Download EY- Cash, capital and dividends

Cash, capital
and dividends:
How Solvency II is challenging
the insurance investor story
March 2016
Contents
Executive summary
1
1. Does the insurer have adequate and
stable solvency?
3
2. What is the expected run rate of
capital generation?
7
3. Can insurers continue to grow
earnings and dividends in a
low growth, low interest rate
environment?
9
4. How are earnings and capital
generation converted to free
cash flow that is available to
shareholders?
14
5. Is the insurer pricing new business
rationally and “earning” its assumed
future margins?
16
Conclusions
20
Executive summary
European insurers have seen strong share price growth from 2012 up to the recent market turbulence in Q1 2016,
driven by improved profitability and strong dividend payouts. This has been underpinned by a simplification of business
models and metrics, with “cash generation” being the central part of the current investment proposition.
Solvency II is prompting a fundamental reappraisal of the investor proposition. The new regulatory regime varies
significantly from that of Solvency I. It also acts as a catalyst for investors to re-examine the sustainability of ever
increasing dividends in a prolonged low growth, low interest rate environment.
What Solvency II means for an investor in the sector is not fully understood. Much of the early disclosure from companies
has been explanatory: how it works, the components of capital (own funds) and solvency capital requirements (SCR),
and high-level reconciliation to previous capital metrics. In particular, this includes Solvency I and economic capital.
Underpinning this has been a reassurance that everything is under control, while pointing to significant uncertainties (for
example, internal model approvals were only received in Q4 2015).
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| Cash, capital and dividends: How Solvency II is challenging the insurance investor story
A clearer picture has emerged from FY results and recent investor days from companies such as Aegon, Allianz, Axa,
NN Group and Prudential. These have addressed investors’ concerns over capital shortfalls and/or dividend rebasing at
a high level, yet a number of questions remain. In our view, insurers need to address five critical questions to determine
expectations for dividends and value:
1. Does the insurer have adequate and stable solvency such that current and future dividend streams are not
constrained?
2. What is the expected run rate of capital generation, and how does that translate to investor returns?
3. Can insurers continue to grow earnings and dividends in a low growth, low interest rate environment?
4. How are earnings and capital generation converted to free cash flow that is available to shareholders?
5. Is the insurer pricing new business rationally and “earning” its future margins embedded in the base balance
sheet through best estimate assumptions?
Both insurers and investors are at an early phase in bringing these themes together.
All company disclosure throughout this report is as of 12 March 2016. We focus on on how insurers have answered
these five questions to date and the challenges that remain. In particular, we examine the tools used to communicate
dividend sustainability through cash, capital and earnings metrics­— at a time when Solvency II is forcing insurers to
re-evaluate their targets and disclosures. (See figure 1 for an explanation of the linkage between capital generation, cash
and dividends.) We believe that in light of Solvency II, insurers have yet to fully articulate their value proposition and
provide the means for investors to assess strategic implementation.
We foresee the need for greater cooperation across finance, risk and actuarial functions to provide coherent information
to internal and external stakeholders. This is likely to require more agile and efficient processes to deliver information in
a timely and cost-effective manner.
Figure 1: Schematic of the investment proposition and the linkage between capital generation, cash and dividends
Investor returns
Dividends
Capital
generation
Earnings
Value
Liquidity
Net asset
value
accretion
Return on
equity > cost
of equity
Growth and
franchise
value add
Cash, capital and dividends: How Solvency II is challenging the insurance investor story |
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1 . D o e s t h e in s u r e r h a v e a d e q u a t e a n d s t a b le
s o lv e n c y s u c h t h a t c u r r e n t a n d f u t u r e
d iv id e n d s t r e a m s a r e n o t c o n s t r a in e d ?
The capital position, in particular the Solvency II ratio, is currently the main focus of disclosure. The insurance industry
remains at an early stage in communicating capital levels and explaining the linkage between regulatory solvency and
sustainable dividend paying capability.
Our analysis of the latest published Solvency II ratios shows an average of 173% (see figure 2). This average has declined
over the reporting season as the number of companies making disclosures has increased.
H o w e a s y is it f o r in v e s t o r s t o c o m p a r e S o lv e n c y II r a t io s ?
At a headline level, it is easy for investors to compare Solvency II ratios from one insurance group to another. However,
several factors complicate the comparison of solvency between peers and geographies, including the use of:
•
Transitional provisions
•
M atching adj ustment
•
Volatility adjustment (especially if dynamic)
•
Ultimate forward rate (UFR)
•
Different group consolidation methods, including those for non-European operations
•
I nternal models
The underlying differences can be material, as it is difficult to present “pure” market consistent Solvency II numbers,
especially for items that are inherent in the base Solvency II position (such as the UFR). Yet, disclosures to date on
specific factors, such as transitional provisions and UFR sensitivity, give an indication of the quantum of capital involved
(see figure 3).
