Report of the Actuarial Function Holder of. The Prudential Assurance Company Limited (PAC)

Report of the Actuarial Function Holder of The Prudential Assurance Company Limited (PAC) on the proposed transfer of the long-term insurance business of the PAC Hong Kong Branch to Prudential Hong Kong Limited (PHKL) D J Belsham FIA Actuarial Function Holder The Prudential Assurance Company Limited August 2013

Contents Page 1. Introduction 3 Part A - Background information 2. Information on The Prudential Assurance Company Limited (PAC) 10 3. Information on the PAC Hong Kong Branch and PAC UK & Europe business 35 4. Financial position of PAC prior to the transfer 57 Part B - Domestication of with-profits business 5. Principles governing the proposed transfer of with-profits business 62 6. Proposed transfer of with-profits business 68 7. Financial impact of the proposed transfer on the with-profits funds of PAC and 113 PHKL at the point of domestication 8. Proposed governance arrangements for the transferring with-profits business 125 9. Assessment of the impact of the company s proposals in relation to withprofits business on transferring and non-transferring policyholders 155 Part C - Domestication of shareholder-backed business 10. Principles governing the transfer of shareholder-backed business 208 11. Proposed transfer of shareholder-backed business 211 12. Financial impact of the proposed transfer on the non-profit and shareholder funds of PAC and PHKL at the point of domestication 13. Assessment of the impact of the company s proposals in relation to shareholder-backed business on transferring and non-transferring policyholders 214 218 Part D Conclusions 14. Conclusions 226 Appendix A - Compliance with Technical Actuarial Standards (TASs) 232 160813 HK AFH report Final 2

REPORT OF THE ACTUARIAL FUNCTION HOLDER OF THE PRUDENTIAL ASSURANCE COMPANY LIMITED The following is the report by D J Belsham, the Actuarial Function Holder of The Prudential Assurance Company Limited (PAC), to the directors of PAC, on the proposed transfer of the long-term insurance business of the PAC Hong Kong branch to Prudential Hong Kong Limited (PHKL), a company incorporated in Hong Kong to undertake long-term insurance business. It is proposed that the transfer will take place on 1 January 2014, or on such other date as may be agreed by PAC and PHKL, and approved by the UK and Hong Kong Courts (the Transfer Date). 1. INTRODUCTION 1.1 The UK financial services regulators, the Prudential Regulation Authority (PRA) and the Financial Conduct Authority (FCA), normally expect the Actuarial Function Holder of a UK company involved in a proposed transfer of long-term insurance business to produce a report which considers the effect of the transfer on the policyholders affected. 1.2 The purpose of this report is to review the proposed transfer of the long-term insurance business of the PAC Hong Kong branch to PHKL. 1.3 PAC is part of a corporate group (the Prudential Group) whose parent company is Prudential plc. The Prudential Group is structured along geographical lines, with separate operating units that include Prudential UK & Europe and Prudential Corporation Asia (PCA). The Hong Kong branch of PAC does not currently fit comfortably into this structure since, from a legal perspective, it is part of PAC, the Prudential UK & Europe holding company, while, from an operating perspective, it is part of PCA. In order to resolve this structural anomaly, the Prudential Group wishes to transfer the Hong Kong business of PAC into two subsidiary companies incorporated in Hong Kong, one company transacting long-term business and the other company transacting general insurance business. This is expected to have the benefit of: (iii) (iv) better aligning the Prudential Group s operating units along regional lines; improving the efficiency of decision making; removing the tensions that currently exist within PAC as a result of the differing risk profiles and regulatory regimes that apply to its Hong Kong and its UK & Europe businesses, leaving each territory to pursue the strategy that best fits the need of its market, policyholders and shareholders; and improving longer-term corporate flexibility. 1.4 In accordance with the desired position set out above, it is proposed that the longterm business of the Hong Kong branch should be transferred from PAC to PHKL, a wholly owned subsidiary of the PAC shareholder fund. This will create a structure whereby, at a future date, PHKL can readily be transferred from PAC to a Prudential Group holding company so as to achieve a full separation of the Prudential Group s UK & Europe and Asian business. I would note that, historically, the Prudential Group s policy has been to transfer any subsidiaries out of PAC s shareholder fund for a consideration equal to the relevant subsidiary s embedded value, and I would 160813 HK AFH report Final 3

