December 13, 2002
Jonathan G. Katz, Secretary
Re: File No. S7-43-02 - Conditions for Use of Non-GAAP Financial Measures
Dear Mr. Katz:
We are submitting this letter in response to the request of the Securities and Exchange Commission (the "Commission" or the "SEC") for comments regarding the Commission's proposal (the "Proposal") to adopt new rules and amendments to address the public communication of non-GAAP financial measures, as directed by Section 401(b) of the Sarbanes-Oxley Act of 2002. We understand from Release Nos. 33-8145 and 34-46768 that the Commission intends to extend these requirements to non-U.S. companies, including U.K. insurance companies that are foreign private issuers required to file reports under Sections 13(a) and 15(d) of the Securities Exchange Act of 1934 (the "Exchange Act").
We welcome the Proposal as a useful measure to enhance the financial disclosure of Exchange Act reporting companies by eliminating the manipulative or misleading use of non-GAAP financial measures in filings with the Commission and other public disclosures. However, we do not believe that investors would benefit, and may indeed be disadvantaged, if the proposed conditions for the use of non-GAAP financial measures were to apply to the supplementary "achieved profits" financial disclosure described in Section I below. For the reasons set forth in this letter, we respectfully request the Commission to concur that it is unnecessary and inappropriate to extend the Proposal's requirements to supplementary "achieved profits" financial disclosure.
U.K. insurance companies use supplementary achieved profits financial disclosure to report prudent estimates of the value created by life insurance business written and managed during the financial period, and in particular for the long-term duration products traditionally written in the United Kingdom. This value is not adequately reflected in either U.K. or U.S. GAAP reporting. It is therefore important to understand the special nature of these products and the limitations of U.K. GAAP and U.S. GAAP reporting in this regard.
Unlike U.S. with-profits long-term savings and pension products, U.K. versions of with-profits products have a far greater discretionary element as to bonuses declared, both during the term of the policy and at termination which directly impact shareholder profit as explained below. The U.K. practice, whereby the company typically receives one ninth of any bonus declared in the year in which it is either credited to the policy or paid to the policyholder, has a significant impact on earnings in that year. Bonuses broadly reflect investment returns and other profits and losses of the fund earned over the lives of the policies.
Part of the reason for the very significant discretionary element is due to smoothing returns to policyholders, which is a fundamental feature of U.K. with-profits contracts. Typically, annual bonuses will be declared during the life of a policy at comparatively low, but from year to year relatively consistent, levels. Terminal bonuses, which represent a significant proportion of total bonuses on a policy, are usually declared at or near the end of the policy's life. They will broadly reflect the policyholders' share of the balance of investment returns and other profits and losses arising on the with-profits fund, attributable to the policy, that have not been credited through annual bonuses in earlier years.
However, bonuses are smoothed from year to year, and between generations of policyholders, to remove some of the vagaries of short-term volatility in investment markets. For example, where a policy matures in a year when the market is down the company will pay out comparatively more through bonuses, compared to underlying investment returns, than in a year when the market is up, when the bonuses are slightly less, compared to underlying investment returns.
The U.K. GAAP accounting for the declaration by U.K. companies of smoothed amounts by way of discretionary bonuses is significantly affected by the application of the Fund for Future Appropriations (the "FFA"). The FFA was introduced by the E.U. Insurance Accounts Directive, which governs the basis of U.K. GAAP reporting for U.K. life insurance companies, to accommodate the unusual features of U.K. with-profits business. The company either contributes to or draws on the FFA in each year depending on the amount of bonuses to be declared investment performance, and other profits and losses of the with-profits fund for the year. The FFA represents amounts that have yet to be allocated between policyholders and shareholders. The FFA appears in the accounts of U.K. insurance companies as a liability, and movements to and from the FFA do not affect shareholders' income or equity. Under U.K. GAAP, for with-profits business, shareholders' income and equity are in most circumstances solely affected by the declaration of bonuses.
These features can be contrasted with U.S. with-profits products, where the participating nature of the product is different and the element of discretionary bonuses is much less significant. The differences between the U.S. GAAP accounting for U.S. with-profits products and more conventional U.S. life insurance products, by comparison with the U.K. equivalent, are relatively modest.
Furthermore, for U.S. with-profit products there is no U.S. GAAP equivalent to the FFA. U.S. GAAP accounting for U.S. with-profit products is reflected in policyholders' benefit obligations, to the extent of vested liabilities, with all other activity being reflected within shareholders' results. Indeed, more generally, there are few common features between U.S. GAAP accounting for U.S. with-profits products and U.K. GAAP accounting for U.K. with-profits products.
