Aviva plc: Adoption of Aviva Market Consistent Embedded Value (MCEV) methodology and impact on results
MCEV notes to the financial statements
1 – Basis of preparation
The summarised consolidated income statement and balance sheet present the group’s results and financial position for the life and related businesses on the Market Consistent Embedded Value (MCEV) basis and for its non-life businesses on the International Financial Reporting Standards (IFRS) basis. The MCEV methodology adopted is in accordance with the MCEV Principles published by the CFO Forum in June 2008 with the exception of the use of an adjusted risk-free yield due to current market conditions for immediate annuities in the UK and Netherlands and for immediate annuities, deferred annuities and other contracts in the US.
The CFO Forum MCEV Principles were designed during a period of relatively stable market conditions. As announced on 19 December 2008, the CFO Forum has agreed to conduct a review of the impact of turbulent market conditions on the MCEV Principles, the result of which may lead to changes to the published MCEV Principles or the issuance of guidance. The particular areas under review include implied volatilities, the cost of non-hedgeable risks, the use of swap rates as a proxy for risk-free rates and the effect of liquidity premia.
The directors consider that Aviva’s MCEV methodology represents a more meaningful basis of reporting the value of the group’s life and related businesses and the drivers of performance than IFRS methodology. This basis values future cash flows from assets consistently with market prices, including more explicit allowance for the impact of uncertainty in future investment returns and other risks. Embedded value is also consistent with the way pricing is assessed and the business is managed.
The results for 2007 and 2006 have been audited by our auditors, Ernst & Young LLP. The results for the six-month period to 30 June 2008 are unaudited but have been reviewed by our auditors.
Covered business
The MCEV calculations cover the following lines of business: life insurance, long-term health and accident insurance, savings, pensions and annuity business written by our life insurance subsidiaries, including managed pension fund business and our share of the other life and related business written in our associated undertakings and joint ventures, as well as the equity release business written in the UK.
Covered business includes the group’s share of our joint ventures including our arrangement with The Royal Bank of Scotland Group (RBSG) and our associated undertakings in India, China, Turkey, Malaysia, Taiwan and South Korea. In addition, the results of group companies providing significant administration, investment management and other services and of group holding companies have been included to the extent that they relate to covered business. Together these businesses are referred to as “Life and related businesses”.
Adjusted risk-free rate
Aviva’s MCEV methodology adopts the CFO Forum Principles and Guidance with the exception of the use of an adjusted risk-free yield due to current market conditions for UK and Netherlands immediate annuities and for immediate annuities, deferred annuities and other contracts in the US. In stable markets, swap curves are an appropriate risk-free rate. 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 therefore been increased above the swap curve due to additional risk-free returns available on backing asset portfolios in the current market. Sensitivity analysis has been provided on the additions to the swap curves.
The risk-free rate is taken as the swap yield curve for the currency of the liability, adjusted by:
| 31 December 2007 Embedded value |
30 June 2008 Embedded value |
2007 second-half New business |
2008 first-half New business |
|
|---|---|---|---|---|
| UK, the Netherlands and US immediate annuities, US deferred annuities and other US contracts | 0.50% | 0.50% | 0.25% | 0.55% |
New business premiums
New business premiums include:
- premiums arising from the sale of new contracts during the period;
- non-contractual additional premiums, including future Department of Work and Pensions (DWP) rebate premiums; and
- expected renewals on new contracts and expected future contractual alterations to new contracts.
The group’s definition of new business under MCEV includes contracts that meet the definition of “non-participating investment” contracts under IFRS.
For products sold to individuals, premiums are considered to represent new business where a new contract has been signed, or where underwriting has been performed. Renewal premiums include contractual renewals, non-contractual variations that are reasonably predictable and recurrent single premiums that are pre-defined and reasonably predictable.
For group products, new business includes new contracts and increases to aggregate premiums under existing contracts. Renewal premiums are based on the level of premium received during the reporting period and allow for premiums expected to be received beyond the expiry of any guaranteed premium rates.
Life and pensions operating earnings
For life and pensions operating earnings, Aviva uses normalised investment returns, which are generally expressed as risk free returns plus an asset risk premium. The use of asset risk premiums reflects management’s long term expectations of asset returns in excess of the reference rate from investing in different asset classes. This assumption does not impact the embedded value as asset risk premia are not recognised until earned.
MCEV methodology
Overview
Under the MCEV methodology, profit is recognised as it is earned over the life of products defined within covered business. The total profit recognised over the lifetime of a policy is the same as under the IFRS basis of reporting, but the timing of recognition is different.