W h a t o c c u r s w h e n s o lv e n c y is lo w e r t h a n e x p e c t e d ?
3
S o f ar there has b een little evidence of capital raising or dividend reb asing directly attrib utab le to solvency pressure,
with one or two exceptions. Though this is not a sector-wide concern at this stage, fear or solvency shortfalls has led to
volatility and/or declines in certain companies’ share prices, especially after FY15 earnings.
| Cash, capital and dividends: H ow S olvency I I is challeng ing the insurance investor story
F ig u r e 2 : C o m p a r is o n o f d is c lo s e d S o lv e n c y II r a t io s
F ig u r e 3 : C o m p a r is o n o f in s u r e r s u s in g t r a n s it io n a l
p r o v is io n s a n d s e n s it iv it y t o t h e U F R
250%
Max: 239%
200%
Upper quartitle: 193%
Average: 173%
150%
Lower quartitle: 147%
G ro u p
T r a n s it io n a l
t e c h n ic a l
p r o v is io n s
U F R
s e n s it iv it y
1 0 0 b p s fa ll
A e g o n
Yes
-6%
A g e a s
N o
Halving of UFR: -17%
A llia n z
N o
-12%
A X A
N o
-19%
M u n ic h R e
N o
N N G ro u p
Yes
-25%
Yes. Only in UK.
N ot availab le
P r u d e n t ia l
Min: 123%
S C O R
N o
S t a n d a r d L if e
Yes
“ V ery limited”
“ N ot sensitive”
N ot availab le
100%
Source: Year-end 2015 company disclosure and EY analysis
Source: Most recently published company disclosure
E x p e c t g r e a t e r v o la t ilit y f o r S o lv e n c y II
Given its market-consistent and risk-based approach, the Solvency II balance sheet is inherently more volatile than its
predecessor under Solvency I. This is a natural consequence of a balance sheet comprised of “risky” assets backing
“risk-free” liabilities, and exacerbated for long-term business assessed on a one-year value at risk (VAR) basis.
This inherent volatility has been a major focus of the industry leading up to Solvency II and was a key reason to introduce
a package of “long-term guarantee measures,” including matching and volatility adjustments. These measures act as
dampeners, but do not remove all market volatility.
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C o m m u n ic a t in g s t r a t e g y in t h e fa c e o f v o la t ilit y
Companies are responding to this expected volatility by publishing sensitivities to key market factors (interest rates,
equities, credit spreads) both at a group and key subsidiary or division level.
Some interesting themes emerge:
•
Sensitivities are not necessarily intuitive, especially to fixed income stresses (e.g., interest rates, swap spreads). For
example, some companies show solvency declines when interest rates both rise and fall.
•
Some companies are markedly less sensitive to certain shocks than others, which suggests either closer matching and/
or more hedging. However, based on our conversations with investors, we anticipate greater focus on credit-spread
sensitivities, particularly in how they have been calculated and what offsets the company assumes.
We also observe that companies have disclosed “simple” shocks, such as parallel shifts in interest rates, or falls to equity
values. This does not capture the complexity of the underlying position, including:
•
Nonlinearities – e.g., a 40% shock is not necessarily double a 20% shock
•
Offsets of diversification in single-factor shocks
•
S ensitivity to movements in dif f erent parts of the interest rate curve, w hich is especially acute at 20 years in Euro due
to the impact of the UFR extrapolation
The answer is not necessarily more granular disclosure, despite
what sell-side analysts may argue. Instead, in our view, what is
needed is a clear articulation of the risk s to w hich the company
is exposed, the appetite for those risks and the risk management
strategy.
We have seen insurers try to contextualize their current solvency position in light of risk appetite, and show solvency
ratio zones where capital management actions kick in. A minority of insurers have expressed how they expect to change
their dividend as a function of their solvency. Comparisons for disclosed Solvency II stresses and capital management
frameworks are shown in figures 4 and 5.
