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  • Cash, capital and dividends:How Solvency II is challenging the insurance investor story

    March 2016

  • 1 | Cash, capital and dividends: How Solvency II is challenging the insurance investor story

    Executive summaryEuropean 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).

    ContentsExecutive summary 1

    1. Does the insurer have adequate and stable solvency?


    2. What is the expected run rate of capital generation?


    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 assumed future margins?


    Conclusions 20

  • 2Cash, 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. Howareearningsandcapitalgenerationconvertedtofreecashflowthatisavailabletoshareholders?

    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



    Return on equity > cost

    of equity

    Capital generation

    Net asset value



    Growth and franchise value add


  • 3 | Cash, capital and dividends: H ow S olvency I I is challeng ing the insurance investor story

    1 . D o e s t h e i n s u r e r h a v e a d e q u a t e a n d s t a b l e s o l v 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 i v i d e n d s t r e a m s a r e n o t c o n s t r a i n 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 i s i t f o r i n v e s t o r s t o c o m p a r e S o l v e n c y I I r a t i o 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 l v e n c y i s l o w e r t h a n e x p e c t e d ?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.

  • 4Cash, capital and dividends: H ow S olvency I I is challeng ing the insurance investor story |

    Source: Most recently published company disclosure

    F i g u r e 3 : C o m p a r i s o n o f i n s u r e r s u s i n g t r a n s i t i o n a l p r o v i s i o n s a n d s e n s i t i v i t y t o t h e U F R

    G r o u p

    T r a n s i t i o n a l t e c h n i c a l

    p r o v i s i o n s

    U F Rs e n s i t i v i t y

    1 0 0 b p s f a l l

    A e g o n Yes -6%

    A g e a s N o Halving of UFR: -17%

    A l l i a n z N o -12%

    A X A N o -19%

    M u n i c h R e N o “ V ery limited”

    N N G r o u p Yes -25%

    P r u d e n t i a l Yes. Only in UK. N ot availab le

    S C O R N o “ N ot sensitive”

    S t a n d a r d L i f e Yes N ot availab le

    F i g u r e 2 : C o m p a r i s o n o f d i s c l o s e d S o l v e n c y I I r a t i o s



    Max: 239%

    Upper quartitle: 193%

    Lower quartitle: 147%

    Min: 123%



    Source: Year-end 2015 company disclosure and EY analysis

    Average: 173%

    E x p e c t g r e a t e r v o l a t i l i t y f o r S o l v e n c y I I 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.

  • 5 | Cash, capital and dividends: H ow S olvency I I is challeng ing the insurance investor story

    F i g u r e 4 : C o m p a r i s o n o f d i s c l o s e d S o l v e n c y I I s t r e s s e s

    Prudential S C O R

    - 15 %

    - 10%

    - 5 %


    5 %

    10%Aeg on Ag eas Allianz AX AAviva

    Equity - 30% I nterest rates - 5 0b ps C redit spread + 100b ps

    Source: Company disclosure and EY analysisNote: Based on most recently disclosed stresses. Where directly comparable stresses are not available these have been interpolated.

    I mpact on solvency coverag e ratio

    C o m m u n i c a t i n g s t r a t e g y i n t h e f a c e o f v o l a t i l i t 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

    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.

    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.

  • 6Cash, capital and dividends: H ow S olvency I I is challeng ing the insurance investor story |

    F i g u r e 5 : C o m p a r i s o n o f d i s c l o s e d c a p i t a l m a n a g e m e n t f r a m e w o r k s

    Source: Company disclosure and EY analysis

    S u m m a r y c a p i t a l m a n a g e m e n t a n d s o l v 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 sTargeting 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 l l i a 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 7 0 % – 2 3 0 %

    S C O R O ptimal targ et rang e 1 8 5 % – 2 2 0 % .

    S t o r e b r a n d Target of greater than 1 3 0 %

    T ar g et so lo capital adeq u acy w ill b e disclosed for the first timeI 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 i g u r e 6 : C o m p a r i s o n o f t a r g e t s o l o e n t i t y s o l v e n c y

    T a r g e t u n i t s o l v e n c y

    A e g o n 1 3 0 % – 1 5 0 % for EEA units.

    A l l i a 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

  • 7 | Cash, capital and dividends: How Solvency II is challenging the insurance investor story

    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.