Calculation of the embedded value
The shareholders’ interest in the life and related businesses is represented by the embedded value. The embedded value is the total of the net worth of the life and related businesses and the value of in-force covered business. Calculations are performed separately for each business and are based on the cash flows of that business, after allowing for both external and intra-group reinsurance. Where one life business has an interest in another, the net worth of that business excludes the interest in the dependent company.
The embedded value is calculated on an after-tax basis applying current legislation and practice together with future known changes. Where gross results are presented, these have been calculated by grossing up post-tax results at the full rate of corporation tax for each country based on opening period tax rates.
Net worth
The net worth is the market value of the shareholders’ funds and the shareholders’ interest in the surplus held in the non-profit component of the long-term business funds, determined on a statutory solvency basis and adjusted to add back any non-admissible assets, and consists of the required capital and free surplus.
Required capital is the market value of assets attributed to the covered business over and above that required to back liabilities for covered business, for which distribution to shareholders is restricted. Required capital is reported net of implicit items permitted on a local regulatory basis to cover minimum solvency margins which are assessed at a local entity level. The level of required capital for each business unit is set equal to the higher of:
- The level of capital at which the local regulator is empowered to take action;
- The capital requirement of the business unit under the group’s economic capital requirements; and,
- The target capital level of the business unit.
This methodology reflects the level of capital considered by the directors to be appropriate to manage the business. The same definition of required capital is used for both existing and new business.
The free surplus is the market value of any assets allocated to, but not required to support, the in-force covered business at the valuation date.
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):
| Reviewed 30 June 2008 % |
Audited 31 December 2007 % |
Audited 31 December 2006 % |
|
|---|---|---|---|
| United Kingdom1 | 100% / 110% | 100% / 110% | 100% / 110% |
| France | 110% | 110% | 110% |
| Ireland | 150% | 150% | 150% |
| Italy2 | 115% / 184% | 115% / 184% | 115% |
| Netherlands (including Belgium and Germany)3 | 193% | 188% | 183% |
| Poland | 150% | 150% | 150% |
| Spain4 | 110% / 125% | 110% / 125% | 110% / 125% |
| North America | 325% | 325% | 325% |
- The required capital in the United Kingdom 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 193% 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.
Value of in-force covered business (VIF)
The value of in-force covered business consists of the following components:
- present value of future profits;
- time value of financial options and guarantees;
- frictional costs of required capital; and,
- cost of residual non-hedgeable risks.
Present value of future profits (PVFP)
This is the present value of the distributable profits to shareholders arising from the in-force covered business projected on a best estimate basis.
Distributable profits generally arise when they are released following actuarial valuations. These valuations are carried out in accordance with any local statutory requirements designed to ensure and demonstrate solvency in long-term business funds. Future distributable profits will depend on experience in a number of areas such as investment return, discontinuance rates, mortality, administration costs, as well as management and policyholder actions. Releases to shareholders arising in future years from the in-force covered business and associated required capital can be projected using assumptions of future experience.
Future profits are projected using best estimate non-economic assumptions and market consistent economic assumptions. In principle, each cash flow is discounted at a rate that appropriately reflects the riskiness of that cash flow, so higher risk cash flows are discounted at higher rates. In practice, the PVFP is calculated using the “certainty equivalent” approach, under which the reference rate is used for both the investment return and the discount rate. This approach ensures that asset cash flows are valued consistently with the market prices of assets without options and guarantees. Further information on the risk-free rates is given in Note 12.
The PVFP includes the capitalised value of profits and losses arising from subsidiary companies providing administration, investment management and other services to the extent that they relate to covered business. This is referred to as the “look through” into service company expenses. In addition, expenses arising in holding companies that relate directly to acquiring or maintaining covered business have been allowed for. Where external companies provide services to the life and related businesses, their charges have been allowed for in the underlying projected cost base.
Time value of financial options and guarantees (TVOG)
The PVFP calculation is based on a single (base) economic scenario. However, a single scenario cannot appropriately allow for the effect of certain product features. If an option or guarantee affects shareholder cash flows in the base scenario, the impact is included in the PVFP and is referred to as the intrinsic value of the option guarantee.
However, future investment returns are uncertain and the actual impact on shareholder profits may be higher or lower. The value of in-force business needs to be adjusted for the impact of the range of potential future outcomes. Stochastic modelling techniques can be used to assess the impact of potential future outcomes, and the difference between the intrinsic value and the total stochastic value is referred to as the time value of the option or guarantee.