F ig u r e 4 : C o m p a r is o n o f d is c lo s e d S o lv e n c y II s t r e s s e s
10%
Aeg on
Ag eas
Allianz
I mpact on solvency coverag e ratio
Aviva
AX A
Prudential
S C O R
5 %
0%
-5 %
- 10%
- 15 %
Equity - 30%
I nterest rates - 5 0b ps
5
Note: Based on most recently disclosed stresses. Where directly
comparable stresses are not available these have been interpolated.
| Cash, capital and dividends: H ow S olvency I I is challeng ing the insurance investor story
C redit spread + 100b ps
Source: Company disclosure and EY analysis
F ig u r e 5 : C o m p a r is o n o f d is c lo s e d c a p it a l m a n a g e m e n t f r a m e w o r k s
S u m m a r y c a p it a l m a n a g e m e n t a n d s o lv e n c y t a r g e t
A e g o n
Target range of 1
4 0 % – 1 7 0 % at g roup level
A g e a s
Targeting 1
7 5 % SCR coverage.
Risk appetite capital limited to 4 0 % of ow n f unds calib rated to a 1 / 3 0 year event
A llia n z
> 1 6 0 % : dividend policy threshold
A S R
> 1 4 0 % : will pay a cash dividend. Risk appetite is to be above 1 2 0 %
A X A
Target range of 1
S C O R
O ptimal targ et rang e
S to re b ra n d
Target of greater than 1
7 0 % – 2 3 0 %
1 8 5 % – 2 2 0 % .
3 0 %
Source: Company disclosure and EY analysis
T ar g et so lo capital adeq u acy w ill b e
disclosed for the first time
I n many cases, sub sidiary operating entities w ill b e
disclosing their reg ulatory solvency on a pub lic b asis f or
the first time. As such, investors will determine whether
dividends are being paid from capital or earnings.
A picture is emerg ing on how much capital should b e
held within the subsidiaries. Disclosures from major
European g roups indicate a targ et ratio of 120% to
140% for solo entities (see figure 6).
F ig u r e 6 : C o m p a r is o n o f t a r g e t s o lo e n t it y s o lv e n c y
T a r g e t u n it s o lv e n c y
A e g o n
1 3 0 % – 1 5 0 % for EEA units.
A llia n z
1 0 0 % – 1 3 0 % af ter stress
A X A
L imited volatility b uf f er ab ove 1 0 0 % .
Source: Company disclosure
Cash, capital and dividends: H ow S olvency I I is challeng ing the insurance investor story |
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2.What is the expected run rate of
capital generation?
Investors need to be confident that insurers have the financial strength to pay a dividend both today and tomorrow.
Under Solvency II, the sources and timing of capital generation will change relative to Solvency I. As shown in figure 7,
sources of capital generation under Solvency II include:
• Excess spread. In most cases liabilities are discounted at the risk-free rate. When insurers earn returns in excess of
the risk-free rate, capital generation will emerge on an ongoing basis. To the extent insurers have increased the liability
discount rate (e.g., using matching adjustment or UFR), there will be a lower embedded excess spread, and therefore,
lower in-force capital generation.
• Non-present value (PV) income streams. This refers to any income streams that are not capitalized on the balance
sheet as part of the best estimate; for example, investment business that falls outside the Solvency II contract
boundary or earnings from non-Solvency II entities, such as asset management or banking operations, as well as
investment return on capital.
• Risk margin unwind. For those insurers with policies that contain significant risks that cannot be hedged, the release
of the risk margin over time will be material. Where the risk margin has been offset by the use of transitional measure
technical provisions (such as in the UK), capital generation will be reduced.
• Operational result. Capital generation gains may occur when insurers are able to deliver actual outcomes ahead of
their best estimate assumptions. Expense efficiency is an obvious focus point.
• Value of new business (VNB) net of required capital. Whether this is positive or negative will depend on the mix of
business and its inherent profitability. We anticipate traditional guaranteed business, including UK annuities, will be
VNB negative given large capital strains.
• Capital management. Structural initiatives to remove capital constraints within operating entities may lead to
one-off gains and/or recurring capital efficiencies. This may have a considerable impact on the insurers’ portfolio or
product mix.
• Market volatility. This often has a significant impact in excess of “expected” capital generation (both positive and
negative depending on market moves).
• Model and assumption changes. Under a best-estimate and PV-based regulatory regime, management will need to
demonstrate that their assumptions at the time of sale (at product or portfolio level) are met.
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| Cash, capital and dividends: How Solvency II is challenging the insurance investor story
Figure 7: Illustrative analysis of sources of capital generation under Solvency II
Capital
management
Market
volatility
Operational result
beyond best estimate
Dividends and
coupons
Model and
assumption
changes
Unwind of risk
margin and SCR
Growth capital
VNB net of
required
capital
Unwind of
UFR, MA and
transitional
provisions
Excess spread;
non-present value
earnings
Opening
surplus
position
In-force
surplus
position
Operating
surplus
position
Closing
surplus
position
Closing surplus
position after
distributions
Cash, capital and dividends: How Solvency II is challenging the insurance investor story |
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3.Can insurers continue to grow earnings
and dividends in a low growth, low
interest rate environment?
