Milliman Client Report

Transcription

1 Milliman Client Report The Part VII transfer of the business of Prudential Retirement Income Limited to The Prudential Assurance Company Limited. The report of the Independent Expert Prepared by: Oliver Gillespie, FIA May 2016

2 CONTENTS 1. Introduction... 4 The Independent Expert... 4 The scope of my report... 4 Qualifications and disclosures... 5 The parties for whom the report has been prepared... 5 Limitations... 6 The Technical Actuarial Standards ( TAS )... 6 The Actuarial Profession Standards ( APS )... 6 The structure of my report The general considerations of the Independent Expert... 7 The role of the Independent Expert... 7 The security of policyholder benefits... 8 Policyholders reasonable expectations and TCF... 8 The conclusions of the Independent Expert... 8 My Supplementary Report The UK life insurance market and regulatory environment The UK regulators The Solvency II regulatory regime The matching adjustment The transitional measures Ring-fenced funds The UK regulatory regime in force prior to Solvency II The governance of UK long-term insurers A firm s risk appetite and internal capital policy The products and long-term insurance business relevant to the proposed Scheme The financial information in this report Reliance on legal opinion Background on PAC Introduction PAC s current fund structure PAC s business PAC s long-term insurance business: the with-profits business and the LT SH business PAC s general insurance business Recent relevant events The Capital Support Arrangement ( CSA ) The PAC walk-away option with respect to PRIL May 2016

3 The Pension Mis-selling Costs Assurance and capital support agreement The PAC Shareholder Risk Appetite ( SRA ) Framework The management of PAC s long-term insurance business The Prudential UK & Europe Investment Committee (the Investment Committee ) The PAC Risk Function Background on PRIL Introduction The PRIL-PAC QS agreement Other reinsurance agreements The CSA Loan arrangements Bulk pension contracts The administration and servicing of the PRIL policies The proposed Scheme The motivation for the implementation of the Scheme Summary of the implementation of the proposed Scheme The structure after the implementation of the proposed Scheme The effect of the implementation of the Scheme on the PRIL policies Introduction The financial strength available to provide security of benefits The profile of risks to which the PRIL policies will be exposed if the Scheme is implemented The governance and management of the PRIL policies The benefit expectations of the PRIL policyholders The effect of the proposed Scheme on the policies currently reinsured into PRIL The effect of the proposed Scheme on the bulk purchase annuity ( BPA ) policies Conclusions for the PRIL policies The reinsurance agreements with companies outside the Prudential Group The effect of the implementation of the Scheme on the PAC policies Introduction The PAC LT SH business The policies of the PAC ring-fenced funds (the PAC WPSF, the DCPSF and the SAIF) The policies of the subsidiaries (other than PRIL) of the PAC shareholder-backed business The PAC general insurance policies Other considerations arising from the Scheme The approach to communication with policyholders Developments for PRIL and PAC since 30 June Project Atlas The future operation of the Scheme The effect of the proposed Scheme on previous schemes Contracts potentially affected by the proposed Scheme May 2016

4 Solvency II requirements Solvency II approvals The ORSA The transition of the SRA Framework to Solvency II The CSAs Quality of capital The non-implementation of the Scheme The reinsurance where PAC or PRIL is the cedant Tax The costs of the Scheme Policyholders rights under the FSCS and FOS Conclusions Appendix 1 Selected financial information before the implementation of the Scheme Appendix 2 Selected financial information after the implementation of the Scheme Appendix 3 Data relied upon Appendix 4 Glossary of Terms May 2016

5 1. INTRODUCTION The Independent Expert 1.1 When an application is made to the High Court of Justice of England and Wales (the Court ) for an order to sanction the transfer of long-term insurance or reinsurance business from one insurer to another, the application is subject to Part VII of the Financial Services and Markets Act 2000 ( FSMA ) and approval by the Court under Section 111 of FSMA. FSMA requires the application to be accompanied by a report on the terms of the Scheme by an Independent Expert. 1.2 I have been appointed by The Prudential Assurance Company Limited ( PAC ) and Prudential Retirement Income Limited ( PRIL ) to report, pursuant to Section 109 of FSMA, in the capacity of the Independent Expert, on the terms of the proposed scheme providing for the transfer of the entire business of PRIL to PAC. 1.3 As with the other costs of the Scheme, and as set out in Section 6, my fees will be borne by the surplus in PRIL and by PAC s shareholder-backed business. 1.4 The purpose of this report is to review the proposed transfer of the business of PRIL to PAC and, in particular, to consider the impact of the proposed transfer on the security of the benefits and the benefit expectations of the existing policyholders of PRIL and PAC. 1.5 In this report ( my report ) I refer to this proposed scheme as the Scheme or this Scheme and throughout the remainder of this report, these terms are used to cover all the proposals included in the scheme of transfer, including any documents referred to therein relating to the proposed implementation and operation of the scheme of transfer. 1.6 The Scheme will be presented to the Court for sanction under Section 111 of FSMA. The scope of my report 1.7 My terms of reference have been reviewed by the Financial Conduct Authority ( FCA ) and the Prudential Regulation Authority ( PRA ). 1.8 My report has been prepared under the terms of the guidance set out in the PRA s Statement of Policy, The Prudential Regulation Authority s approach to insurance business transfers (the PRA Statement of Policy ), and Chapter 18 of the Supervision Manual ( SUP 18 ) contained in the FCA Handbook. 1.9 My report considers the consequences of the Scheme for those policyholders likely to be affected by the implementation of the Scheme: the policyholders of PAC and PRIL I understand that similar schemes are to be presented to: The Royal Court of Jersey to transfer the long-term insurance business carried on by PRIL in or from within Jersey to PAC; and The Royal Court of Guernsey with respect to any policies of long-term insurance business of PRIL issued to residents of Guernsey. and that this report will be presented to the Royal Court of Jersey and the Royal Court of Guernsey, respectively, to satisfy the requirement for a report by an Independent Expert on the terms of those schemes I confirm that the comments and conclusions in this report apply to all policyholders of PRIL and PAC (including PAC s general insurance policyholders) irrespective of their place of residence and/or the jurisdiction within which the business is said to be carried on or in which their policy was issued. References to the Scheme or this Scheme should be taken to include the local schemes in Jersey and Guernsey My report will be presented to the Court and will be made available to policyholders via the Prudential website ( and a summary of my report will be included in the communications pack that is sent to policyholders In assessing the impact of the implementation of the Scheme on the policyholders of PAC and PRIL, and whether those policyholders are being treated fairly as a result of the implementation of the Scheme, I have had regard to: May

6 The likely effect of the implementation of the Scheme on the security of policyholder benefits and on the benefit and other expectations of policyholders created by past practices employed, or statements made, by each company; The Principles and Practices of Financial Management ( PPFM ) of PAC; The report of the Chief Actuary of PAC and PRIL; and The report of the With-Profits Actuary ( WPA ) of PAC There are no documents or other information that I have requested and that have not been provided. Appendix 3 contains a list of the data upon which I have relied As far as I am aware, there are no matters that I have not taken into account in undertaking my assessment of the Scheme and in preparing my report, but that nonetheless should be drawn to the attention of policyholders in their consideration of the terms of the Scheme I have only considered the terms of the Scheme presented to me and I am not required to consider possible alternative schemes. Qualifications and disclosures 1.17 I am a Fellow of the Institute and Faculty of Actuaries, having qualified in 1999, and hold certificates issued by the Institute and Faculty of Actuaries in respect of practising as a life actuary for non-profit, unit-linked and with-profits business I am a partner of Milliman LLP ( Milliman ) and I am based in its UK Life Insurance and Financial Services practice. I am an approved person on the Financial Services Register and I currently hold a number of Chief Actuary roles. I have fulfilled the role of Independent Expert in relation to a number of Part VII transfers that have subsequently been approved by the Court My appointment as the Independent Expert was approved by the PRA (after consulting with the FCA) in a letter dated 25 July 2014 to PAC and reconfirmed in a subsequent letter on 3 November I submitted a statement of independence to the PRA and FCA for review before my approval and this statement of independence has been approved by the PRA and FCA. I confirm that neither I nor Milliman LLP have or have had any direct or indirect interest in either PRIL or PAC or other related firms that could influence my independence. The parties for whom the report has been prepared 1.21 This report, and any extract or summary thereof has been prepared particularly for the use of: The Court; The Royal Court of Guernsey; The Royal Court of Jersey; The Directors and senior management of PAC; The Directors and senior management of PRIL; The FCA and the PRA, and any governmental department or agency having responsibility for the regulation of insurance companies in the UK; The insurance regulator of any EEA country who requests a copy of the report; The Guernsey Financial Services Commission; The Jersey Financial Services Commission; and The professional advisers of any of the above. May

7 1.22 In accordance with the legal requirements under FSMA, copies of my report may be made available to the policyholders of PAC and PRIL and to other interested parties. Limitations 1.23 In preparing my report, I have had access to certain documentary evidence provided by PAC and PRIL, the key elements of which are listed in Appendix 3. I have also had access to, and discussions with, senior management of PAC and PRIL. My conclusions depend on the substantial accuracy of this information without independent verification. I have considered, and am satisfied with, the reasonableness of this information based upon my own experience across the industry This report must be considered in its entirety as individual sections, if considered in isolation, may be misleading. Draft versions of this report should not be relied upon for any purpose. I have provided a summary of my report for inclusion in the policyholder information booklet (and, where relevant, distribution to any persons requesting a copy of it) and, other than this, no summary of my report may be made without my express consent This report has been prepared on an agreed basis for PAC and PRIL in the context of the Scheme and must not be relied upon for any other purpose. No liability will be accepted by Milliman, or me, for any application of my report to a purpose for which it was not intended, nor for the results of any misunderstanding by any user of any aspect of the report. In particular, no liability will be accepted by Milliman or me under the terms of the Contracts (Rights of Third Parties) Act The Technical Actuarial Standards ( TAS ) 1.26 My report has been prepared subject to the terms of the TAS applicable to Transformations ( Transformations TAS ) issued by the Financial Reporting Council. In my opinion, my report complies with the Transformations TAS and is compliant with those elements of the TASs on Data, Modelling, Reporting and Insurance that are applicable to transformations. In complying with these requirements, I note that a number of the key documents listed in Appendix 3 have been prepared or reviewed by individuals who were subject to professional standards in undertaking their work, including, where appropriate, TAS requirements. The Actuarial Profession Standards ( APS ) 1.27 In accordance with the APS issued by the Actuarial Profession, APS X2 requires members to consider whether their work requires an independent peer review In my view this report does require independent peer review and this has been carried out by a senior actuary in Milliman LLP who has not been part of my team working on this assignment. The structure of my report 1.29 Section 2 of this report covers the considerations of the Independent Expert for a Part VII transfer in the UK and Section 3 gives background information on the regulatory regime in the UK Sections 4 and 5 of this report provide background to PAC and PRIL, and Section 6 provides a summary of the Scheme and summarises the key aspects of the Scheme The effects of the implementation of the Scheme on the policies of PRIL and PAC and on the holders of these policies are covered in Sections 7, 8 and 9, and Section 10 contains my conclusions on the Scheme The appendices contain financial information relevant to the companies involved in the Scheme and some relevant background information. May

8 2. THE GENERAL CONSIDERATIONS OF THE INDEPENDENT EXPERT The role of the Independent Expert 2.1 I have compiled my report in accordance with the PRA Statement of Policy (paragraphs 2.27 to 2.40) and with paragraphs 31 to 41 of section 2 of SUP 18, which give guidance on the form of the Scheme Report. 2.2 In considering the proposed Scheme, the concept of treating customers fairly ( TCF ) should be applied. To ensure that customers are treated fairly in the future, it is necessary to establish the ways in which customers have been treated in the past. From the policyholders perspective, the successful implementation of the Scheme must be on the basis that their benefits and fair treatment are not materially adversely affected. 2.3 As described in Section 1 of this report, the Scheme concerns two life insurance companies: PRIL and PAC where PRIL is a wholly owned subsidiary of PAC. I need to consider the terms of the Scheme generally and how the different groups of policyholders of PRIL and PAC and the different generations of policyholders within the different groups are likely to be affected by the implementation of the proposed Scheme. In particular I need to consider: The effect of the implementation of the Scheme on the security of the policyholders contractual rights, including the likelihood and potential effects of the insolvency of the insurer; The effect of the implementation of the Scheme on the reasonable benefit expectations of policyholders; and The effect of the implementation of the Scheme on the service standards and governance applicable to policyholders. 2.4 I am only required to comment on the effects of the implementation of the proposed Scheme on policyholders who enter into contracts with PRIL and PAC prior to the Effective Date of the Scheme. 2.5 Policyholders for this purpose includes persons with certain rights, including contingent rights, under PRIL and PAC s policies. For the purpose of this analysis I have also taken the members of pension schemes which have taken out policies with PRIL or PAC to be policyholders. 2.6 In this report I have not restricted my assessment of the Scheme to adverse effects. 2.7 As described in Section 1, two life companies are involved in the Scheme, each with a different mix of policies and policyholders. 2.8 The type of policy held by a policyholder will be a key determinant of the risks to which the policyholder is exposed. Other than this, the key determinants of the policyholder s risk exposure will be the characteristics of the company in which the policy is held, for example: The size of the company; The amount and quality of capital resources available, other calls on those capital resources and capital support currently available to the company; The internal capital policy of the company; The investment strategy of the company; The mix of business of the company; The company s strategy, and governance around its objectives and strategy: for example, its acquisition and new business strategy; and Other factors, such as operational risks faced by the company, reinsurance arrangements of the company, the company s governance framework and its tax position. 2.9 Some of these risks are company-specific, for example risks arising from the particular mix of business written or from the company s strategy, and some are common to various different groups of policyholders across the companies subject to the Scheme. May

9 The security of policyholder benefits 2.10 As part of my role as Independent Expert for the Scheme, I need to consider the security of policyholder benefits, that is, the effect of the implementation of the Scheme on the likelihood that policyholders will receive their guaranteed benefits when these are due In considering and commenting upon policyholder security, I shall primarily consider policyholders guaranteed benefits and, as appropriate, their reasonable benefit expectations. The amount by which the assets available to support the long-term insurance business exceed the long-term liabilities provides security for the guaranteed benefits. Security is also provided by other capital resources in the insurance company. Policyholders reasonable expectations and TCF 2.12 As Independent Expert, I also need to consider the proposals in the context of the FCA s TCF regime and, in particular, the effect of the implementation of the Scheme on policyholders reasonable benefit expectations This involves considering the effect of the implementation of the Scheme on areas where discretion is involved on behalf of the relevant insurance company with regard to the charges applied to a policy and the benefits (including with-profits bonuses) granted to the policyholder, to confirm that the implementation of the Scheme will not have a material adverse impact on policyholders reasonable expectations in respect of their policy benefits In addition, I need to consider the effect of the implementation of the Scheme on the management, service and governance standards of the company in question to ensure that policyholders reasonable expectations in relation to these areas are not materially adversely affected. The conclusions of the Independent Expert 2.15 As Independent Expert, my assessment of the impact of the implementation of the Scheme on the various affected policies is ultimately a matter of actuarial judgement regarding the likelihood and impact of future possible events. Given the inherent uncertainty of the outcome of such future events and that the effects may differ across different groups of policies, it is not possible to be certain of their effect on the policies In order to acknowledge this inherent uncertainty, the conclusions of the Independent Expert in relation to transfers of long-term insurance business are usually framed using a materiality threshold. If the potential impact under consideration is very unlikely to happen and does not have a significant impact, or is likely to happen but has a very small impact, then it is not considered to have a material effect on the policies The setting of my conclusions in this framework is a consequence of the Court s consideration of prior schemes. In particular, principles stated by Evans-Lombe J. in Re Axa Equity & Law Life Assurance Society plc and AXA Sun Life plc (2001) (based on principles outlined by Hoffman J. in Re London Life Association Ltd (1989)) are often used as the basis for the consideration of insurance business transfers by the Independent Expert and by the Court In particular, Evans-Lombe J. stated in Re AXA Equity & Law that the court is concerned whether a policyholder, employee or other interested person or any group of them will be adversely affected by the scheme. He went on to state: That individual policyholders or groups of policyholders may be adversely affected does not mean that the scheme has to be rejected by the court. The fundamental question is whether the scheme as a whole is fair as between the interests of the different classes of persons affected. The most common interpretation of these (and other relevant) statements has been that a conclusion that no group of policyholders is materially adversely affected by the Scheme provides a sufficient condition to conclude that the fairness of the Scheme as a whole has been demonstrated This is therefore the framework in which I undertake my consideration of the proposed Scheme. My Supplementary Report 2.20 I will prepare a further report (the Supplementary Report ) prior to the final Court Hearing to provide an update for the Court on my conclusions in respect of the effect of the proposed transfer on the different groups of policyholders in light of any significant events subsequent to the date of the finalisation of my main report. May

10 2.21 My Supplementary Report will include analysis of the effects of the proposed Scheme based upon the Solvency II financial results as at 1 January My Supplementary Report will be available to policyholders on the Prudential website. May

