18 - Capital
Capital management objectives
Aviva’s capital management philosophy is focused on capital efficiency and effective risk management to support a progressive dividend policy and EPS growth. Rigorous capital allocation is one of the group’s primary strategic priorities and is ultimately governed by the Group Executive Committee.
The group’s overall capital risk appetite is set and managed with reference to the requirements of a range of different stakeholders including shareholders, policyholders, regulators and rating agencies. In managing capital we seek to:
- maintain sufficient, but not excessive, financial strength to support new business growth and satisfy the requirements of our stakeholders;
- optimise our overall debt to equity structure to enhance our returns to shareholders, subject to our capital risk appetite and balancing the requirements of the range of stakeholders;
- retain financial flexibility by maintaining strong liquidity, including significant unutilised committed credit lines and access to a range of capital markets;
- allocate capital rigorously across the group, to drive value adding growth in accordance with risk appetite;
- increase the dividend on a basis judged prudent, while retaining capital to support future business growth, using dividend cover on an IFRS operating earnings after tax basis in the 1.5 to 2.0 times range as a guide.
Capital resources
The primary sources of capital used by the group are equity shareholders’ funds, preference shares, subordinated debt and borrowings. We also consider and, where efficient to do so, utilise alternative sources of capital such as reinsurance and securitisation in addition to the more traditional sources of funding. Targets are established in relation to regulatory solvency, ratings, liquidity and dividend capacity and are a key tool in managing capital in accordance with our risk appetite and the requirements of our various stakeholders.
Overall, the group has significant resources and financial strength. The ratings of the group’s main operating subsidiaries are AA/AA- (“very strong”) with a stable outlook from Standard & Poor’s, Aa3 (“excellent”) with a stable outlook from Moody’s and A+ (“Superior”) with a stable outlook from AM Best. These ratings reflect the group’s strong liquidity, competitive position, capital base, increasing underlying earnings and strategic and operational management. The Group is subject to a number of regulatory capital tests and also employs economic capital measures to manage capital and risk.
Capital allocation
Capital allocation is undertaken based on a rigorous analysis of a range of financial, strategic, risk and capital factors to ensure that capital is allocated efficiently to value adding business opportunities. A clear management decision making framework, incorporating ongoing operational and strategic performance review, periodic longer term strategic and financial planning and robust due diligence over capital allocation is in place, governed by the Group Executive Committee and Group Capital Management Committee. These processes incorporate various capital profitability metrics, including an assessment of return on capital employed and internal rates of return in relation to hurdle rates to ensure capital is allocated efficiently and that excess business unit capital is repatriated where appropriate.
Different measures of capital
In recognition of the requirements of different stakeholders, the group measures its capital on a number of different bases, all of which are taken into account when managing and allocating capital across the group. These include measures which comply with the regulatory regimes within which the group operates and those which the directors consider appropriate for the management of the business. The primary measures which the group uses are:
(i) Accounting bases
The group reports its results on both an IFRS and a European Embedded Value basis. The directors consider that the European Embedded Value principles provide a more meaningful measure of the long-term underlying value of the capital employed in the group’s life and related businesses. This basis allows for the impact of uncertainty in the future investment returns more explicitly and is consistent with the way the life business is priced and managed. Accordingly, in addition to IFRS, we analyse and measure the net asset value and total capital employed for the group on this basis. This is the basis on which group return on equity is measured and against which the corresponding Group target is expressed.
(ii) Regulatory bases
Individual regulated subsidiaries measure and report solvency based on applicable local regulations, including in the UK the regulations established by the Financial Services Authority (FSA). These measures are also consolidated under the European Insurance Groups Directive (IGD) to calculate regulatory capital adequacy at an aggregate Group level. The Group has fully complied with these regulatory requirements during the year.
(iii) Rating agency bases
The group’s ratings are an important indicator of financial strength and maintenance of these ratings is one of the key drivers of capital risk appetite. Certain rating agencies have proprietary capital models which they use to assess available capital resources against capital requirements, as a component of their overall criteria for assigning ratings. In addition, rating agency measures and targets in respect of gearing and fixed charge cover are important in evaluating the level of borrowings utilised by the group. While not mandatory external requirements, in practice rating agency capital measures tend to act as one of the primary drivers of capital requirements, reflecting the capital strength required in relation to our target ratings.