  • 8Cash, capital and dividends: How Solvency II is challenging the insurance investor story |

    Figure 7: Illustrative analysis of sources of capital generation under Solvency II

    Opening surplus position

    Excess spread; non-present value earnings

    Unwind of risk margin and SCR

    Unwind of UFR, MA and transitional provisions

    VNB net of required capital

    Operational result beyond best estimate

    Capital management

    Growth capital

    Market volatility

    Model and assumption


    In-force surplus position

    Operating surplus position

    Closing surplus position

    Closing surplus position after distributions

    Dividends andcoupons

  • 9 | Cash, capital and dividends: How Solvency II is challenging the insurance investor story

    Figure 8: Change in earnings per share and dividends per share: 31 December 2010 to 31 December 2015





    83%90% 94%























    Aviva Munich Re Standard Life AXA Allianz Prudential Old Mutual Ageas L&G

    DPS EPS Share price



    Source: S&P Capital IQ

    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.

  • 1 0Cash, capital and dividends: H ow S olvency I I is challeng ing the insurance investor story |


    Source: Company disclosure

    G r o 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 0 % and 5 0 % of the insurance result

    A l l i a 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 r o u p 4 0 % - 5 0 % of IFRS net operating result from ongoing business

    S t o r e b r a n d M ore than 3 5 % of result after tax, but before amortization costs

    Payout ratios remain largely linked to IFRS earningsIFRS 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.

    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 strategyDivergence 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

  • 1 1 | Cash, capital and dividends: H ow S olvency I I is challeng ing the insurance investor story

    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 complicationsThe 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.

  • 12Cash, capital and dividends: How Solvency II is challenging 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.

  • 13 | Cash, capital and dividends: How Solvency II is challenging the insurance investor story

  • 1 4Cash, capital and dividends: H ow S olvency I I is challeng ing the insurance investor story |

    A n u m b e r o f i n s u r e r s h a v e r e v i s e d t h e i r c a s h g e n e r a t i o n g u i d a n c e a s a r e s u l t o f S o l v e n c y I I , a s s h o w n b e l o 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 i v 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 l i Targeting net free cash flow generation of more than € 7 b illio n cumulatively f rom 2015 to 2018

    P h o e n i x 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 i a 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.

    4 . H o w a r e e a r n i n g s a n d c a p i t a l g e n e r a t i o n convertedtofreecashflowthatisa v a i l a b l e t o s h a r e h o l d 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.

    Source: Company disclosure

  • 1 5 | Cash, capital and dividends: H ow S olvency I I is challeng ing the insurance investor story

    F i g u r e 1 0 : C o m p a r i s o n o f d i s c l o s e d t a r g e t r e m i t t a n c e r a t i o s

    T a r g e t r e m i t t a n c e r a t i o s

    A X A 7 5 % - 8 5 % of operating free cash flows

    A l l i a n z > 8 0 % of net income by 2018

    Source: Company disclosure

    T a b l e o f d i s c l o s e d f u n g i b i l i t y c o n s t r a i n 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 i a 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 i f e £ 1 . 2 b illio n of restricted surplus at year-end 2015 on group own funds of £ 5 . 5 b illio n

    O l d 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

    F i g u r e 1 1 : C o m p a r i s o n o f f u n g i b i l i t y c o n s t r a i n t s

    Source: Company disclosure

    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 entitiesW 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 pS 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.

  • 1 6Cash, capital and dividends: H ow S olvency I I is challeng ing the insurance investor story |

    5 . I s t h e i n s u r e r p r i c i n g n e w b u s i n e s s r a t i o n a l l y a n d “ e a r n i n g ” i t s a s s u m e d f u t u r e m a r g i n 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 riskCapital-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.

  • 1 7 | Cash, capital and dividends: H ow S olvency I I is challeng ing the insurance investor story

    Figure12:Illustrativeanalysisshowingfirst10yearsofcapitalandcashgenerationfromasinglepremium u n i t - l i n k e d p r o d u c t a s s u m i n g i n v e s t m e n t r e t u r n o f t h e E I O P A r i s k - f r e e c u r v e

    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.

    Day 1 Year 1 Year 2 Year 3 Year 4 Year 5 Year 6 Year 7 Year 8 Year 9 Year 10

    C apital g eneration N et cash g eneration

  • 1 8Cash, capital and dividends: H ow S olvency I I is challeng ing the insurance investor story |

    Figure13:Illustrativeanalysisshowingcapitalgenerationfromanannuityproductoverthefirst10yearswherethem a t c h i n g a d j u s t m e n t i s u s e d

    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

    Day 1 Year 1 Year 2 Year 3 Year 10

    Premium Acquisition expenses Technical Provisions Required capital Excess spread investment return

    Premiums and technical provisions not to scale for illustrative purposes.

  • 19 | Cash, capital and dividends: How Solvency II is challenging the insurance investor story

  • 2 0Cash, capital and dividends: H ow S olvency I I is challeng ing the insurance investor story |

    C o n c l u s i o n sS 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.

  • 2 1 | Cash, capital and dividends: H ow S olvency I I is challeng ing the insurance investor story

    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.

  • Cash, capital and dividends: How Solvency II is challenging the insurance investor story | 22

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