Aviva plc: Adoption of Aviva Market Consistent Embedded Value (MCEV) methodology and impact on results
I – MCEV methodology
Aviva's MCEV methodology is described in the basis of preparation note. Aviva's MCEV methodology, except for the adjustment noted below, follows the CFO Forum's 17 MCEV Principles and supporting guidance issued in June 2008, which set out an improved approach to calculating the valuation of shareholders' interest in a life insurance company.
Due to current market conditions, an adjustment has been made to the risk-free rate for immediate annuity contracts in the UK and the Netherlands and immediate annuities, deferred annuities and other contracts in the US. This does not comply with the CFO Forum Principle 14 which requires that the risk-free rates "should, wherever possible, be the swap yield curve appropriate to the currency of the cash flows". In stable markets, swap curves are an appropriate proxy for risk-free rates; however, in the current turbulent market it is possible, for products where backing asset portfolios can be held to maturity, to earn returns in excess of swaps by investing in corporate bonds and credit default swaps (CDS). The risk free rate for these products has been therefore increased above the swap curve due to additional risk-free returns available in the current market.
Under EEV, the group was already complying with a number of the CFO Forum Principles. Accordingly, the directors regard the adoption of MCEV as an enhancement to the EEV basis of reporting. The new basis is also consistent with the way pricing is assessed and the business is managed.
The MCEV methodology does not change the fundamentals of embedded value reporting, where the life embedded value is the sum of the net worth, representing the value of shareholder assets, and the present value of in-force business (VIF), reflecting the present value of margins locked into statutory reserves.
Of the 17 principles, the following have led to a change in the group's results:
Revised economic basis
Under the CFO Forum MCEV Principles the mechanism through which risk is allowed for in the overall embedded value calculation has changed. Under EEV, in order to reflect the overall risk profile of the group's business, a risk margin within the discount rate allowed for any residual risks that were not explicitly allowed for. Under MCEV, all risks are allowed for explicitly and therefore the risk discount rate does not include any risk margin.
Principle 12 – Economic assumptions, Principle 13 – Investment returns and discount rates and Principle 14 – Reference rates
Under MCEV, each cash flow is discounted at a rate consistent with the riskiness of that cash flow as implied by observable market data. To implement this, the group has used a methodology in which a risk-free reference rate is used for both investment returns and discount rates (a "certainty equivalent" approach).
With the exception of UK and Netherlands immediate annuities and immediate annuities, deferred annuities and other US contracts, the reference rate has been taken in line with CFO Forum guidance as the swap yield curve where this is well defined in a market. For UK and Netherlands immediate annuities and US immediate annuities, deferred annuities and other contracts, an adjusted risk-free rate has been used to reflect the additional risk-free returns in excess of swap yields available in the current markets.
Where swap yields are not available or reliable, the lower of government bond yields and available swap rates (or other similar yield information) from the most highly rated banks in the market have been used. In contrast under EEV, government bonds were used in setting the risk-free rate and for the restated periods the risk-free rates used were typically slightly higher.
As a result of the adoption of MCEV, we have reviewed and reassessed all economic assumptions. As a consequence, the assumed equity risk premium has been revised to 3.5% over swaps from 3.0% over government bonds. The property risk premium has been retained at 2.0%. This reflects management's view of expected asset performance relative to risk-free returns and has been used to calculate expected returns within operating earnings. This assumption does not impact the embedded value as asset risk premia are not recognised until earned. The difference between the operating expected return and the actual return is taken to economic variances. The asset risk premium assumptions also affect the Internal Rate of Return (IRR), the Implied Discount Rate (IDR) and payback period calculations.
Assumptions
Principle 11 – Assessment of appropriate non-economic projection assumptions
We have reviewed our best estimate assumptions to ensure that links to economic scenarios (dynamic assumptions) and other asymmetries are appropriately allowed for. Existing dynamic lapse assumptions in North America have been revised to consider the lower average returns from market consistent scenarios while those in France have been maintained as they are considered to be appropriate. Lapse rates in other business units have been reviewed for evidence of a link between persistency and economic scenarios. As evidence is generally not sufficiently strong to justify dynamic lapse assumptions, uncertainty around lapse rates has been reflected as indirect allowances for asymmetries within the mean best estimate lapse assumptions.
