2nd Mar 2005 07:05
Prudential PLC2 March 2005 PART 2 FINANCIAL REVIEW SALES AND FUNDS UNDER MANAGEMENT Prudential delivered strong growth in sales during 2004 with total new insurancesales up 40 per cent to £12.1 billion at constant exchange rates (CER). Thisresulted in record insurance sales of £1.85 billion on the annual premiumequivalent (APE) basis, an increase of 26 per cent on 2003. At reported exchangerates, APE was up 19 per cent on 2003. In 2004, gross written premiums, including insurance renewal premiums, increased19 per cent to £16.4 billion, reflecting the growth of new insurance sales in2004 and the significant contribution from regular premium business written inprevious years. Total gross investment sales for 2004 were £25.1 billion, up 21 per cent on 2003at CER. Net investment sales of £3.6 billion were up 23 per cent on last year atCER. The strong growth across a number of markets offset the high level ofredemptions in Taiwan, which was the result of market concern about theliquidity of bond funds across the Taiwanese mutual fund market. Total investment funds under management in 2004 increased by 19 per cent from£30.9 billion to £37.1 billion, reflecting net investment flows of £3.6 billionand net market and other movements of £2.6 billion. At 31 December 2004, total insurance and investment funds under management were£187 billion, an increase of 11 per cent from 2003. This marked a record levelof funds under management and the increase was primarily due to the combinationof changes in the market value of investments and the impact of net insuranceand investment sales achieved during the year. Basis of preparation of results Prudential is required to account for its long-term insurance business on themodified statutory basis (MSB) of reporting under UK accounting standards. TheGroup's primary financial statements are therefore prepared on this basis andbroadly reflect the UK solvency-based reporting regime and, for overseasterritories, adjusted local or US GAAP. In broad terms, MSB profits forlong-term business reflect the aggregate of statutory transfers fromwith-profits funds and profits on a traditional deferral and matching approachfor other long-term business. Although the statutory transfers from with-profitsfunds are closely aligned with cash flow generation, the pattern of MSB profitsover time from shareholder-backed long-term businesses will generally differfrom the cash flow pattern. Over time however, aggregate MSB profits will be thesame as aggregate cash flow. Life insurance products are, by their nature, long-term and the profit on thisbusiness is generated over a significant number of years. MSB profits do not, inPrudential's opinion, properly reflect the inherent value of these future profitstreams. Accordingly, in common with other listed UK life assurers, Prudential alsoreports supplementary results for its long-term operations on the achievedprofits basis. These results are combined with the statutory basis results ofthe Group's other operations, including fund management and banking businesses.Reference to operating profit relates to profit including investment returns atthe expected long-term rate of return, but excludes amortisation of goodwill,exceptional items, short-term fluctuations in investment returns and the effectof changes in economic assumptions. In the directors' opinion, the achieved profits basis provides a more realisticreflection of the current performance of the Group's long-term insuranceoperations than results on the MSB basis, as it reflects the businessperformance during the accounting period under review, although both basesshould be considered in forming a view of the Group's performance. ACHIEVED PROFITS BASIS RESULTS The achieved profits basis results for long-term business are prepared inaccordance with the Association of British Insurers' (ABI) guidance for achievedprofits reporting issued in December 2001. This guidance requires that forcountries where capital markets are well developed, the economic assumptionsused for the projection of cash flows are to be on an 'active' basis, which isprimarily based on appropriate government bond returns at each period end. Theeffects of changed economic assumptions on the adjusted opening balance sheetvalue are reflected in the profit reported for the year and excluded fromoperating profit. The active basis is applied to UK and US operations, and those countries in Asiawhere there are well-developed government bond markets (Japan, Korea andUS$-denominated business in Hong Kong). Assumptions in other Asian countriescontinue to be based on an assessment of long-term economic conditions. In 2004, use of the active basis resulted in a decrease in the risk discountrate applied to the UK insurance operations from 7.4 per cent to 7.2 per cent,and a decrease in the UK investment return assumption for the UK with-profitsfund from 6.8 per cent to 6.5 per cent. The decrease primarily reflectsdecreases in the 15-year gilt yield from 4.8 per cent at the end of 2003 to 4.6per cent at the end of 2004. The risk margin over the risk free rate wasmaintained at 2.6 per cent. The expected long-term inflation rate assumptiondecreased from 3.1 per cent to 2.9 per cent, reflecting the difference betweenconventional and index-linked gilts. These changes are a function of the activebasis rather than a change in Prudential's long-term view of future returns andlevels of price inflation. In the US, the risk discount rate has remained at 7.4 per cent. The level ofcapital required to support the business (the 'target surplus') has been taken,as in 2003, to be 200 per cent of the Company Action Level Risk Based Capital,calculated in accordance with the National Association of InsuranceCommissioners' risk-based capital standards for life insurance companies. In Asia, each country has its own specific discount rate. The weighted averagerisk discount rate, which is determined by weighting each Asian country'seconomic assumptions by reference to the achieved profits basis operatingresults for new business written in 2004, was 9.6 per cent in 2004, a decreasefrom 10.4 per cent in 2003. The discount rates used in various countryoperations range between 5 per cent to 19 per cent. The weighted risk discountrate declined during 2004 principally due to lower pre-tax expected long-termnominal rates of