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Chief Financial Officer's report on our 2014 first half financial performance

A strong financial performance with growth in earnings and cash


‘We continue to be proactive in focusing on growing high quality sources of income that are more predictable and more resilient to volatility in economic and investment market conditions.’

Nic Nicandrou
Chief Financial Officer


Prudential has delivered a strong financial performance in the first half of 2014, reporting growth in its key metrics of IFRS operating profit and underlying free surplus generated. All four businesses have recorded improvements in earnings and cash generation as they continue to focus on higher quality sources of income that are more predictable and more resilient to volatility in economic and investment market conditions. These characteristics are further enhanced by the increasing diversification of our business, by product, distribution and geography, and by maintaining a robust balance sheet with a conservative approach to risk management.

Following the major depreciation in currencies against sterling in the second half of 2013, the first half of 2014 has seen further volatility in the world’s currency markets, driven by improving growth prospects and increasing speculation around the timing of possible movements in interest rates. In our key markets, this has been more prominent among the US dollar, US dollar-linked currencies and the Indonesian rupiah, all of which have weakened against sterling since the first half of 2013. For the purpose of reporting our performance in sterling terms, we adopt the normal convention of translating the results of our overseas businesses using average exchange rates for the period. However, the currency translation effect is so pronounced for some parts of the business that it masks the underlying operational trends, rendering it difficult to meaningfully assess performance.

I have, therefore, focused my commentary on the performance of our Asia and US businesses in local currency and have presented percentage growth rates between periods on a constant exchange basis, unless otherwise stated. Growth rates based on actual exchange rates are also shown in the financial tables presented in this report.

As the assets and liabilities of our overseas businesses are translated at period-end exchange rates, the effect of these currency movements has been fully incorporated within reported shareholders’ equity as at 30 June 2014.

Group IFRS operating profit increased by 17 per cent to £1,521 million on a constant exchange rate basis (7 per cent on an actual exchange rate basis) and underlying free surplus generation (net of investment in new business) increased 13 per cent to £1,219 million (6 per cent on an actual exchange rate basis). On the European Embedded Value (EEV) basis of reporting performance, new business profit1 was up 24 per cent to £1,015 million (11 per cent on an actual exchange rate basis), contributing to an 18 per cent increase in EEV operating profit1 to £1,943 million (7 per cent on an actual exchange rate basis). Including the financial impact of short-term movements in investment values and other items reported outside the operating result, the Group generated profit before tax attributable to shareholders on an IFRS basis of £1,424 million, compared to £506 million (on an actual exchange rate basis) in the first half of 2013.

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IFRS profits1

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  AER   CER
  Half year 2014 £m Half year 2013 £m Change
%
  Half year
2013 £m
Change
%
Operating profit before tax            
Long-term business:            
Asia2 483 474 2   406 19
US 686 582 18   538 28
UK 374 341 10   341 10
Long-term business operating profit before tax2 1,543 1,397 10   1,285 20
UK general insurance commission 12 15 (20)   15 (20)
Asset management business:            
M&G (including Prudential Capital) 249 225 11   225 11
Eastspring Investments 42 38 11   34 24
US (5) 34 (115)   31 (116)
Other income and expenditure3 (320) (294) (9)   (294) (9)
Total operating profit based on longer-term investment returns before tax 1,521 1,415 7   1,296 17
Short-term fluctuations in investment returns:            
Insurance operations (14) (725) 98   (679) 98
Other operations (31) (30) (3)   (30) (3)
  (45) (755) 94   (709) 94
Other non-operating items3 (52) (154) 66   (135) 61
Profit before tax attributable to shareholders 1,424 506 181   452 215
Tax charge attributable to shareholders’ returns (279) (141)        
Profit for the period attributable to shareholders 1,145 365        

IFRS earnings per share

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  AER   CER
  Half year 2014 pence Half year 2013 pence Change %   Half year 2013 pence Change %
Basic earnings per share based on operating profit after tax 45.2 42.2 7   38.7 17
Basic earnings per share based on total profit after tax 45.0 14.3 215   12.8 252

IFRS operating profit

Total IFRS operating profit increased by 17 per cent in the first half of 2014 to £1,521 million, driven by profitable business growth in Asia, the US and M&G and the beneficial impact of four bulk annuity transactions in the UK life business.

Asia life operating profit was up 19 per cent (2 per cent on an actual exchange rate basis), with strong growth from all of our operations, particularly Indonesia, Thailand and Vietnam. US life operating profit increased by 28 per cent (18 per cent on an actual exchange rate basis), driven principally by higher variable annuity fee income. UK life operating profit was 10 per cent higher, reflecting contributions totalling £60 million from bulk annuity transactions (2013: £nil), which offset lower profits in the retail business. M&G (including Prudential Capital), our UK-based asset management business and Eastspring Investments, our Asia asset manager, delivered IFRS earnings growth of 11 per cent and 24 per cent, respectively.

