Notes D-F

D: Profit before tax – asset management operations

The profit included in the income statement in respect of asset management operations for the period is as follows:

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2013 £m 2012* £m
M&G US Eastspring
Investments
Half year
Total
Half year
Total
Full year
Total

* The 2012 comparative results have been adjusted retrospectively from those previously published for the application of the new and amended accounting standards described in note B. One of the new accounting standards adopted was IFRS 11 which requires joint ventures to be equity accounted. Accordingly, share of profit from joint ventures and associates is disclosed as a separate line.

Notes

  1. Under IFRS, disclosure details of segment revenue are required. The segment revenue of the Group’s asset management operations is required to include NPH broker-dealer fees which represent commissions received, that are then paid on to the writing brokers on the sale of investment products. This item is for amounts which, reflecting their commercial nature, are also wholly reflected as charges within the income statement. After allowing for these charges, there is no effect on profit from this item.
    The presentation in the table above shows the amounts attributable to this item so that the underlying revenue and charges can be seen.
  2. M&G operating profit based on longer-term investment returns:

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    2013 £m 2012 £m
    Half year Half year Full year
    Asset management fee income 418 351 728
    Other income 3 3 6
    Staff costs (149) (120) (289)
    Other costs (77) (66) (147)
    Underlying profit before performance-related fees 195 168 298
    Share of associate results 5 6 13
    Performance-related fees 4 1 9
    Operating profit from asset management operations 204 175 320
    Operating profit from Prudential Capital 21 24 51
    Total M&G operating profit based on longer-term investment returns 225 199 371

     

    The difference between the fees and other income shown above in respect of asset management operations, and the revenue figure for M&G shown (excluding consolidated investment funds) in the main table primarily relates to total revenue of Prudential Capital (including short-term fluctuations in investment returns) of £51 million (half year 2012: £99 million; full year 2012: £218 million) and commissions which have been netted off in arriving at the fee income of £418 million (half year 2012: £351 million; full year 2012: £728 million) in the table above. The difference in the presentation of commission is aligned with how management reviews the business.
  3. Short-term fluctuations in investment returns for M&G are primarily in respect of unrealised fair value movements on Prudential Capital’s bond portfolio.
Revenue (excluding NPH broker-dealer fees) 612 181 123 916 831 1,739
NPH broker-dealer feesnote (i) 249 249 215 435
Gross revenue 612 430 123 1,165 1,046 2,174
Charges (excluding NPH broker-dealer fees) (401) (147) (96) (644) (513) (1,144)
NPH broker-dealer feesnote (i) (249) (249) (215) (435)
Gross charges (401) (396) (96) (893) (728) (1,579)
Share of profit from joint ventures and associates, net of related tax 5 11 16 14 24
Profit before tax 216 34 38 288 332 619
Comprising:  

Operating profit based on longer-term
investment returnsnote (ii)
225 34 38 297 248 479
Short-term fluctuations in investment
returnsnote (iii)
(9) (9) 42 98
Gain on dilution of Group holdings 42 42
Profit before tax 216 34 38 288 332 619

E: Insurance assets and liabilities – key results features

In addition to the effect of the new accounting pronouncements for 2013 as disclosed in note B, the following features are of particular relevance to the determination of the 2013 results in respect of the measurement of insurance assets and liabilities.

i Asia insurance operations – non-recurrent items

In half year 2013, the IFRS operating profit based on longer-term investment returns for Asia insurance operations included a net £31 million credit (half year 2012: £17 million credit; full year 2012: £48 million credit) representing a small number of non-recurring items that are not anticipated to reoccur in subsequent periods. The full year 2012 operating profit also included the £51 million gain on sale of the stake in China Life of Taiwan.

ii US insurance operations – amortisation of deferred acquisition costs

Under the Group’s basis of applying IFRS 4, the insurance assets and liabilities of Jackson’s life and annuity business are accounted for under US GAAP. In line with industry practice, Jackson applies the mean reversion technique for amortisation of deferred acquisition costs on variable annuity business which dampens the effects of short-term market movements on expected gross profits against which deferred acquisition costs are amortised. To the extent that the mean reversion methodology does not fully dampen the effects of market returns there is a charge or credit for accelerated or decelerated amortisation. For half year 2013, reflecting the positive market returns in the period, there was a credit for decelerated amortisation of £20 million (half year 2012: £25 million; full year 2012: £56 million, as explained in note N).

iii UK insurance operations – allowance for credit risk of the annuity business

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

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

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

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

The allowance for credit risk comprises (i) an amount for long-term best estimate defaults, and (ii) additional provisions for credit risk premium, downgrade resilience and short-term defaults.