Since the financial crisis, the European insurance sector has maintained a track record of increasing its International
Financial Reporting Standards (IFRS) earnings against a backdrop of falling long-term interest rates and weak economic
growth. This has translated into growth that in many cases is stronger in dividends than in IFRS earnings (see figure 8).
Investors are starting to question the sustainability of this — especially as earnings coverage has fallen — and are
increasingly demanding payouts. Navigating this tension is a key challenge for insurers. As a result, a number of
companies have provided more explicit guidance on dividend policy in the past 18 months.
Figure 8: Change in earnings per share and dividends per share: 31 December 2010 to 31 December 2015
300%
267%
250%
200%
176%
152%
150%
131%
137%
101%
100%
84%
63%
50%
47%
32%
24%
49%
53%
31%
94%
90%
83%
52%
38%
28%
23%
28%
0%
-5%
-10%
-2%
-24%
-29%
-50%
Aviva
Munich Re
Standard Life
AXA
DPS
Allianz
EPS
Prudential
Old Mutual
Ageas
L&G
Share price
Source: S&P Capital IQ
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| Cash, capital and dividends: How Solvency II is challenging the insurance investor story
Payout ratios remain largely linked to IFRS earnings
IFRS remains the primary metric for determining dividend payout ratios, with major insurers explicitly linking their
dividend policy to IFRS earnings (see figure 9).
Under Solvency I (with some relative adjustments), IFRS earnings were a good proxy for evolving regulatory solvency.
However, under Solvency II, this relationship is no longer as straightforward depending on the business mix and growth
rate of the insurer.
The link between IFRS and dividend payout guidance has not changed, and instead, has been strengthened by recent
insurer presentations.
Figure9:Comparisonofpayoutratiodefinitionsacrossinsurancegroups
G ro u p
Dividendpayoutratiodefinition
A e g o n
5 0 % of free cash flows after holding costs
A g e a s
B etw een 4
A llia n z
5 0 % of IFRS net income
A X A
4 5 % – 5 5 % of adj usted earning s net of undated deb t interest charg es
N N G ro u p
4 0 % - 5 0 % of IFRS net operating result from ongoing business
S to re b ra n d
M ore than 3
0 % and 5 0 % of the insurance result
5 % of result after tax, but before amortization costs
Source: Company disclosure
W hat co nstr aints do acco u nting ear ning s have o n capital ex tr actio n?
To pay a dividend, insurers must have sufficient distributable reserves. These are increased by retained earnings and
depleted by distributions (dividends, buybacks) and accounting losses (including write-off of intangible items such
as goodwill and deferred acquisition costs (DAC)). A lack of distributable reserves accompanied by weak accounting
earnings can be a major constraint to extracting capital – especially in businesses in run-off with capital emergence
profiles greater than forward earnings.
Restrictions relating to distributable reserves also pose a constraint in terms of capital management under Solvency II.
The volatility of Solvency II ratios cannot always be managed by injecting capital in bad times and extracting capital in
good ones. This approach would lead to the rapid erosion of distributable earnings, and in part has driven group capital
management activity including ancillary own funds and internal reinsurance.
Conflicting metrics may challenge the communication of future strategy
Divergence between accounting and regulatory balance sheets and accompanying income profiles is likely to cause
challenges. In many jurisdictions, it is widely expected that accounting reserving will continue to follow Solvency I
principles for the present, unless companies elect to change methodology.
I n a numb er of continental European countries, a f urther complication arises f rom the reliance on local g enerally
accepted accounting principles (GAAP) to determine profit sharing in traditional participating business - and is often the
basis for tax calculation.
This can require a business to be managed to a local GAAP (often book value) result for profit sharing and fiscal reasons,
but also controlled on a market consistent basis for Solvency II. It is easy to imagine a number of scenarios where these
Cash, capital and dividends: H ow S olvency I I is challeng ing the insurance investor story |
1 0
measures diverge: for example, based on existing disclosure, companies often have significantly different and usually
opposite interest rate capital sensitivities under Solvency I and economic capital measures.
This poses significant challenges for ongoing balance sheet management, especially as books develop over time through
new business, run-off and management actions. Furthermore, accounting for risk management actions, in particular
derivative hedging, may be asymmetric between the underlying position and the hedge. This can lead to volatility in the
income statement, which ultimately impacts profit sharing and distributable earnings.