Taken together, IFRS operating profit from our life insurance operations in Asia, the US and the UK increased 20 per cent to £1,543 million. This increase in profitability of our life operations reflects the growth in the scale of our life operations, driven primarily by positive business inflows. We track the progress that we make in growing our life business by reference to the scale of our obligations to our customers, which are referred to in the financial statements as policyholder liabilities. Each year these liabilities increase as we collect premiums and decrease as we pay claims. The overall scale of these policyholder liabilities is relevant in evaluating our profit potential, in that it is reflective of our ability to earn fees on the unit-linked element and it sizes the risk that we carry on the insurance element, for which Prudential needs to be rewarded.

Shareholder-backed policyholder liabilities and net liability flows4

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  Half year 2014 £m   Half year 2013 £m   Change %
        AER   CER   AER   CER
  Policyholder liabilities Net liability flows5   Policyholder liabilities Net liability flows5   Net liability flows5   Policyholder liabilities Net liability flows5   Net liability flows5
Asia 23,419 891   22,903 1,039   938   2 (14)   (5)
US 112,009 4,977   106,215 5,168   4,781   5 (4)   4
UK 52,687 (140)   50,070 (336)   (336)   5 58   58
Total Group 188,115 5,728   179,188 5,871   5,383   5 (2)   6

Focusing on the business supported by shareholder capital, which accounts for the majority of the life profits, in the course of the first half of 2014 policyholder liabilities increased from £180.1 billion at the start of the year to £188.1 billion at the end of June 2014. The consistent addition of high quality profitable new business and proactive management of the existing in-force portfolio underpins this increase, resulting in positive net flows5 into policyholder liabilities of £5.7 billion in the first half of 2014 driven by positive inflows into both our US and Asia businesses. Net flows into our Jackson business grew by 4 per cent compared to half year 2013, following increased variable annuity new business premiums. Net flows into Asia continue to be positive reflecting the new regular premium business added this period, offset by higher levels of maturities of products reaching their term. Favourable investment market and other movements have contributed a further £6.3 billion to the increase in policyholder liabilities since the start of the year, offset by a £4.0 billion negative foreign currency translation effect.

Analysis of long-term insurance business pre-tax IFRS operating profit based on longer-term investment returns by driver6

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  AER   CER
Half year 2014 £m   Half year 2013 £m   Half year 2013 £m
  Operating profit Average liability Margin bps   Operating profit Average liability Margin bps   Operating profit Average liability Margin bps
Spread income 557 64,741 172   535 65,424 164   499 62,492 160
Fee income 764 106,052 144   667 93,512 143   615 87,678 140
With-profits 150 98,046 31   155 97,336 32   153 96,352 32
Insurance margin 680       613       551    
Margin on revenues 808       858       749    
Acquisition costs* (1,000) 2,300 (43)%   (1,021) 2,162 (47)%   (917) 1,974 (46)%
Administration expenses (701) 178,649 (78)   (682) 166,130 (82)   (618) 156,839 (79)
DAC adjustments 169       175       161    
Expected return on shareholder assets 116       97       92    
Operating profit based on longer-term investment returns 1,543       1,397       1,285    

*The ratio of acquisition costs is calculated as a percentage of APE sales including with-profits sales. Acquisition costs include only those relating to shareholder-backed business.

In the first half of 2014, alongside growing the scale of our life operating profit, we have continued to focus on improving its quality by maintaining our bias for sources of income such as insurance margin and fee income, ahead of spread income; insurance income because it is relatively insensitive to the equity and interest rate cycle, and fee income because it is capital efficient. Our emphasis on growing our offering of risk products such as health and protection, has seen insurance margin grow by 23 per cent (11 per cent on an actual exchange rate basis), while fee income is up 24 per cent (15 per cent on an actual exchange rate basis), primarily reflecting the higher amount of assets that we manage on behalf of our customers. In contrast, the contribution to our profits from spread income has continued to increase at a more subdued rate of 12 per cent (4 per cent on an actual exchange rate basis). The fact that insurance margin and fee income generate a growing proportion of our income represents a healthy evolution in the quality, the resilience and the balance of our earnings.

The costs we have incurred in writing new business and in administering the in-force life businesses have also increased but at a more modest rate than total income, highlighting the advantages of increased scale as we build out our business, while maintaining control of costs.

IFRS operating profit from Asia life insurance was up 19 per cent to £483 million, driven by the increasing scale of the in-force portfolio and our emphasis on growing the proportion of our income that is sourced from regular premium health and protection business. In addition, we continue to focus on our seven ‘sweet spot’ markets of Indonesia, Singapore, Malaysia, Thailand, Vietnam, the Philippines and Hong Kong, which collectively increased IFRS operating profit by 20 per cent. Indonesia IFRS operating profit, our largest market on this measure, was up by 32 per cent to £139 million, reflecting increased insurance and fee income from growth in the in-force book following the high level of regular premium health and protection and unit-linked sales in recent years. We are also encouraged to see further progress among our smaller, fast-growing businesses in South-east Asia, with Thailand, the Philippines and Vietnam reporting a combined 97 per cent increase in profits to £63 million and now accounting for 13 per cent of Asia’s life operating profit compared to 8 per cent in the prior half year. In particular, Thailand’s contribution has benefited from the acquisition of Thanachart Life’s in-force portfolio and profit on new business written through our exclusive relationship with Thanachart Bank, with IFRS operating profit up 150 per cent to £25 million.

