2nd Jun 2005 07:02
Prudential PLC02 June 2005 EMBARGO: 07.00 hours, Thursday 2 June 2005 Prudential plc Economic Capital, Developments in Regulatory and Financial Reporting, and Restatement of 2004 Full Year Results under International Financial Reporting Standards and European Embedded Value Prudential plc publishes today selected 2004 financial information restatedunder European Embedded Value (EEV) and International Financial ReportingStandards (IFRS). The Group's underlying capital strength, cashflow and dividendpolicy are not affected by the adoption of either EEV or IFRS. In addition, we are also explaining the Group's regulatory capital positionunder the Financial Groups Directive (FGD) and the Group's economic capitalposition as at 31 December 2004. Prudential's Group Finance Director, Philip Broadley, said: "We are publishingtoday a comprehensive picture of the Group's economic and regulatory capitalpositions as at 31 December 2004 and the impact of adopting IFRS and EEV on our2004 financial results. We believe that the presentation of this informationwill enable investors to obtain a better understanding of the Group's capitalposition and profitability." European Embedded Value Prudential believes that the EEV methodology represents an improvement overexisting embedded value reporting methods used across Europe and supports itsintroduction. Prudential re-iterates its belief that embedded value reportingprovides investors with a truer measure of the underlying profitability of theGroup's long-term businesses and is a valuable supplement to statutory accounts. As a signatory to the European CFO (Chief Financial Officers) Forum on EuropeanEmbedded Value (EEV) principles, Prudential will adopt EEV methodology for its2005 year-end results. This will replace the Achieved Profit basis, the currentsupplementary basis of reporting. The adoption of the EEV methodology byPrudential results in a 1% reduction in the Group's total shareholders' funds to£8.5bn and an uplift of 8% in the value of new business for the year ending 31December 2004 to £741m. The main impact on the results arises from the effect of changes to the assumedlevel of locked-in capital allocated to each business, the adoption ofproduct-specific risk discount rates, and an explicit valuation of the timevalue of options and guarantees. The EEV results also include the value offuture profits from service companies (including fund management operations)that support the Group's long-term businesses and the UK defined benefitpensions scheme deficit. International Financial Reporting Standards From 1 January 2005, all listed European Groups must prepare their financialstatements in accordance with EU approved International Financial ReportingStandards (IFRS). The IFRS basis replaces the current Modified Statutory Basis. The Financial Review section of Prudential's 2004 Annual Report gave extensiveexplanation of the likely changes, which are confirmed in this announcement.Restatement under IFRS Phase 1 gives rise to a £15m reduction in operatingprofit for 2004 and an increase in shareholders funds of £470m. In conjunction with the adoption of IFRS, Prudential has reviewed all itsaccounting policies and is changing the method used to determine longer termreturns included within operating profits. This change, which is not requiredunder IFRS, increases operating profit by £91m, offset by a correspondingreduction in short-term fluctuations in investment returns, leaving total profitunchanged. Groups Directive Under the Insurance Groups Directive (IGD), introduced in January 2001, Groupsolvency is calculated by aggregating the surplus capital held in the regulatedsubsidiaries, then deducting group borrowings, other than those subordinateddebt issues that qualify as capital. The Financial Groups Directive (FGD), which has applied to Prudential since 1January 2005, involves a similar calculation of Group solvency as for the IGD,but the solvency test under the FGD is a continuous requirement and a regulatoryobligation. Prudential has put in place a regulatory capital projection modelfor all business units to ensure that the Group meets, at all times, thecontinuous solvency requirements. As at 31 December 2004, Prudential had a surplus of £845m on the IGD basis. Economic Capital Prudential has determined its economic capital requirement as the amount ofcapital required to ensure that the Group can meet its existing contractual anddiscretionary policyholder obligations and remain solvent at all times over a25-year time horizon, within a strict target solvency level. Economic capitalmethodology is different from the regulatory capital model used under IGD andFGD in that it allows the Group to take account of its geographic spread and itsability to diversify its risks across its businesses. Prudential's economic capital model, which it has been developing over the pastthree years, is integral to its capital and financial management at both Groupand business unit level. It provides Prudential with a measure of the impact oftaking on different risks in different parts of the world, both in terms of theextreme events that have the potential to deplete its capital base, and the moreday-to-day volatility to which it is exposed. As at 31 December 2004, Prudential had available capital of £3.4bn. Thisrepresents a surplus of £1.6bn over required economic capital of £1.8bn. Further details on each of these developments can be found in the attachedappendices: Appendix A European Embedded Value Page 4Appendix B International Financial Reporting Standards Page 14Appendix C Groups Directive Page 42Appendix D Economic Capital Page 44 -ENDS- Enquiries to: Rebecca Burrows, Group Communications Director 020 7548 3537 Media Investors/ Analysts Clare Staley 020 7548 3719 Andrew Crossley 020 7548 3166Joanne Davidson 