(iv) Economic bases
The group also measures its capital using an economic capital model that takes into account a more realistic set of financial and non-financial assumptions. This model has been developed considerably over the past few years and is increasingly relevant in the internal management and external assessment of the group’s capital resources. The economic capital model is used to assess the group’s capital strength in accordance with the Individual Capital Assessment (ICA) requirements established by the FSA. Further developments are planned to meet the emerging requirements of the Solvency II framework.
Accounting basis and capital employed by segment
The table below shows how our capital, on an EEV basis, is deployed by segment and how that capital is funded.
| 30 June 2008 £m |
31 December 2007 £m |
|
|---|---|---|
| ||
| Long-term savings | 22,900 | 23,272 |
| General insurance and health | 5,212 | 5,487 |
| Other business including fund management | 684 | 1,056 |
| Corporate1 | (32) | (31) |
| Total capital employed | 28,764 | 29,784 |
| Financed by: | ||
| Equity shareholders’ funds | 18,672 | 20,253 |
| Minority interests | 3,385 | 3,131 |
| Direct capital instrument | 990 | 990 |
| Preference shares | 200 | 200 |
| Subordinated debt | 3,911 | 3,054 |
| External debt | 721 | 1,257 |
| Net internal debt | 885 | 899 |
| 28,764 | 29,784 | |
| Net asset value per share – EEV basis | 702p | 772p |
At 30 June 2008 the group had £28.8 billion (31 December 2007: £29.8 billion) of total capital employed in its trading operations, measured on an EEV basis. Net asset value per ordinary share, based on equity shareholders’ funds, has decreased to 702 pence per share (31 December 2007: 772 pence per share).
Total capital employed is financed by a combination of equity shareholders’ funds, preference capital, subordinated debt and borrowings. In addition to our external funding sources, we have certain internal borrowing arrangements in place which allow some of the assets that support technical liabilities to be invested in a pool of central assets for use across the group. These internal debt balances allow for the capital allocated to business operations to exceed the externally sourced capital resources of the group. Although intra-group in nature, they are included as part of the capital base for the purpose of capital management. These arrangements arise in relation to the following:
- Certain subsidiaries, subject to continuing to satisfy standalone capital and liquidity requirements, loan funds to corporate and holding entities, these loans satisfy arms length criteria and all interest payments are made when due.
- Aviva International Insurance (AII) Ltd acts as both a UK general insurer and as the primary holding company for the group’s foreign subsidiaries. Internal capital management mechanisms in place allocate a portion of the total capital of the company to the UK general insurance operations. These mechanisms also allow for some of the assets backing technical liabilities to be made available for use across the group. Balances in respect of these arrangements are also treated as internal debt for capital management purposes.
Net internal debt represents the balance of the above amounts due from corporate and holding entities, less the tangible net assets held by these entities.
On 13 May 2008 the group issued £0.8 billion equivalent of Lower Tier 2 hybrid in a dual-tranche transaction (£400 million and €500 million). £0.6 billion of the proceeds was used to repay short-term Commercial Paper borrowings. This transaction had a positive impact on Group IGD Solvency and Economic capital measures.
Financial leverage, the ratio of the group’s external senior and subordinated debt to EEV capital and reserves, was 20% (31 December 2007: 17%). Fixed charge cover, which measures the extent to which external interest costs, including subordinated debt interest and preference dividends, are covered by EEV operating profit was 11.8 times (31 December 2007: 9.8 times).