In the US, life IFRS operating profit increased by 28 per cent to £686 million, driven by 29 per cent growth in fee income, which now accounts for 48 per cent of Jackson’s total income, compared to 38 per cent in the same period just three years ago. The uplift in fee income in the period reflects average separate account assets of £68 billion in the first half of 2014 compared to £52 billion in the first half of last year, equating to an increase of 31 per cent on a constant exchange rate basis, driven by variable annuity net premium inflows and appreciation in US equity markets. We continue to focus on improving the balance of Jackson’s profits and diversifying its sources of earnings and we are pleased with the continued growth in sales of Elite Access, our variable annuity product without living benefits.

UK life IFRS operating profit was 10 per cent higher than the first half of 2013 at £374 million (2013: £341 million), principally due to a £60 million profit contribution from bulk annuity transactions (2013: £nil), which exceeded a £29 million reduction in profits from new retail annuity business (from £54 million in 2013 to £25 million in 2014).

Asset management net inflows and external funds under management7

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  External net inflows     External funds under management
  AER   CER    
  Half year 2014
£m
Half year 2013
£m
Change %   2013 £m Change %   Half year 2014
£m
Half year 2013
£m
Change %
M&G                    
   Retail 3,784 4,754 (20)   4,754 (20)   71,941 62,655 15
   Institutional 427 (914) 147   (914) 147   60,830 55,484 10
M&G 4,211 3,840 10   3,840 10   132,771 118,139 12
Eastspring8 2,483 2,006 24   1,792 39   21,078 19,268 9
Total asset management 6,694 5,846 15   5,632 19   153,849 137,407 12
                     
Total asset management (inc. MMF) 6,642 5,953 12   5,744 16   158,149 141,674 12

Our asset management businesses in the UK and Asia collectively contributed IFRS operating profit of £291 million, up 12 per cent on the first half of 2013. Similar to our life operations, growth in asset management operating profit primarily reflects the increased scale of this business, as measured by funds managed on behalf of external institutional and retail customers and our internal life insurance operations. Net flows from external parties into these funds (excluding MMF) were £6.7 billion in the first half of 2014 (2013: £5.8 billion on an actual exchange rate basis) and helped drive external retail and institutional funds under management (excluding MMF) to £153.8 billion at 30 June 2014 compared to £137.4 billion at 30 June 2013.

M&G’s IFRS operating profit increased 11 per cent to £227 million (2013: £204 million). Underlying profits, excluding performance-related payments and earnings from associates, increased 10 per cent to £214 million (2013: £195 million), primarily reflecting an 11 per cent uplift in average external funds under management compared to the first half of 2013, following a period of strong net inflows and positive market movements. The positive business mix effect from the increasing proportion of higher-margin external retail business has seen M&G’s average fee income improve to 38 basis points (2013: 36 basis points), with higher income helping to absorb the current phase of increased headcount and infrastructure investment. Reflecting this, the cost income ratio was maintained at 54 per cent (2013: 54 per cent). As in previous periods, we expect the cost/income ratio to increase by the end of 2014 as M&G’s cost run rate is typically higher over the second half of the year.

Our Asia asset management business, Eastspring Investments, has also seen the benefit of higher average funds under management, with IFRS operating profit of £42 million up 24 per cent. In the US, our asset management businesses, PPM America and Curian, and our broker-dealer network, National Planning Holdings, collectively generated an IFRS operating loss of £5 million (2013: profit of £31 million at constant exchange rate) after a £33 million provision related primarily to the potential refund of certain fees by Curian.

IFRS short-term fluctuations

IFRS operating profit is based on longer-term investment return assumptions. The difference between actual investment returns recorded in the income statement and these longer-term returns is reported within short-term fluctuations in investment returns. In the first half of 2014 for our insurance operations these total negative £14 million (2013: negative £725 million on an actual exchange rate basis).

In Asia, positive short-term fluctuations of £119 million primarily reflect net unrealised movements on bond holdings following modest falls in bond yields during the first half of the year across the region.

Negative short-term fluctuations of £226 million in the US mainly represent the net value movement on derivatives held to manage the Group’s exposure to market movements following rises in equity values. Jackson hedges the guarantees offered under its variable annuity proposition on an economic basis and, thus, accepts a degree of variability in its IFRS results in the short term in order to achieve the appropriate economic result. Increases in US equity markets during the first half of the year gave rise to negative mark to market movement on the portfolio of equity hedges, which were not offset by corresponding reductions in the obligations to our customers as many of the guarantees are not accounted for using a fully fair value basis. The net gains on the interest rate hedges generated by the reduction in US interest rates, were insufficient to eliminate the negative equity market effect.

