Aviva 2009 Annual Report Download - page 194

192
Aviva plc Notes to the consolidated financial statements continued
Annual Report and Accounts 2009
24 – Financial investments continued
(b) Fair value methodology
(i) For financial assets carried at fair value, we have categorised the measurement basis into a “fair value hierarchy” as follows:
Quoted market prices in active markets – (‘Level 1’)
Inputs to Level 1 fair values are quoted prices (unadjusted) in active markets for identical assets. An active market is one in which
transactions for the asset occur with sufficient frequency and volume to provide pricing information on an ongoing basis. Examples
are listed equities in active markets, listed debt securities in active markets and quoted unit trusts in active markets.
Modelled with significant observable market inputs – (‘Level 2’)
Inputs to Level 2 fair values are inputs other than quoted prices included within Level 1 that are observable for the asset, either
directly or indirectly. If the asset has a specified (contractual) term, a Level 2 input must be observable for substantially the full term
of the asset. Level 2 inputs include the following:
— Quoted prices for similar (ie not identical) assets in active markets.
— Quoted prices for identical or similar assets in markets that are not active, the prices are not current, or price quotations vary
substantially either over time or among market makers, or in which little information is released publicly.
— Inputs other than quoted prices that are observable for the asset (for example, interest rates and yield curves observable at
commonly quoted intervals, volatilities, prepayment spreads, loss severities, credit risks, and default rates).
— Inputs that are derived principally from, or corroborated by, observable market data by correlation or other means (market-
corroborated inputs).
Examples of these are securities measured using discounted cash flow models based on market observable swap yields, and listed
debt or equity securities in a market that is inactive. Valuations, whether sourced from internal models or third parties incorporate
credit risk by adjusting the spread above the yield curve for government treasury securities for the appropriate amount of credit risk
for each issuer, based on observed market transactions. To the extent observed market spreads are either not used in valuing a
security, or do not fully reflect liquidity risk, our valuation methodology, whether sourced from internal models or third parties,
reflects a liquidity premium.
Where we use broker quotes and no information as to the observability of inputs is provided by the broker, we generally
validate the price quoted by the broker by using internal models with observable inputs. When the price obtained from the broker
and internal model are similar, we look to the inputs used in our internal model to understand the observability of the inputs used
by the broker. In circumstances where internal models are not used to validate broker prices, and the observability of inputs used
by brokers is unavailable, the investment is classified as Level 3. Broker quotes are usually non-binding.
Modelled with significant unobservable market inputs – (‘Level 3’)
Inputs to Level 3 fair values are unobservable inputs for the asset. Unobservable inputs may have been used to measure fair value
to the extent that observable inputs are not available, thereby allowing for situations in which there is little, if any, market activity
for the asset at the measurement date (or market information for the inputs to any valuation models). As such, unobservable
inputs reflect the assumptions the business unit considers that market participants would use in pricing the asset. Examples are
certain private equity investments and private placements.
The majority of the Group’s financial assets are valued based on quoted market information or observable market data. A
small percentage (4%) of total financial assets recorded at fair value, are based on estimates and recorded as Level 3 investments.
Where estimates are used, these are based on a combination of independent third-party evidence and internally developed models,
calibrated to market observable data where possible. Whilst such valuations are sensitive to estimates, it is believed that changing
one or more of the assumptions to reasonably possible alternative assumptions would not change the fair value significantly.
The principal investments classified as Level 3 are:
— Structured bond type products held by our businesses in France and Italy amounting to £7.0 billion, for which there is no active
market. These bonds are valued either using third party counterparty or broker quotes. These bonds are validated against
internal or third party models. Most of these bonds have been classified as Level 3 because either, (i) the third party models
included a significant unobservable liquidity adjustment or (ii) differences between the valuation provided by the counterparty
and broker quotes and the validation model were sufficiently significant to result in a Level 3 classification. At 31 December
2009, the counterparty and broker quotes used to value these products were less than the modelled valuations.
— Notes issued by loan partnerships held by our UK Life business amounting to £1.0 billion, for which there is no active market.
These are valued using counterparty quotes, corroborated against the prices of selected similar securities. In 2009 there was
insufficient market observable transactions in the selected securities to provide a reliable proxy price to corroborate the
counterparty price.
— Private equity investment funds held by our UK Life business amounting to £0.8 billion. In valuing our interest in these funds, we
rely on investment valuation reports received from the fund manager, making adjustments for items such as subsequent draw
downs and distributions between the date of the report and valuation date and the fund manager’s carried interest.
— Certain direct private equity investments and private placements held by our business in the Netherlands and strategic interests
in banking partners held by our Italian business amounting to £0.8 billion. Valuations are based on third-party independent
appraisals, or where internally modelled, transactions in similar entities, discounted cash flow techniques and valuation
multiples, using public and internal management information.
— Other Level 3 investments amount to £1.6 billion and relate to a diverse range of different types of securities held by a number
of businesses throughout the Group.