161 (2009: 159) other partnerships by independent money managers that generally invest in various equities and fixed income loans and securities.
    Derivative assetsnote G3* 645 519
    Partnerships in investment pools and other 554 436
      1,199 955
  4. Summary policyholder liabilities (net of reinsurance) and reserves at 31 December 2010

    The policyholder liabilities, net of reinsurers' share of £694 million (2009: £667 million), reflect balances in respect of the following:

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      2010 £m 2009 £m
    Policy reserves and liabilities on non-linked business:    
    Reserves for future policyholder benefits and claims payable 1,567 1,645
    Deposits on investment contracts (as defined under IFRS ‘grandfathered’ US GAAP) 25,494 23,706
    Guaranteed investment contracts 1,565 1,654
    Unit-linked (variable annuity) business 31,203 20,639
      59,829 47,644

    In addition to the policyholder liabilities above, Jackson has entered into a programme of funding arrangements under contracts which, in substance, are almost identical to GICs. The liabilities under these funding arrangements totalled £1,411 million (2009: £1,444 million) and are included in 'other non-insurance liabilities' in the statement of financial position above.

  5. Equity securities and portfolio holdings in unit trusts include investments in mutual funds, the majority of which are equity based.

b Reconciliation of movement in investments

A reconciliation of the total investments of US insurance operations from the beginning of the year to the end of the year is as follows:

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  Variable annuity separate account assets and liabilities
£m
Fixed annuity, GIC and other business
£m
US insurance operations
Total

£m
At 1 January 2009      
Total investments (including derivative assets) 14,538 31,633 46,171
Less: Derivative liabilities (863) (863)
Directly held investments, net of derivative liabilities 14,538 30,770 45,308
Net cash inflow (outflow) from operating activities 4,050 (1,295) 2,755
Realised losses in the year (529) (529)
Unrealised gains and losses and exchange movements in the year 2,051 (470) 1,581
Movement in the year of directly held investments, net of derivative liabilities 6,101 (2,294) 3,807
At 31 December 2009/1 January 2010      
Total investments (including derivative assets) 20,639 28,937 49,576
Less: Derivative liabilitiesnote G3 (461) (461)
Directly held investments, net of derivative liabilities 20,639 28,476 49,115
Net cash inflow from operating activities 6,441 865 7,306
Realised gains in the year 21 21
Unrealised gains and losses and exchange movements in the year 4,123 2,141 6,264
Movement in the year of directly held investments, net of derivative liabilities 10,564 3,027 13,591
At 31 December 2010      
Total investments (including derivative assets) 31,203 32,302 63,505
Less: Derivative liabilitiesnote G3 (799) (799)
Directly held investments, net of derivative liabilities 31,203 31,503 62,706

c Reconciliation of movement in policyholder liabilities

A reconciliation of the total policyholder liabilities of US insurance operations from the beginning of the year to the end of the year is as follows:

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  Variable annuity separate account liabilities
£m
Fixed annuity, GIC and other business
£m
US insurance operations
Total

£m
At 1 January 2009 14,538 30,823 45,361
Premiums 4,667 4,510 9,177
Surrenders (882) (2,373) (3,255)
Maturities/Deaths (199) (534) (733)
Net flowsnote b 3,586 1,603 5,189
Transfers from general to separate account 984 (984)
Investment-related items and other movementsnote c 3,368 (382) 2,986
Foreign exchange translation differencesnote a (1,837) (3,388) (5,225)
At 31 December 2009/1 January 2010 20,639 27,672 48,311
Premiums 7,420 4,315 11,735
Surrenders (1,403) (2,195) (3,598)
Maturities/Deaths (259) (510) (769)
Net flowsnote b 5,758 1,610 7,368
Transfers from general to separate account 1,411 (1,411)
Investment-related items and other movementsnote c 2,875 589 3,464
Foreign exchange translation differencesnote a 520 860 1,380
At 31 December 2010 31,203 29,320 60,523
Average policyholder liabilities      
2010 25,921 28,496 54,417
2009 17,589 29,248 46,837
Notes
  1. Movements in the year have been translated at an average rate of 1.55 (2009: 1.57). The closing balance has been translated at closing rate of 1.57 (2009: 1.61). Differences upon retranslation are included in foreign exchange translation differences of £1,380 million (2009: £5,225 million).
  2. Net flows for the year were £7,368 million compared with £5,189 million in 2009, driven largely by increased new business volumes for the variable annuity business.
  3. Positive investment-related items and other movements in variable annuity separate account liabilities of £2,875 million in 2010 and £3,368 million in 2009 represent increases in the US equity market during the respective periods. Fixed annuity, GIC and other business investment and other movements primarily reflects the movement in the valuation of the product guarantees and interest credited to policyholder accounts. In 2010, interest credited exceeded the small reduction in the guarantee valuation to give an overall increase in liabilities. In 2009, there was a more significant fall in the valuation of guarantees.

d Information on credit risks of debt securities

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Summary 2010 £m 2009 £m
Carrying value Carrying value
Corporate and government security and commercial loans:    
Government 2,440 379
Publicly traded and SEC Rule 144A securities 14,747 12,959
Non-SEC Rule 144A securities 3,044 3,117
Total 20,231 16,455
Residential mortgage-backed securities 2,784 3,316
Commercial mortgage-backed securities 2,375 2,104
Other debt securities 976 956
Total debt securities 26,366 22,831

i Credit quality

For statutory reporting in the US, debt securities are classified into six quality categories specified by the Securities Valuation Office of the National Association of Insurance Commissioners (NAIC). The categories range from Class 1 (the highest) to Class 6 (the lowest). Performing securities are designated as Classes 1 to 5. Securities in or near default are designated Class 6. Securities designated as Class 3, 4, 5 and 6 are non-investment grade securities. Generally, securities rated AAA to A by nationally recognised statistical ratings organisations are reflected in Class 1, BBB in Class 2, BB in Class 3 and B and below in Classes 4 to 6. If a designation is not currently available from the NAIC, Jackson's investment adviser, PPM America, provides the designation for the purposes of disclosure below.

The following table shows the quality of the publicly traded and non-SEC Rule 144A debt securities by NAIC classifications:

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  2010 2009
Carrying value Carrying value
£m % of total £m % of total
NAIC designation:    
1 5,338 36 4,688 36
2 8,550 58 7,508 58
3 644 5 598 5
4 201 1 122 1
5 11 40
6 3 3
  14,747 100 12,959 100

The following table shows the quality of the non-SEC Rule 144A private placement portfolio by NAIC classifications:

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  2010 2009
Carrying value Carrying value
£m % of total £m % of total
NAIC designation:    
1 1,125 37 1,084 35
2 1,772 58 1,792 57
3 114 4 162 5
4 18 1 54 2
5 13 20 1
6 2 5
  3,044 100 3,117 100

Included within other debt securities of £976 million (2009: £956 million) in the summary shown above are £723 million (2009: £652 million) of asset-backed securities held directly by Jackson, of which £527 million (2009: £447 million) were NAIC designation 1 and £135 million (2009: £152 million) NAIC designation 2. In addition, other debt securities includes £211 million (2009: £172 million) in respect of securities held by the Piedmont trust entity and £42 million (2009: £132 million) from the consolidation of investment funds managed by PPM America.

In addition to the ratings disclosed above, the following table summarises by rating the debt securities, as at 31 December 2010 using Standard and Poor's (S&P), Moody's, Fitch and implicit ratings of mortgage-backed securities (MBS) based on NAIC valuations:

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  2010 £m 2009 £m
  Carrying value Carrying value
S&P – AAA 4,187 3,287
S&P – AA+ to AA– 801 846
S&P – A+ to A– 5,156 5,192
S&P – BBB+ to BBB– 8,202 7,659
S&P – Other 866 895
  19,212 17,879
Moody’s – Aaa 34 273
Moody’s – Aa1 to Aa3 32 43
Moody’s – A1 to A3 36 32
Moody’s – Baa1 to Baa3 73 64
Moody’s – Other 135 57
  310 469
Implicit ratings of MBS based on NAIC valuations (see below)    
NAIC 1 3,083 747
NAIC 2 181 105
NAIC 3-6 232 473
  3,496 1,325
Fitch 176 281
Other* 3,172 2,877
Total debt securities 26,366 22,831
  • *The amounts within Other which are not rated by S&P, Moody's, Fitch nor are MBS securities using the revised regulatory ratings have the following NAIC classifications:

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  2010 £m 2009 £m
NAIC 1 1,193 1,102
NAIC 2 1,849 1,623
NAIC 3-6 130 152
  3,172 2,877

In the table above, with the exception of some residential mortgage-backed securities and commercial mortgage-backed securities for 2010, and for residential mortgage-backed securities for 2009, commercial mortgage-backed securities S&P ratings have been used where available. For securities where S&P ratings are not immediately available, those produced by Moody's and then Fitch have been used as an alternative. During 2009, the NAIC in the US revised the regulatory ratings process for more than 20,000 residential mortgage-backed securities. In addition, in 2010, the NAIC expanded the revised process to include commercial mortgage-backed securities. The table above includes these securities, where held by Jackson, using the regulatory rating levels established by external third parties (PIMCO for residential mortgage-backed securities and BlackRock Solutions for commercial mortgage-backed securities).

ii Determining the fair value of debt securities when the markets are not active

Under IAS 39, unless categorised as 'held to maturity' or 'loans and receivables' debt securities are required to be fair valued. Where available, quoted market prices are used. However, where securities do not have an externally quoted price based on regular trades or are quoted in markets that are no longer active as a result of market conditions, IAS 39 requires that valuation techniques be applied. Note G1 sets out further details of the Group's approach to determining fair value and classifies these fair values into a three level hierarchy as required by IFRS 7. At 31 December 2010, 0.3 per cent of Jackson's debt securities were classified as level 3 (2009: three per cent) comprising fair values where there are significant inputs which are not based on observable market data.

iii Asset-backed securities funds exposures

Included within the debt securities of Jackson at 31 December 2010 are exposures to asset-backed securities as follows:

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  2010 £m 2009 £m
  • *Including Group's economic interest in Piedmont and other consolidated CDO funds.
  • MBS ratings refer to the rating implicit within NAIC risk-based capital valuation (see D3(i)).
RMBS Sub-prime (31 Dec 2010: 40% AAA, 11% AA) 224 194
Alt-A (31 Dec 2010: 15% AAA, 6% AA) 415 443
Prime including agency (31 Dec 2010: 79% AAA, 2% AA) 2,145 2,679
CMBS (31 Dec 2010: 36% AAA, 15% AA) 2,375 2,104
CDO funds (31 Dec 2010: 4% AAA, 4% AA)*, including £1 million exposure to sub-prime 162 79
ABS (31 Dec 2010: 26% AAA, 20% AA), including £37 million exposure to sub-prime 814 877
  6,135 6,376

Jackson defines its exposure to sub-prime mortgages as investments in residential mortgage-backed securities in which the underlying borrowers have a US Fair Isaac Credit Organisation (FICO) credit score of 680 or lower.

iv Debt securities classified as available-for-sale in an unrealised loss position

The following tables show some key attributes of those securities that are in an unrealised loss position at 31 December 2010.

a Fair value of securities as a percentage of book value

The unrealised losses in Jackson's statement of financial position on unimpaired securities are £370 million (2009: £966 million). This relates to assets with fair market value and book value of £4,002 million (2009: £7,254 million) and £4,372 million (2009: £8,220 million) respectively.