investment return and lower weighted long-term rate ofinflation assumptions due to changes in the geographic mix of business in 2004. The overall impact on the Group's achieved profits basis result for 2004 ofusing these revised economic assumptions compared with those used in 2003, was areduction in new business achieved profit (NBAP) of around £13 million and adecrease in achieved profits basis shareholders' funds of £85 million. Achieved Profits Basis Operating Profits Total achieved profits basis operating profits from continuing operations were£1,124 million, up 39 per cent from 2003 at CER. At reported exchange rates, theresult was up 31 per cent. This result reflects a combination of strong growthin all the insurance and funds management businesses. Achieved Profits Basis 2004 2003 Percentage 2004 2003 PercentageOperating Profits Change Change (as reported) (at 2004 (as reported) (as reported) exchange rate) £'m £'m £'m £'mInsurance business UK and Europe 450 359 25% 450 359 25% US 317 176 80% 317 197 61% Asia 381 328 16% 381 365 4% Development expenses (15) (24) 38% (15) (27) 44% ---- ---- ---- ---- ---- ---- 1,133 839 35% 1,133 894 27% ---- ---- ---- ---- ---- ----Fund management business M&G 136 83 64% 136 83 64% US broker dealer and fund (14) (3) (367%) (14) (3) (367%) management Asia fund management 19 11 73% 19 13 46% ---- ---- ---- ---- ---- ---- 141 91 55% 141 93 52% ---- ---- ---- ---- ---- ----Banking Egg (UK) 43 55 (22%) 43 55 (22%)Other income and expenditure (193) (178) (8%) (193) (181) (7%) ---- ---- ---- ---- ---- ----Operating profits from 1,124 807 39% 1,124 861 31%continuing operations ---- ---- ---- ---- ---- ---- Prudential's insurance business achieved significant growth, both in terms ofnew business achieved profits (NBAP) and in-force profit, resulting in a 35 percent increase in operating profit over 2003 at CER. NBAP of £688 million was up23 per cent on the prior year at CER and up 14 per cent at reported exchangerates. In-force profit increased 51 per cent on 2003 at CER to £460 million. Atreported exchange rates, in-force profit was up 46 per cent. Results from fund management and banking business were £184 million, an increaseof 26 per cent at CER on 2003. This was mainly driven by the significantcontribution from M&G. Other income and expenditure was negative £193 million compared with negative£178 million at CER in 2003. This reflected an increase in investment return oncentrally held assets and other income offset by higher interest payable andhead office costs. New Business Achieved Profits (NBAP) In 2004, the Group has generated record new business achieved profits (NBAP)from insurance business of £688 million which was 23 per cent above 2003 at CER,driven by strong sales momentum across all markets. At reported exchange rates,NBAP was up 14 per cent. The average Group NBAP margin of 37 per cent wasslightly down from 38 per cent in 2003. The overall margin has been broadlymaintained over the last two years, reflecting careful management of product mixwithin each business and across the three regions. NBAP from the UK and Europe Insurance Operations was £220 million, an increaseof 40 per cent on 2003. This reflected increased APE sales and a balanced shiftin sales mix. This positive movement arose due to increased sales of moreprofitable bulk annuities partially offset by reduced sales of high marginwith-profit bonds and increased sales of less profitable executive pensions. Individual and bulk annuity margins remained strong at 43 per cent and 46 percent respectively, partly as a consequence of nearly all annuity business nowbeing written in Prudential Retirement Income Limited (PRIL), a shareholderbacked business. 88 per cent of annuities business was written in shareholderbacked funds in 2004, compared with 56 per cent in 2003. Previously, asubstantial proportion of annuity business was written in a subsidiary of thewith-profits fund. PRIL was established in September 2000, initially to write bulk annuitybusiness. This was expanded to include external individual annuity business andPrudential-branded internal vestings (annuity business sales arising frommaturing in-force pension books) in September 2001 and July 2004 respectively. Business to Business (B2B) corporate pensions saw a fall in NBAP margins to 9per cent principally reflecting a change of mix towards the less profitableunit-linked products. Margins on with-profits bonds remained stable at 41 percent. As the unit-linked business has gained scale, with sales growing by 219 per centin 2004, margins have approached a break-even position. In the US, JNL's NBAP of £156 million was up 18 per cent on 2003 at CER and up 5per cent at reported rates. This increase was principally volume driven as aresult of high sales levels recorded during the year. The NBAP margin was 34 percent in 2004, a slight reduction from 35 per cent in 2003 due to a shift inproduct mix and a small impact from economic assumption changes. Jackson National Life's expense ratio has fallen 3 basis points from 2002 tostand at 46 basis points at the end of 2004. We believe Jackson benefits fromits considerable expense advantage relative to its principal competitorsenabling it to maintain these attractive margins. The margin achieved on variable annuity business in 2004 was 37 per centcompared with 36 per cent in 2003. This improvement is a result of pricingchanges instituted early in 2004. For fixed annuity business the margin declinedby 9 per cent over the last 2 years to 32 per cent at the end of 2004. Thereduction in margin is due to a lower fund earned rate as yields have declined,however target spreads have been maintained. In Asia, NBAP of £312 million was up 19 per cent at CER on 2003, reflecting acombination of increased sales and higher NBAP margin. During 2004, APE saleswere up 14 per cent on 2003 and the NBAP margin was 54 per cent, compared with52 per cent in 2003 at CER. The increase in margin was principally due to acombination of changes in country mix and product mix being offset by the impactof assumption changes. In-Force Achieved Profits Total in-force profit in 2004 was £460 million, an increase of 51 per cent on2003 at CER. This was driven by the significant increase in the in-force profitin the US. UK and European in-force profit of £230 million was up 19 per cent on 2003. Theprofits arising