Notes on the Group financial statements

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Page 233

G: Financial assets and liabilities

G1: Financial instruments – designation and fair values

The Group designates all financial assets as either fair value through profit and loss, available-for-sale, or as loans and receivables. Financial liabilities are designated as either fair value through profit and loss or amortised cost, or for investment contracts with discretionary participating features accounted for under IFRS 4 as described in note A4.

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2007 £m
Fair value through profit and loss Available-
for-sale
Loans
and
receivables
Total
carrying
value
Fair value
Financial assets
Cash and cash equivalents 4,951 4,951 4,951
Deposits 7,889 7,889 7,889
Equity securities and portfolio holdings in unit trusts 86,157 86,157 86,157
Debt securities note i 65,349 18,635 83,984 83,984
Loans note ii 7,924 7,924 8,105
Other investments note iii 4,396 4,396 4,396
Accrued investment income 2,023 2,023 2,023
Other debtors 1,297 1,297 1,297
155,902 18,635 24,084 198,621

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2007 £m
Fair value through profit and loss Amortised cost IFRS 4 basis value Total carrying value Fair value
Financial liabilities
Core structural borrowings of shareholder-financed
operationsnotes note i, H13 2,492 2,492 2,476
Operational borrowings attributable to
shareholder-financed operations H13 3,081 3,081 3,081
Borrowings attributable to with-profits funds H13 204 783 987 1,006
Obligations under funding, securities lending and
sale and repurchase agreements 4,081 4,081 4,100
Net asset value attributable to unit holders of
consolidated unit trust and similar funds 3,556 3,556 3,556
Investment contracts with discretionary participating
features note iv 29,550 29,550
Investment contracts without discretionary
participating features 12,110 1,922 14,032 14,034
Other creditors 1,020 1,020 1,020
Other liabilities (including derivatives) 1,081 790 1,871 1,871
16,951 14,169 29,550 60,670
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2006 £m
Fair value
through
profit and loss
Available-
for-sale
Loans and receivables Total
carrying
value
Fair value
Financial assets
Cash and cash equivalents 5,071 5,071 5,071
Deposits 7,759 7,759 7,759
Equity securities and portfolio holdings in unit trusts 78,892 78,892 78,892
Debt securities note i 60,208 21,511 81,719 81,719
Loans note ii 13,754 13,754 14,274
Other investments note iii 3,220 3,220 3,220
Accrued investment income 1,900 1,900 1,900
Other debtors 1,052 1,052 1,052
142,320 21,511 29,536 193,367

Analysed by:

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2006 £m
Fair value
through
profit
and loss
Available-
for-sale
Loans and receivables Total
carrying
value
Fair value
Continuing operations 142,201 19,576 22,434 184,211 184,731
Discontinued banking operations 119 1,935 7,102 9,156 9,156
142,320 21,511 29,536 193,367
 
2006 £m
Fair value
through
profit
and loss
Amortised
cost
IFRS 4 basis value Total
carrying
value
Fair value
Financial liabilities
Banking customer accounts 5,554 5,554 5,554
Core structural borrowings of shareholder-financed
operations note i, H13 3,063 3,063 3,297
Operational borrowings attributable to
shareholder-financed operations H13 5,609 5,609 5,609
Borrowings attributable to with-profits funds H13 553 1,223 1,776 1,798
Obligations under funding, securities lending and
sale and repurchase agreements 4,232 4,232 4,229
Net asset value attributable to unit holders of consolidated
unit trust and similar funds 2,476 2,476 2,476
Investment contracts with discretionary
participating features note iv 28,733 28,733
Investment contracts without discretionary
participating features 11,480 1,562 13,042 13,035
Other creditors 1,398 1,398 1,398
Other liabilities (including derivatives) 663 989 1,652 1,652
15,172 23,630 28,733 67,535

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Analysed by:

