Aviva 2014 Annual Report Download - page 228

Aviva plc Annual report and accounts 2014
Notes to the consolidated financial statements continued
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58 – Risk management continued
Equity risk is also managed using a variety of derivative instruments, including futures and options. Businesses actively model the
performance of equities through the use of risk models, in particular to understand the impact of equity performance on
guarantees, options and bonus rates. At 31 December 2014 the Group’s shareholder funds held £2 billion notional of equity hedge
put spreads, with up to 9 months to maturity with an average strike of 81-61% of the prevailing market levels on 31 December
2014.
Sensitivity to changes in equity prices is given in section ‘(j) risk and capital management’ below.
(ii) Property price risk
The Group is subject to property price risk directly due to holdings of investment properties in a variety of locations worldwide and
indirectly through investments in mortgages and mortgage backed securities. Investment in property is managed at business unit
level, and is subject to local regulations on asset admissibility, liquidity requirements and the expectations of policyholders.
As at 31 December 2014, no material derivative contracts had been entered into to mitigate the effects of changes in property
prices.
Sensitivity to changes in property prices is given in section ‘(j) risk and capital management’ below.
(iii) Interest rate risk
Interest rate risk arises primarily from the Group’s investments in long-term debt and fixed income securities and their movement
relative to the value placed on the insurance liabilities. A number of policyholder product features have an influence on the Group’s
interest rate risk. The major features include guaranteed surrender values, guaranteed annuity options, and minimum surrender
and maturity values. Details of material guarantees and options are given in note 43.
Exposure to interest rate risk is monitored through several measures that include duration, economic capital modelling,
sensitivity testing and stress and scenario testing. The impact of exposure to sustained low interest rates is considered within our
scenario testing.
The Group typically manages interest rate risk by investing in fixed interest securities which closely match the interest rate
sensitivity of the liabilities where this is available. In particular, a key objective is to match the duration of our annuity liabilities with
assets of the same duration. These assets include corporate bonds, residential mortgages and commercial mortgages. Should they
default before maturity, it is assumed that the Group can reinvest in assets of a similar risk and return profile, which is subject to
market conditions. Interest rate risk is also managed in some business units using a variety of derivative instruments, including
futures, options, swaps, caps and floors.
Some of the Group’s products, principally participating contracts, expose us to the risk that changes in interest rates will impact
on profits through a change in the interest spread (the difference between the amounts that we are required to pay under the
contracts and the investment income we are able to earn on the investments supporting our obligations under those contracts).
The primary markets where Aviva is exposed to this risk are the UK, France and Italy.
The low interest rate environment in a number of markets around the world has resulted in our current reinvestment yields
being lower than the overall current portfolio yield, primarily for our investments in fixed income securities and commercial
mortgage loans. We anticipate that interest rates may remain below historical averages for an extended period of time and that
financial markets may continue to have periods of high volatility. Investing activity will continue to decrease the portfolio yield as
long as market yields remain below the current portfolio level. We expect the decline in portfolio yield will result in lower net
investment income in future periods.
Certain of the Group’s product lines, such as protection, are not significantly sensitive to interest rate or market movements.
For unit-linked business, the shareholder margins emerging are typically a mixture of annual management fees and risk/expense
charges. Risk and expense margins will be largely unaffected by low interest rates. Annual management fees may increase in the
short term as the move towards low interest rates increases the value of unit funds. However, in the medium term, unit funds will
grow at a lower rate which will reduce fund charges. For the UK annuities business interest rate exposure is mitigated by closely
matching the duration of liabilities with assets of the same duration.
The UK participating business includes contracts with features such as guaranteed surrender values, guaranteed annuity
options, and minimum surrender and maturity values. These liabilities are managed through duration matching of assets and
liabilities and the use of derivatives, including swaptions. As a result, the Group’s exposure to sustained low interest rates on this
portfolio is not material. The Group’s key exposure to low interest rates arises through its other participating contracts, principally
in Italy and France. Some of these contracts also include features such as guaranteed minimum bonuses, guaranteed investment
returns and guaranteed surrender values. In a low interest rate environment there is a risk that the yield on assets might not be
sufficient to cover these obligations. For certain of its participating contracts the Group is able to amend guaranteed crediting
rates. Our ability to lower crediting rates may be limited by competition, bonus mechanisms and contractual arrangements.
Details of material guarantees and options are given in Note 43. In addition, the following table summarises the weighted
average minimum guaranteed crediting rates and weighted average book value yields on assets as at 31 December 2014 for our
Italian and French participating contracts, where the Group’s key exposure to sustained low interest rates arises.
Weighted
average
minimum
guaranteed
crediting
rate
Weighted
average
book value
yield on
assets
Participating
contract
liabilities £m
France 0.79% 3.91% 61,983
Italy 1.77% 3.74% 8,873
Other1 N/A N/A 41,210
Total N/A N/A 112,066
1. “Other” includes UK participating business
224 | Aviva plc Annual report and accounts 2014