from the unwind of discount from the in-force book werepartially offset by adverse operating assumption changes and other experiencecharges. A charge of £66 million was made reflecting a 40 per cent strengthening of thepersistency assumptions on the closed-book of personal pensions business soldthrough the closed direct sales force channel. This assumption change reflectsPrudential UK's experience over the last three years and, post-tax, representsabout 1 per cent of the overall embedded value of the UK business. Measures to manage and improve the conservation of in-force business have had abeneficial effect on persistency that Prudential UK expects to maintain orimprove. Consequently, Prudential UK has not changed persistency assumptions forall other products. Other charges of £34 million include £21 million of costs associated withcomplying with new regulatory requirements and restructuring. In the US, the in-force profit of £161 million was more than three times higherthan in 2003. This growth reflects improvements from 2003 in net experiencevariances to positive £33 million (an increase of £46 million at CER), changesin operating assumptions to negative £3 million (an increase of £16 million atCER) and changes in other items to positive £12 million (an increase of £37million at CER). Included in other items is a £28 million favourable legalsettlement. The £33 million positive total experience variance includes a £43 millionpositive spread variance (net of risk margin reserve) primarily reflecting afavourable variance in the fixed annuity portfolio. The assumed spread on newfixed annuity business is 155 basis points grading to 175 basis points over fiveyears. Asia's in-force profit (before development expenses and the Asian fundmanagement business) increased to £69 million in 2004 from £67 million in 2003at CER. This reflects a higher unwind of the discount rate as the in-forcebusiness builds scale and lower experience variances, offset by assumptionchanges of £56 million. The assumption changes made in 2004 principally reflecta worsening persistency in Singapore and a revision to expense assumptions inVietnam. Non-insurance Operations M&G M&G's operating profit was £136 million, an increase of 64 per cent on lastyear. This included £26 million in performance-related fees (PRF), of which £20million was generated by PPM Ventures on the exceptionally profitablerealisation of several investments during the year. Underlying profits of £110 million were 57 per cent higher than 2003, achievedas a result of a strong performance across all of M&G's business lines.Significant growth was delivered in the areas of fixed income, retail andproperty; attributable to the continued development of new business streams andthe recovery in stock markets during 2004. In addition, underlying profits werealso boosted by £7 million of one-off provision releases in 2004 that will notrecur in future years. M&G's revenue growth continues to be combined with careful cost control. In2004, M&G enjoyed the first full year of savings from the outsourcing of retailadministration at the end of 2003. This, together with the tight management ofoverhead across the entire business, has resulted in costs remaining flat forthe last four years. US broker dealer and fund management businesses The broker dealer and fund management operations, which includes Curian Capital,reported a total loss of £14 million, compared with a £3 million loss in 2003.This primarily reflects increased losses at Curian Capital as the businesscontinues to build scale. Asian fund management business Profit from Asian fund management operations was £19 million, up 73 per centfrom 2003, reflecting a combination of increasing scale and profitability in theretail business, particularly from the joint venture with ICICI in India, andhigher management fees from the UK and Asian life businesses. Egg Egg's total continuing operating profit in 2004 was £43 million, compared with£55 million in 2003, reflecting an increase in profit from the UK businessoffset by a £17 million impairment charge on the underlying assets of FundsDirect. Egg's UK business delivered a good set of results with a particularlyencouraging performance in the second half of 2004. For the full year, a profitof £74 million was recorded, compared with £73 million in 2003. This representsa solid result considering the increased competition and rising interest ratesthat have impacted the credit card and personal loan markets. Included in the continuing operating results was a charge of £3 million, whichrelated to the migration and other exit costs associated with the transfer ofthe funds supermarket business to Fidelity FundsNetwork. The transfer willresult in annual savings of around £3 million. Following the decision to dispose of its investment in Funds Direct, itsinvestment wrap platform business, Egg provided for a £17 million impairmentcharge against the full carrying value of the underlying assets of Funds Direct. Others Asia's development expenses (excluding the regional head office expenses)reduced by 38 per cent at CER to £15 million, compared with £24 million in 2003.These development expenses primarily related to repositioning the insuranceoperation in Japan. Other net expenditure increased by £15 million to £193 million. This reflectedan increase in investment return and other income offset by higher interestpayable and head office costs. Head office costs (including Asia regional headoffice costs of £29 million) were £83 million, up £16 million on 2003. Theincrease mainly reflects the substantial work being undertaken for theimplementation of International Financial Reporting Standards, Sarbanes Oxleyand other regulatory costs. Total Achieved Profits Basis - Result Before Tax (Year-on-year comparisons below are based on reported exchange rates.) The result before tax and minority interests was a profit of £1,521 million, up82 per cent on 2003. This primarily reflects the strong operating profit fromcontinuing operations of £1,124 million and the lower negative effect of changesin economic assumption of £100 million, compared with negative £540 million in2003. The result also benefited from strong investment performance which wasahead of the long-term investment assumptions. The UK component of short-term fluctuations in investment returns of £402million reflects