Andrew Moss
Group executive director
Dear Shareholder,
To achieve leading financial management and control, we are required to have an increasingly forward-looking view. We are actively involved in the many debates that will affect reporting developments in our industry such as IFRS phase II on insurance contracts and the EU’s Solvency II directive. These are some time from being implemented, yet the debates that will influence their final positions are happening now.
Capital management
Capital strength is important to us since it gives us flexibility to take advantage of opportunities to create value for our shareholders and customers. We have further strengthened our capital position during the year. Equity shareholders’ funds have increased by 18% to £17.5 billion and our excess solvency margin, as measured under the insurance group’s directive, was £3.6 billion (2005: £3.6 billion), reflecting the acquisition of AmerUs having reduced the margin by £0.7 billion and the impact of funding the pension scheme deficit. The underlying strong operational performance demonstrates the capital generative nature of our businesses. The ability to generate capital is a key strength of the group and enables us to fund both organic growth and bolt-on acquisitions from our internal capital resources.
Additionally, rating agencies have recognised this strength by reaffirming the ratings of our main operating subsidiaries, AA/AA- (very strong) from Standard & Poor’s and Aa3 (excellent) from Moody’s, both with a stable outlook.
During 2006, we have continued to develop a capital management framework that utilises individual capital assessment (ICA) principles. Using an ICA model provides a close link between capital and risk management. It is important that we increasingly match the amount of capital that we hold to the relative risks that we face. Our ICA model clearly demonstrates that our diversified business, in terms of geography, products and distribution dramatically reduces the amount of economic capital required to protect against the risk of insolvency. Such risk-based capital models are increasingly being used to inform our decision-making processes and will, in time, allow us to improve capital efficiency.
Our return on equity shareholders' funds of 13.1% (2005: 15.0%), exceeds our stated target return of 12.5%, notwithstanding our opening shareholders’ funds being £3.2 billion higher than a year earlier.
Reporting changes
2006 has been a year of considerable change and development in the financial reporting arena. In March, we published our first financial statements under IFRS, requiring changes to accounting systems and extra disclosures. Additionally, we are now seeing the introduction of enhanced requirements for the narrative elements of our reporting. These changes are challenging our finance teams to understand, produce and explain a much greater volume of information. I was therefore delighted that our hard work in these areas was recognised at the prestigious 2006 IR Magazine UK awards where we won the prize for “best disclosure by a FTSE-100 company”, an excellent achievement.
Solvency II
Solvency II represents a great opportunity for us to establish a fairer deal while promoting Europe as a truly single market. The current system of insurance supervision and regulation is a blunt instrument that has not succeeded in creating a level playing field for insurers, is capital inefficient and can ultimately lead to higher prices for consumers. The industry already suffers from a myriad of different measures against which it is assessed. It will be important to align regulatory and accounting measures more closely with the underlying economics of the business. This is a unique opportunity to shape 21st century supervision to the benefit of all and we are fully committed to the project.
Outlook
We have built a reputation for professionalism and prudence, but we also have a forward thinking outlook. We remain committed to efficiently managing risk and capital, while continuing to seek out innovative ways to improve our processes, controls and risk and capital management.
Andrew Moss
To cope with the ever-developing demands of the financial and regulatory landscape, we have refreshed and revised our finance strategy. The new strategy incorporates the four Cs:
- Capital – Increasingly integrating our management of risk and capital
- Capability – Attracting and retaining talented professionals who add value to our business
- Consistency – Generating trusted data from efficient processes and systems
- Cost – Running a cost-effective finance function across our businesses The four strands of the strategy set out above are fundamental to us achieving our longer term aims for our finance community. They will allow us to provide an operating platform that has a robust risk and control environment, meets FSA requirements and meets the governance expectations of the Aviva board.
Capital structure
We maintain an efficient capital structure using a combination of equity shareholders’ funds, preference capital, subordinated debt and borrowings. This structure is consistent with our risk profile and the regulatory and market requirements of our business. We believe that the European Embedded Value (EEV) provides a more meaningful view of our life operations than IFRS; accordingly, our capital structure is analysed on an EEV basis.
In managing our capital, we seek to:
- Match the profile of our assets and liabilities, taking into account the risks inherent in each business
- Maintain financial strength to support new business growth while still satisfying the requirements of policyholders, regulators and rating agencies
- Retain financial flexibility by maintaining strong liquidity, access to a range of capital markets and significant unutilised committed credit lines
- Allocate capital efficiently to support growth and repatriate excess capital where appropriate
- Manage exposures to movements in exchange rates by aligning the deployment of capital by currency with our capital requirements by currency
Capital management principles
An important aspect of our capital management process is the setting of target rates of return for individual business units. The targets are adjusted to make allowance for risks faced by those business units. Management remuneration is partly based on performance against these targets, therefore encouraging focus on creation of value for the shareholder.