The following table shows the fair value of the debt securities in a gross unrealised loss position for various percentages of book value at 31 December:

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Fair value of securities as a percentage of book value 2010 £m 2009 £m
Fair value Unrealised loss Fair value Unrealised loss
Between 90% and 100% 3,390 (102) 5,127 (169)
Between 80% and 90% 273 (44) 1,201 (203)
Below 80%note d 339 (224) 926 (594)
Total 4,002 (370) 7,254 (966)

Included within the table above are amounts relating to sub-prime and Alt-A securities of:

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Fair value of securities as a percentage of book value 2010 £m 2009 £m
Fair value Unrealised loss Fair value Unrealised loss
Between 90% and 100% 98 (6) 102 (3)
Between 80% and 90% 55 (9) 160 (28)
Below 80%note d 56 (25) 159 (88)
Total 209 (40) 421 (119)

b Unrealised losses by maturity of security

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  2010 £m 2009 £m
Unrealised loss Unrealised loss
Less than 1 year
1 to 5 years (6) (29)
5 to 10 years (47) (127)
More than 10 years (49) (92)
Mortgage-backed and other debt securities (268) (718)
Total (370) (966)

c Age analysis of unrealised losses for the years indicated

The following table shows the aged analysis for all the unrealised losses in the portfolio by reference to the length of time the securities have been in an unrealised loss position:

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  2010 £m 2009 £m
Non– investment grade Investment grade Total Non– investment grade Investment grade Total
Less than 6 months (3) (67) (70) (7) (51) (58)
6 months to 1 year (2) (2) (25) (59) (84)
1 year to 2 years (13) (20) (33) (59) (234) (293)
2 years to 3 years (27) (55) (82) (125) (199) (324)
More than 3 years (58) (125) (183) (35) (172) (207)
  (103) (267) (370) (251) (715) (966)

At 31 December 2010, the gross unrealised losses in the statement of financial position for the sub-prime and Alt-A securities in an unrealised loss position were £40 million (2009: £119 million), as shown above in note (a). Of these losses £1 million (2009: £21 million) relate to securities that have been in an unrealised loss position for less than one year and £39 million (2009: £98 million) to securities that have been in an unrealised loss position for more than one year.

d Securities whose fair value were below 80 per cent of the book value

As shown in the table (a) above, £224 million of the £370 million of gross unrealised losses at 31 December 2010 (2009: £594 million of the £966 million of gross unrealised losses) related to securities whose fair values were below 80 per cent of the book value. The analysis of the £224 million, (2009: £594 million) by category of debt securities and by age analysis indicating the length of time for which their fair value was below 80 per cent of the book value, are as follows:

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Category analysis 2010 £m 2009 £m
Fair
value
Unrealised
loss
Fair
value
Unrealised
loss
Residential mortgage-backed securities    
Prime (including agency) 88 (39) 322 (153)
Alt-A 15 (4) 77 (33)
Sub-prime 41 (20) 82 (55)
  144 (63) 481 (241)
Commercial mortgage-backed securities 8 (29) 87 (86)
Other asset-backed securities 123 (105) 183 (188)
Total structured securities 275 (197) 751 (515)
Corporates 64 (27) 175 (79)
Total 339 (224) 926 (594)

Age analysis of fair value being below 80 per cent for the period indicated:

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Age analysis 2010 £m 2009 £m
Fair
value
Unrealised
loss
Fair
value
Unrealised
loss
Less than 3 months (1) 153 (45)
3 months to 6 months 5 (3)
More than 6 months 339 (223) 768 (546)
  339 (224) 926 (594)

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 2010, interest-sensitive fixed annuities accounted for 19 per cent (2009: 24 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 policyholder of an interest-sensitive fixed annuity pays Jackson a premium, which is credited to the policyholder's account. Periodically, interest is credited to the policyholder's account and in some cases administrative charges are deducted from the policyholder's account. Jackson makes benefit payments at a future date as specified in the policy based on the value of the policyholder's account at that date.

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 (2009: 1.5 per cent to 5.5 per cent) depending on the jurisdiction of issue and the date of issue, with 78 per cent (2009: 82 per cent) of the fund at three per cent or less. The average guarantee rate is 3.1 per cent (2009: 3.1 per cent).

Approximately 45 per cent (2009: 61 per cent) of the interest-sensitive fixed annuities Jackson wrote in 2010 provide for a market value adjustment, that could be positive or negative, on surrenders in the surrender period of the policy. This formula-based 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.

Fixed indexed annuities

Fixed indexed annuities accounted for 9 per cent (2009: 10 per cent) of Jackson's policy and contract liabilities at 31 December 2010. Fixed indexed annuities vary in structure, but generally are deferred annuities that enable policyholders to obtain a portion of an equity-linked return (based on participation rates and caps) but provide a guaranteed minimum return. These guaranteed minimum rates are generally set at 1.25 to 3 per cent.

Jackson hedges the equity return risk on fixed indexed products using futures and options linked to the relevant index as well as through offsetting equity exposure in the VA product. The cost of these hedges is taken into account in setting the index participation rates or caps. Jackson bears the investment and surrender risk on these products.

Immediate annuities

At 31 December 2010, immediate annuities accounted for two per cent (2009: two per cent) of Jackson's policy and contract liabilities. Immediate annuities guarantee a series of payments beginning within a year of purchase and continuing over either a fixed period of years and/or the life of the policyholder. If the term is for the life of the policyholder, then Jackson's primary risk is mortality risk. The implicit interest rate on these products is based on the market conditions that exist at the time the policy is issued and is guaranteed for the term of the annuity.

ii Variable annuities

At 31 December 2010, VAs accounted for 58 per cent (2009: 49 per cent) of Jackson's policy and contract liabilities. VAs are deferred annuities that have the same tax advantages and payout options as interest-sensitive and fixed indexed annuities.

The primary differences between VAs and interest-sensitive or fixed indexed annuities are investment risk and return. If a policyholder chooses a VA, the rate of return depends upon the performance of the selected fund portfolio. Policyholders may allocate their investment to either the fixed or variable account. Investment risk on the variable account is borne by the policyholder, while investment risk on the fixed account is borne by Jackson through guaranteed minimum fixed rates of return. At 31 December 2010, approximately 12 per cent (2009: approximately 14 per cent) of VA funds were in fixed accounts.

Jackson issues VA contracts where it contractually guarantees to the contractholder either a) return of no less than total deposits made to the contract adjusted for any partial withdrawals, b) total deposits made to the contract adjusted for any partial withdrawals plus a minimum return, or c) the highest contract value on a specified anniversary date adjusted for any withdrawals following the contract anniversary. These guarantees include benefits that are payable in the event of death (guaranteed minimum death benefit (GMDB)), annuitisation (guaranteed minimum income benefit (GMIB)), or at specified dates during the accumulation period (guaranteed minimum withdrawal benefit (GMWB)) and guaranteed minimum accumulation benefit (GMAB). Jackson hedges these risks using equity options and futures contracts as described in note D3(f). The GMIB is no longer offered, with existing coverage being reinsured.

iii Life insurance

Jackson's life insurance products accounted for seven per cent (2009: nine per cent) of Jackson's policy and contract liabilities at 31 December 2010. The products offered include variable universal life insurance, term life insurance and interest-sensitive life insurance.

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 2010, institutional products accounted for five per cent of policy and contract liabilities (2009: six 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 less than one per cent (2009: one per cent) of total policyholder reserves.

Medium-term note funding agreements are generally issued to support trust instruments issued on non-US exchanges or to qualified investors (as defined by SEC Rule 144A). Through the funding agreements, Jackson agrees to pay a rate of interest, which may be fixed or floating, to the holders of the trust instruments.

f Exposure to market risk and risk management

Jackson's main exposures are to market risk through its exposure to interest rate risk and equity risk. Approximately 91 per cent (2009: 90 per cent) of its general account investments support interest-sensitive and fixed indexed annuities, life business and surplus and nine per cent (2009: ten per cent) support institutional business. All of these types of business contain considerable interest rate guarantee features and, consequently, require that the assets that support them are primarily fixed income or fixed maturity.

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 connection with its VA contracts; and
  • the risk of loss related to meeting contractual accumulation requirements in FIA contracts.

Jackson enters into financial derivative transactions, including those noted below to reduce and manage business risks. These transactions manage the risk of a change in the value, yield, price, cash flows, or quantity of, or a degree of exposure with respect to assets, liabilities or future cash flows, which Jackson has acquired or incurred.

Jackson uses free-standing derivative instruments for hedging purposes. Additionally, certain liabilities, primarily trust instruments supported by funding agreements, fixed indexed annuities, certain GMWB variable annuity features and reinsured GMIB variable annuity features contain embedded derivatives as defined by IAS 39, 'Financial Instruments: Recognition and Measurement'. Jackson does not account for such derivatives as either fair value or cash flow hedges as might be permitted if the specific hedge documentation requirements of IAS 39 were followed. Financial derivatives, including derivatives embedded in certain host liabilities that have been separated for accounting and financial reporting purposes are carried at fair value.

Value movements on the derivatives are reported within the income statement. In preparing Jackson's segment profit as shown in note B1, value movements on Jackson's derivative contracts, are included within short-term fluctuations in investment returns and excluded from operating results based on longer-term investment returns (defined as segment profit). The types of derivatives used by Jackson and their purpose are as follows:

  • interest rate swaps generally involve the exchange of fixed and floating payments over the period for which Jackson holds the instrument without an exchange of the underlying principal amount. These agreements are used for hedging purposes;
  • put-swaption contracts provide the purchaser with the right, but not the obligation, to require the writer to pay the present value of a long-duration interest rate swap at future exercise dates. Jackson purchases and writes put-swaptions with maturities up to 10 years. Put-swaptions hedge against significant movements in interest rates;
  • equity index futures contracts and equity index options (including various call and put options and put spreads) are used to hedge Jackson's obligations associated with its issuance of fixed indexed immediate and deferred annuities and certain VA guarantees. These annuities and guarantees contain embedded options which are fair valued for financial reporting purposes;
  • total return swaps in which Jackson receives equity returns or returns based on reference pools of assets in exchange for short-term floating rate payments based on notional amounts, are held for both hedging and investment purposes;
  • cross-currency swaps, which embody spot and forward currency swaps and additionally, in some cases, interest rate swaps and equity index swaps, are entered into for the purpose of hedging Jackson's foreign currency denominated funding agreements supporting trust instrument obligations;
  • spread cap options are used as a macro-economic hedge against declining short-term interest rates. Jackson receives quarterly settlements based on the spread between the two-year and the 10-year constant maturity swap rates in excess of a specified spread; and
  • credit default swaps, represent agreements under which Jackson has purchased default protection on certain underlying corporate bonds held in its portfolio. These contracts allow Jackson to sell the protected bonds at par value to the counterparty if a defined default event occurs in exchange for periodic payments made by Jackson for the life of the agreement.