11 3. THE UK LIFE INSURANCE MARKET AND REGULATORY ENVIRONMENT The UK regulators 3.1 Prior to 1 April 2013, regulation of insurance companies was the responsibility of the Financial Services Authority ( FSA ). Since 1 April 2013, responsibility for the regulation of such companies has been split between the PRA and the FCA. 3.2 The PRA is a subsidiary of the Bank of England, and carries out the prudential regulation and supervision of banks, building societies, credit unions, insurers and major investment firms. 3.3 The FCA regulates the conduct of all financial services firms in relation to consumer protection, industry stability and the promotion of healthy competition between providers. 3.4 The PRA has statutory objectives to promote the safety and soundness of the insurers that it regulates, and to contribute to ensuring that policyholders are appropriately protected. More generally, these statutory objectives can be advanced by seeking to ensure that regulated insurers have resilience against failure and that disruption to the stability of the UK financial system from regulated insurers is minimised. The Solvency II regulatory regime Introduction 3.5 A new regulatory solvency framework for the European Economic Area ( EEA ) insurance and reinsurance industry came into effect on 1 January This new regime is known as Solvency II and aims to introduce solvency requirements that better reflect the risks that insurers and reinsurers actually face and to introduce consistency across the EEA. All but the smallest EEA insurance companies are required to adhere to a set of new, risk-based capital requirements and the results will be shared with the public. 3.6 Solvency II is based on three pillars: Under Pillar 1, quantitative requirements define a market consistent 1 framework for valuing the company s assets and liabilities, the results of which will be publicly disclosed. Under Pillar 2, insurers must meet minimum standards for their corporate governance and their risk and capital management. There is a requirement for permanent internal audit and actuarial functions. Insurers must regularly undertake a forward looking assessment of risks, solvency needs and adequacy of capital resources, called the Own Risk and Solvency Assessment ( ORSA ), and senior management must demonstrate that the ORSA actively informs business planning, management actions and risk mitigation. Under Pillar 3, there are explicit requirements governing disclosures to supervisors and policyholders. Firms will produce private reports to supervisors and a public solvency and financial condition report. The Pillar 1 requirements 3.7 The determination of a market consistent value of liabilities under Solvency II requires the insurer to calculate the best estimate liabilities ( BEL ). The expected future obligations of the insurer are projected over the lifetime of the contracts using the most up-to-date financial information and the best estimate actuarial assumptions, and the BEL represents the present value of these projected cash-flows. 3.8 Under Solvency II, a company s Pillar 1 liabilities are called the technical provisions which consist of the sum of the BEL and the risk margin. The risk margin is an adjustment designed to bring the technical provisions up to the amount that another insurance or reinsurance undertaking would be expected to require in order to take over and meet the insurance obligations in an arm s length transaction. 3.9 The Pillar 1 assets are, broadly speaking, held at market value. 1 A market-consistent framework requires the values placed on assets and liabilities to be consistent with the market prices of listed securities and traded derivative instruments. May

12 3.10 The Solvency Capital Requirement ( SCR ) under Solvency II is the capital requirement under Pillar 1, and is intended to be the amount required to ensure that the firm s assets continue to exceed its technical provisions over a one year time frame with a probability of 99.5% The Minimum Capital Requirement ( MCR ), which is lower than the SCR, defines the point of intensive regulatory intervention. The MCR calculation is simpler, more formulaic and less risk-sensitive than the SCR calculation In calculating the SCR, it is expected that most firms will use the standard formula, as prescribed by the European Insurance and Occupational Pensions Authority ( EIOPA ). However, Solvency II also permits firms to use their own internal models (or a combination of a partial internal model and the standard formula) to derive the SCR. These internal models and partial internal models are subject to approval by the relevant regulator: in the UK this is the PRA On 9 March 2015, The Solvency 2 Regulations 2015 were laid before the UK Parliament. These regulations implement, in part, the Solvency II Directive (as amended by the subsequent Omnibus II Directive) into UK law and came into force on 1 January The remainder of the Solvency II Directive has been implemented by the FSMA, by rules and binding requirements imposed by the PRA and the FCA, and by directly applicable regulations made by the European Commission. The PRA has issued final statements on the transposition of Solvency II, as amended by the Omnibus II Directive, into the UK national framework. These set out its approach to the prudential regulation, and its expectations, of firms subject to Solvency II EIOPA has published the implementing technical standards ( ITS ) and guidelines for the new regime and these have been endorsed by the European Commission and are legally binding and apply to all national regulators under the scope of Solvency II Any UK firms intending to use an internal model, transitional measures, a matching adjustment or a volatility adjustment must formally apply to the PRA for approval. Applications have been accepted by the PRA since 1 April 2015 and the PRA has issued a number of consultation papers and other communications which provide further clarity on the approval processes and set out the PRA s expectations of firms The outcome of firms applications for measures to take effect from 1 January 2016 was communicated by the PRA in late The matching adjustment 3.18 In calculating the BEL, the Solvency II rules permit firms to apply to their regulator to make use of the matching adjustment. The matching adjustment is an increase to the discount rate used in the calculation of the BEL that allows firms to take credit for the additional investment return they expect to earn from a hold to maturity investment strategy for their illiquid assets, which are used to back their most stable and predictable liabilities, typically non-profit in payment annuity liabilities Firms using the matching adjustment are subject to various restrictions around the types of asset that are permitted to back the relevant liabilities, the circumstances in which the assets may be traded, and the extent to which mismatching of asset and liability cash flows is permitted. The transitional measures 3.20 Insurers are also permitted to apply to their regulator (the PRA in the UK) to make use of transitional measures. Transitional measures allow firms to phase in the balance sheet impact of moving from the former Solvency I regulatory regime to the Solvency II regulatory regime. The transitional measures can be applied in one of two ways: The transitional measure on technical provisions allows firms to phase in the increase in technical provisions under Solvency II Pillar 1 (in relation to business written prior to 1 January 2016) over a sixteen year period. In the UK, the increase is measured relative to the firm s Solvency I Pillar II liabilities. The transitional measure on the risk-free interest rate allows firms to phase in any reduction in the discount rate used to calculate their liabilities under Solvency II relative to the current regime over a sixteen year period. May

13 3.21 In the UK, it is expected that most life insurers will benefit from the transitional measures. Ring-fenced funds 3.22 Solvency II includes the concept of a ring-fenced fund. This refers to any arrangement where an identified set of assets and liabilities are managed as though they were a separate undertaking, meaning that there are restrictions on the extent to which surplus in the ring-fenced fund may be transferred to shareholders or used to cover losses outside the ring-fenced fund In the UK, many firms have set up ring-fenced funds in order to reflect the arrangements applicable to their withprofits funds (as defined under the previous Pillar I and Pillar II regime) and the with-profits and non-profit business within the with-profits fund. The UK regulatory regime in force prior to Solvency II 3.24 At the 2004 year end the FSA introduced a new risk based capital framework under which companies were required to assess solvency under two regimes, commonly referred to as Pillar I and Pillar II. I describe Pillar I and Pillar II briefly below. Pillar I 3.25 Under Pillar I, assets were, broadly speaking, valued at market value and are subject to various admissibility criteria and limits Liabilities were known as mathematical reserves, and were generally calculated using prudent assumptions, although additional rules applied to firms with significant volumes of with-profits business The overall capital requirement under the Pillar I regime was called the Capital Resources Requirement ( CRR ). The CRR had a number of different components, many of which were calculated using formulae based on various balance sheet statistics, such as mathematical reserves, expense levels and sums insured. Although the CRR did contain some risk-based components, in contrast to the SCR it was not intended to be a fully risk-based measure Additional solvency and reporting requirements were imposed under Pillar I on firms that had significant volumes of with-profits business (commonly known as realistic reporting). PAC was subject to these additional requirements but PRIL was not. Pillar II 3.29 Pillar II was intended to provide a more realistic and complete view of the risks to which the company was exposed The capital requirement under Pillar II was the Individual Capital Assessment ( ICA ), which was the company s own assessment of its risk exposures and the amount and type of capital required to mitigate those risks. The PRA set the capital requirement as being consistent with a 99.5% confidence level that the firm would have been able to meet its liabilities over a one year timeframe or, if appropriate to the firm s business, an equivalent lower confidence level over a longer timeframe The capital requirements so determined were aggregated, allowing for any diversification benefits deemed achievable between those risks. The company was not required to make public the results, or any other details, of its Pillar II exercise. The long-term fund and shareholders fund 3.32 Prior to the implementation of Solvency II, proprietary firms writing long-term insurance business were required to identify the assets attributable to their long-term insurance business and keep those assets separate from shareholder funds in what was referred to as a long-term insurance fund (the LTF ). The other assets of a proprietary company were typically allocated to the shareholders fund (the SHF ). The assets in the LTF were only to be used to support the firm s long-term insurance business and firms were required to maintain assets in the LTF sufficient in value to cover the fund s mathematical reserves Following the implementation of Solvency II, the requirement to maintain a separate LTF has been removed. May

14 The governance of UK long-term insurers 3.34 The Board of Directors of a long-term insurer is normally the firm s governing body, and is ultimately responsible for setting the strategic direction of the firm, overseeing the activities of the firm s day-to-day management and approving the firm s financial statements Under Solvency II, all insurers are required to establish an actuarial function, but it is not defined as being performed by an individual. The actuarial function is responsible for, amongst other things, coordinating the calculation of the technical provisions and expressing opinions on the firm s underwriting policy and the adequacy of the firm s reinsurance arrangements. The person having responsibility for the actuarial function under Solvency II is known in the UK as the Chief Actuary The PRA is introducing a new governance regime for UK insurers called the Senior Insurance Managers Regime ( SIMR ) which became effective on 7 March 2016, and which defines a set of senior insurance management functions ( SIMF ), including: Chief Executive Officer ( CEO ); Chief Financial Officer ( CFO ); Chief Risk Officer ( CRO ); Chief Actuary; Head of Internal Audit; and Chief Underwriting Officer (general insurance firms only) The individuals responsible for these functions will be subject to PRA approval, although there are grandfathering arrangements under which currently approved individuals may take up approved roles under SIMR In addition to the roles listed above, those firms with with-profits business must appoint an actuary (or actuaries) to perform the with-profits actuary function. This individual is the WPA, and his responsibilities include advising the firm s management on the key aspects of the discretion to be exercised affecting those classes of the with-profits business of the firm in respect of which he has been appointed. The WPA role will continue to exist under SIMR and will be one of the SIMFs In relation to each with-profits fund, firms must appoint a with-profits committee ( WPC ) (or a with-profits advisory arrangement if appropriate given the size, nature and complexity of the fund in question). The WPC s role is to advise and provide recommendations to the firm s governing body on the management of the with-profits business, and to act as a means by which the interests of with-profits policyholders are appropriately considered within a firm s governance structures. A firm s risk appetite and internal capital policy 3.40 The Board of a firm is responsible for the management of the company and for its exposure to risk. The Board will typically set out its appetite for risk in a form which references the probability that the Board is willing to accept of not being able to pay policyholder liabilities as they fall due and/or meet regulatory requirements In order to ensure that day-to-day fluctuations in markets and experience do not lead to a breach of their risk appetite and regulatory capital requirements firms usually aim to hold more capital than strictly required to meet the regulatory minimum. The details of the target level of capital buffer are typically set out in the firm s internal capital policy The internal capital policy of a firm is owned by the Board and describes the capital that the Board has determined should be held in the company. Changes to the internal capital policy usually require Board approval and appropriate consultation with the regulators (the PRA) The level of capital required may also be driven by the desire of the Board to maintain a certain credit rating with the rating agencies. May

15 The products and long-term insurance business relevant to the proposed Scheme 3.44 The long-term insurance business that will be the subject of the transfer in the proposed Scheme comprises nonprofit pension annuity business. The particular product types are described below. Immediate individual annuity policies where the policyholder is receiving a regular income at a fixed level (a fixed or level annuity) or regular income with fixed increases or with increases in line with an index (an index linked annuity). These are also called annuities in payment. Deferred group annuity contracts where the underlying policyholders are not yet receiving immediate annuities but will (if they maintain the contract) do so in the future. Individual annuity policies where the policyholder is a former member of a pension scheme that has purchased a buy-out policy with PRIL. Bulk purchase buy-in annuity contracts where the legal policyholder is the group of trustees of a particular UK pension scheme, although the members of the pension scheme also have an interest in the contract A buy-out is a transaction whereby an insurance company takes over legal responsibility for some or all of the liabilities of an occupational pension scheme in return for a single premium. In this way the insurer takes on the investment risk 2 and the longevity risk 3 (as well as any inflation risk 4 ) associated with the scheme s liabilities Under a buy-out, the trustees and sponsor of the pension scheme no longer have any legal links or obligations associated with the scheme (or that part of the scheme that is subject to the transaction), and the members of the scheme become policyholders of the insurer A buy-in is a transaction where an occupational pension scheme buys a bulk annuity contract from an insurance company that is designed to perfectly match some or all of the liabilities of the scheme. In common with a buy-out, the insurer takes on the investment risk and longevity risk (and any inflation risk) but, in contrast to a buy-out, the links of the liabilities with the sponsor and the trustees are maintained and the pensioners remain members of the scheme. The sponsor of the scheme retains ultimate responsibility for meeting the liabilities of the scheme in the event of the failure of the insurer to do so. The financial information in this report 3.48 During 2015, the PRA has granted approval to: PRIL to use the matching adjustment and its internal model for Solvency II reporting; and PAC to use the matching adjustment, the transitional measure on technical provisions and the PAC internal model for Solvency II reporting Appendices 1 and 2 show pro-forma Solvency II balance sheets as at 30 June 2015 for PAC and PRIL which reflect: The use of the matching adjustment; The use of the transitional measure on technical provisions; The use of the final and PRA approved version of the internal model methodology and assumptions; The repayment by PRIL of the contingent loan ( 49 million) from PAC this occurred on 24 March 2016; and 2 Investment risk (in the context of the pension scheme) is the risk that the investments of the pension scheme perform worse than expected, resulting in a shortfall in the assets available to meet the liabilities of the scheme. 3 Longevity risk (in the context of the pension scheme) is the risk that the members of the scheme live longer than expected, resulting in higher than expected liability cash flows for the scheme. 4 Inflation risk (in the context of the pension scheme) is the risk that inflation is higher than expected, resulting in inflation-linked annuity benefit outgo being higher than expected. May

16 The payment of a dividend from PRIL to PAC (expected in the third quarter of 2016) The financial information used in the analysis of the effects of the proposed Scheme as set out in Sections 7, 8 and 9 is the Solvency II information shown in Appendices 1 and The old (pre 1 January 2016) Solvency I Pillar I regime was in force for over 10 years and Solvency I Pillar I financial information was made publicly available in insurance companies PRA returns so, although it is no longer in force, in my view it is the solvency regime most likely to be understood by policyholders. Therefore, I have considered the effect of the implementation of the Scheme on the various groups of policies under the Solvency I Pillar I regime and, in order to provide useful information and additional reassurance to policyholders, I have included, in Sections 7 and 8, a brief summary of my conclusions from this and confirmed whether these conclusions reinforce or contradict the conclusions formed by consideration of the Scheme under the Solvency II regime I have also considered the effect of the proposed Scheme on a Solvency I Pillar II basis and included a similar summary in respect of Solvency I Pillar II I have not carried out an independent review of the Solvency II results as at 30 June 2015 but I note that the Solvency results have been: Reviewed by Prudential s external auditors ( KPMG LLP ); Approved by the Prudential plc Group Audit Committee for external disclosure at the Prudential plc investor conference; and The pro-forma post-scheme Solvency II numbers have been approved by the appropriate committee within PAC (the Financial Reporting Group) I am satisfied it is appropriate to rely upon these Solvency II results for the purpose of this report My Supplementary Report will contain analysis of the effect of the proposed Scheme based upon Solvency II numbers as at 1 January Reliance on legal opinion 3.56 There are a number of aspects of the proposed Scheme that are legal matters and outside of my expertise. For these areas, I have considered whether it is appropriate to take independent legal advice and I have decided that it is appropriate for me to rely on the advice provided to PAC and PRIL by Hogan Lovells International LLP ( Hogan Lovells ), the legal firm retained by PAC and PRIL in respect of this Scheme My reasons for this are: Hogan Lovells is a large international legal firm with a wide range of experience in UK insurance law and Part VII transfers and it is my view that they have the relevant and appropriate qualifications and knowledge of the laws and regulations governing insurance business transfers in the UK. The nature of the information and advice from Hogan Lovells upon which I have relied is factual and in particular concerns how a particular aspect of PAC or PRIL (pre or post the implementation of the proposed Scheme) works in accordance with UK law. As such, I am satisfied that the advice or information given by Hogan Lovells would not be different if they were retained directly by me in respect of the proposed Scheme. For the same reason, I consider it unlikely that I would receive a different answer from a different (but similarly qualified) legal expert I am therefore comfortable that it is appropriate for me to rely on the conclusions of Hogan Lovells in forming my view on the Scheme. May