Regulatory bases
Regulatory basis – Group: European Insurance Groups Directive
| 30 June 2008 |
31 December 2007 |
|
|---|---|---|
| Insurance Groups Directive (IGD) excess solvency | £1.8 billion | £2.9 billion |
| Cover (times) over EU minimum | 1.3 times | 1.5 times |
The group has a regulatory obligation to have positive solvency on a regulatory IGD basis at all times. The group’s risk management processes ensure adequate review of this measure. At 30 June 2008, the estimated excess regulatory capital was £1.8 billion (31 December 2007: £2.9 billion). This measure represents the excess of the aggregate value of regulatory capital employed in our business over the aggregate minimum solvency requirements imposed by local regulators, excluding the surplus held in the group’s UK life funds. The minimum solvency requirement for the group’s European businesses is based on the Solvency I Directive. In broad terms, for EU operations, this is set at 4% and 1% of non-linked and unit-linked life reserves respectively and for Aviva’s general insurance portfolio of business is the higher of 18% of gross premiums or 26% of gross claims, in both cases adjusted to reflect the level of reinsurance recoveries. For the Group’s major non-European businesses (the US, Australia and Canada) a risk charge on assets and liabilities approach is used. The IGD is a pure aggregation test with no credit given for the considerable diversification benefits of Aviva.
Our excess solvency of £1.8 billion reflects a net decrease of £1.1 billion since 31 December 2007 mainly reflecting the market downturn over the last six months.
Regulatory basis – General insurance and International
Our principal UK general insurance regulated subsidiary is Aviva International Insurance Group (AII). The combined businesses of the AII group have a strong solvency position as set out in the table below. On an aggregate basis the estimated excess solvency margin (representing the regulatory value of excess available assets over the required minimum margin) amounted to £1.9 billion (31 December 2007: £3.5 billion) after covering the minimum capital base of £6.3 billion (31 December 2007: £5.5 billion).
| 30 June 2008 |
31 December 2007 |
|
|---|---|---|
| Capital resources | £8.2 billion | £9.0 billion |
| Capital resources requirement | £6.3 billion | £5.5 billion |
| Solvency surplus | £1.9 billion | £3.5 billion |
| Cover | 1.3 times | 1.6 times |
Regulatory basis – Long-term businesses
For the group’s non-participating worldwide life assurance businesses, our capital requirements, expressed as a percentage of the EU minimum, are set for internal management and embedded value reporting purposes as the higher of:
- Target levels set by reference to internal risk assessment and internal objectives, taking account of the level of operational, demographic, market and currency risk
- Minimum capital level (i.e. level of solvency capital at which local regulator is empowered to take action)
The required capital across the group’s life businesses varies between 100% and 250% of EU minimum or equivalent. The weighted average level of required capital for the group’s non-participating life business, expressed as a percentage of the EU minimum (or equivalent) solvency margin has remained stable at 130% (31 December 2007: 130%).
These levels of required capital are used in the calculation of the group’s embedded value to evaluate the cost of locked in capital. At 30 June 2008 the aggregate regulatory requirements based on the EU minimum test amounted to £5.5 billion (31 December 2007: £5.1 billion). At this date, the actual net worth held in the group’s long-term business was £9.7 billion (31 December 2007: £10.5 billion) which represents 176% (31 December 2007: 205%) of these minimum requirements.
Regulatory basis – UK Life with-profit funds
The available capital of the with-profit funds is represented by the realistic inherited estate. The estate represents the assets of the long-term with-profit funds less the realistic liabilities for non-profit policies within the funds, less asset shares aggregated across the with-profit policies and any additional amounts expected at the valuation date to be paid to in-force policyholders in the future in respect of smoothing costs, guarantees and promises. Realistic balance sheet information is shown below for the three main UK with-profit funds; CGNU Life, Commercial Union Life Assurance Company (CULAC) and Norwich Union Life & Pensions (NUL&P). These realistic liabilities have been included within the long-term business provision and the liability for insurance and investment contracts on the group’s IFRS balance sheet at 30 June 2008 and 31 December 2007.
| 30 June 2008 |
31 December 2007 |
||||||
|---|---|---|---|---|---|---|---|
| Estimated realistic assets £bn |
Estimated realistic liabilities1,2 £bn |
Estimated realistic inherited estate3 £bn |
Estimated risk capital margin4 £bn |
Estimated excess £bn |
Estimated excess £bn |
||
| |||||||
| CGNU Life | 13.5 | (12.4) | 1.1 | (0.3) | 0.8 | 1.1 | |
| CULAC | 13.0 | (12.0) | 1.0 | (0.3) | 0.7 | 0.8 | |
| NUL&P5 | 23.3 | (21.6) | 1.7 | (0.4) | 1.3 | 1.3 | |
| Aggregate | 49.8 | (46.0) | 3.8 | (1.0) | 2.8 | 3.2 | |
Investment mix
The aggregate investment mix of the assets in the three main with-profit funds at 30 June 2008 was:
| 30 June 2008 % |
31 December 2007 % |
|
|---|---|---|
| Equity | 30% | 37% |
| Property | 13% | 13% |
| Fixed interest | 42% | 37% |
| Other | 15% | 13% |
| 100% | 100% |
The equity backing ratios, including property, supporting with-profit asset shares are 69% in CGNU Life and CULAC and 68% in NUL&P. New with-profit business is mainly written through CGNU Life.