Note D3(j) parts (iii) and (iv) show the sensitivities of Jackson's results through its exposure to equity risk and interest rate risk.

g Process for setting assumptions and determining contract liabilities

Under the MSB of reporting applied under IFRS 4 for insurance contracts, providing the requirements of the Companies Act, UK GAAP standards and the ABI SORP are met, it is permissible to reflect the previously applied UK GAAP basis. Accordingly, and consistent with the basis explained in note A4, in the case of Jackson the carrying values of insurance assets and liabilities are consolidated into the Group accounts based on US GAAP.

Under US GAAP, investment contracts (as defined for US GAAP purposes) are accounted for by applying in the first instance a retrospective deposit method to determine the liability for policyholder benefits. This is then augmented by potentially three additional amounts. These amounts are for:

  • any amounts that have been assessed to compensate the insurer for services to be performed over future periods (i.e. deferred income);
  • any amounts previously assessed against policyholders that are refundable on termination of the contract; and
  • any probable future loss on the contract (i.e. premium deficiency).

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.

VA contracts written by Jackson may, as described above, provide for GMDB, GMIB, GMWB and GMAB features. In general terms, liabilities for these benefits are accounted for under US GAAP by using estimates of future benefits and fees under best estimate persistency assumptions.

In accordance with US GAAP, the grandfathered basis for IFRS, which specifies how certain guarantee features should be accounted for the GMDB and certain 'for life' GMWB liabilities are not fair valued but are instead determined each period end by estimating the expected value of benefits in excess of the projected account balance and recognising the excess ratably over the life of the contract based on total expected assessments. At 31 December 2010, these liabilities were valued using a series of deterministic investment performance scenarios, a mean investment return of 8.4 per cent (2009: 8.4 per cent) and assumptions for lapse, mortality and expense that are the same as those used in amortising the capitalised acquisition costs.

The direct GMIB liability is determined by estimating the expected value of the annuitisation benefits in excess of the projected account balance at the date of annuitisation and recognising the excess ratably over the accumulation period based on total expected assessments.

The assumptions used for calculating the direct GMIB liability at 31 December 2010 and 2009 are consistent with those used for calculating the GMDB and 'for life' GMWB liabilities. The change in these reserves, along with claim payments and associated fees included in reserves are included along with the hedge results in short-term fluctuations, resulting in removal of the market impact from the operating profit based on longer-term investment returns.

Jackson regularly evaluates estimates used and adjusts the additional GMDB and GMIB liability balances, with a related charge or credit to benefit expense, if actual experience or other evidence suggests that earlier assumptions should be revised.

GMIB benefits are essentially fully reinsured, subject to annual claim limits. As this reinsurance benefit is net settled, it is considered to be a derivative under IAS 39 and is, therefore, recognised at fair value with the change in fair value included as a component of short-term derivative fluctuations.

GMWB 'not for life' 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 short-term fluctuations.

For GMWB and GMIB reinsurance embedded derivatives that are fair valued under IAS 39, Jackson bases its volatility assumptions solely on implied market volatility with no reference to historical volatility levels and explicitly incorporates Jackson's own credit risk in determining discount rates.

Volatility assumptions are based on a weighting of available market data on implied volatility for durations up to ten years, at which point the projected volatility is held constant. Non-performance risk is incorporated into the calculation through the use of discount interest rates sourced from a AA corporate credit curve. Other risk margins, particularly for market illiquidity and policyholder behaviour are also incorporated into the model through the use of explicitly conservative assumptions. On a periodic basis, Jackson rationalises the resulting fair values based on comparisons to other models and market movements.

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 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.

Institutional products are accounted for as investment contracts under IFRS with the liability classified as being in respect of financial instruments rather than insurance contracts, as defined by IFRS 4. In practice, there is no material difference between the IFRS and US GAAP basis of recognition and measurement for these contracts.

Certain institutional products representing obligations issued in currencies other than US dollars have been hedged for changes in exchange rates using cross-currency swaps. The fair value of derivatives embedded in funding agreements, as well as foreign currency transaction gains and losses, are included in the carrying value of the trust instruments supported by funding agreements recorded in other non-insurance liabilities.

Deferred acquisition costs

Under IFRS 4, the Group applies grandfathered US GAAP for measuring the insurance assets and liabilities of Jackson. In the case of Jackson term business, acquisition costs are deferred and amortised in line with expected premiums. For annuity and interest-sensitive life business, acquisition costs are deferred and amortised in line with a combination of historical and future expected gross profits on the relevant contracts. For fixed and indexed annuity and interest-sensitive life business, the key assumption is the long-term spread between the earned rate on investments and the rate credited to policyholders, which is based on an annual spread analysis. Expected gross profits also depend on mortality assumptions, assumed unit costs and terminations other than deaths (including the related charges), all of which are based on a combination of actual experience of Jackson, industry experience and future expectations. A detailed analysis of actual mortality, lapse, and expense experience is performed using internally developed experience studies.

As with fixed and indexed annuity and interest-sensitive life business, acquisition costs for Jackson's variable annuity products are amortised in line with the emergence of profits. The measurement of the amortisation in part reflects current period fees (including those for guaranteed minimum death, income, or withdrawal benefits) earned on assets covering liabilities to policyholders, and the historical and expected level of future gross profits which depends on the assumed level of future fees, as well as components related to mortality, lapse, and expense.

Under US GAAP (as grandfathered under IFRS 4) the projected gross profits reflect an assumed long-term level of equity return which, for Jackson, is 8.4 per cent after deduction of net external fund management fees. This is applied to the period end level of separate account equity assets after application of a mean reversion technique that removes a portion of the effect of levels of short-term variability in current market returns. Under the mean reversion technique applied by Jackson, the projected level of return for each of the next five years is adjusted from period to period so that in combination with the actual rates of return for the preceding two years and the current year, the 8.4 per cent annual return is realized on average over the entire eight year period. Projected returns after the mean reversion period revert back to the 8.4 per cent target. A capping feature, which currently applies due to the very sharp market falls in 2008, is that the projected rates of return for the next five years can be no more than 15 per cent (gross of asset management fee) per annum. If Jackson had not applied the mean reversion methodology and had instead applied a constant 8.4 per cent annual return from today's asset values, the Jackson DAC balance of £3,543 million would fall approximately £80 million to £3,463 million at 31 December 2010.

The amortisation charge to the income statement is reflected in operating profit and short-term fluctuations in investment returns. The amortisation charge to the operating profit in a reporting period will incorporate an element of acceleration or deceleration that reflects the variance between the actual level of return attained and the assumed level in the mean reversion calculation. In 2010, the element of DAC amortisation charge included in operating profit includes £11 million of accelerated amortisation. This amount reflects actual separate account return shortfalls in the periods compared with the assumed level of 15 per cent for the year. For 2009, reflecting the excess of actual separate account returns over the 15 per cent assumed level, the operating profit incorporates a credit for decelerated amortisation of £39 million.

For 2010, the separate account return (gross of asset management fees) was approximately 13 per cent. In 2011, while the capping feature is in effect, each one per cent divergence of the actual separate account return below or above the assumed return of 15 per cent is estimated to give rise to accelerated or decelerated amortisation, respectively, of approximately £6 million (£3 million if the projected rate falls below the 15 per cent cap).

In the absence of significant market declines between now and the end of 2011, Jackson would expect to see higher amortisation levels than normal in 2011. This would essentially represent a reversal of the mean reversion benefits to date, as at that point highly negative returns from 2008 will no longer be included in the mean reverting return calculation.

Statement of changes in equity – 'shadow DAC adjustments'

Consequent upon the positive unrealised valuation movement in 2010 of £1,221 million (2009: positive £2,669 million) there is a debit of £496 million (2009: £1,069 million debit) for altered 'shadow' amortisation booked within other comprehensive income. These adjustments reflect movement from period to period, in the changes to the pattern of reported gross profits that would have happened if the assets reflected in the statement of financial position had been sold, crystallising the unrealised gains or losses, and the proceeds reinvested at the yields currently available in the market. At 31 December 2010 the cumulative 'shadow DAC balance' was negative £520 million (2009: negative £10 million).

h Reinsurance

The principal reinsurance ceded by Jackson outside the Group is on term life insurance, direct and assumed accident and health business and GMIB variable annuity guarantees. In 2010, the premiums for such ceded business amounted to £83 million (2009: £82 million). Net commissions received on ceded business and claims incurred ceded to external reinsurers totalled £12 million and £72 million respectively, during 2010 (2009: £12 million and £66 million respectively). There were no deferred gains or losses on reinsurance contracts in either 2010 or 2009. The reinsurance asset for business ceded outside the Group was £694 million (2009: £667 million).

i Effect of changes in assumptions used to measure insurance assets and liabilities

2010

There are no changes of assumptions that had a material impact on the 2010 results of US insurance operations.

Separately, in 2010, the Group amended its presentation of operating profit for its US insurance operations to exclude the net equity hedge accounting effect of negative £367 million (2009: negative £159 million) relating to its variable and fixed index annuity business and reclassified it as a short-term fluctuation within the Group's supplementary analysis of profit. This is explained further in note A4(d)(ii). This change had no effect on the measurement of insurance assets and liabilities and therefore on total profit or shareholders' equity.

2009

Measurement basis for embedded derivatives of variable annuity business and other policyholder liability

Certain variable annuity products sold by Jackson include Guaranteed Minimum Withdrawal Benefits (GMWB) with lifetime benefits which, in accordance with the Group's accounting policies, are measured within the IFRS balance sheet at fair value. This requires a number of assumptions related to projected future cash flows, including those driven by policyholder behaviours such as lapses, fund selections and withdrawals utilisation.

During 2009 the GMWB utilisation assumptions were revised to take account of the more recent experience of policyholder behaviour. Previously policyholder behaviour for the utilisation of GMWB was assumed to be largely driven by the extent to which benefits were 'in the money'. For 2009, the assumption has been altered to take account of recent experience which shows that the attained age of the policyholder is the key factor in determining utilisation levels. This has led to a release in policyholder liabilities of £96 million which is offset by a corresponding DAC amortisation charge of £68 million to give an overall impact on profit before tax of £28 million. This assumption change has been offset by sundry other assumption changes such that the overall impact on operating profit of policyholder liability assumption changes, after taking into account DAC amortisation offsets, is a charge of £4 million. 2010 has been prepared on a consistent basis to 2009.

j Sensitivity of IFRS basis profit and equity to market and other risks

i Currency fluctuations

Consistent with the Group's accounting policies, the profits of the Group's US operations are translated at average exchange rates and shareholders' equity at the closing rate for the reporting period. For 2010, the rates were US$1.55 (2009: US$1.57) and US$1.57 (2009: US$1.61) to £1 sterling, respectively. A 10 per cent increase or decrease in these rates would reduce or increase profit (loss) before tax attributable to shareholders, profit (loss) for the year and shareholders' equity attributable to US insurance operations respectively as follows:

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  A 10% increase in exchange rates A 10% decrease in exchange rates
2010 £m 2009 £m 2010 £m 2009 £m
Profit (loss) before tax attributable to shareholders note i (41) (44) 50 54
Profit (loss) for the year (31) (54) 37 65
Shareholders’ equity attributable to US insurance operations (347) (274) 424 335
Note
  1. Sensitivity on profit (loss) before tax i.e. aggregate of the operating profit based on longer-term investment returns and short-term fluctuations, as discussed in note B1.

ii Other sensitivities

The principal determinants of variations in operating profit based on longer-term returns are:

  • growth in the size of assets under management covering the liabilities for the contracts in force;
  • variations in fees and other income, offset by variations in market value adjustment payments and, where necessary, strengthening of liabilities;
  • spread returns for the difference between investment returns and rates credited to policyholders; and
  • amortisation of deferred acquisition costs.