020 7548 3708 James Matthews 020 7548 2007 Mike Kempster 020 7548 3738 Brunswick GroupKate Holgate 020 7404 5959 1. •A presentation to analysts and investors will take place at 9:30am at Governor's House, Laurence Pountney Hill, London, EC4R 0HH. A webcast of the presentation and the presentation slides will be available on the Group's website, www.prudential.co.uk. 2. •An interview with Philip Broadley (in video/audio/text) will be available on www.cantos.com and www.prudential.co.uk from 7.00am on 2 June 2005. Prudential plc, a company incorporated and with its principal place of businessin the United Kingdom, and its affiliated companies constitute one of theworld's leading financial services groups. It provides insurance and financialservices directly and through its subsidiaries and affiliates throughout theworld. It has been in existence for over 150 years and has £187bn in assetsunder management, as at 31 December 2004. Prudential plc is not affiliated inany manner with Prudential Financial, Inc, a company whose principal place ofbusiness is in the United States of America. Forward-Looking Statements This statement may contain certain "forward-looking statements" with respect tocertain of Prudential's plans and its current goals and expectations relating toits future financial condition, performance, results, strategy and objectives.Statements containing the words "believes", "intends", "expects", "plans","seeks" and "anticipates", and words of similar meaning, are forward-looking. Bytheir nature, all forward-looking statements involve risk and uncertaintybecause they relate to future events and circumstances which are beyondPrudential's control including among other things, UK domestic and globaleconomic and business conditions, market related risks such as fluctuations ininterest rates and exchange rates, and the performance of financial marketsgenerally; the policies and actions of regulatory authorities, the impact ofcompetition, inflation, and deflation; experience in particular with regard tomortality and morbidity trends, lapse rates and policy renewal rates; thetiming, impact and other uncertainties of future acquisitions or combinationswithin relevant industries; and the impact of changes in capital, solvency oraccounting standards, and tax and other legislation and regulations in thejurisdictions in which Prudential and its affiliates operate. This may forexample result in changes to assumptions used for determining results ofoperations or re-estimations of reserves for future policy benefits. As aresult, Prudential's actual future financial condition, performance and resultsmay differ materially from the plans, goals, and expectations set forth inPrudential's forward-looking statements. Prudential undertakes no obligation toupdate the forward-looking statements contained in this statement or any otherforward-looking statements it may make. Appendix A European Embedded Value (EEV) Principles •Prudential releases today restated 2004 supplementary results on an EEV basis. Key results are shown ahead of full adoption of the EEV principles at the 2005 year end. Highlights of the results on an EEV basis are shown below. EEV basis AP basis 2004 2004 £m £m-------------------------- --------- --------- New Business Profits 741 688 New Business Margin (1) 40% 37% Long-term Business Operating Profit Before Tax (2) 1,238 1,148 Total EEV Shareholder Funds (3) 8,481 8,596-------------------------- --------- --------- (1) Profits are expressed as a percentage of annual premium equivalent (APE) ofinsurance sales. (2) Excluding increase of £101m arising from the discretionary change ofaccounting policy for longer term returns as explained in the IFRS section. (3) Excluding increase of £166m brought about by changes described in the IFRSsection. •The adoption of the EEV principles results in a small change to the embedded value of the Group's business and an uplift in the value of new business. •The Group's underlying capital strength, cashflow, and dividend paying ability are unaffected by the adoption of the EEV principles. •The time value of options and guarantees granted to policyholders included within the Group's embedded value as at 31 December 2004 is £209m. Prudential believes that EEV reporting represents an evolution from the currentachieved profits (AP) basis used for supplementary reporting, and it welcomesthe improved clarity of information that it will provide to investors by theadopting companies. Prudential re-iterates its view that embedded valueinformation provides investors with a much truer picture of the underlyingprofitability of long-term insurance business. 1. •Background In May 2004, the CFO Forum, representing the Chief Financial Officers of 19 European Insurers, published the EEV Principles which are designed to improve the transparency and consistency of embedded value reporting. Member companies agreed to adopt the principles for supplementary reporting no later than the 2005 year-end. Prudential continues to play an active role in the CFO Forum. To enable analysts and investors to understand Prudential's approach and the impact to the results Prudential has decided to provide today a restatement of key 2004 achieved profits results under the EEV principles. However, 2005 interim results will continue to be reported on an achieved profits basis. Full disclosures in respect of the 2004 year end will be provided in December 2005 before Prudential fully adopts the principles in respect of full year 2005 results. 