Final Results - Part 2

Aviva PLC 09 March 2005 PART 2 OF 4 -------------------------------------------------------------------------------------------------------------------- Contents Page Operating and financial review 1 European Embedded Value (EEV) basis Summarised consolidated profit and loss account - EEV basis 20 Earnings per share - EEV basis 21 Consolidated statement of total recognised gains and losses - EEV basis 21 Reconciliation of movements in consolidated shareholders' funds - EEV basis 21 Summarised consolidated balance sheet - EEV basis 22 Segmentation of summarised consolidated balance sheet - EEV basis 23 Basis of preparation - EEV basis 24 EEV methodology 25 Components of life EEV return 27 New business contribution 28 EEV basis - new business contribution before and after the effect of required capital, tax and minority interest 29 Post tax internal rate of return on life and pensions new business 29 Experience variances 30 Operating assumption changes 30 Geographical analysis of life EEV operating return 30 Analysis of movement in life and related businesses embedded value 31 Segmental analysis of life and related businesses embedded value 32 Time value of options and guarantees 33 Minority interest in life and related businesses EEV results 33 Principal economic assumptions - deterministic calculations 34 Principal economic assumptions - stochastic calculation 35 Other assumptions 36 Sensitivity analysis - economic assumptions 37 Sensitivity analysis - non-economic assumptions 39 Modified statutory basis Summarised consolidated profit and loss account - modified statutory basis 40 Earnings per share - modified statutory basis 41 Consolidated statement of total recognised gains and losses 41 Reconciliation of movements in consolidated shareholders' funds 41 Summarised consolidated balance sheet 42 Consolidated cash flow statement 43 Basis of preparation - modified statutory solvency basis 44 Exchange rates 44 Acquisitions 44 Exceptional costs for termination of operations 44 Disposals 45 Geographical analysis of life and pensions and investment sales - new business and total income 46 Geographical analysis of modified statutory life operating profit 47 Geographical analysis of health premiums after reinsurance and operating result 47 Geographical analysis of general insurance premiums after reinsurance and operating result 48 Fund management operating result 50 Non-insurance operations 50 Corporate costs 50 Tax 51 Dividends 52 Earnings per share 52 Statistical supplement Life EEV operating return before tax 54 Supplementary analyses General insurance - geographical ratio analysis 56 General insurance - class of business analyses 59 Appendix A: Group capital structure 62 Appendix B: Restated preliminary opening balance sheet as at 1 January 2004 under International Financial Reporting Standards 70 Shareholder information 86 -------------------------------------------------------------------------------------------------------------------- Page 1 OPERATING AND FINANCIAL REVIEW Group operating profit before tax Following the launch of the European Embedded Value (EEV) principles in May 2004, the Group has adopted these principles for its 31 December 2004 supplementary financial statements. The EEV principles have therefore replaced the Achieved Profits basis previously reported by the Group. Accordingly, the 31 December 2003 comparative figures have been restated. During 2004, the Group continued to focus its core businesses on creating shareholder value. Throughout the year appropriate pricing actions have been taken, the efficiency of claims management processes have improved and cost savings have been made. As a result the Group's operating profit before tax from continuing operations, including life EEV operating return, increased 25% at constant exchange rates to Â£2,344 million (2003: Â£1,906 million). This includes strong performances from both the life and general insurance operations and delivers an increased return on capital of 14.4% (2003: 13.1%) exceeding our target of 10% after inflation. On a modified statutory basis, the operating profit from continuing operations was up 27% to Â£1,861 million (2003: Â£1,490 million). EEV basis MSSB basis ------------- ----------- Restated* 2004 2003 2004 2003 Â£m Â£m Â£m Â£m Life EEV operating return / Modified statutory life profit 1,611 1,496 1,185 1,122 Health 58 61 58 61 Fund management 23 (4) 43 10 General insurance 1,326 911 1,326 911 Non-insurance operations (31) 8 (108) (48) Corporate costs (178) (160) (178) (160) Unallocated interest charges (465) (406) (465) (406) ------------------------------------------------------------------------------------------------------------------ Operating profit before tax 2,344 1,906 1,861 1,490 ================================================================================================================== * Restated for the effect of implementing European Embedded Value principles. Long-term savings In terms of long-term savings new business growth, the Group had a strong finish to the year with worldwide total new business sales up 17% to Â£17.2 billion (2003: Â£14.9 billion). Total new business sales 2004 Local currency growth -------------------------------- ---------------------------- Life and Retail Life and Retail pensions investments Total pensions investments Total Â£m Â£m Â£m % % % Long-term savings sales United Kingdom 7,018 859 7,877 10% 26% 12% Europe (excluding UK) 7,812 527 8,339 22% 49% 23% International 765 243 1,008 (4%) 144% 13% ----------------------------------------------------------------------------------------------------------------- 15,595 1,629 17,224 15% 44% 17% ================================================================================================================= Navigator 661 - 661 5% - 5% In 2004 we saw a gradual return of customer confidence in many of our markets and we captured growth through our trusted brands, strong distribution network and wide product range. Worldwide life and pension sales were up 15% to Â£15,595 million (2003: Â£13,793 million). In the UK, Norwich Union continues to focus on profitable growth, and retained its market-leading position while growing both value and market share. Total sales, including investment sales, increased by 12% to Â£7,877 million (2003: Â£7,051 million), reflecting a strong performance given pricing actions taken throughout the year in pensions, annuities and protection business. Our Continental European businesses now account for over half of life and pensions new business sales and total life and pension sales accelerated, up 22% to Â£7,812 million (2003: Â£6,569 million). Our businesses in France, the Netherlands, Italy and Spain outperformed local market growth and our bancassurance sales in these businesses made strong contributions to local performance. Total bancassurance sales were up 17% to Â£4,022 million (2003: Â£3,507 million) and include sales from our new bancassurance arrangement in France with Credit du Nord. Total retail investment sales were up 44% to Â£1,629 million (2003: Â£1,141 million) reflecting improvement in investor confidence towards equity-backed and property-backed products. In the UK we expect modest market growth in 2005, with a stronger pick-up in 2006 and 2007. We remain very positive about the growth prospects in our continental European markets, particularly through our bancassurance network, where customer penetration rates for insurance products offer significant opportunities. We continue to make further progress in developing our businesses and distribution capability in our Asian life businesses, particularly in India and China to complement our businesses in Singapore and Hong Kong. The region provides excellent longer-term growth potential. -------------------------------------------------------------------------------------------------------------------- Page 2 Life EEV operating return Restated* 2004 2003 Â£m Â£m New business contribution (after the effect of required capital) 516 474 Profit from existing business - expected return 819 761 - experience variances (15) (31) - operating assumption changes (7) 19 Expected return on shareholders' net worth 298 273 ------------------------------------------------------------------------------------------------------------------ Life EEV operating return before tax 1,611 1,496 ================================================================================================================== * Restated for the effect of implementing European Embedded Value principles. Life EEV operating return before tax was higher at Â£1,611 million (2003: Â£1,496 million) driven by higher profits from both new and in-force business. Higher sales volumes and product mix contributed an additional Â£42 million of new business contribution relative to 2003. The combined expected returns on existing business and shareholders' net worth increased by Â£83 million due to higher start of year embedded values. The overall adverse impact of experience variances and operating assumption changes was marginally higher compared to the prior period, although there were a number of significant positive and negative variances in our various life businesses. Under EEV, the calculation of new business margin is now based on new business sales measured as the present value of new business premiums (PVNBP), rather than the current UK industry standard Annual Premium Equivalent (APE) measure of annual premiums plus 10% of single premiums. This change to the basis of calculating margins produces a more meaningful ratio, since profit and income are now calculated using consistent economic and operating assumptions. The table below sets out new business margin information measured on both a PVNBP and APE basis. To facilitate market comparisons new business margins have also been calculated on the traditional basis using sales expressed on an APE basis. Present value of New business New business new business New business margin(2) margin(3) premiums contribution(1) (using PVNBP) (using APE) ---------------- --------------- -------------- -------------- Restated* 2004 2003 2004 2003 2004 2003 2004 2003 Â£m Â£m Â£m Â£m % % % % United Kingdom 9,172 8,516 269 250 2.9% 2.9% 23.1% 22.4% France 2,782 2,224 95 72 3.4% 3.2% 30.9% 29.9% Ireland 561 529 19 28 3.4% 5.3% 22.0% 34.7% Italy 1,799 1,752 48 45 2.7% 2.6% 24.3% 23.2% Netherlands (including Belgium and Luxembourg) 2,168 1,821 80 69 3.7% 3.8% 30.6% 30.8% Poland 241 226 11 5 4.6% 2.2% 29.7% 14.2% Spain 2,110 1,964 143 141 6.8% 7.2% 57.8% 57.2% Other Europe 804 587 5 (1) 0.6% (0.2%) 4.0% (1.0%) Continental Europe 10,465 9,103 401 359 3.9% 3.9% 31.8% 32.0% International 1,050 1,190 36 37 3.4% 3.1% 21.1% 19.8% ------------------------------------------------------------------------------------------------------------------ Total life and pensions business 20,687 18,809 706 646 3.4% 3.4% 27.2% 26.6% ================================================================================================================== * Restated for the effect of implementing European Embedded Value principles. (1) Before effect of required capital which amounted to Â£190 million (2003: Â£172 million). (2) EEV basis new business margin represents the ratio of new business contribution to present value of new business premiums, expressed as a percentage. (3) New business margin represents the ratio of new business contribution on an EEV basis to annual premium equivalent, expressed as a percentage. Our world-wide new business contribution increased by 11% to Â£706 million (2003: Â£646 million) driven by strong growth in the UK, France and the Netherlands. This represents a new business margin using PVNBP of 3.4% (2003: 3.4%) while margins on an APE basis were 27.2% (2003: 26.6%) reflecting the benefits of pricing, cost control measures and business mix. The internal rate of return (IRR) of our life and pensions new business was 12.3% (2003: 12.4%). PVNBP represents the total single premium sales received in the year and the discounted value of premiums expected to be received over the term of the new regular premium contracts, and is expressed at the point of sale. Consequently, the PVNBP calculation is sensitive to changes in the mix of single and annual premium business and changes in product mix, as different products have different terms. PVNBP is also sensitive to interest rate movements. -------------------------------------------------------------------------------------------------------------------- Page 3 UK Norwich Union continues to leverage successfully its strong brand, wide product offering and multi-distribution network to achieve profitable growth, with total sales on a PVNBP basis up 8% to Â£9,172 million (2003: Â£8,516 million). We are well placed for the changes taking place in the market as a result of depolarisation, having already announced distribution agreements with Bankhall, Millfield, Portman Building Society, Sesame in 2004 and, more recently, with Barclays and Fidelity. We start 2005 with a greater degree of confidence in the market, with modest market growth expected in 2005 and a stronger pick up beyond then. New business contribution increased by 8% to Â£269 million (2003: Â£250 million) with a new business margin