Positive fluctuations of £93 million in the UK include net unrealised movements on fixed income assets supporting the capital of the shareholder-backed annuity business, reflecting the fall in bond yields since the end of 2013.

IFRS effective tax rates

In the first half of 2014, the effective tax rate on IFRS operating profit based on longer-term investment returns was 24 per cent in line with the equivalent period last year.

The effective tax rate for the first half of 2014 on the total IFRS profit was 20 per cent (2013: 28 per cent), reflecting both the reduction in corporation tax rates in the UK and certain Asia jurisdictions, as well as the fact that the 2013 effective tax rate was higher than normal due to no tax relief being available on the loss attaching to the held for sale Japan life business.

£1,521m
IFRS operating profit

17%
increase on half year 2013

Free surplus generation

Our ongoing focus on disciplined capital allocation to new business opportunities that offer the most attractive mix of returns and short payback periods, means that we have continued to produce significant amounts of capital, which we measure by reference to free surplus generated. Free surplus generation is a financial metric we use to measure the internal cash generation of our business operations. For the insurance operations it represents amounts maturing from the in-force business during the period, net of amounts reinvested in writing new business, and for asset management it equates to post-tax IFRS profit for the period.

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  AER   CER
  Half year
2014
£m
Half year
2013
£m
Change
%
  Half year
2013
£m
Change
%
Free surplus generation9            
Asia 469 457 3   400 17
US 629 612 3   566 11
UK 303 304   304
M&G (incl. Prudential Capital) 200 175 14   175 14
Underlying free surplus generated from in-force life business and asset management 1,601 1,548 3   1,445 11
Investment in new business (382) (396) 4   (362) (6)
Underlying free surplus generated 1,219 1,152 6   1,083 13
Market related movements, timing differences and other movements (27) 147    
Net cash remitted by business units (974) (844)  
Total movement in free surplus 218 455  
Free surplus at 1 January 4,003 3,689  
Effect of domestication of Hong Kong branch (35)  
Free surplus at end of period 4,186 4,144  

In the first half of 2014, our life in-force and asset management businesses generated £1,601 million of underlying free surplus before reinvestment in new business. This is an increase of 11 per cent compared to the first half of 2013 (3 per cent on an actual exchange rate basis), reflecting higher contributions from Asia, the US and M&G and an unchanged contribution from the UK. For our life insurance businesses, the growth in underlying free surplus generated is driven by our in-force portfolio, which increased its contribution by 12 per cent to £1,361 million. This is a clear indication of our continued success in capturing profitable new business flows, in those markets where growth opportunities are most attractive, and highlights the benefits of targeting low strain, high return business with a fast payback profile. The total stock of free surplus held by our life and asset management operations increased to £4.2 billion as at 30 June 2014 (30 June 2013: £4.1 billion, on an actual exchange rate basis), after financing reinvestment in new business and cash remittances from the business units to Group.

We reinvested £382 million of the free surplus generated in the period into writing new business (2013: £362 million on a constant exchange rate basis) equivalent to a reinvestment rate of 24 per cent, which is in line with recent periods. The amount of free surplus we reinvested in Asia increased 14 per cent to £167 million, while new business profit increased 15 per cent. In the US, new business investment decreased 11 per cent to £173 million despite higher volumes of new business, reflecting the beneficial effect of higher valuation interest rates, proactive actions to restrict sales of the higher strain products and changes in product mix. Reinvestment levels in the UK increased to £42 million (2013: £20 million), primarily due to the higher level of bulk annuity business written in 2014.

The internal rates of return achieved on new business remain attractive at over 20 per cent across all of our business operations and the average payback period10 for business written in the first half of 2014 was three years for Asia, two years for the US and five years for the UK.

We continue to manage cash flows across the Group with a view to achieving a balance between ensuring sufficient remittances are made to service central requirements (including paying the external dividend) and maximising value to shareholders through retention and reinvestment of excess capital in business opportunities.

Holding company cash11

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  AER  
  Half year 2014 £m Half year 2013 £m Change %
Net cash remitted by business units:      
Asia 216 190 14
US 352 294 20
UK 246 226 9
M&G 135 109 24
Prudential Capital 25 25
Net cash remitted by business units 974 844 15
       
Net central outflows (155) (132)  
  819 712  
Corporate activities/other (including foreign exchange) (537) (70)  
Dividend paid (610) (532)  
Net movement in holding company cash (328) 110  
Holding company cash at 1 January 2,230 1,380  
Holding company cash at end of period 1,902 1,490  

Cash remitted by the business units to the corporate centre in the first half of 2014 increased by 15 per cent to £974 million (2013: £844 million on an actual exchange rate basis), with increased contributions from each of our four major business units. Net remittances from Asia were 14 per cent higher at £216 million, reflecting the cash-generative nature of our business growth in the region. As in prior years, Jackson remitted its full year dividend of £352 million in the first half of the year. This remittance represents a new high for Jackson, driven by the strong capital generation in the last year. Remittances from our UK life operations were 9 per cent higher at £246 million. These also have a first half bias as they include the shareholders’ share of the UK with-profit transfer of £193 million. M&G’s remittance increased 24 per cent to £135 million.