For term business, acquisition costs are deferred and amortised in line with expected premiums. For annuity business, acquisition costs are deferred and amortised in line with expected gross profits on the relevant contracts. For interest-sensitive business, the key assumption is the expected long-term spread between the earned rate and the rate credited to policyholders, which is based on an annual spread analysis. In addition, expected gross profits depend on mortality assumptions, assumed unit costs and terminations other than deaths (including the related charges) all of which are based on a combination of actual experience of Jackson, industry experience and future expectations.

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 2010 and 2009 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 benefits. 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. The projected rates of return are capped at no more than 15 per cent for each of the next five years. Further details are explained in note D3(g) above.

Except to the extent of mortality experience, which primarily affects profits through variations in claim payments and GMDB reserves, the profits of Jackson are relatively insensitive to changes in insurance risk.

iii Exposure to equity risk

Variable annuity contracts related

Jackson issues variable annuity contracts through its separate accounts for which investment income and investment gains and losses accrue to, and investment risk is borne by, the contract holder (traditional variable annuities). It also issues variable annuity and life contracts through separate accounts where it contractually guarantees to the contract holder (variable contracts with guarantees) either a) return of no less than deposits made to the contract adjusted for any partial withdrawals, b) total deposits made to the contract adjusted for any partial withdrawals plus a minimum return, or c) the highest contract value on a specified anniversary date adjusted for any withdrawals following the contract anniversary. These guarantees include benefits that are payable in the event of death (GMDB), annuitisation (GMIB), at specified dates during the accumulation period (GMWB) or at the end of a specified period (GMAB).

At 31 December 2010 and 2009, Jackson had variable annuity contracts with guarantees, for which the net amount at risk ('NAR') is generally the amount of guaranteed benefit in excess of current account value, as follows:

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31 December 2010 Minimum return Account value
£m
Net amount at risk
£m
Weighted average attained age Period until expected annuitisation
Return of net deposits plus a minimum return  
GMDB 0-6% 25,540 2,106 64.0 years  
GMWB – Premium only 0% 2,742 149    
GMWB – For life 0-5%* 1,996 415    
GMAB – Premium only 0% 48 1    
Highest specified anniversary account value minus withdrawals post-anniversary  
GMDB   3,742 466 63.3 years  
GMWB – Highest anniversary only   2,010 343    
GMWB – For life   852 196    
Combination net deposits plus minimum return, highest specified anniversary account value minus withdrawals post-anniversary  
GMDB 0-6% 1,768 311 65.7 years  
GMIB 0-6% 1,933 418   5.1 years
GMWB – For life 0-8%* 15,025 672†    

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31 December 2009 Minimum return Account value
£m
Net amount at risk
£m
Weighted average attained age Period until expected annuitisation
Return of net deposits plus a minimum return          
GMDB 0-6% 16,915 2,834 63.8 years  
GMWB – Premium only 0% 2,505 277    
GMWB – For life 0-5%* 1,240 471    
GMAB – Premium only 0% 27 2    
Highest specified anniversary account value minus withdrawals post-anniversary          
GMDB   2,933 691 62.8 years  
GMWB – Highest anniversary only   1,694 496    
GMWB – For life   811 258    
Combination net deposits plus minimum return, highest specified anniversary account value minus withdrawals post-anniversary          
GMDB 0-6% 1,307 384 65.1 years  
GMIB 0-6% 1,815 488   5.9 years
GMWB – For life 0-7%* 6,934 568    
  • *Ranges shown based on simple interest. The upper limits of five per cent, seven per cent and eight per cent simple interest are approximately equal to 4.1 per cent, 5.5 per cent and six per cent respectively, on a compound interest basis over a typical 10-year bonus period.
  • The NAR for GMWB – 'For life' has been estimated as the present value of future expected benefit payments remaining after the amount of the 'not for life' guaranteed benefit is zero.

Account balances of contracts with guarantees were invested in variable separate accounts as follows:

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  2010 £m 2009 £m
Mutual fund type    
Equity 23,841 15,477
Bond 3,417 2,340
Balanced 3,345 2,186
Money market 451 522
Total 31,054 20,525

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 as illustrated above. This risk is managed using a comprehensive equity hedging programme to minimise the risk of a significant economic impact as a result of increases or decreases in equity market levels while taking advantage of naturally offsetting exposures in Jackson's operations. Jackson purchases external futures and options that hedge the risks inherent in these products, while also considering the impact of rising and falling separate account fees.

As a result of this hedging programme, if the equity markets were to increase further in the future, Jackson's free-standing derivatives would decrease in value. However, over time, this movement would be broadly offset by increased separate account fees and reserve decreases, net of the related changes to amortisation of deferred acquisition costs. Due to the nature of the free-standing and embedded derivatives, this hedge, while highly effective on an economic basis, may not completely mute the immediate impact of the market movements as the free-standing derivatives reset immediately while the hedged liabilities reset more slowly and fees are recognised prospectively. The opposite impacts would be observed if the equity markets were to decrease.

At 31 December 2010, 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 benefit, net of related DAC amortisation, before tax of up to £100 million, excluding the impact on future separate account fees (2009: £60 million). After related deferred tax there would have been an estimated increase in shareholders' equity at 31 December 2010 of up to £60 million (2009: £40 million). An immediate decrease in the equity markets of 20 per cent is estimated to result in an accounting benefit, net of related DAC amortisation, before tax of up to £170 million (2009: £110 million), excluding the impact on future separate account fees. After related deferred tax there would have been an estimated increase in shareholders' equity at 31 December 2010 of up to £110 million (2009: £80 million). An immediate increase in the equity markets of 10 and 20 per cent is estimated to result in an approximately equal and opposite estimated effect on profit and shareholders' equity as that disclosed above for a decrease.

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.

Other exposure to equity risk

In addition to the above, Jackson is also exposed to equity risk from its holding of equity securities, partnerships in investment pools and other financial derivatives.

A range of reasonably possible movements in the value of equity securities, partnerships in investment pools and other financial derivatives have been applied to Jackson's holdings at 31 December 2010 and 31 December 2009. The table below shows the sensitivity to a 10 and 20 per cent fall in value and the impact that this would have on pre-tax profit, net of related changes in amortisation of DAC, profit after tax and shareholders' equity.

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  2010 £m 2009 £m
A decrease of 20% A decrease of 10% A decrease of 20% A decrease of 10%
Pre-tax profit, net of related changes in amortisation of DAC (143) (72) (117) (58)
Related deferred tax effects 50 25 41 20
Net sensitivity of profit after tax and shareholders’ equity (93) (47) (76) (38)

A 10 or 20 per cent increase in their value is estimated to have an approximately equal and opposite effect on profit and shareholders' equity to the sensitivities shown above.

In the equity risk sensitivity analysis given above, the Group has considered the impact of an instantaneous 20 per cent fall in equity markets. If equity markets were to fall by more than 20 per cent, the Group believes that this would not be an instantaneous fall but rather this would be expected to occur over a period of time during which the Group would be able to put in place mitigating management actions.

iv Exposure to interest rate risk

Notwithstanding the market risk exposure described in note D3(f), except in the circumstances of interest rate scenarios where the guarantee rates included in contract terms are higher than crediting rates that can be supported from assets held to cover liabilities, the accounting measurement of fixed annuity liabilities of Jackson products is not generally sensitive to interest rate risk. This position derives from the nature of the products and the US GAAP basis of measurement described in notes D3(e) and D3(g). The GMWB features attaching to variable annuity business (other than 'for-life') represents embedded derivatives which are fair valued and so will be sensitive to changes in interest rate.

Debt securities and related derivatives are marked to fair value. Value movements on derivatives, net of related changes to amortisation of DAC and deferred tax, are recorded within profit and loss. Fair value movements on debt securities, net of related changes to amortisation of DAC and deferred tax, are recorded within other comprehensive income. The estimated sensitivity of these items and policyholder liabilities to a one per cent and two per cent decrease and increase in interest rates at 31 December 2010 and 2009 is as follows:

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  2010 £m 2009 £m
A 2% decrease A 1% decrease A 1% increase A 2% increase A 2% decrease A 1% decrease A 1% increase A 2% increase
Profit and loss    
Direct effect    
Derivatives value change 842 363 (277) (529) (319) (148) 159 370
Policyholder liabilities (547) (243) 219 416 (418) (185) 170 334
Related effect on amortisation of DAC 47 23 (34) (63) 364 162 (156) (328)
Pre-tax profit effect:    
Operating profit based on longer-term investment returns 579 245 (181) (345) (144) (62) 56 109
Short-term fluctuations in investment returns (237) (102) 89 169 (229) (109) 117 267
  342 143 (92) (176) (373) (171) 173 376
Related effect on charge for deferred tax (120) (50) 32 62 131 60 (60) (131)
Net profit effect 222 93 (60) (114) (242) (111) 113 245
Other comprehensive income    
Direct effect on carrying value of debt securities 2,663 1,454 (1,454) (2,663) 2,183 1,179 (1,179) (2,183)
Related effect on amortisation of DAC (1,174) (641) 641 1,174 (764) (413) 413 764
Related effect on movement in deferred tax (521) (285) 285 521 (497) (268) 268 497
Net effect 968 528 (528) (968) 922 498 (498) (922)
Total net effect on IFRS equity 1,190 621 (588) (1,082) 680 387 (385) (677)

k Duration of liabilities

The table below shows the carrying value of policyholder liabilities. Separately, the Group uses cash flow projections of expected benefit payments as part of the determination of the value of in-force business when preparing EEV basis results. The table below also shows the maturity profile of the cash flows used for that purpose for 2010 and 2009:

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  2010 £m 2009 £m
Fixed annuity and other business (including GICs and similar contracts) Variable annuity Total Fixed annuity and other business (including GICs and similar contracts) Variable annuity Total
Policyholder liabilities 29,320 31,203 60,523 27,672 20,639 48,311
  % % % % % %
Expected maturity:    
0 to 5 years 50 50 50 52 50 51
5 to 10 years 27 29 28 27 28 28
10 to 15 years 11 12 12 10 12 11
15 to 20 years 5 6 5 5 6 5
20 to 25 years 3 2 3 3 2 2
Over 25 years 4 1 2 3 2 3

The maturity tables shown above have been prepared on a discounted basis. Details of undiscounted cash flows for investment contracts are shown in note G2.

