Free Capital Generation in 2018 Best practices in reporting on Free Capital Generation October 2018
Introduction Free Capital Generation (FCG) Free Capital Generation (FCG) is becoming a prominent disclosure metric in analyst presentations. The ability to generate Free Capital, which is the amount of available own funds in excess of the required capital, is one of the key performance metrics in the insurance industry in Europe. The higher the FCG, the higher the potential dividends, and the higher the opportunities to invest. Although the metric has been generally accepted by analysts, supervisors and the insurance companies, there are still many differences in the definitions used and the way companies report on FCG.This survey explores how European insurance companies report on FCG in analyst presentations and other investor communications. It is a follow-up on the study performed in 2017, which allows us to monitor trends. Survey scope This survey shows the industry s position on: Disclosures on Free Capital Generation Sustainability of Free Capital Generation Relationship between Free Capital Generation and dividend payment Target Solvency ratios Relationship between IFRS equity and Solvency II own funds Opportunities to improve Free Capital Generation All members of the CRO Forum that have an interest in Solvency II disclosures are included in the survey, supplemented with the large Dutch Insurance companies (see appendix I for the full list). Although the survey focusses on external disclosure, FCG is not just relevant for reporting to external stakeholders. It is also essential internal management information, as it provides insight in the (future) performance of different portfolios within the company. The messages shared in this report can help to develop an internal Free Capital monitoring framework as well. 2
Contents 1 Concept of Free Capital Generation Key messages: 1 FCG reporting is a key element in analyst presentations 2 Free Capital Generation disclosure 2 The role of FCG as a performance metric is increasing 3 Free Capital Generation forecast 3 4 No convergence towards a common definition of FCG Limited appetite in the market for providing FCG forecasts 4 FCG as performance measure 5 Typical sustainable FCG is around 10%-20% of SCR 6 Dividend policies remain IFRS oriented 5 FCG and dividend 7 FCG is not yet used as a metric for dividend payment 8 More attention for long term FCG (instead of current SII ratio) 6 Improving the Free Capital Position 3
1.1 Definitions for Free Capital Generation (FCG) Throughout this presentation, the following definitions will be used: Total Free Capital Generation Dividend Paid FC Sustainable FCG SCR EOF TC FC Solvency Capital Requirement Eligible Own Funds Target Capital (e.g.150% of SCR) Free Capital SCR TC EOF Non-sustainable FCG FC FC 2017 2018 The total FCG in a year is the net result of several elements (see next page). A distinction can be made between elements that are considered to be "sustainable" and "non-sustainable". Sustainable means: generated by the company on its own account and net of external and one-off effects (also called organic-, operating-, underlying- or normalized capital generation). The actual change in the Free Capital Position is also determined by non-sustainable elements: external circumstances or one-off actions. Notes: (1) Solvency II is a prudential framework based on prescribed estimates like e.g. yield curve, contract boundaries, which does not necessarily correspond to an economic view. Therefore, Free Capital Generation (FCG) is by definition based on a regulatory calculation. (2) The target of 150%*SCR may vary between companies. For some graphs in this report a threshold of 100%*SCR is used for consistency. 4
1.2 Sources of FCG Definitions used by insurance companies can be quite different, and are subject to change (see section 2.3). We distinguish the following components: Own funds SCR (+) Expected investment return (+/-) New business (+) Release of RM (-) UFR drag (+) SCR release (-) SCR new business (-) Transitionals (+/-) Management actions* (+) Release of TVOG (-) Financing costs (+/-) Management actions* Sustainable FCG Non-economic variance Economic variance Assumption changes Model changes Regulatory changes Management actions* Actual FCG Dividend payment * Management actions can be placed in different categories, depending on the nature of the action. 5
1.3 Main sources of sustainable FCG Although on group level little information is provided on what the main components of the sustainable FCG are, we can generally identify the main sources based on qualitative information, and on information provided by the entities within a group. The relevance of the different components typically varies between Life and Non-Life insurers. Life insurance companies Non-Life insurance companies UFR drag/release of RM and SCR Excess investment return New business Excess investment return New business SCR release/ SCR new business 2 1 3 2 1 3 6
