Aviva 2006 Annual Report Download - page 230

Aviva plc
Annual Report and Accounts 2006 226Financial statements continued
Alternative method of reporting long-term business profits continued
EEV methodology continued
Risk discount rates
Under the EEV methodology, a risk discount rate (RDR) is required to express a stream of expected future distributable profits as a
single value at a particular date (the present value). It is the interest rate that an investment equal to the present value would have to
earn in order to be able to replicate exactly the stream of future profits. The RDR is a combination of a risk free rate to reflect the time
value of money plus a risk margin to make prudent allowance for the risk that experience in future years may differ from that assumed.
In particular, a risk margin is added to allow for the risk that expected additional returns on certain asset classes (e.g. equities) are
not achieved.
Risk discount rates for our life businesses have been calculated using a risk margin based upon a Group Weighted Average Cost of
Capital (WACC). The Group WACC is calculated using a gross risk free interest rate, an equity risk margin, a market assessed risk factor
(beta), and an allowance for the gearing impact of debt financing (including subordinated debt) on a market value basis. The market
assessed risk factor captures the market’s view of the effect of all types of risk on our business, including operational and other
non-economic risk.
The RDR is only one component of the overall allowance for risk in EEV calculations. Risk is also allowed for in the cost of holding
statutory reserving margins, additional required capital and in the time value of options and guarantees. Hence to derive the RDR the
Group WACC is adjusted to reflect the average level of required capital assumed to be held, and to reflect the explicit valuation of the
time value of options and guarantees.
In order to derive risk discount rates for each of our life businesses, the adjusted Group WACC is expressed as a risk margin in excess of
the gross risk free interest rate used in the WACC calculation as described above. This risk margin is used for all our main businesses
including the US. Business-specific discount rates are then calculated as the sum of this risk margin and the appropriate local gross risk
free rate at the valuation date, based on returns on government bonds. A common risk free rate, and hence a common RDR, is used for
all of our businesses within the Eurozone. Additional country-specific risk margins are applied to smaller businesses to reflect additional
economic, political and business-specific risk. For example, risk margins ranging from 3.7% to 8.7% are applied to the Group’s eastern
European and Asian operations. Within each business, a constant RDR has been applied in all futuretime periods and in each of the
economic scenarios underlying the calculation of the time value of options and guarantees.
At each valuation date, the risk margin is reassessed based on current economic factors and is updated only if a significant change has
occurred. In particular, changes in risk profile arising from movements in asset mix are allowed for via the updated risk margin calculation.
Following the review of the risk margin at 31 December 2006, the Directors have decided to leave the life embedded value risk margin
unchanged at 2.7% . The market assessed risk factor (beta) has reduced in recent periods, implying a reduction of the risk in the life
business. Management will keep the risk margin under review and will make adjustments as necessary to reflect past trends and future
expected trends in the riskiness of the life business, based on the beta.
The sensitivity disclosures on page 240 indicate the impact to the embedded value that would arise from a change in the risk
discount rate.
Participating business
Future regular bonuses on participating business are projected in a manner consistent with current bonus rates and expected future
returns on assets deemed to back the policies.
For with-profit funds in the UK and Ireland, for the purpose of recognising the value of the estate, it is assumed that terminal bonuses
areincreased to exhaust all of the assets in the fund over the futurelifetime of the in-force with-profit policies. However,under stochastic
modelling theremay be some extreme economic scenarios when the total assets in the Group’s with-profit funds are not sufficient to pay
all policyholder claims. The average additional shareholder cost arising from this shortfall has been included in the time value of options
and guarantees.
For profit sharing business in continental Europe, wherepolicy benefits and shareholder value depend on the timing of realising gains,
apportionment of unrealised gains between policyholders’ benefits and shareholders reflect contractual requirements as well as existing
practice. Where under certain economic scenarios additional shareholder injections are required to meet policyholder payments, the
average additional cost has been included in the time value of options and guarantees.
Consolidation adjustments
The effect of transactions between our life companies such as loans and reinsurance arrangements has been included in results split
by territory in a consistent manner.No elimination is required on consolidation.
As the EEV methodology incorporates the impact of profits and losses arising from subsidiary companies providing administration,
investment management and other services to the Group’s life companies, the equivalent profits and losses have been removed from
the relevant segment (non insurance or fund management) and areinstead included within the results of life and related businesses.
In addition, the underlying basis of calculation for these profits has changed from the IFRS basis to the EEV basis.
The capitalised value of the future profits and losses from such service companies are included in the embedded value and new business
contribution calculations for the relevant territory, but the net assets (representing historical profits and other amounts) remain under non
insurance or fund management. In order to reconcile the profits arising in the financial period within each segment with the assets on the
opening and closing balance sheets, a transfer of IFRS profits from life and related business to the appropriate segment is deemed to
occur. An equivalent approach has been adopted for expenses within our holding companies.