Aviva plc: Adoption of Aviva Market Consistent Embedded Value (MCEV) methodology and impact on results
H – Impact of MCEV methodology for life and related businesses
The MCEV methodology has introduced the following key changes to embedded value reporting:
- economic assumptions are now market consistent;
- explicit allowance is made for the cost of non-hedgeable risk;
- required capital also takes account of business unit targets; and,
- operating assumptions have been reviewed to confirm that they are probability-weighted, mean best estimates of expected future experience.
In summary, the impact of the restatement to MCEV varies by product type.
Risk contracts, for example term assurances, tend to increase in value under MCEV compared to EEV. This is because these contracts contain lower than average levels of market risk. Under EEV, an aggregate discount rate was used for all contracts. Under MCEV, market and non-market risks are allowed for separately and explicitly.
The impact on savings contracts, for example unit-linked contracts, tends to be broadly neutral. If the assets backing the savings contracts are predominantly invested in lower risk assets then the value will tend to increase as the lower discount rate applied to future cashflows more than offsets the reduced assumed future investment returns. However, contracts with significant guarantees tend to reduce in value under MCEV as the market consistent cost of the guarantees is typically higher than under EEV.
Immediate annuities, deferred annuities and other contracts where shareholders are exposed directly to asset risk tend to reduce in value. MCEV anticipates no profits at outset from the taking of asset risk, whereas EEV recognised the expected profits from taking asset risk, net of expected defaults. This approach is consistent with the market price of corporate bonds and equities. The profits from taking asset risk will be recognised through the earnings from existing business over the life of the contracts. These types of contracts have been referred to as "spread contracts" in this document.
The tables below show how the introduction of MCEV methodology has impacted the results. In particular, they detail the impact of each element of the changes in the move from EEV to MCEV.
Impact of MCEV methodology on embedded value
The embedded values on an MCEV basis at 31 December 2007 and 31 December 2006 were 1% lower at £20,096 million (EEV: £20,319 million) and £18,004 million (EEV: £18,098 million), respectively. This is in line with our expectations, as previously stated, that the group's embedded value would not significantly change as a result of adopting MCEV in a stable market. This reflects Aviva's diversity geographically and by product mix.
The embedded value on an MCEV basis at 30 June 2008 reduced by 6% to £18,579 million (EEV: £19,867 million) due to turbulent market conditions which resulted in the adverse impact of changes in economic assumptions. This is due to the difference in treatment of credit spreads under MCEV as credit spreads widened in the first half of 2008.
Impact of changes in economic assumptions (including discounting at risk-free rate)
In 2008, under EEV, the impact of credit spreads widening was reduced as an allowance was taken for higher expected future investment income which broadly offset the fall in market values within the net worth. Under MCEV, however, no future spreads in excess of risk-free are allowed for. As a result, when credit spreads increased in the first half of 2008, the market value of assets reduced resulting in adverse economic variances with no increase in projected future investment cash flows. This compares with a favourable impact on transition from EEV to MCEV of economic assumptions changes at the end of 2007 and 2006 which reflected the lower discount rate applied under MCEV. This partly offset the cost of residual non-hedgeable risk, the impact of changes in operating assumptions and model changes.
Cost of residual non-hedgeable risk
The cost of residual non-hedgeable risk allows for risks not allowed for elsewhere in the value of future profits from in-force and new business. The cost of residual non-hedgeable risk is equivalent to a 2.5% charge applied to the group-diversified economic capital required to cover the non-hedgeable risks over the life of the contracts. The cost of residual non-hedgeable risk has increased over the restatement period as the required levels of economic capital for non-hedgeable risks have increased.
Changes to required capital
The change to required capital reflects the consideration of business unit targets and the review of economic capital requirements. View the Capital requirements by country under the two bases. Capital requirements have increased for certain businesses under MCEV, notably the US and the Netherlands. For the UK annuity business capital was actually higher in 2006 under EEV than MCEV at 150% of the EU minimum. This was revised down to 100% from 2007 onwards, reflecting the capital fungibility within the UK. Therefore the change to 110% for the UK annuity business under MCEV represents a reduction in capital for 2006 but an increase for 2007 and 2008.
Impact of changes in operating assumptions
This reflects the updating of lapse assumptions for UK, Poland, the US and Spain. These changes are described in Section I.