We have a number of sources of capital available to us and seek to optimise our debt to equity structure so we can maximise returns to our shareholders. We consider alternative sources of capital such as reinsurance and securitisation in addition to more traditional sources of funding. We select capital funding that is appropriate to its deployment and usage.
Capital employed by segment
The table below shows how our capital is deployed by segment and how that capital is funded:
| 2006 £m |
2005 £m |
|
|---|---|---|
| Long-term savings | 19,663 | 15,598 |
| General insurance and health | 5,344 | 5,581 |
| Other business | 1,425 | 1,876 |
| Corporate | (19) | (36) |
| Total capital employed | 26,413 | 23,019 |
| Financed by: | ||
| Equity shareholders’ funds and minority interests | 19,668 | 16,356 |
| Direct capital instrument | 990 | 990 |
| Preference shares | 200 | 200 |
| Subordinated debt | 2,937 | 2,808 |
| External debt | 1,258 | 1,002 |
| Net internal debt | 1,360 | 1,663 |
| 26,413 | 23,019 |
At 31 December 2006, we had £26.4 billion (31 December 2005: £23.0 billion) of total capital employed in our trading operations.
In 2006, the total capital employed increased by £3.4 billion reflecting growth in our long-term savings operations; these increased by £4.0 billion driven by the acquisitions of AmerUs, operational results and movements in equity markets in the year.
In addition to our external funding sources, we have internal debt arrangements in place. These arrangements have allowed the assets that support technical liabilities to be invested in a pool of central assets for use across the group. They have also allowed the redeployment of cash between parts of the business to fund growth. Although these arrangements are intra-group loans, they are included as part of the capital base for the purpose of capital management. Our intra-group loans satisfy arms length criteria and all interest payments have been made when due.
Net internal debt represents the upstream of internal loans from business operations to corporate and holding entities net of tangible assets held by these entities.
The corporate net liabilities represent the element of the pension scheme deficit held centrally.
Financial leverage
Financial leverage, the ratio of the group’s external senior and subordinated debt to EEV capital and reserves was 20% (2005: 22%). 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 10.3 times (2005: 9.6 times).
We are subject to a number of regulatory capital tests and employ realistic scenario tests to allocate capital and manage risk. Overall, the group and its subsidiaries satisfy all existing requirements and, as reported below, has significant resources and capital strength.
The ratings of the group’s main operating subsidiaries are AA/AA- (very strong) with a stable outlook from Standard & Poor’s and Aa3 (excellent) with a stable outlook from Moody’s. These ratings reflect our strong liquidity, competitive position, capital base, increasing underlying earnings and positive strategic management.
Different measures of capital
We measure our capital using different bases that include measures that comply with the regulatory regime in which we operate and measures that the directors consider appropriate for effective management of the business. The measures that we use are:
Accounting basis
We are required to report our results on an IFRS basis; however, the directors consider that EEV principles provide a more relevant and meaningful view of our life operations and so we analyse and measure the net asset value and total capital employed for the group on this basis.
Regulatory basis
Relevant capital and solvency regulations are used to measure and report the financial strength of our insurance subsidiaries. These measures are based on local regulatory requirements and are consolidated under the European Insurance Groups Directive (IGD). The regulatory capital tests verify that we retain an excess of solvency capital above the required minimum level calculated using a series of prudent assumptions about the type of business written by our insurance subsidiaries.
In addition to the FSA realistic reporting regime, the UK Accounting Standards Board requires certain capital disclosures to be made in accordance with Financial Reporting Standard 27, Life Assurance (FRS 27). The purpose of the capital statement is to set out the financial strength of the entity and to provide an analysis of the disposition and constraints over the availability of capital to meet risks and regulatory requirements. The disclosures required by FRS 27 are set out in note 49.
Economic bases
We believe that economic capital provides a clear measurement of the risks facing our business. Additionally, it informs the amount of capital that we need to hold to mitigate the risk of insolvency. We provide full details of our economic measures of capital in the “Risk and capital management” section.
Group
Accounting basis
Our capital funding is allocated so that the capital employed by trading operations is greater than the capital provided to those operations by the shareholders and subordinated debt holders. As a result, we are able to enhance the returns earned on our equity capital.
| 2006 | 2005 | |
|---|---|---|
| Shareholders’ funds – EEV basis | £20.9bn | £17.5bn |
| Total capital employed – EEV basis | £26.4bn | £23.0bn |
| Net asset value per share – EEV basis | 683p | 622p |
Shareholders’ funds have increased by £3.4 billion to £20.9 billion (2005: £17.5 billion), reflecting our strong operational performance in 2006.
