G: Financial assets and liabilities

G1: Financial instruments – Designation and fair values

The Group designates all financial assets as at fair value, either through profit and loss or on an available-for-sale, or as loans and receivables on an amortised cost basis, net of impairment basis. Financial liabilities are designated as either fair value through profit and loss, amortised cost, or as investment contracts with discretionary participation features accounted for under IFRS 4 as described in note A3.

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  2012 £m
  Fair value
through
profit and loss
Available-
for-sale
Loans and
receivables
at amortised
cost
Total
carrying
value
  Fair value
Financial assets            
Cash and cash equivalents 6,384 6,384   6,384
Deposits 12,653 12,653   12,653
Equity securities and portfolio holdings in unit trusts 99,958 99,958   99,958
Debt securitiesnote(i) 107,278 32,825 140,103   140,103
Loansnote(ii) 2,068 9,753 11,821   12,333
Other investmentsnote(iii) 7,900 7,900   7,900
Accrued investment income 2,798 2,798   2,798
Other debtors 1,361 1,361   1,361
  217,204 32,825 32,949 282,978    

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  2012 £m
  Fair value
through
profit and loss
note (v)
Amortised
cost
IFRS 4
basis
value
Total
carrying
value
  Fair value
Financial liabilities            
Core structural borrowings of shareholder-financed operations notes (i), H13 3,554 3,554   4,133
Operational borrowings attributable to shareholder-financed operations H13 2,245 2,245   2,245
Borrowings attributable to with-profits fundsH13 40 993 1,033   1,042
Obligations under funding, securities lending and sale and repurchase agreements 2,436 2,436   2,455
Net asset value attributable to unit holders of consolidated unit trust and similar funds 4,345 4,345   4,345
Investment contracts with discretionary participation featuresnote (iv) 33,812 33,812  
Investment contracts without discretionary participation features 16,309 2,069 18,378   18,419
Other creditors 259 2,522 2,781   2,781
Derivative liabilities 2,829 2,829   2,829
Other liabilities 2,021 1,433 3,454   3,453
  25,803 15,252 33,812 74,867    

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  2011 £m
  Fair value
through
profit and loss
Available-
for-sale
Loans and
receivables
at amortised
cost
Total
carrying
value
  Fair value
Financial assets            
Cash and cash equivalents 7,257 7,257   7,257
Deposits 10,708 10,708   10,708
Equity securities and portfolio holdings in unit trusts 87,349 87,349   87,349
Debt securitiesnote(i) 97,482 27,016 124,498   124,498
Loansnote(ii) 279 9,435 9,714   9,828
Other investmentsnote(iii) 7,509 7,509   7,509
Accrued investment income 2,710 2,710   2,710
Other debtors 987 987   987
  192,619 27,016 31,097 250,732    

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  2011 £m
  Fair value
through
profit and loss
note (v)
Amortised
cost
IFRS 4
basis
value
Total
carrying
value
  Fair value

Notes

  1. As at 31 December 2012 £525 million (2011: £523 million) of convertible bonds were included in debt securities and £673 million (2011: £702 million) were included in borrowings.
  2. Loans and receivables are reported net of allowance for loan losses of £83 million (2011: £89 million).
  3. 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.
  4. 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.
  5. For financial liabilities designated as fair value through profit and loss, the impact on profit from movements in credit risk during 2012 and 2011 was negligible.
Financial liabilities            
Core structural borrowings of shareholder-financed operationsnotes (i), H13 3,611 3,611   3,815
Operational borrowings attributable to shareholder-financed operationsH13 3,340 3,340   3,340
Borrowings attributable to with-profits fundsH13 39 933 972   978
Obligations under funding, securities lending and sale and repurchase agreements 3,114 3,114   3,144
Net asset value attributable to unit holders of consolidated unit trust and similar funds 3,840 3,840   3,840
Investment contracts with discretionary participation featuresnote (iv) 29,745 29,745  
Investment contracts without discretionary participation features 15,056 1,911 16,967   17,008
Other creditors 281 2,263 2,544   2,544
Derivative liabilities 3,054 3,054   3,054
Other liabilities 1,249 1,249   1,249
  22,270 16,421 29,745 68,436    

Determination of fair value

The fair values of the financial instruments for which fair valuation is required under IFRS are determined by the use of current market bid prices for exchange-quoted investments, or by using quotations from independent third parties, such as brokers and pricing services or by using appropriate valuation techniques. Investments valued using valuation techniques include financial investments which by their nature do not have an externally quoted price based on regular trades and financial investments for which markets are no longer active as a result of market conditions eg market illiquidity. The valuation techniques used include comparison to 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. These techniques 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. When determining the inputs into the valuation techniques used priority is given to publicly available prices from independent sources when available, but overall the source of pricing is chosen with the objective of arriving at a fair value measurement which reflects the price at which an orderly transaction would take place between market participants on the measurement date.

