26 – Assets held to cover linked liabilities Certain unit-linked products have been classified as investment contracts, while some are included within the definition of an insurance contract. The assets backing these unit-linked liabilities are included within the relevant balances in the consolidated balance sheet, while the liabilities are included within insurance and investment contract provisions disclosed in notes 35 and 37.
Loans – 1 Debt securities 18,220 13,484 Equity securities 16,332 18,251 Other investments 21,704 16,378 Reinsurance assets 1,232 854 Cash and cash equivalents 2,675 953 27 – Ordinary share capital (a) Details of the Company’s ordinary share capital are as follows: £m £m
The allotted, called up and fully paid share capital of the Company at 31 December 2005 was: 2,395,693,688 (2004: 2,282,385,200) ordinary shares of 25 pence each 599 570
(b) During 2005, a total of 113,308,488 ordinary shares of 25 pence each were allotted and issued by the Company as follows: Share Share
Shares issued under the Group’s employee and executive share option schemes 9,299,569 3 56 Shares issued in connection with acquisitions 87,865,495 22 – Shared issued in lieu of dividends 16,143,424 4 (4)
Shares in lieu of the 2004 final and 2005 interim dividends were issued on 17 May and 17 November 2005 respectively. The issue of shares in lieu of cash dividends is considered a bonus issue under the terms of the Companies Act 1985 and the nominal value of the shares is charged to the share premium account.
(iv) Long-term incentive plan awards These awards have been made to senior Group executives since 2001 and are described in section (b) below and on pages 66 and 67.
(v) Deferred bonus plan awards These awards have been made under the Aviva Deferred Bonus Plan, and are described in section (b) below and on page 74.
(b) Outstanding options and awards (i) Share options At 31 December 2005, options to subscribe for ordinary shares of 25 pence each in the Company were outstanding as follows: Option price Number Option price Number Aviva Savings Related Share Option Scheme p of shares Normally exercisable p of shares Normally exercisable
Option price Number Option price Number RAC Savings Related Share Option Scheme p of shares Normally exercisable p of shares Normally exercisable
28 – Equity compensation plans continued Option price Number Option price Number
General Accident Executive Share Option Scheme p of shares Normally exercisable p of shares Normally exercisable
Other than those grants marked with an asterisk, the exercise of options outstanding under the Aviva Executive Share Option Scheme and the Aviva Executive Share Option Scheme (Delta Lloyd) are subject to the attainment of performance conditions. Options which are not exercised lapse.
The following table summarises information about options outstanding at 31 December 2005: Weighted average Weighted average
The vesting of awards under the Aviva Long-Term Incentive Plan is subject to the attainment of performance conditions as described in the Directors’ remuneration report on page 67. Shares which do not vest, lapse.
Notes to the consolidated financial statements continued 28 – Equity compensation plans continued (iii) Shares to satisfy awards and options Prior to March 2003, it was the practice to satisfy awards and options granted under the executive incentive plans through shares purchased in the market and held by an employee share trust which was established for the purpose of satisfying awards under the various executive incentive plans and funded by the Company. From March 2003, no shares have been purchased by the trust, it being the Company’s current practice to satisfy the awards granted after that date by the issue of new shares at the time of vesting. At 31 December 2005, 1,823,788 shares were held by the employee share trust with an aggregate nominal value of £455,947 and market value of £12.8 million. The trustees have waived their right to dividends on the shares held in this trust. Further details are given in note 29.
(d) Expense charged to income statement The total expense recognised for the year arising from equity compensation plans was as follows £m £m
Share price 632p 528p Expected volatility* 41% 46% Expected volatility of comparator companies’ share price* 44% 50% Correlation between Aviva and competitors’ share price* 64% 55% Expected life 3.0 years 3.0 years Expected dividend yield 4.0% 4.7% Risk free interest rate* 4.7% 4.5%
29 – Shares held by employee trusts Movements in the cost of shares held by employee trusts comprise: Number £m Number £m
Net deduction from shareholders’ funds – 1 Distributed in year (4,070,476) – (1,704,120) (1)
Authorised 200,000,000 cumulative irredeemable preference shares of £1 each 200 200 500,000,000 sterling new preference shares of £1 each 500 –
Em Em 700,000,000 Euro new preference shares of E1 each 700 –
The euro and sterling direct capital instruments (the DCIs) were issued on 25 November 2004, and issue costs of £9 million have been charged to reserves. The DCIs have no fixed redemption date but the Company may, at its sole option, redeem all (but not part) of the DCIs at their principal amount on 28 November 2014 and 27 July 2020 for the euro and sterling DCIs respectively, or on any respective coupon payment date thereafter. In addition, under certain circumstances defined in the terms and conditions of the issue, the Company may at its sole option: (i) redeem all (but not part) of the DCIs at their principal amount at any time prior to 28 November 2014 and 27 July 2020 for the euro and sterling DCIs respectively; (ii) substitute at any time all (but not some only) of the DCIs for, or vary the terms of the DCIs so that they become, Qualifying Tier 1 Securities or Qualifying Upper Tier 2 Securities; (iii) substitute all (but not some only) of the DCIs for fully paid non-cumulative preference shares in the Company. These preference shares could only be redeemed on 28 November 2014 in the case of the euro DCIs and on 27 July 2020 in the case of the sterling DCIs, or in each case on any dividend payment date thereafter. The Company has the right to choose whether or not to pay any dividend on the new shares, and any such dividend payment will be non-cumulative.
The Company has the option to defer coupon payments on the DCIs on any relevant payment date. Deferred coupons shall be satisfied only in the following circumstances, all of which occur at the sole option of the Company: (i) Redemption; or
Arising in the year: Fair value gains/(losses) – 47 (64) 20 – 3 Fair value (gains)/losses transferred to profit – – 109 – – 109 Fair value (gains)/losses transferred to retained earnings on disposals – 18 – – – 18 Reserves credit for equity compensation plans (note 28d) – – – – 21 21 Foreign exchange rate movements 57 – – – – 57 Aggregate tax effect – shareholder tax – (23) 14 (6) – (15)
Balance at 1 January 1,709 1,055 Profit for the year attributable to equity shareholders 1,767 1,275 Actuarial gains and losses on pension schemes (note 42) (547) (145) Dividends and appropriations (note 14) (657) (570) Shares issued in lieu of dividends 100 103 Transaction costs on issue of direct capital instrument – (9) Aggregate tax effect 226 – Other movements (1) –
The shares issued in lieu of dividends are in respect of the transfer to retained earnings from the ordinary dividend account, arising from the treatment of shares issued in lieu of the 2004 final and 2005 interim dividends, as explained in note 27(b).
Equity shares in subsidiaries 320 388 Share of earnings 153 197 Share of other reserves 399 68
Preference shares in General Accident plc 250 250 Preference shares in other subsidiaries 6 7 35 – Insurance liabilities (a) Carrying amount Insurance liabilities at 31 December comprise: General General Long-term insurance Long-term insurance business and health Total business and health Total £m £m £m £m £m £m
Provision for unearned premiums – 5,381 5,381 – 4,923 4,923 Provision arising from liability adequacy tests – 48 48 – 33 33
35 – Insurance liabilities continued (b) Long-term business liabilities (i) Business description The Group underwrites long-term business in a number of countries as follows: – In the United Kingdom mainly in
• ”with-profit” funds of CGNU Life Assurance, Commercial Union Life Assurance, and the With Profit and Provident Mutual funds of Norwich Union Life & Pensions (“NUL&P”), where the with-profits policyholders are entitled to at least 90% of the distributed profits, the shareholders receiving the balance; • ”non-profit” funds of Norwich Union Annuity and NUL&P, where shareholders are entitled to 100% of the distributed profits. Shareholder profits on unitised with-profit business written by Norwich Union Life & Pensions and on stakeholder unitised withprofit business are derived from management fees and policy charges, and emerge in the non-profit funds.
– In France, where the majority of policyholders’ benefits are determined by investment performance, subject to certain guarantees, and shareholders’ profits are derived largely from management fees. In addition, a substantial number of policies participate in investment returns, with the balance being attributable to shareholders.
Notes to the consolidated financial statements continued 35 – Insurance liabilities continued The principal assumptions in the United Kingdom, France and the Netherlands are: (a) United Kingdom With-profit business The valuation of with-profit business has changed significantly during 2005 in accordance with the realistic basis set out by the UK’s Financial Services Authority, adjusted to remove the shareholders’ share of future bonuses. The key elements of the Realistic Balance Sheet methodology are the with-profit benefit reserve (WPBR) and the present value of the expected cost of any payments in excess of the WPBR (referred to as the cost of future policy-related liabilities). The realistic liability for any contract is equal to the sum of the WPBR and the cost of future policy-related liabilities. The WPBR for an individual contract is generally calculated on a retrospective basis, and represents the accumulation of the premiums paid on the contract, allowing for investment return, taxation, expenses and any other charges levied on the contract.
For a small proportion of business, the retrospective approach is not available or inappropriate, so a prospective valuation approach is used instead, including allowance for anticipated future regular and final bonuses.