Accordingly, our net asset value per ordinary share, based on equity shareholders’ funds was higher at 683 pence per share (2005: 622 pence per share).
Regulatory basis – European Insurance Groups Directive
| 2006 | 2005 | |
|---|---|---|
| Insurance Groups Directive (IGD) excess solvency | £3.6bn | £3.6bn |
| Cover (times) | 1.8 times | 1.8 times |
As at 31 December 2006, we had an estimated excess regulatory capital of £3.6 billion (2005: £3.6 billion), as measured under the European Insurance Groups Directive. 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 our UK life funds.
In broad terms, for our long-term business, the minimum solvency requirements are set at 4% and 1% for non-linked and unit-linked reserves respectively. For our general insurance portfolio of business, the minimum solvency requirement 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 our other major non-European businesses (USA, Australia and Canada), a risk charge on assets and liabilities approach is used.
Our excess solvency of £3.6 billion reflects operational performance generating solvency capital during the year, offset by the acquisition of AmerUs, which reduced the solvency surplus by £0.7 billion, and the funding of the pension deficit. From 31 December 2006, we have been required to have positive solvency on an IGD basis. Our risk management processes ensure adequate review of this measure at all times.
Long-term businesses
Regulatory basis
For our non-participating worldwide life insurance businesses, our capital requirements are set as the higher of:
- Target levels set by reference to internal risk assessment and internal objectives
- Minimum capital requirements (ie the level of solvency capital at which the local regulator is empowered to take action).
Having assessed the level of operational, demographic, market and currency risk of each of our life businesses, the required level of capital for each business is quantified and expressed as a percentage of the EU minimum. The required capital across our business varies between 100% and 250% of the EU minimum or equivalent.
The weighted average level of required capital for the whole of our non-participating life businesses, expressed as a percentage of the EU minimum solvency margin or equivalent is 134% (2005: 128%). This is a blended rate and is expected to change over time with changes in the product mix.
The required capital levels discussed above are used in the calculation of our embedded value to assess the cost of locked-in capital. At 31 December 2006, the aggregate regulatory capital, based on the requirements of the EU minimum test amounted to £4.3 billion (31 December 2005: £3.9 billion). As at this date, the actual net worth held in our long-term businesses was £8.9 billion (31 December 2005: £7.2 billion), which represents 206% (31 December 2005: 183%) of these minimum requirements. The increase in this ratio reflects the impact of favourable equity market performance on the net worth and acquisition of AmerUs.
UK life operations
Available capital
The realistic inherited estate represents the available capital of our with-profit funds. It is comprised of the assets of the long-term with-profit funds less the realistic liabilities of non-profit policies, less asset shares aggregated across the with-profit policies and any additional amounts expected at the valuation date to be paid to in-force policy holders 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)
- Norwich Union Life & Pensions (NUL&P)
The realistic liabilities have been included in the gross insurance liabilities and the gross liability for investment contracts on our IFRS balance sheet at 31 December 2006.
| 31 December 2006 | 31 December 2005 | ||||||
|---|---|---|---|---|---|---|---|
| Estimated realistic assets £bn |
Realistic Liabilities*† £bn |
Estimated realistic inherited estate‡ £bn |
Estimated risk capital margin≠ £bn |
Estimated excess £bn |
Estimated excess £bn |
||
| CGNU Life | 14.3 | (11.8) | 2.5 | (0.5) | 2.0 | 1.6 | |
| CULAC | 14.1 | (11.6) | 2.5 | (0.5) | 2.0 | 1.3 | |
| NUL&P# | 27.7 | (25.9) | 1.8 | (0.6) | 1.2 | 0.4 | |
| Aggregate | 56.1 | (49.3) | 6.8 | (1.6) | 5.2 | 3.3 | |
- * Realistic liabilities include shareholders’ proportion of future bonuses of £0.7 billion (31 December 2005: £0.7 billion). Realistic liabilities adjusted to eliminate shareholders’ proportion of future bonuses are £48.6 billion (31 December 2005: £50.5 billion).
- † Realistic liabilities make allowance for guarantees, options and promises on a market consistent stochastic basis. The value of this provision included in realistic liabilities is £0.5 billion, £0.7 billion and £3.0 billion for CGNU Life, CULAC and NUL&P respectively (31 December 2005: £0.7 billion, £0.9 billion and £3.4 billion respectively).
- ‡ The estimated realistic estate at 31 December 2005 was £2.1 billion, £1.9 billion and £1.2 billion for CGNU Life, CULAC and NUL&P respectively.
- ≠ The risk capital margin is 4.2 times covered by the estimated realistic inherited estate (31 December 2005: 2.7 times).