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 from selling the financial instrument being fair valued. In some cases the disclosed value cannot 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 quoted prices if exchange listed, 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 assessment against external counterparties’ valuations.

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.

Level 1, 2 and 3 fair value measurement hierarchy of Group financial instruments

The table below includes financial instruments carried at fair value analysed by level of the IFRS 7 ‘Financial Instruments: Disclosures’ defined fair value hierarchy. This hierarchy is based on the inputs to the fair value measurement and reflects the lowest level input that is significant to that measurement.

The classification criteria and its application to Prudential can be summarised as follows:

Level 1 – quoted prices (unadjusted) in active markets for identical assets and liabilities

Level 1 includes financial instruments where there is clear evidence that the valuation is based on a quoted publicly traded price in an active market (eg exchange listed equities, mutual funds with quoted prices and exchange traded derivatives).

Level 2 – inputs other than quoted prices included within level 1 that are observable either directly (ie as prices) or indirectly (ie derived from prices)

Level 2 includes investments where a direct link to an actively traded price is not readily apparent, but which are valued using inputs which are largely observable either directly (ie as prices) or indirectly (ie derived from prices). A significant proportion of the Group’s Level 2 assets are corporate bonds, structured securities and other non-national government debt securities. These assets, in line with market practice, are generally valued using independent pricing services or third-party broker quotes. These valuations are determined using independent external quotations from multiple sources and are subject to a number of monitoring controls, such as monthly price variances and analysis on prices achieved on subsequent trades.

Pricing services, where available, are used to obtain the third-party broker quotes. Where pricing services providers are used, a single valuation is obtained and applied.

When prices are not available from pricing services, quotes are sourced directly from brokers. Prudential seeks to obtain a number of quotes from different brokers so as to obtain the most comprehensive information available on their executability. Where quotes are sourced directly from brokers, the price used in the valuation is normally selected from one of the quotes based on a number of factors, including the timeliness and regularity of the quotes and the accuracy of the quotes considering the spreads provided. The selected quote is the one which best represents an executable quote for the security at the measurement date.

Generally, no adjustment is made to the prices obtained from independent third parties. Adjustment is made in only limited circumstances, where it is determined that the third-party valuations obtained do not reflect fair value (eg either because the value is stale and/or the values are extremely diverse in range). These are usually securities which are distressed or that could be subject to a debt restructure or where reliable market prices are no longer available due to an inactive market or market dislocation. In these instances, prices are derived using internal valuation techniques including those as described above in this note with the objective of arriving at a fair value measurement which reflects the price at which an orderly transaction would take place between market participants on the measurement date. The techniques used require a number of assumptions relating to variables such as credit risk and interest rates. Examples of such variables include an average credit spread based on the corporate bond universe and the relevant duration of the asset being valued. Prudential measures the input assumptions based on the best available information at the measurement dates. Securities valued in such manner are classified as Level 3 where these significant inputs are not based on observable market data.

Of the total Level 2 debt securities of £105,839 million at 31 December 2012 (31 December 2011: £94,378 million), £8,248 million are valued internally (31 December 2011: £6,847 million). The majority of such securities are valued using matrix pricing, which is based on assessing the credit quality of the underlying borrower to derive a suitable discount rate relative to government securities of a comparable duration. Under matrix pricing, the debt securities are priced taking the credit spreads on comparable quoted public debt securities and applying these to the equivalent debt instruments factoring in 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.

Level 3 – Significant inputs for the asset or liability that are not based on observable market data (unobservable inputs)

Level 3 includes investments which are internally valued or subject to a significant number of unobservable assumptions (eg private equity funds and certain derivatives which are bespoke or long-dated).

At 31 December 2012, the Group held £6,660 million (2011: £4,565 million), 3 per cent of the fair valued financial investments, net of derivative liabilities (2011: 2 per cent), within Level 3.

Of these amounts, £3,916 million (2011: £3,732 million) was held by the Group’s participating funds and therefore shareholders’ profit and equity are not impacted by movements in the valuation of these financial instruments. At 31 December 2012, the £3,916 million (2011: £3,732 million) represented 4.3 per cent (2011: 4.3 per cent) of the total fair valued financial instruments, net of derivative liabilities of the participating funds.