The items included in the cost of future policy related liabilities include: – Maturity Guarantees; – Smoothing (which can be negative); – Guaranteed Annuity Options; – GMP underpin on Section 32 transfers; and
The cost of future policy-related liabilities is determined using a market-consistent approach, mainly based on a stochastic model calibrated to market conditions at the end of the reporting period. Non-market-related assumptions (for example, persistency, mortality and expenses) are based on experience, adjusted to take into account future trends. Where policyholders have valuable guarantees, options or promises, then future persistency is assumed to improve, and future take-up rates of guaranteed annuity options are assumed to increase.
Equities 20% (for UK stocks) Property 15% Gilts 3.25% (NUL&P WP)/4.75% (other WP funds) Corporate bonds 5.25% (NUL&P WP)/6.75% (other WP funds)
Deferred annuities Non-profit – in deferment 3.6% to 4.6% 4.0% to 5.5% Non-profit – in payment 3.6% 4.0%
Annuities in payment Convention annuity 4.0% to 4.6% 4.7% to 5.3%
Mortality assumptions are set with regard to recent company experience and general industry trends. Since 2004, there have been changes to the base tables in order to reflect more closely actual experience.
Assurances Non-profit AM80/AF80 or AM92/AF92 AM80/AF80 or AM92/AF92 or TM92/TF92 or TM92/TF92 adjusted for smoker status and adjusted for smoker status and age/sex specific factors age/sex specific factors
(b) France The majority of provisions arise from a single premium savings product and are based on the accumulated fund value, adjusted to maintain consistency with the value of the assets backing the policyholder liabilities. The net premium method is used for prospective valuations, in accordance with local regulation, where the valuation assumptions depend on the date of issue of the contract. The valuation discount rate also depends on the original duration of the contract and mortality rates are based on industry tables. There have been some reductions to valuation discount rates in 2005.
Life assurances 1.75% to 4.5% 2.5% to 4.5% PM60-64, TD73-77, TD 88/90 Annuities 1.75% to 4.5% 2.5% to 4.5% TPRV (prospective table)
GBM/V 85-90 and GBM/V 90-95 Annuities in deferment and in payment actual swap rate GBMV 76-80, GBMV 85-90,
(c) General insurance and health liabilities Provisions for outstanding claims Significant delays occur in the notification and settlement of claims and a substantial measure of experience and judgement is involved in assessing outstanding liabilities, the ultimate cost of which cannot be known with certainty at the balance sheet date. The reserves for general insurance and health are based on information currently available; however, it is inherent in the nature of the business written that the ultimate liabilities may vary as a result of subsequent developments.
No equalisation or catastrophe reserves have been recognised. This treatment differs from UK GAAP and is explained in note 1 on the first time adoption of IFRS.
Historical claims development is mainly analysed by accident period, although underwriting or notification period is also used where this is considered appropriate. Claim development is separately analysed for each geographic area, as well as by each line of business. Certain lines of business are also further analysed by claim type or type of coverage. In addition, large claims are usually separately addressed, either by being reserved at the face value of loss adjuster estimates or separately projected in order to reflect their future development.
Movements The following changes have occurred in the general insurance and health claims provisions during the year: £m £m
Claims payments made in the year, net of recoveries (6,523) (6,131) Other movements in the claims provisions (9) 27
The Group aims to maintain strong reserves in respect of its non-life and health business in order to protect against adverse future claim experience and development. As claims develop and the ultimate cost of claims become more certain, the absence of adverse claims experience will then result in a release of reserves from earlier accident years, as shown in the loss development tables below. However, in order to maintain strong reserves, the Group transfers much of this release to current accident year (2005) reserves where the development of claims is less mature and there is much greater uncertainty attaching to the ultimate cost of claims. The release from prior accident year reserves during 2005 is also due to an improvement in the estimated ultimate cost of claims.
Two years later (5,303) (4,921) (4,613) Three years later (5,701) (5,233) Four years later (5,966)
Two years later 6,775 6,287 6,124 Three years later 6,798 6,257 Four years later 6,754
Cumulative effect of foreign exchange movements – 13 18 23 29 – 83
Present value recognised in the balance sheet 3,829 796 1,037 1,529 2,020 3,754 12,965
After the effect of reinsurance, the loss development table is: Accident Year £m £m £m £m £m £m £m
Two years later (5,088) (4,779) (4,565) Three years later (5,436) (5,064) Four years later (5,648)
Estimate of net ultimate claims At end of accident year 6,186 6,037 6,218 6,602 6,982
Cumulative effect of foreign exchange movements – – 17 22 29 – 68
Carrying amount at 1 January 5,878 4,285 Asset in respect of new business 183 397 Expected change in existing business asset (128) (109) Variance between actual and expected experience 257 175 Impact of operating assumption changes (1,178) 140 Impact of economic assumption changes 159 70 Other movements 177 145
Changes in reinsurance asset recognised as income 93 56 Reinsurers’ share of portfolio transfers and acquisitions (6) 3 Foreign exchange rate movements 2 – Other movements (5) (9)
Notes to the consolidated financial statements continued 37 – Liability for investment contracts (a) Carrying amount The liability for investment contracts at 31 December comprised: £m £m
Long-term business Participating contracts 47,258 43,974 Non-participating contracts at fair value 29,304 24,903 Non-participating contracts at amortised cost 747 678
Most non-participating investment contracts measured at fair value are unit-linked in structure and the fair value liability is equal to the unit reserve plus additional non-unit reserves if required on a fair value basis. For this business, a deferred acquisition cost asset and deferred income reserve liability are recognised in respect of transaction costs and front-end fees respectively, that relate to the provision of investment management services, and which are amortised on a systematic basis over the contract term. The amount of the related deferred acquisition cost asset is shown in note 25 and the deferred income reserve is shown in note 45.
The effect of changes in main assumptions is given in note 39.
Change in liability 4,546 4,884 Portfolio transfers and acquisitions – 194 Foreign exchange rate movements (76) 10
38 – Financial guarantees and options As a normal part of their operating activities, various Group companies have given guarantees and options, including investment return guarantees, in respect of certain long-term insurance and fund management products.
(iii) Guaranteed annuity options – The Group’s UK with-profit funds have written individual and group pensions which contain guaranteed annuity rate options (GAOs), where the policyholder has the option to take the benefits from a policy in the form of an annuity based on guaranteed conversion rates. The Group also has exposure to GAOs and similar options on deferred annuities.
(iv) Guaranteed minimum pension – The Group’s UK with-profit funds also have certain policies which contain a guaranteed minimum level of pensions as part of the condition of the original transfer from state benefits to the policy.
Notes to the consolidated financial statements continued 38 – Financial guarantees and options continued (c) Overseas life businesses In addition to guarantees written within the Group’s UK life businesses, our overseas businesses have also written contracts containing guarantees and options. Details of the significant guarantees and options provided by overseas life businesses are set out below.
(i) France Guaranteed surrender value and guaranteed minimum bonuses Aviva France has written a number of contracts with such guarantees. The guaranteed surrender value is the accumulated value of the contract including accrued bonuses. Bonuses are based on accounting income from amortised bond portfolios, where the duration of bond portfolios is set in relation to the expected duration of the policies, plus income and releases from realised gains on equity-type investments. Policy reserves are equal to guaranteed surrender values. Local statutory accounting envisages the establishment of a reserve, “Provision pour Aléas Financiers” (PAF), when accounting income is less than 125% of guaranteed minimum credited returns. A PAF of £16 million was established at the end of 2005.
On transition to IFRS, Delta Lloyd changed the reserving basis for most traditional contracts to reflect current market interest rates, for consistency with the reporting of assets at market value. The cost of meeting interest rate guarantees is allowed for directly in the liabilities.
The total liabilities for traditional business at 31 December 2005 are £8 billion (2004: £8 billion) analysed as follows: Restated* Restated*
Liabilities 3% guarantee Liabilities 3% guarantee Liabilities 4% guarantee Liabilities 4% guarantee £m £m £m £m *Restated to reflect the move to the active liability basis under IFRS.
38 – Financial guarantees and options continued (iii) Ireland Guaranteed annuity options Products with similar GAOs to those offered in the UK have been issued in Ireland. The current net of reinsurance provision for such options is £145 million (2004: £125 million). This has been calculated on a deterministic basis, making conservative assumptions for the factors which influence the cost of the guarantee, principally annuitant mortality and long-term interest rates.
These GAOs are “in the money” at current interest rates but the exposure to interest rates under these contracts has been hedged through the use of reinsurance, using derivatives (swaptions). The swaptions effectively guarantee that an interest rate of 5% will be available at the vesting date of these benefits so there is no exposure to a further decrease in interest rates.
(iv) Spain and Italy Guaranteed investment returns and guaranteed surrender values The Group has also written contracts containing guaranteed investment returns and guaranteed surrender values in both Spain and Italy, where traditional profit-sharing products receive an appropriate share of the investment return, assessed on a book value basis, subject to a guaranteed minimum annual return of up to 6% in Spain and 4% in Italy. Liabilities are generally taken as the face value of the contract plus, if required, an explicit provision for guarantees calculated in accordance with local regulations. At 31 December 2005, total liabilities for the Spanish business were £2 billion (2004: £2 billion) with a further reserve of £20 million (2004: £13 million) for guarantees. Total liabilities for the Italian business were £4 billion (2004: £4 billion), with a further provision of £55 million (2004: £49 million) for guarantees. Liabilities are most sensitive to changes in the level of interest rates. It is estimated that provisions for guarantees would need to increase by £66 million (2004: £56 million) in Spain and £12 million (2004: £14 million) in Italy if interest rates fell by 1% from end 2005 values. Under this sensitivity test, the guarantee provision in Spain is calculated conservatively, assuming a long-term market interest rate of 1.68% and no lapses or premium discontinuances.