a Summary statement of financial position

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    Asian insurance operations
With-profits business
note i
£m
Unit-linked assets and liabilities
£m
Other
£m
2010
Total
£m
2009
Total
£m
Assets    
Intangible assets attributable to shareholders:    
Goodwill 236 236 80
Deferred acquisition costs and other intangible assets 939 939 822
Total 1,175 1,175 902
Intangible assets attributable to with-profit funds:    
Deferred acquisition costs and other intangible assets 97 97 97
Deferred tax assets 98 98 132
Other non-investment and non-cash assets 205 94 512 811 880
Investments of long-term business and other operations:    
Investment properties 9 9 11
Investments accounted for using the equity method 2 2 2
Financial investments:    
Loansnote ii 874 466 1,340 1,207
Equity securities and portfolio holdings in unit trusts 4,321 9,637 506 14,464 11,182
Debt securitiesnote d 6,759 3,009 4,340 14,108 9,984
Other investments 192 58 132 382 258
Deposits 6 251 381 638 746
Total investmentsnote b 12,152 12,955 5,836 30,943 23,390
Cash and cash equivalents 536 337 728 1,601 837
Total assets 12,990 13,386 8,349 34,725 26,238
Equity and liabilities    
Equity    
Shareholders’ equity 2,149 2,149 1,462
Non-controlling interests 5 5 1
Total equity 2,154 2,154 1,463
Liabilities    
Policyholder liabilities and unallocated surplus of with-profits funds:    
Contract liabilities (including amounts in respect of contracts classified as investment contracts under IFRS 4) 10,958 12,724 4,992 28,674 21,858
Unallocated surplus of with-profits funds 66 66 53
Total 11,024 12,724 4,992 28,740 21,911
Other non-insurance liabilities:    
Operational borrowings attributable to shareholders-financed operations 189 189 210
Deferred tax liabilities 341 25 129 495 384
Other non-insurance liabilities 1,625 637 885 3,147 2,270
Total liabilities 12,990 13,386 6,195 32,571 24,775
Total equity and liabilities 12,990 13,386 8,349 34,725 26,238
Notes
  1. The statement of financial position for with-profits business comprises the with-profits assets and liabilities of the Hong Kong, Malaysia and Singapore with-profits operations. Assets and liabilities of other participating business are included in the column for 'other business'.
  2. The loans of the Group's Asian insurance operations of £1,340 million (2009: £1,207 million) comprise mortgage loans of £25 million (2009: £13 million), policy loans of £528 million (2009: £437 million) and other loans of £787 million (2009: £757 million). The mortgage and policy loans are secured by properties and life insurance policies respectively. The majority of the other loans are commercial loans held by the Malaysian operation and which are all investment graded by two local rating agencies.

Summary policyholder liabilities (net of reinsurance) and unallocated surplus

At 31 December 2010, the policyholder liabilities (net of reinsurance of £41 million (2009: £18 million)) and unallocated surplus for Asian operations of £28.7 billion (2009: £21.9 billion) comprised the following:

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  2010 £m 2009 £m
Singapore 9,731 6,960
Hong Kong 6,621 5,762
Malaysia 2,544 1,823
Indonesia 1,475 968
Korea 1,897 1,519
Taiwan 968 545
Other countries 5,463 4,316
Total Asian operations 28,699 21,893

b Reconciliation of movement in investments

A reconciliation of the total investments of Asian insurance operations from the beginning of the year to the end of the year is as follows:

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  With-profits business
£m
Unit-linked assets and liabilities
£m
Other
£m
Asian insurance operations
Total

£m
At 1 January 2009        
Total investments (including derivative assets) 8,866 7,330 5,613 21,809
Less: Investments held by consolidated investment funds (705) (153) (243) (1,101)
Less: Derivative liabilities (32) (32)
Directly held investments, net of derivative liabilities 8,161 7,177 5,338 20,676
Net cash inflow from operating activities 565 1,243 1,220 3,028
Disposal of Taiwan agency business (734) (2,527) (3,261)
Realised gains (losses) in the year (183) 1 (61) (243)
Unrealised gains and losses and exchange movements in the year 671 2,048 (393) 2,326
Movement in the year of directly held investments, net of derivative liabilities 1,053 2,558 (1,761) 1,850
At 31 December 2009/1 January 2010  
Total investments (including derivative assets) 9,547 9,953 3,890 23,390
Less: Investments held by consolidated investment funds (270) (218) (230) (718)
Less: Derivative liabilitiesnote G3 (63) (83) (146)
Directly held investments, net of derivative liabilities 9,214 9,735 3,577 22,526
Net cash inflow from operating activities 278 838 1,051 2,167
Realised gains in the year 638 327 19 984
Unrealised gains and losses and exchange movements in the year 993 1,786 522 3,301
Acquisition of UOB Life Assurance Limited 527 3 474 1,004
Movement in the year of directly held investments, net of derivative liabilities 2,436 2,954 2,066 7,456
At 31 December 2010  
Total investments (including derivative assets) 12,152 12,955 5,836 30,943
Less: Investments held by consolidated investment funds (382) (266) (91) (739)
Less: Derivative liabilitiesnote G3 (120) (102) (222)
Directly held investments, net of derivative liabilities 11,650 12,689 5,643 29,982

c Reconciliation of movement in policyholder liabilities and unallocated surplus of with-profits funds

A reconciliation of the total policyholder liabilities and unallocated surplus of with-profits funds of Asian insurance operations from the beginning of the year to the end of the year is as follows:

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  With-profits business
£m
Unit-linked assets and liabilities
£m
Other
£m
Asian insurance operations
Total

£m
  • *Adjusted for transactions in the period and excluding the unallocated surplus of with-profits funds.
At 1 January 2009 8,094 7,220 5,755 21,069
Premiums        
New businessnote ii 46 643 517 1,206
In-force 777 1,223 601 2,601
  823 1,866 1,118 3,807
Surrendersnote iii (361) (666) (174) (1,201)
Maturities/Deaths (253) (19) (70) (342)
Net flows 209 1,181 874 2,264
Change in reserving basis in Malaysianote iv (9) (54) (63)
Change in other reserving basis (4) (4)
Shareholders’ transfers post-tax (20) (20)
Investment-related items and other movements 1,431 2,661 150 4,242
Foreign exchange translation differencesnote i (853) (612) (604) (2,069)
Disposal of Taiwan agency businessnote vi (724) (2,784) (3,508)
At 31 December 2009/1 January 2010 8,861 9,717 3,333 21,911
Comprising:        
– Policyholder liabilities 8,808 9,717 3,333 21,858
– Unallocated surplus of with-profits funds 53 53
Premiums  
New businessnote ii 141 1,072 452 1,665
In-force 897 1,130 616 2,643
  1,038 2,202 1,068 4,308
Surrendersnote iii (441) (1,572) (228) (2,241)
Maturities/Deaths (326) (40) (132) (498)
Net flows 271 590 708 1,569
Change in other reserving basis 19 19
Shareholders’ transfers post-tax (24) (24)
Investment-related items and other movementsnote v 693 1,405 118 2,216
Foreign exchange translation differencesnote i 719 1,009 353 2,081
Acquisition of UOB Life Assurance Limitednote vii 504 3 461 968
At 31 December 2010 11,024 12,724 4,992 28,740
Comprising:  
– Policyholder liabilities 10,958 12,724 4,992 28,674
– Unallocated surplus of with-profits funds 66 66
Average policyholder liability balances*  
2010 10,135 11,222 4,393 25,750
2009 8,371 8,107 3,152 19,630
Notes
  1. Movements in the year have been translated at the average exchange rate for the year ended 31 December 2010. The closing balance has been translated at the closing spot rates as at 31 December 2010. Differences upon retranslation are included in foreign exchange translation differences of positive £2,081 million in 2010 (2009: negative £2,069 million).
  2. The increase in policyholder liabilities due to new business premium for the unit-linked business was predominantly driven by an increase in sales during the year of individual linked products.
  3. Following the recovery of the stock markets in Asia in late 2009 and 2010, policyholders in Asia took the opportunity to capitalise on the increased value of their unit-linked policies through withdrawals, principally in Indonesia, Malaysia, and India.
  4. The depressed state of the investment markets in late 2008 and 2009 resulted in both the number of, and average value of, withdrawals of investment related products decreasing.
  5. The change in reserving basis in Malaysia of £63 million reflects the change made following the adoption of a risk-based capital (RBC) approach to the local regulatory reporting in that country.
  6. The positive investment related items and other movements in 2010 for with-profits (£693 million) and unit-linked business (£1,405 million) are mainly driven from Asian equity market gains in the period.
  7. The disposal of Taiwan agency business reflects the liabilities transferred at the date of disposal.
  8. The acquisition of UOB Life Assurance Limited reflects the liabilities acquired at the date of acquisition.

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 2010 by rating agency ratings:

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  2010
£m
2009
£m
With-profits business Unit-linked business Other business Total Total
S&P – AAA 2,199 349 386 2,934 2,259
S&P – AA+ to AA– 744 100 1,294 2,138 1,594
S&P – A+ to A– 1,337 861 645 2,843 1,496
S&P – BBB+ to BBB– 729 24 160 913 682
S&P – Other 649 465 659 1,773 917
  5,658 1,799 3,144 10,601 6,948
Moody’s – Aaa 49 10 6 65 134
Moody’s – Aa1 to Aa3 44 48 23 115 349
Moody’s – A1 to A3 55 16 59 130 309
Moody’s – Baa1 to Baa3 50 10 35 95 40
Moody’s – Other 31 18 49 15
  229 84 141 454 847
Fitch 4 33 12 49 39
Other 868 1,093 1,043 3,004 2,150
Total debt securities 6,759 3,009 4,340 14,108 9,984

Of the £1,043 million (2009: £517 million) debt securities for other business which are not rated in the table above, £350 million (2009: £225 million) are in respect of government bonds and £666 million (2009: £265 million) are in respect of corporate bonds rated as investment grade by local external ratings agencies, and £5 million (2009: £22 million) structured deposits issued by banks which are themselves rated but where the specific deposits have not been.

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.

The terms and conditions of the contracts written by the Asian operations and, in particular, the products' options and guarantees, vary from territory to territory depending upon local market circumstances.

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. Health and Protection (H&P) policies provide mortality or morbidity benefits and include health, disability, critical illness and accident coverage. H&P 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.

Non-participating long-term products are the only ones where the insurer is contractually obliged to provide guarantees on all benefits. Investment-linked products have the lowest level of guarantee, if any.

Product guarantees in Asia can be broadly classified into four main categories, namely premium rate, cash value and interest rate guarantees, policy renewability and convertibility options.

The risks on death coverage through premium rate guarantees are low due to appropriate product pricing.

Cash value and interest rate guarantees are of three types:

  • Maturity values
    Maturity values are guaranteed for non-participating products and on the guaranteed portion of participating products. Declared annual bonuses are also guaranteed once vested. Future bonus rates and cash dividends are not guaranteed on participating products.
  • Surrender values
    Surrender values are guaranteed for non-participating products and on the guaranteed portion of participating products. The surrender value of declared reversionary bonuses are also guaranteed once vested. Market value adjustments and surrender penalties are used where the law permits such adjustments in cash values.
  • 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.