B. Accounting Bases
1. Modified Statutory Basis of Reporting
Insurance companies in the United Kingdom are required to account for their insurance business on the "modified statutory basis" of reporting under U.K. GAAP. In practice, this statutorily required, insurance industry-specific basis of accounting is greatly influenced by regulatory requirements, which have as their main purpose the monitoring of solvency. As a result, it does not record the value accruing to companies through their writing and management of life insurance business during the financial reporting period, in particular for U.K long-term duration insurance products. In addition, specific requirements governing the long-term insurance business have a considerable impact, such as the accounting requirements for the FFA. For U.K. insurance companies, the modified statutory basis results for with-profits business effectively emulate the company's regulatory reporting position and do not, and are not intended to, reflect financial performance in either a traditional accounting sense, for example as under U.S GAAP, or by reference to value based measures.
The modified statutory basis effectively measures with-profits business on a cash flow basis reflecting bonuses declared. Consistent with the smoothing approach used for setting bonuses, as described earlier, the resultant modified statutory basis profit recognised in any particular reporting period will reflect primarily the effect of investment returns, and other income and expenditure of the with-profits fund in earlier reporting periods, rather than the underlying economic performance of the company in that reporting period. This should be contrasted with a conventional accounting treatment, whereby the underlying economic activity within the with-profits fund would be reflected within shareholders results.
2. U.S. GAAP Reporting
U.S. GAAP accounting is a conventional accounting methodology and has been prepared for U.S. insurance products, which are often of relatively short duration. The U.S. GAAP literature for insurance products does not specifically address the peculiar features of U.K. with-profits business. The appropriate treatment though, as applied by Prudential, is to recognise 10% of pre-bonus earnings of the with-profits fund as they arise in any given year. The 10% share reflects the shareholders' interest in distributions from the fund, as bonuses and statutory transfer to shareholders' funds, i.e. consistent with the one-ninth of cost of bonus referred to above in section I.A. Whilst this gives some insight into underlying performance, it does not address the key item of interest for investors which is the value created for shareholders by writing new business and managing in-force business. Neither U.K. GAAP nor U.S. GAAP attributes any value to the very considerable stream of future income attaching to contracts written during the reporting period and the value of prospective future cashflows to shareholders' funds for the in force business.
SEC rules accept the need to recognise value creation for long duration contracts in the manner in which oil and gas companies are required to report in their filings with the SEC. The required additional information on discounted future net cash flows is, in essence, very similar to the value-based information provided under the achieved profits basis of reporting.
3. Achieved Profits Basis of Reporting
In view of the limitations of GAAP and in response to investor desire for a more appropriate measure of performance, major U.K. life insurance companies listed on the London Stock Exchange and elsewhere, including Prudential, disclose supplemental information on shareholders' interests in future cash flows from long-term insurance contracts. In 1995, the basis for preparing such additional information was codified in the "Guidance on Accounting in Group Accounts for Proprietary Companies long-term Insurance Business" issued by the Association of British Insurers, and refined in 2001 by "Supplementary Reporting for long-term Insurance Business (the Achieved Profits Method)" Results of an individual insurance company's long-term business so presented are referred to as the "achieved profits" of that business.
The achieved profits basis of reporting is designed to place a current value on the future projected cash flows to shareholders of a long-term insurance business and to reflect business performance (both in terms of work done and risks taken on) during the accounting period under review. By the time a policy matures, the total profit that has emerged over time using the achieved profits basis is the same as that calculated under U.K. GAAP. However, the time at which the profit is recognised under the achieved profits basis is brought forward due to the recognition of the present value of contracts written, and contracts developing as business in force, during the relevant reporting period. This takes into consideration prudent best estimate assumptions of future income statement line items (including premiums, investment return, lapses and expenses) and using a risk discount rate that allows for risks inherent in the business.
The U.K. insurance industry encourages achieved profits disclosure because it is, in essence, a value-based approach to measuring results that is well-suited to the long-term duration products traditionally written in the United Kingdom.
II. Reasons the Proposal Should Not Extend to Achieved Profits Measures
A. Industry Standard Alternative Basis of Reporting
Because achieved profits are generally viewed as a superior measure of an insurance company's financial performance to U.K. GAAP results, this basis of accounting is relied upon by rating agencies and the analyst community and is used in the management of major U.K. insurance businesses (including with respect to performance incentives). Consequently, although it is a non-GAAP measure for purposes of the Proposal, its use by U.K. insurers by no means reflects, to use the words of the SEC, the "unilateral development and presentation" of financial performance, nor any "independent decision" as to the "best measure" of such performance.
