Investment Management of Life Assets

Thank you, ladies and gentlemen. I would now like to pass the podium to Garth and Kelvin, who will talk about how we manage our funds businesses.

Garth Jones

Clearly, investment returns play a large part in value creation to a life insurance company. (Incomprehensible) liability management is one of the key risk areas of the business. This is not different in Asia, however, with a dynamic environment and a rapidly developing capital markets, investing the life company assets in Asia presents considerable challenges. I'd like to share with you, together with Kelvin, our approach to this aspect of our business, cause we believe it is a considerable advantage to Prudential, a competitive advantage not only within Asia, but globally.

With 12 different life companies across the region, we have a variety of product types, we have different investment environments, we have different currencies and we have different regulations. So, managing these firms presents a complex investment challenge. With £7,5 billion in assets under management scope to add value from getting this aspect of our business correct is clearly material. We believe we had the right architecture, the right people to build (out?) our added value to competitive advantage.

Locally we didn't have to start from scratch with all this, as I'm sure you are aware well aware Prudential has more than 150 years of experience in managing the Life funds. In the UK we have £75 billion of UK Life fund moneys, and those provide the scale to support a dedicated team of people in London, who focus exclusively on the overall ALM in risk control of the assets; that's the portfolio management PMG we call it. This tremendous depth of experience in this area is a huge competitive advantage to Prudential and something which is extremely difficult to replicate. In Asia, we are fortunate enough to have access to this resource, and we leverage this off extensively as we put in place a similar framework within Asia.

This in summary is our very simple infrastructure for managing the Life assets. We use a 3-stage process: the strategic asses allocation, then tactical asset allocation, and then fund management. We walk through these one by one over the next few slides and illustrate that with some examples.

The first step is strategic asset allocation. We determine what the objectives of the fund should be and then set appropriate asset allocation limits and risk profile limits. This sounds simple, but in reality there are a number of factors at play. Those include things like PRE; capital strength; asset availability, you've heard about Vietnam earlier today; and regulatory constraints. In many of the markets we can only invest domestically, for instance. We aim to assess the impact of various asset and liability strategies in terms of value and risk, both to shareholders and to policy holders. This is done using stochastic modelling techniques for the long term, and deterministic scenarios for both the short term and the long term. The strategic asses allocation takes a market neutral view of the outlook of various types of investment.

Just looking at a simple example of how we use stochastic modelling: you'll see that we assess the distribution of shareholder returns over a variety of economic scenarios for a particular asset mix. In this case, asset mix A has a higher mean return without significantly increased risk. We take the results of that stochastic modelling and then look at the capital required and the various strategies involved, the impact on bonuses, PRE and any potential short-term impact, for instance, if there is an investment shock, as we had a number of times over the last ten years.

The overall objective of strategic asset allocation is to define and determine the asset strategy, which will deliver returns in excess to the liabilities, within a level of risk tolerance. Our aim is to add value over the long term, both to share holders and to policy holders, without undue levels of risk.

I now pass to Kelvin to talk you through the next stage of the process, once the strategic asset allocation is in place on a market neutral basis.

Kelvin Blacklock

Thanks, Garth. As Garth mentioned, the SAA, or Strategic Asset Allocation approach, is really meant to be a market neutral kind of methodology, so we're not really putting investment views into that process. Clearly, in the real world we do. We don't live in equilibrium and markets move. There are also many structural constraints that we have to face in Asia, with the asset classes that are available to us for the investment side of the equation. In recognition of that we have developed this second stage to the investment management process, which we call tactical asset allocation, and the key here is really to try and take advantage of either market misplacing in extreme situations, or to take advantage of structural constraints that we have in the funds. So, again, we are implemented relatively large chances to the -if you like- ideal SAA position. So this can have meaningful impact on some of the factors Garth mentioned, such as PRE or capital requirements. So in that sense it's very much an iteration of the original SAA process to understand whether if we move away from that ideal position the fund can sustain this from a capital point of view, from a PRE point of view, or from a regulatory point of view.

What we are trying to achieve here really, in order of magnitude I'm trying to show on the stylised graph here, is that the original SAA is designed to (sort of) outperform the liabilities over long periods of time by taking adjustments to that position, we would look to enhance value by that order of magnitude versus the original SAA position.