Reattribution of inherited estate
Aviva has been pursuing the possibility of a reattribution of the inherited estate of two of Norwich Union's with-profit funds (CGNU Life and Commercial Union Life Assurance Company (CULAC)). As part of this process in November 2006 Aviva appointed Clare Spottiswoode as independent Policyholder Advocate, a consumer-led role created to represent policyholders under the Financial Services Authority (FSA) rules governing reattribution. Following eighteen months of negotiations between Aviva and the Policyholder Advocate on the reattribution of the inherited estate of the two funds, negotiations have now concluded and an offer of £1 billion has been agreed for the one million eligible policyholders. The intention is to make an offer later this year to each policyholder, that will give them a free choice as to whether to accept the offer or not in a voting process. Norwich Union and Aviva will take into account a number of factors (including financial and practical considerations) before finally deciding to make offers to individual eligible policyholders. The FSA has conducted a preliminary review and has not objected to the offer being put to policyholders, and will make its final review once the policyholder election is complete. Once the election process concludes, the reattribution and associated fund transfer will also require the approval of the High Court and final confirmation by the boards of Aviva and the relevant Norwich Union Life companies. Payments are currently expected to be made in summer 2009.
Regulatory basis – Solvency II
Solvency II represents new legislation which proposes a fundamental review of the capital adequacy regime for the European insurance industry. It aims to establish a revised set of EU-wide capital requirements and risk management standards that will replace the current requirements applicable to European insurance firms and groups. Solvency II is a unique opportunity to modernise the regulation of insurance companies and groups. Aviva’s vision for Solvency II is to establish a risk based and transparent European ‘best in class’ solvency regime, under which the industry’s stakeholders, including customers, investors and regulators, will have greater confidence in the entire industry. Aviva is fully committed to contributing to its success and continues to play an active role in its development through participation in the consultation and quantitative impact studies run by the European Commission and European regulators, as well as working with industry forums and working parties.
Solvency II has the potential to align regulatory capital with internal risk processes and measures, provided the possible problems and pitfalls are avoided. The European Commission published its draft proposal for the high level principles, “Level 1 Framework Directive”, in July 2007. Negotiations on the Framework Directive are gradually drawing to a conclusion and it is hoped significant political agreement will be reached by the end of 2008. It is envisaged that the full suite of rules will be in place by the end of 2010, with full implementation by 2012.
Rating agency bases
Ratings are important in supporting access to debt capital markets and in providing assurance to business partners and policyholders over the financial strength of the group and its ability to service contractual obligations. In recognition of this, the group has solicited rating relationships with a number of rating agencies. Rating agencies generally assign ratings based on an assessment of a range of financial (e.g. capital strength, gearing and fixed charge cover ratios) and non-financial (e.g. competitive position and quality of management) factors. Managing our capital and liquidity position in accordance with the group’s target rating levels is a core consideration in all material capital management and capital allocation decisions.
Economic bases
The group uses a risk based capital model to assess its economic capital requirements and to aid in risk and capital management across the group. This model is also used to support the group’s Individual Capital Assessments (ICA) which are reported to the FSA for all UK regulated insurance businesses. The model is based on a framework for identifying the risks to which business units, and the group as a whole, are exposed. A mixture of scenario based approaches and stochastic models are used to capture the group’s market risk, credit risk, insurance risk and operational risk. Scenarios are specified centrally to provide consistency across businesses and to achieve a minimum standard. Where appropriate, businesses also supplement these with additional risk models specific to their own risk profile. When aggregating capital requirements at business unit and group level, we allow for diversification benefits between risks and between businesses, with restrictions to allow for non-fungibility of capital when appropriate. This means that the aggregate capital requirement is less than the sum of capital required to cover all of the individual risks.