40 – Tax assets and liabilities (a) General Current tax assets and liabilities recoverable or payable in more than one year are £78 million and £339 million (2004: £nil and £435 million) respectively.
40 – Tax assets and liabilities continued (iii) The movement in the net deferred tax liability was as follows: £m £m
Net liability at 1 January (635) (331) Acquisition of subsidiaries (36) – Amounts charged to profit (note 12a) (965) (271) Amounts credited/(charged) to equity (note 12b) 262 (15) Exchange differences 6 (4) Other movements (72) (14)
Deferred tax credited to equity includes amounts in respect of pensions and other post-retirement obligations (£213 million) and unrealised gains on investments (£49 million). The deferred tax charged to the income statement of £965 million represents the remainder of the movements during the year in the items analysed in note 40(b)(ii) above.
Unused amounts reversed (3) (37) (40) Change in the discounted amount arising from passage of time – (13) (13) Change in the discounted amount arising from a change in discount rate applied – 2 2
Notes to the consolidated financial statements continued 42 – Pension obligations (a) Introduction The Group operates a large number of pension schemes around the world, whose members receive benefits on either a defined benefit basis (generally related to final salary) or a defined contribution basis. The only material defined benefit schemes are in the United Kingdom, the Netherlands, Canada and Ireland and, of these, the main United Kingdom scheme is by far the largest. The assets of the main United Kingdom, Irish and Canadian schemes are held in separate trustee-administered funds and, in the Netherlands, the main scheme is held in a separate foundation which invests in the life funds of the Group. An actuarial report has been submitted for each of the defined benefit schemes within the last three years, using appropriate methods for the respective countries on local funding bases.
In the United Kingdom, the Group operates one main pension scheme, the Aviva Staff Pension Scheme. New entrants join the defined contribution section of the scheme, as the defined benefit section is closed to new employees.
For funding purposes, the scheme was valued as at an effective date of 1 April 2005, on a market value basis using the Projected Unit Method.
The employing companies’ contributions to the defined benefit section of the scheme throughout 2005 were 29% of employees’ pensionable salaries together with the cost of redundancies during the year and an additional payment of £51 million. As this section of the scheme is closed to new entrants and the contribution rate is determined using the projected unit method, it is expected that the percentage cost of providing future service benefits will increase as the membership ages. The employers’ contribution rate for 2006 has therefore been increased to 35% of pensionable salaries (expected to be £119 million). The Group has also decided to make further contributions of £540 million into this and the RAC schemes over the next two years.
The contribution rates for members of the defined contribution section throughout 2005 were 8% of pensionable salaries, together with further contributions up to 4% where members contribute, and the cost of the death-in-service benefits. These contribution rates are unchanged for 2006.
The acquisition of RAC plc in May 2005 has resulted in the main RAC scheme now being included in the UK disclosures that follow. A one-off payment of £160 million for deficit funding was made into that scheme during the year, which together with the £540 million allocated above, will bring total additional contributions into the two schemes to £700 million.
Disclosures under the amendment to IAS 19 issued in December 2004 for the material schemes in the United Kingdom, the Netherlands, Canada and Ireland are provided in the following pages. Total pension costs for these schemes have been calculated under IAS 19. Excluding the deficit funding discussed above, total employer contributions for these schemes in 2006 are expected to be £259 million.
(b) Charges to the income statement The total pension costs of the Group’s defined benefit and defined contribution schemes were: £m £m
There were no significant contributions outstanding or prepaid as at either 31 December 2005 or 2004. A
The details for the material defined benefit schemes are shown below. Where schemes provide both defined benefit and defined contribution pensions, the assets and liabilities shown exclude those relating to defined contribution pensions.
The main financial assumptions used to calculate scheme liabilities under IAS 19 are: *Age-related scale increases plus 1.4% (2004: 1.5%).
Notes to the consolidated financial statements continued 42 – Pension obligations continued (iii) The pension expense for these schemes comprises: Total £m £m
Expected return on scheme assets 439 390 Actual return on these assets (1,270) (595) Actuarial (gains) on scheme assets (831) (205) Experience losses/(gains) arising on scheme liabilities 86 (12) Changes in assumptions underlying the present value of the scheme liabilities 1,292 362
Actuarial losses recognised in the statement of recognised income and expense 547 145 *The current year credit mainly arises in the Netherlands as a result of changes in the Dutch health care system which reduce the obligations of the relevant scheme.
The cumulative amount of actuarial gains and losses recognised in the statement of recognised income and expenses since 1 January 2004 (the date of transition to IFRS) is £692 million at 31 December 2005 (2004: £145 million).
(iv) The following disclosures of experience gains and losses will be built up over time to give a five year history: Fair value of scheme assets at the end of the year 8,209 6,286 Present value of scheme liabilities at the end of the year (9,680) (7,179)
Percentage of the scheme assets at the end of the year 10.1% 3.3%
(Deficits)/surplus in the schemes (1,371) (743) (44) (83) (62) (34) 6 (33) (1,471) (893)
42 – Pension obligations continued Plan assets include investments in Group-managed funds in the consolidated balance sheet of £578 million (2004: £2,405 million) in the UK scheme, and insurance policies of £143 million and £732 million (2004: £117 million and £696 million) in the UK and Dutch schemes respectively. Where the investment and insurance policies are in segregated funds with specific asset allocations, they are included in the appropriate line in the table above, otherwise they appear in “Other”. The Dutch insurance policies comprise virtually all the assets in each of the first three lines of the relevant column above, whilst the UK policies are included in “Other”. These insurance policies, totalling £875 million (2004: £813 million) are considered non-transferable under the terms of IAS 19 and so have been treated as other obligations to staff pension schemes within provisions (see note 41). Excluding these policies, the total fair value of scheme assets is £7,334 million (2004 : £5,473 million) and the total IAS 19 obligations to the schemes are therefore £2,346 million (2004: £1,706 million).
Deficits in the schemes at 1 January 6,286 (7,179) (893) Employer contributions 383 – 383 Employee contributions 21 (21) – Benefits paid (281) 281 – Charge to net operating expenses (see (iii) above) (3) (127) (130) Credit/(charge) to investment income (see (iii) above) 439 (407) 32 Actuarial gains/(losses) (see (iii) above) 831 (1,378) (547)
Deficits in the schemes at 1 January 5,696 (6,534) (838) Employer contributions 220 – 220 Employee contributions 9 (9) – Benefits paid (243) 243 – Charge to net operating expenses (see (iii) above) (3) (154) (157) Credit/(charge) to investment income (see (iii) above) 390 (362) 28 Actuarial gains/(losses) (see (iii) above) 205 (350) (145) Exchange rate movements on foreign plans 12 (13) (1)
Borrowings are considered current if the contractual repricing or maturity dates are within a year.
Subordinated debt 5.700% a500 million undated subordinated notes a – – – – – 340 340 5.8%
Debenture loans 2.5% subordinated perpetual loan notes a – – – – – 122 122 7.3
Commercial paper Commercial paper various 881 – – – – – 881 3.9
Securitised mortgage loan notes UK lifetime mortgage business £ – – – – – 1,461 1,461 5.6 Dutch domestic mortgage business a – – – – – 3,732 3,732 3.1
Notional amount Issue date Redemption date Company from at each applicable reset date to £700 million 14 Nov 2001 14 Nov 2036 16 Nov 2026 5 year Benchmark Gilt + 2.85% a800 million 14 Nov 2001 14 Nov 2021 14 Nov 2011 3 month Euribor + 2.12% a650 million 29 Sep 2003 2 Oct 2023 2 Oct 2013 3 month Euribor + 2.08% a500 million 29 Sep 2003 Undated 29 Sep 2015 3 month Euribor + 2.35% £800 million 29 Sep 2003 Undated 29 Sep 2022 5 year Benchmark Gilt + 2.40%
Fixed rate borrowings comprise £317 million (2004: £541 million) of the total carrying value of £334 million (2004: £564 million). Their fair value at 31 December 2005 was £405 million (2004: £622 million).
(iii) Bank loans In September 2004, one of the Group’s UK long-term business subsidiaries, Norwich Union Life & Pensions Limited (NULAP), entered into a securitisation arrangement with The Royal Bank of Scotland Group plc (RBS), to provide funding to cover initial new business acquisition and administration costs in the period when these exceed accumulated premiums received. Under the arrangement, RBS has provided a loan facility of £200 million to NULAP in respect of selected term assurance policies, secured on future premiums and repayment of commissions due from brokers where a policy has lapsed. The funding is repayable over four years from the date of advance, and interest is charged at a floating rate. The balance drawn on the facility at 31 December 2005 was £191 million (2004: £91 million). RBS has no recourse to the policyholder or shareholders’ funds of any companies in the Aviva Group.
As explained in note 17b, the UK long-term business policyholder funds have invested in a number of property limited partnerships (PLPs). The PLPs have raised external debt, secured on their respective property portfolios, and the lenders are only entitled to obtain payment of both interest and principal to the extent there are sufficient resources in the respective PLPs. The lenders have no recourse whatsoever to the policyholder or shareholders’ funds of any companies in the Aviva Group. Loans of £nil (2004: £57 million) included in the tables above relate to those PLPs which have been consolidated as subsidiaries.
(iv) Commercial paper The commercial paper consists of £500 million in the Company (2004: £870 million) and £3 million in France (2004: £11 million). All commercial paper is repayable within one year and is issued in a number of different currencies, primarily sterling, euros and US dollars.
(v) Securitised mortgage loan notes Loan notes have been issued by special purpose securitisation companies in the United Kingdom and the Netherlands. Details of these securitisations are given in note 22.
Net cash inflow 856 1,526 Foreign exchange rate movements (149) 27 Borrowings acquired/loans repaid for non-cash consideration 173 25 Amortisation of discounts and other non-cash items 43 145
Movements in the year 923 1,723 Balance at 1 January 10,090 8,367
43 – Borrowings continued (d) Undrawn borrowings The Group has the following undrawn committed central borrowing facilities available to it, of which £1,000 million (2004: £1,000 million) is used to support the commercial paper programme: £m £m
Expected to be settled within one year 7,384 5,636 Expected to be settled in more than one year 2,101 1,604
(c) Guarantees on long-term savings products Note 38 gives details of guarantees and options given by various Group companies as a normal part of their operating activities, in respect of certain long-term insurance and fund management products. In the United Kingdom, in common with other pension and life policy providers, the Group wrote individual and group pension policies in the 1970s and 1980s with a guaranteed annuity rate option (GAO). Since 1993, such policies have become more valuable to policyholders, and more costly for insurers, as current annuity rates have fallen in line with interest rates and improving longevity. Reserving policies for the cost of GAOs varied until a ruling by the House of Lords in the Equitable Life case in 2000 which effectively required full reserving by all companies. Prior to the ruling, consistent with the Group’s ordinary reserving practice in respect of such obligations, full reserves for GAOs had already been established. No adjustment was made, or was necessary, to the Group’s reserving practice as a result of the ruling. The directors continue to believe that the existing provisions are sufficient.
In May 2002, in accordance with FSA requirements, the Group commenced sending out the second phase of endowment policy update letters, which provide policyholders with information about the performance of their policies and advice as to whether these show a projected shortfall at maturity. The Group will continue to send these updates annually to all mortgage endowment holders, in accordance with FSA requirements. The Group has made provisions totalling £195 million (2004: £130 million) to meet potential mis-selling costs and the associated expenses of investigating complaints. It continues to be the directors’ view that there will be no material effect either on the Group’s liability to meet the expectations of policyholders or on shareholders.
46 – Contingent liabilities and other risk factors continued (f) Other In the course of conducting insurance and investment business, various Group companies receive liability claims, and become involved in actual or threatened litigation arising therefrom. In the opinion of the directors, adequate provisions have been established for such claims and no material loss will arise in this respect.
The Company and several of its subsidiaries have guaranteed the overdrafts and borrowings of certain subsidiaries and associates. In the opinion of the directors, no material loss will arise in respect of these guarantees and indemnities.
Contractual obligations for future repairs and maintenance on investment properties was £8 million (2004: £6 million).
(b) Operating lease commitments (i) Future aggregate minimum lease rentals receivable under non-cancellable operating leases are as follows: £m £m
Within 1 year 26 – Later than 1 year and not later than 5 years 44 – Later than 5 years 13 –
Adjustments for: Share of (profits) losses of joint ventures and associates (358) (242) Dividends received from joint ventures and associates 95 52 (Profit)/loss on sale of investment property (41) (89) (Profit)/loss on sale of property and equipment (2) (8) (Profit)/loss on sale of subsidiaries, joint ventures and associates (153) (34) (Profit)/loss on sale of investments (4,616) (1,979) Fair value (gains)/ losses on investment property (1,571) (1,154) Fair value (gains)/ losses on investments (8,813) (4,197) Fair value (gains)/ losses on borrowings 62 97 Depreciation of property and equipment 112 97 Impairment of goodwill on subsidiaries 43 41 Impairment of other investments and loans 19 3 Impairment of property and equipment – 25 Impairment of acquired value of in-force business and intangibles 35 13 Impairment of non financial assets 38 – Amortisation of premium or discount on debt securities (93) (190) Amortisation of premium or discount on loans (38) 35 Amortisation of premium or discount on borrowings 2 48 Amortisation of acquired value in-force business and intangibles 83 79 Change in unallocated divisible surplus 1,474 1,330 Interest expense on borrowings 609 522 Foreign currency exchange gain/loss 203 (31)
Changes in working capital (Increase)/decrease in reinsurance assets 1,192 (386) (Increase)/decrease in deferred acquisition costs (466) 248 (Increase)/decrease in insurance liabilities and investment contracts 18,581 14,996 (Increase)/decrease in other assets and liabilities 123 3,628
Net purchases of operating assets Purchases of investment property (1,956) (1,321) Proceeds on sale of investment property 1,292 1,245 Financial investments (6,522) (12,803)
Cash consideration for subsidiaries, joint ventures and associates acquired 1,438 540 Less: Cash and cash equivalents acquired with subsidiaries (55) –
Cash proceeds from disposal of subsidiaries, joint ventures and associates 448 327 Net cash and cash equivalents divested with subsidiaries – (19)
Notes to the consolidated financial statements continued 49 – Capital statement FRS27 requires us to produce a capital statement which sets out the financial strength of our Group entities and provides an analysis of the disposition and constraints over the availability of capital to meet risks and regulatory requirements. The capital statement also provides a reconciliation of shareholders’ funds to regulatory capital.
Adjustments onto a regulatory basis: Shareholders’ share of accrued bonus (74) (78) (548) (700) – (700) – (700) – (700) (570)
Regulatory valuation and admissibility restrictions2 281 125 140 546 (1,221) (675) (3,991) (4,666) (953) (5,619) (4,507)
Other non-participating 1. Other sources of capital include Subordinated debt of £2,808 million issued by Aviva and £119 million subordinated perpetual loan notes issued by a Dutch subsidiary undertaking.
2. Including an adjustment for minorities 3. Includes the PM with-profit fund.
49 – Capital statement continued Analysis of movements in capital For the year ended 31 December 2005
Total UK life CGNU with- CULAC with- NUL&P with- with-profit Other UK life Total UK life Overseas life Total life profit fund profit fund profit fund funds operations Operations operations operations £m £m £m £m £m £m £m £m 1. Includes movement in: outstanding claims provision; other technical provision; and obligations to staff pension schemes transferred to provisions.
The main drivers of the variance between actual and expected liability movements are reductions in valuation interest rates for traditional contracts and strong investment return for unit-linked business.
In aggregate, the Group has at its disposal total available capital of £13.6 billion (2004: £12.8 billion), representing the aggregation of the solvency capital of all of our businesses. This capital is available to meet risks and regulatory requirements set by reference to local guidance and EU directives.
After effecting the year-end transfer to shareholders’, the UK with-profit funds’ available capital of £5.2 billion (2004: £4.5 billion) can only be used to provide support for UK with-profits business and is not available to cover other shareholder risks. This is comfortably in excess of the required capital margin and, therefore, the shareholders are not required to provide further capital support to this business.
For the remaining life and general insurance operations, the total available capital amounting to £8.3 billion (2004: £8.3 billion) is significantly higher than the minimum requirements established by regulators and, in principle, the excess is available to shareholders. In practice, management will hold higher levels of capital within each business operation to provide appropriate cover for risk.
In accordance with the FSA’s regulatory rules under its realistic capital regime, the Group is required to hold sufficient capital in its UK life with-profit funds to meet the FSA capital requirements, based on the risk capital margin (RCM). The determination of the RCM depends on various actuarial and other assumptions about potential changes in market prices, and the actions management would take in the event of particular adverse changes in market conditions.
Realistic Required Realistic Realistic orphan capital assets liabilities estate margin Excess Excess £bn £bn £bn £bn £bn £bn 1. These realistic liabilities include the shareholders’ share of future bonuses of £0.7 billion (31 December 2004: £0.5 billion). Realistic liabilities adjusted to eliminate the shareholders’ share of future bonuses are £50.5 billion (31 December 2004: £47 billion).
2. These realistic liabilities make provision for guarantees, options and promises on a market consistent stochastic basis. The value of the provision included within the realistic liabilities is £0.7 billion, £0.9 billion and £3.4 billion for CGNU life, CULAC and NUL&P respectively. (31 December 2004: £0.6 billion, £0.9 billion and £3.3 billion for CGNU life, CULAC and NUL&P respectively).
3. The required capital margin (RCM) is 2.7 times covered by the orphan estate (31 December 2004: 2.6 times).
For overseas life businesses, the amount shown is the minimum requirement under the locally applicable regulatory regimes.
50 – Risk management policies continued This governance structure and policy set is regularly reviewed and updated to reflect internal and external changes. For example, since the regulatory changes brought about by the FSA’s Prudential Sourcebook, which came into effect on 1 January 2004, the Group has placed a greater emphasis on assessment and documentation of risks, controls and an articulation of risk appetite.
1. Types of life insurance risk Life insurance risk in the Group arises through its exposure to mortality and morbidity insurance and exposure to worse than anticipated operating experience on factors such as persistency levels and management and administration expenses. The management of life insurance risk is undertaken primarily in business units but is also monitored at Group level. The impact of life insurance risks is monitored by the business units as part of the control cycle of business management. Exposure is monitored through the assessment of liabilities, the asset liability management framework, profit reporting, financial condition reporting, and the ICA process. Significant insurance risks will be reported through the Group Risk Monitoring framework and overseen by the Life Insurance Risk Committee. At Group level the overall exposure to life insurance risk is measured through the ICA, FCRs, and other management reporting.
2. Risk management The Group has developed a life insurance risk policy and guidelines on the practical application of this policy. Individual life insurance risks are managed at a business unit level.
The Life Insurance Risk committee monitors the risk framework developed and implemented in each business, and receives management information on life insurance risks.
– A product management cycle must be established to review all aspects of emerging experience, particularly mortality and persistency, at regular intervals.
Longevity risk is carefully monitored against the latest external industry data and emerging trends. Whilst individual businesses are responsible for reserving and pricing for annuity business, the Group monitors the exposure to this risk and the capital implications to manage the impact on the group-wide exposure and the capital funding that businesses may require as a consequence. The Group has used reinsurance solutions to reduce the risks from longevity where possible and continually monitors emerging market solutions to mitigate this risk further.
3. Concentrations of life insurance risk The Group writes a diverse mix of business in worldwide markets that are all subject to similar risks (mortality, persistency etc). The Group assesses the relative costs and concentrations of each type of risk through the ICA capital requirements and material issues are escalated to and addressed at the Life Insurance Risk committee. This analysis enables the Group to assess whether accumulations of risk exceeds risk appetite.
50 – Risk management policies continued General Insurance Business The risk management framework for general insurance risks is set out as follows: 1. Types of General Insurance Risk General insurance risk in the Group arises from: – Fluctuations in the timing, frequency and severity of claims and claim settlements relative to expectations; – Unexpected claims arising from a single source, inaccurate pricing of risks when underwritten; – Inadequate reinsurance protection or other risk transfer techniques; and
The majority of the general insurance business underwritten by the Group is of a short tail nature such as motor, household and commercial property insurances. The Group’s underwriting strategy and appetite is agreed by the Executive Committee and communicated via specific policy statements and guidelines.
A General Insurance Risk Committee has been established to monitor and develop the management of risk in the general insurance business units, and to assess the aggregate risk exposure. There are Group policies for underwriting, claims handling, reinsurance and reserving that operate within the Group risk management framework whose implementation is regularly reviewed by this committee.
Business units have developed mechanisms that identify, quantify and manage accumulated exposures to contain them within the limits of the appetite of the Group. The Group has pioneered various developments, such as the Norwich Union UK Digital Flood Map to effectively manage exposures arising from specific perils. Where appropriate such projects are employed throughout the business units to promote the adoption of best practice as a standard.
3. Concentrations of general insurance risk Processes are in place to manage catastrophe risk in individual business units and at a Group level. The Group’s businesses purchase catastrophe reinsurance to protect against significant natural hazard events. Due to the geographic concentration of some large business units in northern Europe, the Group purchases additional catastrophe reinsurance cover to limit Group retentions in the event of a northern European windstorm event.
For a single realistic catastrophic event (for the Group, this is a northern European windstorm) this maximum amount is approximately £350 million which equates to 3.2% of shareholders’ equity on a net basis.
The ALM framework covers a number of areas which are discussed in more detail below.
Liquidity risk The Group has a strong liquidity position and through the application of a Group Liquidity Management policy seeks to maintain sufficient financial resources to meet its obligations as they fall due. In addition to its strong liquidity position, the Group maintains significant committed borrowing facilities from a range of highly rated banks to further mitigate this risk.
The following table provides an analysis of assets into their relevant maturity groups based on the remaining period at the balance sheet date to their contractual maturities.
Analysis of expected maturity of liabilities For each main category of insurance and investment business, the following table shows the gross liability at 31 December 2005 analysed by duration. The total liability is split by duration in proportion to the present value of cash-flows estimated to arise during that period. 31.12.2005 Within Over £m Total 1 year 1-5 years 5-15 years 15 years
The management of market risk is undertaken in both business units and at Group level. Business units manage market risks locally using their ALM framework and within local regulatory constraints. Business units may also be constrained by the requirement to meet policyholders’ reasonable expectations and to minimise or avoid market risk in a number of areas. At Group level, market risk is the responsibility of the Investment Committee which has a remit to manage a number of investment related risks, in particular those faced by the shareholder funds throughout the Group.
For each of the major components of market risk, described in more detail below, the Group has put in place policies and procedures to set out how each risk should be managed and monitored, and the approach to setting an appropriate risk appetite.
At Group level, the financial impact from changes in market risk (such as interest rates, equity prices and property values) is examined through stress tests adopted in the ICA and FCR.
The Group’s foreign exchange policy requires that each of the Group’s subsidiaries maintain sufficient assets in their local currencies to meet local currency liabilities. Therefore, capital held by the Group’s business units should be able to support local business activities regardless of foreign currency movements. However, such movements may impact the value of the Group’s consolidated shareholders’ equity which is expressed in sterling. This aspect of foreign exchange risk is monitored and managed centrally, against pre–determined limits. The Group’s foreign exchange policy is to manage these exposures by aligning the deployment of capital by currency, with the Group’s capital requirements by currency. Limits are set to control the extent to which the deployment of capital is not aligned fully with the Group’s capital requirement for each major currency. Currency borrowings and derivatives are used to manage exposures within the limits that have been set.
The Group manages this risk by adopting close asset liability matching criteria, to minimise the impact of mismatches between the value of assets and liabilities from interest rate movements. Interest rate risk is also controlled through the use of a variety of derivative instruments, including futures, options and swaps, in order to hedge against unfavourable market movements in interest rates inherent in the underlying assets and liabilities.
At 31 December 2005, certain business units had entered into various futures and option agreements to mitigate the effects of potential adverse equity price movements.
The full list of material guarantees and options is set out in Note 38.
(iv) Credit risk Credit risk is the risk of loss in the value of financial assets due to counterparties failing to meet all or part of their obligations.
The following table provides information regarding the aggregated credit risk exposure of the Group at 31 December 2005.
In the event of a catastrophic event the counterparty exposure to a single reinsurer is estimated not to exceed 1.4% of shareholders’ equity.
Operational risks are assessed according to the potential impact and probability of the event concerned. These impact assessments are made against financial, operational and reputational criteria. All operational risks are reported to Group on a quarterly basis. Risks assessed by business units to be at the two highest impact assessments are escalated to Group intra-quarter. This reporting enables the Group to: – Assess and monitor overall operational risk exposures; – Identify any concentrations of operational risk across the Group; – Monitor progress in mitigating overall operational risk; and
Some results of sensitivity testing for long-term business and general insurance and health business are set out below. For each sensitivity test the impact of a change in a single factor is shown, with other assumptions left unchanged. Sensitivity Factor Description of sensitivity factor applied
Expenses The impact of an increase in maintenance expenses by 10%. Assurance mortality/morbidity (life insurance only) The impact of an increase in mortality/morbidity rates for assurance contracts by 5%.
The above sensitivity factors are applied using actuarial and statistical models, with the following pre-tax impacts on profit and shareholders’ equity at 31 December 2005: Long-term business – impact on profit before tax (£m) Interest rates Interest rates Expenses Assurance Annuitant
Investment participating 10 (50) – – – Investment non-participating – – – – –
50 – Risk management policies continued Long-term business – impact before tax on shareholders’ equity (£m)
Interest rates Interest rates Expenses Assurance Annuitant +1% -1% +10% mortality +5% mortality -5%
The sensitivity to a reduction in market interest rates relates primarily to the effect of interest rate guarantees in the Netherlands, with smaller impacts in the UK and other countries. The different impacts of interest rate changes on shareholders’ equity and profit arise from the classification of fixed interest securities as available for sale in some business units, for which movements in unrealised gains would be taken directly to shareholders’ equity.
General insurance and health business – impact on profit before tax (£m) Gross loss
The sensitivity analyses do not take into consideration that the Group’s assets and liabilities are actively managed. Additionally, the financial position of the Group may vary at the time that any actual market movement occurs. For example, the Group’s financial risk management strategy aims to manage the exposure to market fluctuations. As investment markets move past various trigger levels, management actions could include selling investments, changing investment portfolio allocation, adjusting bonuses credited to policyholders, and taking other protective action.
A number of the business units use passive assumptions to calculate their long-term business liabilities. Consequently, the actual impact of a change in the assumptions may not have any impact on the liabilities, whereas assets are held at market value on the balance sheet. In these circumstances, the different measurement bases for liabilities and assets may lead to volatility in shareholder equity. Similarly, for general insurance liabilities, the interest rate sensitivities only affect profit and equity where explicit assumptions are made regarding interest (discount) rates or future inflation.
(a) Cash flow hedges As explained in note 3(b), the Group hedged the foreign exchange risk that it expected to assume as a result of the sale of its general insurance business in Asia, using currency forwards. At 31 December 2005, currency forwards with an aggregate notional principal amount of £nil (2004: £199 million) and a positive fair value of £nil (2004: £3 million) were designated as a cash flow hedge of the foreign exchange exposure arising on the US dollar proceeds from the sale of the Asian businesses.
(b) Fair value hedges The Group had no fair value hedge activity at 31 December 2005.
(c) Net investment hedges To reduce the Group’s exposure to foreign currency risk, the Group has designated a portion of its euro and US dollar denominated debt as a hedge of the net investment in its European subsidiaries. The carrying value of the debt at 31 December 2005 was £1,412 million (2004: £1,688 million). The foreign exchange gain of £22 million (2004: £5 million) on translation of the debt to sterling at the balance sheet date was recognised in the hedging investments reserve in shareholders’ equity.
(d) Non-hedge derivatives The Group’s non-hedge derivative activity at 31 December 2005 was as follows: Contract/ Contract/ notional Fair value Fair value notional Fair value Fair value amount asset liability amount asset liability £m £m £m £m £m £m
Total assets included in the consolidated balance sheet 263,447 239,303 Additional value of internally-generated in-force long-term business 6,454 5,018 Third party funds under management
Total assets under management 316,910 279,747 53 – Related party transactions The Group received income from related parties from transactions made in the normal course of business. Loans to related parties are made on normal arm’s length commercial terms.
Details of loans made to joint ventures and associates may be found in notes 17 and 18 respectively.
Salary and other short-term benefits 24 18 Post-employment benefits 1 1 Equity compensation plans 9 6
Information concerning individual directors’ emoluments, interests and transactions is given on pages 65 to 74.
Expenses Operating expenses C (160) (168) Interest payable to Group companies (238) (184) Interest payable on borrowings (224) (234)
Assets Non-current assets Investments in subsidiaries B 22,919 19,538 Investment in joint venture 17c 22 22 Loans owed by subsidiaries 3,612 3,717 Deferred tax assets D 2 7 Current tax assets 200 270
Equity Ordinary share capital 27 599 570 Preference share capital 30 200 200
Called up capital 799 770 Share premium account 27b 1,167 1,115 Merger reserve E 735 227 Investment valuation reserve E 13,322 11,801 Equity compensation reserve E 43 21 Retained earnings E 1,690 888 Direct Capital Instrument 31 990 990
Financial statements of the Company Statement of recognised income and expense For the year ended 31 December 2005
Net income recognised directly in equity 1,556 2,515 Profit for the year 1,347 94
Balance at 1 January 15,812 12,664 Total recognised income and expense for the year 2,903 2,609 Dividends and appropriations 14 (657) (570) Issue of share capital for the acquisition of RAC plc 3a 530 – Other issues of share capital, net of transaction costs 27 59 25 Shares issued in lieu of dividends 27 100 103 Issue of Direct Capital Instrument, net of transaction costs of £9 million – 981 Other movements (1) –
Financial statements of the Company Cash flow statement For the year ended 31 December 2005
Cash flows from financing activities Funding provided by subsidiaries 880 744 Net drawdown/(repayment) of borrowings (370) (227) Preference dividends paid (17) (17) Ordinary dividends paid (497) (450) Interest paid on borrowings (25) (27)
Financial statements of the Company Notes to the company financial statements For the year ended 31 December 2005
In general, a company is required to determine its IFRS accounting policies and apply these retrospectively to determine its opening balance sheet under IFRS. However, International Financial Reporting Standard 1, First time adoption of International Financial Reporting Standards, (IFRS 1) allows a number of exemptions to this general principle upon adoption of IFRS. Where applicable, the Company has taken advantage of the same transitional arrangements as in the Group, as described in note 1(a).
Adjusted for: Dividend recognition (see (1) below) 6 (1,344) Revaluation of investments in subsidiaries (see (2) below) 1,911 4,200 Pensions (see (3) below) (4) (27) Equity compensation plans (see (4) below) – 28 Direct Capital Instrument interest – 6 Other items (2) 4
Adjusted for: Dividend recognition (see (1) below) (1,372) Pensions (see (3) below) (23) Equity compensation plans (see (4) below) 13
(2) Investments in subsidiaries Under UK GAAP, subsidiaries are stated at current value which, for this purpose, is embedded value for life operations and net asset value for other entities. As a result of applying IAS 39, subsidiaries are stated at their fair values, estimated using applicable valuation models underpinned by the Company’s market capitalisation. This uplift in valuation has increased shareholders’ funds by £1,911 million at 1 January 2004 and by £4,200 million at 31 December 2004.
(ii) In the table above, “Acquisitions” includes the purchase of the entire share capital of RAC plc on 4 May 2005, full details of which are given in note 3(a)(i) on page 106. On 24 August 2005, this investment was transferred to a subsidiary for the same consideration and is included in the heading “disposals” above.
(ii) Pension costs The Company is one of a number of UK companies being charged for its employees participating in the Aviva Staff Pension Scheme, and its contributions are affected by the financial position of the scheme. There is no contractual agreement or policy for charging the net defined benefit cost for this scheme across the participating Group entities but, instead, this cost is recognised in the financial statements of the main UK employing company. The Company therefore recognises a pension expense equal to its contributions payable in the year, together with changes in provisions for the cost of any unfunded benefits, within staff costs above.
Current tax For this year 29 90 Prior year adjustments 30 1
Tax calculated at standard UK corporation tax rate of 30% (2004: 30%) (388) 1 Adjustment to tax charge in respect of prior years 30 2 Non-assessable dividends 513 100 Disallowable expenses (23) (7) Disallowed deferred tax asset (55) –
(iv) The movement in the net deferred tax asset was as follows: £m £m
Net asset at 1 January 7 – Amounts (charged)/credited to profit (5) 7
Arising in the year: Profit for the year – – – 94 Fair value gains on investments in subsidiaries – 2,494 – – Dividends and appropriations – – – (570) Reserves credit for equity compensation plans – – 21 – Shares issued in lieu of dividends – – – 103 Issue of Direct Capital Instrument – – – (9)
G – Derivative financial instruments (i) Non-hedge derivatives The Company’s non-hedge derivative activity at 31 December 2005 was as follows: Contract/ Contract/ notional Fair value Fair value notional Fair value Fair value amount asset liability amount asset liability £m £m £m £m £m £m
Financial statements of the Company Notes to the company financial statements continued
I – Risk management policies The business of the Company is managing its investments in subsidiary operations. Its risks are considered to be the same as those in the operations themselves and full details of the risk management policies are given in note 50.
J – Related party transactions The Company receives dividend and interest income from subsidiaries and pays interest to those subsidiaries in the normal course of business. These activities are reflected in the table below.
Other related party balances comprise dividend and interest receivable and payable, as well as inter-company balances for transactions in the normal course of business.
Services provided to related parties Income earned Receivable at Income earned Receivable in year year end in year at year end £m £m £m £m
Services provided by related parties Expense incurred Payable at Expense incurred Payable at in year year end in year year end £m £m £m £m
This report is made solely to the company’s directors, as a body. Our audit work has been undertaken so that we might state to the company’s directors those matters we are required to state to them in an auditors’ report and for no other purpose. To the fullest extent permitted by law, we do not accept or assume responsibility to anyone other than the company and the company’s directors as a body, for our audit work, for this report, or for the opinions we have formed.
Basis of audit opinion We conducted our audit in accordance with International Standards on Auditing (UK and Ireland) issued by the Auditing Practices Board. An audit includes examination, on a test basis, of evidence relevant to the amounts and disclosures in the alternative method of reporting long-term business. It also includes an assessment of the significant estimates and judgments made by the directors in the preparation of the alternative method of reporting long-term business, and of whether the accounting policies are appropriate to the group’s circumstances, consistently applied and adequately disclosed.
We planned and performed our audit so as to obtain all the information and explanations which we considered necessary in order to provide us with sufficient evidence to give reasonable assurance that the alternative method of reporting long-term business stated on the European Embedded Value basis is free from material misstatement, whether caused by fraud or other irregularity or error. In forming our opinion we also evaluated the overall adequacy of the presentation of the alternative method of reporting long-term business.
Opinion In our opinion the alternative method of reporting long-term business for the year ended 31 December 2005 has been properly prepared in accordance with the European Embedded Value basis, using the methodology and assumptions set out on pages 204 to 206.
Summarised consolidated income statement – EEV basis For the year ended 31 December 2005 1m £m £m
Operating profit before tax attributable to shareholders’ profits 2,668 Life EEV operating return 1,814 1,611 2,281 General insurance and health 1,551 1,259
– Financial Services Compensation Scheme and other levies – (49) 4,124 Variation from longer-term investment return 2,805 662 (597) Effect of economic assumption changes (406) (318) 225 Profit on the disposal of subsidiaries and associates 153 34
7,769 Profit before tax 5,283 2,469 (1,363) Tax on operating profit (927) (618)
(991) Tax on other activities (674) (32) 5,415 Profit for the year 3,682 1,819
Profit after tax for the year on an EEV basis, attributable to ordinary shareholders of Aviva plc 215.1c Basic (pence per share) 146.3p 72.0p 213.4c Diluted (pence per share) 145.1p 71.4p
Summarised consolidated statement of recognised income and expense – EEV basis For the year ended 31 December 2005 £m £m
Total recognised income and expense for the year 3,398 1,929 *Stated before the effect of foreign exchange rate movements, which are reported within the foreign exchange rate movements line.
Balance at 1 January 14,011 11,534 Total recognised income and expense for the year 3,398 1,929 Dividends and appropriations (note 15) (657) (570) Issue of share capital for the acquisition of RAC plc 530 – Other issues of share capital, net of transaction costs 59 25 Shares issued in lieu of dividends 100 103 Issue of direct capital instrument, net of transaction costs of £9 million – 981 Capital contribution from minority shareholders 212 4 Minority share of dividends declared in the year (70) (41) Minority interest in acquired/(disposed) subsidiaries (36) 45 Movement in shares held by employee trusts – 1 Other movements (1) –
Summarised consolidated balance sheet – EEV basis As at 31 December 2005 31 December 31 December 31 December 1m £m £m
Assets 1,164 Acquired value of in-force business and intangible assets 803 516 9,354 Additional value of in-force long-term business 6,454 5,018 3,086 Investments in joint ventures 2,129 1,255 1,283 Investments in associates 885 873 1,283 Property and equipment 885 812
Financial investments 1,475 Deferred tax assets 1,018 908 126 Current tax assets 87 – 11,168 Receivables and other financial assets 7,706 7,509 5,458 Deferred acquisition costs and other assets 3,766 3,189 3,425 Prepayments and accrued income 2,363 2,307 19,900 Cash and cash equivalents 13,732 12,779 670 Assets of operations classified as held for sale 462 –
Segmentation of summarised consolidated balance sheet – EEV basis As at 31 December 2005
Total assets before acquired additional value of in-force long-term business 224,453 38,679 263,132 205,498 33,441 238,939
Acquired additional value of in-force long-term business 315 – 315 364 – 364
Total assets included in the statutory IFRS balance sheet 224,768 38,679 263,447 205,862 33,441 239,303
Equity attributable to ordinary shareholders of Aviva plc on an EEV basis 14,899 11,661
Group’s share included in shareholders’ funds 6,431 4,768 1,663 Minority interest share 329 250 79 Movement in available for sale securities (306) – (306)
Comprises: Embedded value 15,113 13,014 RBSG goodwill 217 217 Goodwill allocated to long-term business 631 595 Notional allocation of IAS 19 pension fund deficit to long-term business3 (363) –
Long-term business net assets on an EEV basis 15,598 13,826 3. The value of the Aviva Pension Scheme deficit has been notionally allocated between segments, based on current funding and the UK Life proportion has been included within the long-term business net assets on an EEV basis.
The results for 2005 and 2004 have been audited by our auditors, Ernst & Young LLP. Their report in respect of 2005 is included in the Report and Accounts on page 199 of this document.
Covered business The EEV calculations cover the following lines of business: life insurance, long-term health and accident insurance, savings, pensions and annuity business written by our life insurance subsidiaries, including managed pension fund business and our share of the other life and related business written in our associated undertakings and joint ventures, as well as the equity release business written in the UK. The adoption of IFRS has resulted in no change to the Group’s definition of new business under EEV and so includes contracts that meet the definition of “non-participating investment” contracts under IFRS.
EEV methodology Overview Under the EEV methodology, profit is recognised as it is earned over the life of products defined within covered business. The total profit recognised over the lifetime of a policy is the same as under the IFRS basis of reporting, but the timing of recognition is different.
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 life business, the net worth of that business excludes the interest in the dependent company.
Risk discount rates Under the EEV methodology, a risk discount rate (RDR) is required to express a stream of expected future distributable profits as a single value at a particular date (the present value). It is the interest rate that an investment equal to the present value would have to earn in order to be able to replicate exactly the stream of future profits. The RDR is a combination of a risk free rate to reflect the time value of money plus a risk margin to make prudent allowance for the risk that experience in future years may differ from that assumed. In particular, a risk margin is added to allow for the risk that expected additional returns on certain asset classes (eg. equities) are not achieved.
Risk discount rates for our life businesses have been calculated using a risk margin based upon a Group Weighted Average Cost of Capital (WACC). The Group WACC is calculated using a gross risk free interest rate, an equity risk margin, a market assessed risk factor (beta), and an allowance for the gearing impact of debt financing (including subordinated debt) on a market value basis. The market assessed risk factor captures the market’s view of the effect of all types of risk on our business, including operational and other non-economic risk.
EEV methodology continued In order to derive risk discount rates for each of our life businesses, the adjusted Group WACC is expressed as a risk margin in excess of the gross risk free interest rate used in the WACC calculation as described above. Business-specific discount rates are then calculated as the sum of this risk margin and the appropriate local gross risk free rate at the valuation date, based on returns on government bonds. A common risk free rate, and hence a common RDR, is used for all of our businesses within the Eurozone. Additional country-specific risk margins are applied to smaller businesses to reflect additional economic, political and business-specific risk for example, risk margins ranging from 3.7% to 8.7% are applied to the Group’s eastern European and Asian operations. Within each business, a constant RDR has been applied in all future time periods and in each of the economic scenarios underlying the calculation of the time value of options and guarantees.
The capitalised value of the future profits and losses from such service companies are included in the embedded value and new business contribution calculations for the relevant territory, but the net assets (representing historical profits and other amounts) remain under non-insurance or fund management. In order to reconcile the profits arising in the financial period within each segment with the assets on the opening and closing balance sheets, a transfer of IFRS profits from life and related business to the appropriate segment is deemed to occur. An equivalent approach has been adopted for expenses within our holding companies.
• the impact of changes in operating assumptions including risk-margins; – the expected investment return on the shareholders' net worth, based upon assumptions applying at the start of the year; – investment return variances caused by differences between the actual return in the period and the expected return based on economic assumptions used to calculate the start of year value; and
Total (after the effect of required capital) 22,246 20,661 612 516 2.8% 2.5%
2. The reduction in the level of required capital in respect of UK annuities from 200% to 150% of the EU minimum has increased the 2005 amount by £13 million (2004 has not been restated).
EEV basis – new business contribution before the effect of required capital, tax and minority interest Present value of new
Annual premium equivalent business premiums New business contribution1 New business margin2 1. Stated before the effect of required capital.
EEV basis – new business contribution after the effect of required capital, tax and minority interest Present value of new
3. New business margin represents the ratio of new business contribution after deducting the effect of required capital, tax and minority interests to PVNBP after deducting the minority interests, expressed as a percentage.
Netherlands (including Belgium and Luxembourg) (8) 12 Rest of Europe 21 23
Analysis of movement in life and related businesses embedded value The following tables provide an analysis of the movement in embedded value for the life and related businesses for 2005 and 2004. The analysis is shown separately for net worth and the value of in-force covered business, and includes amounts transferred between these categories. The transfer from life and related businesses to other segments consists of service company profits and losses during the reported period that have emerged from the value of in-force. Since the “look through” into service companies includes only future profits and losses, these amounts must be eliminated from the closing embedded value.
Embedded value at the beginning of the year – Free surplus 1,894 – Required capital1 4,362
New business contribution (after the effect of required capital) (536) 955 419 Expected return on existing business – return on VIF – 624 624 Expected return on existing business – transfer to net worth 929 (929) – Experience variances and operating assumption changes 96 (115) (19) Expected return on shareholders’ net worth 225 – 225 Investment return variances and economic assumption changes 785 517 1,302
Life EEV return after tax 1,499 1,052 2,551 Exchange rate movements (54) (45) (99) Embedded value from business disposed of (19) (19) (38) Amounts injected into life and related businesses 266 – 266 Amounts released from life and related businesses (751) – (751) Transfer from life and related businesses to other segments 23 – 23 UK Life pension fund deficit transferred to analysis of net assets on an EEV basis2 – 147 147
Embedded value at the beginning of the year – Free surplus 1,721 – Required capital1 4,114
Year ended 31 December 2005 £m £m £m £m £m £m £m £m £m £m
New business contribution (after the effect of required capital) 213 91 13 36 57 13 155 2 32 612
Life EEV operating return before tax 585 321 20 96 318 128 214 33 99 1,814 1. Exceptional expenses in the UK reflect £47 million relating to ongoing transformation of the life business and £101 million of other exceptional and project costs associated with regulatory change and strategic initiatives.
Year ended 31 December 2004 £m £m £m £m £m £m £m £m £m £m
3. Mortality experience across our major businesses continues to be better than our assumptions for protection and annuity business in the UK and protection business in continental Europe.
Previously the tax assumptions had been set at full corporation tax for all future profits, whereas in fact dividend income from subsidiaries is tax exempt. In 2004, the calculation has been refined such that the future tax benefit arising from dividend from subsidiaries has now been recognised. This change results in a £39 million benefit.
Cost of Required Free Present value required capital1 surplus of in-force capital Embedded value
Netherlands (including Belgium and Luxembourg) 2,092 1,454 932 1,023 3,024 2,477
The value of in-force covered business includes the effect of holding shareholders’ capital to support the level of required capital and allowing for projected future releases. This impact reduces the value of in-force covered business at 31 December 2005 by £1,187 million (31 December 2004: £1,195 million).
The embedded value at the end of 2005 includes minority interests of £1,000 million (2004: £796 million). This comprises minority interests in France of £148 million (2004: £120 million), Italy £365 million (2004: £276 million), Netherlands £70 million (2004: £59 million), Poland £106 million (2004: £90 million), Spain £310 million (2004: £244 million) and Other Europe £1 million (2004: £7 million).
The TVOG has increased over the year to £303 million primarily due to the allowance included in new business contribution of £31 million. Also included is an increase of £15 million due to the 40 basis points fall in bond yields in continental Europe during 2005, which have largely been offset by the favourable impacts of investment returns and exchange rates.