Let me show you an example to try and illustrate the point. I'm sure there's many of you aware the credit markets in Asia are relatively new and developing quickly. They are certainly nowhere near the depth and scale that we have in the US market. Many companies have relied on bank financing in Asia, so we don't have the depth of number of companies that borrow in the bonds markets. Some of this stuff I talked about in KL was really (of) the liquidity. If you combine these two factors, (incomprehensible) at the Asian bonds markets are very expensive or there is limited number of companies that we can buy. In sharp contrast to that, the US market is very clearly a deep liquid credit market. So, we have a structural factor at play there when we are considering the asset mix for some of the Life funds. If you layer on top of that the valuation... the chart here just tries to show a snapshot of the valuation differences in Asian credit markets versus the US. I've just chosen Japan, to some extend, but it's a fairly typical example. If you focus on the BBB aspect of the market, you can see that even after a big rally in the US credit spreads, we're getting paid 114-115 for BBB credit risk in the US market. In Japan, in contract, we're getting about 100 basis points less, we're only getting about 14 basis points for BBB credit risk in Japan. Very much driven by too much money chasing too few bonds, in my opinion. So, clearly, from a tactical asset allocation point of view, this presents an opportunity for us. Instead of taking credit exposure in the domestic market, we can take credit exposure in the US market and we get a much deeper, more liquid exposure. And then particularly drawing in the sort of benefits from being in a global group here, we can actually allocate that allocation to the fund, to our colleagues in Chicago. So, we in Asia are not trying to become experts in the US credit market; we are outsourcing a piece of the money to our in-house asset management company in Chicago. And this also has advantages to us. As Garth mentioned, there are many regulatory requirements, capital requirements, so we quite often need a very (dispoke?) portfolio and clearly our colleagues in Chicago are very familiar with these kind of requirements from a customer point of view.

We actually added about 25% of three of the larger Life funds – Singapore, Taiwan and Japan – to (year's fixed) income, various credit risk bands, and this just gives you a sense of the value that's added to these funds over the last 12 months. The red and the blue bars are essentially the US investment grade returns hedged into the local currencies, so for example Singapore hedged into Singapore dollar returns. You can see there are... versus the white bars, which show the local bond market return in the last 12 months. That exposure to US credit has added substantial value to these Life funds. I would stress that this is all done on a pure currency hedged basis. Essentially what we are trying to do is pick up credit spread, pick up diversification and pick up a deeper exposure to credit than we can find in the local Asian markets. Essentially, this trade has worked very well, and I'm sure, as many of you know, we've seen a big compression in credit spreads as well, there is a big decline in US treasure yields. So we are now looking to adjust this tilt and actually diversify further of the international credit exposure, allocating some of money to our colleagues in MMG in London for the European fixed income market.

Let me try and show you another example, also in the bond markets, but this time looking more closer to home into the local currency bond markets. As I discussed in KL, I think many of the region's markets have seen a dramatic decline in yield. You can see that on the left-hand chart here, it shows the actual yields in the Korean bond market. Se we've seen a tremendous decline in that asset yield over the last 5 years from sort of around 20% (at?) the Thai and Asian crisis, to something like 4%. To put that in context: the whole Korean curve is essentially trading on top of the US curve at the moment. For a relatively small country with a relatively high cyclical factor in its growth, that feels a little bit odd just intuitively. Rather than sort of relying on intuitive measure, we've developed kind of more medium-term evaluation measures to assess our understanding of value in these markets. Here is just a simple example of that on the right-hand side it shows the real yield from the Korean bonds. Essentially we just take consensus inflation expectations and take that off the nominal bond yield. Normally you would expect yield around the world to sort of equalise and you can see that at the moment the Korean real yields on the right-hand chart are substantially below the average that (has been) in the rest of the world. And if change in the market in Korea (is staying?) we think with real yields in Korea will only be 2% for the foreseeable future. That -to us- feels like an extreme pricing situation we can try and take advantage of. And for the Korean Life fund, we've actually reduced the ideal neutral duration position by 1 year to try and take advantage of this extreme pricing anomaly.

Another example, this time in the equity markets, is really Korean equities. I guess it's fairly unusual to have two such extreme pricing anomalies in the same market at the same time, but just a simple illustration of that. You know the Korean equity markets have performed quite well over the last 2 or 3 years, outperforming developed markets quite a lot. But the underlying earnings have delivered very strong returns, so the valuation measure, the real earnings yield, if you like, shown on the right-hand side, is actually showing that the market remains very cheap from this valuation measure. So, again, we are trying to illustrate that it's an extreme measure. It hasn't really been in that degree of cheapness, if you like, in a long time, and doesn't seem to sustain itself there for very long. So, again, we've tried to take advantage of that by taking a small 5% allocation for the Korean Life fund into Korean equities.

So, let met just touch on the final stage, which is probably more familiar to all of you, the basis day-to-day fund management aspect of the job. I think the key here is that the fund managers are given a mandate to manage the fund against a clear set of guide lines. That's documented and built in into our front office system, which I think Steve touched on earlier. So in a sense the fund managers don't really have the ability to change the overall risk profile of the fund. They are smaller asset allocation tilt, stock selection tilts within a fairly clearly defined mandate.