2. •Key Results 1. •Overview The 2004 results under the EEV basis are shown below together with previously reported achieved profits results. EEV basis AP basis £m £m -------------------------- ----------- ----------- New business Profits 741 688 New business Margin (1) 40% 37% Long-term Business Operating Profit 1,238 1,148 Before Tax (2) Total EEV Shareholder Funds (3) 8,481 8,596 -------------------------- ----------- ----------- (1) Profits are expressed as a percentage of annual premium equivalent (APE) of insurance sales. (2) Excluding increase of £101m arising from the discretionary change of accounting policy for longer term returns as explained in the IFRS section. (3) Excluding increase of £166m brought about by changes described in the IFRS section. The main drivers of change from an achieved profits basis are changed capitalisation levels, an explicit valuation of the time value of options and guarantees, and changed risk discount rates. The EEV results also include the value of future profits on service companies (including fund management operations) that support the Group's long-term businesses and the UK defined benefit pension scheme deficit. Core debt has been marked to market. For EEV reporting, encumbered capital has been set at economic levels, a bottom up approach has been used for the setting of risk discount rates which are both product-specific and geographically specific, whilst the time value of options and guarantees is explicitly valued using stochastic techniques. Finally, the value of future service company profits has been included within the in-force value of long-term business. The value of the UK defined benefit pension scheme deficit has been included on an IAS 19 basis. 2. •New Business Results 2.2.1. Operating Profit from New Business EEV Basis AP Basis Before tax Before tax £m £m ---------------------- ------------- ------------- UK and Europe Insurance Operations 241 220 Jackson National Life 145 156 Asian Operations 355 312 Total 741 688 ---------------------- ------------- ------------- The table below reconciles the movement from an achieved profits basis to an EEV basis. £m ------------------------------------- ------- Achieved Profits Basis 688 Economic Assumption Changes (3) Time Value of Options and Guarantees (30) Risk Discount Rates 91 JNL Variable Annuity Fees and Benefits 24 Inclusion of Fund Management Profits in respect of 17 Internal Funds Modelling changes and other (18) EEV Basis before change to JNL Tax Gross Up Approach 769 Change in JNL Gross Up Approach (28) EEV Basis 741 ------------------------------------- ------- Total Group new business profits have risen 8 per cent. The overall combined impact of the changed risk discount rates and explicit valuation of options is positive at £61m and this reflects the high proportion of bond-backed linked, non-profit and A&H (1) business, which have lower risk discount rates and minimal options and guarantees. There is no impact from using economic levels of capital as, for the current mix of business, statutory requirements are sufficient to meet our current assessment of economic capital requirements. The current mix of new business has relatively little in the way of options and guarantees. (1) A&H is Accident and Health For Jackson National Life (JNL), as part of the transition to EEV, we have taken the opportunity to simplify the basis on which we calculate the pre-tax results. Under EEV, the net profits are grossed up for tax at the expected tax rate. There is no economic impact from this presentational change. By way of comparison, under the previous method that applied under achieved profits, JNL's pre-tax new business profit would have been (around) £173m. Inclusion of Fund Management profits adds £17m to the new business value. The reconciliation in movement for each of the Group's Business Units is shown in Appendix A1. 2.2.2. New Business Margin EEV basis AP Basis ----------- ---------- % of % of % of % of APE PVNBP APE PVNBP -------------------- -------- -------- -------- -------- UK and Europe Insurance 30 3.4 27 n/a Operations Jackson National Life 32 3.2 34 n/a Asian Operations 62 10.4 54 n/a Total 40 5.0 37 n/a -------------------- -------- -------- -------- -------- Note PVBNBP is defined as the present value of new business premiums. The comments in section 2.2.1 apply here also. 3. •Total Shareholders' Funds EEV Basis AP Basis After tax After tax £m £m ---------------------- ------------- ------------- UK and Europe Insurance 4,228 4,051 Operations Jackson National Life 2,538 2,532 Asian Operations 1,567 1,672 Other 148 341 Total (1) 8,481 8,596 ---------------------- ------------- ------------- (1) Excluding a change of £166m brought about by changes described in the IFRS section. The reconciliation from an achieved profits basis to an EEV basis is shown below. £m ------------------------------------- ------ Achieved Profits Basis 8,596 Economic Assumption Changes 32 Use of Economic Capital (269) Time Value of Options and Guarantees (209) Risk Discount Rates 427 JNL VA fees and benefits 26 Inclusion of Fund Management Profits in respect of 200 Internal Funds Inclusion of Service Company Profits in respect of (7) Covered Business Mark to Market Core Debt (193) Modelling changes and other (122) EEV Basis 8,481 ------------------------------------- ------ The combined impact of increased encumbered capital, explicit valuation of options and guarantees, and the changed risk discount rates is broadly neutral, at £(51)m (less than 1 per cent of shareholders' funds). Inclusion of future profits on fund management businesses in respect of internal funds adds £200m to the embedded value, whilst the explicit modelling of Variable Annuity (VA) fees and benefits in the US adds £26m to the embedded value. There is no impact from the changed gross-up approach for JNL described in section 2.2.1. as shareholders' funds are net of tax. To reflect the leverage of shareholder cashflows, the Group's core debt has been marked to market. This results in a reduction in shareholders' funds of £193m. The time value of options and guarantees