Aviva 2006 Annual Report Download - page 181

Overview Business review Governance Financial statements Other information
Aviva plc
Annual Report and Accounts 2006 177
38 – Financial guarantees and options continued
(iii) Ireland
Guaranteed annuity options
Products with similar GAOs to those offered in the UK have been issued in Ireland. The current net of reinsurance provision for such
options is £152 million (2005: £145 million).This has been calculated on a deterministic basis, making conservative assumptions for the
factors which influence the cost of the guarantee, principally annuitant mortality and long-term interest rates.
These GAOs are “in the money” at current interest rates but the exposure to interest rates under these contracts has been hedged
through the use of reinsurance, using derivatives (swaptions). The swaptions effectively guarantee that an interest rate of 5% will be
available at the vesting date of these benefits so there is no exposure to a further decrease in interest rates.
“No MVR” guarantees
Certain unitised with-profit policies containing “no MVR” guarantees, similar to those in the UK, have been sold in Ireland.
These guarantees are currently “out-of-the-money” by £69 million (2005: £84 million).This has been calculated on a deterministic basis
as the excess of the current policy surrender value over the discounted value (excluding terminal bonus) of the guarantees. The value of
these guarantees is sensitive to the performance of investments held in the with-profit fund. Amounts payable under these guarantees
aredetermined by the bonuses declared on these policies. It is estimated that the guarantees would be out-of-the-money by £74 million
(2005: £74 million) if yields were to increase by 1% per annum and by £31 million (2005: £39 million) if equity markets were to decline
by 10% from year end 2006 levels.
Return of premium guarantee
In 2005, Hibernian Life wrote two tranches of linked bonds with a return of premium guarantee after five or six years. The provision for
these at the end of 2006 is £nil (2005: £3 million).It is expected that the provision would not increase if equity markets were to decline
by 10% from year end 2006 levels. We would not expect any significant impact on this provision as a result of interest movements.
(iv) Spain and Italy
Guaranteed investment returns and guaranteed surrender values
The Group has also written contracts containing guaranteed investment returns and guaranteed surrender values in both Spain and Italy.
Traditional profit-sharing products receive an appropriate share of the investment return, assessed on a book value basis, subject to a
guaranteed minimum annual return of up to 6% in Spain and 4% in Italy on existing business, while on new business the maximum
guaranteed rate is lower.Liabilities are generally taken as the face value of the contract plus, if required, an explicit provision for
guarantees calculated in accordance with local regulations. At 31 December 2006, total liabilities for the Spanish business were
£3 billion (2005: £2 billion)with a further reserve of £18 million (2005: £20 million) for guarantees. Total liabilities for the Italian
business were£5 billion (2005: £4 billion),with a further provision of £46 million (2005: £55 million) for guarantees. Liabilities aremost
sensitive to changes in the level of interest rates. It is estimated that provisions for guarantees would need to increase by £66 million
(2005: £66 million)in Spain and £9 million (2005: £12 million) in Italy if interest rates fell by 1% from end 2006 values. Under this
sensitivity test, the guarantee provision in Spain is calculated conservatively,assuming a long-term market interest rate of 1.42% and
no lapses or premium discontinuances.
(v) United States
Indexed and total return strategy products
In the United States, the Group writes indexed life and deferred annuity products. These products guarantee the return of principal to the
policyholder and credit interest based on certain indices, primarily the Standard & Poor’s 500 Composite Stock Price Index. A portion of
each premium is used to purchase call options to hedge the growth in interest credited to the policyholder. The call options held by the
Group and the options embedded in the policy are both carried at fair value. At 31 December 2006, the total liabilities for indexed
products were £5.4 billion. If interest rates were to increase by 1%, the provision for embedded options would decrease by £51 million
and, if interest rates were to decrease by 1%, the provision would increase by £56 million.
The Group has certain products that credit interest based on a total return strategy, whereby policyholders are allowed to allocate their
premium payments to different asset classes within the general account. The Group guarantees a minimum return of premium plus
approximately 3% interest over the term of the contracts. The linked general account assets are fixed maturity securities, and both the
securities and the contract liabilities are carried at fair value. At 31 December 2006, the liabilities for total return strategy products were
£408 million.
(d) Sensitivity
In providing these guarantees and options, the Group’s capital position is sensitive to fluctuations in financial variables including foreign
currency exchange rates, interest rates, real estate prices and equity prices. Interest rate guaranteed returns, such as those available on
guaranteed annuity options (GAOs), aresensitive to interest rates falling below the guaranteed level. Other guarantees, such as maturity
value guarantees and guarantees in relation to minimum rates of return, aresensitive to fluctuations in the investment returnbelow the
level assumed when the guarantee was made.