17 4. BACKGROUND ON PAC Introduction 4.1 PAC is a proprietary company, whose immediate parent company is Prudential plc, which is also the ultimate holding company of the Prudential Group. 4.2 PAC s principal activity is long-term insurance business, although PAC also conducts some general insurance business. PAC s current fund structure 4.3 PAC currently has three ring-fenced funds as defined under Solvency II. These are: The PAC With-Profits Sub-Fund (the PAC WPSF ); The Defined Charge Participating Sub-Fund (the DCPSF ); and The Scottish Amicable Insurance Fund (the SAIF ). 4.4 Under Solvency II all assets not in a ring-fenced fund must be allocated to either the long-term insurance business or the general insurance business, and there is no required segregation of the long-term insurance business assets between an LTF and an SHF. 4.5 The business outside the ring-fenced funds is called the PAC shareholder-backed business as the working capital for such business has been provided by the PAC SHF. The PAC shareholder-backed business consists of: The PAC long-term shareholder-backed business (the PAC LT SH business ); The PAC short-term shareholder-backed business which is the PAC general insurance business ; and All other assets and liabilities of PAC outside the PAC ring-fenced funds including the wholly owned subsidiaries of PAC: PRIL; Prudential Holborn Life Limited ( PHLL ); Prudential Hong Kong Limited ( PHKL ); Prudential General Insurance Hong Kong Limited ( PG HKL ); Prudential Pensions Limited ( PPL ); and Prudential International Assurance plc ( PIA ). PAC s business 4.6 PAC s business can broadly be split into three parts: PAC s with-profits business The long-term insurance business of PAC s ring-fenced with-profits funds (whether non-profit or with-profits in nature) is referred to in this report as PAC s with-profits business. PAC s LT SH business The PAC LT SH business is all non-profit business and includes the long-term insurance business reinsured in from PRIL under the PRIL-PAC quota share reinsurance agreement. May

18 PAC s general insurance business PAC s general insurance business is maintained separately from the PAC LT SH business but is part of the PAC shareholder-backed business. These policies were originally written in the PAC SHF. PAC s long-term insurance business: the with-profits business and the LT SH business 4.7 PAC s long-term insurance business mainly comprises life and pensions business: Industrial Branch ( IB ) and Ordinary Branch ( OB ) life and pensions conventional with-profits business and OB unitised with-profits ( UWP ) business; Pensions non-profit business consisting primarily of pension annuities in-payment; and Life non-profit and linked business. 4.8 As well as the business written directly by PAC, and the business reinsured in from the other PAC subsidiaries, there have been a number of transfers of long-term insurance business into PAC: Non-profit annuity business transferred in from Prudential Annuities Limited ( PAL ) on 1 October All of the long-term insurance business of PAL was transferred into the PAC WPSF; Business transferred in from PHLL and from Prudential (AN) Limited ( PANL ) on 31 October All the non-profit and unit-linked business of PANL and PHLL was transferred to the PAC Non-Profit Sub-Fund (a sub-fund under the previous solvency regime) (the PAC NPSF ). All of the with-profits business of PANL was transferred to the PAC WPSF. With-profits annuity business transferred in from The Equitable Life Assurance Society ( ELAS ) on 31 December 2007 which was principally allocated to the DCPSF. Business transferred in from Scottish Amicable Life plc ( SAL ) on 31 December 2002: the with-profits elements were allocated to the PAC WPSF and the rest was allocated to the PAC NPSF. Business transferred in from Scottish Amicable Life Assurance Society ( SALAS ) on 30 September 1997 which was allocated principally to a newly created sub-fund, the SAIF. 4.9 PAC also has business written outside the UK. This consists of: Business written by branches of PAC in France, Malta and Poland; Business reinsured into PAC, either from subsidiaries of PAC, or from other insurers outside the Prudential Group; and Business written by branches of ELAS and transferred into PAC on 31 December As described above, under Solvency II the long-term insurance business is divided into the ring-fenced funds (the PAC WPSF, the DCPSF and the SAIF) and the PAC LT SH business. The business written in each of these is described in turn below. The PAC WPSF 4.11 This ring-fenced fund consists of a significant volume of with-profits business, comprising: Business written by PAC, both OB and IB; Transferred business from SAL; and Transferred business from PANL PAC s Maltese and Polish operations are branches of the WPSF. May

19 4.13 The PAC WPSF also contains a significant volume of non-profit business. This consists of: Pension annuities transferred in from PAL on 1 October 2014 under the PAL Scheme; Pension annuities in-payment arising from with-profits pension policies choosing to vest their annuities internally with PAC, that had previously been reinsured to PAL but that were recaptured by PAC on 31 August 2011; Non-profit (including unit-linked) business written by PAC and not allocated to the PAC shareholder-backed business; and Certain types of business originally written by SALAS, and now contained in the Scottish Amicable Account ( SAA ). These are non-profit life policies, unit-linked life policies and unitised with-profits life policies (other than the investment component, which was transferred into the SAIF) The PAC WPSF contains the PAC inherited estate (called surplus funds in Solvency II regulations), which is the excess of the assets in the fund over those expected to be paid out over time to policyholders Up to 10% of the surplus arising in the PAC WPSF is attributable to PAC s shareholders, and the remaining surplus arising within the fund is attributable to the with-profits policyholders (i.e. the PAC WPSF is a 90:10 fund) The PAC WPSF is open to new business, and PAC aims to ensure that there is enough capital in the fund to support new business sales without adversely affecting the existing with-profits business. The DCPSF 4.17 This ring-fenced fund consists of two types of business: The accumulated investment component of premiums paid on the Defined Charge Participating ( DCP ) business. This is calculated as the accumulation of premiums less explicit charges. This component is either reinsured into PAC from PIA or other companies, or written through PAC s branch in France (between 1 January 2001 and 31 December 2003). The with-profits annuities transferred from ELAS on 31 December For this business, charges are defined in the ELAS transfer scheme DCP business is a type of with-profits business on which policyholders only incur charges as specified in the policy or, where relevant, a scheme of transfer. These charges generally accrue to the PAC shareholder-backed business, which also bears any expenses (charges on the reinsured PIA business accrue to PIA). Hence the PAC shareholders receive the profit or loss arising from the expenses on this business The PAC WPSF inherited estate provides capital support for the DCPSF to meet regulatory solvency requirements and to support bonus and investment policy. The PAC WPSF inherited estate also provides a bonus smoothing account for this business, to meet smoothing costs as they arise. In return for this support, an annual capital support charge is payable from the PAC DCPSF to the PAC WPSF inherited estate An annual charge for guarantees is also payable from asset shares in the PAC DCPSF. For non-elas business, these charges accrue to the appropriate bonus smoothing accounts. For ELAS business, the charges are paid to the PAC WPSF in return for the PAC WPSF agreeing to meet any guaranteed benefit payments in excess of asset shares All of the profit from the PAC DCPSF is attributable to the PAC DCPSF policyholders (i.e. the PAC DCPSF is a 100:0 fund), and this profit arises solely from the investment performance. The SAIF 4.22 This ring-fenced fund is closed to new business and contains most of the SALAS business: SALAS s pensions and annuity business (with-profits and non-profit); SALAS s conventional with-profits life business; and The investment component of SALAS s UWP life business. May

20 4.23 The balance of SALAS s business was transferred to the SAA, within the PAC WPSF. The with-profits investment component of the SAA policies is invested in the SAIF This fund also contains the SAIF inherited estate The PAC WPSF provides financial support to the SAIF in the form of the Scottish Amicable Capital Fund ( SACF ) in exchange for an annual charge. SACF remains in the PAC WPSF and does not form part of the SAIF inherited estate. However, SACF is treated as part of the free assets of the SAIF for the purpose of setting bonus and investment policies % of the profit from the SAIF is attributable to the SAIF policyholders (i.e. the SAIF is a 100:0 fund) and the SAIF inherited estate is to be distributed to the SAIF and SAA with-profits policyholders over the lifetime of their policies. The PAC LT SH business 4.27 The LT SH business consists of non-profit (including unit-linked) business and is open to new business. It includes business written in the UK and Poland, the accepted reinsurance business under the PRIL-PAC quota share reinsurance agreement (see below), and unit-linked business transferred from SAL, PAN and PHLL Certain DCP business is included. The investment content of this DCP business (i.e. the accumulated investment content of premiums paid) is held in the DCPSF but the balance of the charges and expenses of the DCP business accrues to the PAC shareholder-backed business The business sold through VitalityLife and its predecessor PruProtect is also included. PAC divested its stake in the joint venture with Discovery (which sold business through the PruHealth and PruProtect brands) in There is a quota share reinsurance agreement in place with Hannover Rueck SE ( Hannover Re ) under which Hannover Re reinsures some of the individual annuity business that was: Written by SAL before 2002 and transferred to PAC in 2002; or Written by PAC between 2002 and 2007 arising from SAL pension policies transferred to PAC in PAC s general insurance business 4.31 PAC does not currently write or sell general insurance policies and does not have any current in-force general insurance policies apart from a small number (approximately 1,000) of claims in payment/under management. These policies currently form part of PAC s shareholder-backed business. Recent relevant events The PAL Scheme 4.32 On 1 October 2014, the entire long-term insurance business of PAL was transferred by means of a Part VII transfer into the PAC WPSF. PAL was de-authorised on 10 March 2015 and the process of liquidating PAL began in November 2015 and should be completed by the end of March The Hong Kong Scheme 4.33 A reorganisation of the business of PAC was approved by the High Court and by the Court of First Instance in the Hong Kong Special Administrative Region of the People s Republic of China, and was implemented on 1 January Under this reorganisation, the long-term insurance business of PAC s Hong Kong branch, including capital to support the writing of future new business in Hong Kong was transferred to PHKL, which is a wholly owned subsidiary of PAC domiciled in Hong Kong. In my report I will refer to this transfer as the Hong Kong Scheme As part of the Hong Kong Scheme, 10.5% (as at 1 January 2014) of both the non-profit annuity liabilities previously reinsured from PAC to PAL and the non-profit annuities transferred into PAC under the PAL Scheme were reinsured on a quota share basis to PHKL. This enabled an appropriate part of the investment of the PAC WPSF inherited estate in this non-profit business to be transferred to PHKL. May

21 4.35 The Hong Kong general insurance business of PAC, which was written in the PAC SHF was also transferred to a Hong Kong incorporated company (Prudential General Insurance Hong Kong Limited), a wholly owned subsidiary of the PAC SHF, on 1 January The quota share reinsurance agreement with PRIL (the PRIL-PAC QS agreement ) 4.36 Effective from 1 January 2016, PRIL currently reinsures 100% of its liabilities (net of other outwards reinsurance arrangements) to PAC on a quota share basis The premium payable to PAC under the PRIL-PAC QS agreement has been retained by PRIL under a "deposit back" arrangement. This arrangement reduces PRIL's credit risk exposure to PAC When the PRIL-PAC QS agreement was set up, the deposit back amount was set to be the quota share (currently 100%) of the Solvency I Pillar I liabilities. Following the introduction of Solvency II the definition of liabilities has been amended to be a fixed percentage of the Solvency II BEL. The percentage has been set at 1 January 2016 as the ratio of the Solvency I Pillar I liabilities as at 31 December 2015 to the Solvency II BEL at that date. Hence from now on, the deposit back amount will run-off in line with the Solvency II BEL Under the terms of the PRIL-PAC QS agreement the deposit back amount is adjusted quarterly. To the extent that the deposit back amount is not sufficient to cover the fixed percentage of the Solvency II BEL (multiplied by the quota share which is currently 100%), PAC must transfer assets to PRIL sufficient to cover the shortfall. Any surplus over the fixed percentage of the BEL is transferred to PAC As part of the reinsurance under the PRIL-PAC QS agreement, PRIL and PAC have granted each other the following security: (a) (b) PRIL has granted PAC a charge over the assets allocated to its long-term insurance business (including the deposit amount). PAC has granted PRIL a charge over the assets allocated to the PAC LT SH business The effect of the charges is that, in an insolvency situation, PRIL or PAC (as the case may be) would rank pari passu with the holders of direct insurance policies issued by the other company. This addresses the fact that, under the Insurers (Reorganisation and Winding-Up) Regulations 2004, as unsecured creditors each company's security interest would otherwise rank behind the holders of direct policies. The permanence of the PRIL-PAC QS agreement 4.42 Prior to 1 January 2016, the PRIL-PAC QS agreement reinsurance percentage was 20% (having previously, until 31 December 2014 been 15%). The legal contract between PAC and PRIL was amended with effect from 1 January 2016 to reflect the increase in the quota share to 100% The terms of the PRIL-PAC QS agreement impose significant restrictions on the circumstances under which either party may terminate the reinsurance agreement. These circumstances include: A material breach by PRIL that is not cured within 60 business days; PRIL losing its regulatory permission; Performance of the agreement becoming unlawful; and A change in control of PRIL PAC is not entitled to terminate the reinsurance agreement as a result of either PRIL s or its own insolvency Save for the specific circumstances set out in the PRIL-PAC QS agreement (including those outlined above), any termination or reduction in the percentage reinsured of the PRIL-PAC QS agreement would require PRIL s consent. It is unlikely that PRIL would consent to the termination of the agreement unless PRIL s solvency position in the absence of the agreement were to improve to such a level that it could provide policyholder security at least equivalent to that achieved through the PRIL-PAC QS agreement Therefore, it is my view that it is very unlikely that the PRIL-PAC QS agreement would be terminated and that neither PRIL nor PAC would wish to terminate or reduce the quota share percentage from 100%. May

22 4.47 The increase in the coverage under the PRIL-PAC QS agreement to 100% occurred only after an extensive and thorough process including a number of reports, meetings, and reviews by the PRA in order to secure the required non-objection from the PRA In order to change this reinsurance percentage again, I understand a similar process would be required to obtain non-objection from the PRA so any subsequent change to the PRIL-PAC QS agreement coverage would be subject to scrutiny from the PRA and due process including (but not limited to): reviews, actuarial and risk reports, and legal scrutiny. The scenario where the PRIL-PAC QS agreement coverage is reduced the QS reduction scenario 4.49 As set out above, circumstances in which the PRIL-PAC QS agreement would be terminated or the percentage reinsured reduced are very unlikely to arise as it is difficult to foresee realistic circumstances in which PRIL or PAC would want to terminate or reduce the QS coverage. However, the PRA has stated that it would review its nonobjection to the PRIL-PAC QS agreement coverage being increased to 100% if the Part VII transfer were not completed in 2016, and so there is at least a theoretical possibility that the PRIL-PAC QS agreement coverage could be reduced back to 20% Therefore, for completeness, an analysis has been carried out of the impact of the implementation of the proposed Scheme on the PRIL policies starting from a position where the percentage reinsured under the PRIL-PAC QS agreement is reduced from 100% to 20%. This is referred to as the QS reduction scenario The PRA s non-objection was in respect of the increase in the PRIL-PAC QS agreement percentage reinsured from 20% to 100% and therefore the withdrawal of this non-objection would see the percentage reinsured reduced to the pre-increase percentage of 20%. I do not consider the termination of the PRIL-PAC QS agreement to be a realistic possibility, principally because it is extremely unlikely that either PAC or PRIL would want this to happen, and I have not carried out analysis of this scenario. The Capital Support Arrangement ( CSA ) 4.52 In December 2014, a legally binding CSA was put in place between PAC and PRIL Under the terms of the CSA (which was amended for Solvency II purposes with effect from 1 January 2016), PAC has undertaken to provide capital support to PRIL when PRIL notifies PAC that its regulatory solvency has fallen below a pre-defined level The aggregate amount of capital support available to PRIL from PAC under the CSA is capped at an agreed amount over a period ending 31 December 2017 (although this will be extended by 12 months if the PRIL Part VII transfer is not completed by this date). Any support beyond this cap would be at the discretion of PAC s directors and would fall outside the terms of the CSA. The PAC walk-away option with respect to PRIL 4.55 In theory PAC has the option to walk away from PRIL in the event that PRIL becomes insolvent on a realistic basis and is unable to pay its claims. As PAC s interest in PRIL is limited to owning the entire issued share capital of PRIL, all of which is fully paid-up, under company law PAC is currently under no legal obligation to provide capital support to PRIL just because it is a shareholder in PRIL. However, PAC is subject to a number of contractual and regulatory obligations which link PAC s financial position to that of PRIL and limit PAC s ability to walk away from PRIL. These are listed below and include PAC s obligations to support PRIL under the PRIL-PAC QS agreement and the CSA While the PRIL-PAC QS agreement reinsurance percentage is 100%, the ability of PAC to walk away from PRIL is significantly restricted: PAC may only terminate the reinsurance agreement in limited circumstances and, in particular, PAC is not entitled to terminate the reinsurance agreement as a result of either PRIL s or its own insolvency. In addition, PRIL has a pari passu charge security over the assets backing the PAC LT SH business. This means that: PAC would only have a realistic walk-away option in the unlikely event that PRIL had the right to terminate the PRIL-PAC QS agreement and recapture the reinsured business, and decided to act on this right; and May