For internal management purposes, our economic capital model is calibrated to our target capital adequacy rating. Financial modelling techniques enhance our practice of active risk and capital management, ensuring sufficient capital is available to protect against unforeseen events and adverse scenarios. Our aim continues to be the optimal usage of capital through appropriate allocation to our businesses. We continue to develop our economic capital modelling capability for all our businesses as part of our development programme to increase the focus on economic capital management.
The FSA uses the results of our ICA process when setting target levels of capital for the UK regulated businesses. In line with FSA requirements, the ICA estimates the capital required to mitigate the risk of insolvency to a 99.5% confidence level over a one year time horizon (equivalent to events occurring in 1 out of 200 years) against financial and non-financial tests.
Capital Generation and Utilisation
As part of its capital management processes, the group regularly reviews the generation and deployment of capital. The table below demonstrates the net capital generation of the group on a regulatory basis. The net capital generated can be considered as a measure of the change in the group’s surplus capital on a regulatory basis. A reconciliation of the movement in IGD surplus is also shown.
| 30 June 2008 £bn |
30 June 2007 £bn |
31 December 2007 £bn |
|
|---|---|---|---|
| Operational capital generation: | |||
| Life in-force profits | 1.1 | 1.1 | 1.9 |
| New business strain | (0.4) | (0.3) | (0.6) |
| Non-life profits | 0.3 | 0.4 | 0.6 |
| Operational capital generated | 1.0 | 1.2 | 1.9 |
| Increase in capital requirements | (0.3) | (0.2) | (0.5) |
| Free operational capital generated | 0.7 | 1.0 | 1.4 |
| Interest cost | (0.1) | (0.1) | (0.2) |
| External dividend | (0.6) | (0.5) | (0.9) |
| Scrip dividend | 0.2 | 0.2 | 0.3 |
| Capital generation after financing | 0.2 | 0.6 | 0.6 |
| Investment return variances and economic assumption changes | (1.7) | 0.5 | 0.2 |
| Profit on disposals | – | – | 0.1 |
| Capital raising | 0.8 | – | – |
| Cost of acquisitions | (0.3) | (0.1) | (0.6) |
| Qualifying assets acquired net of capital requirements | 0.1 | – | 0.1 |
| Pension funding and restructuring costs | (0.4) | – | (0.1) |
| Foreign exchange impact on surplus capital | 0.1 | (0.1) | 0.2 |
| Other | (0.1) | 0.1 | – |
| Net capital (consumed)/generated | (1.3) | 1.0 | 0.5 |
| Reconciliation to movement in IGD surplus | |||
| Opening IGD surplus | 2.9 | 3.5 | 3.5 |
| Net capital (consumed)/generated | (1.3) | 1.0 | 0.5 |
| Regulatory changes | (0.4) | (0.2) | (0.4) |
| Additional capital requirements over regulatory minimum | 0.2 | 0.1 | 0.4 |
| Non-IGD qualifying capital generated within life funds | 0.3 | (0.4) | (0.6) |
| Minorities | (0.1) | (0.1) | (0.2) |
| Other | 0.2 | 0.1 | (0.3) |
| Closing IGD surplus | 1.8 | 4.0 | 2.9 |
Free operational capital generated represents the net of the following:
- Operating profits emerging on a statutory basis for the life in-force business, net of new business strain and before any changes in inadmissible assets, and IFRS operating profits earned by the group’s non-life businesses.
- The increase in capital requirements of the group’s ongoing businesses. Capital requirements represent target operating capital levels rather than regulatory minimum levels, as this is considered a better reflection of capital utilised in the business. For the life businesses this is the capital used in the calculation of the group’s embedded value to evaluate the cost of locked in capital. For general insurance businesses we have calculated target capital based on two times the regulatory minimum. Where appropriate, the increase in capital requirements shown has been adjusted for the impact of foreign exchange movements and other one off changes to required capital.
The reconciliation of the net capital generated to the movement in the group’s IGD surplus takes into account capital generated within life funds which fall outside the perimeter of the group’s IGD calculation.