on a PVNBP basis of 2.9% (2003: 2.9%). Pricing and cost actions have resulted in a change in business mix towards higher margin products and this, together with the securitisation of our protection business has partially offset the impact on the margin of lapse assumption changes. The IRR for the full year improved to 11.4% (2003: 12.1%) from 11.0% in the first half as the second half of the year benefited from improved product mix and the pricing actions we have taken during the year. Life EEV operating return was lower at Â£551 million (2003: Â£597 million). The decrease reflects adverse experience variances and operating assumption changes which in aggregate amounted to a loss of Â£139 million (2003: loss of Â£40 million) which offset the higher contribution to profits from new business and the higher expected returns from existing business and shareholders' net worth of Â£475 million (2003: Â£425 million). Adverse exceptional expenses of Â£153 million (2003: Â£63 million adverse) includes exceptional project costs associated with required regulatory change and other one-off strategic projects. As previously indicated, the Â£65 million of costs for the restructure of our UK life business are also included. The benefits of the cost saving initiatives undertaken in prior years are coming through, with a positive expense experience variance of Â£31 million (2003: loss of Â£8 million). This allowed Norwich Union to reduce maintenance expense loadings, increasing profits by Â£77 million (2003: Â£7 million). Persistency experience on bond, protection, pension and endowment products was greater than our assumptions, generating a loss of Â£50 million (2003: loss of Â£29 million). While action is being taken to improve our current persistency experience, Norwich Union has strengthened the persistency assumptions with a consequential adverse impact on profits of Â£110 million (2003: loss of Â£46 million). The change reflects, both the actual experience and higher assumed levels of unitised with-profit policy surrenders occurring at set policy anniversary dates where market value adjustments (MVAs) do not apply. Norwich Union has again reported mortality profits of Â£51 million (2003: Â£44 million) and better than expected default experience on corporate bond and commercial mortgages of Â£29 million (2003: Â£39 million). Europe (excluding UK) Our Continental European operations delivered accelerated new business life and pensions growth of 18% up to Â£10,465 million (2003: Â£9,103 million) on a PVNBP basis, with particularly strong performances from France, the Netherlands and our bancassurance partnerships in Italy and Spain. New business contribution was Â£401 million (2003: Â£359 million) with a new business margin on a PVNBP basis of 3.9% (2003: 3.9%) and new business margin on an APE basis of 31.8% (2003: 32.0%). France: Aviva France outperformed the market in 2004 with 28% growth in new business sales to Â£2,782 million (2003: Â£2,224 million) on a PVNBP basis. Single premium sales through our partnership with AFER increased by 33% to Â£1,594 million (2003: Â£1,225 million), and sales on a PVNBP basis of unit-linked funds across all distribution channels nearly doubled to Â£818 million. New business contribution increased to Â£95 million (2003: Â£72 million) representing a new business margin on a PVNBP basis of 3.4% (2003: 3.2%), reflecting strong sales of unit-linked products. Life EEV operating return was Â£286 million (2003: Â£228 million) reflecting the improved contribution from new business and higher experience and operating assumption change profits of Â£57 million (2003: Â£29 million). The positive experience variances included Â£21 million of mortality profits on protection business. Recurring levels of tax experience profits of Â£10 million (2003: Â£51 million) have led us to review the tax assumptions improving returns by Â£39 million. Ireland: Hibernian continues to be the third largest Irish life and pensions provider, with an 8% increase in new business sales on a PVNBP basis to Â£561 million (2003: Â£529 million). This performance benefits from both strong single premium pension sales throughout the year and increased sales of savings products in the fourth quarter. New business contribution was Â£19 million (2003: Â£28 million) giving a full year new business margin on a PVNBP basis of 3.4% (2003: 5.3%). The decrease in margin reflects lapse assumption changes on unit-linked pensions business and the competitive market for protection products. Life EEV operating return was Â£40 million (2003: Â£57 million) which includes an adverse impact of Â£16 million due to lapse assumption changes on unit-linked pensions business. Italy: Total new business sales from our Italian business were 5% higher at Â£1,799 million (2003: Â£1,752 million) on a PVNBP basis. New business contribution was Â£48 million (2003: Â£45 million) with an improved new business margin on a PVNBP basis of 2.7% (2003: 2.6%) reflecting increased sales of structured bond products. Life EEV operating return was Â£79 million (2003: Â£70 million). Netherlands (including Belgium and Luxembourg): In 2004, our top five life and pensions business, Delta Lloyd, reported a 22% increase in new business sales to Â£2,168 million (2003: Â£1,821 million) on a PVNBP basis. This includes strong sales across all our major product lines and sales from our bancassurance agreement with ABN AMRO of Â£493 million (2003: Â£345 million) on a PVNBP basis. New business contribution was Â£80 million (2003: Â£69 million) with a full year new business margin on a PVNBP basis of 3.7% (2003: 3.8%). New business margin on an APE basis was broadly flat at 30.6% (2003: 30.8%), reflecting continued favourable business mix and increased business through ABN AMRO in 2004. Life EEV operating return was Â£277 million (2003: Â£198 million) largely reflecting an improvement in experience and operating assumption changes to a profit of Â£33 million (2003: loss of Â£32 million). Exceptional project-related adverse expense experience amounting to Â£12 million (2003: loss of Â£35 million) has caused us to re-evaluate our approach to allowing for these costs. We have now incorporated an appropriate loading within annual maintenance costs, the impact of which was to reduce our reported profits in 2004 by Â£72 million. The impact of this was partially offset by mortality experience profits of Â£17 million. In addition, refinements made to the modelling of tax assumptions and positive asset mix changes have delivered Â£79 million of profits (2003: Â£27 million). -------------------------------------------------------------------------------------------------------------------- Page 4 Poland: CU Polska continues to be one of the market leaders and reported total new business sales of Â£241 million (2003: Â£226 million) on a PVNBP basis. New business contribution was Â£11 million (2003: Â£5 million) with an improvement in margin to 4.6% (2003: 2.2%) reflecting pricing and cost actions. Life EEV operating return was Â£93 million (2003: Â£99 million). Spain: Our bancassurance businesses delivered strong results in 2004 and Aviva Spain continues to be a leading bancassurance business in the Spanish life market. Total sales on a PVNBP basis increased by 10% to Â£2,110 million (2003:Â£1,964 million). New business contribution was Â£143 million (2003: Â£141 million) with a full year new business margin on a PVNBP basis of 6.8% (2003: 7.2%). The fall in margin reflects the lower margin bulk pension transfer business in Bia Galicia in 2004. Excluding one-off business of Â£290 million on a PVNBP basis (2003: Â£210 million) the underlying margin was 7.6% (2003: 6.7%). Life EEV operating return was Â£180 million (2003: Â£165 million), reflecting improved expected returns and experience on in-force business. International Asia offers significant future growth potential and we continue to make good progress in our developing businesses in Singapore, Hong Kong, India and China. Sales through our partnerships in India and China continued to progress well with total sales on a PVNBP basis of Â£56 million (2003: Â£27 million) and Â£66 million (2003: Â£38 million) respectively. Our share of these sales amounted to Â£15 million (2003: Â£7 million) in India and Â£33 million (2003: Â£19 million) in China, representing our 26% and 50% share of the business respectively. Our joint venture life business with Dabur Group in India is now the eighth largest amongst private providers. Distribution is through a number of bancassurance partnerships including ABN AMRO, Canara Bank and the 3,200 strong direct sales force. In China, we now operate in Guangzhou, Beijing and Chengdu. Aviva COFCO began writing group life insurance policies in January 2005, making it one of the first foreign or Sino-foreign life assurers operating in China to write this type of business. Total PVNBP from our International businesses amounted to Â£1,050 million (2003: Â£1,190 million), affected by lower sales of fixed annuity products in the United States. New business contribution was Â£36 million (2003: Â£37 million) with a full year new business margin on a PVNBP basis of 3.4% (2003: 3.1%), benefiting from higher margin sales in Asia. Life EEV operating return from our International businesses was Â£83 million (2003: Â£64 million) reflecting increases in new business contribution from our Asian operations and improved returns on existing business, primarily in Australia, offset by decreased contribution due to lower sales in the US. Bancassurance margins - Before cost of capital, tax and minority interests Bancassurance new business margins before cost of capital, tax and minority interests on a PVNBP basis were 4.9% (2003: 5.1%) and on an APE basis were 41.2% (2003: 41.3%). Present value of New business New business new business New business margin(2) margin(3) premiums contribution(1) (using PVNBP) (using APE) ---------------- --------------- ------------- ------------ Restated* 2004 2003 2004 2003 2004 2003 2004 2003 Â£m Â£m Â£m Â£m % % % % United Kingdom 461 533 12 13 2.6% 2.4% 21.1% 19.4% France 127 - 4 - 3.1% - 23.3% - Italy 1,666 1,512 46 43 2.8% 2.8% 25.1% 25.1% Netherlands 493 387 21 16 4.3% 4.1% 32.2% 32.2% Spain 1,956 1,848 142 143 7.3% 7.7% 63.5% 62.5% Asia 264 160 17 9 6.4% 5.6% 42.0% 35.7% ------------------------------------------------------------------------------------------------------------------ Total bancassurance channels 4,967 4,440 242 224 4.9% 5.0% 41.2% 41.3% ================================================================================================================== * Restated for the effect of implementing European Embedded Value principles. (1) Before effect of required capital which amounted to Â£43 million (2003: Â£39 million). (2) EEV basis new business margin represents the ratio of new business contribution to present value of new business premiums, expressed as a percentage. (3) New business margin represents the ratio of new business contribution on an EEV basis to annual premium equivalent, expressed as a percentage. In the UK, new business margins from life and pensions sales through our partnership with the Royal Bank of Scotland Group (RBSG) increased to 2.6% (2003: 2.4%) on a PVNBP basis reflecting improved product mix, despite lower than expected new business sales volumes in 2004. Norwich Union continues to work with RBSG to deliver improved future sales growth and profitability. -------------------------------------------------------------------------------------------------------------------- Page 5 New business bancassurance margins from our new joint venture with Credit du Nord generated margins of 3.1% on a PVNBP basis. In 2005, as the arrangement beds down, we expect the proportion of unit-linked business, and hence margins, to increase. In the Netherlands, ABN AMRO new business margins increased to 4.3% (2003: 4.1%) and they continue to be higher than the total business in the Netherlands due to more favourable product mix. In Spain, new business bancassurance margins were 7.3% (2003: 7.7%) on a PVNBP basis impacted by the lower margin one-off bulk pension transfer in the year. Excluding one-off business the underlying Spanish bancassurance margin is 8.3% (2003: 7.3%). The PVNBP margin reflects business mix, influenced by marketing campaigns and product launches during the year. New business bancassurance margins from our partnership with DBS in Singapore and Hong Kong were 6.4% (2003: 5.6%) on a PVNBP basis reflecting continued profitable growth. New business margin - after minority interest, tax and cost of capital New business contribution after the cost of capital, tax and the deduction of the minority interest grew by 11% to Â£297 million (2003: Â£272 million), with a margin on a PVNBP basis of 1.6% (2003: 1.6%) and an increased margin on an APE basis of 12.9% (2003: 12.6%). This increasing trend is driven by higher margins in both our bancassurance and non-bancassurance businesses due to pricing measures, and reflects the shift towards unit-linked business. Present value of New business New business new business New business margin(2) margin(3) premiums contribution(1) (using PVNBP) (using APE) ---------------- --------------- ------------- ------------- Restated* 2004 2003 