23 For all practical purposes, policies in the PAC LT SH business are already exposed to the risks associated with the PRIL business In the QS reduction scenario, there remain a number of reasons why in practice it is highly unlikely that PAC would walk away from PRIL: PAC s status as the shareholder of PRIL means that it is the participating undertaking in respect of PRIL and PRIL is managed and reported on as part of PAC. In particular, PAC s Solvency II and internal economic capital results are prepared on a consolidated basis so PAC s financial resources incorporate the financial position of its subsidiaries including PRIL. The financial position of PRIL will therefore affect PAC s financial position and the failure of PRIL or PAC to meet the solo SCR and group-level SCR respectively could lead to regulatory intervention from the PRA. If the financial position of PRIL was such that it affected PAC s capital position, then PAC s ability to pay a dividend would be constrained. PAC cannot freely sell its shares in PRIL to a third party without the prior approval of the PRA and FCA to the change in control over PRIL and this approval would only be given if the PRA and FCA were satisfied with the suitability of the acquirer and financial soundness of the acquisition. PAC would not be able to abandon the shares in PRIL as this would result in PRIL having no shareholder, which is not permitted under English law. Under section 192C of FSMA, the PRA has the power to require an unregulated company to provide capital support to any of its regulated subsidiaries. This means that the PRA may require Prudential plc to provide support to PRIL (or to PAC), restricting the ability of Prudential plc to walk away from PRIL. PRIL and PAC are both members of the Prudential Group, and the policies they sell are marketed under the Prudential brand name. Given the number of policyholders of PRIL and the nature of its insurance business, any attempt by PAC to walk away from PRIL would be likely to result in significant adverse publicity that the Prudential Group would be unlikely to sanction Therefore, I am satisfied that the value to PAC of the walk-away option is negligible whether the PRIL-PAC QS agreement coverage percentage remains at 100% or reduces to 20%. The Pension Mis-selling Costs Assurance and capital support agreement 4.59 Prudential gave an assurance in July 1998 referred to as the Pension Mis-Selling Costs Assurance, that deducting personal pension mis-selling costs from the PAC inherited estate would not have an adverse effect on the level of the bonus paid to policyholders or their reasonable expectations, and that in the unlikely event of this proving not to be the case, the intention was that an appropriate contribution to the long-term fund would be made from shareholders funds A capital support agreement was put in place in 2013 between Prudential plc and PAC to formalise Prudential plc s obligations under the Pension Mis-selling Costs Assurance and to support PAC s solvency. This stipulates that Prudential plc can be required to provide capital support to PAC in that event that PAC s solvency falls below specified levels. The capital support provided under the agreement includes the capital support that might be required to support the Pensions Mis-Selling Costs Assurance in relation to with-profits business. This agreement terminates at the latest in The PAC Shareholder Risk Appetite ( SRA ) Framework 4.61 The PAC SRA Framework includes PAC s internal capital policy in relation to its shareholder-backed business. It is based on a twin peaks approach that makes reference to the regulatory capital requirements (the regulatory peak ) of the PAC shareholder-backed business as well as PAC s internal view of its capital needs (the management capital peak ). It requires PAC to hold a capital buffer that is resilient to stresses that are relevant to the PAC shareholder-backed business and is calibrated to specified confidence levels The PAC Board approved proposals to transition this SRA Framework to Solvency II and these came into effect at the start of The twin peaks structure has been retained with Solvency II Pillars 1 and 2 forming the regulatory and management peaks respectively. May

24 4.63 In order to remain within the updated Solvency II SRA the company must remain capitalised to the twin peaks level after allowance for suitable management actions. The capital buffer required is calibrated such that following a stress event (at the calibrated likelihood) the business remains able to cover its SCR The SRA Framework will be reviewed in Q to reflect: The initial experience of the Solvency II regime in operation. The final 1 January 2016 Solvency II base and stressed valuation results. The management of PAC s long-term insurance business 4.65 As described in Section 3, under the UK regulations that were in force before Solvency II, UK shareholder-owned life insurance companies typically maintained a separate LTF and SHF in order to segregate the assets and liabilities attributable to the long-term insurance business and shareholders respectively In accordance with this, under the previous regime, PAC maintained the PAC SHF and the following sub-funds in its LTF: The PAC Non-Profit Sub-Fund ( NPSF ); The PAC WPSF; The DCPSF; and The SAIF As described above, the PAC WPSF, the DCPSF and the SAIF continue to exist as ring-fenced funds within PAC under the provisions of Solvency II Under Solvency II the requirement to maintain a separate LTF has been removed but PAC continues to maintain the PAC NPSF separately for accounting purposes to allow PAC to identify the financial resources that are allocated to support its long-term insurance business but that are not allocated to its with-profits funds. There is no legal or regulatory requirement to maintain the PAC NPSF or to separate the business formerly (under Solvency I) allocated to the PAC NPSF from the assets and liabilities formerly (under Solvency I) allocated to the PAC SHF and it should be noted that: There are no regulatory restrictions (such as a requirement to carry out a formal actuarial valuation) on the transfer of assets between the PAC NPSF and the PAC SHF; and As there is no legal or regulatory obligation for PAC to maintain this separate identification of the PAC NPSF and the PAC SHF, such a distinction could be removed without breaching any regulatory requirements Therefore, in my appraisal of the proposed Scheme, I can only rely upon the security provided by the fund structure required under the Solvency II regulations as described above in paragraph 4.3 to 4.5 rather than that used in the management of the business by PAC as described in paragraph The Prudential UK & Europe Investment Committee (the Investment Committee ) 4.70 The Investment Committee is an advisory committee (rather than a decision-making committee) and its role is to advise and assist the PAC CFO in making decisions related to investment strategy and the oversight and control of investments and to provide leadership, direction and oversight of the investment strategy and oversight and control of the investments of PAC and the subsidiaries One of the responsibilities of the Investment Committee is to monitor the derivatives and related collateral in the PAC WPSF and the effect of the proposed Scheme on this is covered in Section 8. The PAC Risk Function 4.72 The purpose of the Risk Function is to support and guide the business on all matters relating to risk, helping to make sure that the business operates properly, recognises its financial, regulatory and operational risks and manages them appropriately. May

25 4.73 The head of the Risk Function is the CRO and the Risk Function comprises the following sub functions: Enterprise and Operational Risk. Compliance. Financial & Insurance Risk. The Chief Actuary. The WPA. Financial Crime The monitoring of the risks associated with the PAC WPSF and the derivatives and collateral within it is the responsibility of the Investment Committee and one of the roles of the Risk Function is to review the work carried out by the Investment Committee. The effect of the proposed Scheme on this is covered in Section 8. May

26 5. BACKGROUND ON PRIL Introduction 5.1 PRIL was incorporated in 1970 as Scottish Amicable Pensions Investments Limited, changing its name in It is a proprietary company, the shares of which are wholly owned by the PAC shareholder-backed business. 5.2 PRIL s principal activity is the writing of pension annuity long-term insurance business. PRIL commenced writing annuity new business in 2000 and it is the entity into which the majority of Prudential s UK non-profit annuity new business is written. 5.3 Under Solvency II, PRIL has no ring-fenced funds and its long-term insurance business consists of pension nonprofit annuity business issued to individuals and pension schemes and the reinsurance of annuity business and comprises: Immediate and deferred bulk annuities written by PRIL; Immediate individual annuities written by PRIL; Immediate annuity business reinsured into PRIL from PAC and PPL; and Immediate annuity business reinsured into PRIL from UK insurance companies outside the Prudential Group. The PRIL-PAC QS agreement 5.4 Under the PRIL-PAC QS agreement, PRIL currently reinsures 100% of its liabilities (net of other reinsurance agreements) to PAC. 5.5 A description of the PRIL-PAC QS agreement is given in paragraphs 4.36 to Other reinsurance agreements 5.6 As well as the PRIL-PAC QS agreement, PRIL has reinsurance agreements (where PRIL is the cedant), in place with companies outside the Prudential Group: Hannover Re, SCOR Global Life SE ( SCOR ), Swiss Re Europe S.A. UK branch ( Swiss Re ) and Pacific Life Re Limited ( Pacific Life Re ). 5.7 PRIL also has reinsurance agreements (where PRIL is the reinsurer) in place with PPL, Royal London Mutual Insurance Society Limited ( Royal London ) and Zurich Assurance Limited ( Zurich ) 5.8 Some of the non-profit and index-linked annuities in payment in PAC are reinsured to PRIL, including some issued by PAC in the PAC WPSF, as well as some annuities in PAC s LT SH business that were originally issued by PAN. The reinsurance agreement between PRIL and the PAC WPSF is on-going and includes newly vesting non-profit annuities written up until 1 July Newly vesting annuities written after 1 July 2016 will not be covered by this reinsurance agreement. 5.9 Most of the non-profit annuities in payment written in the SAIF are also ceded to PRIL. The CSA 5.10 In December 2014, a CSA was put in place between PAC and PRIL under which PAC has undertaken to provide capital support to PRIL when PRIL notifies PAC that its regulatory solvency has fallen below a pre-defined level This is described in Section 4 (paragraphs 4.52 to 4.54). Loan arrangements 5.12 As at 1 January 2016, PRIL owed approximately 49 million to PAC under a contingent loan, but this was repaid on 24 March May

27 Bulk pension contracts 5.13 PRIL includes the policies from a number of former occupational pension schemes that have been previously bought out and a number of buy-in annuity contracts. The administration and servicing of the PRIL policies 5.14 The administration and servicing of the PRIL policies is carried out by service companies of the Prudential Group and there is no difference in the administration or servicing between PRIL s policies and PAC s directly written annuity policies. May

28 6. THE PROPOSED SCHEME The motivation for the implementation of the Scheme 6.1 The senior management of PAC and PRIL have described the purpose of the Scheme as to increase the capital management efficiency in PAC and remove operational inefficiencies. In particular, it is expected that the implementation of the Scheme would: Improve the fungibility of capital in PAC, allowing greater flexibility in the allocation of capital across PAC s business, e.g. allocation of PAC assets to support annuities (although the firm would need to adhere to any PRA requirements regarding quality of capital and matching adjustment portfolio restrictions). Remove the cash flow management process between the PAC and PRIL entities, e.g. extracting surplus capital from PRIL or injecting capital in stress scenarios. Remove the risk of capital becoming trapped in PRIL, e.g. dividend trap developing on implementation of IFRS 4 Phase 2. Remove the long-term requirement for a formal CSA between PAC and PRIL. Align further the risks of the PAC and PRIL policyholders. Generate operational efficiencies, primarily relating to reducing the ongoing management and reporting requirements in respect of the PRIL statutory entity. Summary of the implementation of the proposed Scheme 6.2 The Scheme is expected to be presented to the Court for its Directions Hearing in May 2016 and for its Sanctions Hearing in September If approved by the Court then it will be implemented with an Effective Date of 1 October If it is approved by the Court, then on the Effective Date, the policies, assets and liabilities of PRIL will be transferred to the PAC shareholder-backed business and the PRIL long-term insurance business will become part of the PAC LT SH business. Sufficient assets will be retained in PRIL at the level required to enable it to meet its regulatory capital requirements or a higher level as set by the Board. These assets will be transferred to PAC under the terms of the Scheme once PRIL has been de-authorised. Transferring assets and liabilities 6.4 Under the proposed Scheme, all of the long-term insurance business of PRIL will be transferred to PAC and will form part of PAC s LT SH business. 6.5 Using figures as at 30 June 2015, the number of annuities to be transferred is approximately 500,000, constituting approximately 30 billion of Solvency II insurance liabilities. 6.6 On the implementation of the Scheme, the PRIL-PAC QS agreement will terminate as the PRIL business transfers into PAC. 6.7 PRIL s reinsurance agreements in place with Hannover Re, SCOR, Swiss Re and Pacific Life Re will be transferred to PAC as part of the transfer and, after the transfer, they will remain in place but with PAC replacing PRIL as the cedant in each arrangement. 6.8 Additionally, the reinsurance agreements in place between PPL and PRIL, between Royal London and PRIL and between Zurich and PRIL will be transferred so that, following the Scheme, the reinsurer under these arrangements will be PAC rather than PRIL. 6.9 There are also currently reinsurance arrangements between PAC (the PAC WPSF, the SAIF and a small amount of the PAC shareholder-backed business) and PRIL. These reinsurance agreements will effectively terminate as a consequence of the transfer and, in the case of business ceded from the PAC WPSF and the SAIF, will be replaced by intra-company arrangements between the relevant ring-fenced funds and the PAC NPSF (an account May

29 set up in the PAC shareholder-backed business as described in Section 4) that are intended to replicate the effects of the relevant treaties Prior to the implementation of the proposed Scheme, it is expected that the surplus assets in PRIL will be paid to PAC as a dividend (subject to solvency constraints and any constraints related to bulk pension annuities and security structures), with these assets then being loaned back to PRIL. This is expected to take place in the third quarter of 2016 and I will provide an update on this on this in my Supplementary Report PRIL s lifetime mortgage assets and certain property assets have been restructured to meet the matching adjustment requirements under Solvency II. Two new subsidiaries of PRIL have been set up to facilitate this: PERM ( Prudential Equity Release Mortgages Limited ) in respect of the lifetime mortgages, and PREI1 ( Prudential Real Estate Investments 1 Limited ) in respect of certain properties. Loan agreements have been set up between PRIL and PERM and PREI1 to transfer the economic benefits in respect of the lifetime mortgages and the properties respectively As a result of the implementation of the Scheme, the following additional actions are expected to occur on the Effective Date: The loan from PAC to PRIL in relation to PRIL s surplus assets will be repaid to PAC; and The subsidiaries PERM and PREI1 will become subsidiaries of PAC. Administration 6.13 There will be no change to the administrative arrangements for either the transferring PRIL policies or the PAC policies as a result of the implementation of the Scheme. The costs of the proposed Scheme 6.14 PAC and PRIL will each bear their own costs in relation to the Scheme save for certain specified costs which will be split evenly between the two companies. These specified costs are in respect of: My work as Independent Expert in completing this report and my Supplementary Report; The appointment and advice of legal counsel in respect of the Scheme; and Any other costs agreed between the parties The costs borne by PAC will be paid from surplus in the PAC shareholder-backed business and those borne by PRIL will be paid from surplus in PRIL. Jersey and Guernsey policies 6.16 There will be separate schemes of transfer in Jersey, to transfer business carried on in or from within Jersey, and in Guernsey, to transfer policies which were issued to residents of Guernsey These schemes, which will provide for the transfer of this business on the same terms as the Scheme, will require the approval of the Royal Court of Jersey and of the Royal Court of Guernsey as appropriate. Excluded policies 6.18 An Excluded Policy is defined as a PRIL policy that: Was written in an EEA state other than the UK and for which the PRA has not provided the certificate referred to in paragraph 4 of Part 1 of Schedule 12 to FSMA with respect to the relevant EEA state; Is not otherwise capable of being transferred pursuant to FSMA; Is a Guernsey policy, for so long (if at all) as the relevant Guernsey Scheme has not been sanctioned and become effective; or Is a Jersey policy, for so long (if at all) as the relevant Jersey Scheme has not been sanctioned and become effective. May

30 6.19 Any policy that is an Excluded Policy, and as a result cannot be transferred as part of the proposed Scheme on the Effective Date, will be reinsured under the Scheme into PAC through an Excluded Policies reinsurance arrangement from the Effective Date on a basis intended to replicate the financial effects of a transfer of such policies to PAC. The structure after the implementation of the proposed Scheme 6.20 After the implementation of the Scheme, there will be no long-term insurance business in PRIL, with the exception of any Excluded Policies. The current expectation is that there will be no Excluded Policies Assets in PRIL will be transferred into the PAC shareholder-backed business but sufficient assets will be retained in PRIL at the level required to enable PRIL to meet its regulatory capital requirements or at a higher level as set by the Board All the PRIL long-term insurance business will become part of the PAC shareholder-backed business following the implementation of the Scheme PRIL will eventually be de-authorised and liquidated and, when this happens, the remaining assets in PRIL will be transferred to PAC. May

31 7. THE EFFECT OF THE IMPLEMENTATION OF THE SCHEME ON THE PRIL POLICIES Introduction 7.1 In this section I consider the effect of the implementation of the Scheme on the PRIL policies. As described in Section 5, the PRIL business consists of non-profit pension annuities and the reinsurance of annuity business and comprises: Immediate and deferred bulk annuities written by PRIL; Immediate individual annuities written by PRIL; Immediate annuity business reinsured into PRIL from PAC and PPL; and Immediate annuity business reinsured into PRIL from UK insurance companies outside the Prudential Group. 7.2 Under the proposed Scheme, the entire business of PRIL will be transferred into PAC and will become part of the PAC shareholder-backed business so that the policies issued by PRIL will become direct policies of PAC. Therefore, the key points to consider are: The financial strength available to provide security for the benefits under the PRIL policies after the implementation of the Scheme compared to that currently available; Any change to the profile of risks to which the PRIL policies will be exposed as a result of being transferred from a subsidiary of PAC to become part of PAC s shareholder-backed business; Any effect of the implementation of the Scheme on the benefit expectations of the PRIL policyholders, including the service standards, management and governance these policyholders should expect after the implementation of the Scheme; and The effect of the implementation of the Scheme on those policies currently reinsured into PRIL. 7.3 These are considered in turn below. The financial strength available to provide security of benefits 7.4 The PRIL-PAC QS agreement and other reinsurance arrangements are described in Section While PRIL currently has outwards reinsurance agreements in place with PAC, Hannover Re, SCOR, Swiss Re, and Pacific Life Re, PRIL remains responsible for paying the benefits under the policies when they are due. PRIL will, under the various reinsurance agreements, subsequently claim an appropriate amount from the relevant reinsurer. 7.6 Security for the benefits payable under the transferring PRIL policies is currently provided in the following ways: a. PRIL s own assets: i. The assets in PRIL held under the deposit back arrangement. These assets are the first call to pay the benefits of the PRIL policies so security principally depends on the amount of assets held under the deposit back arrangement and therefore on the basis, and levels of conservatism within the basis, used for the calculation of this amount. Under the terms of the PRIL-PAC QS agreement the amount of these assets is adjusted quarterly as described in Section 4. ii. Other assets in PRIL. Ultimate responsibility for the payment of benefits under the PRIL policies rests with PRIL, so if the deposit back assets are exhausted, the other assets in PRIL could be used to pay claims. b. Assets in PAC: i. To the extent that the deposit back amount is not sufficient to cover the liabilities of the PRIL policies, PRIL can claim under the PRIL-PAC QS agreement for PAC to inject assets sufficient to cover the shortfall. May