- # The NUL&P fund includes the Provident Mutual (PM) fund, which has realistic assets and liabilities of £2.3 billion and therefore does not impact the realistic inherited estate.
The aggregate investment mix of assets in the three main with-profit funds at 31 December 2006 was:
| 31 December 2006 % |
31 December 2005 % |
|
|---|---|---|
| Equity | 42 | 42 |
| Property | 16 | 15 |
| Fixed interest | 36 | 37 |
| Other | 6 | 6 |
| Total | 100 | 100 |
The equity backing ratios, including property, supporting with-profit asset shares are 74% in CGNU Life, 74% in CULAC and 65% in NUL&P. With-profit business is mainly written through CGNU Life.
Possible reattribution of the inherited estate
We continue to investigate the possibility of a reattribution of the inherited estate of two of our with-profit funds: CGNU Life and CULAC. In February 2006, we announced the nomination of Clare Spottiswoode as policyholder advocate, a consumer led role created to represent policyholders, under new Financial Services Authority (FSA) rule governing reattribution.
In November, we agreed terms of reference with Clare Spottiswoode, and she has agreed to accept the role of independent policyholder advocate. The appointment has been approved by the FSA. We are confident that Clare Spottiswoode’s experience as both a regulator, and as a company director, makes her qualified to represent independently the with-profit policyholders’ interests and negotiate on their behalf. During her nomination period, Clare Spottiswoode has:
- Established an independent office
- Set up a technical team, including actuarial and legal support
- Familiarised herself with a reattribution scheme under FSA rules
- Prepared plans for extensive consultation with policyholders
- Agreed her terms of reference for any reattribution with Aviva, in consultation with the FSA.
At this stage, no decision has been taken to proceed with the reattribution, which will only take place if there is agreement on a fair outcome for policyholders and shareholders. This will include agreement by us and the independent policyholder advocate on any incentive payments to eligible with-profit policyholders.
General insurance
Economic basis
We use a number of measures of risk-based capital to assess the capital requirements for our general insurance businesses. Financial modelling techniques enhance our practice of active capital management, verifying that sufficient capital is available to protect against unforeseen events and adverse scenarios, and to manage risk. Our aim continues to be an optimal use of capital.
UK regulatory basis
Our main UK regulated general insurance subsidiaries are Aviva International Insurance Group (AII) and Norwich Union Insurance (NUI). The combined businesses of AII and NUI have strong solvency positions. The table below sets out the regulatory capital position of the general insurance groups at 31 December 2006:
| 2006 | 2005 | |||
|---|---|---|---|---|
| NUI | AII group | NUI and AII group pro forma |
NUI and AII group pro forma restated |
|
| Capital resources (£bn) | 1.1 | 7.4 | 8.5 | 7.5 |
| Capital resources requirements (£bn) | 0.4 | 4.1 | 4.5 | 4.0 |
| Solvency surplus (£bn) | 0.7 | 3.3 | 4.0 | 3.5 |
| Cover (times) | 3.1 | 1.8 | 1.9 | 1.9 |
In aggregate, the estimated excess solvency surplus, representing the capital resources assets over the capital resources requirement, was £4.0 billion (31 December 2005 restated: £3.5 billion) after covering a minimum capital base of £4.5 billion (31 December 2005 restated: £4.0 billion).
The 2005 figures for AII group, and consequently the NUI and All group pro forma, have been restated to reflect admissability and counterparty restrictions relating to intercompany balances following a revised application of the technical rules. There is no economic impact on the All group or on our capital adequacy (IGD) calculation.
Risk
The Group’s approach to risk and capital management
As part of our overall corporate governance framework we have established a risk and financial management structure whose primary objective is to protect the group from events that hinder the achievement of our objectives, our financial performance, or cause us to fail to exploit opportunities.
We have established a number of policies that deal with the management of both financial and non-financial risks. These policies set out risk appetite, risk management and control and business conduct standards for the group’s worldwide operations. They enable a broadly consistent approach to the management of risk by business units.
For each policy, a member of senior management is responsible for overseeing compliance with that policy throughout the group.
Additionally, we operate a number of oversight committees, to monitor aggregate risk data, take risk management decisions, and to enforce the implementation of the policies. Our finance and risk management committee structure is set out below.
Our governance structure and policies are regularly reviewed to reflect the changing commercial and regulatory environment, and our own organisational structure.
Risk Committees: Financial and Operating Risk
Risk and capital management
We believe that the measurement of economic capital provides a clear and consistent way to monitor and compare the risks in our businesses.
We have developed a capital management framework using Individual Capital Assessment (ICA) principles for identifying the risks that business units, and the group as a whole are exposed to, quantifying their impact on economic capital.