the difference between an actual investment return deliveredfor the with-profits life fund of 13.4 per cent and the long-term assumed returnof 6.5 per cent. Short-term investment fluctuations in the US were £207 million. This includes apositive £161 million which represents the difference between actual net bondgains and the five-year average amount included in operating profit, and apositive £24 million in relation to changed expectations of future profitabilityon in-force variable annuity business, due to the separate account returnexceeding the long-term return reported in operating profit. In 2004, actual netbond gains were £48 million, compared with £39 million of bond losses in 2003. In Asia, short-term investment fluctuations were £48 million, compared with £1million last year. This mainly reflects the rising equity markets in a number ofcountries and falling bond yields in Singapore. In the UK, economic assumption changes of negative £19 million reflect theimpact of the decrease in the future investment return assumption offset by thedecrease in the risk discount rate. In the US, economic assumption changes were negative £53 million and included areduction in the projected earned rate, a reduction in the spread assumption forequity-linked indexed annuities business in-force prior to 2002 and an increasein inflation rates. Asia's negative economic assumption change of £28 million primarily reflects achange in Taiwan as a result of an increase in the discount rate and a change inthe fund earned rate assumption. Amortisation of goodwill was £97 million in 2004 compared to £98 million in2003. Profits on the disposals of Jackson Federal Bank and the Group's 15 per centinterest in Life Assurance Holding Corporation Limited were £41 million and £7million respectively. In France, an exit cost provision of £113 million was established in July 2004following Egg's announcement of its intention to withdraw from the Frenchmarket. £96 million of the provision had been used by 31 December 2004 and it isexpected that the withdrawal can be completed within the provision established. Total Achieved Profits Basis - Result After Tax The result after tax of £485 million and minority interests of positive £10million, was a profit of £1,046 million. The effective tax rate at an operating profit level was 29 per cent, reflectingthe lower effective tax rates in the UK and certain Asian territories. The effective tax rate at a total achieved profit level was 32 per cent on aprofit of £1,521 million. The higher effective rate of tax compared with that atan operating profit level is primarily due to amortisation of goodwill not beingdeductible for tax purposes. MODIFIED STATUTORY BASIS (MSB) RESULTS MSB Operating Profits MSB Operating Profits 2004 2003 Percentage 2004 2003 Percentage Change Change (as reported) (at 2004 (as reported) (as reported) exchange rate) £'m £'m £'m £'mInsurance business UK and Europe 305 256 19% 305 256 19% US 196 128 53% 196 143 37% Asia 126 77 64% 126 85 48% Development expenses (15) (24) 38% (15) (27) 44% ---- ---- ---- ---- ---- ---- 612 437 40% 612 457 34% ---- ---- ---- ---- ---- ----Fund management business M&G 136 83 64% 136 83 64% US broker dealer and fund (14) (3) (367%) (14) (3) (367%) management Asia fund management 19 11 73% 19 13 46% ---- ---- ---- ---- ---- ---- 141 91 55% 141 93 52% ---- ---- ---- ---- ---- ----Banking Egg (UK) 43 55 (22%) 43 55 (22%)Other income and expenditure (193) (178) 8% (193) (181) 7% ---- ---- ---- ---- ---- ----Operating profits from 603 405 49% 603 424 42%continuing operations ---- ---- ---- ---- ---- ---- Reference to operating profit relates to profit including investment returns atthe expected long-term rate of return but excludes amortisation of goodwill,exceptional items and short-term fluctuations in investment returns. Group operating profit from continuing operations on the modified statutorybasis (MSB) was £603 million, an increase of 49 per cent from 2003 at CER. Atreported exchange rates, operating profit was up 42 per cent on last year. Thisreflects strong growth in insurance and funds management businesses. In the UK, MSB operating profit was £305 million in 2004, an increase of 19 percent on 2003. This included a four-fold increase in PRIL's profit from £31million to £124 million. This more than offset the £17 million reduction in theprofit from the with-profits fund, which fell due to lower annual and terminalbonus rates announced in February 2004. In the US, JNL's operating profit from continuing operations of £182 million wasup 46 per cent on 2003. Total MSB operating profit for long-term business fromcontinuing operations was £196 million, up 53 per cent from £128 million in2003. Growth in the long-term business operating profit reflects JNL's clear focus onprofitability and its ability to deliver improved investment returns. In 2004,spread income was £169 million higher than in 2003 and variable annuity feeincome was at a record level due to the significant growth (47 per cent) inseparate account assets. In addition, there were two one-off items, a favourablelegal settlement of £28 million and a positive £8 million adjustment arisingfrom the adoption of SOP 03-01 "Accounting and Reporting by InsuranceEnterprises for Certain Non-traditional Long Duration Contracts and for SeparateAccounts". This adjustment relates to a change in the method of valuing certainliabilities. Prudential Corporation Asia's operating profit for long-term business beforedevelopment expenses of £15 million was £126 million, an increase of 64 per centon 2003 at CER. At reported rates, operating profit was 48 per cent up on lastyear. The majority of this profit currently still comes from the larger and moreestablished operations of Singapore, Hong Kong and Malaysia, which represented£110 million of the total in 2004, compared to £86 million last year. Five lifeoperations made MSB losses; China, India and Korea reflecting their rapidbuilding of scale while Thailand is marginally loss making and Japan's lossreduced significantly over 2003 due to lower new business strain, reducedmanagement expenses and mark to market gains on investments. Total MSB Profits - Result Before Tax (Year-on-year comparisons below are based on reported exchange rates.) MSB profits before tax and minority interests were £650 million in 2004,compared with £350 million in 2003. This mainly reflects growth in operatingprofits of £227 million and improvement in short-term fluctuations in investmentreturn, up £138 million from last year to positive £229 million. Amortisation of goodwill was £97 million in 2004 compared with £98 million in2003. Profits on the disposals of Jackson Federal Bank and the Group's 15 per centinterest in Life Assurance Holding Corporation Limited were £41 million and £7million respectively. In France, an exit cost provision of £113 million was established in July 2004following Egg's announcement of its intention to withdraw from the Frenchmarket. £96 million of the provision had been used by 31 December 2004 and it isexpected that the withdrawal can be completed within the provision established. Total MSB Profits - Result After Tax MSB profit after tax and minority interests was £428 million, after a tax chargeof £232 million. The effective tax rate at an operating profit level was 30 per cent, a blend ofthe effective tax rates of 35 per cent in the US, 33 per cent in Asia and 28 percent in the UK. The effective tax rate of 28 per cent on the UK results reflectsthe basis of taxation on profits arising from the life fund. The effective tax rate at a total MSB profit level was 36 per cent on a profitof £650 million. The higher effective rate of tax compared with that at anoperating profit level is primarily due to amortisation of goodwill not beingdeductible for tax purposes. Earnings per Share Earnings per share, based on achieved profits basis operating profit after taxand related minority interests, but before amortisation of goodwill, were up11.8 pence to 37.2 pence. The 2003 figure has been restated from 26.4 pence to25.4 pence to adjust for the bonus element of the Rights Issue. Earnings pershare, based on MSB operating profit after tax and related minority interests,but before amortisation of goodwill, were 19.2 pence, compared with a restated2003 figure of 12.4 pence. Basic earnings per share, based on total achieved profits basis profit for theyear after minority interests, were 49.1 pence, compared with a restated figureof 23.4 pence in 2003. Basic earnings per share, based on MSB profit for theyear after minority interests, were 20.1 pence, 10.1 pence up from a restated2003 figure of 10.0 pence. Dividend per Share As outlined in the rights issue prospectus, Prudential has maintained itscurrent dividend policy, with the proposed 2004 final dividend payment per sharetaking account of the bonus element of the rights issue. The shares issued as part of the rights issue were issued at a discount tomarket price (308 pence per share versus a closing share price of 458 pence pershare on the day immediately preceding the announcement of the rights issue). Itis therefore necessary to restate the Company's previously reported earnings andpreviously declared dividends per share for this bonus element. The bonus adjustment is equal to the closing share price on the final dayPrudential's shares traded cum-rights (19 October 2004) divided by thetheoretical ex-rights price (TERP) as outlined in the attached table: Market price cum-rights (Tuesday 19 October 2004) (pence) A 422.00Rights issue price (pence) B 308.00Number of shares pre rights issue (million) C 2,023.29Number of shares issued through rights issue (million) D 337.22 (A x C) + (B x D)Theoretical ex-rights price (pence) TERP = ------------------ 405.71 C + DBonus adjustment TERP / A 0.9614 The resulting bonus adjustment factor used for restating earnings and dividendsper share using the methodology outlined above is 0.9614. The final dividend per share for 2003 was 10.3 pence after adjusting for thebonus element of the rights issue (10.7 pence before the adjustment). Theinterim dividend for 2004 was 5.4 pence (5.2 pence after adjustment for therights issue). The Board recommends a full year dividend per share for 2004 of 15.84 pence, anincrease of 3.0 per cent over the full year 2003 dividend of 15.38 pence, afteradjustment for the bonus element of the rights issue. The 2004 dividend is covered 1.2 times by post-tax modified statutory basisprofit for the financial year after minority interests. Balance sheet Explanation of Balance Sheet Structure The Group's capital on an MSB basis comprises of shareholders' funds £4,281million; subordinated long term and perpetual debt of £1,429 million; othersenior debt £1,761 million and the Fund for Future Appropriations (FFA) £16.7billion. Shareholders' funds include the £1,021 million of new share capital allotted asa result of the rights issue in October 2004. Subordinated or hybrid debt is debt capital which has some equity like featuresand which would rank below other senior debt in the event of a liquidation.These features allow hybrid debt to be treated as capital for FSA regulatorypurposes. All of the Group's hybrid which qualifies in this way is held at theGroup level and is therefore taken as capital into the parent solvency testunder the Financial Groups Directive (FGD). The FSA has established a structure for determining how much hybrid debt cancount as capital which is similar to that used for banks. It categorises capitalas Tier 1 (equity and preference shares), Upper Tier 2 debt and Lower Tier 2debt. Up to 15 per cent of Tier 1 can be in the form of hybrid debt and called"Innovative Tier 1". At 31 December 2004, the Group held £638 million ofInnovative Tier 1 capital, in the form of perpetual securities, nil Upper Tier 2and £921 million of Lower Tier 2 capital. Following the implementation of theFGD, it is advantageous to the Group from a regulatory capital standpoint toraise its long-term debt in hybrid form and it is the Group's policy to takeadvantage of favourable market conditions as they arise to do so. The FFA represents assets in the Life Fund which have not yet been allocatedeither to policyholders or shareholders and which are not available to the Groupas a whole other than as they emerge through the statutory transfer of theshareholders' share of the surplus as it emerges from the fund over time. Asset and Liability Management Prudential manages its assets and liabilities locally, in accordance with localregulatory requirements and reflecting the differing types of liabilitiesPrudential has in each business. As a result of the diversity of productsPrudential offers and the different