32 ii. In the extreme scenario where PAC did not have sufficient assets to meet its liabilities, the ring-fenced fund structure within PAC would break down. In this scenario the effect of the pari passu charge granted to PRIL in connection with the reinsurance agreement is that PRIL would be treated as if it were a direct policyholder of the PAC LT SH business and would be entitled to claim in priority to other unsecured creditors in respect of the assets previously attributed to the PAC LT SH business. iii. If the assets backing the PAC LT SH business were insufficient, PRIL would also be entitled to claim (as a general creditor of PAC) in respect of other assets of PAC. These assets include surplus assets held in respect of the PAC general insurance business and those in the inherited estates of the PAC WPSF and the SAIF. PRIL s claim in respect of these assets would not be in priority to other creditors and would rank behind the claims of the direct policyholders of PAC. c. The reinsurance agreements with companies outside the Prudential Group Under these agreements, the reinsurers must reimburse PRIL for certain proportions of the benefit payments in respect of the PRIL policies covered by the relevant agreement. 7.7 The security provided by PAC for the benefits payable under the PRIL policies (bullet b above) would be reduced by the existence of the walk-away option in favour of PAC. However, as described in Section 4, in practice the circumstances when the walk-away option could be used are extremely remote whether the coverage percentage under the PRIL-PAC QS agreement is 100% or 20%. 7.8 In addition, the CSA in place between PAC and PRIL commits PAC to providing a defined amount of capital support to PRIL until 31 December 2017 (with an automatic one year extension if the Scheme is not implemented), which would constrain PAC s ability to walk away from PRIL until after this date even in the absence of the PRIL-PAC QS agreement. 7.9 Following the implementation of the Scheme, PRIL policyholders will rank equally with all existing PAC policyholders in respect of all of the assets in PAC in an insolvency situation and therefore PAC will have a legal obligation to meet 100% of the liabilities in respect of the transferring business and will no longer have the option to walk away In the following paragraphs of this section, I consider the relative financial strength available to provide support for the transferring PRIL policies on a Solvency II basis before and after the implementation of the Scheme as at 30 June This is followed by a sub-section covering the effect on the previous Pillar I regime, and a sub-section on the protection afforded the transferring policyholders by the SRA and capital policies that apply to PRIL and PAC. The effect of the Scheme on a Solvency II basis 7.11 The tables in Appendices 1 and 2 show the current financial strength of PAC and PRIL and the projected post- Scheme strength of PAC as at 30 June 2015 under Solvency II Pillar I and show that: Prior to the implementation of the Scheme: o The capital resources (including the assets that have been deposited back under the quota share treaty) of PRIL covered its SCR with a ratio of 332%, with excess capital (after capital requirements) of 0.9 billion. These figures are presented taking account of the expected payment of a dividend from PRIL to PAC that is expected to take place in the third quarter of 2016 (in respect of the increase in the QS percentage to 100%) and the repayment of the contingent loan by PRIL (which took place on 24 March 2016); and o The capital resources of PAC s shareholder-backed business covered its SCR with a ratio of 152%, with excess capital (after capital requirements and allowing for the impact of the transitional measures) of 3.4 billion. If the Scheme had been implemented on 30 June 2015, the capital resources of PAC s shareholder-backed business would have covered its SCR with a ratio of 152%, with excess capital (after capital requirements and allowing for the impact of the transitional measures) of 3.4 billion After the implementation of the proposed Scheme, the assets of PRIL will have been transferred into PAC s shareholder-backed business (except for those assets required to meet PRIL s residual regulatory requirements and any extra assets specified by the Board which will be held back temporarily until PRIL is de-authorised). May

33 Security for the transferring PRIL policies will be derived from all of the assets of PAC including the assets transferred from PRIL, the assets attributed to PAC s shareholder-backed business and the reinsurance contracts with the various reinsurers. The existing PAC LT SH business and PAC general insurance business will also be deriving support from these assets As stated above, based on the financial information as at 30 June 2015, the coverage of the Solvency II SCR in PRIL is currently 332% and this coverage percentage is projected to be 152% in the PAC shareholder-backed business after the Scheme is implemented The assets deposited back with PRIL under the PRIL-PAC QS agreement are currently used to pay the guaranteed benefits of the PRIL policies. In a scenario in which losses on assets or liabilities emerge or increase elsewhere in PAC s business, the deposited back assets could not be accessed to cover those losses and liabilities. This means that the PRIL policies currently enjoy priority access to the assets deposited back with PRIL and the deposit amount provides security to PRIL policies Following the implementation of the Scheme, the deposit amount will be transferred into PAC and will not be segregated to provide security for the transferring PRIL policies This projected decrease in the SCR coverage ratio and the loss of the priority access might, in isolation, be taken to imply an adverse impact on the security of the transferring PRIL policies. However, it should be noted that: The SCR coverage ratios are indicators or proxies of financial strength and a significant decrease in the coverage ratio does not necessarily indicate a significant or material reduction in security. Although the financial strength of the PAC shareholder-backed business is projected to be lower after the implementation of the Scheme than that currently in PRIL, at 152% (based on 30 June 2015 financial information) the PAC shareholder-backed business remains strong and the probability of PAC being unable to pay the claims in respect of its shareholder-backed business is sufficiently remote for there to be no material change in the security of benefits under the transferring PRIL policies. The financial information as at 30 June 2015 shows that the PAC shareholder-backed business is projected to have had a large amount of capital ( 3.4 billion) available to provide support if the Scheme had been implemented on this date. This provides security to the PRIL policyholders following the implementation of the Scheme. Although the level of capital (as at 30 June 2015) in PRIL is high at 332% of the SCR, this is significantly in excess of the regulatory requirements and the requirements set out by the Board in the SRA statement. There is no obligation for this level of capital to be maintained in PRIL and, in particular, if the Scheme were not to be implemented it would not be unreasonable for PAC (as the sole owner of PRIL) to transfer some of this excess capital out and reduce the level of excess capital in PRIL substantially. As described in Section 4, PAC has a number of ring-fenced funds: the PAC WPSF, the DCPSF and the SAIF. In the extreme scenario where although PAC as a whole was solvent, the assets of the PAC shareholderbacked business were insufficient to enable PAC to meet its liabilities on the PAC shareholder-backed business as they fell due and all other lines of available capital support for the PAC shareholder-backed business had been exhausted, support could be provided by the ring-fenced funds and PAC would consider using the assets of the ring-fenced funds to meet the liabilities on the PAC shareholder-backed business. In particular it should be noted that the PAC WPSF and the SAIF have inherited estates. The tables in Appendices 1 and 2 show that the ring-fenced funds are not directly affected by the Scheme and also show that the with-profits business had a capital coverage ratio of 210% (based on 30 June 2015 financial information), so that (albeit in the extreme scenario) the with-profits business could offer substantial support to the PRIL policies after the implementation of the proposed Scheme I am satisfied that the reduction in the SCR coverage ratio and the loss of the priority access to the deposited back amount will not have a material adverse effect on the security of the benefits under the transferring PRIL policies. The effect of the Scheme under the previous Solvency I regulatory regime 7.18 As set out in Section 3, I have also considered the effect of the implementation of the Scheme on the various groups of policies on the old (pre 1 January 2016) Solvency I regime based on financial information as at 31 December May

34 7.19 This financial information shows that under Solvency I there is a similar picture to that under Solvency II: under both Pillar I and Pillar II the implementation of the Scheme would have led to a reduction in the capital coverage ratio for the transferring PRIL policies. For the same reasons as in respect of the Solvency II regime, I am satisfied that the implementation of the Scheme would not have a material adverse effect on the security of benefits under the transferring PRIL policies. The PAC SRA and internal capital policy 7.20 The risk appetite framework that applies to PAC s shareholder-backed business is described in Section 4 and is called the PAC SRA Framework. This framework requires PAC s shareholder-backed business to be able to meet economic and regulatory capital requirements following a stress event The PAC SRA will not change as a result of the implementation of the Scheme, and currently applies to the PAC shareholder-backed business, including the business reinsured into PAC from PRIL. Therefore, the transferring PRIL policyholders will be subject to the same risk appetite framework after the implementation of the Scheme and the implementation of the Scheme will have no impact on the security afforded to PRIL policyholders by the risk appetite framework to which their policies are subject Following the introduction of Solvency II, the PAC SRA is being reviewed and the potential effect of this review for PRIL and PAC policyholders is covered in Section 9. The impact of changes to economic conditions 7.23 PAC has provided me with results of sensitivities that it has carried out to estimate the impact of various changes in market conditions on its financial position under Solvency II Pillar 1. These sensitivities comprise: 20% fall in equity values; 40% fall in equity values; 50bps fall in interest rates; 100bps increase in interest rates; and 100bps increase in credit spreads The figures I have seen show that the PAC shareholder-backed business remains financially strong under all of the sensitivities listed above Since 30 June 2015 there have been some significant changes in the financial markets including: a decrease in fixed interest yields, a decrease in overall equity values, and an increase in credit spreads. In particular, since 30 June 2015, fixed interest yields have fallen by more than 50bps, i.e. by more than the interest rate sensitivity listed above. However, the sensitivity information provided indicates that if the interest rate sensitivity were to double to 100bps, the PAC shareholder-backed business would remain materially stronger than 100% SCR coverage In order to consider the impact of the changes in financial markets, PAC has provided me with Solvency II financial information as at 1 January 2016, 31 January 2016 and 29 February This information shows that, although PAC s solvency position and its position relative to its SRA has weakened: PAC s financial strength remains materially above 100% coverage of its SCR From the point of view of the transferring PRIL policies, the changes in market conditions that affect PAC s solvency position will affect the security of the PRIL business both before and after the implementation of the Scheme. Therefore, I am satisfied that the changes in market conditions will not affect the conclusions regarding the impact of the implementation of the proposed Scheme on the security of benefits of the PRIL policies. PAC s business plans, which include a reduced, selective appetite for new annuity business, are expected to result in a material improvement to PAC s coverage of its SCR in the future Therefore I am satisfied that the changes to economic conditions since 30 June 2015 will not affect the conclusions in relation to the impact of the implementation of the proposed Scheme on the security of benefits of the PRIL policies. May

35 Conclusions regarding financial strength 7.28 Overall, the financial information on a Solvency II basis shows that the impact of the implementation of the Scheme on the overall financial strength available to support the PRIL business is small. I am satisfied that viewing the effect of the implementation of the Scheme through the previous Solvency I regime leads to a similar conclusion I am satisfied that the implementation of the proposed Scheme will not have a material adverse effect on the financial strength available to support the security of the guaranteed benefits under the PRIL policies I am satisfied that changes to market conditions would not cause a change to my conclusions in relation to the impact of the proposed Scheme on the financial strength available to support PRIL. The QS reduction scenario 7.31 As described in t 4, I have considered the impact of the implementation of the Scheme on the PRIL policies in the scenario where the QS percentage reinsured is reduced to 20% - the QS reduction scenario In the QS reduction scenario, it is likely that PRIL would require capital support or an injection of capital from PAC. As this is a hypothetical scenario it is not possible to know the form or level of such capital support nor what PRIL s ultimate capital position would be in this scenario but it seems reasonable to assume that PAC would seek to capitalise PRIL to a level consistent with PAC s SRA, and that at a minimum it would fulfil its obligations under the existing PAC/PRIL CSA, which would remain in place until 31 December After the implementation of the Scheme in the QS reduction scenario, the PRIL policyholders will have access to PAC s capital resources without the need for capital injections or other capital support from PAC under the terms of the CSA. As described above, PAC s capital resources are considerable with 3.4 billion of assets in excess of its SCR and an SCR coverage ratio of 152%, based on 30 June 2015 financial information. Once in PAC the PRIL business would have the security afforded to PAC policyholders from the PAC SRA Given this is a hypothetical scenario it is not possible to compare the SCR coverage ratios before and after the implementation of the proposed Scheme but the reasons why any reduction in coverage ratios, and the loss of priority access to the deposited back assets, would not have a material adverse effect on the security of the guaranteed benefits under the PRIL policies are as set out above (paragraph 7.16) I am therefore satisfied that, in the QS reduction scenario, the implementation of the proposed Scheme will not have a material adverse effect on the financial strength available to support the security of the guaranteed benefits under the PRIL policies. The profile of risks to which the PRIL policies will be exposed if the Scheme is implemented 7.36 After the implementation of the Scheme, the PRIL policies will be part of the PAC shareholder-backed business and will be exposed directly to the risks of that business Alongside its non-profit annuity business PAC s shareholder-backed business also contains a variety of non-profit unit-linked business, other non-profit, non-linked business, and general insurance business that is not found in PRIL. Therefore, in comparison to the PRIL long-term insurance business, the PAC shareholder-backed business is exposed to different risks through its product offerings: for example mortality, morbidity and lapse risk on its nonlinked protection business, and market and lapse risk on its linked business In addition, the annuities directly written in PAC s LT SH business may have originated through different sources and sales channels from those annuities directly written in PRIL One of the most significant assets in PAC s shareholder-backed business is the shareholder interest in future transfers or SHIFT asset, which represents the value to PAC s shareholder-backed business of future shareholder transfers from the PAC WPSF. As a result of this, PAC s shareholder-backed business is exposed to risks affecting the PAC WPSF such as equity and property risk Another significant asset of PAC s shareholder-backed business is the value of future profits expected to be received from PHKL, and therefore PAC s shareholder-backed business is exposed to any risks to the profitability of PHKL. May

36 7.41 There are therefore a number of risks to which PAC is exposed directly through the nature of its business and its investments, but to which PRIL is not currently exposed through its directly written business Consequently, the profile of risks to which the transferring policyholders are exposed will change if the proposed Scheme is implemented I have seen PAC s own assessment of the relative materiality of the risks in the PAC shareholder-backed business in its 2015 ORSA (based on the 31 December 2014 financial information) and I note the following: The risks of the PAC shareholder-backed business are dominated by those associated with non-profit annuity business in PAC and PRIL, such as credit risk and longevity risk. The PRIL policies are already exposed to credit and longevity risk by virtue of PRIL s own annuity business but the level and type of credit and longevity risk is likely to be different following a transfer to PAC due to the different origination of the PAC shareholderbacked business as described above. The risks associated with PAC s other business, such as market, mortality, morbidity and lapse risk on nonannuity business are less material in the context of the PAC shareholder-backed business as a whole. The largest risk in the PAC shareholder-backed business that is not already present in PRIL is equity risk, through the SHIFT asset. Where the PRIL policies are exposed to new risks, these risks will provide a degree of diversification to the risks to which the PRIL policies are currently exposed To the extent that the deposit amount needs to be topped up, PRIL is currently indirectly exposed to the risks in PAC as PRIL relies on PAC to fulfil its obligations under the PRIL-PAC QS agreement (even if PRIL is partially protected from the risks in PAC as a result of the deposit back arrangement and the pari passu security) and under the CSA between PRIL and PAC The Solvency II liabilities and capital requirements reflect the risks that are faced by the company and the policyholders of that company, and the financial figures before and after the implementation of the proposed Scheme are influenced by the change in risk exposures of the transferring policyholders. These show that after the implementation of the Scheme the PAC shareholder-backed business is projected to have enough capital to cover its risk exposures and remain within the risk appetite of the company (the SRA) and therefore comfortably in excess of the regulatory requirements I am satisfied that, although the profile of the risk exposures of the transferring PRIL business will change as a result of the implementation of the Scheme, the capital held will reflect this and that therefore there will not be a material adverse effect on the PRIL policies In the QS reduction scenario, the implementation of the proposed Scheme will increase the exposure of the PRIL policies to the risks of the PAC policies and therefore the profile of risks to which the PRIL business is exposed will change due to the different types of business within PAC The capital held against the risks of the PRIL policies will be determined by the PAC SRA and will reflect the risk profile and exposures of PAC s business as a whole which will, after the implementation of the proposed scheme, include the transferring PRIL business I am satisfied that, although the implementation of the proposed Scheme from the QS reduction scenario will change the profile of risk exposures of the transferring PRIL business, there will not be a material adverse effect on the PRIL policies. The governance and management of the PRIL policies 7.50 The PRIL policies are all currently administered and serviced by the same service provider as the PAC policies and, after the implementation of the Scheme, these policies will continue to be serviced from the same systems and by the same administration teams. There will be no change to the administration and service standards applied to the PRIL policies There will be no changes to the policies terms and conditions, except that the policies will become policies of PAC The PRIL business is currently managed by, and subject to the governance of, the Board of PRIL. As PRIL is owned by PAC, and as PAC is the reinsurer to 100% of PRIL s liabilities, PAC has a significant influence over the May