Our ICA estimates how much capital is needed to mitigate the risk of insolvency to a selected remote level, based on a number of stress tests applied to the capital position of the business. These tests, covering both investment and insurance scenarios, are specified centrally to provide consistency between business units to achieve a minimum standard. Additionally, business units can supplement the tests with others applicable to their own situation. The events that are tested may not occur at the same time; therefore we allow for the degree of correlation between them that we might expect. We also allow for diversification benefits (ie when two very different risks have offsetting impacts if they happen at the same time) when aggregating risks, or when aggregating business unit results. This means that the sum of the risks is less than the total of all the individual risks.
The ICA works to a 99.5% confidence level of solvency over one year (equivalent to events occurring in one out of 200 years), in line with UK Financial Services Authority (FSA) regulatory requirements. An ICA has been developed for all material parts of the group, and the results of financial and operating experience tests are linked to our risk reporting model. We also produce projections of the ICA requirement over a number of years to show how the economic capital position is likely to evolve.
ICAs have now been produced for a number of years and the results are used as a basis for discussion with the FSA. ICA analysis is now used in our key decision making processes.
Our ICA uses a mixture of scenario-based testing and risk-based capital models. We are continuing to develop our risk-based capital modelling capability for all of our businesses as part of our longer term program to introduce more complex risk modelling techniques. These risk-based capital techniques will provide a more detailed assessment of the capital needs of the business over a range of probabilities of insolvency and different time horizons. We intend to operate our business increasingly by reference to economic and risk-based capital (RBC) requirements.
We also use financial condition reports (FCRs). FCRs cover the medium-term financial outlook of the business, including forecasts of the overall financial position and key performance indicators under a variety of economic and operating scenarios, allowing for new business sales, to inform our capital and risk management decisions.
We monitor specific risks on a regular basis through our risk-monitoring framework. Our businesses are required to disclose all material risks along with information on the likelihood and severity of these risks and the mitigating actions taken or planned. This process enables us to assess the overall risk exposure of the group, to develop a group-wide risk map identifying concentrations of risk and to define the risks that we are prepared to accept. This risk map is continually monitored and is refreshed quarterly.
The risks facing Aviva
Our ICA models inform us about the relative impact on economic capital from the risks we face, enabling us to formulate mitigating strategies. The types of risks in our business and the way in which we manage them are discussed in detail below.
Market risk
We are exposed to considerable potential adverse financial impact from changes in the values of our investments, caused by changes to interest rates, property prices, and foreign exchange rates. Our business has market risk from fluctuations in both the values of assets held and the value of liabilities. At a group level, we have market risk from owning a portfolio of international businesses whose values can change, and from assets that support the liabilities of our staff pension scheme.
We recognise that such risk is inevitable from the businesses that we run, and that a certain level of market risk is acceptable in order to deliver benefits to both policyholders and shareholders.
For each type of market risk, we have developed clear policies and procedures on how that risk should be monitored and managed, either within our business units or at a group level. Our group investment committee (GIC) is responsible for overseeing market risk and asset liability management.
For example, the GIC identifies the levels of market movement at which mitigating actions should be taken. Actions could include buying downside protection against movements in equity prices or interest rates. The GIC also considers aggregation of market risk, including indirect market risk exposure from our staff pension schemes, and formulates risk appetite decisions for the amounts invested in different types of asset.
We also continually monitor the financial impact of changes to market values through a number of measurements of economic capital or sensitivities to key performance indicators.
Several of our longer term savings businesses sell products where the majority of the market risk is borne by the policyholder. Any market risk attributable to policyholders is prudently managed to satisfy the policyholders’ objectives for risk and reward.
Our market risk policy sets out the minimum principles that business units are expected to follow in managing the assets backing the technical insurance liabilities. We have set standards for the way businesses should match their liabilities with appropriate assets, and have a clear decision-making and monitoring process to be followed when liabilities cannot be matched or a degree of mismatching is desired. We regularly monitor how business units are performing asset liability management (ALM) at both the group investment committee and group asset liability management committee. ALM issues are considered as part of our business risk reporting, and in determining ICA and RBC capital requirements.
Equity price risk
Our largest market risk exposure is to changes in equity prices. We believe in the long-term benefits of holding equities and are prepared to accept the consequential shorter term fluctuations in our shareholder funds. For example a 10% decrease in equity prices* causes a £768 million pre-tax decrease in the level of shareholders’ funds on an IFRS basis and on an EEV basis would reduce embedded value by £1,065 million, net of tax.
Our GIC continually monitors exposure against a risk appetite set and agreed by the Board, and has a process in place to manage the exposure in different market conditions, including extreme movements.
We monitor concentrations of equity risk, for example from material shareholdings in our strategic business partners, or from equities held in our staff pension schemes. We formulate our equity risk management strategy taking into account the full range of our equity holdings.