Included within the £2,703 million Level 3 fair valued financial investments, net of derivative liabilities at 31 December 2012 (2011: £800 million) held to support non-linked shareholder-backed business were loans of £1,842 million, attaching to the purchase of REALIC in 2012 held to back the liabilities for funds withheld under reinsurance arrangement. The funds withheld liability, which was also accounted for on a fair value basis and classified as Level 3, amounted to £2,021 million at 31 December 2012. This liability is included within Other financial liabilities held at fair value in the table below.

Excluding the financial investments of £1,842 million held to back the funds withheld liability under REALIC’s reinsurance arrangement, the Level 3 fair valued financial investments, net of derivative liabilities, supporting non-linked shareholder-backed business at 31 December 2012 were £861 million (2011: £800 million) (representing 1.2 per cent of the total fair valued financial investments net of derivative liabilities backing this business (2011: 1.3 per cent)). Of this amount, £837 million of net assets are externally valued and £24 million of net liabilities are internally valued (2011: net assets of £757 million and £43 million respectively). Internal valuations, which represent 0.03 per cent of the total fair valued financial investments net of derivative liabilities supporting non-linked shareholder-backed business at 31 December 2012 (2011: 0.1 per cent), are inherently more subjective than external valuations.

If the value of all Level 3 investments backing non-linked shareholder-backed business valued internally was varied downwards by 10 per cent, the change in valuation would be £2 million (2011: £4 million), which would reduce shareholders’ equity by this amount before tax. Of this amount, a £1 million increase (2011: £1 million decrease) would pass through the income statement substantially as part of short-term fluctuations in investment returns outside of operating profit and a £3 million decrease (2011: £3 million decrease) would be included as part of other comprehensive income, being unrealised movements on assets classified as available-for-sale.

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  31 December 2012 £m
  Level 1 Level 2 Level 3 Total

* The Level 3 loans and other financial liabilities held by the non-linked shareholder-backed business include amounts of £1,842 million and £(2,021) million, respectively relating to the reinsurance arrangements attaching to the purchase of REALIC as described in note I1.

Analysis of financial investments, net of derivative liabilities by business type        
With-profits        
Equity securities and portfolio holdings in unit trusts 22,129 2,496 480 25,105
Debt securities 15,910 45,550 542 62,002
Other investments (including derivative assets) 108 1,743 2,894 4,745
Derivative liabilities (61) (1,072) (1,133)
Total financial investments, net of derivative liabilities 38,086 48,717 3,916 90,719
Percentage of total 42% 54% 4% 100%
Unit-linked and variable annuity separate account        
Equity securities and portfolio holdings in unit trusts 73,632 189 39 73,860
Debt securities 3,843 5,659 2 9,504
Other investments (including derivative assets) 47 10 57
Derivative liabilities (1) (1)
Total financial investments, net of derivative liabilities 77,522 5,857 41 83,420
Percentage of total 93% 7% 0% 100%
Non-linked shareholder-backed        
Loans 226 1,842* 2,068
Equity securities and portfolio holdings in unit trusts 937 7 49 993
Debt securities 13,721 54,630 246 68,597
Other investments (including derivative assets) 31 2,306 761 3,098
Derivative liabilities (16) (1,484) (195) (1,695)
Total financial investments, net of derivative liabilities 14,673 55,685 2,703 73,061
Percentage of total 20% 76% 4% 100%
Group total analysis, including other financial liabilities held at fair value        
Group total        
Loans 226 1,842* 2,068
Equity securities and portfolio holdings in unit trusts 96,698 2,692 568 99,958
Debt securities 33,474 105,839 790 140,103
Other investments (including derivative assets) 186 4,059 3,655 7,900
Derivative liabilities (77) (2,557) (195) (2,829)
Total financial investments, net of derivative liabilities 130,281 110,259 6,660 247,200
Borrowings attributable to the with-profits fund held at fair value (40) (40)
Investment contracts liabilities without discretionary participation features held at fair value (16,309) (16,309)
Net asset value attributable to unit holders of consolidated unit trusts and similar funds (3,309) (430) (606) (4,345)
Other financial liabilities held at fair value (259) (2,021)* (2,280)
Total financial instruments at fair value 126,972 93,221 4,033 224,226
Percentage of total 57% 41% 2% 100%

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  31 December 2011 £m
  Level 1 Level 2 Level 3 Total
Analysis of financial investments, net of derivative liabilities by business type        
With-profits        
Equity securities and portfolio holdings in unit trusts 24,001 1,762 284 26,047
Debt securities 13,298 43,279 655 57,232
Other investments (including derivative assets) 252 1,378 2,793 4,423
Derivative liabilities (214) (1,127) (1,341)
Total financial investments, net of derivative liabilities 37,337 45,292 3,732 86,361
Percentage of total 43% 53% 4% 100%
Unit-linked and variable annuity separate account        
Equity securities and portfolio holdings in unit trusts 59,662 198 30 59,890
Debt securities 4,160 4,698 3 8,861
Other investments (including derivative assets) 18 95 113
Derivative liabilities (2) (7) (9)
Total financial investments, net of derivative liabilities 63,838 4,984 33 68,855
Percentage of total 93% 7% 0% 100%
Non-linked shareholder-backed        
Loans 279 279
Equity securities and portfolio holdings in unit trusts 1,175 176 61 1,412
Debt securities 11,753 46,401 251 58,405
Other investments (including derivative assets) 30 2,237 706 2,973
Derivative liabilities (78) (1,408) (218) (1,704)
Total financial investments, net of derivative liabilities 12,880 47,685 800 61,365
Percentage of total 21% 78% 1% 100%
Group total analysis, including other financial liabilities held at fair value        
Group total        
Loans 279 279
Equity securities and portfolio holdings in unit trusts 84,838 2,136 375 87,349
Debt securities 29,211 94,378 909 124,498
Other investments (including derivative assets) 300 3,710 3,499 7,509
Derivative liabilities (294) (2,542) (218) (3,054)
Total financial investments, net of derivative liabilities 114,055 97,961 4,565 216,581
Borrowings attributable to the with-profits fund held at fair value (39) (39)
Investment contracts liabilities without discretionary participation features held at fair value (15,056) (15,056)
Net asset value attributable to unit holders of consolidated unit trusts and similar funds (2,586) (805) (449) (3,840)
Other financial liabilities held at fair value (281) (281)
Total financial instruments at fair value 111,469 81,780 4,116 197,365
Percentage of total 57% 41% 2% 100%

Reconciliation of movements in Level 3 financial instruments measured at fair value

The following tables reconcile the value of Level 3 financial instruments at 1 January 2012 to that presented at 31 December 2012 and at 1 January 2011 to that presented at 31 December 2011.

Total investment return recorded in the income statement represents interest and dividend income, realised gains and losses, unrealised gains and losses on financial instruments classified at fair value through profit and loss and foreign exchange movements on an individual entity’s overseas investments.

Total gains and losses recorded in other comprehensive income includes unrealised gains and losses on debt securities held as available-for-sale within Jackson and foreign exchange movements arising from the retranslation of the Group’s overseas subsidiaries and branches.

The transfers in and out of Level 3 during 2012 represent sundry individual financial investments, none of which are materially significant as highlighted in the table below:

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  £m
  At
1 Jan
Total
gains/
losses in
income
statement
Total
gains/
losses
recorded
in other
compre-
hensive
income
Acquisi-
tion of
REALIC
Pur-
chases
Sales Settled Issued Transfers
into
level 3
Transfers
out of
level 3
At
31 Dec
2012                      
Loans (46) (42) 1,858 (12) 84 1,842
Equity securities and portfolio holdings in unit trusts 375 49 44 255 (98) 6 (63) 568
Debt securities 909 65 (3) 260 (217) (73) 18 (169) 790
Other investments (including derivative assets) 3,499 250 (61) 482 (515) 3,655
Derivative liabilities (218) 13 10 (195)
Total financial investments, net of derivative liabilities 4,565 331 (62) 1,858 997 (830) (85) 84 24 (222) 6,660
Net asset value attributable to unit holders of consolidated unit trusts and similar funds (449) (20) (47) 2 1 (93) (606)
Other financial investments 41 46 (2,075) 73 (106) (2,021)
Total 4,116 352 (63) (217) 999 (829) (12) (115) 24 (222) 4,033
                       
2011                      
Equity securities and portfolio holdings in unit trusts 576 50 (1) 62 (278) (34) 375
Debt securities 1,117 46 5 274 (490) (21) 51 (73) 909
Other investments (including derivative assets) 3,106 224 (50) 691 (417) (55) 3,499
Derivative liabilities (226) (17) 25 (218)
Total financial investments, net of derivative liabilities 4,573 303 (46) 1,027 (1,185) (21) 51 (137) 4,565
Net asset value attributable to unit holders of consolidated unit trusts and similar funds (379) (78) (10) 18 (449)
Total 4,194 225 (46) 1,017 (1,167) (21) 51 (137) 4,116

Of the total gains and losses in the income statement of £357 million (2011: £225 million), £126 million (2011: £99 million) relates to financial instruments still held at the end of the year, which can be analysed as follows:

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  2012 £m 2011 £m
Equity securities 27 49
Debt securities 51 20
Other investments 48 176
Derivative liabilities (68)
Net asset value attributable to unit holders of consolidated unit trusts and similar funds (78)
Total 126 99

Transfers between Level 1 and Level 2

During 2012, the transfers between levels within the Group’s portfolio were primarily transfers from Level 1 to Level 2 of £600 million (2011: £335 million) and transfers from Level 2 to Level 1 of £227 million (2011: nil). These transfers which relate to equity securities and debt securities arose to reflect the change in the observability of the inputs used in valuing these securities.

Interest income and expense

The interest income on financial assets not at fair value through profit and loss for the year ended 31 December 2012 from continuing operations was £1,886 million (2011: £1,814 million).

The interest expense on financial liabilities not at fair value through profit and loss for the year ended 31 December 2012 from continuing operations was £420 million (2011: £456 million).

G2: Market risk

Interest rate risk

The following table shows an analysis of the classes of financial assets and liabilities except for cash and cash equivalents 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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  2012 £m
  Fair value
interest
rate risk
Cash flow
interest
rate risk
Not directly
exposed to
interest
rate risk
Total
Financial assets        
Deposits 1,021 11,445 187 12,653
Debt securities 131,732 7,851 520 140,103
Loans 8,992 2,809 20 11,821
Other investments (including derivatives) 1,896 1,126 4,878 7,900
  143,641 23,231 5,605 172,477
Financial liabilities        
Core structural borrowings of shareholder-financed operations 3,279 275 3,554
Operational borrowings attributable to shareholder-financed operations 574 1,670 1 2,245
Borrowings attributable to with-profits funds 379 562 92 1,033
Obligations under funding, securities lending and sale and repurchase agreements 403 2,033 2,436
Investment contracts without discretionary participation features 1,179 894 16,305 18,378
Derivative liabilities 974 576 1,279 2,829
Other liabilities 165 116 3,173 3,454
  6,953 6,126 20,850 33,929

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  2011 £m
  Fair value
interest
rate risk
Cash flow
interest
rate risk
Not directly
exposed to
interest
rate risk
Total
Financial assets        
Deposits 790 9,439 479 10,708
Debt securities 117,988 5,788 722 124,498
Loans 6,424 3,091 199 9,714
Other investments (including derivatives) 1,912 1,077 4,520 7,509
  127,114 19,395 5,920 152,429
Financial liabilities        
Core structural borrowings of shareholder-financed operations 3,362 249 3,611
Operational borrowings attributable to shareholder-financed operations 3,114 213 13 3,340
Borrowings attributable to with-profits funds 120 743 109 972
Obligations under funding, securities lending and sale and repurchase agreements 580 2,534 3,114
Investment contracts without discretionary participation features 1,011 903 15,053 16,967
Derivative liabilities 1,426 615 1,013 3,054
Other liabilities 158 142 949 1,249
  9,771 5,399 17,137 32,307

Liquidity analysis

i Contractual maturities of financial liabilities

The following table sets out the contractual maturities for applicable classes of financial liabilities, excluding derivative liabilities and investment contracts that are separately presented. The financial liabilities are included in the column relating to the contractual maturities at the undiscounted cash flows (including contractual interest payments) due to be paid assuming conditions are consistent with those of year end.

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  2012 £m
  Total
carrying
value
  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
Financial liabilities                    
Core structural borrowings of shareholder-financed operationsH13 3,554   140 791 603 958 1,038 691 1,753 5,974
Operational borrowings attributable to shareholder-financed operationsH13 2,245   1,708 558 2,266
Borrowings attributable to with-profits fundsH13 1,033   115 542 199 71 12 73 194 1,206
Obligations under funding, securities lending and sale and repurchase agreements 2,436   2,436 2,436
Other liabilities 3,453   945 45 5 2,458 3,453
Net asset value attributable to unit holders of consolidated unit-trusts and similar funds 4,345   4,345 4,345
Other creditors 2,781   2,515 23 36 73 70 406 3,123
  19,847   12,204 1,959 843 1,102 1,120 1,170 4,405 22,803

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  2011 £m
  Total
carrying
value
  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
Financial liabilities                    
Core structural borrowings of shareholder-financed operationsH13 3,611   245 624 606 840 1,243 737 1,834 6,129
Operational borrowings attributable to shareholder-financed operationsH13 3,340   2,971 394 3,365
Borrowings attributable to with-profits fundsH13 972   199 418 158 100 5 97 139 1,116
Obligations under funding, securities lending and sale and repurchase agreements 3,114   3,114 3,114
Other liabilities 1,249   842 106 5 296 1,249
Net asset value attributable to unit holders of consolidated unit-trusts and similar funds 3,840   3,840 3,840
Other creditors 2,544   2,268 20 27 36 45 148 2,544
  18,670   13,479 1,562 796 976 1,293 982 2,269 21,357

ii Maturity analysis of derivatives

The following table provides a maturity analysis of derivative assets and liabilities:

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  2012 £m
  Total
carrying
value
1 year
or less
After 1
year to
3 years
After 3
years to
5 years
After
5 years
Total
Net derivative position 1,033 1,025 (22) (14) (50) 939

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  2011 £m
  Total
carrying
value
1 year
or less
After 1
year to
3 years
After 3
years to
5 years
After
5 years
Total
Net derivative position 601 731 (18) (11) (31) 671

The net derivative positions as shown in the table above comprise the following derivative assets and liabilities:

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  2012 £m 2011 £m
Derivative assets 3,862 3,655
Derivative liabilities (2,829) (3,054)
Net derivative position 1,033 601

The majority of derivative assets and liabilities have been included at fair value within the one year or less column, representing the basis on which they are managed (ie to manage principally asset or liability value exposures). Contractual maturities are not considered essential for an understanding of the timing of the cash flows for these instruments and, in particular, the Group has no cash flow hedges. The only exception is certain identified interest rate swaps which are fully expected to be held until maturity solely for the purposes of matching cash flows on separately held assets and liabilities. For these instruments the undiscounted cash flows (including contractual interest amounts) due to be paid under the swap contract assuming conditions are consistent with those at year end are included in the column relating to the contractual maturity of the derivative.

The table below shows the maturity profile for investment contracts on an undiscounted basis to the nearest £ billion. This maturity profile has been based on the cash flow projections of expected benefit payments as part of the determination of the value of in-force business when preparing EEV basis results.

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  2012 £bn
  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
Total
undis-
counted
value
  Total
carrying
value
Life assurance investment contracts 4 16 15 11 8 10 64   52

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  2011 £bn
  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
Total
undis-
counted
value
  Total
carrying
value
Life assurance investment contracts 3 12 13 11 9 10 58   47

Most investment contracts have options to surrender early, albeit these are often subject to surrender or other penalties. It is therefore the case that most contracts could be said to have a contractual maturity of less than one year, but in reality the additional charges and term of the contracts means these are unlikely to be exercised in practice and the more useful information is to present information on expected payment.

The maturity profile above excludes certain corporate unit-linked business with gross policyholder liabilities of £12 billion (2011: £11 billion) which has no stated maturity but which is repayable on demand.

This table has been prepared on an undiscounted basis and accordingly the amounts shown for life assurance investment contracts differ from those disclosed on the statement of financial position. Durations of long-term business contracts, covering insurance and investment contracts, on a discounted basis are included in section D.

The vast majority of the Group’s financial assets are held to back the Group’s policyholder liabilities. Although asset/liability matching is an important component of managing policyholder liabilities (both those classified as insurance and those classified as investments), this profile is mainly relevant for managing market risk rather than liquidity risk. Within each business unit this asset/liability matching is performed on a portfolio by portfolio basis.

In terms of liquidity risk a large proportion of the policyholder liabilities contain discretionary surrender values or surrender charges, meaning that many of the Group’s liabilities are expected to be held for the long term. Much of the Group’s investment portfolios is in marketable securities, which can therefore be converted quickly to liquid assets.

For the reasons above, an analysis of the Group’s assets by contractual maturity is not considered necessary to evaluate the nature and extent of the Group’s liquidity risk.

Market and other financial risks

The Group’s maximum exposure to credit risk of financial instruments before any allowance for collateral or allocation of losses to policyholders is represented by the carrying value of financial instruments on the balance sheet that have exposures to credit risk. These assets comprise cash and cash equivalents, deposits, debt securities, loans and derivative assets, and other debtors, the carrying value of which are disclosed at the start of this note and note G3 for derivative assets. The collateral in place in relation to derivatives is described in G4. Notes D2a(iv), D3a(ii)(ii) and D4a(iii), describe the security for these loans held by the Group, as disclosed at the start of this note.

Of the total loans and receivables held, £25 million (2011: £39 million) are past their due date but have not been impaired. Of the total past due but not impaired, £18 million is less than one year past their due date (2011: £3 million). The Group expects full recovery of these loans and receivables.

No further analysis has been provided of the element of loans and receivables that was neither past due nor impaired for the total portfolio. This is on the grounds of immateriality of the difference between the neither past due nor impaired elements and the total portfolio.

Financial assets that would have been past due or impaired had the terms not been renegotiated amounted to £86 million (2011: £90 million).

In addition, during the year the Group took possession of £16 million (2011: £13 million) of other collateral held as security, which mainly consists of assets that could be readily convertible into cash.

Further details of collateral and pledges are provided in note G4.

Currency risk

As at 31 December 2012, the Group held 19 per cent (2011: 21 per cent) and 7 per cent (2011: 9 per cent) of its financial assets and financial liabilities respectively, in currencies, mainly US dollar and Euro, other than the functional currency of the relevant business unit.

Financial assets, of which 56 per cent (2011: 55 per cent) are held by the PAC with-profits fund, allow the PAC with-profits fund to obtain exposure to foreign equity markets.

Financial liabilities, of which 28 per cent (2011: 28 per cent) are held by the PAC with-profits fund, mainly relate to foreign currency borrowings.

The exchange risks inherent in these exposures are mitigated through the use of derivatives, mainly forward currency contracts (note G3).

The amount of exchange loss recognised in the income statement in 2012, except for those arising on financial instruments measured at fair value through profit and loss, is £213 million (2011: £1 million gain). This constitutes £1 million loss (2011: £11 million loss) on Medium Term Notes (MTN) liabilities and £212 million of net loss (2011: £12 million net gain), mainly arising on investments of the PAC with-profits fund. The gains/losses on MTN liabilities are fully offset by value movements on cross-currency swaps, which are measured at fair value through profit and loss.

G3: Derivatives and Hedging

Derivatives

The Group enters into a variety of exchange traded and over-the-counter derivative financial instruments, including futures, options, forward currency contracts and swaps such as interest rate swaps, cross-currency swaps, swaptions and credit default swaps.

All over-the-counter derivative transactions, with the exception of some Asia transactions, are conducted under standardised ISDA (International Swaps and Derivatives Association Inc) master agreements and the Group has collateral agreements between the individual Group entities and relevant counterparties in place under each of these market master agreements.

The total fair value balances of derivative assets and liabilities as at 31 December 2012 were as follows:

Download as excel file

  2012 £m
  UK
insurance
operations
US
insurance
operations
Asia
insurance
operations
Asset
management
Unallocated
to a segment
Group
total
Derivative assets 1,349 1,546 927 38 2 3,862
Derivative liabilities (1,007) (645) (837) (150) (190) (2,829)
  342 901 90 (112) (188) 1,033

Download as excel file

  2011 £m
  UK
insurance
operations
US
insurance
operations
Asia
insurance
operations
Asset
management
Unallocated
to a segment
Group
total
Derivative assets 1,461 1,677 444 71 2 3,655
Derivative liabilities (1,298) (887) (480) (182) (207) (3,054)
  163 790 (36) (111) (205) 601

The above derivative assets are included in ‘other investments’ in the primary statements.

These derivatives are used for efficient portfolio management to obtain cost effective and efficient exposure to various markets in accordance with the Group’s investment strategies and to manage exposure to interest rate, currency, credit and other business risks. See also note D3 for use of derivatives by the Group’s US operations.

The Group uses various interest rate derivative instruments such as interest rate swaps to reduce exposure to interest rate volatility.

The UK with-profits funds use derivatives for the purposes of efficient portfolio management or reduction in investment risks. For UK annuity business derivatives are used to assist with asset and liability cash flow matching.

Some of the Group’s products, especially those sold in the US, have certain guarantee features linked to equity indexes. A mismatch between guaranteed product liabilities and the performance of the underlying assets backing them, exposes the Group to equity index risk. In order to mitigate this risk, the relevant business units purchase swaptions, equity options and futures to match asset performance with liabilities under equity-indexed products.

The US operations and some of the UK operations hold large amounts of interest-rate sensitive investments that contain credit risks on which a certain level of defaults is expected. These entities have purchased some swaptions in order to manage the default risk on certain underlying assets and hence reduce the amount of regulatory capital held to support the assets.

Hedging

The Group has formally assessed and documented the effectiveness of the following hedges under IAS 39.

Fair value hedges

The Group has chosen to designate as a fair value hedge certain fixed to floating rate swaps which hedge the fair value exposure to interest rate movements of certain of the Group’s operational borrowings.