As yet, only a limited number of insurers are providing reconciliation between Solvency II and IFRS equity. To our
knowledge, no insurer has publicly reconciled IFRS earnings to Solvency II capital generation.
The slow death of embedded value?
For many years, embedded value (EV), whether traditional embedded value, European embedded value or market
consistent embedded value (MCEV), has been a key pillar of life insurance disclosure. EV metrics are often heavily
entrenched into insurance manag ement f rom product pricing f ramew ork s throug h economic capital into compensation
key performance indicators (KPIs).
For many, Solvency II offers an opportunity to move away from EV and to streamline reporting and the finance function.
S olvency I I arg uab ly of f ers a more coherent f ramew ork – capturing lif e and nonlif e insurance – as w ell as a more
meaningful measure with a “real” basis and regulatory scrutiny.
We anticipate the industry will wean itself slowly off EV. In particular, we expect those who disclose MCEV will discontinue
to do so faster than those who currently disclose EEV. We expect that some of the EV-based metrics such as VNB and
internal rates of return will continue for a longer period of time.
IFRS 4 Phase II will cause further complications
The rollout of IFRS 4 Phase II will lead to insurers using a more market based approach to valuing their liabilities, which
for many will be a significant change in valuation approach. To some degree, this will bring the IFRS balance sheet
more in line with Solvency II; however, significant differences are likely to remain. In particular, the pattern of profit
recognitions will remain very different.
1 1
| Cash, capital and dividends: H ow S olvency I I is challeng ing the insurance investor story
•IFRS 4 Phase II adds another layer of complexity to disclosure
As of January 2021, this new accounting standard for insurance contracts will also have market-based valuation
features, pulling disclosure closer to Solvency II; however, fundamental differences will remain.
•Restricting Day 1 profit
IFRS 4 Phase II will not allow a Day 1 accounting profit on insurance contracts. Instead, the profit will be
recognized over the lifetime of the contract.
•Asymmetric recognition of assumption changes
Similarly, Solvency II and current IFRS allow an immediate recognition of assumption changes in profit. For example,
the present values of improved expense assumptions are recognized on the day of the contract. As a result,
symmetric profits and losses are recognized immediately.
For IFRS 4 Phase II, profits (i.e., improved expense assumptions) will be again spread over the lifetime of the
contract. Meanwhile, the negative impact of an assumption change will be recognized immediately.
•Limited overlap with Solvency II
There are possible areas of overlap, such as the use of probability-weighted best estimate cash flows. However, the
discrepancies are likely to remain significant; i.e., in discount rates (where the UFR is used) and risk adjustment.
Cash, capital and dividends: How Solvency II is challenging the insurance investor story |
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| Cash, capital and dividends: How Solvency II is challenging the insurance investor story
4 . H o w a r e e a r n in g s a n d c a p it a l g e n e r a t io n
convertedtofreecashflowthatis
a v a ila b le t o s h a r e h o ld e r s ?
The underpinning of dividend payouts by “cash generation” has been a key part of the insurance sector’s investor story
in recent years. “Cash” in this context has generally referred to normalized free surplus generation on a Solvency I basis.
Investors have responded strongly to this simplified message of an industry throwing off large and predictable amounts
of cash. This is a welcome move to a tangible measure that can be modeled after the focus on MCEV, which was neither
tangible nor stable, especially in the financial crisis.
What are the cash vs. capital generation expectations under Solvency II?
The aim of providing enhanced cash disclosure was to remove many of the distortions introduced by IFRS, such as the
deferral of acquisition costs. This provided a clearer path for investors to understand dividend paying ability. In addition,
generally speaking, Solvency I surplus could also be thought of as cash, which could be paid to shareholders.
The definitions of cash generation continue to vary significantly by insurance group. Not all of these include regulatory
capital, though some use a number of “biting” constraints, including rating agency and internal metrics.
Many of these definitions of cash will need to be updated under Solvency II, either to reflect a more accurate view of
capital g eneration or to capture true cash constraints w ithin b usiness units, w hich can rang e f rom earning s to capital to
liquidity.
S o f ar, f ew insurers have disclosed how S olvency I I w ill impact their ab ility to g enerate capital or the implications of
market volatility. We expect this to be an increasing source of investor focus, as insurers disclose central holdings of
buffer liquidity, payback periods and internal rates of return on new business.
A n u m b e r o f in s u r e r s h a v e r e v is e d t h e ir c a s h g e n e r a t io n g u id a n c e a s a r e s u lt o f S o lv e n c y II, a s s h o w n b e lo w :
A e g o n
Cumulative free cash flows target € 3 . 3 b illio n by 2018 set at the 2016 Investor Day
updated for Solvency II. The Dutch and UK operations are expected to resume dividend
payments in 2016 and 2017 respectively.