included in total shareholders' funds breaks down geographically as follows. Time Value of Options and Guarantees £m ----------------------- ------------------------ UK and Europe Insurance Operations 84 Jackson National Life 101 Asian Operations 24 Total 209 ----------------------- ------------------------ Prudential's exposure to the time value of options and guarantees based on the approach required by the EEV principles is relatively small at £209m or 2.5 per cent of the total Group shareholders' funds of £8.5bn. This is a direct result of Prudential's risk-based approach to management. By ensuring that the guarantees offered on our products are kept prudently low and by actively taking advantage of the management actions open to us we are able to minimise our shareholder exposures. The UK and Asia numbers of £84m and £24m reflect the fact that the majority of the guarantees are contained within with-profits products which are supported by healthy estates, and that we have increased encumbered capital to our target economic capital levels. JNL's number is also low due to the explicit charges on VA products used to meet the cost of any guarantees and the ability to change crediting rates in line with credit experience on fixed annuity business. 4. •Operating Profits EEV Basis AP Basis Before tax Before tax £m £m ----------------------------- --------- ----------- In-force long-term Business Operating 497 460 Profits Total long-term Business Operating 1,238 1,148 Profits Total Group Operating Profits from 1,212 1,144 Continuing Operations ----------------------------- --------- ----------- The main reasons behind the change in the in-force long-term business operating profits are increased unwind amounts, contribution from fund management businesses and in Asia additional expected interest income on economic capital notionally allocated to Asia (1) and the contribution from fund management business. (1) This results in an equal and opposite impact to interest income on central shareholder funds The impact of the discretionary changes in accounting policy for longer term returns as described in the IFRS section is to increase the total long-term business result by £101m whilst total operating profit for the Group increases from £1,212m to £1,307m. Appendix A2 provides further detail. 3. •Basis of Preparation 1. •Overall Approach The results presented in section 2 have been prepared using the EEV Principlesfor the Group's long-term business including fund management operations andservice companies that support the long-term businesses. The results of theGroup's other businesses have been incorporated on a modified statutory basis.In adopting the principles there has been no change in the definition oflong-term new business. The shareholders' interest in the Group's long-term business comprises, •the present value of future shareholder cash flows from in-force covered business (value of in-force business), less a deduction for the cost of locked-in ('encumbered') capital; •the locked-in ('encumbered') capital; and •shareholders' net worth in excess of encumbered capital. A full stochastic valuation has been undertaken to determine the value of thein-force business including the cost of capital. A deterministic valuation ofthe in-force business is also derived using consistent assumptions and the timevalue of the financial options and guarantees is derived as the differencebetween the two. The main changes Prudential has made in moving to an EEV basisof reporting are in the following areas. •encumbered capital; •valuation of financial options and guarantees; •risk discount rates; and •valuation of fund management companies that support the Group's long-term businesses In most other respects the approach that Prudential uses for its achievedprofits reporting already conforms to the requirements of the EEV Principles sothere has been no change in respect of these areas. Further detail on Prudential's approach is given below. 3.2. Capital In adopting the EEV principles, Prudential has decided to set encumbered capitalat its internal targets for economic capital, which have been assessed usinginternal models but without any credit for the significant geographicaldiversification benefits that exist within the Prudential Group. Forwith-profits business written into a segregated life fund, both in the UK andAsia, the capital available within the fund is sufficient to meet the economiccapital requirements. For all shareholder-backed business we lock-in the higherof economic capital and the local statutory minimum requirement. In the UK,economic capital requirements for annuity business are fully met by Pillar Irequirements being 4% of mathematical reserves (as used for achieved profitsreporting), which are also sufficient to meet Pillar II requirements asdetermined in the Individual Capital Assessment (ICA) submitted to the FinancialServices Authority (FSA). In the US, the level of capital that has previouslybeen locked in for achieved profits reporting, namely 235 per cent of the NAIC's(1) Company Action Level (CAL), is sufficient to meet the economic capitalrequirement. In Asia, our economic capital target is substantially higher thanlocal statutory requirements in total. Economic capital requirements vary byterritory, but in aggregate, the capital requirement is equivalent to theFinancial Groups Directive (FGD) requirement. (1) NAIC is the National Association of Insurance Commissioners (2) This is equivalent to 470% of the Authorised Control Level (ACL) The table below summarises the levels of encumbered capital for keyshareholder-backed business. Capital as a percentage of Relevant Statutory Requirement-------------------- --------------------------------- UK Annuity Business 100% of EU minimum Jackson National Life 235% of CAL Asian Operations 100% of