Aviva 2009 Annual Report Download - page 292

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Aviva plc MCEV financial statements continued
Annual Report and Accounts 2009
Calculation of the embedded value
The shareholders’ interest in the life and related businesses is represented by the embedded value. The embedded value is the total
of the net worth of the life and related businesses and the value of in-force covered business. Calculations are performed
separately for each business and are based on the cash flows of that business, after allowing for both external and intra-group
reinsurance. Where one life business has an interest in another, the net worth of that business excludes the interest in the
dependent company.
The embedded value is calculated on an after-tax basis applying current legislation and practice together with future known
changes. Where gross results are presented, these have been calculated by grossing up post-tax results at the full rate of
corporation tax for each country based on opening period tax rates, apart from the US, where a nil tax rate has been used
in the post-tax results, and consequently for ‘grossing up’.
Net worth
The net worth is the market value of the shareholders’ funds and the shareholders’ interest in the surplus held in the non-profit
component of the long-term business funds, determined on a statutory solvency basis and adjusted to add back any non-
admissible assets, and consists of the required capital and free surplus.
Required capital is the market value of assets attributed to the covered business over and above that required to back liabilities
for covered business, for which distribution to shareholders is restricted. Required capital is reported net of implicit items permitted
on a local regulatory basis to cover minimum solvency margins which are assessed at a local entity level. The level of required
capital for each business unit is set equal to the higher of:
— The level of capital at which the local regulator is empowered to take action;
— The capital requirement of the business unit under the group’s economic capital requirements; and
— The target capital level of the business unit.
This methodology reflects the level of capital considered by the directors to be appropriate to manage the business, and includes
any additional shareholder funds not available for distribution, such as the reattributed inherited estate in the UK. The same
definition of required capital is used for both existing and new business.
The free surplus is the market value of any assets allocated to, but not required to support, the in-force covered business at the
valuation date. The level of required capital across the business units expressed as a percentage of the EU minimum solvency
margin (or equivalent) can be found on page 308.
Value of in-force covered business (VIF)
The value of in-force covered business consists of the following components:
— present value of future profits;
— time value of financial options and guarantees;
— frictional costs of required capital; and
— cost of residual non-hedgeable risks.
Present value of future profits (PVFP)
This is the present value of the distributable profits to shareholders arising from the in-force covered business projected on a best
estimate basis.
Distributable profits generally arise when they are released following actuarial valuations. These valuations are carried out
in accordance with any local statutory requirements designed to ensure and demonstrate solvency in long-term business funds.
Future distributable profits will depend on experience in a number of areas such as investment return, discontinuance rates,
mortality, administration costs, as well as management and policyholder actions. Releases to shareholders arising in future years
from the in-force covered business and associated required capital can be projected using assumptions of future experience.
Future profits are projected using best estimate non-economic assumptions and market consistent economic assumptions.
In principle, each cash flow is discounted at a rate that appropriately reflects the riskiness of that cash flow, so higher risk cash
flows are discounted at higher rates. In practice, the PVFP is calculated using the “certainty equivalent” approach, under which the
reference rate is used for both the investment return and the discount rate. This approach ensures that asset cash flows are valued
consistently with the market prices of assets without options and guarantees. Further information on the risk-free rates is given in
note M18.
The PVFP includes the capitalised value of profits and losses arising from subsidiary companies providing administration,
investment management and other services to the extent that they relate to covered business. This is referred to as the “look
through” into service company expenses. In addition, expenses arising in holding companies that relate directly to acquiring or
maintaining covered business have been allowed for. Where external companies provide services to the life and related businesses,
their charges have been allowed for in the underlying projected cost base.