Aviva 2006 Annual Report Download - page 62

Aviva plc
Annual Report and Accounts 2006 58
Finance continued
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.
Wemonitor 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.
Weare 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.
Wegenerally 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 staffpension 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.
Business review continued
*Effect of decrease in equity prices includes the effect of a 10% decrease in property prices.