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2006 £m
Fair value
through
profit
and loss
Amortised cost IFRS 4
basis value
Total
carrying
value
Fair value
Continuing operations 15,018 14,578 28,733 58,329 29,817
Discontinued banking operations 154 9,052 9,206 9,231
15,172 23,630 28,733 67,535

Notes

i As at 31 December 2007, £722 million (2006: £624 million) of convertible bonds were included in debt securities and £278 million (2006: £279 million) were included in borrowings.

ii Loans and receivables are reported net of allowance for loan losses of £13 million (2006:£14 million).

iii See note G3 for details of the derivative assets included. The balance also contains the PAC with-profits fund’s participation in various investment funds and limited liability property partnerships.

iv It is impractical to determine the fair value of investment contracts with discretionary participation features due to the lack of a reliable basis to measure such features.

v For financial liabilities designated as fair value through profit and loss there was no impact on profit from movements in credit risk during 2007 (2006: £nil).

Determination of fair value

The fair values of the financial assets and liabilities as shown on the table above have been determined on the following bases.

The fair values of the financial instruments for which fair valuation is required under IFRS and which are in an active market are determined by the use of current market bid prices for quoted investments, or by using quotations from independent third parties, such as brokers and pricing services. If the market for a financial investment of the Group is not active, the Group establishes fair value by using valuation techniques. The valuation techniques include the use of recent arm’s length transactions, reference to other instruments that are substantially the same, discounted cash flow analysis, option adjusted spread models and if applicable enterprise valuation and may include a number of assumptions relating to variables such as credit risk and interest rates. Changes in assumptions relating to these variables could positively or negatively impact the reported fair value of these instruments.

The fair value estimates are made at a specific point in time, based upon available market information and judgements about the financial instruments, including estimates of the timing and amount of expected future cash flows and the credit standing of counterparties. Such estimates do not reflect any premium or discount that could result from offering for sale at one time the Group’s entire holdings of a particular financial instrument, nor do they consider the tax impact of the realisation of unrealised gains or losses. In some cases the fair value estimates cannot be substantiated by comparison to independent markets, nor can the disclosed value be realised in immediate settlement of the financial instrument.

The loans and receivables have been shown net of provisions for impairment. The fair value of loans has been estimated from discounted cash flows expected to be received. The rate of discount used was the market rate of interest.

The estimated fair value of derivative financial instruments reflects the estimated amount the Group would receive or pay in an arm’s length transaction. This amount is determined using quotations from independent third parties or valued internally using standard market practices. In accordance with the Group’s risk management framework, all internally generated valuations are subject to independent assessment against external counterparties’ valuations.

The fair value of borrowings is based on quoted market prices, where available.

Refer to section A4 for the determination of fair value for investment contracts without fixed and guaranteed terms (notably UK unit-linked policies). For investment contracts in the US with fixed and guaranteed terms the fair value is determined based on the present value of future cash flows discounted at current interest rates.

The fair value of other financial liabilities is determined using discounted cash flows of the amounts expected to be paid.

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Use of valuation techniques

The carrying value of investments on the balance sheet of the Group which are not on active markets and therefore valued using valuation techniques as described above are as follows:

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2007 £m
UK
with-profits
funds
Shareholder-backed business
UK (PRIL) US Total Total
Debt securities 3,002 509 2,863 3,372 6,374
Equity securities 629 629
Other investments 2,108 743 743 2,851
5,739 509 3,606 4,115 9,854
 
2006 £m
UK
with-profits
fund
Shareholder-backed business
UK (PRIL) US Total Total
Debt securities 2,945 396 2,859 3,255 6,200
Equity securities 59 59
Other investments 1,499 453 453 1,952
4,503 396 3,312 3,708 8,211

The majority of the financial investments valued using valuation techniques were debt securities. Of the debt securities valued using valuation techniques of £6,374 million (2006: £6,200 million) at 31 December 2007, debt securities with a fair value of £3,511 million (2006: £3,341 million) were held by UK operations. £3,002 million (2006: £2,945 million) of this amount related to securities held by with-profits operations and £509 million (2006: £396 million) related to securities held by the shareholder-backed UK annuity subsidiary Prudential Retirement Income Limited (PRIL). Debt securities valued using valuation techniques held by the US operations were £2,863 million (2006: £2,859 million).