Stochastic modelling typically involves projecting the future cash flows of the business under thousands of economic scenarios that are representative of the possible future outcomes for market variables such as interest rates and equity returns. Under a market consistent approach, the economic scenarios generated reflect the market’s tendency towards risk aversion. Allowance is made, where appropriate, for the effect of management and/or policyholder actions in different economic conditions on future assumptions such as asset mix, bonus rates and surrender rates.
Stochastic models are calibrated to market yield curves and volatility levels at the valuation date. Tests are performed to confirm that the scenarios used produce results that replicate the market price of traded instruments.
Where evidence exists that persistency rates are linked to economic scenarios, dynamic lapse assumptions are set that vary depending on the individual scenarios. This cost is included in the TVOG. Dynamic lapses are modelled for parts of the US and French business. Asymmetries in non-economic assumptions that are linked to economic scenarios, but that have insufficient evidence for credible dynamic assumptions, are allowed for within mean best estimate assumptions.
Frictional costs of required capital
The additional costs to a shareholder of holding the assets backing required capital within an insurance company rather than directly in the market are called frictional costs. They are explicitly deducted from the PVFP. The additional costs allowed for are the taxation costs and any additional investment expenses on the assets backing the required capital. The level of required capital has been set out above in the net worth section.
Frictional costs are calculated by projecting forwards the future levels of required statutory capital. Tax on investment return and investment expenses are payable on the assets backing required capital up until the point that they are released to shareholders.
Cost of residual non-hedgeable risks (CNHR)
The cost of residual non-hedgeable risks (CNHR) 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 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 used 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 ICA results for those risks considered. The capital 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. Asymmetric risks allowed for in the TVOG or PVFP are described earlier in the Basis of Preparation and in Note 7(c). No allowance has been made within the cost of non-hedgeable risk for symmetrical risks as these are diversifiable by investors.
Participating business
Future regular bonuses on participating business are projected in a manner consistent with current bonus rates and expected future market-consistent returns on assets deemed to back the policies.
For with-profit funds in the UK and Ireland, for the purpose of recognising the value of the estate, it is assumed that terminal bonuses are increased to exhaust all of the assets in the fund over the future lifetime of the in-force with-profit policies. However, under stochastic modelling there may be some extreme economic scenarios when the total assets in the group’s with-profit funds are not sufficient to pay all policyholder claims. The average additional shareholder cost arising from this shortfall has been included in the TVOG.
For profit sharing business in continental Europe, where policy benefits and shareholder value depend on the timing of realising gains, the apportionment of unrealised gains between policyholders and shareholders reflect contractual requirements as well as existing practice. Under certain economic scenarios where additional shareholder injections are required to meet policyholder payments, the average additional cost has been included in the TVOG.
The embedded value of the US spread-based products anticipates the application of management discretion allowed for contractually within the policies, subject to contractual guarantees. This includes the ability to change the crediting rates and indexed strategies available within the policy. Consideration is taken of the economic environment assumed in future projections and returns in excess of the reference rate are not assumed. Anticipated market and policyholder reaction to management action has been considered. The anticipated management action is consistent with current decision rules and has been approved and signed off by management and legal counsel.
Consolidation adjustments
The effect of transactions between group life companies such as loans and reinsurance arrangements have been included in the results split by territory in a consistent manner. No elimination is required on consolidation.
As the MCEV methodology incorporates the impact of profits and losses arising from subsidiary companies providing administration, investment management and other services to the group’s life companies, the equivalent profits and losses have been removed from the relevant segment (non-insurance or fund management) and are instead included within the results of life and related businesses. In addition, the underlying basis of calculation for these profits has changed from the IFRS basis to the MCEV basis.
The capitalised value of the future profits and losses from such service companies are included in the embedded value and value of new business calculations for the relevant business, but the net assets (representing historical profits and other amounts) remain under non-insurance or fund management. In order to reconcile the profits arising in the financial period within each segment with the assets on the opening and closing balance sheets, a transfer of IFRS profits from life and related business to the appropriate segment is deemed to occur. An equivalent approach has been adopted for expenses within our holding companies.
The assessments of goodwill, intangibles and pension schemes relating to life insurance business utilise the IFRS measurement basis.