The increases reflect underlying earnings growth and have been supported by our approach to hedging large non-sterling remittances 12 months in advance. Hitherto, this approach has sheltered remittances from Asia and the US from the effects of local currency depreciation relative to sterling, first observed at the start of the second half of 2013. However, the transitory benefit of this approach will unwind going forward. Furthermore, the announcements made by the UK Chancellor in the March Budget and other regulatory developments in the UK, require us to increase the level of investment in our UK pre and post-retirement customer proposition, and this will temper remittances in the short term.

Cash remitted to the Group in the first half of 2014 was used to meet central costs of £155 million (2013: £132 million) and payment of the 2013 final dividend of £610 million (2013: £532 million). In addition, £503 million (US$850 million) of central cash was used to finance the initial up front payment for the renewal of the distribution agreement with Standard Chartered Bank. Total holding company cash at the end of June 2014 was £1.9 billion compared to £2.2 billion at the end of 2013.

£974m
net cash remittances from business units

15%
increase on half year 2013

EEV Profits1

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  AER   CER
  Half year 2014 £m Half year 2013 £m Change %   Half year 2013 £m Change %
Post-tax operating profit            
Long-term business:            
Asia2 832 827 1   715 16
US 777 707 10   654 19
UK 388 304 28   304 28
Long-term business post-tax operating profit2 1,997 1,838 9   1,673 19
UK general insurance commission 9 11 (18)   11 (18)
Asset management business:            
M&G (including Prudential Capital) 200 175 14   175 14
Eastspring Investments 36 32 13   29 24
US (5) 21 (124)   19 (126)
Other income and expenditure12 (294) (256) (15)   (256) (15)
Post-tax operating profit based on longer-term investment returns 1,943 1,821 7   1,651 18
Short-term fluctuations in investment returns:            
Insurance operations 452 (564) 180   (528) 186
Other operations (20) (23) 13   (23) 13
  432 (587) 174   (551) 178
Effect of changes in economic assumptions (368) 534 (169)   527 (170)
Other non-operating items12 (73) 156 (147)   161 (145)
Profit for the period attributable to shareholders 1,934 1,924 1   1,788 8

Earnings per share

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    AER   CER
  Half year 2014 pence Half year 2013 pence Change %   Half year 2013 pence Change %
Basic earnings per share based on post-tax operating profit 76.3 71.5 7   64.8 18
Basic earnings per share based on post-tax total profit 75.9 75.5 1   70.2 8

As previously announced, from 1 January 2014 the basis of EEV results has been altered to be on a post-tax basis and, accordingly, 2014 half year results and all comparatives are shown on a comparable basis.

EEV operating profit1

On an EEV basis, Group post-tax operating profit based on longer-term investment returns was 18 per cent higher (7 per cent on an actual exchange rate basis) at £1,943 million in the first half of 2014. The increase is primarily due to higher profits from the Group’s life businesses, which generated new business profit of £1,015 million (up 24 per cent on a constant exchange rate basis or 11 per cent on an actual exchange rate basis) and in-force profit of £982 million2 (up 15 per cent on a constant exchange rate basis or 6 per cent on an actual exchange rate basis).

In Asia, EEV life operating profit was up 16 per cent to £832 million2, with in-force profits up 18 per cent to £338 million2, benefiting from increased scale across all of our operations. Asia new business profit was 15 per cent higher at £494 million, reflecting volume growth from the continued build out of our agency and bancassurance distribution platform, and management actions to improve product mix, geographic mix and pricing. The increase in new business profit continues to be driven by our seven ‘sweet spot’ markets of South-east Asia (Hong Kong, Indonesia, Singapore, Malaysia, Thailand, the Philippines and Vietnam), which increased their contribution by 15 per cent, despite a broadly unchanged result from Indonesia. Excluding Indonesia, new business profit from the remaining six ‘sweet spot’ markets was 18 per cent higher, demonstrating the benefits of operating a diverse business platform in the region.

Jackson’s EEV life operating profit increased by 19 per cent to £777 million, driven by growth in new business profit, where we continue to see attractive economics. In-force profit increased by 10 per cent compared to the prior half year, reflecting higher unwind from the larger book of existing business and an increased contribution from spread, persistency and mortality experience profits, the result of our disciplined approach to the way we manage and reserve for the risks of this business. US new business profit improved significantly, up 31 per cent to £376 million, reflecting the 18 per cent increase in sales volume and the benefit of Jackson’s product and pricing actions in the course of the last 12 months. The 50 basis points reduction in 10-year Treasury yields since the end of 2013 has reversed the positive movement in yields in the second half of 2013, and therefore has no impact on a period-on-period comparison of new business economics.