A v iv a
The excess cash flow target for 2016 is £800 million as stated in 2014 year end results.
A X A
Annual operating free cash flow should increase by € 0 . 5 b illio n under S olvency I I ,
due to lower capital consumption in new life and savings business.
G e n e r a li
Targeting net free cash flow generation of more than € 7 b illio n cumulatively f rom
2015 to 2018
P h o e n ix
Reduced its 2015 cash generation target to £200-250 million f rom £500-550 million
in 2014 with a view to retaining capital within its operating entities as it moves to
Solvency II. The long-term cash generation target for 2014-2019 remains unchanged at
£ 2 . 8 b illio n.
P r u d e n t ia l
At the end of 2014, the target for cumulated cash generation was £ 1 0 b illio n b y the end
of 2017. This was not changed in the January 2016 Group solvency II update. Solvency
II will not affect in-force free surplus generation from the US, Asian or asset management
operations, as these will remain subject to local regulatory capital regimes. UK operations
are expected to see a £200 million fall over the period 2015 to 2025.
Source: Company disclosure
Cash, capital and dividends: H ow S olvency I I is challeng ing the insurance investor story |
1 4
Do own funds held in excess of the regulatory requirement represent available assets?
Under Solvency I, surplus assets in excess of required capital were considered liquid assets. Under Solvency II, this relationship
is no longer so simple.
There is greater potential to hold negative reserves for certain products compared to Solvency I; for example, the present value
of future profits for unit-linked products. This can result in situations where an insurer may have own funds that are neither
distributable (as not yet earned under applicable accounting) nor realizable (as the capital item represents future rather than
current cash).
Renewed focus on cash dividends from
o per ating entities
W e b elieve many insurers w ill increasing ly f ocus on cash
remittance f rom their operating entities rather than cash
generation as they did under Solvency I. Cash generation
under S olvency I I remains untested as a metric, in
particular in times of mark et volatility, and insurers are
naturally cautious ab out adopting a potentially unstab le or
unreliable measure.
O nly a f ew insurers currently disclose targ et remittance
ratios in a Solvency II environment, as shown in figure 10.
These are expressed as a percentage of capital generation
or earning s, providing investors w ith the ab ility to assess
the expected amount of cash released from an insurer’s
operating entities. We believe that few insurers currently
have the operational capab ility to proj ect their capital
g eneration and, theref ore, the amount of cash they can
expect to remit to the rest of the group.
Developing remittance targ ets w ill b e critical to ensuring
that investors can form an expectation of the dividend
paying capacity of the g roup, especially if EV disclosure
falls away as we expect.
Centr aliz ing cash w ithin the g r o u p
S olvency I I is an incentive f or insurers to hold capital
centrally and outside of operating entities. When capital
cannot b e transf erred b etw een operating entities, it is
excluded from consolidated solvency ratios. Available
capital can be trimmed significantly as disclosed in figure
11. In practice, the severity of fungibility assessments vary
across the sector.
W e anticipate that a numb er of insurers w ill b e
implementing solutions to remove dividend traps and
upstream capital to improve their remittance and solvency
ratios.
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| Cash, capital and dividends: H ow S olvency I I is challeng ing the insurance investor story
F ig u r e 1 0 : C o m p a r is o n o f d is c lo s e d t a r g e t r e m it t a n c e
r a t io s
T a r g e t r e m it t a n c e r a t io s
A X A
7 5 % - 8 5 % of operating free cash flows
A llia n z
> 8 0 % of net income by 2018
Source: Company disclosure
F ig u r e 1 1 : C o m p a r is o n o f f u n g ib ilit y c o n s t r a in t s
T a b le o f d is c lo s e d f u n g ib ilit y c o n s t r a in t s
A g e a s
€ 1 . 5 b illlio n on elig ib le ow n f unds of
€ 8 b illio n at year-end 2015
P r u d e n t ia l
£1.4 billion of surplus from Asia excluded
f rom g roup ow n f unds of £ 1 9 . 4 b illio n to
£ 2 0 . 1 b illio n at year-end 2015.
S t a n d a r d L if e
£ 1 . 2 b illio n of restricted surplus at year-end
2015 on group own funds of £ 5 . 5 b illio n
O ld M u t u a l
£ 0 . 9 b illio n of restricted surplus at year-end
2015 on group own funds of £ 6 b illio n
Source: Company disclosure
5 . Is t h e in s u r e r p r ic in g n e w b u s in e s s
r a t io n a lly a n d “ e a r n in g ” it s a s s u m e d
f u t u r e m a r g in s ?