expect this to be the case in the event of PHKL being transferred to a Prudential Group holding company. 1.5 Under the proposed terms of the transfer, all of the long-term insurance business of PAC s Hong Kong branch, including capital to support the writing of future new business in Hong Kong, will be transferred to PHKL. The long-term insurance business to be transferred amounts to c.1.3m policies, with liabilities (including accounting liabilities and derivative liabilities) on a local Hong Kong regulatory basis as at 31 December 2012 of c. 9.4bn. The business comprises: (iii) with-profits policies (principally conventional whole of life policies) written in PAC s With-Profits Sub-Fund (WPSF); non-profit policies (principally conventional and unit-linked whole of life policies) written in PAC s Non-Profit Sub-Fund (NPSF); and a small amount of non-profit business (mainly riders to with-profits policies) written in the WPSF. 1.6 The transfer will take place by means of a Scheme (the Main Scheme) which will be presented for approval to: the Hong Kong Court, under section 24 of the Hong Kong Insurance Companies Ordinance (Cap 41); and the UK Court, under Part VII of the Financial Services and Markets Act 2000 (the FSMA 2000). Some policies may have to be excluded from the Main Scheme due to the fact that they cover risks arising in EEA States, over which, in this context, the UK Court has no jurisdiction. The transfer of these policies will be effected by means of a separate Scheme (the EEA Policies Scheme), which will be presented for approval to the Hong Kong Court only. The terms of the EEA Policies Scheme will be identical to the Main Scheme. References in this report to the Scheme relate to both the Main Scheme and the EEA Policies Scheme. The transfer will not proceed unless the Main Scheme and the EEA Policies Scheme are approved by the Hong Kong Court on terms that are satisfactory to PAC and PHKL. The transfer will also not proceed unless the English Court, having accepted jurisdiction to hear the transfer application, approves the Main Scheme on terms that are satisfactory to PAC and PHKL. This report should be read in conjunction with the Scheme. 1.7 The company s proposed transfer of with-profits business assumes that the risk levels of the Hong Kong and UK & Europe business will be aligned at, or will be capable of being aligned within nine months of, the Transfer Date. The alignment of the risk levels, the risk of misalignment arising prior to the Transfer Date, and the ability of the company to correct any misalignment, will accordingly be reviewed by various parties (including myself, as PAC Actuarial Function Holder, and the Independent Actuaries referred to in section 1.13 below) in supplementary reports shortly before the sanctions hearings of the Hong Kong and English Courts. The supplementary reports will be made available to the Hong Kong and English Courts and the Hong Kong and UK financial services regulators, and the transfer will not proceed if the 160813 HK AFH report Final 4

review of risk profiles does not provide the necessary confirmation that the risk levels will be aligned at, or will be capable of being aligned within nine months of, the Transfer Date. In addition, the Scheme will not become effective unless the Independent Actuaries, not more than 2 days prior to the Transfer Date, confirm to PAC, PHKL and the Hong Kong and UK financial services regulators in writing that, as far as they are aware and based on discussions with myself as Actuarial Function Holder: no event has occurred which would result in the risk levels of the Hong Kong and UK & Europe with-profits business not being aligned; or if such an event has occurred, the risk levels are capable of being aligned within nine months of the Transfer Date. 1.8 The transfer will also be implemented by means of a reinsurance treaty between PAC and PHKL (the PAL Reassurance Treaty), under which PAC s interest in certain UK non-profit annuity business written in the WPSF and in its subsidiary, Prudential Annuities Limited (PAL), will be apportioned between PAC and PHKL. Various capital support arrangements in connection with the transfer will also be put in place between PAC and PHKL, between Prudential plc and PAC, between Prudential plc and PHKL, and between Prudential plc and the Hong Kong Insurance Authority, in order to protect the security and reasonable benefit expectations of both the transferring and non-transferring policyholders. 1.9 It is intended that the Hong Kong branch business in PAC s WPSF will be transferred to the With-Profits Fund (WPF) of PHKL, and that the Hong Kong branch business in PAC s NPSF will be transferred to the Non-Profit Fund (NPF) of PHKL. The value of the assets to be transferred to the WPF will include a share of the inherited estate in the WPSF (the PAC inherited estate). The share of the PAC inherited estate that is allocated to the WPF will take into account PHKL's anticipated requirement for capital to fund the writing of new business in the WPF after the Transfer Date. The value of assets to be transferred to the NPF will also include capital to support the writing of new business in the NPF after the Transfer Date. The value of assets to be transferred from PAC to PHKL on the Transfer Date will be agreed by PAC and PHKL prior to the Transfer Date, and the amount transferred will subsequently be adjusted to reflect the actual position at the Transfer Date based on valuations of the UK & Europe and Hong Kong business at that date. The calculations undertaken at the Transfer Date will be subject to the approval of the PAC Board and the PHKL Board, having regard to reviews by myself (as PAC Actuarial Function Holder), the PHKL Actuary and, in the case of with-profits business, the PAC With-Profits Actuary, the PAC With-Profits Committee and the PHKL With-Profits Committee appointed under the Scheme. The calculations will also be subject to independent review under a process approved by the UK financial services regulators. 1.10 In this report, I have considered the transfer from the perspective of both the transferring Hong Kong policyholders and PAC s remaining UK & Europe policyholders. I have not explicitly considered the transfer from the perspective of the UK & Europe policyholders in the various insurance companies which PAC owns or partly owns since, in my opinion: 160813 HK AFH report Final 5

the transfer of the long-term insurance business in the Hong Kong branch to PHKL will not alter the financial strength of these companies on a stand-alone basis; and in view of their reliance on PAC for financial support in adverse scenarios, the interests of policyholders in these companies are aligned with those of nonprofit policyholders in either the WPSF (for companies owned by the WPSF) or the NPSF (for companies owned or partly owned by the PAC shareholder fund). My conclusions regarding the fairness of the transfer in relation to the remaining PAC UK & Europe policyholders will therefore apply equally to policyholders in these subsidiaries. 1.11 I am a Fellow of the Institute and Faculty of Actuaries, having qualified in 1988, and hold a certificate issued by the Institute and Faculty of Actuaries to act as a Life Actuary (including with-profits). I am also a Fellow of the Actuarial Society of Hong Kong. I have been the PAC Appointed Actuary, and subsequently the PAC Actuarial Function Holder, since 1998. As such, I have also been the Appointed Actuary of PAC s Hong Kong branch since 1998. I am also a Director of PAC, and a shareholder in PAC s ultimate owner, Prudential plc. I have been employed by Prudential since 1983, and am a member of the company s UK defined benefit pension scheme. 1.12 Richard Myers, the With-Profits Actuary of PAC, has produced a separate report that comments on the Scheme from the perspective of the transferring Hong Kong withprofits policyholders and the remaining UK & Europe with-profits policyholders. John McKenzie, the Scottish Amicable Monitoring Actuary, has also produced a report for the Scottish Amicable Board commenting on the Scheme from the perspective of policyholders in the Scottish Amicable Insurance Fund and the Scottish Amicable Account. 1.13 Both the UK and Hong Kong Courts require that an Independent Actuary should be appointed to produce a report on the terms of the Scheme. In accordance with these requirements, two Independent Actuaries, one working in each territory, have been retained by PAC to produce a joint report to both Courts. The Independent Actuary working in the UK is Nick Dumbreck of Milliman, and the Independent Actuary working in Hong Kong is Paul Sinnott, also of Milliman. Their joint appointments have been communicated to the PRA and FCA, and the Hong Kong Insurance Authority, who have not objected to their appointments. A copy of this report will be provided to Messrs Dumbreck and Sinnott, who have both had the opportunity to review various drafts of it. 1.14 This report is structured as follows: Part A Background information Part A of the report, comprising sections 2 to 4, provides background information on the operation of PAC that is relevant to the domestication proposal. In particular: 160813 HK AFH report Final 6

- section 2 sets out information on the current operation of PAC as a whole, - section 3 sets out information on the current operation of the PAC Hong Kong branch and PAC s UK & Europe business, and - section 4 sets out the financial position of PAC as at 31 December 2012 and 31 December 2011. Part B Domestication of with-profits business Part B of the report, comprising sections 5 to 9, deals with the proposed transfer of the long-term insurance business of the Hong Kong branch in the WPSF. In particular: - section 5 sets out the principles underpinning the transfer, - section 6 sets out the details of the proposed transfer, including the capital backing with-profits business that is available for apportionment, and the company s proposed method for apportioning that capital, - section 7 sets out the impact of the proposed apportionment on the financial position of the with-profits funds of PAC and PHKL, assuming that the transfer had taken place on 31 December 2012, - section 8 discusses the governance arrangements that will apply postdomestication to the transferring with-profits business, and - section 9 sets out my comments on the company s proposal for the transfer of with-profits business, in terms of its impact on the benefit security and reasonable benefit expectations of the affected policyholders. Part C Domestication of shareholder-backed business Part C of the report, comprising sections 10 to 13, deals with the proposed transfer of the long-term insurance business of the Hong Kong branch in PAC s NPSF. In particular: - section 10 sets out the principles underpinning the transfer, - section 11 sets out the details of the proposed transfer, including the company s proposed method of apportioning the capital backing the shareholder-backed business, - section 12 sets out the impact of the proposed apportionment on the financial position of the non-profit and shareholder funds of PAC and PHKL, assuming that the transfer had taken place on 31 December 2012, and - section 13 sets out my comments on the company s proposal for the transfer of non-profit business, in terms of its impact on the benefit security and reasonable benefit expectations of the affected policyholders. Part D Conclusions Part D of the report (which comprises section 14) sets out my conclusions. 160813 HK AFH report Final 7

1.15 It is proposed that, at the same time as the transfer of the long-term insurance business of the PAC Hong Kong branch to PHKL, the general insurance business of the PAC Hong Kong branch will be transferred to a Hong Kong incorporated company, Prudential General Insurance Hong Kong Limited, which has been established (also as a subsidiary of the PAC shareholder fund) to undertake general insurance business. The general insurance business will be transferred by way of a separate process. I have not considered the transfer of the general insurance business in this report since I would not expect the transfer of this business to have any impact on the benefit security or reasonable benefit expectations of PAC s long-term insurance business policyholders. This reflects the fact that the general insurance business in Hong Kong is: (iii) operationally separate from the long-term insurance business; backed by a separate pool of shareholder capital, which is not used to back the long-term insurance business; and relatively small, with liabilities of c. 40m (measured on the local Hong Kong solvency basis) as at 31 December 2012. The transfer amount in respect of this business will comprise assets equal to the liabilities (of c. 40m), plus additional capital of c. 28m (of which roughly half comprises the net assets of the business), amounting to c. 68m in total. The conclusions in this report will therefore remain valid whether or not the transfer of general insurance business takes place. 1.16 This report is subject to, and complies with, all relevant Technical Actuarial Standards (TASs) adopted by the Financial Reporting Council (FRC) in the UK, in particular: - Technical Actuarial Standard (R) - Reporting Actuarial Information, - Technical Actuarial Standard (D) Data, - Technical Actuarial Standard (M) Modelling, - the Insurance Technical Actuarial Standard, and - the Transformations Technical Actuarial Standard. In the terminology used by the FRC, this report may be regarded as constituting an aggregate report in that, in places, it summarises results that have been discussed in more detail in other reports ( component reports ). A list of the relevant component reports is set out in Appendix A.2. 1.17 This report is an abridged version of a fuller report to the directors of PAC on the proposed transfer. The full report includes information, including results of the company s Pillar II valuation, that are confidential to the company and its regulators. Copies of the full report have been provided to the PAC Board, PAC With-Profits Committee, PAC With-Profits Actuary, Scottish Amicable Board, Scottish Amicable Monitoring Actuary, PHKL Appointed Actuary Designate, the Independent Actuaries, the PRA, the FCA and the Hong Kong Insurance Authority in order to assist their assessments of the company s proposals. 160813 HK AFH report Final 8

Part A: Background information 160813 HK AFH report Final 9

2. INFORMATION ON THE PRUDENTIAL ASSURANCE COMPANY LIMITED (PAC) 2.1 Company information 2.1.1 PAC is a proprietary company, the shares of which are wholly owned by its immediate parent company, Prudential plc, which is also the ultimate holding company of the Prudential Group. 2.1.2 PAC s principal activity is long-term insurance business, which is written in the company s long-term insurance fund; PAC also conducts some general insurance business, which is written in the company s shareholder fund. 2.1.3 PAC s long-term insurance business consists of: Ordinary Branch (OB) life and annuity, pensions, permanent health and linked long-term insurance business; and Industrial Branch (IB) life business. The OB and IB funds were merged in 1988 to form what is now the WPSF, and the IB was closed to new business on 1 January 1995. The company s long-term insurance business includes conventional with-profits, accumulating with-profits, non-linked non-profit and linked business. PAC s longterm insurance business is predominantly with-profits, and is written mainly in the UK. 2.1.4 The company s UK business consists of: (iii) (iv) (v) (vi) business written directly in PAC, business reinsured into PAC from its insurance subsidiaries, business transferred into PAC from Prudential Holborn Life Limited (PHLL) and Prudential (AN) Limited (PANL) on 31 October 2010, business transferred into PAC from The Equitable Life Assurance Society (ELAS) on 31 December 2007, business transferred into PAC from Scottish Amicable Life plc (SAL) on 31 December 2002, and business transferred into PAC from the Scottish Amicable Life Assurance Society (SALAS) on 30 September 1997. 2.1.5 PAC also contains business written outside of the UK, comprising: business written by its branches in Hong Kong, Poland, France and Malta, business reinsured into PAC by its insurance subsidiaries, including Prudential International Assurance plc (PIA), or by other external insurers such as Canada Life Assurance (Europe) Limited, and 160813 HK AFH report Final 10

(iii) business written by overseas branches of ELAS and transferred into PAC on 31 December 2007. 2.1.6 Some of PAC s property-linked business is reinsured to the internal linked funds of other life assurance companies, including PAC s insurance subsidiaries. As at 31 December 2010, most of PAC s non-profit and index-linked annuities in payment were reinsured to Prudential Annuities Limited (PAL), a wholly-owned subsidiary of the WPSF, or Prudential Retirement Income Limited (PRIL), which is owned by the shareholder fund of PAC. However, as described in section 2.9 below, the annuities reinsured to PAL were recaptured by PAC in August 2011, and the bulk of the remaining directly written non-profit annuities in PAL were reinsured into the WPSF with effect from 31 October 2012. 2.1.7 New business in the UK is currently distributed through intermediaries, direct to businesses or direct to the customer, including through a small direct salesforce. Historically, the bulk of the company s business was distributed through its direct salesforce. New business in Hong Kong is distributed by the branch s salesforce, and through bank distribution partners. New business in Poland is distributed by the branch s salesforce. The other overseas branches of PAC are closed to new business. 2.1.8 In accordance with UK regulations, PAC has a shareholder fund and a separate ringfenced long-term insurance fund. The long-term insurance fund is itself divided into four sub-funds to facilitate the management of the various risk-bearing and profitsharing arrangements that apply. These sub-funds are described in section 2.2 below. 2.1.9 The PAC shareholder fund and the WPSF own (or partly own) a number of UK & Europe insurance companies, and the companies owned as at 31 December 2012 are shown in Figure 2.1 below. Figure 2.1 PAC fund structure General Insurance Fund Shareholder Fund Other The Prudential Assurance Company limited (PAC) Long-Term Insurance Fund With-Profits Sub-Fund (WPSF) "90:10" Defined Charge Participating Sub-Fund (DCPSF) "100:0" Scottish Amicable Insurance Fund (SAIF) "100:0" Non Profit Sub-Fund (NPSF) "0:100" Prudential Retirement Income Limited (PRIL) Prudential Annuities Limited (PAL) Prudential Pensions Limited (PPL) Prudential International Assurance plc (PIA) Prudential Holborn Life Limited (PHLL) Prudential Health Limited (PHL) (25%) Prudential Health Insurance Limited (PHIL) (25%) The directors of PAC regularly review the financial condition of the company's longterm insurance business and the amount of any profits made by the business. The directors then determine the amount of those profits that should be distributed amongst with-profits policyholders or transferred to the PAC shareholder fund, with the balance being carried forward as part of the long-term insurance business. Profits retained in the business can be used to increase the reserves held for particular liabilities of the business or to support the business in other ways. 160813 HK AFH report Final 11

The numerical descriptions of the sub-funds in Figure 2.1 above refer to the basis of allocation of the profits that are declared for distribution amongst with-profits policyholders, or for transfer to the PAC shareholder fund; thus: (iii) no less than 90% of any such profits attributable to the WPSF are allocated to the with-profits policyholders, with the balance being available to be transferred to the PAC shareholder fund. The WPSF is therefore described as a 90:10 sub-fund; 100% of any such profits attributable to SAIF and the DCPSF are allocated to the with-profits policyholders. These funds are therefore described as 100:0 sub-funds; and 100% of any such profits attributable to the NPSF, with the exception of surplus generated in respect of the PruProtect business, are available to be transferred to the PAC shareholder fund. The NPSF is therefore described as a 0:100 sub-fund. For the PruProtect business, the surplus is shared between the PAC shareholder fund and Prudential's joint venture partner, Discovery Offshore Holdings Limited. 2.1.10 The PAC shareholder fund also contains general insurance business written in both the UK and Hong Kong. 2.2 Long-term insurance fund structure 2.2.1 This section describes how the sub-funds of the PAC long-term insurance fund are managed. 2.2.1.1 With-Profits Sub-Fund (WPSF) The WPSF consists mainly of with-profits business, which comprises: (iii) business written by PAC, both OB (including business written in Hong Kong, Poland and Malta) and IB, business written by SAL, and subsequently transferred into PAC, and business written by PANL, and subsequently transferred into PAC. The WPSF also contains some non-profit business, which consists of: (iii) (iv) the non-profit (including unit-linked) business written by PAC in the UK and Hong Kong that is not allocated to the NPSF (see section 2.2.1.4 below), certain types of business originally written by SALAS and now allocated to the Scottish Amicable Account (SAA) in the WPSF, non-profit pension annuity business arising from with-profits pension policies choosing to vest their annuities internally with PAC. This business was previously reinsured to PAL, but was recaptured in August 2011, and non-profit pension annuity business which was reinsured from PAL on 31 October 2012. 160813 HK AFH report Final 12

The WPSF contains the PAC inherited estate, which consists of assets in the fund over and above the amounts that the company would expect to pay out over time to existing policyholders as claim values (see section 2.8 below). The WPSF also owns PAL, the operation of which is described in section 2.9 below. 2.2.1.2 Defined Charge Participating Sub-Fund (DCPSF) The DCPSF comprises: business reinsured into PAC from PIA or other companies, business written through PAC s French branch (between 1 January 2001 and 31 December 2003), and (iii) the business transferred from ELAS on 31 December 2007. Defined Charge Participating business is defined as with-profits business on which policyholders incur only the charges stated explicitly in their policies, or which are permitted by the Scheme relating to the transfer of with-profits annuity business from ELAS to PAC under Part VII of the FSMA 2000. For each of the different types of business in the DCPSF, the following charges can be levied on asset shares: an annual management charge, which is paid to the NPSF, which (as described in section 2.2.1.4) bears all of the corresponding expenses. PAC s shareholders therefore receive any profits or losses arising from the difference between the charges and expenses on the DCPSF business; an annual capital support charge, which is paid to the PAC inherited estate (the DCPSF contains only asset shares, and does not have an estate of its own). The PAC inherited estate (which is held in the WPSF) supports the business in the DCPSF by: (a) providing capital to meet regulatory solvency requirements, and to support bonus and investment policy; and (b) providing financing, by means of bonus smoothing accounts which are maintained in the inherited estate, to meet smoothing costs as they arise. The bonus smoothing accounts are credited or debited as appropriate with any differences between claim payments made from the DCPSF and the relevant policies underlying asset shares. It is intended that these smoothing transfers should generate no net gain to either sub-fund over the long term; (iii) an annual charge for guarantees. The treatment of these charges differs between ELAS and non-elas business, as follows: (a) for non-elas business, the charges, and the associated guarantee costs, accrue to the appropriate bonus smoothing accounts. The accounts are, therefore, effectively bonus smoothing and guarantee accounts, and it is the combined smoothing and guarantee costs which it is intended should tend to zero over the long-term. Charges on the relevant business are levied at the point of claim; and 160813 HK AFH report Final 13

(b) for ELAS business, the charges are paid to the WPSF in return for the WPSF accepting responsibility to meet any guaranteed benefit payments in excess of the underlying asset shares. In addition, an up-front premium for guarantees was paid by ELAS to the PAC inherited estate at the date of transfer, with the premium being calculated to be sufficient (at that time, and using the assumptions agreed by PAC and ELAS) to meet expected future guarantee costs after deduction of the value of expected future annual guarantee charges. A further up-front premium was paid by ELAS to the PAC inherited estate to limit the impact that changes in actual, or PAC s view of future, mortality in respect of the ELAS annuities could have on the level of non-guaranteed income on these policies. 2.2.1.3 Scottish Amicable Insurance Fund (SAIF) SAIF is a closed sub-fund that contains the bulk of the business originally written by SALAS and transferred to PAC on 30 September 1997 under a Scheme made under Schedule 2C to the Insurance Companies Act 1982 in relation to the demutualisation of SALAS (the SALAS Scheme). The balance of SALAS s business was transferred to the WPSF, and is allocated to the Scottish Amicable Account (SAA). The withprofits investment element of SAA policies (i.e. the accumulation of premiums less charges) is invested in SAIF, and is thus managed with all other SAIF with-profits policies. SAIF also contains the SAIF inherited estate. Under the terms of the SALAS Scheme, the SAIF inherited estate will be distributed to the SAIF and SAA withprofits policyholders over the lifetime of their policies as an addition to the withprofits benefits arising in SAIF. In accordance with the SALAS Scheme, SAIF is provided with financial support from the WPSF by means of the Scottish Amicable Capital Fund (SACF), in return for an annual charge fixed at 1% p.a. of the mean value of SACF, which SAIF pays to the PAC inherited estate. SACF is treated as part of the assets of SAIF for the purposes of setting SAIF s bonus and investment policy. However, SACF remains in the WPSF and does not form part of the SAIF inherited estate. SACF cannot exceed 15% of the with-profits fund in SAIF, and will therefore reduce in size as SAIF reduces as a result of policyholder pay-outs. SACF would be used to fund any final deficit in the SAIF bonus smoothing account and could, in extremis, be required to meet the cost of guarantees arising on policies in SAIF. The SALAS Scheme states that the Scottish Amicable Funds (i.e. SAIF and SACF) must be managed in accordance with the Principles of Financial Management which are set out in the SALAS Scheme. These Principles include the over-arching provision that the Scottish Amicable Funds should be managed in a sound and prudent fashion, and provide a framework for setting bonus and investment policy for the Scottish Amicable Funds on a basis that is fair to both SAIF and SAA policyholders and other PAC policyholders. 160813 HK AFH report Final 14

2.2.1.4 Non-Profit Sub-Fund (NPSF) The NPSF consists of such non-profit and unit-linked business as has been allocated to this sub-fund, and includes business written in the UK, Hong Kong and Poland. The NPSF includes the non-profit and unit-linked business of PANL and PHLL that was transferred into PAC on 31 October 2010. The NPSF also includes all of PAC s Defined Charge Participating business, apart from the business which was transferred from ELAS. The investment element of the Defined Charge Participating business held in the NPSF is allocated to the DCPSF. All management charges for the Defined Charge Participating business held in the NPSF are credited to the NPSF, which bears all of the expenses of this business. The business transferred from ELAS is allocated to the DCPSF; however, the NPSF bears all the expenses of this business and, in return, receives an annual management charge on the ELAS asset shares. 2.3 Management of PAC 2.3.1 The PAC Board is responsible for the management of the company s long-term insurance business, including its exposure to risk. 2.3.2 In managing risk, the PAC Board is responsible for: determining the company s risk appetite. This, in conjunction with the company s available working capital, determines the company s risk capacity from time to time, and managing the overall risk level of the company and the long-term insurance fund, including its four sub-funds, having regard to that risk capacity. 2.3.3 In order to ensure that the company s operations remain within its risk capacity, the PAC Board manages the types and volumes of new business accepted (particularly in relation to the guarantees given), and sets the bonus and investment policy of its with-profits business, having regard to the available capital in the long-term insurance fund. 2.3.4 The company s current risk appetite, as determined by the Board, in relation to withprofits business is to hold sufficient capital to ensure that, over the long-term: (iii) liabilities to policyholders can be met as they fall due, on an open fund basis, with the company s own calibration of a AAA level of confidence, regulatory capital requirements can be covered, on a closed fund basis, with the company s own calibration of a AA level of confidence, and regulatory capital requirements can be covered, on an open fund basis, with the company s own calibration of a A level of confidence. For test, the liabilities to be covered include both the underlying asset shares and the cost of guarantees, and the available capital is assessed on a fully realistic basis. 160813 HK AFH report Final 15

For tests and (iii), the regulatory capital requirement is taken as the higher of the Pillar I Peak 1, Pillar I Peak 2 and Pillar II requirements. A lower level of confidence is targeted for these tests than for test since the biting Pillar II capital requirement is itself calibrated to cover a 1 in 200 adverse event. For all three tests, the calculation of the capital requirement: - reflects the key risks to which the with-profits funds are exposed, - is assessed using a run-off approach based on a blend of market implied yields and volatilities and the company s own long-term equilibrium assumptions, - is based on fully realistic management actions in relation to the operation of the with-profits funds, - assumes the availability of shareholder capital support (to the extent of the PAC Pension Mis-Selling Costs Assurance (see 2.8.16 below)) in adverse scenarios, and (where relevant) - includes new business in line with the company s business plan over the full projection period. 2.3.5 The risk level of the WPSF (and hence the continuing appropriateness of the subfund s bonus and investment policy, and projected new business volumes) is assessed annually using stochastic asset/liability modelling. This stochastic modelling investigates the potential future development of the with-profits fund in a large number of simulated investment scenarios. In assessing the risk level of the WPSF, allowance is made for the potential capital support that the sub-fund may need to provide to SAIF, the DCPSF and PAL in adverse scenarios, and for the charges for capital support that are expected to be received from SAIF and the DCPSF. 2.3.6 Similar investigations are carried out in respect of SAIF in order to ensure that the risk of statutory insolvency for SAIF and SACF combined remains similar to that of the WPSF and DCPSF, as required by the SALAS Principles of Financial Management described in 2.2.1.3 above. The risk profiles of the WPSF and SAIF are reported in the company s Financial Condition Reports. 2.3.7 The company s investment policy, bonus policy, and management and pricing of guarantees and new business are described in sections 2.4-2.7 below. The available capital in relation to with-profits business is discussed in section 2.8 below. 2.3.8 As explained in section 2.2.1.1 above, PAC writes with-profits business in both the UK & Europe and Hong Kong in a single with-profits sub-fund (the WPSF), with a single inherited estate. In order to ensure the fair treatment of policyholders, in terms of both the risks they bear and the returns they can expect to receive, the company s philosophy is to seek to ensure that the business written in different territories has a similar aggregate level of risk. An assessment of the extent to which the risks of the UK & Europe and Hong Kong business are aligned is carried out on at least an annual basis. The company s approach to ensuring risk alignment between territories is discussed in more detail in section 3.4 below. 2.3.9 For shareholder-backed business, the Prudential Group s preferred approach to capital management is (insofar as possible) to hold surplus capital in excess of its insurance companies regulatory capital requirements at Group level, and to provide additional capital support (to PAC and to other entities) as required to write new 160813 HK AFH report Final 16

business, or to maintain solvency in the event of adverse experience. In accordance with this approach, PAC aims to hold sufficient capital to meet its agreed solo risk appetite statement for shareholder-backed business, and relies on Prudential plc for additional capital support as required. In response to recent general regulatory guidance, PAC and Prudential plc have agreed to enter into a formal, legally enforceable capital support arrangement (CSA), under which Prudential plc will have an obligation to provide PAC with additional capital support, up to an agreed maximum level, in the event of PAC s solvency falling below specified levels. The capital support provided under the CSA will include the capital support that might be required under the PAC Pension Mis-Selling Costs Assurance in relation to withprofits business, as described in section 2.8.16 below. The detailed terms of the CSA are currently under discussion between PAC, Prudential plc and the UK regulators. 2.3.10 The availability of the additional Group capital support in adverse scenarios is managed through the Group s on-going compliance with its own risk appetite statement. 2.4 Investment management 2.4.1 The PAC Board is responsible for setting the investment strategy of the company and, as noted in section 2.3.3 above, it manages this strategy as part of the management of the overall risk level of the long-term insurance fund. 2.4.2 For non-profit business the investment strategy is as follows: Unit-linked business A policy of close matching between the linked assets and unit liabilities is followed, with units in the linked funds being created to match the unit liability to the policyholder. Annuities For annuities, a policy of close matching of asset and liability cash-flows is followed. Investment is primarily in corporate and government bonds. (iii) Other non-profit business For other non-profit business, liabilities are matched by assets having regard to the general nature and duration of the liabilities. 2.4.3 For with-profits business, the company s investment strategy is to seek to secure the highest total return (allowing for the effect of taxation and investment expenses) whilst: (iii) maintaining an acceptable overall risk level (having regard to the currency, nature and outstanding duration of the liabilities) for the long-term insurance fund, maintaining an appropriate and broad mix of suitable investments, and protecting appropriately the relative interests of all groups of policyholders. 2.4.4 The company seeks to include all with-profits policies in a common asset pool wherever it is appropriate for them to share a common investment policy. The major 160813 HK AFH report Final 17

asset pools of the UK & Europe and Hong Kong business are described in section 3.5.1 below. 2.4.5 As described in sections 2.3.3-2.3.6 above, a stochastic asset/liability model is used to identify the range of broad asset mixes for each with-profits asset pool that would be consistent with the risk appetite of the fund. The company selects from that range an appropriate strategic asset mix for the pool, consisting of a diversified portfolio of assets which is intended to maximise the expected long-run investment return, subject to the risk level and liquidity needs of the asset pool. The stochastic model allows for all material types of investment risk, including market risk and credit risk. 2.4.6 The resulting investment policy for with-profits business is to invest in highly diversified portfolios of UK and overseas assets (with currency risk relative to the underlying liabilities being hedged out as considered appropriate). This policy aims to avoid large losses connected with default or bankruptcy of an individual company, and also generates country diversification. The assets may include any available assets which enhance the risk/return balance; they will consist mainly of exchangetraded equity and bond investments, but may also include less liquid investments such as direct property or private equity and debt. In the context of the current financial strength, the nature of the assets held, and the cash flow characteristics of the with-profits sub-funds, liquidity is not in general a major issue. The investments will not include shares in Prudential plc, but may include shares in other Prudential Group companies. 2.4.7 All assets of the WPSF, SAIF and the DCPSF would normally be available to be traded. The only exception is PAL, a subsidiary company of the WPSF, the operation of which is described in section 2.9 below. 2.4.8 In setting the investment policies for the with-profits asset pools, the directors do not rely on assets held outside the relevant pool except that: (iii) the investment policies for the WPSF with-profits asset pools have regard to the capital support provided by the PAC inherited estate, and the availability of shareholder resources under the PAC Pension Mis-Selling Costs Assurance described in section 2.8.16 below, the DCPSF investment policy relies on the capital support provided by the PAC inherited estate, and the investment policy for SAIF relies on the capital support provided by SACF to pursue an investment policy appropriate to an open fund i.e. higher real (equity and property) assets than would otherwise be appropriate for a closed fund. 2.5 Bonus policy 2.5.1 The PAC Board is responsible for setting the company s bonus policy and, as noted in section 2.3.3 above, it manages this policy as part of the management of the overall risk level of the company and the long-term insurance fund. 2.5.2 The main objectives of the company s bonus distribution policy are: to give each with-profits policyholder a return on the premiums paid reflecting the return on the underlying investments over the time the policyholder has held the policy, smoothing the peaks and troughs of investment performance, and 160813 HK AFH report Final 18

