Aviva 2009 Annual Report Download - page 293

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Performance review
Aviva plc MCEV financial statements continued
Corporate responsibility
Annual Report and Accounts 2009
Governance
Shareholder information
Financial statements IFRS
Financial statements MCEV
Other information
M1 – Basis of preparation continued
Time value of financial options and guarantees (TVOG)
The PVFP calculation is based on a single (base) economic scenario. However, a single scenario cannot appropriately allow for
the effect of certain product features. If an option or guarantee affects shareholder cash flows in the base scenario, the impact
is included in the PVFP and is referred to as the intrinsic value of the option guarantee.
However, future investment returns are uncertain and the actual impact on shareholder profits may be higher or lower.
The value of in-force business needs to be adjusted for the impact of the range of potential future outcomes. Stochastic
modelling techniques can be used to assess the impact of potential future outcomes, and the difference between the intrinsic
value and the total stochastic value is referred to as the time value of the option or guarantee.
Stochastic modelling typically involves projecting the future cash flows of the business under thousands of economic scenarios
that are representative of the possible future outcomes for market variables such as interest rates and equity returns. Under a
market consistent approach, the economic scenarios generated reflect the market’s tendency towards risk aversion. Allowance
is made, where appropriate, for the effect of management and/or policyholder actions in different economic conditions on future
assumptions such as asset mix, bonus rates and surrender rates.
Stochastic models are calibrated to market yield curves and volatility levels at the valuation date. Tests are performed to
confirm that the scenarios used produce results that replicate the market price of traded instruments.
Where evidence exists that persistency rates are linked to economic scenarios, dynamic lapse assumptions are set that vary
depending on the individual scenarios. This cost is included in the TVOG. Dynamic lapses are modelled for parts of the US and
French businesses. Asymmetries in non-economic assumptions that are linked to economic scenarios, but that have insufficient
evidence for credible dynamic assumptions, are allowed for within mean best estimate assumptions.
Frictional costs of required capital
The additional costs to a shareholder of holding the assets backing required capital within an insurance company rather than
directly in the market are called frictional costs. They are explicitly deducted from the PVFP. The additional costs allowed for are the
taxation costs and any additional investment expenses on the assets backing the required capital. The level of required capital has
been set out above in the net worth section.
Frictional costs are calculated by projecting forwards the future levels of required capital. Tax on investment return and
investment expenses are payable on the assets backing required capital, up until the point that they are released to shareholders.
Cost of residual non-hedgeable risks (CNHR)
The cost of residual non-hedgeable risks (CNHR) covers risks not already allowed for in the time value of options and guarantees or
the PVFP. The allowance includes the impact of both non-hedgeable financial and non-financial risks. The most significant risk not
included in the PVFP or TVOG is operational risk.
The methodology includes a cost of non-hedgeable risk equivalent to a charge of 2.5% applied to group-diversified capital.
The cost has been calculated as a 1.5% charge applied to business unit-level capital that is, allowing for diversification within a
business unit, but not between business units. The charge was set so as to give an aggregate allowance that was in excess of the
expected operational risk costs arising from the in-force covered business over its remaining lifetime.
The capital levels used are projected to be sufficient to cover non-hedgeable risks at the 99.5% confidence level one-year after
the valuation date. The capital is equal to the capital from the ICA results for those risks considered. The capital has been projected
as running off over the remaining life of the in-force portfolio in line with the drivers of the capital requirement.
In addition to the operational risk allowance, financial non-hedgeable risks and other product level asymmetries have been
allowed for. These allowances are not material as significant financial non-hedgeable risks and product level asymmetries are either
modelled explicitly and included in the TVOG or are included in the PVFP through the use of appropriate best estimate
assumptions.
Asymmetric risks allowed for in the TVOG or PVFP are described earlier in the Basis of preparation. No allowance has been
made within the cost of non-hedgeable risk for symmetrical risks as these are diversifiable by investors.
Participating business
Future regular bonuses on participating business are projected in a manner consistent with current bonus rates and expected
future market-consistent 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 are increased to exhaust all of the assets in the fund over the future lifetime of the in-force with-profit policies. However,
under stochastic modelling there may 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 TVOG.
For profit sharing business in continental Europe, where policy benefits and shareholder value depend on the timing of
realising gains, the apportionment of unrealised gains between policyholders and shareholders reflect contractual requirements
as well as existing practice. Under certain economic scenarios where additional shareholder injections are required to meet
policyholder payments, the average additional cost has been included in the TVOG.
The embedded value of the US spread-based products anticipates the application of management discretion allowed for
contractually within the policies, subject to contractual guarantees. This includes the ability to change the crediting rates and
indexed strategies available within the policy. Consideration is taken of the economic environment assumed in future projections
and returns in excess of the reference rate are not assumed. Anticipated market and policyholder reaction to management action
has been considered. The anticipated management action is consistent with current decision rules and has been approved and
signed off by management and legal counsel.
Financial statements MCEV