Prudential Retirement Income Limited (PRIL) is the principal company which writes the UK’s shareholder-backed business.

The weighted components of the bond spread over swap rates for shareholder-backed fixed and linked annuity business for PRIL at 30 June 2013, 30 June 2012 and 31 December 2012, based on the asset mix at the relevant balance sheet date are shown below.

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30 Jun 2013 bps
Pillar 1
regulatory
basis
Adjustment
from
regulatory to
IFRS basis
IFRS
basis
Bond spread over swap ratesnote (i) 157 157
Credit risk allowance:  

Long-term expected defaultsnote (ii) 15 15
Additional provisionsnote (iii) 49 (22) 27
Total credit risk allowance 64 (22) 42
Liquidity premium 93 22 115

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30 Jun 2012 bps
Pillar 1
regulatory
basis
Adjustment
from
regulatory to
IFRS basis
IFRS
basis
Bond spread over swap ratesnote (i) 191 191
Credit risk allowance:
Long-term expected defaultsnote (ii) 16 16
Additional provisionsnote (iii) 50 (23) 27
Total credit risk allowance 66 (23) 43
Liquidity premium 125 23 148

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31 Dec 2012 bps
Pillar 1
regulatory
basis
Adjustment
from
regulatory to
IFRS basis
IFRS
basis

Notes

  1. Bond spread over swap rates reflect market observed data.
  2. Long-term expected defaults are derived by applying Moody's data from 1970 to 2009 and the definition of the credit rating used is the second highest credit rating published by Moody's, Standard & Poor's and Fitch.
  3. Additional provisions comprise credit risk premium, which is derived from Moody's data from 1970 to 2009, an allowance for a one notch downgrade of the portfolio subject to credit risk, and an additional allowance for short-term defaults.
Bond spread over swap ratesnote (i) 161 161
Credit risk allowance:
Long-term expected defaultsnote (ii) 15 15
Additional provisionsnote (iii) 50 (23) 27
Total credit risk allowance 65 (23) 42
Liquidity premium 96 23 119

The prudent Pillar 1 regulatory basis reflects the overriding objective of maintaining sufficient provisions and capital to ensure payments to policyholders can be made. The approach for IFRS aims to establish liabilities that are closer to ‘best estimate’.

The movement in the first half of 2013 of the average basis points allowance for PRIL on the IFRS basis is as follows:

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Pillar 1
regulatory
basis
bps
IFRS
basis
bps
Total Total
Total allowance for credit risk at 31 December 2012 65 42
Credit rating changes 1 1
Asset trading (1) (1)
Asset mix (effect of market value movements)
New business and other (1)
Total allowance for credit risk at 30 June 2013 64 42

The methodology applied is to retain favourable credit experience in short-term allowances for credit risk on the IFRS basis but such surplus experience is not retained in the Pillar 1 credit provisions.

Overall the movement has led to the credit allowance for Pillar 1 purposes to be 41 per cent (30 June 2012: 35 per cent; 31 December 2012: 40 per cent) of the bond spread over swap rates. For IFRS purposes it represents 27 per cent (30 June 2012: 22 per cent; 31 December 2012: 26 per cent) of the bond spread over swap rates.

The reserves for credit risk allowance at 30 June 2013 for the UK shareholder annuity fund were as follows:

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Pillar 1
regulatory
basis
£bn
IFRS
basis
£bn
Total Total
PRIL 1.8 1.1
PAC non-profit sub-fund 0.2 0.1
Total – 30 June 2013 2.0 1.2
Total – 31 December 2012 2.1 1.3
Total – 30 June 2012 2.1 1.3

F: Short-term fluctuations in investment returns on shareholder-backed business

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2013 £m 2012* £m
Half year Half year Full year

* The 2012 comparative results have been adjusted retrospectively from those previously published for the application of the new and amended accounting standards described in note B. In addition, to facilitate comparisons of results that reflect the Group's retained operations, the short-term fluctuations in investment returns attributable to the held for sale Japan Life business are included separately within the supplementary analysis of profit.

Notes

  1. General overview of defaults
    The Group did not experience any defaults on its shareholder-backed debt securities portfolio in half year 2013 and 2012.
  2. Asia insurance operations
    In Asia, the negative short-term fluctuations of £(137) million (half year 2012: positive £26 million; full year 2012: positive £54 million) primarily reflect net unrealised movements on bond holdings following a rise in bond yields during the period.
  3. US insurance operations
    The short-term fluctuations in investment returns for US insurance operations comprise the following items:

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    2013 £m 2012 £m
    Half year Half year Full year


    The short-term fluctuations in investment returns shown in the table above are stated net of the related change to amortisation of deferred acquisition costs of £242 million (half year 2012: £80 million; full year 2012: £76 million). See note N.