    The guarantees are borne by shareholders for non-participating and investment-linked (non-investment guarantees only) products. Participating product guarantees are predominantly supported by the segregated life funds and their estates.

Whole of life contracts with floor levels of policyholder benefits that accrue at rates set at inception and do not vary subsequently with market conditions are written in the Korean life operations. This is to a much lesser extent than the policies written by the Taiwan agency business which was sold in the first half of 2009, as Korea has a much higher proportion of linked and health business. The Korean business has non-linked liabilities and linked liabilities at 31 December 2010 of £408 million and £1,491 million respectively (2009: £349 million and £1,173 million respectively).

The other area of note in respect of guarantees is the Japanese business where pricing rates are higher than current bond yields. Lapse risk is a feature in that policyholders could potentially surrender their policies on guaranteed terms if interest rates significantly increased leaving the potential for losses if bond values had depreciated significantly. However, the business is matched to a relatively short realistic liability duration.

The method for determining liabilities of insurance contracts for UK GAAP and IFRS purposes for some Asian operations is based on US GAAP principles and this method applies to contracts with cash value and interest rate guarantees. Following standard US GAAP procedure, premium deficiency reserve calculations are performed each year to establish whether the carrying values of the liabilities are sufficient.

On the US GAAP basis the calculations are deterministic, that is to say based on a single set of projections, and expected long-term rates of return are applied.

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. The exposure to market risk of the Group arising from its Asian operations is therefore 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.

g Process for setting assumptions and determining liabilities

The future policyholder benefit provisions for Asian businesses in the Group's IFRS accounts and previously under the MSB, are determined in accordance with methods prescribed by local GAAP adjusted to comply, where necessary, with UK GAAP.

For Asian operations in countries where local GAAP is not well established and in which the business written is primarily non-participating and linked business, US GAAP is used as the most appropriate reporting basis. This basis is applied in Japan, Vietnam and Taiwan. The future policyholder benefit provisions for non-linked business are determined using the net level premium method, with an allowance for surrenders, maintenance and claims expenses. Rates of interest used in establishing the policyholder benefit provisions vary by operation depending on the circumstances attaching to each block of business.

h Reinsurance

The Asian businesses cede only minor amounts of business outside the Group with immaterial effects on reported profit. During 2010, reinsurance premiums for externally ceded business were £146 million (2009: £119 million) and the reinsurance assets were £41 million (2009: £18 million) in aggregate.

i Effect of changes in bases, estimates and assumptions used to measure insurance assets and liabilities

2010

In 2010, one-off changes made to reserving assumptions resulted in a release from liabilities of £19 million.

2009

In 2009, the local regulatory basis in Malaysia was replaced by the Malaysian authority's risk-based capital (RBC) framework. In the light of this development, the Company has remeasured the liabilities by reference to the method applied under the new RBC framework, but with an overlay constraint to the method such that negative reserves derived at an individual policyholder level are not included. This change resulted in a one-off release from liabilities at 1 January 2009 of £63 million. Excluding the change in Malaysia, the 2009 result for Asian operations was reduced by the effect of a number of individually small assumption changes of, in aggregate £4 million.

j Sensitivity of IFRS basis profit and equity to market and other risks

Currency translation

Consistent with the Group's accounting policies, the profits of the Asian insurance operations are translated at average exchange rates and shareholders' equity at the closing rate for the reporting period. For 2010, the rates for the most significant operations are given in note B4.

A 10 per cent increase or decrease in these rates would have reduced or increased profit before tax attributable to shareholders, profit for the year and shareholders' equity, excluding goodwill, attributable to Asian operations respectively as follows:

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  A 10% increase in exchange rates A 10% decrease in exchange rates
2010 £m 2009 £m 2010 £m 2009 £m
(Loss) profit before tax attributable to shareholdersnote i (65) (40) 80 49
(Loss) profit for the year (58) (35) 71 43
Shareholders' equity, excluding goodwill, attributable to Asian operations (193) (129) 236 158
Note
  1. 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 but excluding the loss on sale and results for Taiwan agency business, as discussed in note B1.

Other risks

i With-profits business

Similar principles to those explained for UK with-profits business apply to profit emergence for the Asian with-profits business. Correspondingly, the profit emergence reflects bonus declaration and is relatively insensitive to period by period fluctuations in insurance risk or interest rate movements.

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

a Interest rate risk

Asian operations offer a range of insurance and investment products, predominately with-profits and non-participating term, whole life endowment and unit-linked. Excluding with-profit and unit-linked business, the results of the Asian business are sensitive to the vagaries of routine movements in interest rates.

For the purposes of analysing sensitivity to variations in interest rates, it has been determined for the majority of territories that a movement of one per cent in the 10 year government bond rate can be considered reasonably possible.

At 31 December 2010, 10 year government bond rates vary from territory to territory and range from 1.1 per cent to 12.25 per cent (2009: 1.3 per cent to 11.45 per cent). Exception to this arises in Japan and Taiwan where reasonably possible interest rate movements have been determined as 0.5 per cent (2009: Japan and Taiwan 0.5 per cent). These reasonably possible changes would have the following impact:

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  2010 £m 2009 £m
A decrease of 1%
note i
A decrease of 1%
note i
Pre-tax profit 110 91
Related deferred tax (where applicable) (41) (22)
Net effect on profit and equity 69 69
Note
  1. One per cent sensitivity has been used in all territories (except Japan and Taiwan (0.5 per cent)) (2009: Japan and Taiwan 0.5 per cent). The pre-tax impacts, if they arose, would mostly be recorded within the category short-term fluctuations in investments returns in the Group's segmental analysis of profit before tax. At 31 December 2010, an increase in the rates of one per cent (Japan and Taiwan (0.5 per cent)) (2009: one per cent except Japan and Taiwan 0.5 per cent) is estimated to have the effect of decreasing pre-tax profit by £112 million (2009: £109 million). After adjusting these results for deferred tax the reasonable possible effect on shareholders' equity is a decrease of £82 million (2009: £83 million).

b Equity price risk

The non-linked shareholder business has limited exposure to equity and property investment (£515 million at 31 December 2010). Generally changes in equity and property investment values are not automatically matched by investments in policyholder liabilities. However, for the Vietnam business, to the extent that equity investment appreciation is realised through sales of securities then policyholders' liabilities are adjusted to the extent that policyholders participate.

The estimated sensitivity to a 10 and 20 per cent change in equity and property prices for shareholder-backed Asian other business, which would be reflected in the short-term fluctuation component of the Group's segmental analysis of profit before tax at 31 December 2010 and 2009, would be as follows:

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  2010 £m 2009 £m
A decrease of 20% A decrease of 10% A decrease of 20% A decrease of 10%
Pre-tax profit (103) (52) (58) (29)
Related deferred tax (where applicable) 10 5 8 4
Net effect on profit and equity (93) (47) (50) (25)

A 10 or 20 per cent increase in their value is estimated to have an approximately equal and opposite effect on profit and shareholders' equity to the sensitivities shown above.

In the equity risk sensitivity analysis given above the Group has considered the impact of an instantaneous 20 per cent fall in equity markets. If equity markets were to fall by more than 20 per cent, the Group believes that this would not be an instantaneous fall but rather this would be expected to occur over a period of time during which the Group would be able to put in place mitigating management actions.

c Insurance risk

Many of the territories in Asia are exposed to mortality/morbidity risk and provision is made within IFRS policyholder liabilities on a prudent regulatory basis to cover the potential exposure. If these prudent assumptions were strengthened by five per cent (estimated at one in ten year shock) then it is estimated that post-tax IFRS profit would be impacted by approximately £21 million (2009: £9 million) (with a corresponding change to IFRS shareholders' equity). Mortality/morbidity has a symmetrical effect on portfolio and so a weakening of mortality/morbidity assumptions would have an approximately equal and opposite similar impact.

k Duration of liabilities

The table below shows the carrying value of policyholder liabilities. Separately the Group uses cash flow projections of expected benefit payments as part of the determination of the value of in-force business when preparing EEV basis results. The table below also shows the maturity profile of the cash flows, taking account of expected future premiums and investment returns used for that purpose for 2010 and 2009:

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  2010 £m 2009 £m
Policyholder liabilities 28,674 21,858
  % %
Expected maturity:    
0 to 5 years 24 24
5 to 10 years 20 21
10 to 15 years 15 15
15 to 20 years 12 12
20 to 25 years 10 9
Over 25 years 19 19

a Summary statement

The Group's estimated capital position for life assurance businesses with reconciliations to shareholders' equity is shown below. Available capital for each fund or group of companies is determined by reference to local regulation at 31 December 2010 and 2009.

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  2010 £m
31 December 2010 SAIF WPSF
note i
Total PAC with-
profits fund
Other UK life assurance subsidi-
aries and funds

note ii
Jackson Asian life assurance subsidi-
aries
Total life assurance operations M&G
(including Prudential Capital)
Parent company and share-
holders' equity of other subsidi-
aries and funds
Group total
Group share-holders’ equity  
Held outside long-term funds:  
Net assets 716 3,815 1,913 6,444 254 (1,532) 5,166
Goodwill 236 236 1,153 77 1,466
Total 716 3,815 2,149 6,680 1,407 (1,455) 6,632
Held in long-term fundsnote iii 1,399 1,399 1,399
Total Group shareholders’ equity 2,115 3,815 2,149 8,079 1,407 (1,455) 8,031
Adjustments to regulatory basis    
Unallocated surplus of with-profits fundsnote v 10,187 10,187 66 10,253  
Shareholders’ share of realistic liabilities (2,938) (2,938) (2,938)  
Deferred acquisition costs of non-participating business not recognised for regulatory reporting purposes and goodwill (13) (13) (116) (3,543) (993) (4,665)  
Jackson surplus notesnote iv 159 159  
Investment and policyholder liabilities valuation differences between IFRS basis and regulatory basis for Jacksonnote viii 1,900 1,900  
Adjustment from IAS 19 basis pension deficit attributable to WPSF to pension liability for regulatory purposesnote vii 60 60 60  
Valuation difference on PAL between IFRS basis and regulatory basis (1,202) (1,202) (1,202)  
Other adjustments to restate these amounts to a regulatory basis (with SAIF and the WPSF on a Peak 2 realistic basis)note v 706 706 (292) 576 156 1,146  
Total adjustments 6,800 6,800 (408) (908) (771) 4,713  
Total available capital resources of life assurance businesses on local regulatory bases 6,800 6,800 1,707 2,907 1,378 12,792  