It is an important industry-wide and investor-accepted and approved approach to measuring results. By way of example, the financial position of a leading U.K. insurer making a recent rights issue to the market was discussed, by both the company and analysts, by reference to its achieved profits basis financial position. This emphasis on value based reporting measures for UK life insurance companies is a recurrent and routine feature by market commentators.
We would further note that there is a growing tendency outside the United Kingdom for insurers to report performance using similar valuation techniques, for example, in the Continental European and Canadian life insurance industries.
In addition, achieved profits disclosure is not a selective or misleading presentation of results to which the Proposal is addressed, as such profits are presented as a supplement to full U.K. GAAP results by means of an achieved profits income statement and balance sheet (which include the statutory basis results of non-life insurance business), together with notes thereto. Although no U.K. legislation addresses the provision of supplementary financial information generally, U.K. listing requirements prohibit such information from being overly prominent in results and other market announcements.
This widely accepted industry standard measure is, therefore, not the kind of non-GAAP financial information to which the Proposal is targeted, as it would in no way "obscure GAAP results" or make it "hard for investors to compare an issuer's financial information with other reporting periods and with other companies." On the contrary, it supplements U.K. GAAP results in Prudential's annual report on Form 20-F and provides a U.S. audience with the tools used by the U.K. investment and analyst community to gauge the financial performance of U.K. insurance companies.
Furthermore, given that U.K. GAAP is in the process of being replaced by International Accounting Standards, the continued presentation of achieved profits will provide investors with continuity of financial reporting.
B. The Requirement to Reconcile to GAAP
The purpose of the Proposal's requirement to reconcile non-GAAP measures to GAAP is to ensure transparency of comparable GAAP measures as they affect individual items of net income and assets and liabilities.
This objective is unobtainable by comparing results determined on the achieved profits basis, which necessarily reflect the application of discounted cash flow techniques, with GAAP results, which reflect an historic basis accounting methodology.
An investor seeking to value a company using achieved profits basis reporting reconciled to GAAP would be in significant danger of being misled or confused by a reconciliation between these fundamentally different accounting methodologies.
Such a reconciliation would be extremely complex, expensive and of no value to investors.
Moreover, the application of the Proposal to the achieved profits basis of reporting may result in registrants ceasing to make such information available in the United States, thereby depriving U.S. investors of the tools used by the U.K. investment and analyst community to gauge the financial performance of U.K. insurance companies.
C. Analogous Treatment of Oil and Gas Companies
Because the Commission has made the additional discounted future net cash flow information for oil and gas companies set out in Statement of Financial Accounting Standards (SFAS) No. 69 (paragraphs 30-34) mandatory in filings with the SEC pursuant to Item 302 of Regulation S-K, we assume it is not the type of non-GAAP financial information that the Proposal seeks to regulate. Accordingly, it would be incongruous for the Commission to extend the Proposal's requirements to achieved profits disclosure given the similarities between achieved profits and the information required by SFAS No. 69. As with discounted net cash flows of oil and gas operations, achieved profits results rely on expert assumptions that consider future cash inflows (based on, inter alia, contractual arrangements) and cash outflows (based on, inter alia, best estimates of future policyholder benefits, expense inflation and other costs). Like the achieved profits basis, SFAS No. 69 is a widely accepted industry standard measure of reporting relied upon by the investment and analyst community and by rating agencies.
The principal objective behind the proposed rules-to eliminate the manipulative or misleading use of non-GAAP financial measures and to enhance the comparability associated with the use of such information-would not be furthered by requiring U.K. insurance companies to reconcile achieved profits disclosure to GAAP. This is because achieved profits financial information is not a unilateral or independent measure of reporting, which the Proposal is intended to regulate. Rather, it is an industry standard alternative basis of reporting relied upon by the investment and analyst community in the U.K. and abroad. Investors would stand to gain very little, at the expense of suffering confusion or deprivation of a valuable source of financial information, should the Proposal's GAAP reconciliation requirement extend to such disclosure. Moreover, whether the Proposal extends to achieved profits disclosure or not, registrants will continue to be subject to liability under the U.S. federal securities laws, including the antifraud provisions of the Exchange Act and Rule 10b-5 thereunder.
Please do not hesitate to contact me if you have any questions about this matter.
David Martin, Senior Manager, Group Finance
cc: The Honorable Harvey L. Pitt, Chairman