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:
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:
- the expected level of future defaults;
- the credit risk premium that is required to compensate for the potential volatility in default levels;
- the liquidity premium that is required to compensate for the lower liquidity of corporate bonds relative to swaps; and
- 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.
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:
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: