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Chief Financial Officer’s report on the 2016 financial performance

Showcasing the resilience of our earnings, cash and capital

The Group’s performance has once again been led by Asia, with double digit growth across new business profit, IFRS operating profit and free surplus generation for the seventh year in a row.

Nic Nicandrou
Chief Financial Officer

Nic Nicandrou

I am particularly pleased to be able to report that Prudential’s financial performance in 2016 has showcased the resilience of our earnings, cash and capital. While these are qualities I have mentioned in previous reports, the external events of 2016 have seen them tested repeatedly across our businesses during a year of significant uncertainty, market volatility and unexpected political and regulatory events. By remaining focused on our strategy and on disciplined execution, our business withstood the effect of these events and successfully adapted to changes in market conditions, regulatory intervention and shifts in consumer preference, to deliver a strong operating performance in 2016 and an improved capital position.

Prudential’s financial attributes and multiple, diverse levers of growth have enabled the Group to absorb not only the areas of earnings pressure known at the beginning of the year, but also the fluctuations of both equity markets and yields. New business profit, IFRS operating profit and free surplus generation, the three financial measures that we use to track delivery of our ‘growth and cash’ agenda, have all increased in 2016 when expressed on an actual exchange rate basis. This achievement demonstrates the benefits of our scale and the strength of our business model which is well diversified by geography, currency and source of earnings. The 2016 results also highlight the earnings power of our growing in-force book of business and our ability to add large new business volumes which are an important store of future value.

The year-on-year trends of the three ‘growth and cash’ measures are also positive when expressed on a constant exchange rate basis, except for IFRS operating profit, where we have seen a marginal fall due to the effect of one-off impacts in our UK Life operations.

The Group’s performance has once-again been led by Asia, with double digit growth across new business profit, IFRS operating profit and free surplus generation for the seventh year in a row. This underlines the scale and quality of our regional franchise, characterised by the high proportion of recurring income and bias for protection business that is uncoupled from market effects. In our insurance and asset management businesses in the UK and US, we have continued to build our earnings base with growth in assets managed on behalf of our customers.

2016 has seen sterling weakening against most global currencies, which is positive for the translation of results from our sizeable non-sterling operations. However, to aid understanding of the underlying progress in these businesses, we continue to express and comment on the performance trends of our Asia and US operations on a constant currency basis.

The key financial highlights in 2016 were as follows:

  • New business profit1 was 11 per cent2,3 higher at £3,088 million (up 24 per cent on an actual exchange rate basis), primarily as a result of higher volumes with APE sales up 8 per cent2,3. Growth was strongest in Asia, where new business profit increased 22 per cent on a 19 per cent uplift in APE sales and improvements in country and channel mix. The contribution to new business profit from Jackson declined by 13 per cent, reflecting lower variable annuity sales volumes. UK life retail new business profit grew by 33 per cent, driven by strong consumer demand for products offering access to our PruFund investment option, which resulted in a 33 per cent increase in retail APE sales. There was no bulk annuity new business profit as we withdrew from this market in 2016.
  • IFRS operating profit based on longer-term investment returns (IFRS operating profit) was 2 per cent3 lower at £4,256 million (up 7 per cent on an actual exchange rate basis). IFRS operating profit from our Asia life insurance and asset management businesses grew by 15 per cent3 to £1,644 million, reflecting continued business momentum. In the US, Jackson’s total IFRS operating profit increased by 7 per cent, mainly due to growth in fee income on higher asset balances, which outweighed the anticipated reduction in spread earnings. In the UK, total IFRS operating profit was 31 per cent lower than the prior year, as a result of significantly reduced profits from annuity new business following our withdrawal from the bulk annuity market, the lower contribution from actions to support solvency and a provision for the cost of undertaking a review of past non-advised annuity sales practices and related potential redress. M&G’s operating profit was 4 per cent lower, reflecting the earnings impact of the recent period of net fund outflows.
  • Underlying free surplus generation1,4, our preferred measure of cash generation from our life and asset management businesses, increased by 10 per cent3 to £3,588 million (up 18 per cent on an actual exchange rate basis), after financing new business growth. The increase reflects a higher contribution from our growing in-force book of business, as we continue to focus on high-return new business with fast payback periods and includes the benefit from capital actions in the UK and the US.
  • Group shareholders’ Solvency II capital surplus7 was estimated at £12.5 billion at 31 December 2016, equivalent to a cover ratio of 201 per cent6 (1 January 2016: £9.7 billion, 193 per cent). The improvement in the period primarily reflects the continuing strength of the Group’s operating capital generation in excess of growing dividend payments to shareholders, and also includes the benefit of debt issued in the year.
  • Full year ordinary dividend increased by 12 per cent to 43.5 pence per share, reflecting our strong 2016 performance and our confidence in the future prospects of our Group.

Global investment market movements during 2016 were dominated by the sharp drop in long-term yields over the first three-quarters, and the subsequent recovery into the end of the year prompted by more favourable growth expectations in the US. Equity market performance was notably stronger in the second half of the year, contributing to a generally positive movement for 2016 overall in the countries in which we operate. Over the full year, the US S&P 500 index was up 10 per cent, the UK FTSE 100 index up 12 per cent and the MSCI Asia ex-Japan index up 5 per cent. We have taken steps to reduce the investment market sensitivity of our earnings and balance sheet, but remain significant long-term holders of financial assets to back the commitments that we have made to our customers. Short-term fluctuations in both these assets and related liabilities are reported outside the operating result, which is based on long-term investment return assumptions. These short-term fluctuations were overall negative in 2016, primarily as a result of movements in the value of derivatives used by Jackson to protect the economics of its business from adverse market shocks. As a result, total IFRS post-tax profit was £1,921 million (2015: £2,579 million on an actual exchange rate basis) and total EEV post-tax profit was £4,516 million (2015: £3,951 million on an actual exchange rate basis).

Reflecting the combined effects of improved operating results on an actual exchange rate basis, negative short-term investment fluctuations and positive currency movements of £1.2 billion, IFRS shareholders’ equity was 13 per cent higher at £14.7 billion. Similarly, EEV basis shareholders’ equity was up 22 per cent5 at £39.0 billion. As at 31 December 2016, the Group’s Solvency II capital surplus7 was £12.5 billion, equivalent to a cover ratio of 201 per cent6 (1 January 2016: £9.7 billion, 193 per cent).

IFRS profit

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Actual exchange rate   Constant exchange rate
  2016 £m 2015 £m Change %   2015 £m Change %
Operating profit before tax based on longer-term investment returns            
Long-term business:            
Asia3 1,503 1,171 28   1,303 15
US 2,052 1,691 21   1,908 8
UK 799 1,167 (32)   1,167 (32)
Long-term business operating profit3 4,354 4,029 8   4,378 (1)
UK general insurance commission 29 28 4   28 4
Asset management business:            
M&G 425 442 (4)   442 (4)
Prudential Capital 27 19 42   19 42
Eastspring Investments 141 115 23   128 10
US (4) 11 (136)   13 (131)
Other income and expenditure8 (716) (675) (6)   (675) (6)
Total operating profit based on longer-term investment returns before tax3 4,256 3,969 7   4,333 (2)
Non-operating items:            
(Loss)/Profit attaching to held for sale Korea business (227) 56 n/a   62 n/a
Other non-operating items8 (1,754) (877) (100)   (958) (83)
Profit before tax attributable to shareholders 2,275 3,148 (28)   3,437 (34)
Tax charge attributable to shareholders’ returns (354) (569) 38   (621) 43
Profit for the year attributable to shareholders 1,921 2,579 (26)   2,816 (32)

IFRS earnings per share

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  Actual exchange rate   Constant exchange rate
  2016 pence 2015 pence Change %   2015 pence Change %
Basic earnings per share based on operating profit after tax 131.3 124.6 5   136.0 (3)
Basic earnings per share based on total profit after tax 75.0 101.0 (26)   110.1 (32)

IFRS operating profit based on longer-term investment returns

Total IFRS operating profit declined by 2 per cent3 (7 per cent increase on an actual exchange rate basis) in 2016 to £4,256 million, with increases in Asia and the US offset by anticipated declines in the contribution from our UK businesses.

  • Asia total operating profit of £1,644 million was 15 per cent3 higher than the previous year (28 per cent on an actual exchange rate basis), with strong growth in both life insurance and asset management through Eastspring Investments.
  • US total operating profit at £2,048 million increased by 7 per cent (20 per cent increase on an actual exchange rate basis), driven by higher fee income from growth in Jackson’s separate account asset base and lower amortisation of deferred acquisition costs, which together exceeded the anticipated reduction in spread income.
  • UK total operating profit was 31 per cent lower at £828 million. This decline reflects lower profit from new annuity business, down from £123 million to £41 million in 2016 as we scale down our participation in the annuity market, a lower contribution from management actions to support solvency, down from £400 million to £332 million, and the establishment of a £175 million provision for the cost of undertaking a review of past non-advised annuity sales practices and related potential redress.
  • M&G operating profit was 4 per cent lower at £425 million. The impact of recent asset outflows from retail funds on overall funds under management has been partially offset by the benefit of positive market movements.

IFRS operating profit by business £m (% vs 2015)

Pie chart showing IFRS operating profit by business

At the beginning of the year, we expected that earnings would contract in a few discrete areas of the business: at M&G, due to the impact of outflows on funds under management and the corresponding fee income; in Jackson’s spread business portfolio as a result of persistently low interest rates; and in our UK life business given our withdrawal from the bulk annuity market. These identified effects have emerged largely as expected. However, our focus on cost control and the effective management of our in-force book of business have mitigated the overall impact of these anticipated adverse effects. Earnings have also benefited from continued growth in the premium base in Asia and the level of aggregate assets managed by our life and asset management operations across the Group, which together underpin the longer-term earnings progression of our business.

Life insurance operations: Taken together, IFRS operating profit from our life insurance operations in Asia, the US and the UK was 1 per cent3 lower at £4,354 million (8 per cent increase on an actual exchange rate basis).

IFRS operating profit in our life insurance operations in Asia was 15 per cent3 higher at £1,503 million (up 28 per cent on an actual exchange rate basis), reflecting our ability to translate top-line growth into shareholder value. The performance is underpinned by the recurring premium income nature of our in-force book and the highly diverse nature of our earnings by geography and by source. Insurance income was up 24 per cent, reflecting our continued focus on health and protection business. At a country level, we have seen double-digit growth in six markets, led by Hong Kong (up 40 per cent), China (up 83 per cent) and growth of 15 per cent or more from Malaysia, Thailand, Vietnam and Taiwan. These markets have more than compensated for the impact of lower earnings growth in Indonesia and Singapore, following deliberate actions taken to improve the quality of new business flows.

In the US , life IFRS operating profit was 8 per cent higher at £2,052 million (up 21 per cent on an actual exchange rate basis), reflecting the resilient performance of Jackson’s franchise in an environment of market volatility and sector-wide disruption following the announcement of the Department of Labor’s fiduciary duty rule in April 2016. Average separate account balances increased by 5 per cent, resulting in a 3 per cent rise in fee income, while the result also benefited from scale efficiencies. As expected, lower yields in the year have impacted spread income, which decreased by 5 per cent.

UK life IFRS operating profit declined by 32 per cent to £799 million (2015: £1,167 million). Within this total, the contribution from our core in-force with-profits and annuity business was £601 million (2015: £644 million), including an unchanged transfer to shareholders from the with-profits funds of £269 million. The balance of the result reflects the contribution from other activities which are either non-core or are not expected to recur to the same extent going forward.

Profit from new annuity business reduced from £123 million in 2015 to £41 million, as we scaled down our participation in the annuity market. In response to the volatile investment market environment during 2016, we took a number of asset and liability actions to improve the solvency position of our UK life operations and further mitigate market risk, generating combined profits of £332 million (2015: £400 million). Of this amount, £197 million related to profit from longevity reinsurance transactions (2015: £231 million) and £135 million (2015: £169 million) from the effect of repositioning the fixed income asset portfolio. In response to the findings of the FCA’s thematic review of non-advised annuity sales practices, the UK business will review internally vesting annuities sold without advice after 1 July 2008. Reflecting this, the UK life 2016 result includes a provision of £175 million for the cost of this review and related potential redress. The provision does not include potential insurance recoveries of up to £175 million.

We track the progress that we make in growing our life insurance 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 increase as we write new business and collect regular premiums from existing customers and decrease as we pay claims and policies mature. The overall scale of these policyholder liabilities is relevant in the evaluation of our profit potential in that it reflects, for example, our ability to earn fees on the unit-linked element and indicates the scale of the insurance element, another key source of profitability for the Group.

Shareholder-backed policyholder liabilities and net liability flows9 £m

Chart showing Shareholder-backed policyholder liabilities and net liability flows

Focusing on the business supported by shareholder capital, which generates over 90 per cent of the life profit, in 2016 net flows into our businesses were overall positive at £3.6 billion, reflecting our focus on both retaining our existing customers and attracting new business to drive long-term value creation. The weakening of sterling during the year contributed a total £32.4 billion positive foreign exchange movement which, together with favourable investment and other movements, led to a £46.2 billion increase in policyholder liabilities, with much of this arising in the second half of the year.

Policyholder liabilities and net liability flows in with-profits business9,25

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  2016 £m   2015 £m
Actual Exchange Rate   Actual Exchange Rate
At 1 January 2016 Net liability flows10 Market and other movements At 31 December 2016 At 1 January 2015 Net liability flows10 Market and other movements At 31 December 2015
Asia 20,934 3,696 5,303 29,933   18,612 2,102 220 20,934
UK 100,069 1,119 11,958 113,146   99,427 (968) 1,610 100,069
Total Group 121,003 4,815 17,261 143,079   118,039 1,134 1,830 121,003

The 18 per cent increase in policyholder liabilities in our with-profits business to £143.1 billion (2015: £121.0 billion), reflects the growing popularity with consumers seeking protection from the impact of volatile market conditions. In the course of 2016, net liability flows increased to £4.8 billion across our Asian and UK operations. As returns from these funds are smoothed and shared with customers, the emergence of shareholder profit is more gradual. This business, nevertheless, remains an important source of future shareholder value.

Analysis of long-term insurance business IFRS operating profit by driver3,10
£m (% vs 2015)

Chart showing Analysis of long-term insurance business IFRS operating profit by driver

Alongside growing our overall level of life operating profit, we continue to maintain our bias for higher-quality sources of income such as insurance margin and fee income. We favour insurance margin because it is relatively insensitive to the equity and interest rate cycle and prefer fee income to spread income because it is more capital-efficient. In line with this approach, on a constant exchange rate basis, insurance margin has increased by 7 per cent (up 19 per cent on an actual exchange rate basis) and fee income by 3 per cent (up 15 per cent on an actual exchange rate basis), while spread income decreased by 8 per cent (up 2 per cent on an actual exchange rate basis).

Asset management: Movements in asset management operating profit are also primarily influenced by changes in the scale of these businesses, as measured by funds managed on behalf of external institutional and retail customers and our internal life insurance operations. In 2016, IFRS operating profit from our asset management businesses was marginally lower at £589 million (2015: £602 million on a constant exchange rate basis), primarily due to the impact of negative net flows in M&G.

Asset management external net flows and external funds under management13,14 £m

Chart showing Asset management external net flows and external funds under management

M&G’s IFRS operating profit declined by 4 per cent to £425 million (2015: £442 million), reflecting the impact on revenues of lower average assets under management during the year, following the net outflows experienced since the second quarter of 2015. As these net outflows were primarily from the higher margin retail business, they had a disproportionately adverse impact on earnings. The same dynamics have seen the cost-income ratio move up 2 percentage points to 59 per cent.

Despite continued outflows in 2016, external assets under management at 31 December 2016 were 8 per cent higher than a year ago at £136.8 billion, benefiting from positive investment market movements, particularly in the second half of the year and a return to positive net flows for retail business in the fourth quarter of £942 million. Including the assets managed for internal life operations, M&G’s total assets under management rose to £264.9 billion (2015: £246.1 billion).

Our Asia-based asset manager, Eastspring Investments, increased IFRS operating profit by 10 per cent (up 23 per cent on an actual exchange rate basis) to £141 million, reflecting the positive effect on average assets under management of favourable market movements and £2.2 billion net inflows in the second half of the year. Although a shift in the mix of assets away from higher-margin equity funds has moderated the overall revenue margin, scale efficiencies have resulted in an improvement in the cost-income ratio to 56 per cent (2015: 58 per cent). External assets under management at 31 December 2016 increased to £38.0 billion (31 December 2015: £30.3 billion). Including money market funds and the assets managed for internal life operations, Eastspring Investment’s total assets under management rose to a record £117.9 billion (2015: £89.1 billion).

IFRS non-operating items8

IFRS non-operating items consist of short-term fluctuations, the results attaching to the held for sale life business in Korea and other non-operating items.

Short-term investment fluctuations represent the most significant component of non-operating items and are discussed further below.

The result of the held for sale Korea life business, a loss of £227 million, comprises both the write down of the IFRS net assets to sales proceeds (net of costs) and the profits for the year. The comparative profits for the year have been similarly reclassified as non-operating for consistency of presentation.

Other non-operating items of negative £76 million mainly represent the amortisation of acquisition accounting adjustments arising principally on the acquisition of the REALIC business in 2012 (2015: negative £76 million on an actual exchange rate basis). Additionally, 2015 non-operating items included a loss of £46 million from the recycling of exchange losses on the sale of the Japan business.

IFRS short-term investment fluctuations

IFRS operating profit is based on longer-term investment return assumptions. The difference between actual investment returns recorded in the income statement and the assumed longer-term returns is reported within short-term fluctuations in investment returns. In 2016, the total short-term fluctuations in investment returns relating to the life operations were negative £1,482 million and comprised negative £225 million for Asia, negative £1,455 million in the US and positive £198 million in the UK.

The Asia negative £225 million short-term fluctuations principally reflected the net impact of changes in interest rates and equity markets across the region.

In the US, Jackson provides certain guarantees on its annuity products, the value of which would typically rise when equity markets fall and long-term interest rates decline. Jackson charges fees for these guarantees which are in turn used to purchase downside protection in the form of options and futures to mitigate the effect of equity market falls, and swaps and swaptions to cushion the impact of drops in long-term interest rates. Under IFRS, accounting for the movement in the valuation of these derivatives, which are all fair valued, is asymmetrical to the movement in guarantee liabilities, which are not fair valued in all cases. Jackson designs its hedge programme to protect the economics of the business from large movements in investment markets and accepts the variability in accounting results. The negative short-term fluctuations of £1,455 million in the year mainly reflect the effect of the increase in equity markets on net value movements on the guarantees and associated derivatives with the S&P 500 index closing at 10 per cent higher than at the start of the year. While the resulting negative mark-to-market movements on these hedging instruments are recorded in 2016, the related increases in fee income that arise from the higher asset values managed, will be recognised and reported in future years.

The UK non-operating profit of positive £198 million mainly reflects gains on bonds backing annuity capital and shareholders’ funds following the 70 basis points fall in 15-year UK gilt yields in 2016.

The negative short-term fluctuations in investment returns for other operations of negative £196 million (2015: negative £61 million) include unrealised value movements on financial instruments.

IFRS effective tax rates

In 2016, the effective tax rate on IFRS operating profit based on longer-term investment returns was 21 per cent (2015: 20 per cent), reflecting a larger contribution to operating profit from Jackson which attracts a higher rate of tax.

The 2016 effective tax rate on the total IFRS profit was 16 per cent (2015: 18 per cent), reflecting a smaller contribution to the total profit from Jackson which attracts higher rate of tax.

The main driver of the Group’s effective tax rate is the relative mix of the profits between countries with higher tax rates (such as the US, Indonesia, and Malaysia), and countries with lower tax rates (such as Hong Kong, Singapore and the UK). The UK has enacted legislation to reduce the corporation tax rate in stages from 20 per cent to 17 per cent from 1 April 2020. The effect of reductions to 17 per cent is reflected in the full year 2016 results. Following the US elections, there is the prospect of significant tax reform occurring in the US, which potentially could reduce the US corporate income tax rate from the current 35 per cent. A number of Asian countries, most notably Indonesia, have indicated they are considering reducing corporation tax rates, but no legislative proposals have been announced to date.

We do not expect that changes being introduced in the UK and other countries to implement recommendations made by the OECD’s base erosion and profit shifting project to reform the international tax regime to have any significant impact on the Group.

Total tax contribution

The Group continues to make significant tax contributions in the countries in which it operates, with £2,890 million remitted to tax authorities in 2016. This was lower than the equivalent amount of £3,004 million in 2015, reflecting lower corporation tax payments, partly offset by increases in other taxes borne and taxes collected. In the US a change of basis for taxing derivatives which affects the timing but not the quantum of tax payable accelerated tax payments from 2016 into 2015.

Publication of tax strategy

In 2017, a new UK requirement for large UK businesses to publish their tax strategy will take effect. Prudential’s tax strategy, together with further details of the tax payments made in 2016, will be available on the Group’s website before 30 June 2017.

New business performance

Life EEV new business profit1 and APE new business sales (APE sales)

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  Actual exchange rate Constant exchange rate
  2016 £m 2015 £m Change %   2015 £m Change %
  APE sales New business profit APE sales New business profit APE sales New business profit   APE sales New business profit APE sales New business profit
Asia3 3,599 2,030 2,712 1,482 33 37   3,020 1,660 19 22
US 1,561 790 1,729 809 (10) (2)   1,950 913 (20) (13)
UK retail2 1,160 268 874 201 33 33   874 201 33 33
Total Group excluding bulk annuities2,3 6,320 3,088 5,315 2,492 19 24   5,844 2,774 8 11
UK bulk annuities 151 117 (100) (100)   151 117 (100) (100)
Total Group3 6,320 3,088 5,466 2,609 16 18   5,995 2,891 5 7

New business performance £m (% vs 2015)

Pie chart showing New business performance

Life insurance new business profit1 was up 11 per cent2,3 (24 per cent on an actual exchange rate basis) to £3,088 million, reflecting the net outcome from strong growth in Asia and in UK retail business and reduced contribution from our US operations.

Life insurance new business APE sales increased by 8 per cent2,3 (19 per cent on an actual exchange rate basis) to £6,320 million led by Asia and the UK.

In Asia new business profit was 22 per cent3 higher at £2,030 million, outpacing new business APE sales in the region which increased by 19 per cent3 to £3,599 million (up 37 per cent and 33 per cent respectively on an actual exchange rate basis). APE sales progression has been strongest in the agency channel, up 23 per cent, as we continue to drive improvements in productivity and invest in recruitment initiatives to underpin future sales prospects. The fourth quarter saw an acceleration in the positive trends observed earlier in the year; overall APE increased to over £1 billion for the first time in a discrete quarter, with eight of our markets in the region growing by 20 per cent or more. Despite the strength of this growth our focus on quality is undiminished, with regular premiums on long-term contracts accounting for over 93 per cent of APE sales and a continuing high proportion of new business from health and protection coverage (62 per cent of new business profit). This favourable mix provides a high level of recurring income and an earnings profile that is significantly less correlated to investment markets.

Our businesses in China and Hong Kong have performed well in 2016, with APE sales increasing by 31 per cent and 40 per cent, respectively, and demonstrating the extent of the opportunity in these markets. In Hong Kong, we continue to generate business from both Mainland China residents and local customers, with a strong bias for regular premiums (94 per cent of APE sales) and an increasing contribution from health and protection business (up 43 per cent). 2016 saw increased intervention by the Chinese authorities in relation to capital controls and we continue to monitor developments, which to date have not had a meaningful impact on our business in Hong Kong. In China, we have pivoted the business towards higher quality regular premium business driven by our increased scale in the agency channel, and sales of single premiums have reduced as we de-emphasised further new spread-based business across the region in 2016.

In Indonesia, trading conditions remain challenging, and in such an environment we have retained our more cautious approach to new business, resulting in a 25 per cent reduction in APE sales. However, sales performance in the fourth quarter was more encouraging with a more modest period-on-period decline in APE sales of 3 per cent and a return to growth in the month of December. In Malaysia, APE sales were up 8 per cent, driven by improvements in the conventional agency channel and increased contributions from our bancassurance partners. In Singapore, where APE sales were up 1 per cent in 2016, new business performance has improved through the year which saw APE sales in the second half increase by 12 per cent relative to the equivalent period last year, driven by increased agent activation and a recovery in bancassurance sales.

The 22 per cent increase in new business profit primarily reflects the effect of higher APE sales volumes (up 19 per cent) and positive effects from changes in country mix and channel mix.

In the US, uncertainty following the announcement of the Department of Labor’s fiduciary duty rule on the distribution of retirement market products has contributed to a marked decline of 22 per cent16 in industry sales of variable annuities. Jackson’s APE sales from all our variable annuity products were also lower as a result, down 25 per cent. Notwithstanding this reduction in sales, net inflows into Jackson’s separate account asset balances, which drive fee-based earnings on variable annuity business, remained positive at £4.4 billion. More favourable market conditions in the institutional product market provided Jackson with the opportunity to write APE sales of £184 million compared to £138 million in 2015.

Jackson’s new business profit of £790 million declined by 13 per cent overall, although this represents a smaller decrease than the reduction in sales volumes, demonstrating the benefit of improved business mix and a modest uplift from higher interest rates. The economics on new business in variable annuities remain extremely attractive, with high internal rates of return and short payback periods.

In our UK life business, our strategy of extending customer access to PruFund’s with-profits investment option via additional product wrappers continues to drive growth in retail APE sales, which increased 33 per cent to £1,160 million. In the current low interest rate environment, consumers are attracted to PruFund’s smoothed multi-asset fund returns and the financial security attaching to its strong capitalisation. We have seen notable success with the build out of PruFund through individual pensions (up 104 per cent), income drawdown (up 62 per cent) and ISAs (up 70 per cent), although our more established PruFund investment bonds also increased 21 per cent. Reflecting this strong performance, total PruFund assets under management of £24.7 billion as at 31 December 2016 were 50 per cent higher than at the start of the year.

UK’s retail new business profit of £268 million increased by 33 per cent reflecting the increased sales volume and positive effects from changes in product mix.

Free surplus generation

Free surplus generation is the financial metric we use to measure the internal cash generation of our business operations. For life insurance operations it represents amounts maturing from the in-force business during the year, net of amounts reinvested in writing new business. For asset management it equates to post-tax IFRS profit for the period.

This metric is based on the capital regimes which apply locally in the various jurisdictions in which our life businesses operate. The introduction of Solvency II with effect from 1 January 2016 has altered the regime locally applied to our UK life business, so the 2016 UK life free surplus figures reflect this change. The 2015 UK life comparatives are unchanged as they reflect the regime that applied at that time. Solvency II does not directly impact the way capital is generated locally in the US and in our Asian life operations, so there is no change in the way free surplus is calculated for these businesses.

In 2016 underlying free surplus generation, after investment in new business, increased by 10 per cent2 to £3,588 million.

Free surplus generation

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  Actual exchange rate   Constant exchange rate
2016 £m 2015 £m Change %   2015 £m Change %
Free surplus generation1,4            
Asia3 1,335 1,052 27   1,176 14
US 1,863 1,433 30   1,616 15
UK 930 900 3   900 3
M&G 341 358 (5)   358 (5)
Prudential Capital 22 18 22   18 22
Underlying free surplus generated from in-force life business and asset management3 4,491 3,761 19   4,068 10
Investment in new business3 (903) (718) (26)   (792) (14)
Underlying free surplus generated3 3,588 3,043 18   3,276 10
Market related movements, timing differences and other movements (588) 289        
Net cash remitted by business units (1,718) (1,625)        
Total movement in free surplus 1,282 1,707        
Free surplus at end of year1,17 6,575 5,293        

The 10 per cent3 increase in free surplus generated1 by our life insurance and asset management businesses to £4,491 million (up 19 per cent3 on an actual exchange rate basis) reflects our growing scale and the highly capital-generative nature of our business model. In 2016, a key contributor to this growth has been derived from the positive momentum of Asia’s in-force life insurance portfolio, which provides an important underpin to this metric and helps absorb cyclicality elsewhere in the Group. We drive this metric by targeting markets and products that have low-strain, high-return and fast payback profiles and by delivering both good service and value to improve customer retention. Our ability to generate both growth and cash is a distinctive feature of Prudential. The closing value of free surplus in our life and asset management operations was £6.6 billion at 31 December 2016, after financing reinvestment in new business and funding cash remittances from the business units to Group.

In Asia, growth in the in-force life portfolio, combined with post-tax asset management profits from Eastspring Investments, contributed to free surplus generation of £1,335 million, up 14 per cent. In the US, in-force free surplus generation increased 15 per cent, reflecting higher expected returns and a benefit of £236 million from contingent financing of specific US statutory reserves, which strengthened Jackson’s local statutory capital position. In the UK, free surplus generation1 was 3 per cent higher at £930 million, including a net contribution of £206 million (2015: £275 million) from management actions taken in the year to improve solvency, net of the provision for the cost of undertaking a review of past non-advised annuity sales practices and related potential redress.

We invested £903 million of the free surplus generated1 during the period in writing new business (2015: £792 million, including bulk annuities) equivalent to an increase of 14 per cent.

Asia remains the primary destination for reinvestment of capital given its higher margin organic growth opportunities. Investment of free surplus in new business was 12 per cent3 higher at £476 million, which is lower than the 19 per cent3 growth in APE sales, mainly due to positive mix effects. We continue to generate internal rates of return in excess of 20 per cent, with an average payback period of three years.

In the US, new business investment was broadly consistent with 2015 at £298 million, reflecting a greater proportion of variable annuity premiums being directed to the fixed account option and higher institutional volumes. At just 2 per cent of new business single premium sales, Jackson’s overall strain remains low, supporting the generation of high returns on capital. New business economics on Jackson’s sales remain extremely attractive, with business written at an overall internal rate of return in excess of 20 per cent and payback periods averaging two years.

The new business investment1 in the UK was £129 million (2015: £65 million), although comparisons are distorted by the application of different capital regimes in the two periods, with investment in 2016 including a significantly higher strain for new non-profit annuities under the new Solvency II regime, despite the much reduced sales. Following our decision in June 2016 to stop writing annuity business in the open market and our action in early February 2017 to direct internal vestings to a panel of providers, UK new business strain is expected to reduce significantly in 2017.

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 capital in business opportunities.

Business unit remittance18

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  Actual exchange rate
2016 £m 2015 £m
Net cash remitted by business units:    
Asia 516 467
US 420 470
UK 300 301
M&G 290 302
Prudential Capital 45 55
Other UK 147 30
Net cash remitted by business units 1,718 1,625
Holding company cash at 31 December 2,626 2,173

Movement in central cash £m

Chart showing Movement in central cash

Cash remitted to the corporate centre in 2016 amounted to £1,718 million, driven by higher remittances from Asia (up 21 per cent, after adjusting for £42 million of proceeds in 2015 from the sale of our Japan life business). Jackson made sizeable remittances of £420 million, albeit lower than last year when more supportive markets enhanced capital formation. The remittance from UK Life of £300 million was in line with 2015, while the remittance from M&G of £290 million was lower than last year reflecting lower levels of post-tax earnings in the year. Actions completed in the period, including internal restructuring that has enabled us to access central resources previously held at intermediary holding and other companies, contributed a further £147 million.

Cash remitted to the Group in 2016 was used to meet central costs of £416 million (2015: £354 million), pay the 2015 second interim ordinary, 2015 special and 2016 first interim dividends and finance the final up-front payment for the renewal of the distribution agreement with Standard Chartered Bank. These movements combined with the net proceeds of debt raised in the year and other corporate cash flows led to holding company cash increasing from £2,173 million to £2,626 million over 2016.

EEV profit1

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  Actual exchange rate   Constant exchange rate
  2016 £m 2015 £m Change %   2015 £m Change %
Post-tax operating profit based on longer-term investment returns            
Long-term business:            
Asia3 3,074 2,280 35   2,555 20
US 1,971 1,808 9   2,040 (3)
UK 643 863 (25)   863 (25)
Long-term business post-tax operating profit3 5,688 4,951 15   5,458 4
UK general insurance commission 23 22 5   22 5
Asset management business:            
M&G 341 358 (5)   358 (5)
Prudential Capital 22 18 22   18 22
Eastspring Investments 125 101 24   112 12
US (3) 7 (143)   8 (138)
Other income and expenditure19 (699) (617) (13)   (617) (13)
Post-tax operating profit based on longer-term investment returns3 5,497 4,840 14   5,359 3
Non-operating items:            
(Loss)/Profit attaching to held for sale Korea business (410) 39 n/a   42 n/a
Other non-operating items19 (571) (928) 38   (1,057) 46
Post-tax profit for the year attributable to shareholders 4,516 3,951 14   4,344 4

Earnings per share1

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  Actual exchange rate   Constant exchange rate
  2016 pence 2015 pence Change %   2015 pence Change %
Basic earnings per share based on post-tax operating profit3 214.7 189.6 13   209.9 2
Basic earnings per share based on post-tax total profit 176.4 154.8 14   170.2 4

EEV operating profit

On an EEV basis, Group post-tax operating profit based1 on longer-term investment return increased by 3 per cent3 (up 14 per cent on an actual exchange rate basis) to £5,497 million in 2016. Prudential adopts an active basis of setting the future return assumptions used to calculate the Group’s EEV basis operating profit. These assumptions are therefore based on the 31 December 2016 long-term interest rates which were lower in our key markets of the UK, Indonesia and Singapore, and higher in other markets including US, Hong Kong and Malaysia. The impact of these movements in the full year results broadly offset.

The EEV operating profit includes new business profit1 from the Group’s life business, which increased by 11 per cent3 (up 24 per cent on an actual exchange rate basis) to £3,088 million and in-force life business profit1 of £2,600 million, which was 1 per cent3 higher than prior year (up 11 per cent on an actual exchange rate basis). Experience and assumptions changes were positive at £706 million (2015: £741 million), reflecting our ongoing focus on managing the in-force book for value.

EEV operating profit by business £m (% vs FY15)

Pie chart showing EEV operating profit by business

Capital position, financing and liquidity

Capital position

With effect from 1 January 2016, the Group is required to adopt Solvency II as its consolidated capital regime. This was developed by the EU in order to harmonise the various regimes previously applied across EU member states. As the regime was primarily designed with European life products in mind, it is a poor fit with Prudential’s business given the predominantly non-EU footprint of the Group. The one year value at risk nature of the Solvency II test, which has its roots in banking regulation where risk positions can be priced and readily traded, runs counter to the multi-year nature of life insurance business, where the illiquid nature of liabilities renders such potential market solutions theoretical and not grounded in established sector practices. It also means that solvency capital will be highly volatile.

While Solvency II does not fully recognise the economic capital strength of the Group, we implemented it in 2016 having received internal model approval from the Prudential Regulation Authority in December 2015.

Analysis of movement in Group shareholder Solvency II surplus20

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  2016 £bn 2015 £bn
Estimated Solvency II surplus at 1 January/economic capital surplus at 1 January 9.7 9.7
Operating experience 2.7 2.4
Non-operating experience (including market movements) (1.1) (0.6)
Other capital movements    
Subordinated debt issuance 1.2 0.6
Foreign currency translation impacts 1.6 0.2
Dividends paid (1.3) (1.0)
Methodology and calibration changes (0.3) (1.6)
Estimated Solvency II surplus at 31 December 12.5 9.7

The high quality and recurring nature of our operating capital generation and our disciplined approach to managing balance sheet risk enabled us to enter the new Solvency II regime on 1 January 2016 with a strong Group shareholders’ capital surplus of £9.7 billion. These factors also provided meaningful protection against the significant adverse market-driven effects on this metric in the first half of 2016. Reflecting the improvement in long-term yields during the last three months of the year, combined with strong operating capital generation and the beneficial effects of debt issued, the Group shareholders’ Solvency II capital surplus was estimated at £12.5 billion at 31 December 2016, equivalent to a cover ratio of 201 per cent6,7 (1 January 2016: 193 per cent).

Solvency II surplus £bn

Chart showing Solvency II surplus

In July 2013, Prudential plc was listed by the Financial Stability Board as one of nine companies to be designated as a Global Systemically Important Insurer, a classification that was reaffirmed in November 2016. Prudential is monitoring the development and potential impact of the related framework of policy measures and is engaging closely with the Prudential Regulation Authority on the implications of this designation.

Local statutory capital

All of our subsidiaries continue to hold appropriate capital levels on a local regulatory basis. In the UK, at 31 December 2016 the Prudential Assurance Company Limited and its subsidiaries had an estimated Solvency II shareholder surplus21 of £4.6 billion (equivalent to a cover ratio of 163 per cent) and a with-profits surplus22 of £3.7 billion (equivalent to a cover ratio of 179 per cent). In the US, the combination of a high start of year capital level coupled with strong operational capital formation in the year and specific actions taken to strengthen further Jackson’s local statutory capital position led to an increase in its Risk Based Capital ratio to 485 per cent (2015: 481 per cent).

Debt portfolio

The Group continues to maintain a high-quality defensively positioned debt portfolio. Shareholders’ exposure to credit is concentrated in the UK annuity portfolio and the US general account, mainly attributable to Jackson’s fixed annuity portfolio. The credit exposure is well diversified, with investment grade securities representing 96 per cent of our UK portfolio and 98 per cent of our US portfolio at end-2016. During 2016, default losses were minimal and reported impairments of £35 million across these two portfolios were in line with those in 2015.

Net core structural borrowings £bn (EEV basis)

Chart showing Net core structural borrowings

Financing and liquidity

Our financing and central liquidity position remained strong throughout the year. Our central cash resources amounted to £2.6 billion at 31 December 2016 (31 December 2015: £2.2 billion). Total core structural borrowings increased by £1.8 billion to £6.8 billion following the issue of US$1 billion (£800 million at 31 December 2016) 5.25 per cent tier 2 perpetual subordinated debt in June 2016, US$725 million (£580 million at 31 December 2016) 4.38 per cent tier 2 perpetual subordinated debt in September 2016 and the impact of currency movements.

In addition to its net core structural borrowings of shareholder-financed operations set out above, the Group also has access to funding via the money markets and has in place an unlimited global commercial paper programme. As at 31 December 2016, we had issued commercial paper under this programme totalling £70 million and US$1,213 million, to finance non-core borrowings.

Prudential’s holding company currently has access to £2.6 billion of syndicated and bilateral committed revolving credit facilities provided by 19 major international banks, expiring in 2021 and 2022. Apart from small drawdowns to test the process, these facilities have never been drawn, and there were no amounts outstanding at 31 December 2016. The medium-term note programme, the SEC registered shelf 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.

Shareholders’ funds

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  IFRS   EEV
  2016 £m 2015 £m   2016 £m 2015 £m
Profit after tax for the year 1,921 2,579   4,516 3,951
Exchange movements, net of related tax 1,161 118   4,211 244
Unrealised gains and losses on Jackson fixed income securities classified as available for sale23 31 (629)  
Dividends (1,267) (974)   (1,267) (974)
Market to market value movements on Jackson assets backing surplus and required capital   (11) (76)
Other (135) 50   (367) 53
Net increase in shareholders’ funds 1,711 1,144   7,082 3,198
Shareholders’ funds at 1 January 12,956 11,812   31,886 29,161
Shareholders’ funds at 31 December 14,667 12,956   38,968 32,359
Effect of implementation of Solvency II at 1 January 2016         (473)
Revised shareholders’ funds at 1 January 2016         31,886
Shareholders’ value per share 568p 504p   1,510p 1,240p
Return on shareholders’ funds24 26% 27%   17% 17%

IFRS shareholders’ funds £bn

Chart showing IFRS shareholders' funds

EEV shareholders’ funds £bn

Chart showing EEV shareholders' funds

In 2016, UK sterling weakened relative to the US dollar and various Asian currencies. With approximately 49 per cent of the Group’s IFRS net assets (71 per cent of the Group’s EEV net assets) denominated in non-sterling currencies this generated a positive foreign exchange movement on net assets in the period.

This movement, together with profit after tax, movement in other comprehensive income and dividends paid, has led to the Group’s IFRS shareholders’ funds at 31 December 2016 increasing by 13 per cent to £14.7 billion (31 December 2015: £13.0 billion on an actual exchange rate basis).

The introduction of Solvency II at the start of 2016 changed the capital dynamics of our UK life operations which are directly impacted by this change. In overview, it permitted the inclusion of future profits in the available capital of the business but increased the statutory capital requirements. Factoring these and other consequential methodology changes in the EEV calculations of the UK life business produced a net charge of £473 million, equivalent to 5 per cent of the UK’s embedded value (just over 1 per cent of the Group’s embedded value at the start of the year). For our operations in Asia and the US, there is no impact on the EEV results since Solvency II does not act as the local constraint on the ability to distribute capital to the Group.