It's a little bit hard to see on this chart, just to give you a sense of the relative proportion of valued added that we are seeking from this process. The blue lines: original SAA, desired return, then the dotted line is the sort of TAA contribution. And then overlaid on that is essentially the fund management contribution. Maybe an easier way to look at it is... and this is worthwhile doing over longer periods of time, this is just the sort of cumulative effect of just exclusively just the investment management part of the process. This isn't really rocket size. This is very much what fund manager do around the world. We take relatively small tilts against the benchmark, like I'm trying to illustrate here, 1% or 2% tilts against the neutral position that we have and then within the stock selection we are really trying to add maybe 1% per annum within each of the asset buckets. So you know the guys in America have been tasked to trying to add 50 basis points per annum over an index that we've given them. So this just illustrates the kind of returns and obviously we don't get it right all the time. The global equity performance in this example is issuing a negative return. So, again, the idea is that we have a balanced set of underlying sub-portfolios dedicated to individual managers with clear mandates.

I guess, this is all theory and you want to see is it working in practise and what's the value add? This just shows the sort of cumulative performance for a number of our funds. If you just bear with me, I'll explain the charts. On the left-hand side are the Life funds, which is essentially the general accounts for the larger businesses in Asia. If you focus on the 3-year bar, essentially that shows about that 80% of these funds outperform their benchmark in the order of 3% per annum. And more importantly, the progression is important. So, we are not having a 3% out-performance in 1 year, we're having roundabout 50 basis points, 100 basis points and as that builds up over 2 or 3 years we end up in a 3% out-performance situation over time. Similarly, on the right-hand side, the Unit Linked funds show a similar sort of risk profile. There is actually a larger number of funds here across more markets, so it's -if you like- a more meaningful representation of this process working. And again, the blue bar over the 3-year period shows that 80% of these Unit Linked funds are out-performing by a magnitude of more than 3% versus their benchmark.

Maybe another way to show that, which is perhaps more visible, is just trying to turn this into a hard cash number. So we just looked at this in a very simplistic manner taking the average out-performance for the Life funds in several countries and just multiplying that by the average funds under management over the last 3 years. And you can see that for the larger Asian Life funds that degree of out-performance is translating into about £40 to £50 million worth of value add to these business. Obviously, the UK Life fund is a much larger asset (bulk?) in the first place, but the same degree of out-performance is translating into a larger number, something like £100 million worth of out-performance for that business.

I guess, one other question around all of this is the risk control and corporate governance. I'd like to just pass you back to Garth, who covers that aspect of this investment of this investment management process.

Garth Jones

Thanks, Kelvin. Yes, this slide sets out our governance architecture in a simple diagram. We have a very strong governance architecture in place, both at a local level and at a regional level. We have a strategic asset allocation steering committee at the regional level. That has actuaries on it, has investment managers and it's lead by one of the actuaries within Pete Lloyd's team, primarily from a liability perspective. The TA steering committee also works on the regional level, has exactly the same members, but in that case is driven by a member of Kelvin's team, who is a quant economist, because it's more asset lead. Each local investment committee has obviously the local fiduciary duty and responsibility for the investments. We discuss with the local investment committee the SAA and TAA recommendations and the TAA and SAA discussions that we have are very useful that there is ownership at a local level, that people are comfortable that those will discharge their duties obviously; and also useful in terms of input for instance what is the local PRE, what is...(inaudible) round, are there any changes that have been thought about, and so on.
We operate what's called the "two green lights system". One at the local level and one regional level, as a check-and-balance in the system. And the risk profile of the fund is then wrapped up within an investment management agreement and if the SAA or TAA changes then clearly the investment management agreement changes and that is then passed to the fund managers. And we put those in place, even where the funds are managed internally; so even if we have a local investment department that handles some of the assets, we will have an internal investment management agreement that deals with that.

So, in summary we believe that we have a very strong competitive in asset liability management; we have a robust process and architecture that is sustainable; we leverage the strengths of the Prudential Group, particularly the PMG in London; we have a track record of delivering consistent risk controlled out-performance; and we have a great track-record of adding significant value without taking undue risk. Thank you.

I now pass over to Mark.

Mark Norbom

Thanks, guys. Well, we'll bring up some chairs and we will go into the next Q&A. I just wanted to make a few comments. First, in terms of operating excellence: I mean, we brought up a few of the major ways in which we're trying to build our business to be greater than the sum of its parts. The people side to sustain our growth, compliance to sustain the trust in our company, consolidation of our scale and best practises and the Genesis model and the hub-and-spoke model, to drive the productivity and service levels to our customers. And then the investment management side, which, I think, Kelvin and Garth showed, is controlled but also is flexible enough to give us the opportunity to take advantage of in-balances or opportunities in the diversity of markets that we operate in. So, that'd be great.

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