Solvency II recognizes much of a product’s profitability at inception in the valuation of the reserves. We anticipate
investors will scrutinize the assumptions underlying these reserves more closely, especially as they relate to VNB. As a
result, we expect the market will apply higher multiples to those companies with a better track record of realizing their
assumptions, as this indicates a higher-quality (i.e., more reliable) income stream.
This requires disciplined operational management and, potentially, new disclosure and internal analysis. (There are
parallels with nonlife reserve triangles as a confidence level for establishing initial material assumptions.)
Capital-light products heavily exposed to market volatility and expense risk
Capital-light products, such as non-guaranteed unit-linked savings, realize strong capital generation on inception, as
expected profit margins are captured in the Solvency II balance sheet as a negative reserve. (See figure 12)
This ability to recognize the expected value of fees at inception also highlights the difference between Solvency II capital
generation and both IFRS profits and actual cash generation.
On an ongoing basis, capital generation and regulatory solvency are likely to be heavily correlated and pro-cyclical to
capital market movements. Where markets move, regulatory solvency will be highly geared to expenses. For example,
a 20% decline in the stock market is unlikely to be offset by a similar fall in expenses paid by the insurer. This will be
recognized immediately in the Solvency II balance sheet. The equivalent opposite effect will be seen when markets rise.
Cash, capital and dividends: H ow S olvency I I is challeng ing the insurance investor story |
1 6
Figure12:Illustrativeanalysisshowingfirst10yearsofcapitalandcashgenerationfromasinglepremium
u n it - lin k e d p r o d u c t a s s u m in g in v e s t m e n t r e t u r n o f t h e E IO P A r is k - f r e e c u r v e
C apital g eneration
Day 1
Year 1
Year 2
Year 3
Year 4
Year 5
Year 6
Year 7
Year 8
N et cash g eneration
Year 9
Year 10
Meeting return on equity hurdle rates may challenge capital intensive business
For long-term guaranteed business, such as UK annuities, new business strain (the difference between premiums
received, and the sum of technical provisions and required capital) is expected to increase significantly – in some cases by
a factor of two to three times Solvency I equivalents.
O nce in f orce, the k ey sources of cash and capital g eneration w ill b e the credit risk premium, unw ind of risk marg in and
SCR (see figure 13). The use of the matching adjustment by many annuity writers means that a proportion of the credit
spread available on the assets backing the liabilities is recognized at inception. This proportionally reduces the ongoing
capital generation.
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| Cash, capital and dividends: H ow S olvency I I is challeng ing the insurance investor story
All things being equal, more capital will be held for longer periods of time, which depresses the return on capital.
Insurers are responding in a number of ways to address these issues:
•
Shifting new business mix to unguaranteed/capital light products
•
Aiming to increase pricing for new guaranteed business, and to lower guarantees and/or move to term rather than
annual g uarantees
•
Making more extensive use of reinsurance to reduce SCR and risk margin
•
Considering selective disposals to free-up capital encumbered in the back book to redeploy into better return products
Figure13:Illustrativeanalysisshowingcapitalgenerationfromanannuityproductoverthefirst10yearswherethe
m a t c h in g a d ju s t m e n t is u s e d
Day 1
Premium
Year 1
Acquisition expenses
Year 2
Year 3
Technical Provisions
Year 10
Required capital
Excess spread investment return
Premiums and technical provisions not to scale for illustrative purposes.
Cash, capital and dividends: H ow S olvency I I is challeng ing the insurance investor story |
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19
| Cash, capital and dividends: How Solvency II is challenging the insurance investor story
C o n c lu s io n s
S olvency I I chang es k ey aspects of the current insurance investor proposition,
but not the fundamental investment rationale: predictable and attractive
dividend yield, underpinned by a simple set of earnings and capital metrics. The
challeng e f or the industry is to persuade investors that S olvency I I is at w orst
neutral to dividends, and that earning s and returns can continue to g row ag ainst
the backdrop of macro-economic headwinds.
We return to the questions posed at the beginning and reflect on how we see
insurers will need to respond to the challenges discussed.
D o es the insu r er have adeq u ate and stab le so lvency capital
such that current and future dividend streams are not
co nstr ained?
Disclosure of the capital position and capital sensitivities will not be sufficient.