Interest rate risk
Interest rate risk is the risk that arises from both the products we sell and the value of our investments due to changes in the level of interest rates. For example, long-term debt and fixed income securities are both exposed to fluctuations in interest rates. We are exposed to reductions in interest rates on business carrying investment return guarantees, and to interest rate increases on business carrying surrender value guarantees. A 1% decrease in interest rates would increase shareholders’ funds on an IFRS basis by £806 million pre-tax and on an EEV basis would increase embedded value by £310 million, net of tax. Sensitivities to increases in interest rates are shown in note 50 and the section on EEV reporting.
We manage our interest rate risk in a number of ways. In some categories of our long-term business, we reduce interest rate risk through the close matching of assets and liabilities. On short-term business such as general insurance business, we require a close matching of assets and liabilities by duration to minimise this risk.
If we cannot entirely remove exposure through matching, we also use a variety of derivative instruments including futures, options, swaps, caps and floors in order to hedge against unfavourable market movements in interest rates.
Property price risk
We invest in property assets, in a variety of locations worldwide that are exposed to fluctuation in values. We believe investing in these assets provides long-term benefits for our businesses and clients. Investment in property is managed locally by our business units, subject to the risk appetite of that business unit, and within any local regulations on asset admissibility or liquidity.
Foreign currency exchange risk
We operate internationally and we are therefore exposed to the financial impact arising from changes in the exchange rates of various currencies. Over half of our premium income arises in currencies other than sterling and our net assets are denominated in a variety of currencies, but predominantly in sterling, euros and US dollars.
We generally do not hedge foreign currency revenues, as we prefer to retain revenue locally in each business to support business growth, to meet local and regulatory market requirements, and to maintain sufficient assets in their local currency to match local currency liabilities. We are also exposed to some exchange risk from assets held in staff pension schemes, as a part of the investment strategy agreed with the scheme trustees.
Movements in exchange rates may affect the value of consolidated shareholders’ equity, which is expressed in sterling. This aspect of foreign exchange risk is monitored centrally against limits that we have set to control the extent to which capital deployment and capital requirements are not aligned. We use currency borrowings and derivatives when necessary to keep currency exposures within these predetermined limits, and to hedge specific foreign exchange risks when we feel it is appropriate; for example, in any acquisition or disposal activity.
Derivatives risk
We use derivatives in a number of our businesses to enable efficient investment management, to hedge investment risks, or as part of structured retail savings products. Derivatives can involve complex financial transactions and to minimise the risks involved we have set minimum standards we expect our businesses to adopt when using derivatives and our group derivatives committee monitors exposures, the control framework, and approves any proposed transactions that fall outside the local business unit policy limits.
Shareholders equity by currency
1 Sterling
2 Euro
3 US dollar
4 Other
Credit risk exposures
1 AAA
2 AA
3 A
4 BBB
5 Speculative grade and not rated**
** Not Rated includes mortgages and other debt that does not attract an external rating.
Credit risk
We have a significant exposure to credit risk through our investments in corporate bonds, commercial mortgages, and other securities. We hold these investments for the benefit of both our policyholders and shareholders. We monitor and manage two types of credit risk. Firstly, we manage the exposure to individual counterparties, by measuring exposure against centrally set limits. The aggregate exposure we are prepared to accept takes account of credit ratings issued by rating agencies such as Standard & Poor’s. We also manage the level of risk we are prepared to take, and we are using increasingly detailed analysis to define our optimal balance between risk and reward, monitoring the types of investment available to us to achieve best our aims.
Our group credit committee (GCC) takes responsibility for monitoring credit exposures to individual counterparties and determining who we are prepared to work with. Our GIC sets the credit risk appetite as part of our overall management of market risk.
We are also exposed to credit risk through our use of reinsurance. Our reinsurance security committee, part of our GCC, verifies that reinsurance arrangements are only placed with providers who meet our counterparty credit standards.
Life Insurance risk
Our life insurance businesses are exposed to the full range of life insurance risks from the products that they have written, typically mortality, morbidity risk, as well as experience on persistency and unforeseen expenses.
Our policy on life insurance risk sets out the practice standards we expect our business units to follow in underwriting such risks, and our life insurance risk committee regularly monitors its application, and develops detailed guidance on managing the major areas of risk, and sponsors the sharing of best practice between businesses.
We have a significant exposure to annuity business and our most significant life insurance risk is associated with longevity. Longevity statistics are monitored in detail, compared with emerging industry trends, and the results are used to inform both the reserving and pricing of annuities. Inevitably, there remains uncertainty about the development of future longevity that cannot be removed. Should our annuitant mortality assumptions worsen by 5% then shareholders’ equity would decrease by £300 million pre-tax on an IFRS basis and decrease embedded value by £185 million on an EEV basis, net of tax.