Whilst reviewing best estimate assumptions, we have also taken the opportunity to revise a number of demographic experience assumptions. In aggregate, these changes have no material impact on the embedded value however, the impact on individual business units are as follows:
UK Life – On pensions business, the assumed transfer rate assumptions have increased reflecting an allowance for asymmetries. The effect of this change and other minor changes in demographic assumptions for UK Life business was a reduction in the embedded value of £134 million at 30 June 2008, £142 million at 31 December 2007 and £84 million at 31 December 2006.
For MCEV, we have revised our definition of required capital and used consistent levels of required capital throughout the restatement. In contrast under EEV, the level of required capital held for the UK annuity business reduced in 2007 with the impact broadly offset by a change in annuitant mortality assumptions. In order to provide a meaningful comparison of MCEV and EEV profit in 2007, the mortality assumption change has been treated as an adjustment to the opening balance sheet, reducing the MCEV at 31 December 2006 by £117 million. There is no change to the embedded value at 31 December 2007.
Poland – Life and pensions lapse assumptions have been reduced reflecting emerging experience. This results in increases in the embedded value of £165 million at 30 June 2008, £143 million at 31 December 2007 and £142 million at 31 December 2006.
Spain – The lapse assumptions on bancassurance, group risk and unit linked business were revised using the latest calendar year experience where negative trends were discernible, excluding any possible future positive effects that may emerge from existing and new management actions to control lapses. Additional adjustments were made to allow for the asymmetric impacts of policyholder behaviour. These revisions resulted in a decrease in the embedded value of £36 million at 30 June 2008, £33 million at 31 December 2007 and £30 million at 31 December 2006.
USA – On Fixed and Indexed Annuity business lapse rates have been changed by including an allowance for partial withdrawals to allow for the emerging best estimate view. In addition, on the same products, there have been other, less significant, changes to the lapse rates to reflect our latest view of experience. The impact of these changes is a decrease in the embedded value of £70 million at 30 June 2008, £69 million at 31 December 2007 and £62 million at 31 December 2006.
Principle 15 – Stochastic models
Stochastic models have been used for all material covered business classes. These have been calibrated to market conditions at the valuation dates.
Principle 5 – Required capital
Under the CFO Forum MCEV Principles, the level of required capital should reflect at least the minimum level of solvency capital below which the local supervisor is empowered to take action. In addition it should include any further capital which is not available for distribution to shareholders because it is required to meet internal objectives. For each business we have assessed the required capital as the amount deemed to be locked in to support the business objectives and to meet regulatory requirements. We have also taken into account the group's pricing bases and internal economic capital targets.
The directors consider that, in all cases, the level of required capital represents an appropriate level of capital to be carried to match the risks of the group's current portfolio of business.
The table below summarises the level of required capital across the business units, expressed as a percentage of the EU minimum solvency margin (or equivalent):
| Capital requirement % of EU minimum (or equivalent) |
2007 MCEV basis % |
2007 EEV basis % |
|---|---|---|
| United Kingdom1 | 100% / 110% | 100% |
| France | 110% | 115% |
| Ireland | 150% | 150% |
| Italy2 | 115% / 184% | 115% |
| Netherlands (including Belgium and Germany)3 | 188% | 150% |
| Poland | 150% | 150% |
| Spain4 | 110% / 125% | 110% / 125% |
| North America | 325% | 250% |
- The required capital in the United Kingdom under the EEV basis was 100% following the change made in 2007 to the required capital in Norwich Union Annuity Limited (NUA). The required capital under MCEV is 100% for unit-linked and other non-participating business and 110% for annuity business.
- Required capital in Italy under MCEV is 184% of the EU minimum for Eurovita and 115% for other companies.
- Required capital in the Netherlands is 188% for full-year 2007 and 190% for the six months to 30 June 2008. This capital level is the aggregate capital required for the Netherlands.
- Required capital in Spain is 125% of the EU minimum for Aviva Vida y Pensiones and 110% for bancassurance companies.
The required capital across the group's life businesses varies between 100% and 325% of the EU minimum solvency margin (or equivalent). The weighted average level of required capital as a percentage of the EU minimum solvency margin (or equivalent) has increased to 139% on an MCEV basis (EEV: 130%).