The fair value of the derivatives designated as fair value hedges above at 31 December 2012, was an asset of less than £1 million (2011: asset of £3 million). Movements in the fair value of the hedging instruments of a net loss of £3 million (2011: net loss of £2 million) and the hedged items of a net gain of £3 million (2011: net gain of £2 million) are recorded in the income statement in respect of the fair value hedges above.

Net investment hedges

The Group has designated perpetual subordinated capital securities totalling US$2.85 billion (2011: US$2.85 billion) as a net investment hedge to hedge the currency risks related to the net investment in Jackson. The carrying value of the subordinated capital securities was £1,746 million as at 31 December 2012 (2011: £1,823 million). The foreign exchange loss of £81 million (2011: loss of £18 million) on translation of the borrowings to pounds sterling at the statement of financial position date is recognised in the translation reserve in shareholders’ equity.

This net investment hedge was 100 per cent effective.

Cash flow hedges

The Group has no cash flow hedges in place.

G4: Derecognition and collateral

Securities lending and reverse repurchase agreements

The Group has entered into securities lending (including repurchase agreements) whereby blocks of securities are loaned to third parties, primarily major brokerage firms. The amounts above the fair value of the loaned securities required to be held as collateral by the agreements depend on the quality of the collateral, calculated on a daily basis. The loaned securities are not removed from the Group’s consolidated statement of financial position, rather they are retained within the appropriate investment classification. Collateral typically consists of cash, debt securities, equity securities and letters of credit. At 31 December 2012, the Group had lent £3,015 million (2011: £7,843 million) of securities of which £2,047 million (2011: £5,820 million) was lent by the PAC with-profits fund and held collateral under such agreements of £3,137 million (2011: £8,160 million) of which £2,138 million (2011: £6,108 million) was held by the PAC with-profits fund.

At 31 December 2012, the Group had entered into reverse repurchase transactions under which it purchased securities and had taken on the obligation to resell the securities for the purchase price of £943 million (2011: £1,607 million), together with accrued interest.

Collateral and pledges under derivative transactions

At 31 December 2012, the Group had pledged £754 million (2011: £840 million) for liabilities and held collateral of £1,964 million (2011: £1,953 million) in respect of over-the-counter derivative transactions.

These transactions are conducted under terms that are usual and customary to collateralised transactions including, where relevant, standard securities lending and repurchase agreement.

G5: Impairment of financial assets

In accordance with the Group’s accounting policy set out in note A3, impairment reviews were performed for available-for-sale securities and loans and receivables. In addition, impairment reviews were undertaken for the reinsurers’ share of insurance contract liabilities.

During the year ended 31 December 2012, impairment losses of £50 million (2011: £126 million) were recognised for available-for-sale securities and loans and receivables analysed as shown in the attached table.

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  2012 £m 2011 £m

* Relates to loans held by the UK with-profits fund and mortgage loans held by Jackson

Available-for-sale securities held by Jackson 37 62
Loans and receivables* 13 64
  50 126

Impairment losses recognised on available-for-sale securities amounted to £37 million (2011: £62 million). Of this amount, 22 per cent (2011: 34 per cent) has been recorded on structured asset-backed securities, primarily due to reduced cash flow expectations on such securities that are collateralised by diversified pools of primarily below investment grade securities. Of the losses related to the impairment of fixed maturity securities, the top five individual corporate issuers made up 74 per cent (2011: 75 per cent), reflecting a deteriorating business outlook of the companies concerned. The impairment losses have been recorded in ‘investment return’ in the income statement.

In 2012, the Group realised gross losses on sales of available-for-sale securities of £44 million (2011: £43 million) with 64 per cent (2011: 64 per cent) of these losses related to the disposal of fixed maturity securities of 10 (2011: 10) individual issuers, which were disposed of as part of risk reduction programmes intended to limit future credit loss exposure. Of the £44 million (2011: £43 million), £23 million (2011: £32 million) relates to losses on sales of impaired and deteriorating securities.

The effect of those reasonably likely changes in the key assumptions that underpin the assessment of whether impairment has taken place depends on the factors described in note A4. A key indicator of whether such impairment may arise in future, and the potential amounts at risk, is the profile of gross unrealised losses for fixed maturity securities accounted for on an available-for-sale basis by reference to the time periods by which the securities have been held continuously in an unrealised loss position and by reference to the maturity date of the securities concerned.

For 2012, the amount of gross unrealised losses for fixed maturity securities classified as available-for-sale under IFRS in an unrealised loss position was £178 million (2011: £246 million). Notes B1 and D3 provide further details on the impairment charges and unrealised losses of Jackson’s available-for-sale securities.

 
 

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