to ensure that with-profits policyholders in each sub-fund receive a fair share of the profits distributed from that sub-fund by way of bonus additions to their policies. 2.5.3 To retain flexibility in the company s investment policy, and to protect the on-going solvency of the fund, for most types of with-profits product the company aims to keep a substantial proportion of pay-out values in non-guaranteed form (i.e. payable as final bonus) and determines regular bonus rates accordingly. In normal investment conditions, rates of regular bonus are determined for each type of policy primarily by targeting them on a prudent proportion of the long-term expected future investment return on the underlying assets. The expected future investment return is reduced as appropriate for each type of policy to allow for items such as expenses, charges, tax and shareholders transfers. The target rates may be modified (and may differ by product type, or by date of payment of the premiums or date of issue of the policy) if the accumulated guaranteed bonus is particularly high or low relative to the targeted position, or if solvency is threatened. When target bonus levels change, the PAC Board has regard to the overall financial strength of the long-term insurance fund when determining the length of time over which it will seek to achieve the amended prudent target bonus level. In normal investment conditions, the company expects changes to regular bonus rates to be made gradually over time, and changes are not expected to exceed 1% p.a. over any year. However, the directors retain the discretion as to whether or not to declare a regular bonus each year, and there is no limit on the amount by which regular bonus rates can change. Further detail on the approach to determining annual bonuses for UK & Europe and Hong Kong business is set out in section 3.6 below. 2.5.4 Pay-out values are set by reference to the earnings of the underlying investments, except where guaranteed minimum benefits increase the total amount payable. In order to meet this objective, pay-out values are targeted on the asset shares of sample policies or groups of sample policies. These asset shares are calculated by accumulating the premiums paid (less allowance for expenses and charges) at the actual rates of investment return earned on the underlying assets over the lifetime of the policy (allowing for the effect of tax on the investment returns and of tax relief on expenses for life business), making appropriate allowance for miscellaneous profits and losses. In addition, for policies where a partial encashment of with-profits benefits has been taken (for example, regular withdrawals, part surrenders or switches), the asset share is reduced to reflect the benefits that have been encashed. The detailed treatment of miscellaneous profits and losses in relation to asset shares varies by product and sub-fund. However, the underlying principle adopted is that miscellaneous profits and losses arising in respect of SAIF, WPSF UK business and WPSF Hong Kong business should be applied to with-profits asset shares in the same sub-fund and territory (business in Poland and in the DCPSF does not generate any miscellaneous surplus). The primary sources of miscellaneous profits and losses are: in the case of UK & Europe business, profits from certain PAL and ex-pal business (as described in section 2.9 below), profits from other non-profit business written in the WPSF, and the release over time of the reserves that are 160813 HK AFH report Final 19

held to back unclaimed (typically IB) policies. Profits and losses on discontinuance (other than profits or losses from smoothing), which arise on some groups of with-profits policies, are credited to surviving policies in that group; and in the case of Hong Kong business, profits on surrenders of with-profits policies (where payouts are targeted on less than 100% of asset share, as described in section 3.6.4 below) and profits from non-profit business (including non-profit riders to with-profits policies) that has been written in the WPSF. The only exception to the principle that pay-out values should be set by reference to the earnings on the underlying investments is IB business in the UK & Europe. When the OB assets and IB assets were merged in 1988, the IB assets included a relatively larger inherited estate. In order to protect the reasonable expectations of IB policyholders, PAC undertook to link IB policy bonuses to OB policy bonuses as follows: for IB policies issued before July 1988, total bonus additions will not be less than 90% of those on corresponding OB policies; and for IB policies issued from July 1988, total bonus additions will be 100% of those on corresponding OB policies. Consequently, IB pay-out values depend on the corresponding OB pay-out values and do not reflect the IB asset shares, unless use of the IB asset shares would result in a higher claim amount for business issued before July 1988. The relationship between IB and OB asset shares is reviewed annually. 2.5.5 Final bonus rates are set so that, in normal investment conditions, pay-out values change only gradually over time. In normal circumstances, PAC expects most policy pay-out values to move within specified guidelines. Greater flexibility may be required in certain circumstances, for example following a significant rise or fall in market values (either sudden or over a period of years), and in such situations the PAC Board may decide to vary the standard bonus smoothing limits to protect the overall interests of policyholders. Such situations arose in November 2008 and February 2009, when pay-out values on most UK & Europe policies were reduced by amounts greater than the normal limits. With effect from 31 December 2005, PAC has been required to publish target ranges in relation to payouts on its UK with-profits business and the business reinsured into PAC by PIA and Canada Life Assurance (Europe) Limited. In accordance with this requirement, the company aims to ensure, in normal circumstances, that, at each bonus declaration date, 90% of all payouts in the period covered by the declaration are expected to fall in the range 80-120% of specimen asset shares. However, any substantial movement in the market value of the assets of the relevant with-profits fund may take a significant proportion of pay-out values outside the target range. This may lead to a mid-year bonus declaration being made in order to bring more pay-out values within the target range. The company s intention is that smoothing profits and losses should balance out over time, so that in the long run with-profits policyholders in each sub-fund, or within a product group with a specific smoothing account, neither gain nor lose as a result of the company s smoothing policy. The cumulative cost of smoothing and guarantees is monitored, and the short-term cost of smoothing is constrained only by the impact 160813 HK AFH report Final 20