Aviva 2006 Annual Report Download - page 243

Overview Business review Governance Financial statements Other information
Aviva plc
Annual Report and Accounts 2006 239
Principal economic assumptions – deterministic calculations continued
For the UK, the statistics are the same over all projection horizons. Assumptions are also required for correlations between asset classes.
These have been set based on an assessment of historical data. Returns for corporate fixed interest investments in each scenario are equal
to the return on Government bonds plus a fixed additional amount, based on current spreads less a margin for credit risk.
International
Model
Government nominal interest rates are generated by a model that projects a full yield curve at annual intervals. The model assumes that
the logarithm of the short rate follows a mean reverting process subject to two normally distributed random shocks. This ensures that
nominal interest rates are always positive, the distribution of future interest rates remains credible, and the model can be calibrated to
give a good fit to the initial yield curve.
The total annual return on equities is calculated as the return on 1-year bonds plus an excess return. The excess return is assumed to have
alognormal distribution. The model also generates property total returns and real yield curves, although these are not significant asset
classes for Aviva outside the UK.
Asset Classes
The most important assets arefixed rate bonds of various durations. In some businesses equities are also an important asset class.
Summary Statistics
The following table sets out the means and standard deviations of future euro and US dollars returns at 31 December 2006 for the three
most significant asset classes: equities (in the case of Euro), short-term bonds (defined to be of 1-year duration) and long-term bonds
(defined to be 10-year zero coupon bonds). In the accumulation of 10-year bonds, it is assumed that these are held for one year, sold as
9-year bonds then the proceeds are reinvested in 10-year bonds, although in practice businesses follow more complex asset strategies or
tend to adopt a buy and hold strategy. Correlations between asset classes have been set using the same approach as described for the
United Kingdom.
5-year return 10-year return 20-year return
Mean1StDev2Mean1StDev2Mean1StDev2
Euro
Short Government Bonds 3.7% 1.7% 3.7% 3.0% 3.8% 5.3%
Long Government Bonds 4.2% 3.8% 4.1% 2.9% 4.1% 3.3%
Equities 7.0% 19.5% 6.9% 19.3% 6.9% 19.0%
US dollar
Short Government Bonds 4.5% 2.0% 4.4% 3.5% 4.7% 6.7%
Long Government Bonds 5.0% 4.5% 4.8% 3.7% 5.0% 4.4%
1. Means have been calculated by accumulating a unit investment for the required number of years in each simulation, averaging the accumulation across all simulations,
and converting the result to an equivalent annual rate (by taking the nth root of the average accumulation minus 1).
2. Standard deviations have been calculated by accumulating a unit investment for the required number of years in each simulation, taking the natural logarithm of the result,
calculating the variance of this statistic, dividing by the projection period (n years) and taking the square root. This makes the result comparable to implied volatilities quoted in
investment markets.
Other assumptions
Taxation
Current tax legislation and rates have been assumed to continue unaltered, except where changes in future tax rates have been
announced.
Demographic assumptions
Assumed future mortality, morbidity and lapse rates have been derived from an analysis of Aviva’s recent operating experience. Where
appropriate, surrender and option take up rate assumptions that vary according to the investment scenario under consideration have
been used in the calculation of the time value of options and guarantees, based on our assessment of likely policyholder behaviour in
different investment scenarios.
Expense assumptions
Management expenses and operating expenses of holding companies attributed to life and related businesses have been included in the
EEV calculations and split between expenses relating to the acquisition of new business, the maintenance of business in-force and project
expenses. Future expense assumptions include an allowance for maintenance expenses and a proportion of recurring project expenses.
Certain expenses of an exceptional nature, when they occur, are identified separately and are generally charged as incurred. No future
productivity gains have been anticipated.
Where subsidiary companies provide administration, investment management or other services to businesses included in the European
Embedded Value calculations, the value of profits or losses arising from these services have been included in the embedded value and
new business contribution.
Valuation of debt
Borrowings in the EEV consolidated balance sheet are valued on an IFRS basis, consistent with the primary financial statements.
At 31 December 2006 the market value of the Group’s external debt, subordinated debt, preference shares including General Accident plc
preference shares of £250 million (classified as minority interests) and direct capital instrument was £5,991 million (31 December 2005:
£5,868 million).