In the UK, EEV life operating profit of £388 million equates to a 28 per cent increase over the first half of 2013, due to a combination of both higher in-force, and new business profit. Life in-force profit increased to £243 million (2013: £204 million), mainly as a result of the positive impact of a higher unwind driven by the uplift in long-term yields. New business profit increased 45 per cent to £145 million (2013: £100 million), reflecting a contribution of £69 million from four bulk annuity transactions in the first half of 2014 (2013: £nil). In UK retail, new business profit was down 24 per cent at £76 million (2013: £100 million), on lower sales volumes of individual annuities and negative mix effects from lower proportions of higher margin individual annuities.

EEV non-operating profit1

EEV operating profit is based on longer-term investment returns and excludes the effect of short-term volatility arising from market movements and the effects of changes from economic assumptions. These items are captured in non-operating profit which reduced the 2014 results by a net £9 million (2013: £103 million increase on an actual exchange rate basis).

EEV short-term fluctuations1

Short-term fluctuations in investment returns reflect the element of non-operating profit which relates to the difference between the actual investment returns achieved and those assumed in arriving at the reported operating profit.

Short-term fluctuations in investment returns for insurance operations of positive £452 million include positive £245 million for Asia, positive £95 million for our US operations and positive £112 million in the UK.

In Asia and the UK, positive short-term fluctuations principally reflect unrealised movements on bond holdings in the period. In the US, the favourable impact of market movements on the expected level of future fee income from the variable annuity separate accounts has more than offset the net value movements on derivatives held to manage Group’s equity and interest rates exposure.

Effect of changes in economic assumptions1

The reduction in long-term yields since the end of 2013 has an adverse impact on the future earnings that we expect to generate from our existing book of business. Once this and other changes in investment market conditions are factored into the EEV calculations they gave rise to a negative movement of £368 million in the first half of 2014 (2013: positive £534 million on an actual exchange rate basis) partly offsetting the effects of short-term fluctuations above.

EEV effective tax rates

In the first half of 2014, the effective tax rate on operating profit based on longer-term investment returns was 26 per cent (2013: 27 per cent) and on the total EEV profit was 22 per cent (2013: 23 per cent). The 2014 effective tax rates reflect the reduction in corporation tax rates in the UK and certain Asia jurisdictions.

£1,943m
EEV operating profit

18%
increase on half year 2013

Capital position, financing and liquidity

Capital position

We continue to operate with a strong solvency position, while maintaining high levels of liquidity and capital generation. At 30 June 2014 our IGD surplus is estimated at £4.1 billion before deducting the 2014 interim dividend, equivalent to available capital covering our capital requirement 2.3 times.

All of our subsidiaries continue to hold strong capital positions on a local regulatory basis. We continue to experience no defaults and modest levels of impairments across our fixed income securities portfolios. Notwithstanding, we have retained our cautious stance on credit risk and have maintained our sizeable £1.9 billion credit default reserves in our UK annuity operations. Further information on our capital and solvency position is provided in the Chief Risk Officer’s summary of the risks facing our business and our capital strength.

Solvency II is scheduled to come into effect on 1 January 2016 and we continue to engage with HM Treasury, the Prudential Regulation Authority, industry bodies and our peers to ensure that the final and full requirements of Solvency II are both workable and effective. At full year 2013, we provided our economic capital position based on our Solvency II internal model. This result was based on an assumption of US equivalence, with no restrictions being placed on the economic value of overseas surplus, and the internal model on which these calculations are based has not yet been reviewed or approved by the Prudential Regulation Authority. Other key elements of the basis which are likely to be updated in the future as Solvency II regulations become clearer relate to the liability discount rate for UK annuities, the impact of transitional arrangements and the credit risk adjustment to the risk-free rate. Therefore, the results represent an estimate of our Solvency II capital position, assessed against a draft set of rules, with a number of key working assumptions, and the eventual Solvency II capital position will change as we iterate both the methodology and the internal model to reflect final rules and regulatory feedback.

On this basis at 31 December 2013, our economic capital13 surplus was estimated at £11.3 billion, which is equivalent to an economic solvency ratio of 257 per cent. We will provide an update, factoring in developments and any PRA feedback, as part of full year 2014 reporting.

Financing and liquidity

Shareholders’ net core structural borrowings and ratings

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  30 Jun 2014 £m   30 Jun 2013 £m
  IFRS basis Mark to market value EEV basis   IFRS basis Mark to market value EEV basis
Shareholders’ borrowings in holding company 4,146 452 4,598   3,710 360 4,070
Prudential Capital 275 275   275 275
Jackson surplus notes 146 41 187   164 25 189
Total 4,567 493 5,060   4,149 385 4,534
Less: Holding company cash and short-term investments (1,902) (1,902)   (1,490) (1,490)
Net core structural borrowings of shareholder-financed operations 2,665 493 3,158   2,659 385 3,044

Our financing and liquidity position remained strong throughout the period. Our central cash resources amounted to £1.9 billion at 30 June 2014, up from £1.5 billion at 30 June 2013, and we currently retain a further £2.5 billion of untapped committed liquidity facilities.