The Group’s EEV basis shareholders’ funds also increased by 22 per cent5 to £39.0 billion (31 December 2015: £31.9 billion on an actual exchange rate basis), equivalent of 1,510 pence per share, up from 1,240 pence per share5 at 31 December 2015.

Corporate transactions

Sale of Korea life insurance business

In November 2016 we announced the sale of our Korea life insurance business, PCA Life Insurance Co., Ltd. to Mirae Asset Life Insurance Co., Ltd., for KRW170 billion (equivalent to £114 million at 31 December 2016 closing exchange rate) cash consideration. The completion of this sale is subject to regulatory approval. Consistent with the classification of the business as held for sale, the IFRS and EEV carrying values have been set to £105 million, representing the estimated proceeds, net of related expenses of £9 million. The IFRS loss of £227 million and EEV loss of £410 million comprises the 2016 reduction on writing down the carrying value of the business to the agreed sale proceeds (net of costs) together with its profits for the year. The comparative profits for the year have been similarly reclassified as non-operating for consistency of presentation.

Entrance into Zambia

In June 2016 we completed the acquisition of Professional Life Assurance of Zambia, increasing Prudential’s insurance business footprint in Africa to four markets. Across Ghana, Kenya, Uganda and now Zambia we are gradually laying the foundations for what we hope will become a meaningful component of the Group in the years to come. Our current focus in these businesses is on growing our distribution; at 31 December we had 1,750 agents and were active in 181 branches of our four local bank partners (three exclusive) across these businesses.

Dividend

During 2016 the Group’s dividend policy was updated. The Board will maintain its focus on delivering a growing ordinary dividend. In line with this policy, Prudential aims to grow the ordinary dividend by 5 per cent per annum. The potential for additional distributions will continue to be determined after taking into account the Group’s financial flexibility across a broad range of financial metrics and our assessment of opportunities to generate attractive returns by investing in specific areas of the business.

The Board has decided to increase the full-year ordinary dividend by 12 per cent to 43.5 pence per share, reflecting our strong 2016 financial performance and our confidence in the future prospects of the Group. In line with this, the Directors have approved a second interim ordinary dividend of 30.57 pence per share (2015: 26.47 pence per share). In 2015, a special dividend of 10 pence per share was also awarded.

Notes

  1. The 2016 EEV basis results for UK insurance operations have been prepared on a basis that reflect the Solvency II regime, effective from 1 January 2016. The 2015 comparative results for UK insurance operations reflect the Solvency I basis.
  2. Excluding UK bulk annuities as Prudential has withdrawn from this market.
  3. Following its reclassification to held for sale during 2016, operating results exclude the results of the Korea life business. The 2015 comparative results have been similarly adjusted.
  4. Free surplus represents ‘underlying free surplus’ based on operating movements, including the general insurance commission earned during the year and excludes market movements, foreign exchange, capital movements, shareholders’ other income and expenditure and centrally arising restructuring and Solvency II implementation costs.
  5. Includes adjustment for opening EEV shareholders’ funds of negative £0.5 billion for the impact of Solvency II as at 1 January 2016.
  6. Before allowing for second interim ordinary dividend.
  7. The Group Solvency II surplus represents the shareholder capital position excluding the contribution to Own Funds and the Solvency Capital Requirement from ring-fenced with-profits funds and staff pension schemes in surplus. The estimated solvency position includes the impact of recalculated transitionals at the valuation date, which has reduced the Group shareholder surplus from £12.9 billion to £12.5 billion. The formal Quantitative Reporting Templates (Solvency II regulatory templates) will include transitional measures without this recalculation.
  8. Refer to note B1.1 in IFRS financial statements for the breakdown of other income and expenditure and other non-operating items.
  9. Includes Group’s proportionate share of the liabilities and associated flows of the insurance joint ventures and associates in Asia.
  10. Defined as movements in policyholder liabilities arising from premiums (net of charges), surrenders/withdrawals, maturities and deaths.
  11. Following its reclassification to held for sale during 2016, the shareholder-backed policyholder liabilities for Korea exclude the value of policyholder liabilities held at 1 January 2016 and 2016 net liability flows for Korea life business.
  12. For basis of preparation see note I (a) of Additional unaudited IFRS financial information.
  13. Includes Group’s proportionate share in PPM South Africa and the Asia asset management joint ventures.
  14. For our asset management business the level of funds managed on behalf of third parties, which are not therefore recorded on the balance sheet, is a driver of profitability. We therefore analyse the movement in the funds under management each period, focusing between those which are external to the Group and those held by the insurance business and included on the Group balance sheet. This is analysed in note II(b) of the Additional IFRS financial information.
  15. Net inflows exclude Asia Money Market Fund (MMF) inflows of £403 million (2015: net inflows £1,065 million). External funds under management exclude Asia MMF balances of £7,714 million (2015: £6,006 million).
  16. LIMRA/Secure Retirement Institute, US Individual Annuity Participants Report 3Q YTD 2016.
  17. The 2015 comparative includes an adjustment to opening free surplus representing the impact of Solvency II at 1 January 2016, together with the effect of a reclassification between long-term business and other operations, as discussed in note 9(v) of the EEV basis results.
  18. Net cash remitted by business units are included in the Holding company cash flow, which is disclosed in detail in note II(a) of Additional unaudited IFRS financial information.
  19. 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.
  20. The methodology and assumptions used in calculating the Solvency II capital results are set out in note II(c) of Additional unaudited financial information.
  21. The UK Solvency II surplus represents the shareholder capital position excluding the contribution to Own Funds and the Solvency Capital Requirement from ring fenced with-profits funds and staff pension scheme in surplus. The estimated solvency position includes the impact of recalculated transitionals at the valuation date.
  22. The with-profits Solvency II surplus represents the contribution to Own Funds and the Solvency Capital Requirement from ring fenced funds. The estimated solvency position includes the impact of recalculated transitionals at the valuation date.
  23. Net of related charges to deferred acquisition costs and tax.
  24. Operating profit after tax and non-controlling interests as percentage of opening shareholders’ funds.
  25. Includes Unallocated surplus of with-profits business.

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