These debt securities include private debt securities such as private placements, project finance, asset securitisations and local authority securities. The securities are mainly long-dated and not regularly traded and are valued internally using market standard practices. The majority of the debt securities above are valued using matrix pricing, which is based on assessing credit quality of the underlying borrower to derive a suitable discount rate relative to government securities. Under matrix pricing, the debt securities are priced by taking the credit spreads on comparable quoted public debt securities and applied to the equivalent debt instruments factoring a specified liquidity premium. The majority of the parameters used in this valuation technique are readily observable in the market and, therefore, are not subject to interpretation.

For the UK operations, in accordance with the Group’s Risk Management Framework, all internally generated calculations are subject to independent assessment by the Group’s Fair Value Committees which comprise members who are independent of the fund managers involved in the day-to-day trading in these assets.

In addition to private debt securities, debt securities of US operations valued using valuation techniques also included securities held by the Piedmont trust entity, an 80 per cent Jackson held static trust formed as a result of a securitisation of asset-backed securities in 2003 that are accounted for on an available-for-sale basis. As at 31 December 2007, the fair value of these Piedmont assets valued using valuation techniques was £316 million (2006: £405 million). Significant estimates and judgements are also employed in valuing certain asset-backed and mortgage-backed securities held by the Piedmont trust entity. These valuations may impact reported shareholder profit and loss amounts through the determination of impairment and recovery amounts.

Whilst management believes that the estimates and assumptions employed in developing the fair value estimates are reasonable and present management’s best estimate of such values, a reasonable range of values exists with respect to most assumptions utilised in determining these values. As a result of the potentially significant variability in the estimates of the assumptions used in these models, the range of reasonable estimates of the fair value of these securities is significant.

Management has obtained broker bids on these Piedmont trust assets that represent the value at which the Group could sell the investments, if forced. These bids are not based on full knowledge and hence analysis of the investments, but represent the best estimate of the worst case decline in market value of these securities. The broker bids for these securities at 31 December 2007 totalled £260 million, a difference of £56 million (2006: £372 million, a difference of £33 million), from the fair value applied.

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The equity securities and other investments which included property and other partnerships in investment pools, venture investments and derivative assets as shown on the table above are valued using valuation techniques which apply less readily observable market factors and more non-observable factors than the matrix pricing technique as used for the majority of the debt securities. In addition to the investments shown above, there are some minor amounts valued using valuation techniques in the Group’s Asian operations.

The total amount of the change in fair value estimation using valuation techniques, including valuation techniques based on assumptions not wholly supported by observable market prices or rates, recognised in the income statement in 2007 was a gain of £101 million (2006: gain of £47 million) for the with-profits fund investments. Changes in values of assets of the with-profits funds are reflected in policyholder liabilities and unallocated surplus. Due to the liability accounting treatment of unallocated surplus, changes in values of securities held by with-profits funds have no direct effect on the profit or loss attributable to shareholders or shareholders’ equity.

The total amount of the change in fair value estimation using valuation techniques, including those based on assumptions not wholly supported by observable market prices or rates, recognised in the income statement in 2007 and which was attributable to shareholders, was a gain of £138 million (2006: gain of £68 million) for the PRIL and US investments.

Interest income and expense

The interest income on financial assets not at fair value through profit and loss for the year ended 31 December 2007 from continuing operations was £2,016 million (2006: £2,006 million).

The interest expense on financial liabilities not at fair value through profit and loss for the year ended 31 December 2007 from continuing operations was £842 million (2006: £890 million).

