Aviva 2014 Annual Report Download - page 304

Aviva plc Annual report and accounts 2014
Shareholder information continued
300
up entirely, the impact on the financial and currency markets
would be significant and could impact materially all financial
institutions, including the Group. Past political negotiations in
the United States over raising the U.S. debt ceiling indicate that
a risk of sovereign debt default and the potential adverse impact
on global markets which could result from this is not limited to
the eurozone. Such events could adversely affect our business
and results of operations, financial condition and liquidity.
Credit spread volatility may adversely affect the net
unrealised value of the our investment portfolio and the
results of our operations.
Our exposure to credit spreads primarily relates to market price
variability associated with changes in credit spreads in our
investment portfolio, which is largely held to maturity. Credit
spread moves may be caused by changes in the perception of
the creditworthiness of a company, or from market factors such
as the market’s risk appetite and liquidity. A widening of credit
spreads will generally reduce the value of fixed income securities
we hold. Conversely, credit spread tightening will generally
increase the value of fixed income securities we hold. It can be
difficult to value certain of our securities if trading becomes less
liquid. Accordingly, valuations of investments may include
assumptions or estimates that may have significant period to
period changes that could have a material adverse effect on our
consolidated results of operations or financial condition.
Downturns in the net unrealised value of our investment
portfolio may also have a material adverse effect on our
regulatory capital surplus based on the EU Insurance Groups
Directive and under the Individual Capital Assessment required
by the Prudential Regulation Authority (“PRA”) in the UK.
Although the our financial statements reflect the market value
of assets, our priority remains the management of assets and
liabilities over the longer term.
Losses due to defaults by counterparties, including potential
sovereign debt defaults or restructurings, could adversely
affect the value of our investments and reduce our
profitability and shareholders’ equity.
We choose to take and manage credit risk through investment
assets partly to increase returns to policyholders whose policies
the assets back, and partly to optimise the return for
shareholders.
We have a significant exposure to third parties that owe us
money, securities or other assets who may not perform under
their payment obligations. These parties include private sector
and government (or government-backed) issuers whose debt
securities we hold in our investment portfolios (including
mortgage-backed, asset-backed, government bonds and other
types of securities), borrowers under residential and commercial
mortgages and other loans, re-insurers to which we have ceded
insurance risks, customers, trading counterparties, and
counterparties under swap and other derivative contracts. We
also execute transactions with other counterparties in the
financial services industry, including brokers and dealers,
commercial and investment banks, hedge funds and other
investment funds, insurance groups and institutions. Many of
these transactions expose us to credit risk in the event of default
of our counterparty.
In addition, with respect to secured transactions, our credit
risk may be increased when the collateral held by us cannot be
realised or is liquidated at prices insufficient to recover the full
amount of the loan or other value due. We also have exposure
to financial institutions in the form of unsecured debt
instruments and derivative transactions. Such losses or
impairments to the carrying value of these assets could
materially and adversely affect the our financial condition and
results of operations.
We use reinsurance and hedging programmes to hedge various
risks, including certain guaranteed minimum benefit contained
in many of our long-term insurance and fund management
products. These programmes cannot eliminate all of the risks
and no assurance can be given as to the extent to which such
programmes will be effective in reducing such risks. We enter
into a variety of derivative instruments, including options,
forwards, interest rate and currency swaps, with a number of
counterparties. Our obligations under our fund management
and life products are not changed by our hedging activities and
we are liable for our obligations even if our derivative
counterparties do not pay us. Defaults by such counterparties
could have a material adverse effect on our financial condition
and results of operations.
We are also susceptible to an adverse financial outcome
from a change in third-party credit standing. As well as having a
potential impact on asset values and, as a result, our financial
condition and results of operations, credit rating movements
can also impact our solvency position where regulatory capital
requirements are linked to the credit rating of the investments
held. Such movements could impact on the Group’s solvency,
profitability and shareholders’ equity.
Market risks relating to Aviva’s business
Changes in interest rates may cause policyholders to
surrender their contracts, reduce the value of our investment
portfolio and may have an adverse impact on our asset and
liability matching, which could adversely affect our results of
operation and financial condition.
Interest rates are highly sensitive to many factors, including
governmental, monetary and tax policies, domestic and
international economic and political considerations, inflationary
factors, fiscal deficits, trade surpluses or deficits, regulatory
requirements and other factors beyond our control.
Our exposure to interest rate risk relates primarily to the
market price and cash flow variability of assets and liabilities
associated with changes in interest rates.
Some of our products, principally traditional participating
products, universal life insurance and annuities expose us to the
risk that changes in interest rates will reduce our ‘spread’, or the
difference between the amounts that we are required to pay
under the contracts and the rate of return we are able to earn
on investments intended to support obligations under the
contracts. Our spread is a key component of our net income.
As interest rates decrease or remain at low levels, we may be
forced to reinvest proceeds from investments that have matured
or have been prepaid or sold at lower yields, reducing our
investment return. Moreover, borrowers may prepay or redeem
the fixed-income securities, commercial mortgages and
mortgage-backed securities in our investment portfolio with
greater frequency in order to borrow at lower market rates,
which increases this risk. Lowering interest crediting or
policyholder bonus rates can help offset decreases in investment
margins on some products. However, our ability to lower these
rates could be limited by competition or by contractually
guaranteed minimum rates and may not match the timing or
magnitude of changes in asset yields. As a result, our spread
could decrease or potentially become negative. Our expectation
for future spreads is an important component in the
amortisation of policy acquisition costs and significantly lower
spreads may cause us to accelerate amortisation, thereby
reducing net income in the affected reporting period. In
addition, during periods of declining interest rates, the
guarantees within existing life insurance and annuity products
may be more attractive to consumers, resulting in increased
premium payments on products with flexible premium features,
and a higher percentage of insurance policies remaining in force
from year to year, during a period when our new investments
carry lower returns. Accordingly, during periods of declining
300 | Aviva plc Annual report and accounts 2014