The 3 Biggest Risks Facing Aviva

Published in Company Comment on 5 December 2012

What should investors in Aviva (LSE: AV.) be worried about?

As the UK's largest insurer, and one of Europe's leading providers of life and general insurance, Aviva (LSE: AV) (NYSE: AV.US) provides around 43 million customers with insurance, savings, and investment products. And undeniably, this £10.5bn FTSE 100 (UKX) constituent business is presently attracting the attentions of bargain-hunting investors.

It's not difficult to see why: often described in the press as ‘troubled', Aviva in recent times has seen boardroom battles, changes at the top, shareholder revolts, and indifferent results. Last year, for instance, the company earned a pre-tax profit of just £635m on revenues of £30bn.

But equally, it's a business with very evident attractions. Today, with its shares changing hands at 361p, the company is rated on a cheap-looking prospective price-to-earnings ratio (P/E) of 7, and offers income investors a very tempting forecast dividend yield of 7.5%.

But how safe is that share price? And -- of vital importance to income investors -- how safe is that dividend? In short, how could an investment in Aviva adversely impact investors' wealth?

In this series, I set out to answer just these questions. My starting point: Aviva's latest annual report, where the company's directors are obliged to address the issue of risk.

Risk management

One immediate thing that I'm looking for is an acknowledgement that risks do exist, and that they need managing.

The good news? As you'd expect from a business of Aviva's size and calibre, the company has in place a risk management policy, a system of regular reviews, and a number of high-level committees tasked with monitoring the risks that the business has identified. And more than most businesses, risk is Aviva's business: as an insurer, risks are what it takes on.

But what, precisely, are those risks that the company faces?

Read the small print, and Aviva identifies no fewer than 19 risks as having a significant prospective impact on the company's financial performance. They range from reputational risk to liquidity risk, and from fraud to natural catastrophes.

So let's take a look at three of the biggest.

Capital adequacy

It's no secret that one of the most difficult issues faced by Aviva is its capital position. In short, is the business adequately capitalised?

Nor is this a question that Aviva can answer on its own: increasingly, regulators such as the Financial Services Authority are making the running -- and recent press reports hint at just such concerns as lying behind the abrupt departure of former chief executive Andrew Moss in the summer. As Aviva puts it:

"The primary objective of capital management is to optimise the balance between return and risk, while maintaining economic and regulatory capital in accordance with risk appetite. Aviva's capital and risk management objectives are closely interlinked, and support the dividend policy and earnings per share growth, while also recognising the critical importance of protecting policyholder and other stakeholder interests."

It is, admittedly, a tough issue to get exactly right. As the company itself notes, it aims to "maintain sufficient, but not excessive, financial strength, in accordance with risk appetite, to support new business growth and satisfy the requirements of our regulators and other stakeholders giving both our customers and shareholders assurance of our financial strength."

In other words, too little capital puts the business at risk from adverse circumstances, and exacerbates the possibility that it will need to tap shareholders for more capital -- either through a rights issue, or cutting or eliminating the dividend, or both. But too much capital leaves opportunities untapped, with funds lying idle instead of being put to work.

Market risk

Today, Aviva's share price is under half of its pre-crisis level. Why? Primarily, worries over market risks, in short -- persistent fears around the company's exposure to the eurozone, sub-prime debt (some of it sovereign), dodgy property loans, and similar risks. As Aviva puts it:

"[There is a] risk of adverse financial impacts due to changes in fair values or future cash flows from fluctuations in interest rates, foreign currency exchange rates, equity prices and property values."

Again, it's a tough one to get right. As Aviva says, the firm actively seeks out some market risks as part of its investment and product strategy -- and investors would expect it to do nothing else.

That said, Aviva does explain that it has a limited appetite for interest rate risk, as it doesn't believe that this is adequately rewarded, and that it seeks to actively manage foreign currency risk by matching assets and liabilities in applicable currencies, and by hedging.

Brand and reputation

If there's one adjective that you don't want to see attached to the firm holding your pension savings, or providing you with insurance, it's the word ‘troubled'. Just ask former shareholders of Northern Rock, or Bradford & Bingley, or Halifax Bank of Scotland, who saw customers scrabbling to take out their money as the financial crisis hit.

Yet, undeniably, the word ‘troubled' -- or its equivalents -- is what Aviva customers are often seeing. And boardroom shenanigans and abrupt changes at the top don't help. Or, as Aviva puts it:

"[There is a] risk of loss of franchise value due to damage of our brand or our reputation with customers, distributors, investors and regulators."

Here, at last, is a risk that Aviva can do something about. As the company says: "We continually seek opportunities to improve processes, with the outcome of improved customer proposition, sustained customer confidence and a positive regulatory reputation."

Moreover, in 2011 there were specific initiatives to monitor metrics -- including customer advocacy, retention and complaints -- in order to deal with any adverse impact from media speculation and customers' use of social networking sites. Shareholders may not always regard PR and similar marketing expenditures as value-for-money, but in this instance, Aviva shareholders should probably give thanks.

Risk vs. reward

Finally, two superstar investors who are well-used to weighing risks are Neil Woodford and Warren Buffett.

On a dividend re‑invested basis over the 15 years to 31 December 2011, Neil Woodford delivered a return of 347%, versus the FTSE All‑Share's distinctly more modest 42% performance. Warren Buffett, for his part, has delivered returns of over 20% per annum since 1965, transforming himself into the world's third-wealthiest person.

Each, as it happens, are the subject of two special reports prepared by Motley Fool analysts. And they're yours to freely download, without any obligation.

So click here to download this free special report profiling the investment logic behind eight of Mr Woodford's largest and most successful current picks.

And click here to discover which beaten-down British share Warren Buffett has been buying of late -- and why he bought it, and the price he paid

Malcolm owns shares in Aviva, but not in any other companies mentioned here. 

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The opinions expressed here are those of the individual writers and are not representative of The Motley Fool. If you spot any comments that are unsuitable hit the flag to alert our moderators.

Arborbridge 05 Dec 2012 , 6:26pm

I'm still not sure what the answer is, and I can't figure out why MF thinks a reference to Buffett and Woodford would help. In fact, it gets incredibly tiresome to find irrelevant references to them on every write up. Surely it's counterproductive: do you get a discount in their funds/shares for constantly bleating on?

Malcolm, unusually, you've come up with a waste of space. Sorry.


Unevercantell 05 Dec 2012 , 9:05pm

Seriously, you have some great insightful writers on this site. I’d follow G A Chester, just for instance, off a cliff and actually have done! Really clever and, more importantly, interesting guy, and not the only one. Reluctantly even I, your most loyal champion, (and I mean that because I have taken great value and notably increased my wealth from frequenting this site and reading the commentary, am getting a bit hacked off at the mandatory boilerplate text shoehorned onto every article. We, your readership, are not Warren Buffett or Neil Woodford. I’d hazard a guess that that the vast majority of your readership/audience has portfolios in five or six figures. We are not in the Woodford/Buffett league. Equally we don’t want to just buy their stuff. They play a different game. Since you got this Woodford/Buffett bee in your bonnet (presumably for financially advantageous reasons) the quality of the commentary has notably declined. You need to find your MoJo again.

torata 05 Dec 2012 , 9:18pm

"But how safe is that share price? And -- of vital importance to income investors -- how safe is that dividend? In short, how could an investment in Aviva adversely impact investors' wealth?"

And the answer is?

theRealGrinch 05 Dec 2012 , 11:31pm

another vote to ditch the automated and repetitive buffoon and deadwood stuff

bakon 06 Dec 2012 , 8:59am

This site really needs a cookie or the like for people to indicate yes we get the Buffet and Woodford fascination, I've read what I need to - please don't show me that blurb anymore. Or once someone has downloaded the report don't show the link anymore. Should be easy enough to implement, It's been going on too long.

goodlifer 06 Dec 2012 , 9:13am

Many of us would be more forgiving if you were to come clean and tell us what the MF gets paid for trying to sell
(a) Warren Buffett, and
(b) Neil Woodford.

drfuzz 06 Dec 2012 , 11:25am

I've got to agree with many of the comments above. I've been visiting the fool since the late 90s, and have enjoyed the articles of many writers including current writers Malcolm, the two Tonys and GA Chester. However in the last year, good articles have become rarer and advertising more common. Out of curiousity I looked at the ad for Fool freelance writers yeseterday and found out that freelancers are encouraged to use 20% of their article to promote free MF reports, and to focus on writing theme-linked series of short articles on FTSE 100 companies. The problem is that the result is lots of articles like this which unfortunately, IMO, provide very little insight. After the first paragraph you could replace "Aviva" with the name of any FTSE 100 financial in this article and it would read the same and you'd not really be any wiser at the end.

While the need for advertising is understandable, there is more than one way to skin a cat. And this focus on series doesn't seem to be producing good articles in general (you may argue turning good writers to bad ones)! I'll keep coming back for the podcasts, though...

boydduk 06 Dec 2012 , 4:31pm

Shouldn't any article on dividend make mention of the dividend cover? Isn't this a useful measure of whether the divident is sustainable?

rober00 06 Dec 2012 , 4:44pm

I used to spend up to an hour at a time on MF.

Because of all of the above on average I now spend 5 minutes and shrinking.

ANuvver 06 Dec 2012 , 7:43pm

Improving "processes" and "customer proposition".
Sigh. It's ISO9k all over again. By all means crack down on underperforming divisions, but don't tie up a substantial amount of your workforce retraining them to design forms about how to have meetings about how to design forms...

Oh well, I'm in for the long haul. It's big enough and has a reasonable chance of shedding the extra pounds.

ANuvver 06 Dec 2012 , 7:49pm

...but if there's any strong hint they can't maintain the dividend they'll tank quicker than you can say "this station is Snaresbrook, next stop South Woodford".

F958B 06 Dec 2012 , 8:03pm


Dividend cover is a tricky one. Utilities have very stable and predictable revenues and often operate with dividend cover around 1.3 and interest cover around 3x.

Companies with more erratic earnings tend to need higher dividend cover and interest cover.

This was demonstrated well during 2008-9 when, for instance, Rio Tinto had 4x dividend cover in 2007 yet still had to cut the dividend by more than half in 2009.
HSBC had 2x cover in 2007, but had to make two consecutive cuts; halving the dividend and even then it was only just covered.
Same with many other companies.
Yet going into the 2008-9 crisis, Sainsbury had cover of 1.6, but this had strengthened to 1.7 after the crisis, and the dividend had been raised by about 10% each year through the crisis.

So it's not just the dividend and its cover, but the quality of the earnings stream which underpins it.

Aviva have spectacularly demonstrated poor resilience, with dividend cuts in 2003 (from 38p to 23p) and again in 2010 (from 33p to 24p). Even today the dividend remains significantly below its prior two peaks.

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