37 management of PRIL and detailed information is regularly passed to the PAC Board. In addition, the PRIL Board and the PAC Board have at least one common member The PAC Board is currently responsible for the governance of a significant number of non-profit annuities in the PAC shareholder-backed business and in the PAC WPSF, as well as the reinsured PRIL liabilities, and so has appropriate experience and expertise in the management of non-profit annuity business PAC has shared with me its SIMR Governance Map and this was approved by the PAC Board in February The Governance Map focuses on governance at the PAC level but covers PRIL and PPL as these form the inscope insurance entities for which PAC is the principal operating company. The roles of the various committees, including Audit and Risk & Capital, established by the PAC Board include oversight of PRIL and PPL as well as of PAC itself The implementation of the proposed Scheme will have no material effect on PAC's implementation of the PRA's SIMR and I am satisfied that, after the implementation of the Scheme (when the PAC Board will have responsibility for the governance of the PRIL policies) the management and governance arrangements applicable to the PRIL policies will be consistent with those currently in place. The benefit expectations of the PRIL policyholders 7.56 As stated above the transferring PRIL business consists of non-profit pension annuities and the reinsurance of annuity business. The policies reinsured into PRIL are considered below but the remainder of the transferring business is UK immediate and deferred annuities and, as such, policyholders expectations in respect of their benefits are that: They receive their income as guaranteed under the policy, on the dates specified, from the point of purchase (if the annuity is in payment) or from the point of vesting (if the annuity is deferred); and The administration, servicing, management, and governance of the policies are in line with the contractual terms under the policies As discussed above, I am satisfied that: The implementation of the Scheme will not have a material adverse effect on the security of the guaranteed benefits of the PRIL policies; The implementation of the Scheme will not lead to any change to the contractual benefits under any of the PRIL policies; The implementation of the Scheme will not affect the administration and service standards applicable to the holders of the PRIL policies; and The implementation of the Scheme will not have a material adverse effect on the management or the governance of the PRIL policies For these reasons I am satisfied that the implementation of the Scheme will not have a material adverse effect on the benefit expectations of the PRIL policyholders. The effect of the proposed Scheme on the policies currently reinsured into PRIL 7.59 PRIL currently accepts reinsurance from PPL, Royal London, Zurich and PAC. The PRIL-PAC QS agreement retrocedes 100% of these liabilities to PAC Following the implementation of the Scheme: The reinsurance agreements in respect of policies reinsured to PRIL from the PAC WPSF and the SAIF will fall away and be replaced by inter-fund agreements to replicate the terms of the current reinsurance to PRIL, but with the PAC shareholder-backed business fulfilling the responsibilities of the reinsurer. Hogan Lovells, the legal advisers retained by Prudential in respect of this Scheme, have confirmed that the inter-fund agreements do replicate the previous reinsurance agreements. As discussed in Section 3, I am satisfied that it is appropriate for me to rely on their conclusions. May

38 The reinsurance agreements in respect of policies reinsured to PRIL from Royal London and Zurich will continue with PAC as reinsurer rather than PRIL The same comments and conclusions apply to these policies as are outlined for the PRIL policies above and for the same reasons I am satisfied that the implementation of the Scheme will not have a material adverse effect on the security or benefit expectations of the policies currently reinsured into PRIL. The effect of the proposed Scheme on the bulk purchase annuity ( BPA ) policies 7.62 PRIL has entered into a number of transactions with occupational pension schemes under which PRIL provides a BPA policy to match some or all of the liability cash flows of the pension scheme These bulk deals give various rights to the schemes trustees which may include: Termination rights and/or rights in relation to collateral in the event of PRIL s or PAC s failure to maintain specified levels of regulatory solvency under Solvency II; Security arrangements in which PRIL has granted a charge over a segregated account within PRIL to the relevant trustee; and Security arrangements in which the relevant trustee has granted a charge over a segregated account with the trustee s custodian bank to PRIL Most of the large BPA policies have termination triggers based on the solvency levels in PRIL and PAC and, if the Scheme is implemented, the termination triggers that reference PRIL will switch to reference PAC. In all but one case the PRIL termination triggers will be less onerous than the existing PAC termination triggers and accordingly the existing trigger that references PAC will remain the more onerous test. The transfer will not affect the Solvency II position of PAC so the likelihood of termination will not increase as a result of the Scheme with the exception of a slight increase for one of the smaller schemes where the PRIL termination trigger will become the biting test The implementation of Solvency II has required the recalibration of the termination triggers to reflect the new regulatory environment and all of the BPA pension schemes now have triggers that reference the solvency position of PRIL under Solvency II. These termination triggers will switch to reference PAC after the implementation of the proposed Scheme The implementation of the Scheme will mean that PAC will hold any collateral rather than PRIL and, as with the termination triggers, the capital triggers that relate to the relevant collateral obligations mostly already include a reference to PAC as well as PRIL, and if they do not the PRIL trigger will be amended by the proposed Scheme to refer to PAC in place of PRIL. I am satisfied that the implementation of the proposed Scheme will not have a material effect on the collateral amounts held in respect of the capital triggers I understand that there are currently no BPA policies where the implementation of the Scheme would cause a breach of obligations in the security deeds other than in the case of one scheme where PRIL will seek to amend the related security deed prior to the date of the Sanctions Hearing PRIL has some BPA policies where formal legal agreements do not exist as the agreements have been entered into by PRIL solely on the basis of quotation documents. Most of these BPA policies have subsequently been converted to individual policies issued by PRIL to the Scheme members with complete documentation but there are some that have not yet been converted. The lack of formal legal agreements gives rise to certain risks, including: The risk of disputes that would normally be governed by contractual provisions; and The risk that reserves would need to be increased due to legal uncertainty However, the implementation of the Scheme will not affect the extent of the risks associated with the incomplete contractual information including the risk of disputes Hogan Lovells, has, as part of its work for Prudential, carried out due diligence in relation to the BPA policies. This due diligence has identified certain BPA policies that provide that, inter alia, a transfer of the policy to PAC under Part VII of FSMA will constitute an event of default unless PAC has at least an equivalent credit rating to PRIL both immediately before and immediately after the transfer. May

39 7.71 I will consider this further in my Supplementary Report but I expect this requirement will be satisfied due to the following: The credit ratings provider Moody s has provided financial strength ratings for PAC and PRIL. These describe both PAC and PRIL as of high quality and subject to very low credit risk. PAC has similarly high ratings from S&P ( very strong ) and Fitch ( very high credit quality ). All the ratings are considered to be on stable outlook. The ratings for PAC are determined on the basis that PRIL is consolidated into PAC so I would not expect any change as a result of the proposed Scheme Some BPA policies also expressly reserve the Scheme trustees right to participate in the Court process but it is my understanding that they could do this in any case As discussed in Section 3, I am satisfied that it is appropriate for me to rely on the conclusions of the due diligence carried out by Hogan Lovells Overall I am satisfied that the implementation of the Scheme will not have a material adverse effect on the pension schemes which hold BPA policies with PRIL or their members. Conclusions for the PRIL policies 7.75 I am satisfied that both in the current situation where the PRIL-PAC QS agreement percentage is 100% and in the hypothetical QS reduction scenario, the implementation of the Scheme will not have a material adverse effect on: The security of benefits under the PRIL policies; The benefit expectations of the PRIL policyholders; or The service standards and governance applicable to the PRIL policies. The reinsurance agreements with companies outside the Prudential Group 7.76 Following the implementation of the Scheme, the agreements under which various reinsurers outside the Prudential Group provide reinsurance to PRIL will remain in place, with PAC becoming the cedant The implementation of the Scheme will have no effect on these reinsurers or on the operation of the reinsurance agreements between PRIL (or PAC after the Scheme) and these reinsurers. May

40 8. THE EFFECT OF THE IMPLEMENTATION OF THE SCHEME ON THE PAC POLICIES Introduction 8.1 In this section I consider the effect of the implementation of the Scheme on the PAC policies, which, as described in Section 4, can be divided into the following groups: The policies of the PAC LT SH business; The policies in the ring-fenced funds: the PAC WPSF, the DCPSF, and the SAIF; The policies of the subsidiaries (other than PRIL) within the PAC shareholder-backed business; and The PAC general insurance policies. 8.2 For each group of policies, I consider the likely effects of the implementation of the Scheme on the security of the guaranteed benefits and on the benefit expectations of the holders of those policies. The PAC LT SH business Introduction 8.3 Under the PRIL-PAC QS agreement, the PRIL long-term insurance business is currently 100% reinsured (net of other reinsurance arrangements) into PAC and, the effect of the pari passu charge granted to PRIL in connection with the reinsurance agreement is that PRIL would be treated as if it were a direct policyholder of the PAC LT SH business and would be entitled to claim in priority to other unsecured creditors and would rank equally with the existing direct policies of the PAC LT SH business in the event of PAC s insolvency. 8.4 In this section I consider the effect of the implementation of the Scheme on the security of the guaranteed benefits and on the benefit expectations of the current policyholders with policies in the PAC LT SH business. 8.5 The key issues to consider are: The financial strength available to provide security for the benefits under the PAC LT SH business after the implementation of the Scheme compared to that currently available to provide benefit security; Any change to the profile of risks to which the PAC LT SH business will be exposed as a result of the implementation of the Scheme; and Any effect of the implementation of the Scheme on the benefit expectations of the PAC LT SH business policyholders, including the service standards, management and governance these policyholders should expect after the implementation of the Scheme. The financial strength available to provide security of benefits Solvency II 8.6 Currently, the security of the guaranteed benefits of the policies in the PAC LT SH business is provided by a combination of: The assets backing the technical provisions held in respect of the guaranteed benefits of the PAC LT SH business; The assets allocated to the PAC shareholder-backed business in excess of the technical provisions in respect of the PAC LT SH business and the PAC general insurance business; Assets elsewhere in PAC; and The reinsurance agreements with companies outside the Prudential Group. May

41 8.7 After the implementation of the Scheme, the security of the guaranteed benefits of the policies of the PAC LT SH business will continue to be provided by these elements. In particular: The implementation of the Scheme will have no effect on the technical provisions held in relation to the current PAC LT SH business. The tables in Appendices 1 and 2 show the current financial strength of PAC and PRIL and the projected post- Scheme strength of PAC as at 30 June 2015 under Solvency II Pillar 1 and show that: Prior to the implementation of the Scheme (as at 30 June 2015): o o The capital resources of the PAC shareholder-backed business (including the value of its subsidiary PRIL) covered its SCR with a ratio of 152%; and The excess capital (after capital requirements and allowing for the impact of the transitional measures) in the PAC shareholder-backed business was 3.4 billion. If the Scheme had been implemented on 30 June 2015: o o The capital resources of the PAC shareholder-backed business would have covered its SCR with a ratio of 152%; and The excess capital (after capital requirements and allowing for the impact of the transitional measures) of the PAC shareholder-backed business would have been 3.4 billion. 8.8 The Solvency II financial information therefore shows that the implementation of the Scheme is not expected to affect the Solvency II position of PAC s shareholder-backed business. 8.9 The implementation of the Scheme will have no effect on the reinsurance agreements with companies outside the Prudential Group The implementation of the Scheme will have no direct effect on the with-profits business of PAC nor on the potential support provided by the with-profits business in the extreme scenario where the resources of the PAC shareholderbacked business are insufficient to meet its liabilities. The previous Solvency I regulatory regime 8.11 As set out in Section 3, I have also considered the effect of the implementation of the Scheme on the various groups of policies on the old (pre 1 January 2016) Solvency I regime based on financial information as at 31 December Based on the Pillar I financial information, the implementation of the proposed Scheme would have resulted in an improvement to the financial strength supporting the policies of the PAC shareholder-backed business. However it should be noted that this improvement resulted from the reversal of a Pillar I restriction regarding the capital resources requirement required when business is wholly reinsured and so could be considered more a quirk of the previous reporting regime (that does not occur under the Solvency II regime) rather than a genuine improvement in financial strength The implementation of the Scheme would have had no impact on the Pillar II position of PAC s shareholder-backed business. The PAC SRA 8.14 The risk appetite framework that applies to PAC s shareholder-backed business is described in Section 4 and is called the PAC SRA Framework. This framework requires PAC s shareholder-backed business to be able to meet economic and regulatory capital requirements following a stress event 8.15 The implementation of the Scheme will have no impact on the terms of the PAC SRA Framework, and no impact on the level of solvency of the PAC shareholder-backed business relative to the PAC SRA. Therefore there will be no change to the level of protection afforded to PAC policyholders by the PAC SRA as a result of the implementation of the Scheme Following the introduction of Solvency II, the PAC SRA is being reviewed and the potential effect of this review for PRIL and PAC policyholders is covered in Section 9. May

42 The impact of changes to economic conditions 8.17 As discussed in Section 7, PAC has provided me with results of sensitivities that it has carried out that estimate the impact of various changes in market conditions on its financial position under Solvency II as at 30 June These sensitivities show that the PAC shareholder-backed business remains financially strong in all the scenarios considered Since 30 June 2015 there have been some significant changes in the financial markets including: a decrease in fixed interest yields, a decrease in general equity values, and an increase in credit spreads. In order to consider the impact of the changes in financial markets, PAC has provided me with Solvency II financial information as at 1 January 2016, 31 January 2016 and 29 February This information shows that, although PAC s solvency position and its position relative to its SRA has weakened: PAC remains materially financially stronger than 100% coverage of its SCR. The financial position of PAC will be unaffected by the implementation of the Scheme, and therefore changes in PAC s SCR coverage as a result of changes in market conditions would not change my conclusions on the effects of the implementation of the proposed Scheme on the PAC policyholders. PAC s business plans, which include a reduced, selective appetite for new annuity business, are expected to result in a material improvement to PAC s coverage of its SCR in the future Therefore I am satisfied that the changes to economic conditions since 30 June 2015 will not affect the conclusions in relation to the impact of the implementation of the proposed Scheme on the security of benefits of the PAC policies. The QS reduction scenario 8.20 As described in Section 4, I have considered the impact of the implementation of the Scheme on the PAC policies in the scenario where the QS percentage reinsured is reduced to 20% - the QS reduction scenario As set out in Section 4, the walk-away option has negligible value to PAC in the QS reduction scenario and as a result PAC is already exposed to the risks of the PRIL business. Hence I am satisfied that the implementation of the proposed Scheme will not, from the perspective of the PAC LT SH business, have a materially different impact than in the current situation where the PRIL-PAC QS percentage is 100%. Conclusions regarding financial strength 8.22 I am satisfied that the implementation of the Scheme will not have a material adverse effect on the financial strength available to support the security of the benefits under the PAC LT SH business I am satisfied that this conclusion is unchanged by the changes to market conditions since 30 June 2015 and that this conclusion holds whether the Scheme is implemented in the current situation where the PRIL-PAC QS agreement coverage is 100%, or in the hypothetical QS reduction scenario where this percentage is 20%. The profile of risks to which the PAC LT SH business is exposed 8.24 The key risk for the policyholders of the PAC LT SH business is that the implementation of the Scheme results in an increased risk to the security of their benefits due to an increased exposure to the risks associated with the long-term insurance business currently in PRIL The implementation of the Scheme transfers the direct responsibility for the PRIL policies, and for holding assets sufficient to cover the capital requirements of the PRIL business, from PRIL to PAC. This means that, in the event of a loss emerging on the PRIL business, assets allocated to the PAC shareholder-backed business will fund the loss As described in Section 4, prior to the implementation of the Scheme there is, in theory at least, the option available to PAC to walk-away from PRIL. However, as described in detail in Section 4: The terms of the PRIL-PAC QS agreement limit the rights of PAC to terminate the reinsurance; PRIL has a pari passu charge over the assets allocated to the PAC LT SH business; and May

43 There is a CSA in place between PAC and PRIL that commits PAC to provide capital support to PRIL until 31 December 2017, whether or not the PRIL-PAC QS agreement is in place The combination of the 100% QS agreement and the CSA means that the walk-away option has a negligible value to the PAC LT SH business, which is already exposed, for all practical purposes, to the risks associated with the PRIL business As described in Section 4, in the unlikely QS reduction scenario the walk-away option also has a negligible value to PAC Following the implementation of the Scheme, PAC will have a legal obligation to meet 100% of the liabilities in respect of the transferring business and that commitment will rank pari passu with PAC s obligations to its current direct policyholders. Therefore, there will no longer be a walk-away option I am satisfied that the value of the walk-away option is negligible and that the loss of it as a result of the Scheme would not have a material adverse effect on the policyholders of the PAC LT SH business The extent to which PAC policyholders will become exposed to new risks as a result of the implementation of the Scheme is relatively small. However, there will be some increase in PAC s exposure to the risk of reinsurer default in relation to PRIL s external reinsurance treaties with Hannover Re, SCOR, Swiss Re and Pacific Life Re. However, PAC is already indirectly exposed to this risk through the PRIL-PAC QS agreement and the PRIL-PAC CSA, and there is therefore no material change to the risk profile of PAC policyholders I am satisfied that the implementation of the Scheme will not have a material adverse effect on the profile of risks to which the existing policyholders of the PAC LT SH business are exposed and that this conclusion holds whether the Scheme is implemented in the current situation where the PRIL-PAC QS agreement coverage is 100%, or in the hypothetical QS reduction scenario where this coverage percentage is reduced to 20%. The benefit expectations of the PAC LT SH business 8.33 The policies of the PAC LT SH business are non-profit or unit-linked in nature and, as such, policyholders expectations in respect of their benefits are that: They receive their contractual benefits as set out under the policy; The policies are operated in accordance with their contractual terms; and The administration, servicing, management, and governance of the policies are in line with the contractual terms under the policies and do not deteriorate as a result of the transfer The implementation of the Scheme will not have any effect on the contractual benefits under any of the policies of the PAC LT SH business, the administration and service standards applicable to the holders of policies in the PAC LT SH business, or to the management and governance of policies in the PAC LT SH business As discussed above, I am satisfied that the implementation of the Scheme will not have a material adverse effect on the security of the guaranteed benefits of the policies in the PAC LT SH business For these reasons I am satisfied that the implementation of the Scheme will not have a material adverse effect on the benefit expectations of the policyholders of the PAC LT SH business and that this conclusion holds whether the Scheme is implemented in the current situation where the PRIL-PAC QS agreement coverage is 100%, or in the hypothetical QS reduction scenario where this coverage percentage is reduced to 20%. Conclusions for the PAC LT SH business 8.37 I am satisfied that both in the current situation where the QS percentage is 100% and in the hypothetical QS reduction scenario, the implementation of the Scheme will not have a material adverse effect on: The security of benefits of the policyholders of the PAC LT SH business; The benefit expectations of the policyholders of the PAC LT SH business; or The service standards and governance applicable to the policyholders of the PAC LT SH business. May