Other
This mainly reflects modelling refinements in the US, France and the Netherlands.
| Embedded value | Reviewed 30 June 2008 £m |
Audited 31 December 2007 £m |
Audited 31 December 2006 £m |
|---|---|---|---|
| EEV basis as reported | 19,867 | 20,319 | 18,098 |
| Impact of changes in economic assumptions (including discounting at risk-free rate) | (365) | 521 | 624 |
| Cost of residual non-hedgeable risk | (604) | (568) | (491) |
| Changes to required capital | (86) | (69) | (6) |
| Impact of changes in operating assumptions | (93) | (134) | (155) |
| Other | (140) | 27 | (66) |
| MCEV basis gross of minority interests | 18,579 | 20,096 | 18,004 |
| Minority interests | (2,002) | (1,848) | (1,498) |
| MCEV basis net of minority interests | 16,577 | 18,248 | 16,506 |
Analysed by:
| MCEV Restated 6 months 2008 £m |
EEV Reported 6 months 2008 £m |
MCEV Restated Full year 2007 £m |
EEV Reported Full year 2007 £m |
MCEV Restated Full year 2006 £m |
EEV Reported Full year 2006 £m |
|
|---|---|---|---|---|---|---|
| Reviewed | Reviewed | Audited | Audited | Audited | Audited | |
| United Kingdom | 5,776 | 6,547 | 6,911 | 7,106 | 6,535 | 6,636 |
| Europe | 11,109 | 10,949 | 11,293 | 10,988 | 9,690 | 9,524 |
| North America | 974 | 1,714 | 1,206 | 1,588 | 1,268 | 1,478 |
| Asia Pacific | 720 | 657 | 686 | 637 | 511 | 460 |
| Embedded value gross of minority interests | 18,579 | 19,867 | 20,096 | 20,319 | 18,004 | 18,098 |
In the United Kingdom, the embedded value has reduced on an MCEV basis compared to EEV due to business mix as the lower embedded value of annuities more than offset the higher value of term assurance. This effect increases over the restatement period as corporate bond yields have increased.
The impact of MCEV on the embedded value in Europe is relatively neutral reflecting the diversity of our European portfolio by geography and product. Excluding the Netherlands, the Europe business mix is predominantly risk and savings. In the Netherlands, contracts and their backing assets contain a significant amount of equity and credit risk. This tends to reduce the value under MCEV. Overall, the impact on the aggregate Europe embedded value is limited.
North America sells predominantly spread-type contracts. As MCEV makes no allowance for investment returns in excess of the risk-free rate, the MCEV value reduces substantially compared to EEV. The impact of adopting MCEV has increased over the restatement period as risk-free rates have reduced and corporate bond spreads have increased.
The embedded value of our businesses in Asia Pacific increases under MCEV as EEV included territory-specific additional margins in the risk discount rate. This has been changed to an allowance in the cost of residual non-hedgeable risks under MCEV which results in an increase in value. Additionally, the Asia Pacific business is predominantly risk and savings business.
Impact of MCEV methodology on new business
The group's life and pensions sales, as measured by the present value of new business premiums (PVNBP), in the first half of 2008 were 5% higher at £18,214 million on an MCEV basis (EEV: £17,283 million) and for 2007 were 4% higher at £32,722 million (EEV: £31,600 million). PVNBP is higher under MCEV as this reflects the use of the risk-free discount rate. This is lower than the risk discount rate used under EEV which included a risk margin to allow for both economic and non-economic risks that were not explicitly allowed for elsewhere.
The impact of economic assumption changes depends on the proportion of regular premium business and the difference between the EEV risk discount rate and the risk-free rate. As the risk free rate has reduced between 2007 and half-year 2008, the impact on PVNBP increased.
The new business tables below provide life and pensions sales, the value of new business and new business margins net of minority interests and tax where applicable. This is consistent with the CFO Forum required presentation of the analysis of earnings, which is shown net of tax and minority interests.