G2: Market risk

Interest rate risk

The following table shows an analysis of the classes of financial assets and liabilities and their direct exposure to interest rate risk. Each applicable class of the Group’s financial assets or liabilities is analysed between those exposed to fair value interest rate risk, cash flow interest rate risk and those with no direct interest rate risk exposure:

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2007 £m
Fair value interest
rate risk
Cash flow interest
rate risk
Not directly
exposed to interest
rate risk
Total
Financial assets
Cash and cash equivalents 4,951 4,951
Deposits 678 7,211 7,889
Debt securities 76,481 7,503 83,984
Loans 4,319 3,605 7,924
Other investments (including derivatives) 664 285 3,447 4,396
82,142 18,604 8,398 109,144
Financial liabilities
Core structural borrowings of shareholder-financed operations 2,492 2,492
Operational borrowings attributable to shareholder-financed operations 2,743 331 7 3,081
Borrowings attributable to with-profits funds 451 441 95 987
Obligations under funding, securities lending and sale and
repurchase agreements 594 3,487 4,081
Investment contracts without discretionary participation features 1,922 12,110 14,032
Other liabilities (including derivatives) 422 243 1,206 1,871
8,624 4,502 13,418 26,544

Page 238
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2006 £m
Fair value interest rate risk Cash flow interest rate risk Not directly exposed to rate risk Total continuing operations Discontinued banking operations Total
Financial assets
Cash and cash equivalents 5,065 5,065 6 5,071
Deposits 4,872 2,887 7,759 7,759
Debt securities 53,938 25,805 79,743 1,976 81,719
Loans 4,521 2,137 6,658 7,096 13,754
Other investments (including derivatives) 292 342 2,508 3,142 78 3,220
Total for continuing operations 63,623 31,171 7,573 102,367
Discontinued banking operations 1,566 7,584 6 9,156
65,189 38,755 7,579 111,523
Financial liabilities
Banking customer accounts 5,554 5,554
Core structural borrowings of
shareholder-financed operations 2,612 2,612 451 3,063
Operational borrowings attributable to
shareholder-financed operations 2,282 501 7 2,790 2,819 5,609
Borrowings attributable to with-profits funds 1,486 219 71 1,776 1,776
Obligations under funding, securities lending
and sale and repurchase agreements 851 3,381 4,232 4,232
Investment contracts without discretionary
participation features 1,562 11,480 13,042 13,042
Other liabilities (including derivatives) 393 225 652 1,270 382 1,652
Total for continuing operations 9,186 4,326 12,210 25,722
Discontinued banking operations 451 8,527 228 9,206
9,637 12,853 12,438 34,928

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Liquidity analysis

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2007 £m
1 year
or less
After
1 year to
5 years
After
5 years to
10 years
After
10 years to
15 years
After
15 years to
20 years
Over
20 years
No stated
maturity
Total
carrying
value
Financial liabilities
Core structural borrowings of
shareholder-financed operations H13 248 366 315 801 762 2,492
Operational borrowings attributable to
shareholder-financed operations H13 2,618 51 355 57 3,081
Borrowings attributable to with-profits
funds H13 103 232 265 83 304 987
Obligations under funding, stocklending and
sale and repurchase agreements 4,081 4,081
Other liabilities (including derivatives) 1,314 181 12 33 6 173 152 1,871
8,116 712 632 399 321 1,114 1,218 12,512

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2006 £m
1 year
or less
After
1 year to
5 years
After
5 years to
10 years
After
10 years to
15 years
After
15 years to
20 years
Over
20 years
No stated
maturity
Total
carrying
value
Financial liabilities
Core structural borrowings of
shareholder-financed operationsH13 150 248 335 313 803 763 2,612
Operational borrowings attributable to
shareholder-financed operationsH13 2,048 61 521 160 2,790
Borrowings attributable to with-profits
fundsH13 33 331 541 19 57 795 1,776
Obligations under funding, stocklending and sale
and repurchase agreements 4,232 4,232
Other liabilities (including derivatives) 749 203 19 39 7 125 128 1,270
Total for continuing operations 7,212 843 1,081 374 339 1,145 1,686 12,680
Discontinued operations 6,869 1,886 250 201 9,206