regulatory environments in which itoperates, Prudential employs different methods of asset/liability management onboth an in-force and new business basis. Stochastic modelling of assets andliabilities is undertaken in the UK, the US and Asia to assess economic capitalrequirements for different confidence intervals and time horizons. In addition,reserve adequacy testing under a range of scenarios and dynamic solvencyanalysis is carried out, including under certain scenarios mandated by the US,the UK and Asian regulators. Weighted Average Cost of Capital (WACC) Our commitment to our shareholders is to maximise the value of Prudential overtime by delivering superior financial returns. Prudential's weighted averagecost of capital (WACC) is 8.7 per cent, which is based on the net core debt andshares outstanding at the end of 2004, an equity market premium of 3 per centand a market Beta of 1.6. Prudential's core debt at the end of 2004 is net ofthe rights issue proceeds which have increased the proportion of the Group'scapital funded by equity and therefore increased the Group's WACC. Rights issue The strength of Prudential's businesses and positive developments in a number ofits markets represent an opportunity to enhance its market position and generateimproved returns for its shareholders. A strong financial position at a Grouplevel will provide increased financial flexibility and allow Prudential tocapitalise on these opportunities as they arise. In response to these developments the Board took the decision in October 2004 tolaunch a 1 for 6 Rights Issue. The majority of the net proceeds of the rights issue (£1,021 million) will beused to provide capital to support Prudential's growth plans for the UK and tofund a potential opportunity to increase its ownership from 26 per cent to 49per cent of its joint venture life insurance business with ICICI in India. Theremainder of the proceeds will be used to ensure that Prudential meets theparent company solvency test under the EU Financial Group Directive ("FGD") thatbecame effective from 1 January 2005. The proceeds of the Rights issue haveinitially been invested centrally within the Group in fixed interest securities. Shareholders' Funds On the achieved profits basis, which recognises the shareholders' interest inlong-term businesses, shareholders' funds at 31 December 2004 were £8.6 billion,up £1.6 billion from 31 December 2003. Modified statutory basis (MSB) shareholders' funds, which are not affected byfluctuations in the value of investments in the Group's with-profits funds were£4.3 billion, an increase of £1.1 billion from 31 December 2003. Internal rate of return (IRR) of insurance operations United Kingdom and Europe Prudential allocates shareholder capital to support new business growth across awide range of products in the UK. The weighted average post-tax Internal Rate ofReturn (IRR) on the capital allocated to new business growth in the UK in 2004was 12 per cent. This reflected an IRR of 20 per cent for annuity products, 7per cent for unit-linked bonds, 3 per cent for corporate pensions and 1 per centfor protection products. By the financial year ending 2007, Prudential is targeting an IRR of 14 per centon the capital required to support new business sold in that year in the UK,including individual product targets of 20 per cent for annuity products, 8 percent for unit-linked bonds, 15 per cent for corporate pensions and 15 per centfor protection products. United States For JNL, the average IRR on new business was 13 per cent which we believe to beabove the returns being earned currently in the US life insurance industry. Asia In Asia we have target IRRs on new business at a country level of 10 per centover the country risk discount rate. Risk discount rates vary from 5 per cent to19 per cent depending upon the maturity of the market. These target rates ofreturn are average rates and the marginal return on capital on a particularproduct could be above or below the target. We have, however, achieved or exceeded the target in each of Asia's markets in2004 except for Thailand and Japan. In Japan the returns on capital are belowour target, a result of restructuring and withdrawing from some business linesin 2003. The restructured business needs to build scale to achieve its target.In Thailand the returns on capital are below our target as this operation isrelatively small. In aggregate, IRR on new business exceeded 20 per cent onaverage risk discount rates for 2004 of 9.6 per cent. Cash Flow The table below shows the Group holding company cash flow. Prudential believesthat this format gives a clearer presentation of the use of the Group'sresources than the FRS 1 statement required by UK GAAP. 2004 2003 £m £m ---- ----Cash remitted by business unitsUK life fund transfer * 208 286UK - other dividends (including special dividend) 100 120JNL 62 48Asia 67 48M&G 84 84 ---- ----Total cash remitted to group 521 586Net interest paid (144) (127)Dividends paid (323) (447)Scrip dividends and share options 119 30 ---- ----Cash remittances after interest and dividends 173 42Tax received 34 77Corporate activities (31) 58 ---- ----Cash flow before investment in businesses 176 177Capital invested in business units:UK and Europe (189) (23)JNL 0 0Asia (158) (145)Other 0 (5) ---- ----(Decrease) / increase in cash before rights issue proceeds (171) 4Rights issues proceeds 1,021 0 ---- ----Increase in cash 850 4 ---- ----* - in respect of prior year bonus declarations The Group received £521 million in cash remittances from business units in 2004(2003: £586 million) comprising the shareholders' statutory life fund transferof £208 million relating to earlier bonus declarations, together with dividendsand interest from subsidiaries of £313 million. The shareholder transfer in 2005representing 2004's profits from the PAC with-profits fund, is expected to beapproximately £198 million. Prudential UK Insurance Operations paid a £100 million special dividend from thePAC shareholders' funds in respect of profits arising from earlier businessdisposals. A similar amount will also be distributed from PAC shareholders'funds in 2005. The level of scrip dividend take-up in 2004 (for both the 2003final and 2004 interim dividend) was greater than the corresponding take-up in2003, in part due to the change in basis of the election offered toshareholders. After