FGD-------------------- --------------------------------- 3.3. Valuation of Options and Guarantees Options and guarantees have two components of value, intrinsic value and timevalue. The intrinsic value measures the value of the options and guarantees onthe chosen valuation assumptions (i.e. the extent to which they are 'in themoney'). The time value measures the additional value of the options andguarantees that arises from changing future financial conditions. The intrinsic value of options and guarantees is directly included in theembedded value calculated using deterministic assumptions while the time valueis captured through the use of stochastic techniques for the embedded valuecalculation that involve the projection of distributable profits under many(1,000 to 5,000) scenarios in which economic and financial factors are allowedto vary in a manner that is representative of possible future market behaviour.The time value is then determined by taking the difference between the averagepresent value of distributable profits under all these scenarios and thedeterministic embedded value referred to above. As required by the EEVprinciples, the option valuation is a real world one and not a market consistentvalue and uses investment return and risk discount rate assumptions which areconsistent with the main deterministic models. 3.4. Risk Discount Rates Principle G10.7 to G10.9 of the European Embedded Value Principles state that, "Discount rates used to determine the present value of future cash flows shouldbe set equal to risk free rates plus a risk margin. The risk margin shouldreflect any risk associated with the emergence of distributable earnings that isnot allowed for elsewhere in the valuation. Valuation of financing types of reinsurance and debt, including subordinated andcontingent debt, should ensure that the combined impact of their servicing costsand discount rates assumption does not distort the valuation of the underlyingbusiness. Risk discount rates may vary between product groups and territories." Prudential has adopted a bottom-up approach to the calculation of risk discountrates as we believe the intention of the EEV principles in this area is thatthey should relate to the risks within each product. Having considered thevarious options, Prudential firmly believes that a bottom-up approach is thebest way to achieve this. The risk discount rate so derived does not reflect amarket cost of capital but the risk of volatility associated with the casflowsin the embedded value model. Risk discount rates vary by major product group ineach territory and are derived using the formula, risk discount rate = risk free rate + ( product specific beta x equity riskpremium ) + additional margin of 50 bps The risk discount rates reflect the market risk inherent in each product groupand hence the volatility of product cashflows. They are determined byconsidering how the profits from each product are impacted by changes inexpected returns on various asset classes, and by converting this into arelative rate of return it is possible to derive a product specific beta. Afurther additional prudential margin of 50bps has been added to all riskdiscount rates. In setting risk discount rates any material financial optionsand guarantees that have been explicitly valued are excluded from thecalculation whilst capital levels are consistent with the economic capitallevels described in section 3.2 above. Asset backing reflects the actual assetsheld at the valuation date and projection assumptions used are the same as thosedescribed in section 3.5 and 3.6. An example of the calculation may be found atthe Group's website (www.prudential.co.uk). For Prudential's UK annuity business, which is well matched, the predominantfinancial risks are credit risk and interest rate risk. For this line ofbusiness the existing achieved profits embedded values and risk discount rateshave been carried over following validation by comparison to a market consistentvaluation. Weighted average risk discount rates are given below for each business unit Business New Business Achieved in-force Profits---------------------- ------------ ----------- ----------- UK and Europe Insurance 7.1% 7.1% 7.2%Operations Jackson National Life 5.8% 6.1% 7.4% Asian Operations 7.9% 8.0% 9.6% Group 7.2% 7.3% 7.8%---------------------- ------------ ----------- ----------- The in-force risk discount rate has been weighted using the value of in-forcewhilst the new business risk discount rate has been weighted by new businessprofits. It should be noted that these are just weighted summaries of the riskdiscount rates and are shown to give an indication of how they compare toachieved profits risk discount rates. The rates actually used are those derivedfor each specific product group. 3.5. Economic Assumptions and Stochastic Asset Model 3.5.1. Deterministic Calculations The principles used to set economic assumptions are set out below. Economic assumptions vary by territory, with risk free rates based on actualgovernment bond yields at the date of the valuation in territories withdeveloped capital markets and on the long-term view of Prudential's economistsfor those territories in Asia with less developed capital markets. Expectedreturns on equity and property asset classes are derived by adding a riskpremium, also based on the long-term view of Prudential's economists in respectof each territory, to the risk free rate. In the UK the equity risk premium is3.0 per cent above risk free rates which compares to 2.5 per cent previouslyused for achieved profits reporting. In order to maintain consistency with EEVreporting, the interim 2005 achieved profits equity risk premium assumption willnow rise to 3.0 per cent with a corresponding increase in the AP risk discountrate. The equity risk premium in the US is also 