The Group’s core structural borrowings at 30 June 2014 were £4,567 million (31 December 2013: £4,636 million on an actual exchange rate basis) on an IFRS basis and comprised £4,146 million (31 December 2013: £4,211 million on an actual exchange rate basis) of debt held by the holding company, and £421 million (31 December 2013: £425 million on an actual exchange rate basis) of debt held by the Group’s subsidiaries, Prudential Capital and Jackson.

In addition to its net core structural borrowings of shareholder-financed operations set out above, the Group also has access to funding via the debt capital markets and has in place an unlimited global commercial paper programme. As at 30 June 2014, we had issued commercial paper under this programme totalling £236 million, US$2,305 million, €75 million and AU$10 million to finance non-core borrowings.

Prudential’s holding company currently has access to £2.5 billion of syndicated and bilateral committed revolving credit facilities, provided by 18 major international banks, expiring between 2016 and 2019. Apart from small drawdowns to test the process, these facilities have never been drawn, and there were no amounts outstanding at 30 June 2014. The medium term note programme, the commercial paper programme and the committed revolving credit facilities are all available for general corporate purposes and to support the liquidity needs of Prudential’s holding company and are intended to maintain a strong and flexible funding capacity.

Prudential manages the Group’s core debt within a target level consistent with its current debt ratings. At 30 June 2014, the gearing ratio (debt, net of cash and short-term investments, as a proportion of IFRS shareholders’ funds plus net debt) was 20 per cent, compared to 20 per cent at 31 December 2013. Prudential plc has strong debt ratings from Standard & Poor’s, Moody’s and Fitch. Prudential’s long-term senior debt is rated A+, A2 and A from Standard & Poor’s, Moody’s and Fitch, while short-term ratings are A-1, P-1 and F1 respectively. All ratings on Prudential and its subsidiaries are on stable outlook except PAC, which was placed on negative outlook by Moody’s in April 2014 following the pension changes set out in the March 2014 UK budget.

The financial strength of PAC is rated AA by Standard & Poor’s, Aa2 by Moody’s and AA by Fitch.

Jackson National Life Insurance Company’s financial strength is rated AA by Standard & Poor’s, A1 by Moody’s and AA by Fitch.

Prudential Assurance Co. Singapore (Pte) Ltd.’s (Prudential Singapore) financial strength is rated AA by Standard & Poor’s.

Shareholders’ funds

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  IFRS   EEV
  Half year 2014 £m Half year 2013 £m Full year 2013 £m   Half year 2014 £m Half year 2013 £m Full year 2013 £m
Profit after tax for the period 1,145 365 1,346   1,934 1,924 4,358
Exchange movements, net of related tax (117) 232 (255)   (377) 693 (1,077)
Unrealised gains and losses on Jackson securities classified as available for sale14 527 (837) (1,034)  
Dividends (610) (532) (781)   (610) (532) (781)
Other 30 38 15   101 (6) (87)
Net increase (decrease) in shareholders’ funds 975 (734) (709)   1,048 2,079 2,413
Shareholders’ funds at beginning of the period 9,650 10,359 10,359   24,856 22,443 22,443
Effect of domestication of Hong Kong branch   (11)
Shareholders’ funds at end of the period 10,625 9,625 9,650   25,893 24,522 24,856
Shareholders' value per share 414p 376p 377p   1,009p 958p 971p
Return on shareholders' funds15 24% 21% 23%   16% 16% 19%

During the first half of 2014 the performance of the equity markets in the countries that we operate in has been broadly positive, with US S&P 500 index up 6.1 per cent and the MSCI Asia ex-Japan index higher by 5.5 per cent, while the UK FTSE 100 index was flat. Continued speculation on global growth prospects and the timing of key interest rate decisions has led to some volatility in long-term yields, with most markets experiencing a small decline in 10-year bond yields since the end of 2013. Lower yields generate beneficial value movements on our holdings of fixed income securities which have given rise to positive short-term investment variances in some of our operations.

In addition, the continued appreciation of sterling against most global currencies, referenced earlier in this report, has a negative translational impact on conversion of local balance sheets to sterling.

Taking these non-operating movements into account, the Group’s EEV shareholders’ funds has increased by 4 per cent during the first half of 2014 to £25.9 billion (31 December 2013: £24.9 billion on an actual exchange rate basis). On a per share basis EEV at 30 June 2014 stood at 1,009 pence, up from 971 pence at 31 December 2013.

Under IFRS, shareholders’ funds at 30 June 2014 of £10.6 billion were 9 per cent higher than 31 December 2013 of £9.7 billion (on an actual exchange rate basis), reflecting positive operating results in the period and favourable movements in non-operating items.