The required capital for annuity business in the United Kingdom is 110% under MCEV compared to 100% under EEV as economic capital requirements become higher than statutory capital requirements towards the end of the contracts. We have reviewed the economic capital requirements of our businesses and this has resulted in changes to the required capital in the Netherlands, Eurovita in Italy and France. The required capital level in France has reduced as economic capital is below the statutory capital requirement. In Aviva USA, required capital of 325% reflects rating agency commitments.
Principle 8 – Frictional costs of required capital
Under the CFO Forum MCEV Principles, the cost of holding the required capital is taken to be the present value of any additional taxation and investment costs that shareholders will incur as a result of the capital being tied up within the company rather than it being directly invested in the market. These additional costs are known as frictional costs and a deduction for these has been taken in all the value of in-force and new business numbers quoted, except where stated.
The frictional costs calculated under MCEV are significantly less than the cost of capital under EEV. This reflects the difference between the risk discount rate, which included an explicit risk margin, and the expected post-tax investment return on the assets backing the required capital. Under MCEV, risks are modelled explicitly and the risk margin is not needed. Where implicit items have been allowed by local regulators, these have been deducted from the level of required capital at each balance sheet date in the table below.
| MCEV basis | EEV basis | |||||
|---|---|---|---|---|---|---|
| Group cost of capital | Total Frictional costs £m |
Required capital £m |
Frictional costs/ Required capital % |
Cost of capital £m |
Required capital £m |
Cost of capital/ Required capital % |
| 30 June 2008 Reviewed | 964 | 7,419 | 13% | 1,783 | 6,751 | 26% |
| 31 December 2007 Audited | 852 | 6,895 | 12% | 1,588 | 6,331 | 25% |
| 31 December 2006 Audited | 733 | 5,834 | 13% | 1,450 | 5,314 | 27% |
Risk allowances within the value of in-force
In the table below there is a comparison at a group level of the impact of the risk allowances on the VIF on both the EEV and MCEV basis.
The present value of future profits (PVFP) is the present value of the distributable profits to shareholders arising from the in-force covered business projected using economic and best estimate non-economic assumptions as described above. In order to calculate the present value of in-force (VIF) it is necessary to allow explicitly for all risks not allowed for in this discounting process. This includes the frictional cost of required capital outlined above, the time value of financial options and guarantees and any residual non-hedgeable risks. Hedgeable market risks are allowed for on a market consistent basis through the use of risk-free investment return and discount rate assumptions.
| Reviewed 30 June 2008 |
Audited 31 December 2007 |
|||
|---|---|---|---|---|
| Gross of minority interests | MCEV £m |
EEV £m |
MCEV £m |
EEV £m |
| Present value of future profits (PVFP) | 11,539 | 12,364 | 11,881 | 11,841 |
| Frictional costs (MCEV)/cost of capital (EEV) | (964) | (1,783) | (852) | (1,588) |
| Cost of residual non-hedgeable risk | (604) | – | (568) | – |
| Time value of financial options and guarantees | (893) | (444) | (745) | (392) |
| Value of in-force covered business (VIF) | 9,078 | 10,137 | 9,716 | 9,861 |
Principle 7 – Financial options and guarantees
Financial options and guarantees can affect shareholder cash flows in an asymmetric way. In adverse scenarios shareholders can be liable for the entire cost of the option or guarantee, whereas in favourable scenarios shareholders may get only part of the benefit. Under MCEV and EEV methodologies, we explicitly calculate the time value of financial options and guarantees (TVOG) using stochastic simulations. This is determined by deducting the average value of shareholder cash flows under a large number of stochastic economic scenarios from the deterministic shareholder value under best estimate assumptions (the PVFP).
The TVOG is higher under MCEV than EEV as market-consistent scenarios are more heavily weighted to scenarios with low investment returns, increasing the cost of guarantees. The removal of asset risk premiums from the valuation of options and guarantees is most significant in the US, France and Netherlands. The TVOG also increases as future cashflows are discounted at a rate consistent with risk-free returns in each scenario, rather than the higher, constant risk-discount rate used under EEV.
Market volatility assumptions have been used for MCEV compared to long-term expected volatilities under EEV. Market volatilities are typically higher than long-term, expected volatilities over the restatement period. This has increased the TVOG.