| PVNBP | Reviewed 6 months 2008 £m |
Audited Full year 2007 £m |
|---|---|---|
| EEV basis as reported | 17,283 | 31,600 |
| Impact of changes in economic assumptions (including discounting at risk-free rate) | 997 | 970 |
| Impact of changes in operating assumptions | (66) | 152 |
| MCEV basis gross of minority interests | 18,214 | 32,722 |
| Minority interests | (2,048) | (4,333) |
| MCEV basis net of minority interests | 16,166 | 28,389 |
Analysed by:
| Net of minority interests | Gross of minority interests | |||
|---|---|---|---|---|
| Reviewed 6 months 2008 |
MCEV Restated £m |
EEV Reported £m |
MCEV Restated £m |
EEV Reported £m |
| United Kingdom | 6,010 | 5,863 | 6,010 | 5,863 |
| Europe | 7,037 | 6,364 | 9,081 | 8,431 |
| North America | 2,227 | 2,205 | 2,227 | 2,205 |
| Asia Pacific | 892 | 781 | 896 | 784 |
| Total life and pension PVNBP | 16,166 | 15,213 | 18,214 | 17,283 |
| Net of minority interests | Gross of minority interests | |||
|---|---|---|---|---|
| Audited Full year 2007 |
MCEV Restated £m |
EEV Reported £m |
MCEV Restated £m |
EEV Reported £m |
| United Kingdom | 11,797 | 11,655 | 11,797 | 11,655 |
| Europe | 11,359 | 10,726 | 15,684 | 14,914 |
| North America | 3,646 | 3,602 | 3,646 | 3,602 |
| Asia Pacific | 1,587 | 1,421 | 1,595 | 1,429 |
| Total life and pension PVNBP | 28,389 | 27,404 | 32,722 | 31,600 |
Value of new business and new business margin
The value of new business reduced to £352 million for the six months to 30 June 2008 (EEV new business contribution after the effect of required capital: £488 million) and £897 million in 2007 from £912 million after the effect of required capital reported under EEV. This, combined with the increase in PVNBP has resulted in a lower group margin of 1.9% on an MCEV basis for half year 2008 (margin after required capital on an EEV basis: 2.8%) and 2.7% for 2007, compared to 2.9% on an EEV basis.
| Value of new business | Reviewed 6 months 2008 £m |
Audited Full year 2007 £m |
|---|---|---|
| EEV basis as reported (after the effect of required capital) | 488 | 912 |
| Impact of changes in economic assumptions (including discounting at risk-free rate) | (67) | 138 |
| Cost of residual non-hedgeable risk | (59) | (91) |
| Changes to required capital | (11) | (16) |
| Impact of changes in operating assumptions | 2 | (35) |
| Other | (1) | (11) |
| MCEV basis gross of tax and minority interests | 352 | 897 |
| Tax and minority interests | (173) | (393) |
| MCEV basis net of tax and minority interests | 179 | 504 |
Analysed by:
| Net of tax and minority interests | Gross of tax and minority interests | |||
|---|---|---|---|---|
| Reviewed 6 months 2008 |
MCEV Restated £m |
EEV Reported £m |
MCEV Restated £m |
EEV Reported £m |
| United Kingdom | 53 | 111 | 73 | 154 |
| Europe | 106 | 109 | 255 | 245 |
| North America | (5) | 44 | (8) | 68 |
| Asia Pacific | 25 | 16 | 32 | 21 |
| Total value of new business | 179 | 280 | 352 | 488 |
| Net of tax and minority interests | Gross of tax and minority interests | |||
|---|---|---|---|---|
| Audited Full year 2007 |
MCEV Restated £m |
EEV Reported £m |
MCEV Restated £m |
EEV Reported £m |
| United Kingdom | 195 | 214 | 278 | 305 |
| Europe | 225 | 213 | 502 | 456 |
| North America | 34 | 70 | 52 | 108 |
| Asia Pacific | 50 | 32 | 65 | 43 |
| Total value of new business | 504 | 529 | 897 | 912 |
| Net of tax and minority interests | Gross of tax and minority interests | |||
|---|---|---|---|---|
| Reviewed 6 months 2008 |
MCEV Restated % |
EEV Reported % |
MCEV Restated % |
EEV Reported % |
| United Kingdom | 0.9% | 1.9% | 1.2% | 2.6% |
| Europe | 1.5% | 1.7% | 2.8% | 2.9% |
| North America | (0.2)% | 2.0% | (0.4)% | 3.1% |
| Asia Pacific | 2.8% | 2.0% | 3.6% | 2.7% |
| New business margin | 1.1% | 1.8% | 1.9% | 2.8% |
| Net of tax and minority interests | Gross of tax and minority interests | |||
|---|---|---|---|---|
| Audited Full year 2007 |
MCEV Restated % |
EEV Reported % |
MCEV Restated % |
EEV Reported % |
| United Kingdom | 1.7% | 1.8% | 2.4% | 2.6% |
| Europe | 2.0% | 2.0% | 3.2% | 3.1% |
| North America | 0.9% | 1.9% | 1.4% | 3.0% |
| Asia Pacific | 3.2% | 2.3% | 4.1% | 3.0% |
| New business margin | 1.8% | 1.9% | 2.7% | 2.9% |
United Kingdom
The reduction in margin under MCEV is attributable to the non-recognition of that element of the asset yield (net of credit default allowances) which we have secured above the risk-free rate. This effect is more pronounced in the first half of 2008 due to the widening of asset yields secured (net of credit default allowances) over the risk-free rate. The half year 2008 margin also reflects the greater proportion of annuity business in this period.