dividends and interest paid, there was a net inflow of £173million (2003: £42 million). During 2004, the Group invested £31 million in corporate activities (2003: £58million receipt, arising from disposal proceeds and exceptional tax receipts). The Group invested £347 million during 2004 in its business units (2003: £173million). Investment in the UK Insurance Operations amounted to £189 million.This amount is expected to increase to around £250 million in 2005. Investmentin Asia in 2004 of £158 million is expected to remain broadly the same in 2005.In 2006, based on current plans and expectations, Prudential expects Asia to bea net capital provider to the Group. Together with the proceeds from the rights issue of £1,021 million, there was atotal increase in cash of £850 million (2003: £4 million). Shareholders' Borrowings and Financial Flexibility As a result of the holding company's net funds inflow of £850 million andexchange conversion gains of £49 million, net core borrowings at 31 December2004 were £1,236 million, compared with £2,135 million at 31 December 2003. After adjusting for holding company cash and short-term investments of £1,561million, core structural borrowings of shareholder-financed operations at theend of 2004 totalled £2,797 million, compared with £2,567 million at the end of2003. This increase reflected the issue of US$250 million (£137 million attransaction rate) Perpetual Subordinated Capital Securities and additionalshort-term borrowings of £150 million, partially offset by exchange conversiongains of £57 million. Core long-term loans at the end of 2004 included £1,762million at fixed rates of interest with maturity dates ranging from 2005 toperpetuity. £898 million of the core borrowings were denominated in US dollars,to hedge partially the currency exposure arising from the Group's investment inJackson National Life (JNL). Prudential has in place an unlimited global commercial paper programme. At 31December 2004 commercial paper of £517 million, US$761 million and €445 millionhad been issued under this programme. Prudential also has in place a £5,000million medium-term note (MTN) programme. At 31 December 2004 subordinated debtoutstandings under this programme were £435 million and €520 million, and seniordebt outstandings were US$18 million. In addition the holding company has accessto £1,400 million committed revolving credit facilities, provided by 14 majorinternational banks and a £500 million committed securities lending liquidityfacility. These facilities have not been drawn on during the year. Thecommercial paper programme, the MTN programme, the committed revolving creditfacilities and the committed securities lending liquidity facility are availablefor general corporate purposes and to support the liquidity needs of the parentcompany. The Group is funded centrally, except for Egg, which is responsible for its ownfinancing. The Group's core debt is managed to be within a target levelconsistent with its current debt ratings. At 31 December 2004, the gearingratio, on an achieved profit basis including hybrid debt (net of cash andshort-term investments) was 13 per cent compared with 23 per cent at 31 December2003. Prudential plc enjoys strong debt ratings from both Standard & Poor's andMoody's. Prudential long-term senior debt is rated AA- (negative outlook) and A2(stable outlook) from Standard & Poor's and Moody's respectively, whileshort-term ratings are A1+ and P-1. Based on the achieved profits basis operating profit from continuing operationsand interest payable on core structural borrowings, interest cover was 8.3 timesin 2004 compared with 6.6 times in 2003 (or 7.0 times based on restated achievedprofit in 2003). Fund for Future Appropriations During 2004, the fund for future appropriations, which represents the excess ofassets over policyholder liabilities for the Group's with-profits funds on astatutory basis, grew to £16.7 billion from £12.7 billion in 2003. This reflectsan increase in the cumulative retained earnings arising on with-profits businessthat have yet to be allocated to policyholders or shareholders. The change in2004 predominantly reflects the positive investment return earned by the PACwith-profits fund as a result of investment gains in the UK equity market. Developments in Regulatory Solvency Requirements The Financial Groups Directive ("FGD"), which affects groups with significantcross-sector activities in insurance and banking/investment services, came intoforce for Prudential from 1 January 2005. Prior to this, since 1 January 2001Prudential was required to meet the solvency requirements of the InsuranceGroups Directive ("IGD"), as implemented by the Financial Services Authority("FSA"). The FSA has implemented the FGD by applying the sectoral rules of thelargest sector, hence a group such as Prudential is classified as aninsurance-led conglomerate and is required to focus on the capital adequacyrequirements of the IGD, the Fourth Life Directive and the Insurance CompanyAccounts Directive. The FGD requires a continuous parent company solvency test which requires theaggregating of surplus capital held in the regulated subsidiaries, from whichgroup borrowings are deducted, other than those subordinated debt issues whichqualify as capital. The test is passed when this aggregate number is positive. Anegative result at any point in time is a notifiable breach of UK regulatoryrequirements. Additionally, the FSA has indicated that it will require publicdisclosure of the FGD solvency position from 31 December 2005, for which thedetailed rules on disclosure have yet to be published. In practice, whetherPrudential is classified as a financial conglomerate or insurance group, thereis very little difference in application of the rules. This is because the FSAhas decided to make the test mandatory from 31 December 2006 to all insurancegroups, and requires public disclosure of the group solvency position from 31December 2005. Due to the geographically diverse nature of Prudential's operations, theapplication of these requirements to Prudential are complex. In particular, formany of our Asian operations, the assets, liabilities and capital requirementshave to be recalculated based on FSA regulations as if the companies weredirectly subject to FSA regulation. Our current estimate of our FGD position isthat at the end of the