3.0 per cent, unchanged fromachieved profits reporting. In Asia, equity risk premiums range from 2.8 percent to 5.3 per cent. Assumptions for other asset classes, such as corporatebond spreads, are set consistently as best estimate assumptions. The investment return assumptions as derived above are applied to the actualassets held at the valuation date to derive the overall fund-earned rate. The table below summarises the principal financial assumptions. EEV Basis AP Basis---------------------------------- ---------- ---------- UK and Europe Insurance Operations Pre-tax expected long-term nominalrates of investment return: UK equities 7.6% 7.1% Overseas equities 7.3% to 8.3% 6.8% to 7.8% Property 6.3% 6.3% Gilts 4.6% 4.6% Corporate bonds 5.5% 5.5% Expected long-term rate of inflation 2.9% 2.9% Post-tax expected long-term nominalrate of return: Pension business (where no tax 6.8% 6.5%applies) Life business 5.9% 5.7% US Operations (Jackson National Life) Expected long-term spread betweenearned rate and rate credited topolicyholders for single premium 1.75% 1.75%deferred annuity business US 10 year treasury bond rate at 31 4.3% 4.3%December 2004 US Equities 7.3% 7.3% Asian Operations Inflation 0.0% to 7.8% 0.0% to 7.8% Government Bond Yield 1.9% to 13.0% 1.8% to 13.0% Equity 4.9% to 15.8% 4.9% to 15.8%---------------------------------- ---------- ---------- 3.5.2. Stochastic Calculations The economic assumptions used for the stochastic calculations are consistentwith those used for the deterministic calculations described in section 3.5.1.Assumptions specific to the stochastic calculations such as equity volatilityand credit losses reflect local market conditions and are based on a combinationof actual market data, historic market data and the long-term views ofPrudential's economists. Common principles have been adopted across the Groupfor the stochastic asset models, for example, separate modelling of individualasset classes but with allowance for correlation between the various assetclasses. Details are given below of the key characteristics of each model. UK and Europe Insurance Operations •Interest rates are projected using a two-factor model calibrated to actual market data. •The risk premium on equity assets is assumed to follow a lognormal distribution. •The corporate bond return is calculated as the return on a zero-coupon bond plus a spread. The spread process is a mean reverting stochastic process. •Property returns are modelled in a similar fashion to corporate bonds, namely as the return on a riskless bond, plus a risk premium, plus a process representative of the change in residual values and the change in value of the call option on rents. The rates to which the model has been calibrated are as follows: Mean (1) Standard Deviation (2)---------------- ---------------- ---------------- Government Bond Yield 4.6% 1.9% Corporate Bond Yield 5.5% 5.8% Equities 7.6% 20.0% Property 6.3% 15.0%---------------- ---------------- ---------------- (1) Means have been derived as the annualised arithmetic average return acrossall simulations and durations (2) Standard deviations have been calculated by taking the variance of theannualised average return in each year across all simulations, taking the squareroot and averaging overall durations. For interest rates the standard deviationrelates to the change in yield. Jackson National Life •Interest rates are projected using a three-factor model calibrated to actual market data. •Corporate bond returns are based on Treasury securities plus a spread that has been calibrated to current market conditions and varies by credit quality. •Variable Annuity equity and bond returns have been stochastically generated using a regime-switching lognormal model with parameters determined by reference to historical data. The volatility of equity fund returns ranges from 17.5 per cent to 28.0 per cent depending on risk class, and the volatility of bond funds ranges from 1.6 per cent to 4.7 per cent. Asian Operations The same asset return model, appropriately calibrated, as used in the UK hasbeen used for the Asian operations. The principal asset classes are governmentand corporate bonds. Equity holdings are much lower than in the UK whilstproperty is not held as an investment asset. Mean Standard Deviation---------------- ---------------- ---------------- Government Bond Yield (3) 1.9% to 13.0% 0.7% to 3.7% Equity Risk Premiums 2.8% to 5.3% 22.0% to 25.0%---------------- ---------------- ---------------- (3) Long Government bond yield (10 year duration) Management Actions In deriving the in-force value various management actions in response toemerging investment and fund solvency conditions have been modelled. Managementactions encompass, but are not confined to, the following areas. •Levels of reversionary bonuses and credited rates •Total claim values •Investment allocation decisions In all instances the modelled actions are in accordance with approved localpractice and therefore reflect the options actually available to management. Inthe UK, the actions assumed were the same as those adopted for the realisticbalance sheet (Pillar I, Peak 2) included in the regulatory return. 