Other economic assumptions Required capital relating to with-profit business is assumed to be covered by the surplus within the with-profit funds and no effect has been attributed to shareholders.
Bonus rates on participating business have been set at levels consistent with the economic assumptions and Aviva’s medium-term bonus plans. The distribution of profit between policyholders and shareholders within the with-profit funds assumes that the shareholder interest in conventional with-profit business in the UK and Ireland continues at the current rate of one ninth of the cost of bonus.
United Kingdom Model Overall asset returns have been generated assuming that the portfolio total return has a lognormal distribution. The mean and standard deviation of the overall asset return have been calculated using the evolving asset mix of the fund and assumptions over the mean and standard deviation of each asset class, together with correlations between them.
The total annual return on equities is calculated as the return on one-year bonds plus an excess return. The excess return is assumed to have a lognormal distribution. The model also generates property total returns and real yield curves, although these are not significant asset classes for Aviva outside the UK.
Mean1 StDev2 Mean1 StDev2 Mean1 StDev2 1. Means have been calculated by accumulating a unit investment for the required number of years in each simulation, averaging the accumulation across all simulations, and converting the result to an equivalent annual rate (by taking the nth root of the average accumulation minus 1).
2. Standard deviations have been calculated by accumulating a unit investment for the required number of years in each simulation, taking the natural logarithm of the result, calculating the variance of this statistic, dividing by the projection period (n years) and taking the square root. This makes the result comparable to implied volatilities quoted in investment markets.
Expense assumptions Management expenses and operating expenses of holding companies attributed to life and related businesses have been included in the EEV calculations and split between expenses relating to the acquisition of new business, the maintenance of business in-force and project expenses. Future expense assumptions include an allowance for maintenance expenses and a proportion of recurring project expenses. Certain expenses of an exceptional nature, when they occur, are identified separately and are generally charged as incurred. No future productivity gains have been anticipated.
Borrowings excluding non-recourse funding – EEV basis 4,710 4,897 Less: Operational financing by businesses (900) (598)
External debt and subordinated debt – EEV basis 3,810 4,299 Add: Preference shares (including General Accident plc) and direct capital instrument 1,440 1,440
Market value of external debt, subordinated debt, preference shares and direct capital instrument 5,868 5,953
Embedded value (net of tax) on page 213 rates rates rates rates
Netherlands (including Belgium and Luxembourg) 3,024 275 (310) 335 (335) 100
Sensitivities will also vary according to the current economic assumptions, mainly due to the impact of changes to both the intrinsic cost and time value of options and guarantees. Options and guarantees are the main reason for the asymmetry of the sensitivities where the guarantee impacts to different extents under the different scenarios. This can be seen in the sensitivity of a 1% movement in the interest rate for the Netherlands, where there is a significant amount of business with investment return guarantees. The reduction of 40 basis points to the assumed pre-tax investment returns at 31 December 2005 has significantly increased this sensitivity, reflecting the level of the guarantees relative to the interest rate assumption.
Sensitivity analysis – economic assumptions continued in equity/ in equity/ New business contribution before As reported property property required capital (gross of tax) on page 207 returns returns 2005 £m £m £m
Changing the assumption of the required capital backing annuities to 100%, increases the reported value of new business contribution reported after the effect of required capital for 2005 by £13 million and increases the embedded value by £90 million, as shown on page 219.
Sensitivity analysis – non-economic assumptions continued No future management actions are modelled in reaction to the changing non-economic assumptions. In each sensitivity calculation, all other assumptions remain unchanged.
Embedded value As reported maintenance decrease in in mortality/ (net of tax) on page 213 expenses lapse rates morbidity rates
United Kingdom BSM Group plc CGNU Life Assurance Limited CGU Bonus Limited CGU Insurance plc CGU International Insurance plc CGU Underwriting Limited Commercial Union Life Assurance Company Limited General Accident plc Gresham Insurance Company Limited Haven Insurance Policies Limited Lex Employee Benefit Trustees Limited Lex Transfleet Limited London & Edinburgh Insurance Group Limited Morley Fund Management International Limited Morley Fund Management Limited Morley Pooled Pensions Limited Morley Properties Limited Norwich Union Annuity Limited Norwich Union Collective Investments Limited Norwich Union Consumer Products Limited Norwich Union Equity Release Limited Norwich Union Healthcare Limited Norwich Union Insurance Limited Norwich Union Investment Funds Limited Norwich Union Insurance Services Limited Norwich Union Life & Pensions Limited Norwich Union Life Direct Limited Norwich Union Linked Life Assurance Limited Norwich Union Personal Finance Limited Ocean Marine Insurance Company Limited, The RAC Brand Management Limited RAC Financial Holdings Limited RAC Financial Services Limited RAC Holdings Limited RAC Insurance Limited RAC Investments Limited RAC Motoring Services RAC plc Travellers’ Insurance Association Limited World Auxiliary Insurance Corporation Limited, The
Associates and joint ventures The Group has ongoing interests in the following operations that are classified as associates or joint ventures. Further details of those operations that were most significant in 2005 are set out in notes 17 and 18 on pages 131 to 133.
Managing your shareholding Shareholders who have any queries in respect of their shareholding should contact the Company’s Registrar, Lloyds TSB Registrars. Contact details can be found on page 225. In addition to assisting with general queries, the Registrar can help with the following: Amalgamating different share accounts Shareholders receiving more than one copy of this Annual Report, could have more than one record for their shareholding on the share register. To avoid duplicate mailings, the Registrar can arrange for accounts to be amalgamated.
E-communications Shareholders may choose to receive their communications from the Company (for example, the Notice of Meeting and Annual Review) electronically. This enables a faster receipt of documents and also has the effect of reducing the Company’s printing, paper and postage costs and the associated environmental impacts. To receive communications electronically, log onto www.aviva.com/shareholders and register for shareholder e-communications. We have arranged with The CarbonNeutral Company Limited that, for the first 10,000 shareholders electing to receive communications electronically, a tree will be planted in an area selected for reforestation in the United Kingdom. Further details can be found in the enclosed leaflet.
Share Dealing We have arranged the following services that can be used to buy or sell Aviva shares. Alternatively, if shareholders hold a share certificate they can also use any bank, building society or stockbroker offering share dealing facilities. Shareholders in any doubt about buying or selling their shares should seek professional financial advice.
Share dealing facilities for UK shareholders/share account members – To buy or sell shares over the telephone or internet, shareholders can contact Shareview Dealing, arranged through Lloyds TSB
Registrars. For telephone purchases or sales call 0870 850 0852* between 8.00am and 4.30pm, Monday to Friday and for internet purchases or sales log on to www.shareview.co.uk/dealing
– NatWest Stockbrokers provide a Share Dealing Service via the telephone or at certain NatWest branches for Aviva Share Account holders only. For more information or to find your nearest NatWest share dealing branch, contact NatWest Stockbrokers on 0845 122 0689. NatWest Stockbrokers Limited is operated by a joint venture between The Royal Bank of Scotland Group plc and The Toronto-Dominion Bank. Registered Number: 1959479 England. Registered Office: Waterhouse Square, 138-142 Holborn, London EC1N 2TH. Member of the London Stock Exchange and OFEX. Authorised and regulated by the Financial Services Authority.
Share Dealing continued Share dealing facilities for overseas shareholders To sell Aviva shares over the telephone, shareholders can contact Barclays Stockbrokers on +44 (0)141 352 3959. Non-UK residents will need to provide documentation to use this service and details will be provided on registration. Regulations prevent this service from being offered to US residents. Settlement proceeds will be sent to either a UK sterling bank account or by sterling cheque.
ShareGift The Orr Mackintosh Foundation operates a voluntary charity share donation scheme for shareholders who wish to dispose of small numbers of shares whose value makes it uneconomical to sell them. Details of the scheme are available from ShareGift at www.sharegift.org or can be obtained from the Company’s Registrar. During the year the Company operated a postal Share Dealing Service to shareholders holding 750 or less shares. This service gave shareholders the option to donate their shares or any proceeds from the sale of these shares to ShareGift and resulted in donations to ShareGift in excess of £170,000.
Share price Shareholders can access the current share price of Aviva ordinary shares at www.aviva.com or alternatively can call 0906 843 2197†.
The categories of ordinary shareholders and the range and size of shareholdings as at 31 December 2005 are set out below: Analysis of shareholders No. of shareholders % No. of shares %
Preference Shares First dividend payment for 83⁄8% cumulative irredeemable preference shares 31 March First dividend payment for 83⁄4% cumulative irredeemable preference shares 30 June Second dividend payment for 83⁄8% cumulative irredeemable preference shares 30 September Second dividend payment for 83⁄4% cumulative irredeemable preference shares 31 December
Business review 16 Group overview 16 Basis of preparation 17 Strategy and values 18 Financial position and performance 24 Business segment performance 24 Long-term savings and fund management 32 General insurance, health and related services 38 Other corporate information 38 Group capital structure 39 Group capital strength and solvency 42 Corporate social responsibility 44 Employees 46 Financial reporting 47 Risk and risk management
Aviva plc on the alternative method of reporting long-term business profits 200 Alternative method of reporting long-term business 222 Aviva Group of companies 223 Shareholder services
Corporate and single company Peps Barclays Stockbrokers Limited Tay House 0870 514 3263* 300 Bath Street