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31 December 2010 2010 £m
SAIF WPSF
note i
Total PAC with-profits fund Other UK life assurance subsidiaries and funds
note ii
Jackson Asian life assurance subsidiaries Total life assurance operations
Policyholder liabilities  
With-profits liabilities of UK regulated with-profits funds:  
Insurance contracts 9,115 31,395 40,510 5,284 45,794
Investment contracts (with discretionary participation features) 376 25,237 25,613 119 25,732
Total 9,491 56,632 66,123 5,403 71,526
Other liabilities:  
Insurance contracts:  
With-profits liabilities of non-UK regulated funds 5,555 5,555
Unit-linked, including variable annuity 2,128 2,128 8,882 31,203 12,724 54,937
Other life assurance business 268 13,067 13,335 19,297 27,438 4,935 65,005
Investment contracts without discretionary participation features (principally unit-linked and similar contracts in the UK and GIC liabilities of Jackson)note vi 15,765 1,882 57 17,704
Total 268 15,195 15,463 43,944 60,523 23,271 143,201
Total policyholder liabilities shown in the consolidated statement of financial position 9,759 71,827 81,586 43,944 60,523 28,674 214,727

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  2009 £m
31 December 2009 SAIF WPSF
note i
Total PAC with-
profits fund
Other UK life assurance subsidi-
aries and funds

note ii
Jackson Asian life assurance subsidi-
aries
Total life assurance operations M&G
(including Prudential Capital)
Parent company and share-
holders' equity of other subsidi-
aries and funds
Group total
Group shareholders’ equity  
Held outside long-term funds:  
Net assets 788 3,011 1,382 5,181 173 (1,507) 3,847
Goodwill 80 80 1,153 77 1,310
Total 788 3,011 1,462 5,261 1,326 (1,430) 5,157
Held in long-term fundsnote iii 1,114 1,114 1,114
Total Group shareholders’ equity 1,902 3,011 1,462 6,375 1,326 (1,430) 6,271
Adjustments to regulatory basis  
Unallocated surplus of with-profits fundsnote v 9,966 9,966 53 10,019
Shareholders’ share of realistic liabilities (3,001) (3,001) (3,001)
Deferred acquisition costs of non-participating business not recognised for regulatory reporting purposes and goodwill (2) (7) (9) (124) (3,092) (786) (4,011)
Jackson surplus notesnote iv 154 154
Investment and policyholder liabilities valuation differences between IFRS basis and regulatory basis for Jacksonnote viii 2,221 2,221
Adjustment from IAS 19 basis pension deficit attributable to WPSF to pension liability for regulatory purposesnote vii 65 65 65
Valuation difference on PAL between IFRS basis and regulatory basis (1,294) (1,294) (1,294)
Other adjustments to restate these amounts to a regulatory basis (with SAIF and the WPSF on a Peak 2 realistic basis)note v 2 703 705 (171) 194 400 1,128
Total adjustments 6,432 6,432 (295) (523) (333) 5,281
Total available capital resources of life assurance businesses on local regulatory bases 6,432 6,432 1,607 2,488 1,129 11,656

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31 December 2009 2010 £m
SAIF WPSF
note i
Total PAC with-profits fund Other UK life assurance subsidiaries and funds
note ii
Jackson Asian life assurance subsidiaries Total life assurance operations
Policyholder liabilities  
With-profits liabilities of UK regulated with-profits funds:  
Insurance contracts 9,285 28,449 37,734 4,766 42,500
Investment contracts (with discretionary participation features) 396 24,384 24,780 100 24,880
Total 9,681 52,833 62,514 4,866 67,380
Other liabilities:              
Insurance contracts:              
With-profits liabilities of non-UK regulated funds 3,942 3,942
Unit-linked, including variable annuity 1,998 1,998 6,793 20,639 9,717 39,147
Other life assurance business 291 12,726 13,017 18,113 25,707 3,287 60,124
Investment contracts without discretionary participation features (principally unit-linked and similar contracts in the UK and GIC liabilities of Jackson)note vi 13,794 1,965 46 15,805
Total 291 14,724 15,015 38,700 48,311 16,992 119,018
Total policyholder liabilities shown in the consolidated statement of financial position 9,972 67,557 77,529 38,700 48,311 21,858 186,398
Notes
  1. WPSF unallocated surplus includes amounts related to the Hong Kong branch. Policyholder liabilities of the Hong Kong branch are included in the amounts of Asian life assurance subsidiaries.
  2. Excluding PAC shareholders' equity that is included in 'parent company and shareholders' equity of other subsidiaries and funds'.
  3. The term shareholders' equity held in long-term funds refers to the excess of assets over liabilities attributable to shareholders of funds which are required by law to be maintained with segregated assets and liabilities.
  4. For regulatory purposes the Jackson surplus notes are accounted for as capital.
  5. Other adjustments to shareholders' equity and unallocated surplus include amounts for the value of non-participating business for UK regulated with-profits funds, deferred tax, admissibility and other items measured differently on the regulatory basis. For Jackson the principal reconciling item is deferred tax related to the differences between IFRS and regulatory bases as shown in the table above and other methodology differences.
  6. Insurance business accounted for as financial instruments under IAS 39.
  7. In determining the IAS 19 adjustment for the purposes of this table the deficit in the Group's main pension scheme used for the calculation includes amounts for investments in Prudential insurance policies (see note I3).
  8. The investment and policyholder liabilities valuation difference between IFRS and regulatory bases for Jackson is mainly due to not all investments being carried at fair value under the regulatory basis and also due to the valuation difference on annuity reserves.

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 of the Group's major operations are shown below.

i UK insurance operations

The FSA rules which govern the Prudential regulation of insurance form part of the Prudential Sourcebook for Insurers, the General Prudential Sourcebook and Interim Prudential Sourcebook for Insurers. Overall, the net requirements of the General Prudential Sourcebook are intended to align the capital adequacy requirements for insurance business more closely with those of banking and investment firms and building societies, for example, by addressing tiers of capital, rather than looking at net admissible assets. An insurer must hold capital resources equal at least to the Minimum Capital Requirement (MCR).

The Prudential Sourcebook for Insurers also contains rules on Individual Capital Assessments. Under these rules and the rules of the General Prudential Sourcebook all insurers must assess for themselves the amount of capital needed to back their business. If the FSA views the results of this assessment as insufficient, it may draw up its own Individual Capital Guidance for a firm, which can be superimposed as a requirement.

PAC WPSF and SAIF

Under FSA rules, insurers with with-profits liabilities of more than £500 million must hold capital equal to the higher of the MCR and the Enhanced Capital Requirement (ECR). The ECR is intended to provide a more risk responsive and 'realistic' measure of a with-profit insurer's capital requirements, whereas the MCR is broadly speaking equivalent to the previous required minimum margin under the Interim Prudential Sourcebook and satisfies the minimum EU Standards.

Determination of the ECR involves the comparison of two separate measurements of the firm's resources requirement, which the FSA refers to as the 'twin peaks' approach.

The two separate peaks are:

  1. The requirement comprised by the mathematical reserves plus the 'Long-Term Insurance Capital Requirement' (LTICR), together known as the 'regulatory peak'; and
  2. a calculation of the 'realistic' present value of the insurer's expected future contractual liabilities together with projected 'fair' discretionary bonuses to policyholders, plus a risk capital margin, together known as the 'realistic peak'.

Available capital of the WPSF and SAIF of £6.8 billion (2009: £6.4 billion) represents the excess of assets over liabilities on the FSA realistic basis. Unlike the previously discussed FRS 27 basis, realistic liabilities on the regulatory basis include the shareholders' share of future bonuses. These amounts are shown before deduction of the risk capital margin (RCM) which is estimated to be £1.5 billion at 31 December 2010 (2009: £1.4 billion).

The FSA's basis of setting the RCM is to target a level broadly equivalent to a Standard & Poor's credit rating of BBB and to judge this by ensuring there are sufficient assets to absorb a one in 200 year event. The RCM calculation achieves this by setting rules for the determination of margins to cover defined stress changes in asset values and yields for market risk, credit risk and termination risk for with-profits policies.

As noted in section D2(g)(ii), PAC has discretion in its management actions in the case of adverse investment conditions. Management actions encompass, but are not confined to, investment allocation decisions, levels of reversionary bonuses, crediting rates and total claim values. To illustrate the flexibility of management actions, rates of regular bonus are determined for each type of policy primarily by targeting them at a prudent proportion of the long-term expected future investment return on the underlying assets. The expected future investment return is reduced as appropriate for each type of policy to allow for items such as expenses, charges, tax and shareholders' transfers. However, the rates declared may differ by product type, or by date of payment of the premiums or date of issue of the policy, if the accumulated annual bonuses are particularly high or low relative to a prudent proportion of the achieved investment return.

When target bonus levels change, the PAC Board has regard to the overall financial strength of the long-term fund when determining the length of time over which it will seek to achieve the amended product target bonus level.

In normal investment conditions, PAC expects changes to regular bonus rates to be gradual over time and changes are not expected to exceed one per cent per annum over any year. However, discretion is retained as to whether or not a regular bonus is declared each year, and there is no limit on the amount by which regular bonus rates can be changed.

As regards smoothing of maturity and death benefits, in normal circumstances PAC does not expect most pay-out values on policies of the same duration to change by more than 10 per cent up or down from one year to the next, although some larger changes may occur to balance pay-out values between different policies. Greater flexibility may be required in certain circumstances, for example, following a significant rise or fall in market values (either sudden or over a period of years) and in such situations the PAC Board may decide to vary the standard bonus smoothing limits to protect the overall interests of policyholders.

For surrender benefits, any substantial fall in the market value of the assets of the with-profits sub-fund would lead to changes in the application of MVRs for accumulating with-profits policies, firstly to increase the size of MVRs already being applied and, secondly, to extend the range of policies for which an MVR is applied.

Other UK life assurance subsidiaries and funds

The available capital of £1,707 million (2009: £1,607 million) reflects the excess of regulatory basis assets over liabilities of the subsidiaries and funds, before deduction of the capital resources requirement of £1,086 million (2009: £952 million).

The capital resources requirement for these companies broadly reflects a formula which, for active funds, equates to a percentage of regulatory reserves plus a percentage of death strains. Death strains represent the payments made to policyholders upon death in excess of amounts explicitly allocated to fund the provisions for policyholders claims and maturities.

ii Jackson

The regulatory framework for Jackson is governed by the requirements of the US NAIC approved risk-based capital standards. Under these requirements life insurance companies report for the most part on a formula-based capital standard that they calculate by applying factors to various asset, premium and reserve items and separate model based calculations of risk associated primarily with variable annuity products. The risk-based capital formula takes into account the risk characteristics of a company, including asset risk, insurance risk, interest rate risk, market risk and business risk.

The available capital of Jackson shown above of £2,907 million (2009: £2,488 million) reflects US regulatory basis assets less liabilities including asset valuation reserves. The asset valuation reserve is designed to provide for future credit-related losses on debt securities and losses on equity investments. Available capital includes a reduction for the effect of the interest maintenance reserve, which is designed by state regulators to defer recognition of non-credit related realised capital gains and losses and to recognise them rateably in the future.

Jackson's risk-based capital ratio is significantly in excess of regulatory requirements. At 31 December 2010, Jackson had a permitted practice in effect as granted by the local regulator allowing Jackson to carry certain interest rate swaps at book value, as if statutory hedge accounting were in place, instead of at fair value as would have been otherwise required. Jackson was also required to demonstrate the effectiveness of its interest rate swap programme pursuant to the Michigan Insurance Code. The total effect of this permitted practice, which expires on 1 October 2011 was to increase statutory surplus by £83 million at 31 December 2010.

iii Asian operations

The available capital shown above of £1,378 million (2009: £1,129 million) represents the excess of local regulatory basis assets over liabilities before deduction of required capital of £572 million (2009: £438 million). These amounts have been determined applying the local regulations in each of the operations.

The businesses in Asia are subject to local capital requirements in the jurisdictions in which they operate. The Hong Kong business branch of PAC and its capital requirements are subsumed within those of the PAC long-term fund. For the other material Asian operations, the details of the basis of determining regulatory capital and regulatory capital requirements are as follows:

Singapore

In Singapore a risk-based regulatory framework applies rather than one based on a net premium approach.

For participating business, a gross premium reserve, determined using prudent best estimate assumptions and which makes allowance for future bonus, is held. The amount held is subject to a minimum of the higher of the assets attributed to participating business and a gross premium reserve calculated on specified assumptions, but without allowance for future bonus, that include prescribed provisions for adverse deviations (PADs).

For non-participating business, gross premium reserves are held. For linked business the value of units is held together with a non-unit reserve calculated in accordance with standard actuarial methodology.

Indonesia

Policy reserves for traditional business are determined on a modified net premium basis. The valuation interest rates are capped at nine per cent for local currency products and five per cent for foreign currency products.

For linked business the value of units is held together with a non-unit reserve calculated in accordance with standard actuarial methodology. Solvency capital is determined using a risk-based capital approach. Insurance companies in Indonesia are expected to maintain the level of net assets above 120 per cent of solvency capital. Due to the 2008 financial crisis, the local regulator provided relief in solvency capital and the measure continues until further notice.

Japan

Mathematical reserves for traditional business are determined on a net premium basis using prescribed mortality and interest rates. Interest rates reflect the original pricing assumptions.

For linked business the value of units is held together with a non-unit reserve calculated in accordance with standard actuarial methodology.

With regard to solvency, the adjusted solvency capital assets of the Company must exceed 200 per cent of the risk related capital requirement value at risk. It is thus a risk-based capital approach.

Malaysia

In Malaysia, a risk-based capital framework applies since 2009.

For participating business, a gross premium reserve on the guaranteed and non-guaranteed benefits determined using best estimate assumptions is held. The amount held is subject to a minimum of a gross premium reserve on the guaranteed benefits, determined using best estimate assumptions along with provisions of risk margin for adverse deviations (PRADs) discounted at the risk-free rate.

For non-participating business, gross premium reserves determined using best estimate assumptions along with provisions of risk margin for adverse deviations (PRADs) discounted at the risk-free rate are held. For linked business the value of units is held together with a non-unit reserve calculated in accordance with standard actuarial methodology.

The risk-free rate is derived from a yield curve of zero-coupon spot yields of Malaysian Government Securities.

Vietnam

Mathematical reserves are calculated using a modified net premium approach, using a stable set of assumptions agreed with the regulator.

The capital requirement is determined as four per cent of reserves plus a specified percentage of 0.1 per cent of sums at risk for policies with original term less than or equal to five years or 0.3 per cent of sums at risk for policies with original term of more than five years. An additional capital requirement of Vietnamese Dong 200 billion is also required for companies transacting unit-linked business.

Korea

Policy reserves for traditional business are determined on net premium reserve basis using pricing mortality and prescribed standard interest rates.

For linked business, the value of units is held together with the non-unit reserves calculated in accordance with regulatory standard actuarial methodology.

The capital requirement in Korea has moved to a risk-based regulatory framework in April 2009 with a two-year transition period where insurers can choose between the prior and new framework. The risk-based regulatory framework was adopted in 2009 by the Company. Under the new framework, insurance companies in Korea are expected to maintain a level of free surplus in excess of the capital requirements with the general target level of solvency margin being in excess of 150 per cent of the risk-based capital.

iv Group capital requirements

In addition to the requirements at individual company level, FSA requirements under the IGD apply additional prudential requirements for the Group as a whole. Discussion of the Group's estimated IGD position at 31 December 2010, together with market risk sensitivity disclosure provided to key management, is provided in the business review section of the Group's 2010 Annual Report and in section C.

c Movements in total available capital

Total available capital for the Group's life assurance operations has changed during 2010 as follows:

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  2010 £m
WPSF
note i
Other UK life assurance subsidiaries and funds
note iii
Jackson
note ii
Asian life assurance subsidiaries
note iv
Group total
Available capital at 31 December 2009 6,432 1,607 2,488 1,129 11,656
Changes in assumptions (83) 30 (2) (55)
Changes in management policy 364 364
Changes in regulatory requirements (60) (60)
New business and other factors(note v) 87 70 479 251 887
Available capital at 31 December 2010 6,800 1,707 2,907 1,378 12,792

Details on the movement for 2009 is as follows:

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  2009 £m
WPSF
note i
Other UK life assurance subsidiaries and funds
note iii
Jackson
note ii
Asian life assurance subsidiaries
note iv
Group total
Available capital at 31 December 2008 5,362 1,053 2,758 1,410 10,583
Changes in assumptions 18 23 2 43
Changes in management policy 26 (101) (75)
Changes in regulatory requirements 128 178 306
New business and other factors(note v) 1,052 505 (398) (360) 799
Available capital at 31 December 2009 6,432 1,607 2,488 1,129 11,656
Notes
  1. WPSF

    The increase in 2010 reflects primarily the positive effect of changes in management policy in respect of hedge strategy, asset allocation, and other risk alignment changes.

    The increase in 2009 reflected primarily the positive investment returns earned on the opening available capital and £18 million positive effect of changes in assumptions on a regulatory basis.

  2. Jackson

    The increase of £419 million in 2010 reflects an underlying increase of £340 million (applying the 2010 year end exchange rate of $1.57:£1) and £79 million of exchange translation gains.

    The decrease of £270 million in 2009 reflected an underlying increase of £33 million (applying the 2009 year end exchange rate of $1.61:£1) and £303 million of exchange translation loss.

    The underlying movement of the available capital of Jackson included the effects of capital contributions, dividends paid to the parent company, impairment losses and also the effects of hedging transactions.

  3. Other UK life assurance subsidiaries and funds

    The effect from the changes in assumptions of valuation interest rates on insurance liabilities is broadly matched by the corresponding effect on assets leaving no significant impact on the available capital.

  4. Asian life assurance subsidiaries

    The increase of £251 million in 2010 reflects an underlying increase of £127 million (applying the relevant 2010 year end exchange rates) and £124 million of exchange translation gain. The underlying increase of available capital in 2010 included the effects of the acquisition of UOB Life Assurance Limited in Singapore in February 2010.

    The decrease of £281 million in 2009 reflected an underlying decrease of £152 million (applying the relevant 2009 year end exchange rates) and £129 million of exchange translation loss. The underlying decrease of available capital in 2009 included the effects of the change to a risk-based capital framework in Malaysia from 1 January 2009 as explained in section b above and also the sale of the Taiwan agency business in June 2009.

  5. New business and other factors comprise the effect of changes in new business, valuation interest rate, investment return, foreign exchange and other factors.

d Transferability of available capital

For PAC and all other UK long-term insurers, long-term business assets and liabilities must, by law, be maintained in funds separate from those for the assets and liabilities attributable to non-life insurance business or to shareholders. Only the 'established surplus', the excess of assets over liabilities in the long-term fund determined through a formal valuation, may be transferred so as to be available for other purposes. Distributions from the with-profits sub-fund to shareholders reflect the shareholders' one-ninth share of the cost of declared policyholders' bonuses.

Accordingly, the excess of assets over liabilities of the PAC long-term fund is retained within that company. The retention of the capital enables it to support with-profits and other business of the fund by, for example, providing the benefits associated with smoothing and guarantees. It also provides investment flexibility for the fund's assets by meeting the regulatory capital requirements that demonstrate solvency and by absorbing the costs of significant events or fundamental changes in its long-term business without affecting the bonus and investment policies.

For other UK long-term business subsidiaries, the amounts retained within the companies are at levels which provide an appropriate level of capital strength in excess of the regulatory minimum.

For Jackson, capital retention is maintained at a level consistent with an appropriate rating by Standard & Poor's. Currently Jackson is rated AA. Jackson can pay dividends on its capital stock only out of earned surplus unless prior regulatory approval is obtained. Furthermore, dividends which exceed the greater of statutory net gain from operations for the prior year or 10 per cent of Jackson's statutory surplus require prior regulatory approval.

For Asian subsidiaries, the amounts retained within the companies are at levels that provide an appropriate level of capital strength in excess of the local regulatory minimum. For ring-fenced with-profits funds, the excess of assets over liabilities is retained with distribution tied to the shareholders' share of bonuses through declaration of actuarially determined surplus. The Singapore and Malaysian businesses may, in general, remit dividends to the UK, provided the statutory insurance fund meets the capital adequacy standard required under local statutory regulations.

Available capital of the non-insurance business units is transferable to the life assurance businesses after taking account of an appropriate level of operating capital, based on local regulatory solvency targets, over and above basis liabilities. The economic capital model described in section D1 (concentration of risks) takes into account restrictions on mobility of capital across the Group with capital transfers to and from business units triggered at a solvency level consistent with these targets. The model takes into account restrictions on the availability to the Group of the estate of the various with-profits funds throughout the Group.

e Sensitivity of liabilities and total capital to changed market conditions and capital management policies

Prudential manages its assets, liabilities and capital locally, in accordance with local regulatory requirements and reflecting the different types of liabilities Prudential has in each business. As a result of the diversity of products offered by Prudential and the different regulatory requirements in which it operates, Prudential employs differing methods of asset/liability and capital management, depending on the business concerned.

Stochastic modelling of assets and liabilities is undertaken in the UK, Jackson and Asia to assess the economic capital requirements under different confidence intervals and time horizons. In addition, reserve adequacy testing under a range of scenarios and dynamic solvency testing is carried out, including under certain scenarios mandated by the UK, US and Asian regulators.

A stochastic approach models the inter-relationship between asset and liability movements, taking into account asset correlation, management actions and policyholder behaviour under a large number of alternative economic scenarios. These scenarios are projected forward over a period of time, typically 25 years or longer, and the liabilities and solvency position of the fund are calculated in each scenario in each future year. The fund's policy on management actions, including bonus and investment policy, continue to be set in order that they are consistent with the available capital and the targeted risk of default.

The sensitivity of liabilities and other components of total capital vary depending upon the type of business concerned and this conditions the approach to asset/liability management.

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.

f Intra-group arrangements in respect of SAIF

Should the assets of SAIF be inadequate to meet the guaranteed benefit obligations to the policyholders of SAIF, the PAC long-term fund would be liable to cover any such deficiency.

Due to the quality and diversity of the assets in SAIF and the ability of SAIF to revise guaranteed benefits in the event of an asset shortfall, the directors believe that the probability of either the PAC long-term fund or the Group's shareholders' funds, under their obligation to maintain the capital position of long-term funds generally, having to contribute to SAIF is remote.

 

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