Post-balance sheet events
On 10 September 2008, Aviva plc ("Aviva") announced that its Dutch business, Delta Lloyd Group ("Delta Lloyd") had reached a settlement for compensation with regard to unit-linked insurance policies, which have been the subject of an industry review. The adverse impact on Delta Lloyd's embedded value is expected to be approximately £230 million* (pre-tax). This settlement will be shown as an exceptional item in the Aviva group's results for the year ending 31 December 2008 therefore, £71 million (pre-tax) which has been provided for in the 30 June 2008 results is also treated as an exceptional item. Only a limited impact on IFRS profit is anticipated, as IFRS provisions already established on the basis of Dutch regulatory requirements are considered adequate.
Except for the item above we are aware of no post-balance sheet events impacting our half year 2008 and full year 2007 results.
* €300 million translated at an average exchange rate of €1.29
Restatement for the change in accounting policy for latent reserves
As part of the Company’s aim to continuously improve the relevance and reliability of its external financial reporting, Aviva undertook a review of the Group’s General Insurance Reserving Policy in 2008.
As part of this review the Group concluded that estimating all of our latent claim provisions on an undiscounted basis, and discounting back to current values, represented an improvement to the existing estimation technique. This approach is in line with best practice for long-term liabilities and moves the measurement of latent claims onto a more economic basis, consistent with our internal model for economic capital and the measurement model being proposed for both IFRS Phase II and Solvency II.
Further this approach improves consistency with the reporting of other long-tail classes of business which are already being discounted, namely certain London Markets latent claims and Netherlands Permanent Health and Injury Business.
Discount rate
The discount rate that has been applied is based on the relevant swap curve in the relevant currency at the reporting date, having regard to the duration of expected settlement of the claims. The rate, based on the swap curve, is set at the start of the accounting period with any change in discount rates between the start and end of the accounting period being reflected below operating profit as an economic assumption change. The range of rates used is between 3.6% and 6.3% depending on the duration of the claim and the reporting date. We estimate that latent claims will be payable for around the next 35 to 40 years with an average duration of 15 years.
IFRS Treatment
The application of discounting to all of our latent claims reserves for IFRS purposes represents a change in accounting policy and therefore has been applied retrospectively. The cumulative impact of discounting on our opening position as at 1 January 2007 is £153 million which will be treated as a prior period adjustment.
The impact of the change in accounting policy on the general insurance and health claims provisions and our results for the six months ended 30 June 2008, the full year ended 31 December 2007 and the opening 1 January 2007 position is set out below.
| General insurance and health claims provisions | Reviewed 30 June 2008 £m |
Audited 31 December 2007 £m |
Audited 1 January 2007 £m |
|---|---|---|---|
| Carrying amount as reported, net of reinsurance | 11,410 | 11,424 | 10,980 |
| Impact of discounting | |||
| Prior period adjustment brought forward | (145) | (153) | (153) |
| Impact on operating profit | 10 | 12 | – |
| Impact on short-term fluctuations and economic assumption changes | (6) | (2) | – |
| Impact of foreign exchange movements | (1) | (2) | – |
| (142) | (145) | (153) | |
| Carrying amount restated, net of reinsurance | 11,268 | 11,279 | 10,827 |
The impact on shareholders’ funds after tax was £105 million, £107 million and £112 million at 30 June 2008, 31 December 2007 and 31 December 2006 respectively.
Restatement for the consolidation of funds
The long-term business net assets on an MCEV basis have been restated to reanalyse the amounts previously classified as minority interest on property investment vehicles to net asset value attributable to unitholders. This change recognises that the property investment vehicles are unit trusts and, as a result, the third-party holding should be recognised as a liability rather than a minority interest holding. Prior period comparatives have been restated with a reduction in minority interest and an increase in amounts due to unitholders of £838 million, £758 million and £431 million at 30 June 2008, 31 December 2007 and 31 December 2006 respectively.
During 2008, we identified certain specialised investment vehicles that the group manages required consolidation in accordance with IAS 27. This results in grossing up assets and liabilities for the effect of the third-party participation. As a result, the figures for investment property, debt securities, equity securities, other investments and net assets attributable to unitholders as at 31 December 2007 and 31 December 2006 have been restated.
Neither of these adjustments has any impact on profit or cash flow in any reported period.
Treatment of shares held by employee trusts
Employee share trusts have purchased the Company’s shares in the market to satisfy awards under various share plans. At 30 June 2008 and 31 December 2007, these trusts held shares with a cost of £10 million which, on materiality grounds, were included within other financial assets rather than being shown as a deduction from total shareholders’ equity in the consolidated balance sheet. In view of the Company’s current policy of purchasing shares in the market rather than issuing new shares, which will lead to larger balances on this account, we have restated the 30 June 2008 and 31 December 2007 figures accordingly.