Our business units manage mortality and morbidity risk on protection business using reinsurance and while they can select reinsurers locally, we review reinsurance coverage across the group and our overall reinsurance program is assessed centrally to manage group-wide risk exposures. Sensitivity tests show that we are not materially affected by mortality risk. Our equity reduces by only £20 million for a 5% worsening in assurance mortality experience on an IFRS basis and decreases embedded value by £165 million on an EEV basis, net of tax.
Persistency risk is managed at a business unit level through frequent monitoring of current experience, benchmarked against local market information. Actual experience against the expected level of lapses is also assessed within the analysis of embedded value operating profit. Where possible, the financial impact of lapses is reduced through appropriate product design. The group life insurance risk committee has developed guidelines on persistency management, sharing best practice on the setting of lapse assumptions, product design, experience monitoring, and management action.
Expenses are managed at a business unit level, as part of general business management.
General Insurance risk
Our general insurance businesses are exposed to a typical range of general insurance risks from the business that they underwrite. Such risks include:
- Fluctuation in the timing, frequency and severity of claims and claim settlements compared to that expected when the business was written
- Unexpected claims arising from a single source
- Inadequate reinsurance protection or other risk transfer techniques
- Inadequate reserves.
Our group general insurance risk committee (GIRC) oversees the risk management framework, within a clearly communicated underwriting strategy. We have, as a group, made a clear statement on the target for the combined operating ratio (COR). To achieve this goal, we operate technical management committees focusing on each of our key general insurance risks in detail for example, underwriting, claims management, and reinsurance.
Our largest risk is claims incurred from catastrophe events. This risk is controlled through monitoring risk aggregations and using catastrophe reinsurance cover.
Another material risk is the impact of worsening claims ratios. This risk is actively managed through business unit focus on underwriting discipline, control of claims management, and finding innovative solutions to the way we measure and price the risk we underwrite. For example, our UK business has developed digital flood mapping to understand better the risk to household insurance from flood damage, and has developed “telematics”, our Pay As You Drive™ technology to provide a closer link between risk and pricing.
We actively use reinsurance to help reduce the financial impact of a catastrophe and to manage the volatility of our earnings. Reinsurance purchases are reviewed annually at both business unit and group level to verify that the protection we have purchased matches the level of exposure. Reinsurance arrangements are only placed with providers who meet our counterparty security standards. We use extensive financial modelling and actuarial analysis to optimise the cost and risk management benefits from our reinsurance program.
We cede much of our worldwide catastrophe risk to third-party reinsurers, but retain a pooled element for our own account, gaining diversification benefits. Our total retained risk increases as catastrophe events become more remote, so that our total loss from our most concentrated exposure (northern European wind storm) is approximately £370 million for a one in ten year event, compared to approximately £700 million for a one in 100 year event.
Liquidity risk
Maintaining sufficient available liquid assets to meet our obligations as they fall due is an important part of our financial management practice. Our business units must all operate controls to identify sources of liquidity risk, monitor potential exposures, and manage their liquidity requirements. At group level, we maintain a prudent level of liquidity consistent with the expectations of the FSA and the investment community. We also maintain a buffer of liquid assets to cover unforeseen contingencies including the provision of temporary funds to any of our business units that experience temporary liquidity shortfalls.
Operational risk
We are also exposed to operational risk arising from inadequately controlled internal processes or systems, human error and from external events. This includes all risks that we are exposed to, other than the financial risks described above and strategic and group risks. Operational risks include, for example, information technology, information security, human resources, project management, outsourcing, tax, legal, fraud and compliance.
Our business units are primarily responsible for identifying, managing and reporting these risks as part of our quarterly risk reporting processes. Each operational risk is assessed by considering the potential impact and the probability of the event occurring. Impact assessments are made against financial, operational and reputational criteria.
Business unit management teams must be satisfied that all material risks falling outside our risk appetite are being mitigated, monitored and reported at an appropriate level. Any risks with a high impact level are continually monitored centrally.
Our operational risk committee (ORC) determines the risk appetite that the group can work within for these types of risk, assesses and monitors overall operational risk exposures, identifying any concentrations of operational risk across the group, and in particular verifies that mitigating action plans are implemented.
Accounting basis of preparation
International Financial Reporting Standards (IFRS)
The consolidated financial statements and financial data contained in the report and accounts has been prepared using the group’s accounting policies on an IFRS basis. These policies are in accordance with standards issued by the IASB and endorsed by the EU, including the early adoption of IFRS 7 as detailed in policy A. The date of transition from UK GAAP to IFRS was 1 January 2004.