    Notes

    1. The charges on the debt securities of Jackson comprise the following:

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      2013 £m 2012 £m
      Half year Half year Full year
      Prime (including agency) 2 1 (4)
      Alt-A 1 (1)
      Sub-prime (1) (3) (3)
      Total residential mortgage-backed securities 1 (1) (8)
      Corporate debt securities (2) (12) (14)
      Other (20) (25)
      Total (1) (33) (47)
    2. The risk margin reserve (RMR) charge for longer-term credit-related losses included in operating profit based on longer-term investment returns of Jackson for half year 2013 is based on an average annual RMR of 25 basis points (half year 2012: 27 basis points; full year 2012: 26 basis points) on average book values of US$54.3 billion (half year 2012: US$44.2 billion; full year 2012: US$47.6 billion) as shown below:

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        Half year 2013
      Moody’s rating category (or equivalent under NAIC ratings of MBS) Average
      book value
      US$m
      RMR
      %
        Annual expected loss
        US$m   £m
      A3 or higher 27,411 0.11   (31)   (20)
      Baa1, 2 or 3 24,187 0.25   (61)   (40)
      Ba1, 2 or 3 1,633 1.14   (19)   (12)
      B1, 2 or 3 608 2.73   (17)   (11)
      Below B3 423 2.15   (9)   (6)
      Total 54,262 0.25   (137)   (89)
      Related change to amortisation of deferred acquisition costs   26   17
      Risk margin reserve charge to operating profit for longer-term credit related losses   (111)   (72)


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        Half year 2013
      Moody’s rating category (or equivalent under NAIC ratings of MBS) Average
      book value
      US$m
      RMR
      %
        Annual expected loss
        US$m   £m
      A3 or higher 21,149 0.11   (23)   (15)
      Baa1, 2 or 3 20,655 0.26   (54)   (34)
      Ba1, 2 or 3 1,616 1.11   (18)   (11)
      B1, 2 or 3 560 2.97   (17)   (11)
      Below B3 174 3.77   (6)   (4)
      Total 44,154 0.27   (118)   (75)
      Related change to amortisation of deferred acquisition costs   18   11
      Risk margin reserve charge to operating profit for longer-term credit related losses   (100)   (64)
      † Annual expected loss as shown in the summary table above. The charge for the half year 2013 was £(44) million (half year 2012: £(38) million).

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        Full year 2012
      Moody’s rating category (or equivalent under NAIC ratings of MBS) Average
      book value
      US$m
      RMR
      %
        Annual expected loss
        US$m   £m
      A3 or higher 23,129 0.11   (26)   (16)
      Baa1, 2 or 3 21,892 0.26   (56)   (36)
      Ba1, 2 or 3 1,604 1.12   (18)   (11)
      B1, 2 or 3 597 2.82   (17)   (11)
      Below B3 342 2.44   (8)   (5)
      Total 47,564 0.26   (125)   (79)
      Related change to amortisation of deferred acquisition costs   21   13
      Risk margin reserve charge to operating profit for longer-term credit related losses   (104)   (66)
      Consistent with the basis of measurement of insurance assets and liabilities for Jackson’s IFRS results, the charges and credits to operating profits based on longer-term investment returns are partially offset by related changes to amortisation of deferred acquisition costs.
    3. Derivatives (other than equity-related): loss of £(380) million (half year 2012: gain of £179 million; full year 2012: gain of £135 million) net of related change to amortisation of deferred acquisition costs.
      These losses and gains are in respect of duration lengthening interest rate swaps and swaptions and for the GMIB reinsurance. The swaps and swaptions are undertaken to manage interest rate exposures and durations within the general account and the variable annuity and fixed index annuity guarantees (as described in note (d) below). The GMIB reinsurance is in place so as to fully insulate Jackson from the GMIB exposure.
      The amounts principally reflect the fair value movement on these instruments, net of related changes to amortisation of deferred acquisition costs.
      Under the Group’s IFRS reporting of Jackson’s derivatives (other than equity-related) programme significant accounting mismatches arise. This is because:

      – The derivatives are required to be fair valued with the value movements booked in the income statement;
      – As noted above, part of the derivative value movements arises in respect of interest rate exposures within Jackson’s guarantee liabilities for variable annuity and fixed index annuity business which are only partially fair valued under IFRS (see below);
      – The GMIB liability is valued under the US GAAP insurance measurement basis applied for IFRS in a way that substantially does not recognise the effect of market movements. However, notwithstanding that the liability is fully reinsured, as the reinsurance asset is net settled it is deemed a derivative under IAS 39 which requires fair valuation; and
      – Fair value movements on Jackson’s debt securities are booked in other comprehensive income rather than the income statement.
    4. Net equity hedge result: loss of £(166) million (half year 2012: loss of £(320) million; full year 2012: loss of £(302) million).
      These amounts are in respect of the equity-based derivatives and associated guarantee liabilities of Jackson’s variable and fixed index annuity business. The equity-based derivatives are undertaken to manage the equity risk exposure of the guarantee liabilities. The economic exposure of these guarantee liabilities also includes the effects of changes in interest rates which are managed through the swaps and swaptions programmes described in note (c) above.

      The amounts reflect the net effect of:
      – Fair value movements on free-standing equity derivatives;
      – The accounting value movements on the variable annuity and fixed index annuity guarantee liabilities;
      – Fee assessments and claim payments in respect of guarantee liabilities; and
      – Related changes to DAC amortisation.

      Under the Group’s IFRS reporting of Jackson’s equity-based derivatives and associated guarantee liabilities significant accounting mismatches arise.
      This is because:

      – The free standing derivatives and GMWB ‘not for life’ embedded derivative liabilities are required to be fair valued. These fair value movements include the effects of changes to levels of equity markets, implied volatility and interest rates. The interest rate exposure is managed through the derivative programme explained above in note (c); and
      – The GMDB and GMWB ‘for life’ guarantees are valued under the US GAAP insurance measurement basis applied for IFRS in a way that substantially does not recognise the effect of equity market and interest rate changes.
    Charges in the period in investment returns:  
    Defaults
    Losses on sales of impaired and deteriorating bonds (2) (16) (23)
    Bond write downs (5) (25) (37)
    Recoveries/reversals 6 8 13
    Total charges in the periodnote (a) (1) (33) (47)
    Less: risk margin charge included in operating profit based on longer-term investment returnsnote (b) 44 38 79
      43 5 32
    Interest-related realised gains (losses):  
    Arising in the period 34 29 94
    Less: amortisation of gains and losses arising in current and prior periods to operating profit based on longer-term investment returns (45) (44) (91)
      (11) (15) 3
    Related change to amortisation of deferred acquisition costs (8) 2 (3)
    Total short-term fluctuations in investment returns related to debt securities 24 (8) 32
    Derivatives (other than equity-related): market value movement (net of related change to amortisation of deferred acquisition costs)note (c) (380) 179 135
    Net equity hedge results (net of related change to amortisation of deferred acquisition costs)note (d) (166) (320) (302)
    Equity type investments: actual less longer-term return (net of related change to amortisation of deferred acquisition costs)note C 63 22 23
    Other items (net of related change to amortisation of deferred acquisition costs) 18 2 22
    Total (441) (125) (90)
    In addition to the items discussed above, for US insurance operations, included within the statement of Other Comprehensive Income is a decrease in net unrealised gains on debt securities classified as available-for-sale of £1,707 million (half year 2012: increase in net unrealised gains of £482 million; full year 2012: an increase in net unrealised gains of £862 million). Temporary market value movements do not reflect defaults or impairments. Additional details on the movement in the value of the Jackson portfolio are included in note R.
  4. UK insurance operations
    The negative short-term fluctuations for UK insurance operations of £(147) million (half year 2012: positive £5 million; full year 2012: positive £136 million) reflect net investment movements arising in the period on fixed income assets backing the capital of the annuity business following the rise in bond yields during the period.
  5. Economic hedge value movements
    This item represented the costs on short-dated hedge contracts taken out in first half of 2012 to provide downside protection against severe equity market falls through a period of particular uncertainty with respect to the Eurozone. The hedge contracts were terminated in the second half of 2012.
  6. Other
    Short-term fluctuations in investment returns of other operations, in addition to the previously discussed economic hedge value movement, were negative £(30) million (half year 2012: positive £62 million; full year 2012: positive £119 million) representing unrealised value movements on investments, including centrally held swaps to manage foreign exchange and certain macroeconomic exposures of the Group.
Insurance operations:  
Asianote (ii) (137) 26 54
USnote (iii) (441) (125) (90)
UKnote (iv) (147) 5 136
Other operations:  
Economic hedge value movementsnote (v) (15) (32)
Othernote (vi) (30) 62 119
Totalnote (i) (755) (47) 187
 
 

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