44 The policies of the PAC ring-fenced funds (the PAC WPSF, the DCPSF and the SAIF) Policies reinsured to PRIL 8.38 The PAC WPSF and the SAIF currently reinsure some non-profit annuity liabilities to PRIL and these are then reinsured on to PAC under the PRIL-PAC QS agreement The reinsurance arrangements (in respect of the PAC WPSF and the SAIF business) will terminate upon the implementation of the proposed Scheme and be replaced by intra-company arrangements between these two ringfenced funds and the PAC shareholder-backed business (the PAC NPSF) set up to replicate the effects of the terminated arrangements. Hogan Lovells has reviewed the terms of the intra-company arrangements and is satisfied that they do replicate the terminated arrangements. For the reasons given in Section 3, I consider it is appropriate for me to rely on Hogan Lovells in this matter The current reinsurance agreements between PRIL and PAC include terms that entitle the parties to terminate the agreements on notice in a limited range of circumstances, for example, if PRIL went into liquidation, or there was a material breach by either party of its obligations. Since the agreements are contracts between two legal entities, they could in theory also be terminated at any time by mutual agreement between the companies In contrast, the intra-company arrangements will not be contracts in the strict legal sense, and the termination provisions that apply to the existing agreements will not be relevant to the intra-company arrangements. The new arrangements would therefore only terminate if PAC decided to unwind them However, in practice, given the regulated nature of PRIL and PAC's business and the potential for any change in the risk profile of each company to affect its policyholders, any proposal to terminate the intra-company arrangements would be subject to the same regulatory principles that would apply to a termination of the reinsurance arrangements, and in particular it can be expected that termination would only occur following notice to the PRA (this would be consistent with paragraph 2.4 of the Notifications part of the PRA Rulebook) and if the relevant actuarial functions, the With-Profits Committee and the WPA were each satisfied with the proposal Given that the PAC WPSF and SAIF annuity policies currently reinsured into PRIL will, after the transfer be reinsured into the PAC shareholder-backed business, my conclusions in relation to PRIL policyholders in Section 7 apply equally to those policyholders whose policies are reinsured into PRIL from the PAC WPSF and the SAIF. Changes in the risks to which the policies of the PAC ring-fenced funds are exposed 8.44 Under the proposed Scheme, there will be no business transferred into or out of the WPSF, the DCPSF or the SAIF. Therefore the only other potential changes to the risk exposure of the with-profits funds that could arise as a result of the implementation of the Scheme are: The possibility that there may be extra calls on the capital in the PAC shareholder-backed business due to the business being transferred into PAC under the Scheme, restricting the capital available to PAC s with-profits funds; and/or The possibility that the implementation of the Scheme will increase the contagion risk to the with-profits funds of PAC by increasing the probability of the claims-paying insolvency of PAC (at which point the ring-fencing of PAC s with-profits business would break down) As described in Section 4, both in the scenario where the PRIL-PAC QS agreement coverage remains at 100%, and the hypothetical QS reduction scenario where it is reduced to 20%, the value to PAC of the theoretical walkaway option is negligible and therefore PAC is, in effect, currently exposed to the risks from the PRIL policies, and the tables in Appendices 1 and 2 show that the implementation of the Scheme would not have a material adverse effect on the financial strength available to provide support to the PAC shareholder-backed business Therefore I am satisfied that the implementation of the Scheme will not have a material impact on the risk of extra calls on the capital of PAC or on the probability of PAC being unable to pay its claims. This conclusion holds both in the current situation where the QS percentage is 100% and in the hypothetical QS reduction scenario. Derivative contracts currently backed by collateral held in the PAC WPSF and PRIL 8.47 Currently, any derivative contracts entered into on behalf of any of the PAC funds are collateralised using assets in the PAC WPSF and derivative contracts entered into by PRIL are collateralised using assets in PRIL. Under the May

45 terms of an inter-fund memorandum, if the PAC WPSF is required to post any collateral in respect of a derivative contract on behalf of one of the funds, it is immediately reimbursed by the relevant PAC fund After the implementation of the Scheme, collateral in respect of the derivative contracts currently in PRIL will be provided by the PAC WPSF The implementation of the European Market Infrastructure Regulation ( EMIR ) requirements will mean that any derivatives that are subject to the clearing obligations and any new derivatives will require cash collateral to be posted by the PAC WPSF with the benefiting fund reimbursing the PAC WPSF There is therefore the risk to the PAC WPSF that: These extra collateral requirements mean that the PAC WPSF is required to hold more cash than it would otherwise, which results in a detrimental effect on the returns payable under the with-profits policies; and If the extra derivatives under-perform to the extent that the collateral in the PAC WPSF is not sufficient then, in an extreme scenario, the PAC WPSF could be at risk of insolvency. The EMIR rules impose requirements around the collateralisation of derivative contracts. In the event that the implementation of the Scheme were to cause derivatives held by PRIL to become subject to the EMIR requirements, this could result in a requirement to post cash collateral in relation to those derivatives (which would not be the case absent the proposed Scheme) However: In respect of derivatives held by PRIL, collateral may currently be posted in the form of investment grade bonds and this is not expected to result in material restrictions in the context of the PAC WPSF investment strategy. The derivatives held by PRIL are small in the context of the derivatives already collateralised in the PAC WPSF. Based on figures as at 1 January 2016 the derivatives in the PAC WPSF have a notional value of approximately 52 billion, of which 11 billion is in relation to interest rate swaps (the only derivative class expected to be subject to central clearing at the expected Effective Date of the Scheme). PRIL s derivatives have a notional value of approximately 7 billion, of which 0.8 billion is in relation to interest rate swaps. Prudential has obtained legal advice from Hogan Lovells, supported by opinion from Counsel, that although there has been no judicial consideration or regulatory guidance on whether a Part VII transfer amounts to a novation within the terms of EMIR, implementation of the proposed Scheme should not result in any of the current derivative arrangements becoming subject to the additional requirements of EMIR. In the event that these derivative arrangements are subject to the EMIR clearing requirements, Prudential has made a prudent estimate of the potential costs which may be incurred and the cost is immaterial in the context of the PAC WPSF and the PAC shareholder-backed business I understand that the level of cash collateral being posted as new derivatives are written and the contribution of the PAC WPSF to the collateral pool will be monitored by the Investment Committee (as described in Section 4) in order to make sure the risks listed above do not manifest and adversely affect the PAC WPSF policies. The WPA is represented on the Investment Committee and he will thus be able to monitor the effects of the collateral pool and its assets on the security of benefits and benefit expectations in respect of the policies in the PAC WPSF A limit on the cash contributed by the PAC WPSF to the collateral pool will be set and approved by the Investment Committee and therefore the WPA will be able to take a view as to the appropriateness of the limit. It is anticipated that pre-emptive action could be taken to ensure the limit is not breached and there are a number of potential preemptive actions that could be taken that include: Posting collateral from other PAC portfolios; Reducing the level of derivatives used; and/or Restructuring the derivative contracts that require collateral to be posted The governance for each of these actions varies, but all will require at least the review and assent of the Investment Committee (or a party with suitable delegated authority from the Investment Committee), as well as a review by the UK Risk Function (as described in Section 4) including the WPA team. The normal escalation rights that exist May

46 for the WPA (including escalation to the Board and informing the regulator) can be used if the WPA believes policyholders are being disadvantaged and his advice/opinion is being ignored The WPA has confirmed that, in his view, the proposed arrangements for the monitoring of collateral and the process for taking action to protect with-profits policyholders if necessary are appropriate If necessary, alternative arrangements will be made to ensure the PAC WPSF policyholders are not disadvantaged such as requiring other PAC portfolios to post cash to the collateral pool, or granting a temporary exemption for the limit breach. Such a temporary exemption would be granted by the Investment Committee to allow for various mitigating circumstances, and could be combined with actions to ensure that policyholders are adequately protected, e.g. by compensating the WPSF asset shares for the returns forgone from holding the cash required to post on behalf of other portfolios I am satisfied that the implementation of Scheme and its effects (if any) on the derivative contracts currently collateralised in the PAC WPSF and PRIL will not lead to any material adverse effect on the security of the benefits of the policies in the PAC WPSF or on the benefit expectations of those policyholders This conclusion holds both in the current situation where the QS percentage is 100% and in the hypothetical QS reduction scenario. The benefit expectations of the policyholders of the ring-fenced funds 8.59 After the implementation of the Scheme, the PAC Board will remain responsible for the governance of the withprofits business in the PAC WPSF and the DCPSF and its actions in relation to with-profits business will continue to be reviewed by the PAC With-Profits Committee. The implementation of the Scheme will not lead to any change to the terms of reference of the Board or the PAC With-Profits Committee in relation to the governance of withprofits business The implementation of the Scheme will have no effect on the management and governance of the with-profits business of the SAIF I am satisfied that the implementation of the Scheme will not affect the service standards, investment management, management or governance of the policies in the PAC WPSF, the DCPSF and the SAIF and therefore that the implementation of the Scheme will not have a material adverse effect on the benefit expectations of the policyholders of the PAC WPSF, the DCPSF and the SAIF This conclusion holds both in the current situation where the QS percentage is 100% and in the hypothetical QS reduction scenario. Conclusions for the PAC ring-fenced funds 8.63 I am satisfied that the implementation of the Scheme will not have a material adverse effect on the security of the benefits under the policies of the PAC ring-fenced funds or on the benefit expectations of the policyholders of the PAC ring-fenced funds For the avoidance of doubt, this conclusion applies equally to holders of long-term insurance policies that are wholly or partially reinsured into the PAC ring-fenced funds This conclusion holds both in the current situation where the QS percentage is 100% and in the hypothetical QS reduction scenario. The policies of the subsidiaries (other than PRIL) of the PAC shareholder-backed business 8.66 The current subsidiaries (aside from PRIL) of the PAC shareholder-backed business are: PHLL; PHKL; PG HKL; PPL; and May

47 PIA After the implementation of the proposed Scheme these companies will remain subsidiaries within the PAC shareholder-backed business and there will be no business transferred into or out of them As stated above, I do not expect the implementation of the Scheme to have a material impact on the likelihood of extra calls on the capital in PAC, and therefore I am satisfied that the implementation of the Scheme will not have a material adverse effect on the security of the benefits under the policies of the subsidiaries of the PAC shareholder-backed business There will be no changes to the terms and conditions of the policies of the subsidiaries of the PAC shareholderbacked business and the policy servicing arrangements, investment management, management and governance for these policies will not change as a result of the implementation of the Scheme I am therefore satisfied that the implementation of the Scheme will not have a material adverse effect on the benefit expectations of the policyholders of the subsidiaries of the PAC shareholder-backed business. This conclusion holds both in the current situation where the QS percentage is 100% and in the hypothetical QS reduction scenario. The PAC general insurance policies 8.71 PAC does not currently write or sell general insurance policies and does not have any current in-force general insurance policies apart from a small number (approximately 1,500) of claims in payment/under management. These policies were originally written in the PAC SHF and currently form part of PAC s shareholder-backed business As stated above, I do not expect the implementation of the Scheme to have a material impact on the likelihood of extra calls on the capital in PAC, and therefore I am satisfied that the implementation of the Scheme will not have a material adverse effect on the security of the benefits of the general insurance policyholders The policy servicing arrangements, management and governance for the PAC general insurance policies will not change as a result of the implementation of the Scheme I am therefore satisfied that the implementation of the Scheme will not have a material adverse effect on the benefit expectations of the general insurance policyholders. This conclusion holds both in the current situation where the QS percentage is 100% and in the hypothetical QS reduction scenario. May

48 9. OTHER CONSIDERATIONS ARISING FROM THE SCHEME The approach to communication with policyholders 9.1 Regulations made under FSMA require a communication regarding the proposed transfer to be sent to every policyholder of the parties to the Scheme. However, this requirement may be waived at the discretion of the Court, which will give consideration to issues such as the practicality and costs of sending notices against the likely benefits for policyholders of receiving such communications. In order to comply with the PRA Statement of Policy and SUP G, the companies are expected to notify the policyholders, or interested persons, at least six weeks before the date of the Court hearing at which the application to sanction the Scheme will be heard. 9.2 Prudential will publish a notice in a form approved by the PRA in the London Gazette, the Edinburgh Gazette, the Belfast Gazette and the following national newspapers in the UK: The Times (UK and international edition), The Telegraph, The Guardian, The Observer, The Sunday Times, The Sunday Telegraph, The Financial Times (UK and international edition), The London Evening Standard, The Daily Mail, The Sun, The Mirror, and the Mail on Sunday. In addition Prudential will publish a notice in the following professional publications in the UK: Insolvency News (an online publication), Money Marketing, Financial Adviser, and Pensions Expert. 9.3 Prudential has asked the PRA to notify all EEA states of the proposed Scheme and Prudential will take out notices in national newspapers in those EEA states where a material number of PRIL policyholders are currently resident. These are Cyprus, France, Germany, Italy, Ireland, Portugal and Spain. 9.4 Prudential proposes to send a communication pack to all the transferring policyholders of PRIL for whom Prudential has a valid name and address on its computerised database. The communication pack will include an explanatory letter, the formal notice of the transfer, and a summary of my report. The communication pack will also include information on the options available to the policyholder if they have any concerns about the transfer. 9.5 Policyholders and other interested parties will be able to obtain information from the Prudential website which will contain documents regarding the Scheme including the full Scheme document, this report, a summary of this report, and the communications pack regarding the Scheme. 9.6 Prudential intends to seek a waiver from the requirement to send a written notice to PAC policyholders as they believe it would be disproportionate to do so and in particular: The PAC policies will remain as PAC policies as they are not being transferred under the proposed Scheme; There will be no change to the terms and conditions of any such policy; There will be no change to the governance arrangements applicable to such policies; and There will be no material adverse effect on the security of benefits or to the benefit expectations under any such policy. 9.7 I am satisfied that the proposed approach to communication with policyholders, including the application for the waiver from mailing PAC policyholders, is fair and reasonable. Developments for PRIL and PAC since 30 June There have been a number of developments since the date of the financial figures in this report (30 June 2015) that could have a significant effect on the financial position of PRIL. These include: PRIL entered into four reinsurance arrangements structured as longevity swaps in respect of 4.0 billion of liabilities. o o A treaty with SCOR for an 80% quota share of a number of historical BPA policies with gross liabilities of 1.4 billion ( 1.1 billion quota share ceded). Two treaties with Pacific Life Re for 100% quota share: one in respect of two BPA policies with gross liabilities of 0.6 billion and the other in respect of individual annuities written or reinsured by PRIL with gross liabilities of 1.5 billion. May

49 o A treaty with Swiss Re for 90% quota share of one of the BPA policies entered into during 2015 with gross liabilities of 0.4 billion ( 0.4 billion ceded). PAC entered into a reinsurance arrangement structured as a longevity swap with Hannover Re for an 85% quota share in respect of a subset of individual annuity business written by SAL with gross liabilities of 0.9 billion ( 0.8 billion ceded). PRIL has written a number of new BPA policies with a total premium of 0.3 billion. PRIL has written 0.2 billion of new individual annuity business. PAC paid a dividend ( 358 million) to Prudential plc, PRIL sold a ( 200 million) medium term note to Prudential plc in exchange for cash, and PRIL subsequently loaned the proceeds of this sale to PAC. PRIL s lifetime mortgage assets and certain property assets have been restructured to meet the matching adjustment requirements under Solvency II by setting up two new subsidiaries (PERM and PREI1). 9.9 These transactions are not currently reflected in the financial information shown in this report. However: The PRILPAC QS agreement covers 100% of the PRIL business and therefore it will cover all the policies mentioned above so PAC is already exposed to the risks from these policies; and The draft S2 financials as at 31 January 2016 show that the solvency position of PAC is reduced but remains strong Therefore, based on the information available at this time, I am satisfied that it is unlikely that these transactions will have a material effect on my conclusions I shall present figures including the effect of the transactions listed above, and any other subsequent transactions, and re-evaluate the effect of the implementation of the proposed Scheme on the different groups of affected policyholders in my Supplementary Report If there are any further developments with respect to other Part VII transfers I will deal with the implications for this Scheme, and the policyholders concerned in this Scheme, in my Supplementary Report. Project Atlas 9.13 PAC management have made me aware of a project currently underway in PAC whose aim is to design and implement appropriate retirement solutions to support their customers and the need to appropriately manage the shareholders requirements. One of the main outcomes of Project Atlas is that PAC now has a reduced, selective appetite for new annuity business At this stage, I am not aware of any material impact arising from this that could affect my assessment of the Part VII transfer but this project will evolve over time and, if there are any developments pertinent to the Scheme before the proposed date of the Sanction Court hearing, I will consider those in my Supplementary Report as appropriate I am satisfied that any parts of this project implemented after the Scheme is approved by the Court will be subject to the usual governance and regulatory oversight. The future operation of the Scheme 9.16 If the Scheme is approved by the Court (and subject to any subsequent amendment of the Scheme, as considered below), the Directors of PAC are committed to implementing the Scheme as set out in the Scheme document in accordance with their fiduciary responsibilities under UK company law. Failure to do so may result in the Directors and PAC being in breach of a Court Order if such Court Order were not amended At any time after the Court s sanction of the Scheme, PAC must apply to the Court for sanction of any amendments to it, except where the amendment is considered to be minor or technical, in which case PAC is only required to notify the PRA and FCA The various balance sheet figures for technical provisions and asset values will be calculated by the firm s actuaries and accountants and will be subject to external audit. The business being transferred consists of non-profit May