2004 2003 2004 2003 2004 2003 Â£m Â£m Â£m Â£m % % % % Bancassurance channels 2,728 2,499 74 66 2.7% 2.6% 22.5% 21.2% Other distribution channels 15,379 14,148 223 206 1.5% 1.5% 11.3% 11.2% ------------------------------------------------------------------------------------------------------------------ Total life and pensions business 18,107 16,647 297 272 1.6% 1.6% 12.9% 12.6% ================================================================================================================== * Restated for the effect of implementing European Embedded Value principles. (1) After the effect required capital, tax and minority interest. (2) EEV basis new business margin represents the ratio of new business contribution to present value of new business premiums, expressed as a percentage. (3) New business margin represents the ratio of new business contribution on an EEV basis to annual premium equivalent, expressed as a percentage. Life operating profit on a modified statutory basis On a modified statutory basis, our life operating profit amounted to Â£1,185 million (2003: Â£1,122 million). As a result of falling annual and final bonus rates, our UK with-profit result has decreased to Â£107 million (2003: Â£145 million). The UK non-profit result of Â£478 million (2003: Â£433 million) reflects a higher surplus on existing business. In Continental Europe, life modified statutory profit increased to Â£566 million (2003: Â£506 million) with strong results across most of our businesses, particularly in the Netherlands, Italy and Spain. Operating profit in the Netherlands increased to Â£166 million (2003: Â£107 million) as increased investment return and focus on controlling costs delivered profitable growth. Operating profit in Spain increased to Â£61 million (2003: Â£50 million) largely driven by the impact of higher volumes of risk business, which delivers statutory earnings in the first year, and higher investment returns. Operating profit in Italy increased to Â£43 million (2003: Â£30 million) largely driven by increased sales of structured bonds and higher investment returns. In Poland, operating profit decreased to Â£84 million (2003: Â£103 million) as 2003 included a one-off benefit of Â£21 million following regulatory changes in the level of required reserves on pensions business. Health Premium income after reinsurance from our health business was Â£994 million (2003: Â£1,066 million), with total operating profit of Â£58 million (2003: Â£61 million). Our business in the Netherlands continued to be the main contributor to the results with operating profit of Â£38 million (2003: Â£39 million) where we continue to focus on reviewing the profitability of business on renewal which has led to the loss of volume during the year, with little impact on operating profits. The total combined operating ratio for the health business was 100% (2003: 101%). Fund management The steady recovery across global equity markets during 2004 resulted in increased operating profits on an MSSB basis of Â£43 million (2003: Â£10 million)for our worldwide fund management operations. Assets under management at 31 December 2004 increased to Â£273 billion (2003: Â£240 billion), driven by the benefit of new business flows in the period and the improvement in worldwide investment markets. Our UK fund management business comprises Morley Fund Management retail and institutional business, our retail investment business operating as Norwich Union, and our collective investment business with RBSG. These businesses reported a profit of Â£10 million (2003: loss of Â£6 million). Morley's UK businesses reported a profit of Â£12 million (2003: Â£3 million) due to an increase in fee income, reflecting the improvement in investment markets and the benefit of performance fees, and controlled operating costs. Within the Group results are further profits of Â£12 million (2003: Â£6 million) relating to other Morley businesses including the pooled pensions business and the overseas operations. This brings the contribution that Morley makes to the total group result on a MSSB basis to Â£24 million (2003: Â£9 million). -------------------------------------------------------------------------------------------------------------------- Page 6 Operating result through Norwich Union retail investment businesses improved to Â£5 million (2003: loss of Â£3 million) benefiting from lower costs. The loss of Â£7 million (2003: loss of Â£6 million) reported by our new collective investment vehicle with RBSG is due to new business strain from sales of regular premium investment business. Aviva Gestion d'Actifs, maintained its reputation for strong investment performance, with over 65% of our funds in the top quartile for returns over three years. Operating profit was Â£17 million (2003: Â£13 million) on an MSSB basis. In Australia our master trust fund administration business, Navigator, reported increased sales of Â£648 million (2003: Â£617 million) benefiting from improvements in product offerings and a more competitive fee structure. These sales are excluded from the Group's headline new business figures. Operating profit increased in Australia by Â£8 million due to the improvement in investment markets and tight cost control. Sales from our Navigator business in Singapore were Â£13 million (2003: Â£8 million). The embedded value of our Navigator Australian business was Â£54 million (2003: Â£53 million) on an EEV basis. On an EEV basis, the reported operating profits in respect of fund management were Â£23 million (2003: loss of Â£4 million) and principally relate to fund management profits on transactions with third parties and the management of group internal non-life funds. General insurance Our worldwide general insurance operations reported excellent results with a 47% increase in total operating profit to Â£1,326 million (2003: Â£911 million). We continue to see the benefits of our strategy of focusing on personal and small commercial business, underpinned by our strict adherence to our operational disciplines of focused underwriting and efficient claims handling despite an increasingly competitive environment. Our worldwide combined operating ratio (COR) improved to 96.7% (2003: 100%), with the UK, Ireland, the Netherlands and Canada reporting CORs of 97%, 87%, 95% and 97% respectively. This outperforms our target Group COR of 100% set for each year from 2004 to 2006 across the worldwide general insurance business. The underwriting result improved to a profit of Â£301 million (2003: loss of Â£54 million) due to strong underwriting disciplines, and lower claims frequency, and is underpinned by a strong reserving basis. Also included is the benefit of better than expected weather-related claims experience of Â£50 million (2003: Â£40 million) and the non-recurrence of the prior year reserve strengthening in 2003 of Â£70 million in our Canadian subsidiary, Pilot. The worldwide expense ratio from continuing operations was 10.9% (2003: 11.3%). The improvement reflects our continued focus on achieving enhanced efficiencies and the benefit of our cost savings initiatives. Our claims reserves are calculated within a range of possible outcomes and our actuarial analysis suggests that our claims reserves across the Group are strong. Our longer-term investment return improved to Â£1,025 million (2003: Â£965 million) reflecting, in part, the higher start of year investment values and the returns earned on the positive cash flows during 2004. Net written premiums Underwriting result* Operating profit* -------------------- -------------------- ------------------ 2004 2003 2004 2003 2004 2003 Â£m Â£m Â£m Â£m Â£m Â£m United Kingdom 5,434 5,135 158 50 832 676 Europe (excluding UK) 2,018 1,915 99 6 295 193 International 1,363 1,474 44 (110) 199 42 ------------------------------------------------------------------------------------------------------------------ Continuing operations 8,815 8,524 301 (54) 1,326 911 ================================================================================================================== * Excludes the change in the equalisation provision of Â£23 million (2003: Â£49 million). UK In the UK, Norwich Union Insurance (NUI) delivered an increased operating profit of Â£832 million (2003: Â£676 million), with excellent results in both personal and commercial lines. Our multi-distribution strategy supports sustainable, profitable growth, with a 6% year on year growth in net written premiums to Â£5,434 million (22% growth in Retail which is now around 17% of net written premiums). Better than expected weather-related claims experience has benefited our result by Â£50 million (2003: Â£30 million) and we have delivered a 2% improvement in COR to 97%. This performance has been achieved in an environment of significant organisational change and preparation for the FSA regulatory regime. Our personal lines COR has improved to 100%. We achieved modest rate increases (2% in personal motor and 1% in homeowners), and there is no evidence of significant rate cutting in the personal lines market. Disciplined underwriting, allied with a Â£55 million increase in claims cost savings through our supply chain management across our business lines, has enabled us to sustain profitability. We have delivered an excellent commercial lines COR of 94% (2003: 96%). Commercial rate increases are moderating (4% for commercial property and 7% for commercial liability), but maintaining our focus on the SME sector and rigorous cost control has enabled us to increase levels of profitability. We have kept our promise to deliver a full year expense ratio of 10.0%, reaffirming our position as a low-cost provider. During 2004 we successfully completed the offshoring migration of 1,200 roles, bringing the total number of jobs relocated to around 2,600. We continue to invest in market-leading initiatives, including digital flood maps and 'Pay As You Drive'TM insurance, which will help to provide the competitive advantage required to maintain our COR levels through the underwriting cycle. -------------------------------------------------------------------------------------------------------------------- Page 7 A key part of our strategy is to increase access to our customers through broader propositions that include non-insurance products and services. In August, we acquired HPI Group Holdings Ltd (HPI), the UK's leading independent provider of vehicle information and checking services, at a cost of Â£120 million. This acquisition fits well with our strategy of offering customers motoring solutions, strengthening our position as a service provider while offering further distribution opportunities. In addition, we have launched a 'Pay As You Drive'TM Young Drivers' product aimed at 18-21 year-olds. Young drivers now have the chance to get more affordable insurance premiums, which will be based on when and how often they drive their car. In a Professional Broking magazine survey we were voted the best insurer for service. We also won the Insurance Times' general insurer of the year for the second year running. NUI is in advanced negotiations with Barclays to become their sole provider of their general insurance products. This will include the provision of household products, in addition to the motor and travel portfolio we currently underwrite. The deal will strengthen our market position, supports our strategy of building mutually beneficial partnerships to distribute our products and is a step towards becoming the preferred partner of the UK's best brands. Europe (excluding UK) In Continental Europe, our general insurance businesses produced total operating profit of Â£295 million (2003: Â£193 million) with significant improvements in performance in Ireland and the Netherlands. Weather-related claims in 2004 were in line with long-term averages whereas 2003 included a benefit of Â£10 million in this respect. In France our business reported a slight improvement in the underwriting result to a loss of Â£8 million (2003: loss of Â£9 million) with net premiums rising to Â£524 million (2003: Â£515 million). We achieved a COR of 101% (2003: 102%), as we continue to maintain our underwriting and cost control disciplines. The longer-term investment return in France was lower at Â£40 million (2003: Â£44 million). In Ireland, the market became progressively more competitive throughout 2004 and, as a result, premiums in Hibernian, our market-leading general insurance business in Ireland, decreased to Â£545 million (2003: Â£611 million). We reported a substantial improvement in operating profit of Â£153 million (2003: Â£91 million) with a COR of 87% (2003: 97%), underlining the success of our selective underwriting strategy and focus on containing claims costs. We continue to participate in market initiatives to control claims including the introduction of discounts to penalty point free drivers and those who complete our Ignition driver training programme. Weather-related claims were in line with long-term averages (2003: Â£7 million benefit). The Irish market remains very price competitive, with continuing external pressures for providers to reduce rates. The Government has been instrumental in changing the business environment and has reduced the cost of tort awards, which has consequently led to premium reductions. We have made substantial progress in renewing key business partnerships in our intermediary market, and have successfully increased the customer base in our direct channel. The benefits of these actions should help to support short to medium-term growth. In the Netherlands, operating profit increased to Â£71 million (2003: Â£35 million) with an improved COR of 95% (2003: 101%), reflecting cost control initiatives, including the benefits of the shared service centre which commenced at the end of 2003. The results also include the ABN AMRO general insurance operations with a COR of 90% (2003: 93%). Our focus is on motor and property personal lines and small commercial risks, particularly in the income protection and absenteeism sectors, which we anticipated will grow in importance in the market. A number of products were updated and new products launched during the year to complement our existing offering. International Our International businesses recorded an operating profit from continuing operations of Â£199 million (2003: Â£42 million). The 2003 result included a Â£70 million claims reserve strengthening in our Canadian subsidiary, Pilot. Our Canadian general insurance business reported increased operating profits of Â£152 million (2003: Â£82 million excluding impact of Pilot) and a COR of 97% (2003: 101% excluding the impact of Pilot). The result benefits from rate increases in all lines of business, albeit at a lower rate than 2003, and improved claims frequency. Aviva Canada successfully launched at the end of 2003 the President's Choice Financial (PCF) Corporate Partnership initiative with Loblaw's, Canada's largest supermarket chain, widening our distribution capability. In a number of provinces, successful legislative motor reforms have led to lower claims costs and lower premiums for customers, as expected. The operating profit from our other international businesses of Â£47 million (2003: Â£30 million) includes the results of the Group's captive and Â£21 million (2003: Â£22 million) from our Asian businesses. In September 2004, we agreed to sell our Asian general insurance operations to Mitsui Sumitomo Insurance Co Limited for Â£250 million, a multiple of 3.5 times book value. These operations comprise our businesses in Singapore, Malaysia, Thailand, Indonesia, Hong Kong, the Philippines, Marianas, Macau and Taiwan. The sale will be completed in stages with the first stage completed in February 2005. The second stage is anticipated to complete later in the year. The results of this business will continue to be included until the sale is formally completed. Had the sale completed on 31 December 2004, we would have reported a pre-tax profit on disposal of Â£169 million. Non-insurance operations The result of the Group's non-insurance operations on an MSSB basis was a loss of Â£108 million (2003: loss of Â£48 million). On an EEV basis, non-insurance losses amounted to Â£31 million (2003: profit of Â£8 million). The main difference between the two bases relates to the exclusion of NU Life Services losses arising on services provided to UK life businesses which are factored into the life EEV operating return. -------------------------------------------------------------------------------------------------------------------- Page 8 The deterioration in the non-insurance result is principally due to a one-off Â£40 million vacant property provision following the completion of a UK-wide owner-occupied property strategy review which assessed current requirements in light of headcount reductions in the UK in recent years. Corporate costs Corporate costs were higher in the year at Â£178 million (2003: Â£160 million) and include global finance transformation programme (GFTP) costs of Â£85 million (2003: Â£60 million). The GFTP costs reflect the peak of the considerable investment required in response to the significant accounting and regulatory external changes that the Group must comply with now and over the foreseeable future. We expect GFTP costs to reduce to around Â£40 million in 2005 when the programme will be completed. Other corporate costs were lower at Â£93 million (2003: Â£100 million). Unallocated interest charges These charges comprise internal and external interest on external borrowings, subordinated debt and intra-group loans not allocated to local business operations. Total interest costs were Â£465 million (2003: Â£406 million). External interest costs were Â£246 million (2003: Â£210 million), and include the full year's charge of Â£95 million on the subordinated debt issued in September 2003, offset by the impact of interest rate falls and the repayment of senior debt. Internal interest costs were higher at Â£219 million (2003: Â£196 million). We took advantage of the low interest rate environment and favourable market conditions to issue a direct capital instrument which was four times oversubscribed and raised a sterling equivalent of Â£990 million. This transaction allowed us to lock into favourable funding rates and will be used to repay existing senior debt over the course of 2005 and will leave overall debt levels unchanged. This also enhanced our strong regulatory capital position, whilst leaving the financial leverage of the Group unchanged. The issuance of the direct capital instrument is treated and accounted for as equity, in accordance with FRS 4 'Capital Instruments', and hence the interest charge is treated as an appropriation of profits. Accordingly, the interest charge is not included within operating profit as external interest but is shown as an appropriation in the profit and loss statement. The charge for the year was Â£6 million. The accounting treatment does not affect the calculation of dividend cover or return on capital employed as non-ordinary share appropriations are excluded in calculating these key performance indicators. Cost savings Reducing costs and improving our operational efficiency continued to be one of our key objectives for 2004. Throughout the year we have taken actions and announced a number of initiatives to reduce our cost base. At the 2003 year end, we announced that we expected to achieve in 2004 estimated annualised savings of Â£250 million and earned savings of Â£225 million, both relative to the 2002 cost base for cost saving initiatives announced in the prior years. We have successfully achieved these targets delivering earned savings of Â£225 million in 2004 and accordingly, we expect to achieve annualised savings of Â£250 million in 2005. In 2004, we have achieved a net pre-tax benefit to the profit and loss account in 2004 relative to 2003 of Â£52 million which is greater than the Â£20 million previously announced. This benefit includes lower than anticipated one-off GFTP and off-shoring costs for 2004. The table below provides an analysis of the net pre-tax benefit to the profit and loss account across each business for the Â£52 million saved in 2004 relative to 2003. Update on cost savings in 2004 compared to 2003 Benefit to the profit and loss account Â£m UK life 43 UK general insurance 27 Other businesses - Corporate costs (18) ------------------------------------------------------------------------------------------------------------------- Total 52 =================================================================================================================== By the end of 2004 we successfully completed the offshoring migration of 3,700 jobs across our UK life and general insurance operations to India to service the Group's UK life and general insurance businesses and our general insurance operations in Canada. In 2004, total upfront costs incurred on these initiatives were around Â£50 million (2003: Â£66 million). As previously announced we expect to have around 7,000 staff working in our offshore operations by 2007. In addition to the cost initiatives shown above, we also announced in 2004 the restructuring of our UK life business. The one-off cost incurred in 2004 to achieve cost savings was Â£65 million and further one-off costs of Â£88 million are expected over the next three years. These are expected to deliver annualised savings of Â£130 million by the end of 2007. -------------------------------------------------------------------------------------------------------------------- Page 9 Profit on ordinary activities before tax EEV basis MSSB basis --------------- -------------- Restated* 2004 2003 2004 2003 Â£m Â£m Â£m Â£m Operating profit before tax 2,344 1,906 1,861 1,490 Amortisation of goodwill (120) (103) (120) (103) Amortisation of acquired additional value of in-force long-term business - - (126) (135) Financial Services Compensation Scheme and other levies (49) - (49) - Change in claims equalisation provision (23) (49) (23) (49) Exceptional costs for termination of operations (50) (19) (50) (19) Loss on disposal of subsidiary undertakings (136) (6) (136) (6) Effect of economic assumption changes (318) (55) - - Short-term fluctuations in investment return - general insurance and shareholder business 64 83 64 83 Variation from longer-term investment return - life business 501 696 67 129 ------------------------------------------------------------------------------------------------------------------ Profit on ordinary activities before tax 2,213 2,453 1,488 1,390 ================================================================================================================== * Restated for the effect of implementing European Embedded Value principles. On an EEV basis the profit before tax was Â£2,213 million (2003: Â£2,453 million), which includes losses on the disposal of subsidiaries of Â£136 million (2003: Â£6 million loss), positive variations from the assumed levels of longer-term investment returns of Â£565 million (2003: Â£779 million) and the negative impact of economic assumption changes of Â£318 million (2003: loss of Â£55 million). In July 2004, the Group disposed of its Your Move estate agency and e.surveying business for a total consideration of Â£42 million, with net assets disposed of Â£12 million. We achieved an economic profit on disposal of Â£26 million after deducting the associated disposal costs of Â£4 million. However, the loss on sale of Â£141 million has arisen due to the requirement to incorporate in the calculation Â£167 million of goodwill previously written off to reserves. The same goodwill amount is also credited directly to the profit and loss account reserve and therefore has a neutral effect on shareholders' funds. The variance from the longer-term investment return reflects the benefit of unrealised gains on the Group's life embedded value, following higher than assumed overall equity returns during the year and higher market values for fixed income securities arising from falling bond yields. Long-term economic assumptions are revised at each period close. These assumptions are set by reference to the long-term bond yields and have been revised downwards at 31 December 2004 in both the UK and the Euro zone by 20 and 60 basis points respectively. Lower long-term economic assumptions have the effect of reducing the expected value of future profits from in-force life contracts, reducing profits by Â£318 million. The short-term fluctuations in investment return for non-life businesses of Â£64 million (2003: Â£83 million) reflect a combination of the positive impact of decreases in short and medium terms bond yields across our major European businesses year on year and higher actual returns on equities compared to our longer-term investment return assumptions. The profit before tax on a modified statutory basis was Â£1,488 million (2003:Â£1,390 million). This improvement reflects the continued strong operational performance in our core businesses, particularly in the general insurance businesses. The taxation charge for the period was Â£647 million (2003: Â£739 million) on an EEV basis and includes Â£651 million in respect of the operating profit from continuing operations, which is equivalent to an effective rate of 27.8% (2003: 29.5%). On a modified statutory basis the effective rate on operating profit from continuing operations amounted to 24.5% (2003: 27.0%). The tax charge for the year includes one-off tax credits of around Â£200 million, as a result of offsetting UK tax losses from prior years against current year profits. These losses were previously treated as unrecognised deferred tax assets. Dividends Ordinary dividends The Group has a progressive dividend policy of growing the dividend by approximately 5% per annum whilst retaining cover at between 1.5 to 2 times the operating earnings after tax, measured on a modified statutory solvency basis. In line with this policy, the Board has recommended a final ordinary dividend of 16.00 pence net per share (2003: 15.15 pence) payable on 17 May 2005 to shareholders on the register on 18 March 2005. This equates to 5% growth in the total dividend for 2004 of 25.36 pence (2003: 24.15 pence) and a dividend cover for the year ended 31 December 2004 of 2.25 times (2003: 1.82 times). 8 3/8% cumulative irredeemable preference shares of Â£1 each The Board has declared a dividend payment of 4 3/16% per share for the six month period ending 31 March 2005 payable on 31 March 2005 to preference shareholders on the register on 18 March 2005. 8 3/4% cumulative irredeemable preference shares of Â£1 each The Board has declared a dividend payment of 4 3/8% per share for the six month period ending on 30 June 2005 payable on 30 June 2005 to preference shareholders on the register on 3 June 2005. -------------------------------------------------------------------------------------------------------------------- Page 10 International Financial Reporting Standards (IFRS) The European Union requires all European listed groups to prepare their consolidated financial statements using standards issued by the International Accounting Standards Board (IASB) with effect from 1 January 2005. The Aviva group's consolidated accounts for 2005 will therefore be prepared under IFRS, rather than UK GAAP. Comparative figures will be required for 2004, together with reconciliations of income and shareholders' equity to the previously reported UK GAAP figures. We made excellent progress through 2004 in our preparations for reporting under IFRS and continued to be a leading participant in the dialogue with the IASB in helping to shape the new accounting and reporting framework for our sector. In the course of 2004, we commenced a market education of the impact of IFRS on Aviva's financials and highlighted the likely consequences of adopting these new reporting standards. In accordance with the guidance from The Committee of European Securities Regulators (CESR) we have incorporated within the 2004 preliminary announcement balance sheet restatement information relating to 31 December 2003 together with those accounting policies that Aviva will adopt for 2005, which apply to the balance sheet. Accounting policies relating to the income statement will be published in August 2005 with our first set of IFRS results. In overview our work to date on implementing IFRS has led us to the following preliminary conclusions: a) accounting for substantially all of the general insurance business and approximately 85% of our long-term business will be unchanged. The remaining 15% of our life products will be accounted under International Accounting Standard (IAS) 39 - Financial instruments; b) IFRS is a technical accounting change to the way we report and present our consolidated MSSB results. There is no change to the underlying economics of Aviva's business; and c) IFRS will not impact our dividend policy nor significantly impact the Group's solvency calculations which are the subject of separate regulation. As anticipated, the impact of implementing IFRS on our balance sheet at 31 December 2003 is a reduction of Â£250 million on our reported statutory basis equity shareholders' funds. Life EEV is unaffected by the impact of IFRS and so those adjustments relating to the life segment do not change life shareholders' funds on an EEV basis. The reduction of Â£250 million includes a Â£106 million decrease to the life segment's equity shareholders' funds. This is stated after a notional allocation of Â£211 million of the IAS 19 pension deficit relating to UK life covered business, in line with the pension disclosures on page 58. A reconciliation between UK GAAP and IFRS basis shareholders' funds is also included in this preliminary announcement. We will report our first set of results under IFRS as part of the interim announcement in August 2005. Group capital structure The Group maintains an efficient capital structure from a combination of equity shareholders' funds, preference capital, subordinated debt and borrowings, consistent with the Group's risk profile and the regulatory and market requirements of its business. The Group is subject to a number of regulatory capital tests and also employs a number of realistic tests to allocate capital and manage risk. Overall, the Group comfortably meets all of these requirements and has significant resources and financial strength. We report on these below. The ratings of the Group's main operating subsidiaries are AA/AA- ('very strong') with a stable outlook from Standard & Poor's and Aa2 ('excellent') from Moody's. These ratings were reaffirmed in September 2004 and reflect the Group's financial and capital strength, strong underlying earnings and positive strategic management. Capital management In managing its capital, the Group seeks to: (i) match the profile of its assets and liabilities, taking account of the risks inherent in each business. In the case of the Group's life operations, which have long-term liabilities, the majority of capital is held in fixed income securities. A significant proportion of the capital supporting the Group's general insurance and health operations is held in equities, reflecting the relatively low risk profile of these businesses; (ii) maintain financial strength to support new business growth and satisfy the requirements of its policyholders, regulators and rating agencies; (iii) retain financial flexibility by maintaining strong liquidity, including significant unutilised committed credit lines, and access to a range of capital markets; (iv) allocate capital efficiently to support growth and repatriate excess capital where appropriate; and (v) manage exposures to movement in exchange rates by aligning the deployment of capital by currency with the Group's capital requirements by currency. An important aspect of the Group's overall capital management process is the setting of target risk-adjusted rates of return for individual business units, which are aligned to performance objectives and ensure that the Group is focused on the creation of value for shareholders. The Group has a number of sources of capital available to it and seeks to optimise its debt to equity structure in order to ensure that it can consistently maximise returns to shareholders. The Group considers not only the traditional sources of capital funding but the alternative sources of capital including reinsurance and securitisation, as appropriate, when assessing its deployment and usage of capital. -------------------------------------------------------------------------------------------------------------------- Page 11 Return on capital employed The Group's return on capital employed for the year increased to 14.4% (2003: 13.1%) reflecting the strong operational performances of our businesses particularly general insurance. The normalised return is based on the post-tax operating profit including the EEV operating return, before amortisation of goodwill and exceptional items, expressed as a percentage of the opening equity capital on an EEV basis. Different measures of capital The Group measures its capital on a number of different bases. These include measures which comply with the regulatory regime within which the Group operates and those which the directors consider appropriate for the management of the business. The measures which the Group uses are:- i) Accounting bases Although the Group is required to report its results on the modified statutory solvency basis, the directors consider that the European Embedded Value principles provide a more accurate and meaningful reflection of the Group's life operations and accordingly we analyse and measure the net asset value and total capital employed for the Group on this basis. ii) Regulatory bases In reporting the financial strength of our insurance subsidiaries the Group measures the capital and solvency using the regulations prescribed by the Financial Services Authority (FSA). These regulatory capital tests are based upon required levels of solvency capital and a series of prudent assumptions in respect of the type of business written by the Group's insurance subsidiaries. iii) Economic bases Notwithstanding the required levels of capital laid out by the FSA, the Group also measures its capital using risk based capital techniques which take into account a more realistic set of assumptions. These bases have been under considerable development over the past few years and have become more relevant in the assessment of the Group's financial strength. In addition they include measures used by rating agencies in measuring and assessing the financial strength of the Group. Group Accounting bases The Group's capital, from all funding sources, has been allocated such that the capital employed by trading operations is greater than the capital provided by its shareholders and its subordinated debt holders. As a result, the Group is able to enhance the returns earned on its equity capital. At 31 December 2004 the Group had Â£19.3 billion (31 December 2003: Â£17.8 billion) of total capital employed in its trading operations which is efficiently financed by a combination of equity shareholders' funds, preference capital, subordinated debt and borrowings. 2004 2003 Total shareholders' funds - EEV basis (including minority interests) Â£14.1 billion Â£11.7 billion Total capital employed by business operations Â£19.3 billion Â£17.8 billion Net asset value per share 532 pence 484 pence The improvement in shareholders' funds reflects strong operational performance and the issuance of the direct capital instrument which raised Â£990 million. Net asset value per ordinary share, based on equity shareholders' funds, was higher by 10% at 532 pence per share after adding back the equalisation provision of Â£388 million (31 December 2003: Â£364 million). Regulatory bases EU Groups directive 2004 2003 Insurance Groups Directive (IGD) excess solvency Â£3.6 billion Â£2.4 billion Cover (times) over EU minimum 1.9 times 1.7 times Aviva Group had an estimated excess regulatory capital, as measured under the EU Groups Directive, of Â£3.6 billion at 31 December 2004 (31 December 2003: Â£2.4 billion). This measure represents the excess of the aggregate value of regulatory capital employed in our business over the aggregate minimum solvency requirements imposed by local regulators, excluding the surplus held in the Group's UK life funds. The minimum solvency requirement for the Group's European businesses is based on the Solvency 1 Directive. In broad terms, for EU operations, this is set at 4% and 1% of non-linked and unit-linked life reserves respectively and for Aviva's general insurance portfolio of business is the higher of 18% of gross premiums or 26% of gross claims, in both cases adjusted to reflect the level of reinsurance recoveries. For the Group's major non-European businesses (the US, Australia and Canada) a risk charge on assets and liabilities approach is used. In November 2004 the Group enhanced its strong regulatory position through issuing Â£990 million of a direct capital instrument. Completion of the Asian general insurance business sale in 2005 will improve the IGD excess solvency by Â£0.2 billion. -------------------------------------------------------------------------------------------------------------------- Page 12 From 1 January 2005, the Group is required to monitor its capital in accordance with the requirements of the Prudential Sourcebook (PSB) as set out by the FSA. As a result, during the course of 2004 we have evolved the Group's risk and governance frameworks to ensure compliance and have finalised the parameters and assumptions that underpin the internal capital adequacy (ICA) assessment. An evaluation of our framework by the FSA will take place during the course of 2005. Furthermore, from 1 January 2006, the Group will be required to have a positive IGD basis solvency level at all times. The FSA has introduced further changes to the valuation rules which will apply during 2005. These include changes to the valuation of non-insurance subsidiaries which will be restated from market value to net asset value (estimated to reduce IGD by Â£0.6 billion) and an allowance for pension scheme deficits (estimated to reduce IGD by Â£0.4 billion). The former change will be applied from 1 January 2005 while the latter will apply from 1 July 2005. General insurance Regulatory basis Our principal UK general insurance regulated subsidiaries are CGU International Insurance group (CGUII) and Norwich Union Insurance (NUI). The combined businesses of the CGUII group and NUI group have strong solvency positions. On an aggregate basis the estimated excess solvency margin (representing the regulatory value of excess available assets over the required minimum margin) increased significantly to Â£5.5 billion (31 December 2003: Â£4.0 billion) after covering the required minimum margin of Â£3.9 billion (31 December 2003: Â£3.4 billion). The table below sets out the regulatory basis of these general insurance groups at 31 December 2004 and 31 December 2003. 