All assumptions have been reviewed to ensure that asymmetries are modelled explicitly where material. Dynamic lapse assumptions have been used in the US and France, since in these countries we have sufficient evidence to be able to set credible assumptions.
For many contracts there is general uncertainty about future lapse rates and the evidence for dynamic lapse behaviour is limited. In such cases we have included an allowance in the mean best estimate assumption where it is considered appropriate.
Principle 9 – Cost of residual non-hedgeable risks
The cost of residual non-hedgeable risks covers risks not already allowed for in the time value of options and guarantees or the PVFP. The allowance includes the impact of both non-hedgeable financial and non-financial risks. The most significant risk not included in the PVFP or TVOG is operational risk.
Aviva's methodology includes a cost of non-hedgeable risk equivalent to a charge of 2.5% applied to Group-diversified capital. The allowance equals £604 million, £568 million and £491 million at the 30 June 2008, 31 December 2007 and 31 December 2006 balance sheet dates. The cost has been calculated as a 1.5% charge applied to business unit-level capital that is, allowing for diversification within a business unit, but not between business units. The charge was set so as to give an aggregate allowance that was in excess of the expected operational risk costs arising from the in-force covered business over its remaining lifetime.
The capital levels are projected to be sufficient to cover non-hedgeable risks at the 99.5% confidence level one-year after the valuation date. The capital is equal to the capital from the independently reviewed ICA results for those risks considered and has been projected as running-off over the remaining life of the in-force portfolio in line with the drivers of the capital requirement.
In addition to the operational risk allowance, financial non-hedgeable risks and other product level asymmetries have been allowed for. These allowances are not material as significant financial non-hedgeable risks and product level asymmetries are either modelled explicitly and included in the TVOG or are included in the PVFP through the use of appropriate best estimate assumptions. No allowance has been made within the cost of non-hedgeable risk for symmetrical risks as such risks are diversifiable by investors.
Principle 10 – New business and renewals
The group's definition of new business under the previous methodology is consistent with Principle 10 and therefore there has been no change in our classification of premiums as new business or renewals.
The CFO Forum has stated that the value of new business should be calculated using economic assumptions in line with market conditions at the point of sale for all business; however, it recognises that this is not practical and therefore allows companies to make reasonable approximations to this. Aviva has complied with this principle by calculating the value of new business on a quarterly basis with the assumptions being taken as those appropriate to the start of each quarter. For interest sensitive contracts that are re-priced more frequently than quarterly, weekly or monthly economic assumptions have been used.
The calculation of the present value of new business premiums (PVNBP) is equal to the discounted value of new regular premiums plus the total amount of single premiums received in the period. The discounted value of regular premiums is based on the policy conditions of the contracts sold, and the same projection assumptions are used for calculating the value of new business. Under MCEV, the risk free discount rate is used which is lower than the risk discount rate previously used under EEV, and hence the PVNBP generated by each regular premium contract if higher.
The Impact of MCEV methodology on new business tables set out the present value of life and pensions new business premiums, the value of new business and the new business margin expressed as a percentage of that value on both bases.
Implied discount rates
As described earlier, under MCEV methodology the risk-free reference rate is used to discount the cash flows to calculate the present value of future profits. Deductions are then made for risk allowances to arrive at the MCEV. It is possible to calculate a discount rate that when applied to all expected cash flows including expected asset spread earnings, gives a value of future profits that equates to the MCEV. This is the implied discount rate (IDR). The IDR would typically be higher than the EEV discount rate as EEV explicitly allows for options and guarantees.
| Audited 31 December 2007 |
Total in-force business % |
New business % |
|---|---|---|
| United Kingdom | 8.4% | 10.2% |
| Europe | 7.5% | 6.8% |
| North America | 14.3% | 19.3% |
| Asia Pacific | 9.4% | 8.5% |
| Average | 8.0% | 9.1% |
The IDR for existing business in the UK and the US reflects the amount of credit spread business.
Outside the UK and the US, new business IDRs are lower than for existing business, indicating that the level of market risk in new business has reduced. This reflects new business sales of products where the policyholder takes a greater level of investment risk, such as unit-linked products, and lower levels of guarantees.