Europe
For Europe, the value of new business is higher than EEV in 2007, caused mainly by the positive impact of economic assumption changes. The small decrease in 2008 is mainly driven by the more adverse impact of economic assumption changes in the Netherlands, due to the sale of several large group contracts, which are adversely affected by the move to MCEV, and market movements increasing the expected costs of policyholder guarantees on contracts written during the period.
North America
North America margins reduce as the main product types are deferred annuity and other spread-type contracts. MCEV does not recognise at outset any earnings in excess of the risk-free rate. In 2008 the adverse impact is made more pronounced as the risk-free rate in the US has reduced over the 6-month period.
Asia Pacific
The Asia Pacific value of new business increases under MCEV, as EEV included territory-specific additional margins in the risk discount rate. This has been changed to an allowance in the cost of residual non-hedgeable risks under MCEV which results in an increase in value. The majority of the business sold in Asia is savings business and the margin for this business has increased by around 50%.
Impact of MCEV methodology on life and pension earnings
| Reviewed 6 months 2008 £m |
Audited Full year 2007 £m |
|
|---|---|---|
| Group life and pension earnings | ||
| EEV basis as reported | 1,480 | 2,753 |
| Impact of changes in economic assumptions (including discounting at risk-free rate) | (268) | (133) |
| Cost of residual non-hedgeable risk | (14) | (49) |
| Changes to required capital | (8) | (86) |
| Impact of changes in operating assumptions | 44 | 46 |
| Other | 46 | 13 |
| MCEV earnings gross of tax and minority interests | 1,280 | 2,544 |
| Tax and minority interests | (506) | (977) |
| MCEV earnings net of tax and minority interests | 774 | 1,567 |
Analysed by:
| MCEV Restated 6 months 2008 £m |
EEV Reported 6 months 2008 £m |
MCEV Restated Full year 2007 £m |
EEV Reported Full year 2007 £m |
|
|---|---|---|---|---|
| Reviewed | Reviewed | Audited | Audited | |
| United Kingdom | 417 | 471 | 822 | 864 |
| Europe | 728 | 823 | 1,503 | 1,543 |
| North America | 74 | 139 | 124 | 255 |
| Asia Pacific | 61 | 47 | 95 | 91 |
| Life and pension operating earnings before tax | 1,280 | 1,480 | 2,544 | 2,753 |
United Kingdom
UK operating earnings have reduced largely reflecting the change in the value of new business. Other changes reflect the aggregate impact of minor items and the reclassification under MCEV of credit default experience profits from operating earnings to economic variances.
Europe
European operating earnings are lower than EEV in both periods. The larger fall in 2008 is mainly driven by the negative impact of economic assumption changes, where, particularly in France and the Netherlands, the market falls and increased market volatility have had a more severe impact on the cost of policyholder guarantees than under EEV.
Operational assumption changes and other impacts were favourable overall in 2008 and adverse overall in 2007. In 2007, the other impacts are driven mainly by the Netherlands (updating assumptions in the German with profits fund model increased the shareholder share of surplus in positive scenarios) and Spain (the removal of positive credit default assumption changes that are no longer relevant under MCEV), offset by France (modelling refinements). In 2008, the positive other impacts in France are due to modelling refinements, and in the Netherlands, are due to the impact of the re-allocation out of operating profit of a provision held due to settlement for compensation with regard to unit-linked insurance policies, which have been the subject of an industry review.
North America
As the business has been growing, the return on the existing business has been more than offset by the lower recognised value of new business.
Asia Pacific
The value of new business has increased by around 50% as discussed above. Other changes are due to the strengthening of annuitant mortality assumptions and the analysis of lapse experience.