2.1 FCG disclosure This page shows the type of information disclosed when reporting the bridge between YE2016 and YE217 Solvency II ratios. It shows whether an explicit reference is made to the amount of Free Capital Generated (left graph) in the information provided to analysts. The graph on the right shows the change over time. FCG has a prominent place in nearly all investor reports. For YE 2016, there were still companies only disclosing the opening and closing Solvency II ratio. For YE 2017, a great majority (84%) makes an explicit reference to the amount of FC generated throughout the year. The role of Free Capital Generation as a performance metric is increasing. Is there an explicit reference to the amount of FC generated during the year? Market development No 16% 100% 80% No 24% No 16% 60% 40% Yes 76% Yes 84% 20% Yes 84% 0% 2016 2017 7
2.2 Sustainable FCG This page shows whether companies provide information on the part of the FCG that they consider to be sustainable (left graph), and whether there are any changes in disclosure between YE2016 and YE2017 reporting. The companies reporting on the amount of sustainable FCG make a clear split between internal and external FCG-sources. A great majority of companies that provide FCG information to their analysts, also provide information on what part they consider to be sustainable: 74% of the companies provide these details, 10% do not provide these details, 16% do not provide any information on FCG at all (see previous slide). The number of companies providing this information has increased from 48% in 2016, to 74% in 2017. The way reports are set up shows that definitions on what is considered sustainable still differ between companies. Companies do not disclose what elements of FCG are considered sustainable. Usually, non-sustainable elements such as economic variance, model updates, dividend payment are reported separately. Split between sustainable and non-sustainable FCG Market development No reference to FCG at all 16% No 10% 100% 80% 60% No Ref 24% No 29% No Ref 16% No 11% 40% Yes 74% 20% Yes 48% Yes 74% 0% 2016 2017 8
2.3 FCG definition Companies provide little information on what elements they recognize in their FCG reporting. The reports show great differences in the way FCG is reported. Despite the large differences in FCG reporting, there is no convergence yet. Only 31% of the companies has changed the way they report on FCG. From discussions with clients, we know there is a lot of debate on the definitions used and the way it is reported, but in external reports only little has changed during 2017. There is no clear trend of the amount of information disclosed. During 2016, we noticed companies became more open about the FCG components. For 2017, we see only reports on aggregated level ( operational capital generation, organic capital generation, etc.), not on the components underlying the FCG. Has the definition/presentation of "sustainable FCG" changed compared to last reporting year? No 69% Yes 31% 9
3. FCG outlook formal forecast Analysts are primarily interested in the ability to generate FC in the future. This page shows how many companies provide a formal forecast (a promise to investors) for future FCG. Only a small fraction (16%) of the companies provide a formal forecast of the expected future FCG (see graph). This number did not significantly change during 2017 (was 14% in 2016). The companies that provided a forecast in 2016, did not manage to realize this ambition. The forecasts made in 2017 (for 2018 onwards) are roughly in line with the amount of sustainable FCG in 2017. Although sensitivities are very common when reporting on Solvency II ratios, no companies provide sensitivities on the amount of future FCG. Is an FCG forecast provided? Yes 16% No 84% 10
Sustainable FCG (as % of SCR) 4 Performance during the year The graphs below show the total (i.e. sustainable* plus non-sustainable) FC generation and the sustainable FC generation as a % of the SCR, in the form of a histogram (left graph) and correlation diagram (right graph). The total capital generation is corrected for dividend paid, to compare sustainable with total capital generation prior to dividend pay-out. The distribution of total capital generation is much wider than the distribution for sustainable capital. We expect this to be caused by relatively large potential yearly fluctuations from the non-sustainably generated capital. There is no clear correlation between the sustainable FCG and the total FCG (as a % of SCR). FC generated last year as a % of SCR Sustainable vs total FCG (only positive values shown) 10 40% 8 6 Total FCG Sustainable FCG 30% 20% 4 2 10% 0 <=-10% >-10% but <0% >0% but <=10% >10% but <=20% >20% but <=30% >30% 0% 0% 10% 20% 30% 40% Total FCG (as % of SCR) *Terminology to refer to the sustainable FC varies widely. The graphs present the amounts of which we expect that analysts will interpret this as the sustainable portion of the total FC generation. 11