I nsurers w ill need to translate risk appetite into a capital manag ement
framework, and articulate a coherent story of acceptable ranges and expected
volatility as expressed by sensitivities. We anticipate target capital ranges will
b ecome narrow and low er as insurers and investors b ecome more comf ortab le
with reporting and managing the Solvency II balance sheet.
Insurers will need to develop a more extensive toolkit to assess the trade-offs
between earnings, capital and volatility, the associated cost-benefit analysis, as
well as a broader set of capital management tools.
W e anticipate capital manag ement w ill b ecome a core competency of insurers
going forward.
W hat is the ex pected r u n r ate o f capital g ener atio n, and ho w
do es that tr anslate to r etu r ns to investo r s?
I nsurers w ill need to improve their ab ility to f orecast their cash and capital
generation under Solvency II, and the sensitivities. In many cases, this requires
a fundamental reappraisal of financial planning and analysis (FP&A) to include
balance sheet planning and forecasting. Insurers will need to improve their
ab ility to f orecast their cash and capital g eneration under S olvency I I , and the
sensitivities to the base case.
We anticipate investors will require more uniform and forward-looking metrics.
This is likely to include an emphasis on risk-based, rather than volume-based,
new b usiness marg in measures, w hich demonstrate the value of new b usiness
per unit of risk capital employed, as well as indications of payback periods.
Can insu r er s co ntinu e to g r o w ear ning s and dividends in a lo w
g r o w th, lo w inter est r ate w o r ld?
Insurers are undoubtedly facing earnings’ headwinds from low interest rates and
low gross domestic product (GDP) growth. This directly impacts the business
model, including lower operational leverage and investment returns. There are
also second order impacts such as the sof t nonlif e insurance mark et, caused in
part by the inflow of alternative capital searching for yield.
Cash, capital and dividends: H ow S olvency I I is challeng ing the insurance investor story |
2 0
Against this backdrop, we anticipate insurers will focus on a number of levers to drive earnings and dividends:
•
Operational efficiency to cut costs and harvest productivity g ains f rom b etter inf ormation technolog y and b usiness
processes
•
R eshaping o f the new b u siness pr o po sitio n to improve customer experience, as well as increase margins and reduce
capital strain
•
In-force management to drive value from back books through a range of customer, operational and capital actions.
These programs require senior management sponsorship as well as organizational stamina to deliver incremental value
at a time when insurers, especially finance functions, are already stretched. However, absent such a commitment to
change and value, there is a significant risk that the macroeconomic headwinds will negatively impact earnings and
dividends.
How are earnings and capital generation converted to free cash flow that is available to
shar eho lder s?
Given the differences between IFRS and Solvency II, as well as the untested regulatory appetite for internal dividends,
insurers will need to track free cash and free cash flow carefully. This will immediately manifest itself in remittance
disclosures. We anticipate published measures will evolve to demonstrate conversion of capital and earnings to cash. The
starting point is likely to be more extensive use of metrics for internal rate of return, payback periods and remittance
ratios.
Is the insurer pricing new business rationally and “earning” future margins embedded in the
base balance sheet through best estimate assumptions?
Though investors are strongly interested in current dividends, insurers need to remember longer term value will only be
created through both:
•
Investing capital to generate returns in excess of the cost of capital, and developing a profitable new business franchise
•
Running in-force business in-line with or better than ex-ante expectations, whether from a cost, yield, capital or
customer perspective to deliver value that is capitaliz ed at inception
I n either case, investors w ill f ocus on the credib ility of b oth the assumptions underpinning the b usiness and
management’s ability to deliver the expected results. Building this credibility will require:
•
N ew b u siness str ateg y : A focus managing through understanding product mix, distribution channels, targeting
customers, sales efficiency, margins, new business value and payback periods
•
Capital allo catio n: S plit of g ross capital g eneration b etw een reinvesting into the b usiness and w hat is availab le to
shareholders; process and metrics f or prioritiz ing investment, including rates of return and active portf olio review to
exit or turnaround subscale and underperforming businesses
•
Delivery on assumptions: The present value of future expected cash flows is a significant component in the Solvency
II balance sheet, so investors and management will need to understand that a) the assumptions were valid in the first
place; and b) the cash flows are achieved in practice. Given the market-based nature of Solvency II, and the discounted
nature of cash flows, it can be challenging internally (and is impossible externally) to disaggregate outcomes and
compare ex-post outcomes against ex-ante assumptions.
For many companies, this information is not readily available or easy to produce. While short-term projects can be
implemented, this is an area that requires a strong focus on data, information feeds and thoughtful analysis in order to
produce useful results.
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| Cash, capital and dividends: H ow S olvency I I is challeng ing the insurance investor story
EY contacts
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