3.6. Non-Economic Assumptions Demographic Assumptions Mortality and morbidity assumptions are based on an analysis of recentexperience and reflect expected future experience. Where relevant, whencalculating the time value of in-force business, policyholder withdrawal ratesare allowed to vary in line in line with the emerging investment conditionsaccording to management's expectations ("dynamic lapses"). Expense Assumptions Expense levels, including those of service companies that support the company'slong-term business operations, are based on internal expense analysisinvestigations and are appropriately allocated to acquisition of new businessand renewal of in-force business. Exceptional expenses are identified separatelyand reported separately. No productivity gains have been assumed. With Profits Business and Treatment of Estate Where participating business is written into segregated life funds, the timevalue of options and guarantees reflects established profit participation rules. Projected bonus rates are consistent with the projected investment return andinclude the impact of management action taken in response to emerging investmentconditions. In the UK, which has the largest life fund of the Group, shareholders' interestin the estate is derived by increasing terminal bonus rates so as to exhaust theestate over the lifetime of the in-force with-profits business. In those fewextreme scenarios where the total assets of the life fund are insufficient tomeet policyholder claims in full, the excess cost is fully attributed toshareholders. In other territories with participating business, any required shareholderinjections required to meet contractual and other payments required by localpractice are also included in the time value of options and guarantees. Theshareholder's share in any positive residual estate has been determined as thepresent value of 10 per cent of that amount as at the end of the projection. Anydeficits are fully attributed to shareholders. Taxation and Other Legislation Current taxation and other legislation has been assumed to continue unalteredexcept where changes have been announced and the relevant legislation passed. Fund Management and Service Companies The value of future profits or losses from fund management and service companiesthat support the Group's long-term businesses are included in the in-force valueof the Group's long-term business. However, the statutory profits actuallyemerging continue to be shown together with profits from external fundmanagement business. The excess or shortfall of EEV profits over actualstatutory profits is included within the long-term business non-operatingresult. The assumptions used to value these businesses are consistent with those used tovalue the underlying long-term business. The value ascribed to the Group's fundmanagement businesses is shown as follows. Value of Fund Management Business £m----------------------- ----------------------- UK and Europe 123 Jackson National Life 20 Asia 57 Total 200----------------------- ----------------------- The value of future profits from service companies is negligible at £(7)m . Appendix A1: Reconciliation of Movement for New Business Profits UK and Europe Insurance Operations £m---------------------------------- --------- Achieved Profits Basis 220 Economic Assumptions 10 Time Value of Options and Guarantees (5) Risk Discount Rates 6 Fund Management 10 EEV Basis 241---------------------------------- --------- JNL £m---------------------------------- --------- Achieved Profits Basis 156 Economic Assumptions (8) Time Value of Options and Guarantees (29) Risk Discount Rates 30 JNL VA Fees and Benefits 24 Fund Management 4 Other (4) EEV Basis before change to JNL Tax Gross Up Approach 173 Change to JNL Gross Up Approach (28) EEV Basis 145---------------------------------- --------- Asian Operations £m---------------------------------- --------- Achieved Profits Basis 312 Economic Assumptions (5) Time Value of Options and Guarantees 0 Risk Discount Rates 55 Fund Management 3 Other (10) EEV Basis 355---------------------------------- --------- Appendix A2: Total Operating Profit Before Tax and Impact of IFRS AP Basis EEV Basis Impact of IFRS £m £m £m---------------------------- -------- -------- ----------- New Business Profits 688 741 741 In-force 460 497 598 Total Long-Term 1,148 1,238 1,339 Fund Management - M&G 136 136 136 - US Broker Dealer, Curian and (14) (14) (14)Fund Management - Asia Fund Management 19 19 19 Asia Development Costs (15) (15) (15) Egg 63 63 61 Other (193) (215) (219) Total Profit Before Tax from 1,144 1,212 1,307Continuing Operations ---------------------------- -------- -------- ----------- Note The IFRS changes include the impact of associated discretionary changes. APPENDIX B INTERNATIONAL FINANCIAL REPORTING STANDARDS ("IFRS") •Prudential has today released selected financial information of restated 2004 results following the adoption of International Financial Reporting Standards. •The adoption of IFRS has little impact on reported operating results (based on longer-term returns). •Proforma IFRS basis operating results before shareholder tax of £608m for the year ended 31 December 2004 compare with operating results previously published under UK GAAP of £623m. •The adoption of IFRS gives rise to changed valuation bases of derivatives and fixed income securities of Jackson National Life ("JNL"). These changes are likely to give rise to increased volatility in total profits and shareholders' equity. •Notwithstanding this increased volatility, the Company is of the view that the IFRS changes are not significant to an understanding of the Group's financial position. •In addition to the IFRS basis changes Prudential has chosen to make a discretionary change to the basis of determining investment returns included in operating profits for fixed income securities. This change is so as to reflect longer-term returns rather than 5 year averaged credit experience. After making this change, proforma IFRS basis operating profits for continuing operations for 2004 are £699m. Total IFRS profit before shareholder tax for continuing operations (including actual investment returns) of £985m is unaffected by this change. •The 2004 Achieved Profits basis ("AP basis") results have also been restated for the relevant IFRS changes as described elsewhere in this announcement. 