year we have a surplus of at least £800 million. The European Union is continuing to develop a new prudential framework forinsurance companies, "the Solvency II project". The main aim of this frameworkis to ensure the financial stability of the insurance industry and protectpolicyholders through establishing solvency requirements better matched to thetrue risks of the business. Like Basel 2, the new approach is expected to bebased on the concept of three pillars - minimum capital requirements,supervisory review of firms' assessments of risk and enhanced disclosurerequirements. In particular, companies will be encouraged to improve their riskmanagement processes, including making use of internal economic capital modelsto enable a better understanding of the business. The emphasis on transparencyand comparability would help ensure a level playing field. Solvency II is being lead by the European Commission's (EC) Internal MarketDirector-General. The EC have directed the Committee of European Insurance andOccupational Pensions Supervisors (CEIOPS) to provide input on many technicalaspects of the framework. To this end, the EC and CEIOPS have jointly issuedCalls for Advice in order to incorporate broader feedback from industry. The expected outcome of the CEIOPS working groups is a draft directive for theCommission. Final agreement on the terms of the new Directive is not expectedbefore 2007 followed by implementation in 2009. Financial Strength of Insurance Operations United Kingdom A common measure of financial strength in the United Kingdom for long-terminsurance business is the free asset ratio. The free asset ratio is the ratio ofassets less liabilities to liabilities, and is expressed as a percentage ofliabilities. On a comparable basis with 2003, the free asset (or previousregulatory Form 9) ratio of the Prudential Assurance Company (PAC) long-termfund was approximately 14.8 per cent at the end of 2004, compared with 10.5 percent at 31 December 2003. The valuation has been prepared, in our opinion, on a conservative basis inaccordance with the current FSA valuation rules, and without the use of implicititems. No allowance has been taken for the present value of future profits andthe PAC long-term fund has not entered into any financial reinsurance contracts.Certain reinsurance treaties with a value of approximately £49 million, whichwere transferred from Scottish Amicable Life when that Company's businesstransferred into the PAC long-term fund at the end of 2002, were converted intoa contingent loan during 2004. The fund is very strong with an inherited estate measured on an essentiallydeterministic valuation basis of more than £6.5 billion compared withapproximately £6 billion at the end of 2003. On a realistic basis, withliabilities recorded on a market consistent basis, the free assets are valued ataround £5 billion before a deduction for the risk capital margin. The PAC long-term fund is rated AA+ by Standard & Poor's and Aa1 by Moody's. The table below shows the change in the investment mix of Prudential's mainwith-profits fund: 1999 2003 2004 % % % UK equities 58% 33% 33%International equities 14% 15% 15%Bonds 13% 31% 29%Property 11% 17% 18%Cash and other asset classes 4% 4% 5%Total 100% 100% 100% For the UK main with-profits fund 86 per cent of fixed income securities areinvestment grade with 23 per cent rated AA or above. For Prudential AnnuitiesLimited 98 per cent of the fixed income securities are investment grade with 46per cent rated AA or above. For Prudential Retirement Income Limited 98 per centof total assets are investment grade with 57 per cent rated AA or above. With-profits contracts are long-term contracts with relatively low guaranteedamounts, the nature of which permits Prudential to invest primarily in equitiesand property. However, over the period from 1999 to mid-2001 the fund reducedits exposure to equities. There was also a re-weighting within equities out ofthe UK and into overseas equities. This change in asset mix reflectedPrudential's view that equity valuations were high and that other assets,particularly corporate bonds, were relatively attractive. The change withinequities improved the fund's diversification and reduced expected fundvolatility. The change in asset mix in recent years has had a substantialbeneficial impact on investment returns. The broad asset mix will continue to bereviewed as the economic environment and market valuations change. The investment return on the Prudential main with-profits fund was 13.4 per centin the year to 31 December 2004 compared with the rise in the FTSE All Share(Total Return) Index of 12.8 per cent over the same period. Over the last tenyears the with-profits fund has consistently generated positive fund returnswith 3, 5 and 10 year compound returns of 6.7 per cent per annum, 3.8 per centper annum and 10.3 per cent per annum respectively. These returns demonstratethe benefits of the fund's strategic asset allocation and long-termoutperformance. During 2004 there was no change to the strategic assetallocation of the fund. There has been no significant reduction in the level ofthe fund's equity holdings during the year or subsequently. United States The capital adequacy position of Jackson National Life remains strong, with astrong risk-based capital ratio of 4.3 times the NAIC Company Action Level RiskBased Capital. JNL's financial strength is rated AA by Standard & Poor's(negative outlook) and A1 by Moody's. JNL's invested asset mix on a US regulatory basis (including Jackson NationalLife of New York but excluding policy loans and reverse repo leverage) is asfollows: 2002 2003 2004 % % % Bonds:Investment Grade Public 60 58 60Investment Grade Private 20 19 19Non Investment Grade Public 4 5 4Non Investment Grade Private 3 2 2Commercial Mortgages 8 10 11Private equities and real estate 3 4 3Equities, cash and other assets 2 2 1Total 100% 100% 100% Asia Prudential Corporation Asia maintains solvency margins in each of its operationsso that these are at or above the local regulatory requirements. Across theregion less than 20 per cent of non-linked funds are invested in equities. In the life operations with larger in-force books, both Singapore and Malaysiahave discrete life funds, good investment returns and in 2004 saw their freeRelated Shares:
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