£25.9bn
EEV shareholders' funds, equivalent to

1,009p
per share

Corporate transactions

Bancassurance partnership with Standard Chartered PLC

On 12 March 2014, the Group announced that it had entered into an agreement expanding the term and geographic scope of its strategic pan-Asian bancassurance partnership with Standard Chartered PLC. Under the new 15-year agreement, which commenced on 1 July 2014, a wide range of Prudential life insurance products are exclusively distributed through Standard Chartered branches in nine markets – Hong Kong, Singapore, Indonesia, Thailand, Malaysia, the Philippines, Vietnam, India and Taiwan – subject to applicable regulations in each country. In China and South Korea, Standard Chartered will distribute Prudential’s life insurance products on a preferred basis. Prudential and Standard Chartered have also agreed to explore additional opportunities to collaborate in due course elsewhere in Asia and in Africa, subject to existing exclusivity arrangements and regulatory restrictions.

As part of this transaction Prudential has agreed to pay Standard Chartered Bank an initial fee of US$1.25 billion which is not dependent on future sales volumes. Of this total, US$850 million was settled in the first half of 2014. The remainder will be paid in two equal instalments of US$200 million each in April 2015 and April 2016. For IFRS and EEV financial reporting purposes the full value of this fee, equivalent to £731 million, has been accounted as an intangible asset. In calculating the Group’s IGD surplus, the fee has been written off as no value is attributed to intangible assets under this basis.

Domestication of Hong Kong Branch

On 1 January 2014, the Group completed the process of domestication of the Hong Kong branch of The Prudential Assurance Company Limited. The branch was transferred on 1 January 2014 to two new Hong Kong incorporated Prudential companies, one providing life insurance and the other providing general insurance – Prudential Hong Kong Limited and Prudential General Insurance Hong Kong Limited. On the Prudential Regulation Authority’s pillar 1 peak 2 basis £12.1 billion of assets, £12.0 billion of liabilities, net of reinsurers’ share (including policyholder asset share liabilities, and £1.2 billion of inherited estate) and £0.1 billion of shareholders’ funds (for the excess assets of the transferred non-participating business) have been transferred.

Agreement to sell Japan life business

The Group’s closed book life insurance business in Japan, PCA Life Insurance Company Limited, has been classified as held for sale. This classification reflects the expected disposal of the business on which an agreement to sell was reached in July 2013. The sale has yet to be completed.

Acquisition of Express Life of Ghana

In April 2014 we completed the acquisition of Express Life of Ghana for £14 million.

Notes

  1. The 2014 EEV results of the Group are presented on a post-tax basis and, accordingly, the half year and full year 2013 results are shown on a comparable basis.
  2. After Asia development costs.
  3. Refer to note B1.1 in IFRS financial statements for the breakdown of other income and expenditure, and other non-operating items.
  4. Includes Group’s proportionate share of the liabilities and associated flows of the insurance joint ventures in Asia.
  5. Defined as movements in shareholder-backed policyholder liabilities arising from premiums (net of charges), surrenders/withdrawals, maturities and deaths.
  6. For basis of preparation see note I of Additional IFRS financial information.
  7. Includes Group’s proportionate share in PPM South Africa and the Asia asset management joint ventures.
  8. Net inflows exclude Asia Money Market Fund (MMF) outflows of £52 million (half year 2013: net inflows £107 million). External funds under management exclude Asia MMF balances of £4,300 million (half year 2013: £4,701 million).
  9. Free surplus generation represents ‘underlying free surplus’ based on operating movements, including the general insurance commission earned during the period and excludes market movements, foreign exchange, capital movements, shareholders’ other income and expenditure and centrally arising restructuring and Solvency II implementation costs. In addition, following its reclassification as held for sale during 2013, operating results exclude the result of the Japan life insurance business.
  10. Payback period, measured on an undiscounted basis, is the time in which the initial ‘cash’ outflow of investment is expected to be recovered from the ‘cash’ inflows generated by the investment. The ‘cash’ outflow is measured by our investment of free surplus in new business sales. The payback period equals the time taken for new business sales to generate free surplus to cover this investment.
  11. The detailed holding company cash flow is disclosed in note IV of Additional unaudited IFRS financial information.
  12. Refer to the EEV basis supplementary information – Post-tax operating profit based on longer-term investment returns and Post-tax summarised consolidated income statement, for the breakdown of other income and expenditure, and other non-operating items.
  13. The methodology and assumptions used in calculating the economic capital results are set out in note II of Additional unaudited financial information in full year 2013 results. The economic solvency ratio is based on the Group’s Solvency II internal model which will be subject to Prudential Regulation Authority review and approval before its formal adoption in 2016. We do not expect to submit our Solvency II internal model to the Prudential Regulation Authority for approval until 2015 and therefore these economic capital disclosures should not be interpreted as outputs from an approved internal model.
  14. Net of related charges to deferred acquisition costs and tax.
  15. Annualised operating profit after tax and non-controlling interests as percentage of opening shareholders’ funds.
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