2004 ------------------------------------------------- NUI and CGUII Group NUI plc CGUII Group pro forma Regulated asset value Â£bn Â£1.0 bn Â£8.4 bn Â£9.4 bn Required minimum margin Â£bn Â£0.4 bn Â£3.5 bn Â£3.9 bn Excess solvency margin Â£bn Â£0.6 bn Â£4.9 bn Â£5.5 bn Cover (times) 2.6 times 2.4 times 2.4 times 2003 ------------------------------------------------- NUI and CGUII Group NUI plc CGUII Group pro forma Regulated asset value Â£bn Â£0.9 bn Â£6.5 bn Â£7.4 bn Required minimum margin Â£bn Â£0.3 bn Â£3.1 bn Â£3.4 bn Excess solvency margin Â£bn Â£0.6 bn Â£3.4 bn Â£4.0 bn Cover (times) 3.0 times 2.1 times 2.1 times Economic bases - Risk based capital The Group uses risk based capital as one of several measures to assess its capital requirements for its general insurance businesses. Financial modelling techniques enhance our practice of active capital management, ensuring sufficient capital is available to protect against unforeseen events and adverse scenarios, and risk management. Our objective continues to be the optimal usage of capital through appropriate allocation to our businesses. The introduction of the ICA regime has resulted in the calculation of the realistic capital needed to meet policyholder requirements under a range of adverse scenarios. As a result we have been in discussion with our regulator for both our life and general insurance business to agree specific risk adjusted capital requirements. Our risk based capital model underpins our ICA modelling, and will form the basis of our discussions with the regulator in agreeing such capital requirements, along with our strong risk management processes. We continue to evolve our risk based capital modelling capability for both our life and general insurance businesses as part of our longer-term development programme for more complex risk modelling techniques, and increasingly operate our business by reference to economic and risk based capital requirements. Our current risk based capital methodology for general insurance business assesses insurance, market and credit risks and makes prudent allowance for diversification benefits. We look at the level of capital necessary to enable the general insurance business to meet the statutory minimum solvency margin over a five year period with 99% probability of not requiring further capital. We consider risks over a five year period allowing for planned levels of business growth. Based on our model, our risk based capital requirement may be expressed as 34% of net written premiums which is equivalent to Â£3.3 billion (2003 Â£3.3 billion) of capital. This compares with a total of Â£4.6 billion (2003: Â£4.5 billion) of shareholders' capital employed in the general insurance businesses. Life operations Economic bases For the Group's non-participating worldwide life assurance business the Group has set its capital requirements as the higher of: - Target levels set by reference to own internal risk assessment and internal objectives - Minimum capital level (i.e. level of solvency capital at which local regulator empowered to take action) -------------------------------------------------------------------------------------------------------------------- Page 13 Having undertaken an assessment of the level of operational, demographic, market and currency risk of each of our life businesses, we have quantified the levels of capital required for each business. We have expressed these as a percentage of EU minimum. The required capital across all the Group's businesses varies depending on the level of operational, market and currency risk, between 100% and 200% of EU minimum or equivalent. In the UK we have assessed the required capital for our annuity book at 200% of the EU minimum and the remainder of the non-profit portfolio has been set at 100% of the EU minimum. The weighted average level of required capital for the Group's non-participating life business, expressed as a percentage of the EU minimum solvency margin is 135%. This is a blended rate and we would expect this to change over time with product mix. These levels of required capital are used in the calculation of the Group's embedded value to evaluate the cost of locked in capital. At 31 December 2004 the regulatory capital held in the Group's long-term business amounted to Â£6.3 billion which represents 175% of the EU minimum requirements. UK Life operations We manage the strength of our funds through a variety of different means. We have the option to use, where appropriate, financial reinsurance, securitisation, shareholder funds and policyholder funds. UK non-profit funds In July 2004 we announced our proposals to simplify the structure of many of our non-profit funds by transferring them into Norwich Union Life and Pensions (NUL&P). The transfer of these funds occurred effective 1 January 2005 and will create a simpler and more efficient structure for Norwich Union. We continue to evaluate as a strategy the reattribution of the orphan estate in the interests of both policyholders and shareholders. UK with-profit funds Under the Memorandum of Understanding (MoU) entered into with the ASB relating to FRS27, we are required to disclose information on the realistic balance sheets for the groups UK life with-profit funds, the group's capital position statement and financial options and guarantees. These are set out in the following paragraphs. Regulatory basis The FSA published the Prudential Sourcebook (PSB) for insurers which is applicable for 31 December 2004 year ends. The PSB formally introduces the FSA's realistic reporting regime setting out a realistic basis of measurement for assets and liabilities and also the realistic capital requirements. The Group's UK life businesses are required to hold sufficient capital to meet the FSA's capital requirements. Under the FSA's realistic reporting regime, the UK with-profits business' capital requirement is determined from the 'twin peaks' approach, such that capital resources must be sufficient to cover the greater of the statutory and realistic liability and capital requirements. The businesses must also take into account the ICA which considers certain business risks not reflected in the twin peaks approach. For UK non-participating business, the capital requirement is calculated on the statutory basis, which is based on EU Directives. In 2004 realistic results have been prepared in accordance with the PSB. The results make appropriate allowance for all the liabilities of the with-profit funds, including provision for future bonuses, the fair value of the guarantees, options and promises on a market consistent basis and the cost of shareholder transfers and tax associated with future bonuses. The calculations also make allowance for how the with-profit funds are expected to be run, for example investment policy, and how policyholders are expected to behave, for example persistency. The available capital of the with-profit funds is represented by the realistic orphan estate. The estate represents the assets of the long-term with-profit funds less the realistic liabilities for non-profit policies, less asset shares aggregated across the with-profit policies and any additional amounts expected at the valuation date to be paid to in-force policyholders in the future in respect of smoothing costs and guarantees. Realistic balance sheet information is shown below for the three main UK with-profits funds, CGNU Life, Commercial Union Life Assurance Company (CULAC) and Norwich Union Life and Pensions (NUL&P). 31 December 2004 --------------------------------------------------------------------------------------- Estimated Estimated Estimated Estimated Realistic Realistic liabilities Realistic orphan required capital Estimated assets (1), (2) estate(3) margin(4) excess Â£bn Â£bn Â£bn Â£bn Â£bn CGNU Life 12.2 10.5 1.7 0.3 1.4 CULAC 13.5 11.9 1.6 0.4 1.2 NUL&P 26.3 25.1 1.2 1.0 0.2 ------------------------------------------------------------------------------------------------------------------- Aggregate 52.0 47.5 4.5 1.7 2.8 =================================================================================================================== (1) Realistic liabilities include shareholders' share of future bonuses of Â£0.5 billion. Realistic liabilities adjusted to eliminate the shareholders' share of future bonuses are Â£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 realistic liabilities is Â£0.6 billion, Â£0.9 billion and Â£3.3 billion for CGNU Life, CULAC and NUL&P respectively. (3) Estimated realistic orphan estate at 31 December 2003 was Â£1.3 billion, Â£1.6 billion and Â£1.4 billion for CGNU Life, CULAC and NUL&P respectively. (4) The required capital margin (RCM) is 2.6 times covered by the orphan estate in aggregate (2003: 2.5 times). -------------------------------------------------------------------------------------------------------------------- Page 14 The aggregate investment mix of the realistic assets at the year end was: 31 December 31 December 2004 2003 % % Equity 36% 38% Property 15% 16% Fixed interest 43% 42% Other 6% 4% ------------------------------------------------------------------------------------------------------------------- 100% 100% =================================================================================================================== Equity backing ratios, including property, supporting with-profit asset shares is 66% in CGNU Life and CULAC and 54% in NUL&P. With-profit new business is mainly written through CGNU Life. Calculation of the realistic liabilities requires various assumptions to be made as follows: Investment related assumptions - Our objective in setting these assumptions is that where parameters can be determined from instruments traded in the market, then our assumptions would reproduce the prices of these traded instruments. This approach is taken for assumptions for risk free rates, equity and fixed interest volatility. Where assumptions cannot be determined in this way, for example correlation, then this is based on past market experience. Risk free rates at 31 December 2004 have been determined as the annualised spot yields for the gilt market, sourced from the Bank of England, increased by 10 basis points. The increase reflects the result that gilt yield is a little less than true risk free because of the highly liquid nature. Assumptions for volatility have been sourced from various investment banks based on the market price of traded options. Demographic assumptions - Assumptions for persistency, mortality and option take up rates are set to achieve a realistic best estimate. Assumptions are based on own and industry experience, and allow for anticipated future trends. Management assumptions - Management may exercise discretion in the operation of the with-profit business, through for example, smoothing of payouts, the level of annual bonuses and investment policy. How management exercises this discretion is described in the Principles and Practices of Financial Management (PPFM). The assumptions made about how management will exercise discretion in the calculation of the realistic liability are consistent with the PPFM, with the objective of achieving a realistic best estimate. The key assumptions for the three main with-profit funds are shown below: Financial CGNU CULAC NUL&P Risk free rate 4.66% 4.66% 4.68% Equity volatility 18.3% 18.3% 18.3% Property volatility 15.0% 15.0% 15.0% Option take up Guarantee annuity 75.0% 85.0% 90.0% No MVR guarantee 75.0% first opportunity; 25.0% second opportunity FRS27 Group capital statement In addition to the new FSA realistic reporting regime, the UK Accounting Standards Board (ASB) issued a new financial reporting standard in December 2004, known as FRS 27, requiring certain capital disclosures to be made. The purpose of the capital statement is to set out the financial strength of the entity and to provide 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. The capital statement below has been prepared in accordance with MoU entered into by Aviva, the ASB and other insurers in relation to the application of FRS 27 in 2004, and shows available capital resources for the Group. 31 December 2004 ------------------------------------------------------------------------- UK Other Overseas with-profit UK life life Total Other funds operations(3) operations Life operations(4) Total Â£bn Â£bn Â£bn Â£bn Â£bn Â£bn Total Shareholders' funds (MSSB basis) - 3.0 4.1 7.1 2.1 9.2 Other sources of capital (1) - - 0.2 0.2 2.8 3.0 Fund for Future Appropriations 8.1 0.3 0.8 9.2 - 9.2 Adjustments onto a regulatory basis(2) (3.6) (1.9) (0.6) (6.1) (2.5) (8.6) ------------------------------------------------------------------------------------------------------------------ Total available capital 4.5 1.4 4.5 10.4 2.4 12.8 ================================================================================================================== (1) Other sources of capital represents: Subordinated debt of Â£2,823 million issued by Aviva plc and Â£129 million subordinated perpetual loan notes issued by a Dutch subsidiary undertaking. (2) Including an adjustment for minorities. (3) Other UK life operations include Â£300 million of fund for future appropriations, relating to Hibernian life which is owned by UK life shareholders' funds. (4) Other operations include general insurance and fund management businesses. -------------------------------------------------------------------------------------------------------------------- Page 15 In aggregate the group has at its disposal a total available capital of Â£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. The UK with-profits funds' available capital of Â£4.5 billion can only be used to provide support for UK with-profits business and is not available to cover other shareholder risks. At Â£4.5 billion, it 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 Â£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. As the total available capital of Â£12.8 billion is arrived at on the basis of local regulatory guidance, which evaluates assets and liabilities prudently, it understates the economic capital of the business which is considerably higher. This is a limitation of the Group Capital Statement which, to be more meaningful, needs to evaluate available capital on an economic basis and compare it with the risk capital required for each individual operation, after allowing for the considerable diversification benefits that exist in our group. The available capital resources in each regulated entity are generally subject to restrictions as to their availability to meet requirements that may arise elsewhere in the Group. The principal restrictions are: (i) UK with-profit funds (CGNU Life, CULAC and NUL&P) - any available surplus held in each fund can only be used to meet the requirements of the fund itself or be distributed to policyholders and shareholders. With- profits policyholders are entitled to at least 90% of the distributed profits while the shareholders receive the balance. The latter distribution would be subject to a tax charge, which is met by the fund in the case of CGNU Life, CULAC and NUL&P. (ii) UK non-participating funds - any available surplus held in these is attributable to shareholders. Capital within the non-profit funds may be made available to meet requirements elsewhere in the Group subject to meeting the regulatory requirements of the fund. Any transfer of the surplus may give rise to a tax charge subject to availability of tax relief elsewhere in the Group. (iii) Overseas life operations - the capital requirements and corresponding regulatory capital held by overseas businesses are calculated using the locally applicable regulatory regime. The available capital resources in all these businesses are subject to local regulatory restrictions which may constrain management's ability to utilise these in other parts of the Group. Any transfer of available capital may give rise to a tax charge subject to availability of tax relief elsewhere in the Group. In addition to its external funding sources, the Group has a number of internal loan arrangements in place. These have allowed assets supporting technical liabilities to be invested into the pool of central assets for use across the Group. They have also enabled shareholders to deploy cash from some parts of the business to others in order to fund growth. In addition to these internal loan arrangements, the Group has in place a number of internal reinsurance contracts which are structured to manage the capital position between certain life funds. All these internal contracts satisfy arms length criteria, and all payments have been made when due. Sensitivity analysis Sensitivity of Group shareholders' funds The sensitivity of the Group's shareholders' funds on an EEV basis at 31 December 2004 to a 10% fall in global equity markets or a rise of 1% in global interest rates is as follows: Interest 31 December 31 December Equities rates 2003 2004 down 10% up 1% Â£bn Â£bn Â£bn Â£bn 12.0 Long-term savings(1) 13.2 12.5 13.1 5.8 General insurance and other 6.1 5.9 5.8 (6.1) Borrowings(2) (5.2) (5.2) (5.2) ------------------------------------------------------------------------------------------------------------------- 11.7 Shareholders' funds 14.1 13.2 13.7 =================================================================================================================== (1) Assumes EEV assumptions adjusted to reflect revised bond yields. (2) Comprising internal, external and subordinated debt, net of corporate tangible net assets. These sensitivities assume a full tax charge/credit on market value appreciation/falls. -------------------------------------------------------------------------------------------------------------------- Page 16 Sensitivity of Insurance Liabilities Insurance liabilities are sensitive to changes in market conditions and other assumptions which have been factored into their calculation, such as mortality or persistency rates. In some cases allowance is also made when calculating liabilities for the effect of management and/or policyholder actions in different economic conditions on future assumptions such as asset mix, bonus rates and surrender values. Market conditions - assumptions are made about investment returns and interest rates. Any adverse change in either variable will increase liabilities with the effect of reducing available capital. However, such changes will also impact corresponding asset valuation, changes in which may result in further decreases in available capital, or in certain cases may offset the impact of liability movements. Assumptions - long term trend differences in mortality, morbidity or persistency rates will result in the need to change assumptions. This may require a strengthening or release of reserves. Depending on policy type this sensitivity will differ - for example a change in mortality rates will have a different impact for annuity contract liabilities when compared to term assurance liabilities. In addition to assumptions made for persistency, assumptions are made about policyholders behaviour in relation to guarantees and options. In turn these assumptions are sensitive to both investment return and interest rates. UK with-profit funds - Available capital The amount of available capital, that is the excess of the value of assets over the realistic value of the liabilities, is sensitive to both the current level of investment markets and the assumptions made. In addition the capital requirement for with-profit funds which is based on the FSA's risk capital margin (RCM), takes into account the sensitivity to certain changes in conditions. The level of the RCM is set such that sufficient capital is required to meet a series of prescribed adverse shocks, consisting of falls in equity and property values, changes in fixed interest yields, rises in defaults on corporate bonds and similar instruments and adverse persistency experience. Within these shocks, allowance is made for how management would respond, consistent with PPFM, for example through changes to bonus rates and investment profiles. Financial guarantees and options As a normal part of operating activities, various Group companies have given guarantees and options, including interest rate guarantees, in respect of certain long-term insurance and fund management products. Valuation of guarantees and options under EEV The reported cost to shareholders of the options and guarantees provided under life contracts is represented by the valuation of options and guarantees under the EEV methodology. This includes two components: the intrinsic value and the time value. The intrinsic value is the cost to shareholders arising under the best estimate assumptions and is allowed for in the calculation of the present value of in-force business. The time value, which is calculated separately, is the additional cost to shareholders arising from variability of future investment returns, and reflects the fact that in some adverse economic scenarios shareholders will incur additional costs associated with the guarantees under the EEV methodology. The time value is calculated on a stochastic basis, using 'real world' assumptions to evaluate the mean cost, which is deducted from the embedded value. At 31 December 2004 this amounted to Â£274 million (2003: Â£232 million). Further details are provided on page 33. Provision for guarantees and options under MSSB reporting The costs of guarantees and options are not material to the level of technical provisions held and the overall level of shareholders' capital. Most guarantees are in the UK with-profit fund and are covered by the estate. Elsewhere, where guarantees exist, they are matched by a high quality government and corporate bond portfolio which reduces the time value costs. Where the exposure is not fully matched, we adopt hedging techniques and hold appropriate technical reserves; and finally, where interest rate guarantees are provided in our current product set, these are set-up rates of 1-2% and are priced into the contracts. As required by FRS27, additional disclosure setting out details of material guarantees and options has been provided below. A financial option or guarantee is one whose potential value is affected by the behaviour of financial variables, and not by those features of life assurance contracts where the potential changes in policyholder benefits arise solely from insurance risk. Except for 'UK life with-profits' business the liabilities for guarantee and option costs described below relate to the statutory provision currently held within the Group's MSSB liabilities. These liabilities are different to the shareholder cost of guarantees and options under EEV described above. The main reasons for the difference are as follows: - In many cases, the shareholder cost of guarantees and options is lower than the full amount of the liability. For example, for UK with-profit business, the shareholder cost is lower because some of the cost can be absorbed by the excess assets in the with-profit fund. - The shareholder cost of options and guarantees is calculated using 'real world' stochastic economic scenarios, whereas the option and guarantee liabilities are calculated using a combination of market consistent stochastic scenarios in the UK and deterministic regulatory assumptions elsewhere. In providing these guarantees and options, the Group's capital position is sensitive to market risk, such as adverse fluctuations in financial variables including foreign currency exchange rates, interest rates, real estate prices and equity prices. Interest rate guaranteed returns, such as those available on guaranteed annuity options (GAOs), are sensitive to interest rates falling below the guaranteed level, other guarantees such as maturity value guarantees in relation to minimum rates of return are sensitive to fluctuations in the investment return below the level assumed when the guarantee was made. The Group carefully manages its exposure to market risk. -------------------------------------------------------------------------------------------------------------------- Page 17 UK life With-profits business In the UK, from 31 December 2004, life insurers are required to comply with the FSA's realistic reporting regime for their with-profit funds for the calculation of FSA liabilities. Provision is made for guarantees and options within the FSA realistic liabilities of the UK with-profit life funds. Under the FSA's rules these must be measured at fair value using market consistent stochastic models. A stochastic approach includes measuring the time value of guarantees and options, which represents the additional cost arising from uncertainty surrounding future economic conditions. The time value is evaluated by projecting a large number of possible future outcomes under a wide range of economic scenarios, for example possible outcomes for interest rates and equity returns. The Group's UK life insurance subsidiaries have written various with-profit life insurance contracts which include guarantees and options. The Group's with-profit liabilities measured on a realistic basis include explicit provision for these guarantees and options which are measured in accordance with the FSA's rules. The realistic liabilities have not been included within the MSSB balance sheet for 2004 but will be incorporated in the statutory balance sheet from 1 January 2005 in accordance with FRS27. The material guarantees, options and promises in the UK with-profits are: Maturity value guarantees - Substantially all of the conventional with-profit business and a significant proportion of unitised with-profit business have minimum maturity values reflecting the sums assured plus declared annual bonuses. In addition the guarantee fund has offered maturity value guarantees on certain unit-linked products. No market valuation reduction (no MVR) guarantees - For unitised business, there are a number of circumstances where a 'no MVR' guarantee is applied, for example on certain policy anniversaries, guaranteeing that no reduction will be applied to reflect the difference between the guaranteed value of the policy and the market value of the underlying assets. 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 annuity based on guaranteed conversion rates. The Group also has exposure to GAOs and similar options on deferred annuities. Guaranteed Minimum Pension (Transfer Plan (Section 32)) - The Group's UK with-profit funds also have certain Section 32 policies which contain a guaranteed minimum level of pensions as part of the condition of the original transfer from state benefits to the policy. In addition, while these do not constitute guarantees, the Group has made promises to certain policyholders in relation to mortgage endowments that payments on these policies will meet the mortgage value, provided investment returns exceed 6% per annum net of tax between 1 January 2000 and maturity and the investment returns on the excess assets are sufficient to meet the top up costs. Non-profit business The Group's UK life business has also written contracts which include guarantees and options within its non-profit funds. The Group's UK non-profit funds are not subject to the requirements of the FSA's realistic reporting regime and therefore liabilities are evaluated by reference to local statutory reserving rules. Provision for guarantees and options in the non-profit funds has been included on this basis within the MSSB liabilities. Guaranteed annuity options - Similar options to those written in the with-profit fund have been written in relation to non-profit products. Provision for these guarantees does not materially differ from a provision based on a market consistent stochastic model and amount to Â£47 million at 31 December 2004. Guaranteed unit price on certain products - Certain unit-linked pension products linked to long-term life insurance funds provide policyholders with a guaranteed unit price of Â£1 at retirement or death. No additional provision is made for this guarantee as the investment management strategy for these funds is designed to ensure that the guarantee can be met from the fund, mitigating the impact of large falls in investment values and interest rates. Overseas life business In addition to guarantees written within the Group's UK life businesses, the Group's 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. France Guaranteed surrender values 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 plus income and releases from realised gains on any equity type investments. Policy liabilities equal guaranteed surrender values. Local statutory accounting envisages the establishment of a liability, 'Provision pour Aleas Financiers' (PAF), when accounting income is less than 125% of guaranteed minimum credited returns. No PAF was established at the end of 2004. The most significant of these contracts is the AFER Euro fund which has total liabilities of Â£21 billion at 31 December 2004. The guaranteed bonus on this contract equals 65% of the average of the last two years declared bonus rates (or 60% of the TME index rates if higher) and was 3.69% for 2004 in comparison to an accounting income from the fund of 5.25%. -------------------------------------------------------------------------------------------------------------------- Page 18 Non-AFER contracts with guaranteed surrender values had liabilities of Â£6 billion at 31 December 2004 and guaranteed annual bonus rates are between 0% and 4.5% (except for some larger guarantees of up to 7.0% on some older contracts which account for less than 2.4% of these liabilities). For non-AFER business, the accounting income return exceeded guaranteed bonus rates in 2004. Guaranteed death and maturity benefit In France the Group has also sold unit-linked policies where the death and maturity benefit is guaranteed to be at least equal to the premiums paid. The reserve held in the Group's MSSB balance sheet at the end of 2004 for this guarantee is Â£17 million. The reserve for guaranteed death and maturity benefits is determined using a realistic reserving basis under which the cost of guarantees is calculated using a standard option pricing formula. At the end of 2004 total sums at risk for these contracts were Â£182 million in comparison to total unit-linked funds of Â£6 billion. The average age of policyholders was approximately 53. The cost of guarantees is sensitive to stock market levels and interest rates. It is estimated that this cost would increase by Â£18 million if yields were to increase by 1% per annum and equity markets were to decline by 10% from end 2004 levels. These figures do not take into account that Aviva has the ability to review the charges for this option. Netherlands Guaranteed minimum return at maturity In the Netherlands it is market practice to guarantee a minimum return at maturity on traditional savings and pensions contracts. Guarantees on older lines of business are 4% per annum, while for business written since 1 September 1999 the guarantee is 3% per annum. In accordance with market practice, it is expected that guarantees will be financed from unrealised gains on assets. On Group pensions business, it is often possible to recapture guarantee costs through adjustments to surrender values or to premium rates. Under Dutch regulation, liability testing is carried out to determine if additional liabilities are required for portfolio guarantees. No such reserves were required at the end of 2004. The total liabilities for traditional business at end 2004 are Â£8 billion analysed as follows: Liabilities Liabilities 3% guarantee 4% guarantee Â£m Â£m Individual 1,104 3,408 Group Pensions 263 3,702 ------------------------------------------------------------------------------------------------------------------ Total 1,367 7,110 ================================================================================================================== Although interest rates were below 4% at end 2004, no adequacy reserves were required. A further fall in interest rates below 3% would require adequacy reserves to be set up to prevent liabilities from becoming inadequately covered. Delta Lloyd has certain unit-linked contracts which provide a guaranteed minimum return at maturity from 4% per annum to 2% per annum. Provisions consist of unit values plus an additional provision for the guarantee. A stochastic approach has been used to assess the appropriate level of provision for the guarantee. The additional provision for the guarantee was Â£118 million. An additional provision of Â£27 million in respect of investment return guarantees on Group segregated fund business is held. It is estimated that the provision would increase by Â£234 million if bond yields were to reduce by 1% per annum and by Â£49 million if equity markets were to decline by 10% from end 2004 levels. 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 Â£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. The current liability is therefore valued at its maximum value. 'No MVR' guarantees Certain unitised with-profit policies containing 'no MVR' guarantees, similar to those in the UK, have been sold in Ireland. The current provision for these guarantees is Â£102 million which has been calculated on a deterministic basis as the excess of the current policy surrender value over the discounted value of the guarantees. The value of these guarantees is sensitive to the performance of investments held in the with-profits fund. Amounts payable under these guarantees are determined by the bonuses declared on these policies. An adverse change in market conditions such as a 20% fall in equity values would reduce available free assets by Â£69 million. 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 end 2004, total liabilities for traditional profit sharing Spanish business were Â£2 billion with a further provision of Â£13 million for guarantees. Total liabilities for Italian business were Â£4 billion with a further provision of Â£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 Â£56 million in Spain and Â£14 million in Italy if interest rates were 1% lower from the end 2004 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. -------------------------------------------------------------------------------------------------------------------- Page 19 Glossary Life profits reporting In reporting the headline operating profit, life profits have been included using the European Embedded Value basis. This is used throughout the Aviva Group to assess performance, having adopted the EEV Principles. We have focused on the EEV basis, as we believe EEV operating return is a more realistic measure of the performance of the businesses than modified statutory basis. The modified statutory basis is used in our financial statements and, on this basis, the operating profit before tax on continuing operations amounted to Â£1,861 million (2003: Â£1,490 million). The EEV methodology adopted is in accordance with the EEV Principles introduced by the CFO Forum. Definitions of Group key performance indicators and other terms Annual premium equivalent (APE) - UK industry standard for calculating life, pensions and investment new business levels. It equals the total of new annualised regular premiums plus 10% of single premiums. Assets under management - Represents all assets managed by the Group including funds held on behalf of third parties. CGUII - A principal UK general insurance company and the parent of the majority of the Group's overseas general insurance and life assurance subsidiaries. Combined operating ratio (COR) - The aggregate of incurred claims expressed as a percentage of earned premiums and written expenses and written commissions expressed as a percentage of written premiums. Covered business - The contracts to which the EEV methodology has, in line with the EEV Principles, been applied. EU solvency - The excess of assets over liabilities and the world-wide minimum solvency margins, excluding goodwill and the additional value of in-force long-term business, and excluding the surplus held in the Group's life funds. The Group solvency calculation is determined according to the UK Financial Services Authority application of EU Insurance Groups Directive rules. Financial Options and - Features of the covered business conferring potentially valuable guarantees Guarantees underlying, or options to change, the level or nature of policyholder benefits and exercisable at the discretion of the policyholder, whose potential value is impacted by the behaviour of financial variables. Free Surplus - The amount of any capital and surplus allocated to, but not required to support, the in-force covered business. Gross risk free yields - Gross of tax yields on risk free fixed interest investments, generally Government bonds. Holding Company - A legal entity with a function of being a consolidating entity for primary financial reporting of covered business. Implicit items - Amounts allowed by local regulators to be deducted from capital amounts when determining the EU required minimum margin. Life EEV operating return - Operating return on the EEV basis relating to the lines of business included in the embedded value calculations. From continuing operations and is stated before tax, amortisation of goodwill and exceptional items. Life EEV return - Total return on the EEV basis relating to the lines of business included in the embedded value calculations. From continuing operations and is stated before amortisation of goodwill and exceptional items. Look-through basis - Inclusion of the capitalised value of profits and losses arising from subsidiary companies providing administration, investment management and other services to the extent that they relate to covered business. Modified statutory operating - From continuing operations, and is stated before tax, amortisation of goodwill, profit amortisation of acquired additional value of in-force long-term business and exceptional items. Net asset value per ordinary - Net asset value divided by the number of ordinary shares in issue. Net asset share value is based on equity shareholders' funds, adding back the equalisation provision of Â£388 million (31 December 2003: Â£364 million). New business contribution - Is calculated using the same economic assumptions as those used to determine the embedded values at the beginning of each year and is stated before tax and the effect of required capital. New business margin - New business margins are calculated as the new business contribution divided by the present value of new business premiums (PVNBP), and expressed as a percentage. Previously, under the Achieved Profits basis, they were expressed as new business contribution divided by premiums measured on an annual premium equivalent (APE) basis. Orphan estate - The assets of the long-term with-profit funds less the realistic reserves for non-profit policies, less asset shares aggregated across the with-profit policies and any additional amounts expected at the valuation date to be paid to in-force policyholders in the future in respect of smoothing costs and guarantees. Present value of new business - Present value of new regular premiums plus 100% of single premiums, calculated premiums (PVNBP) using assumptions consistent with those used to determine new business contribution. Required Capital - The amount of assets, over and above the value placed on liabilities in respect of covered business, whose distribution to shareholders is restricted. Service companies - Companies providing administration or fund management services to the covered business. Solvency cover - The excess of the regulatory value of total assets over total liabilities, divided by the regulatory value of the required minimum solvency margin. Statutory Basis - The valuation basis and approach used for reporting financial statements to local regulators. Stochastic Techniques - Techniques that incorporate the potential future variability in assumptions affecting their outcome. Time Value and Intrinsic Value - A financial option or guarantee has two elements of value, the time value and intrinsic value. The intrinsic value is the discounted value of the option or guarantee at expiry, assuming that future economic conditions follow best estimate assumptions. The time value is the additional value arising from uncertainty about future economic conditions. END PART 2 OF 4 This information is provided by RNS The company news service from the London Stock Exchange RORRR

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