The 3 Biggest Risks Facing Aviva
LONDON -- As the U.K.'s largest insurer, and one of Europe's leading providers of life and general insurance, Aviva provides around 43 million customers with insurance, savings, and investment products. And undeniably, this 10.5 billion pound FTSE 100 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 635 million pounds on revenues of 30 billion pounds.
But equally, it's a business with very evident attractions. Today, with its shares changing hands at 361 pence, the company is rated on a cheap-looking prospective price-to-earnings ratio 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.
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.
It's no secret that one of the most difficult issues faced by Aviva is its capital position. In short, is the business adequately capitalized?
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.
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 Dec. 31, 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.
The article The 3 Biggest Risks Facing Aviva originally appeared on Fool.com.Malcolm Wheatley owns shares in Aviva, but not in any other companies mentioned here. The Motley Fool has no positions in the stocks mentioned above. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.