Aviva 2013 Annual Report Download - page 302

Aviva plc
Annual report and accounts 2013
300
Shareholder information continued
We have a significant exposure to third parties that owe us
money, securities or other assets who may not perform under
their payment obligations. These parties include private sector
and government (or government-backed) issuers whose debt
securities we hold in our investment portfolios (including
mortgage-backed, asset-backed, government bonds and other
types of securities), borrowers under residential and commercial
mortgages and other loans, re-insurers to which we have ceded
insurance risks, customers, trading counterparties, and
counterparties under swap and other derivative contracts.
We also execute transactions with other counterparties in the
financial services industry, including brokers and dealers,
commercial and investment banks, hedge funds and other
investment funds, insurance groups and institutions. Many of
these transactions expose us to credit risk in the event of default
of our counterparty.
In addition, with respect to secured transactions, our credit
risk may be increased when the collateral held by us cannot be
realised or is liquidated at prices insufficient to recover the full
amount of the loan or other value due. We also have exposure
to financial institutions in the form of unsecured debt
instruments and derivative transactions. Such losses or
impairments to the carrying value of these assets could
materially and adversely affect our financial condition and
results of operations.
We use reinsurance and hedging programmes to hedge
various risks, including certain guaranteed minimum benefit
contained in many of our long-term insurance and fund
management products. These programmes cannot eliminate all
of the risks and no assurance can be given as to the extent to
which such programmes will be effective in reducing such risks.
We enter into a variety of derivative instruments, including
options, forwards, interest rate and currency swaps, with a
number of counterparties. Our obligations under our fund
management and life products are not changed by our hedging
activities and we are liable for our obligations even if our
derivative counterparties do not pay us. Defaults by such
counterparties could have a material adverse effect on our
financial condition and results of operations.
We are also susceptible to an adverse financial outcome
from a change in third-party credit standing. As well as having
a potential impact on spreads, credit rating movements can
also impact on our solvency and our profitability and
shareholders’ equity.
Market risks relating to Aviva’s business
Changes in interest rates may cause policyholders to
surrender their contracts, reduce the value of our investment
portfolio and impact our asset and liability matching,
which could adversely affect our results of operation and
financial condition.
Our exposure to interest rate risk relates primarily to the market
price and cash flow variability of assets and liabilities associated
with changes in interest rates.
Some of our products, principally traditional participating
products, universal life insurance and annuities, expose us to the
risk that changes in interest rates will reduce our ‘spread’, or the
difference between the amounts that we are required to pay
under the contracts and the rate of return we are able to earn
on investments intended to support obligations under the
contracts. Our spread is a key component of our net income.
As interest rates decrease or remain at low levels, we may be
forced to reinvest proceeds from investments that have matured
or have been prepaid or sold at lower yields, reducing our
investment return. Moreover, borrowers may prepay or redeem
the fixed-income securities, commercial mortgages and
mortgage-backed securities in our investment portfolio with
greater frequency in order to borrow at lower market rates
which increases this risk. Lowering interest crediting or
policyholder bonus rates can help offset decreases in investment
margins on some products. However, our ability to lower these
rates could be limited by competition or by contractually
guaranteed minimum rates and may not match the timing or
magnitude of changes in asset yields. As a result, our spread
could decrease or potentially become negative. Our expectation
for future spreads is an important component in the
amortisation of policy acquisition costs and significantly lower
spreads may cause us to accelerate amortisation, thereby
reducing net income in the affected reporting period. In
addition, during periods of declining interest rates, the
guarantees within existing life insurance and annuity products
may be more attractive to consumers, resulting in increased
premium payments on products with flexible premium features,
and a higher percentage of insurance policies remaining in force
from year to year, during a period when our new investments
carry lower returns. Accordingly, during periods of declining
interest rates, profitability may suffer as the result of a decrease
in the spread between interest rates credited to policyholders
and returns on our investment portfolio.
Increases in market interest rates could also negatively affect
our profitability. This could arise as the accommodative
monetary policies of central banks, in particular the US Federal
Reserve and the Bank of England, are wound down or stopped.
Surrenders of life insurance policies may increase as
policyholders seek higher returns and higher guaranteed
minimum returns. Obtaining cash to satisfy these surrenders
may require us to liquidate fixed maturity investments at a time
when market prices for those assets are depressed which may
result in realised investment losses. Regardless of whether we
realise an investment loss, these cash payments would result in
a decrease in total invested assets, and may decrease our net
income. Premature withdrawals may also cause us to accelerate
amortisation of policy acquisition costs, which would also
reduce our net income.
Our mitigation efforts with respect to interest rate risk are
primarily focused on maintaining an investment portfolio with
diversified maturities that has a weighted average duration
approximately equal to the duration of our estimated liability
cash flow profile. However, it may not be possible to hold assets
that will provide cash flows to exactly match those relating to
policyholder liabilities, in particular in jurisdictions with less
developed bond markets and in certain markets where
regulated surrender value or maturity values are set with
reference to the interest rate environment prevailing at the time
of policy issue. This is due to the duration and uncertainty of the
liability cash flows and the lack of sufficient assets of suitable
duration. This results in a residual asset/liability mismatch risk
that can be managed but not eliminated. In addition, our
estimate of the liability cash flow profile may be inaccurate for
other reasons, such as varying mortality or general insurance
claims, and we may be forced to liquidate investments prior to
maturity at a loss in order to cover the liability. Such a loss could
have a material adverse effect on our results of operations and
financial condition.
Changes in short or long term inflation may cause
policyholders to surrender their contracts, increase the size
of our claims payments and expenses and reduce the value
of our investments, which could adversely affect our results
of operations and financial condition.
We are subject to inflation risk through our holdings of fixed
interest and other investments and as a result of the potential
for the cost of claims and expenses to rise faster than
anticipated in our pricing or reserving. Changes in inflation
could also affect the value perceived to be offered by our
policies and so adversely affect persistency levels.