1. Background The European Union ("EU") requires that all listed European Groups prepare their2005 financial statements in accordance with EU approved IFRS. The IFRS basis ofreporting replaces UK GAAP. The IFRS changes of themselves are not significant to an understanding of theGroup's financial position. The Financial Review section of Prudential's 2004 Annual Report gave extensiveexplanation of the likely changes, which are confirmed in this announcement. Theprincipal effect of the IFRS changes is that the reported impact of JNL'shedging strategy and the financial position of the Group's UK defined benefitpension schemes are brought more into focus. 2. Key Results Detailed notes on the basis of preparation and main features of the changesfollow in sections 3 and 4 of this announcement. Also included with thisannouncement are schedules of selected financial information (Schedules B1 toB6) which provide summary details of the IFRS and restated AP basis results. The changed basis of reporting also includes a discretionary change to thepresentation of investment returns for the Group's shareholder backednon-participating business that is unrelated to IFRS. The IFRS changes and thediscretionary change give rise to the following summary impact on full year 2004IFRS and AP basis results and shareholders' funds at 1 January 2005. IFRS Basis Results Discretionary Required change for change Change Previously longer-term to to published*1 investment statutory Statutory proforma Proforma (UK GAAP) returns IFRS IFRS*2 IFRS IFRS*2 Year ended 31 December £m £m £m £m £m £m2004 ------------------------ -------- -------- ------ ------- ------ ------- Operating profit based onlonger-term investmentreturns, beforeamortisation of goodwilland shareholder tax ofcontinuing operations: JNL 196 100 0 296 - 296 Other operations 427 (9) (6) 412 (9) 403 ---- ---------------------- -------- -------- ------ ------- ------ ------- Total 623 91 (6)*3 708 (9)*3 699 ==== ====================== ======== ======== ====== ======= ====== ======= Representing: ------- ------ ------- IFRS basis results 617 (9) 608 before discretionary change for longer-term investment returns Effect of 91 - 91 discretionary change ------- ------ ------- of policy for longer-term investment returns IFRS basis results 708 (9) 699 after discretionary change for longer-term investment returns ==== ====================== ======== ======== ====== ======= ====== ======= Total profit, including 758 - 92 850 135 985actual investment return,before shareholders' tax ofcontinuing operations ==== ====================== ======== ======== ====== ======= ====== ======= Shareholders' Equity(capital and reserves) •As at 31 4,281 - 209 4,490 261 4,751 December 2004 •Transition adjustment - - 236 236 (261) (25) following full application of IAS 32, IAS 39 and IFRS 4 •As at 1 January 4,281 - 445 4,726 - 4,726 2005 ==== ====================== ======== ======== ====== ======= ====== ======= Achieved Profits ("AP") Basis Results Discretionary--------------------------------------- change for longer-term Previously investment IFRS published*1 returns change Restated Year ended 31 December 2004 £m £m £m £m------------------------------- -------- ---------- ------- ------- Group AP operating profit, based on 1,144 101 (6) 1,239longer-term investment returns, beforetax of continuing operations ------------------------------- -------- ---------- ------- ------- Total Group AP profit, including actual 1,629 - 85 1,714investment returns, before tax ofcontinuing operations ------------------------------- -------- ---------- ------- ------- Group AP Shareholders' Equity •As at 31 December 2004 8,596 - 166 8,762 •Transition adjustment following application of IAS39 - (25) (25) and IFRS4 •As at 1 January 2005 8,596 141 8,737 ------------------------------- -------- ---------- ------- ------- *1 Figures shown as 'previously published' relate to continuing operations and exclude amounts attached to discontinued activities, including Egg's Funds Direct operations. *2 See notes a to d of section 3.1 for basis of preparation and context of references to 'statutory' and 'proforma' bases of presentation. *3 Total changes arising from IFRS shown above give rise to a reduction of £15m in operating profit - as referred to in the overview press release. The statutory IFRS basis financial information included within this announcementestablishes the results attributable to shareholders, on the basis of selectedfinancial information, to be included in the Group's interim 2005 results andits first annual financial statements for the year ended 31 December 2005. Dueto the continuing work of the International Accounting Standards Board (IASB)and possible amendments to the interpretative guidance, the Group's accountingpolicies, and consequently the information presented, may change prior to thepublication of the first IFRS results in July 2005 and/or the 2005 full yearresults to be published in mid March 2006. Additional details on the basis of preparation, of the Group's principalaccounting policies, and supplementary results schedules are to be included on 2June 2005 on the Group's website (www.prudential.co.uk) with the details of thisannouncement. 3. IFRS basis results 1. •Summary Discretionary change for Required longer-term change Previously investment to Statutory Change to Proforma published*1 returns statutory IFRS*2 proforma IFRS*2 (UK GAAP) (note b) IFRS (note a) IFRS (note a) Year ended 31 December £m £m £m £m £m £m2004 -------------------- -------- -------- ------ ------ ------- ------- Operating profit basedon longer-terminvestment returns,before amortisationof goodwill andshareholder tax ofcontinuingoperations (note c) JNL 196 100 0 296 0 296 Other operations 427 (9) (6) 412 (9) 403 ---- ------------------ -------- -------- ------ ------ ------- -------Related Shares:
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