Where applicable, the financial statements have also been prepared in accordance with the Statement of Recommended Practice (SORP) on accounting for insurance business issued by the Association of British Insurers (ABI) in December 2005, as amended in December 2006.
IFRS 7 covers disclosures for financial instruments, and replaces earlier standards on this subject. Although the new standard extends the disclosures in the financial statements in several places, it does not affect the policies themselves.
The only change to the accounting policies in 2006 has been from an amendment to the financial instruments standard (IAS 39) that deals with accounting for financial guarantee contracts. While not material at the consolidated group level, this does affect the company and its subsidiaries in respect of inter-company guarantees given and taken.
European Embedded Value (EEV) basis of reporting
We present the results and financial position of our life and related businesses on an EEV basis, in addition to the IFRS basis. The directors’ opinion is that the EEV basis provides a more relevant and transparent view of the performance of the life and related operations year-on-year than the results presented under the IFRS basis. The EEV methodology adopted is in accordance with the EEV Principles introduced by the CFO Forum in May 2004, and the additional guidance on EEV disclosures published by the CFO Forum in October 2005.
On an EEV basis, the value of a policy recorded in the year of sale takes into account future cash flows relating to that policy. Various assumptions are used to estimate the present value of a policy. In subsequent years, the present value of the policy is adjusted only to reflect changes in the assumptions used.
In contrast, on an IFRS basis, the value of a sale does not take into account future cash flows. These subsequent cash flows are recorded in the year in which they occur. The recorded value of a sale will reflect the premium received to date, the cost of setting up an appropriate reserve, costs incurred in acquiring that business and an allowance to recognise some of these acquisition costs should be deferred and earned in line with the premium. Therefore, the value associated with writing the same business will be recorded differently in the year of sale on EEV and IFRS bases. However, the total profit recognised over the full lifetime of an insurance policy is the same as under the IFRS basis of reporting. We believe that the EEV basis gives a fairer indication of the profitability of business on inception.
Additionally, shareholders’ funds on an EEV basis incorporate internally generated additional value of in-force business (AVIF), which is excluded for IFRS reporting. Our incentive schemes and internal management reporting are aligned to the EEV basis. These financial statements include supplementary information on EEV reporting in the “Alternative method of reporting long-term business” section.
Longer term investment return
The long-term nature of much of our operations means that short-term realised and unrealised gains and losses on general insurance and health business are shown as an adjustment to operating profit. We focus instead on operating profit incorporating a longer term investment return (LTIR). Our rates of return that we use for equity and property in our LTIR methodology are aligned with the rates that we use under EEV principles. For fixed interest securities, we include the amortisation of premiums or discounts arising on purchase, thereby producing an LTIR that is equivalent to the gross redemption yield.
Critical accounting policies and estimates
The preparation of our financial statements requires us to make estimates and assumptions that affect items reported in the consolidated income statement, balance sheet, other primary statements and notes to the financial statements. All estimates are based on management’s current knowledge, assumptions based on that knowledge, and their predictions of future events and actions. Actual results can always differ from estimates, possibly significantly.
The table below sets out those items that we consider particularly susceptible to changes in estimates and assumptions, and the relevant accounting policy. Full details of the accounting policies.
| Item | Accounting policy |
|---|---|
| Insurance product classification | E |
| Insurance and participating investment contract liabilities | J |
| Goodwill, AVIF and other intangible assets | M |
| Impairment of financial investments | R |
| Fair value of derivative financial instruments | S |
| Deferred acquisition costs and other assets | U |
| Provisions and contingent liabilities | X |
| Pension obligations | Y |
| Deferred tax | Z |
Future accounting developments
We seek to take an active role in the development of new accounting standards, via industry forums and working parties, and reviewing and providing comment on proposals from the International Accounting Standards Board (IASB).
Phase II of the IASB’s project on insurance contracts remains the most significant area that we are tracking. During 2006, the insurance industry has worked closely with the IASB in seeking to develop a comprehensive global accounting standard for insurance that will reflect the economics of our business. In June 2006, the CFO Forum representing the large European insurers, in which we play an active role, published principles for measurement and recognition of insurance liabilities. We now await publication of the IASB’s preliminary views in the first quarter of 2007. This is the first stage in the development of the IASB’s standard and it is unlikely to be finalised before the end of 2009 at the earliest. The range of possible outcomes remains large; therefore, it is too early to predict the impact this change in accounting will have. While this standard is under development, we will continue to focus on EEV as the best measure of value for our long-term business.
We continue to monitor other major IASB projects including financial statement presentation, liabilities, revenue recognition and fair value measurement. The announcement from the IASB that no new standards or major amendments would become mandatory before 2009 and that the level of public consultation in the development of new standards would increase was welcomed.