50 business and therefore the most important aspect is that PAC will continue to meet any guaranteed liabilities, including the annuities in payment, and that sufficient resources are put aside to enable this In my opinion there are reasonable safeguards in place to ensure that, if approved by the Court, the Scheme will be operated as presented to the Court. The effect of the proposed Scheme on previous schemes 9.20 Hogan Lovells has reviewed the past Schemes of PAC and PRIL and has confirmed that there were not enduring provisions in those Schemes which would be affected by this Scheme and which I would therefore need to consider in the context of the proposed transfer. As discussed in Section 3, I am satisfied that it is appropriate for me to rely on the conclusions of Hogan Lovells in relation to the Scheme. Contracts potentially affected by the proposed Scheme 9.21 Hogan Lovells has carried out legal due diligence on the contracts which are potentially affected by the implementation of the proposed Scheme and identified any actions that need to be undertaken/addressed prior to the Effective Date The material issues such as amending security arrangements in connection with certain bulk policies (as set out in Section 7) are already being progressed to ensure that there is no breach of such arrangements following the implementation of the proposed Scheme Having had access to Hogan Lovells s due diligence I am satisfied that there are no impacts on contracts (outside of those addressed in Sections 7, 8 and 9) which I need to consider in the context of the proposed transfer. As discussed in Section 3, I am satisfied that it is appropriate for me to rely on the work of Hogan Lovells in relation to the Scheme. Solvency II requirements 9.24 PAC and PRIL are currently part of the same group and have a similar level of preparedness for the demands of the new Solvency II regime PAC s Board, PRIL s Board, and the senior management of both companies are confident that both companies are able to meet the Solvency II requirements going forward I am satisfied that the implementation of the Scheme will not, in itself, have any effect on the ability of PAC or PRIL to meet the demands of Solvency II. Solvency II approvals Introduction 9.27 PRIL and PAC have both received a number of approvals in relation to Solvency II, and in particular in relation to: The Prudential Group internal model used to calculate the SCRs of PRIL and PAC; The use of the matching adjustment; and The use of the transitional measure on technical provisions. The internal model 9.28 The implementation of the proposed Scheme will change the structure of the Prudential Group and therefore the Prudential UK & E CRO considered whether the changes to the Prudential Group internal model that would be required in order to reflect the proposed Scheme would be classified as a major change and therefore require approval from the PRA Following review, the CRO has concluded that the implementation of the Scheme does not constitute a change of significant complexity, and in particular is not driven by a material change in the risk profile of PAC, and that May

51 therefore any changes required to the Prudential Group internal model should not be designated as a major change and therefore would not require re-approval by the PRA of the internal model This decision was documented in a paper presented to the Prudential internal model governance oversight committee and I am therefore satisfied that the implementation of the Scheme will not result in material changes to the Prudential Group internal model. The matching adjustment 9.31 PRIL and PAC both currently have approval to use the matching adjustment in their Solvency II financial results and PAC s approval includes the reinsured PRIL liabilities. PAC has sought guidance from the PRA on the process required to ensure continued matching adjustment approval in PAC for both the existing PAC business and the transferring PRIL business, and this request is currently under consideration by the PRA In the absence of this PRA guidance, my working assumption in preparing my report has been that, although the implementation of the Scheme will lead to some amendments to the matching adjustment applications, these amendments will be minor and that permission to continue to apply the matching adjustment to the PRIL policies after the implementation of the Scheme will not be withheld. The transitional measure 9.33 The implementation of the Scheme will formalise the economic risk transfer that has already occurred through the PRIL-PAC QS agreement and therefore will not result in a material change to the risk profile of PAC and consequently a recalculation of PAC s transitional measure is not required PRIL does not currently have a transitional measure as, due to the PRIL-PAC QS agreement, the PRIL business contributes to the PAC transitional measure Therefore, in my view, PAC will not be required to submit a reapplication for approval of its transitional measure. The QS reduction scenario 9.36 The QS reduction scenario is a hypothetical scenario but it is reasonable to assume that, in this scenario, PRIL would have applied for and received approval for both the matching adjustment and a transitional measure The process for the transferral of these approvals is not clear but it is not unreasonable to assume that, after the implementation of the proposed Scheme, PAC would be able, with a small amount of extra work, to secure approvals such that it could apply the matching adjustment to the transferred in PRIL business and that it could recalculate its transitional measure Therefore, although in the QS reduction scenario, there would be some further work required in respect of securing PRA approvals for the matching adjustment and the transitional measure on technical provisions, I see no reason why these would not be achievable. The ORSA 9.39 Whilst the implementation of the Scheme will result in a change to Prudential s structure, the economic effect of the Scheme will be minimal due to the PRIL-PAC QS agreement. Therefore I do not expect the implementation of the Scheme to materially affect PAC s assessment of its risk profile in its ORSA In addition, the implementation of the Scheme does not affect the internal assessment of PAC s management in relation to PAC s capital needs I am therefore satisfied that the implementation of the Scheme does not materially affect PAC s assessment of its risk profile or capital needs in its ORSA. The transition of the SRA Framework to Solvency II 9.42 The PAC Board has approved proposals to transition the SRA Framework (as described in Section 4) to Solvency II and these came into effect at the start of The twin peaks structure has been retained with Solvency II Pillars 1 and 2 forming the regulatory and management peaks respectively. May

52 9.43 In order to remain within the updated Solvency II SRA the company must remain capitalised to the twin peaks level after allowance for suitable management actions. The capital buffer required is calibrated such that following a stress event the business remains able to cover its SCR The SRA Framework will be reviewed in Q to reflect: The initial experience of the Solvency II regime in operation. The final 1 January 2016 Solvency II base and stressed valuation results When compared to the current SRA, where there is no such restriction, any PRA restriction on when the transitional measure must be recalculated will not have an adverse effect on the security provided to policyholders by the SRA PAC has made me aware of a number of proposed developments to the PAC SRA Framework but nothing has been finalised at this time. I will comment on this Q2 update to the SRA in my Supplementary Report as appropriate, but the proposed developments for the SRA that I have seen would not have a material adverse effect on the security of policyholder benefits and so would not change my conclusions regarding the Scheme. The CSAs 9.47 As described in Section 4, there is a CSA in place between PAC and Prudential plc whereby support is provided from Prudential plc to PAC. The proposed Scheme would have no impact on this CSA There is a CSA in place between PAC and PRIL which will be terminated by the implementation of the Scheme. Quality of capital 9.49 The implementation of the Scheme will have no material adverse effect on the quality of capital held by PAC. The non-implementation of the Scheme 9.50 If the Scheme does not proceed for any reason, then the PRIL policies will not become policies of PAC and PRIL will remain a wholly owned subsidiary within the PAC shareholder-backed business. Assuming the PRA does not rescind its non-objection, the PRIL-PAC QS agreement will remain in place with the coverage proportion at 100% and the deposit amount calculated according to a fixed percentage of the Solvency II BEL as described in Section The PAC/PRIL CSA would also remain in place In the scenario where the Scheme does not proceed and the PRA rescinds its non-objection to the increase in the PRIL-PAC QS agreement coverage, the reinsurance percentage would be changed to 20% following a similar process to that undertaken when PRA non-objection was obtained for the increase in reinsurance percentage to 100%, including scrutiny from the PRA and due process including (but not limited to): reviews, actuarial and risk reports, and legal scrutiny. If the QS reinsurance coverage was reduced it is likely that PRIL would need to be recapitalised. The reinsurance where PAC or PRIL is the cedant 9.53 Under the terms of the Scheme, there will be no change to the reinsurance contracts for which PAC is the cedant The reinsurance arrangements in respect of which PRIL is the cedant will transfer to PAC (with the exception of the PRIL-PAC QS agreement which will be terminated). Currently the security granted to counterparties on these contracts is in respect of all the long-term insurance business of PRIL, and PAC and PRIL are engaging with the various counterparties to ensure that the security after the implementation of the proposed Scheme will be in respect of the PAC LT SH business. PAC and PRIL will also seek to agree such amendments as may be necessary to the security to ensure it does not result in a breach of any of PAC s existing security I am satisfied that the Scheme will not have a material adverse effect on the reinsurers of the PAC and PRIL policies. May

53 Tax 9.56 The Scheme should have no material impact on the corporation tax position of either PRIL or PAC. No incremental tax will become due on the date of the transfer and the normal corporation tax position will apply to both companies: PRIL will be taxed on any profits that emerge prior to the transfer and PAC will be taxed on subsequent profits The various ancillary transactions such as the transfer of the subsidiaries (PERM and PREI1) to PAC and the transfer of PRIL s shareholder fund assets to PAC, do not give rise to any unusual tax consequences There are not expected to be any changes to the tax position of the transferring PRIL policies or of the existing PAC policies as a result of the implementation of the Scheme, and they will continue to be subject to the same tax regime Therefore, the transfer of PRIL s liabilities to PAC is not expected to have a material impact on the tax position of PRIL or PAC or on the taxation of any policyholders within PRIL or PAC. The costs of the Scheme 9.60 As described in Section 6, PAC and PRIL shall bear their own costs and expenses in respect of the proposed Scheme with the exception of the fees of legal counsel and of my work as Independent Expert, which will be shared equally The costs of the Scheme will be met from the surplus of the PAC shareholder-backed business and the surplus in PRIL as allocated to PAC and PRIL respectively I am satisfied that this is reasonable. Policyholders rights under the FSCS and FOS 9.63 The implementation of the Scheme will have no impact on the rights of the policyholders of PAC or PRIL in relation to the Financial Services Compensation Scheme ( FSCS ) or Financial Ombudsman Service ( FOS ). May

54 10. CONCLUSIONS 10.1 I confirm that I have considered the issues affecting the policyholders of PRIL, and of PAC separately (as set out in Sections 7 and 8) and that I do not consider further subdivisions (other than those in this report) to be necessary I am satisfied that the implementation of the Scheme will not have a material adverse effect on: The security of benefits of the policyholders of PRIL and PAC; The benefit expectations of the policyholders of PRIL and PAC; or The service standards and governance applicable to the PRIL and PAC policies This conclusion also holds in the hypothetical QS reduction scenario in which the QS reinsurance percentage is 20% when the proposed Scheme is implemented. Oliver Gillespie 5 May 2016 Fellow of the Institute and Faculty of Actuaries May

55 APPENDIX 1 SELECTED FINANCIAL INFORMATION BEFORE THE IMPLEMENTATION OF THE SCHEME Solvency II financial information as at 30 June Jun-15 PRIL PAC shareholderbacked business (excl. PRIL) Total PAC shareholderbacked business With-profits business bn bn bn bn Assets (net of current liabilities) Technical provisions (net of transitional measure) Surplus assets SCR Excess capital Capital cover 332% 141% 152% 210% The figures in this table are presented allowing for: - The PRIL-PAC QS agreement which reinsures 100% of the PRIL business to PAC; - The repayment of a contingent loan the loan was from PAC to PRIL and this was repaid on 24 March 2016; and - The expected impact of the proposed dividend to be paid from PRIL to PAC (expected in the third quarter of 2016). May

56 APPENDIX 2 SELECTED FINANCIAL INFORMATION AFTER THE IMPLEMENTATION OF THE SCHEME Solvency II financial information as at 30 June Jun-15 PRIL PAC shareholderbacked business (excl. PRIL) Total PAC shareholderbacked business With-profits business bn bn bn bn Assets (net of current liabilities) Technical provisions (net of transitional measure) Surplus assets SCR Excess capital Capital cover 152% 152% 210% The figures in this table are presented allowing for: - The PRIL-PAC QS agreement which reinsures 100% of the PRIL business to PAC; - The repayment of a contingent loan the loan was from PAC to PRIL and this was repaid on 24 March 2016; and - The expected impact of the proposed dividend to be paid from PRIL to PAC (expected in the third quarter of 2016). May

57 APPENDIX 3 DATA RELIED UPON In addition to discussions (both orally and electronically) with Prudential staff, I have relied upon the public and non-public information shown in the table below in formulating my conclusions: Document The report of the Chief Actuary of The Prudential Assurance Company Limited and Prudential Retirement Income Limited on the proposed Scheme draft 26 April 2016 PRIL Scheme draft 29 April 2016 First Witness Statement of Mr Derek Nigel Beeton draft 29 April 2016 Report of the With-Profits Actuary final 3 May 2016 SIMR governance map 30 December 2015 PRIL Part VII transfer: legal advice from Hogan Lovells International LLP 28 April 2016 The Prudential Assurance Company Limited PRA Returns 2014 The Prudential Retirement Income Limited PRA Returns 2014 PRIL to PAC reinsurance treaty PRIL: Part VII company proposal 11 March 2016 Bulks PRIL Part VII 4 August 2015 PRIL to PAC reinsurance June 2015 AFH report v4.0 UKIO solvency update: 31 January 2016 UKIO Solvency update: end February 2016 Tables for CA&IE reports v10 PRIL: Mailing population approach final 3 May 2016 Project Atlas update for Excom 14 January 2016 May

58 APPENDIX 4 GLOSSARY OF TERMS A glossary of abbreviations used throughout the report is given below. A APS Asset share Actuarial Profession Standards The total premiums paid by policyholders, accumulated by actual investment returns, less attributable expenses, benefits paid and other relevant deductions. B BCRR BEL Base Capital Resources Requirement The best estimate liability under Solvency II C Credit spreads CRR CSA Credit spreads are the differences between corporate bond yields and risk-free (government bond) yields at various bond quality ratings and durations. Capital Resources Requirement Capital Support Arrangement D DCP DCPSF Defined Charge Participating Defined Charge Participating Sub-Fund E EEA European Economic Area Effective Date The date on which the transfer is effected (expected to be 1 October 2016) ELAS Equitable Life Assurance Society EMIR European Market Infrastructure Regulation Equity release Equity release products aim to unlock equity held in domestic homes without the need for individuals to sell their property. There are two main types of equity release product; home reversions and lifetime mortgages. EU European Union F FCA Financial Conduct Authority FSA Financial Services Authority FSMA Financial Services and Markets Act 2000 H Hogan Lovells Hogan Lovells International LLP May

59 I IB ICA ICG Inflation risk Investment risk L Lifetime mortgage Longevity risk LTF LTICR LT SH business Industrial Branch Individual Capital Assessment Individual Capital Guidance In the context of the pension scheme this is the risk that inflation is higher than expected, resulting in inflation-linked annuity benefit outgo being higher than expected. In the context of the pension scheme this is the risk that the investments of the pension scheme perform worse than expected, resulting in a shortfall in the assets available to meet the liabilities of the scheme. Lifetime mortgages are a type of equity release product and they are designed to unlock equity held in domestic properties. A loan is secured against an individual s property and repayment of the capital (and usually the interest) occurs when the property is sold. This is usually upon death of the property owner. In the context of the pension scheme this is the risk that the members of the scheme live longer than expected, resulting in higher than expected liability cash flows for the scheme. The long-term insurance Fund The long-term Insurance Capital Requirement The long-term shareholder backed business M MCR Minimum Capital Requirement O OB ORSA Ordinary Branch Own Risk and Solvency Assessment P PAC The Prudential Assurance Company Limited PAC DCPSF The PAC Defined Charge Participating Sub-Fund PAC GI business The PAC general insurance business PAC LTF The PAC Long Term Business Fund PAC LT SH business The PAC long-term shareholder-backed business PAC NPSF The PAC Non-Profit Sub-Fund PAC shareholder-backed business The business outside the PAC RFF. This consists of the PAC LT SH business, the general insurance business, the subsidiaries of the PAC shareholder fund and all other PAC business outside the ring-fenced funds. PAC SHF The PAC Shareholders Fund PAC SRA The PAC Shareholder Risk Appetite PAC WPSF The PAC With-Profits Sub-Fund May

60 PAL PAN PERM PHKL PHLL PIA PPFM PPL PRA PREI1 PRIL Prudential Annuities Limited Prudential (AN) Limited Prudential Equity Release Mortgages Limited Prudential Hong Kong Limited Prudential Holborn Life Limited Prudential International Assurance Principles and Practices of Financial Management Prudential Pensions Limited Prudential Regulation Authority Prudential Real Estate Investments 1 Limited Prudential Retirement Income Limited Q QS Quota share QS reduction scenario The scenario where the PRIL-PAC QS agreement percentage reinsured is reduced from 100% to 20%. R RCR RFF Resilience Capital Requirement Ring-fenced funds S SAA SACF SAIF SAL SALAS SCR SHF SHIFT asset SIMR SRA Scottish Amicable Account Scottish Amicable Capital Fund Scottish Amicable Insurance Fund Scottish Amicable Life Plc Scottish Amicable Life Assurance Society Solvency Capital Requirement Shareholders Fund The shareholders interest in future transfers asset: the value to PAC s shareholder-backed business of future shareholder transfers from the PAC WPSF The PRA s Senior Insurance Managers Regime The Shareholders Risk Appetite T TAS TCF Technical Actuarial Standards Treating Customers Fairly U UWP Unitised With-Profits May

61 UK & E United Kingdom and Europe W WPA WPC With-Profits Actuary With-Profits Committee May