5.1 Dividends and Solvency II ratio Paying (predictable) dividends is essential for investors, while the regulator will require an adequate level of OF. This page shows how this dividend payment impacts the Solvency II ratio. On average dividend pay-out amount to a deterioration of 7.9% of the Solvency II-ratio (see graph)*. Last year (2016), the average was 7.6%. Although Solvency II is a constraint for most insurers, the majority express their dividend in terms of Net Profit. Dividend targets typically lie in range of 40-50% of Net Profit (not shown in graph). Dividends as percentage of Free Capital typically lie in range of 5-10% (not shown). Deterioration of SII-ratio following dividend pay-out in 2017 0% -2% -4% -6% -8% Average: -7.9% -10% -12% -14% *The graph shows the actual paid dividend in FY2017, applied to the Solvency II ratio at YE2017 12
5.2 Dividend policy Approximately 50% of the companies in the survey do explicitly mention the basis for the determination of the dividend amount in publicly available documents. The factors included in the dividend policy are shown in the graph. The most frequently used metrics for determining the dividend amount are the IFRS profit, regulatory requirements and the solvency position. For many companies there is an explicit link between the Solvency II position and the determination of the dividend amount. The Free Capital Generation itself (as defined in this survey) is, similar to last year, not yet observed as a metric. Despite the increasing relevance of Free Capital Generation metrics, there are only a few changes in dividend policy (not shown in the graph). Basis for determination of the dividend amount* Strategic considerations Leverage ratio Regulatory requirements Liquidity position Solvency II ratio/capital position Operating result/income (IFRS) 0% 50% 100% *Please note that companies for which insufficient public information was available on the determination of the dividend amount were excluded from this graph. 13
Dividend / free captial 5.3 Capital deployment Companies used their Free Capital for dividend and several other means in 2017 as in shown in the top graph. The bottom graph shows the amount of dividend paid out in relation to the Solvency II ratio. All companies paid dividend in 2017 (top graph). Although the capital position (Solvency II ratio) is often mentioned as an explicit factor for the determination of the dividend amount, there is no clear relationship (bottom graph) between the actual amount of dividend paid out (as a % of the available Free Capital) and the Solvency II ratio*. A lot of the companies were engaged in share buy-back programs over the course of 2017. These programs were likely set up to counter dilution caused by (stock) dividends. Additionally share buy-back programs are fiscally more attractive compared to (additional) dividend payments. Capital deployment 26% 42% 11% 21% 100% 53% 0% 20% 40% 60% 80% 100% Other Cost of external debt/ hybrids Additional market risk Management actions Dividend Share buyback Dividend as % of Free Capital vs SII ratio 20% 15% 10% 5% *Only explicit references to capital deployments were included in these figures. It is possible that more actions were taken but were not explicitly mentioned 0% 130% 180% 230% 280% SII Ratio 14
5.4 Target Solvency ratios Most companies express an ambition for their Solvency II ratio and define limits as part of their capital management policy. The ambitions and limits are summarized on this page. Investors should not expect dividend payments below the lower limit. The target Solvency II ratio lies in the range of 160% to 175%. Several insurers relate their Solvency II ratios to a desired external benchmark rating. Companies are less open on how dividend policies and target levels are related to the Solvency II ratio. Solvency II ratios and target ratios 350% 300% 250% 200% 150% 100% 50% 0% Current SII ratio SII Target Dividend minimum High SII target Low SII target 15
IFRS Profit / IFRS Equity 5.5 Dividends, IFRS profit and FCG The higher the FCG, the higher the amount of dividend that can be paid out. The amount of FCG that is paid to investors varies strongly over the companies. One would expect a direct relationship between the change in OF and IFRS profit, but this is not immediately apparent. The top graph shows the dividends paid as percentage of sustainable capital generation. - The median amount insurers have paid out was 36% - 75% of the insurers have paid out more than 24% - 25% of the insurers have paid out more than 60% There is no clear relationship between the change in Own Funds and the IFRS profit (bottom graph). This is surprising as the change in Own Funds could be seen as a profit metric in the Solvency II world. We envision that the introduction of IFRS 17 will lead to a more apparent relationship between change in Own Funds and IFRS profit as the valuation of the technical provisions will be more in line with a market value approach. Dividend as % of sustainable capital generation 0% 20% 40% 60% 80% 100% Relation between change in OF and IFRS profit 30% 25% 20% 15% 10% 5% 0% -20% -10% 0% 10% 20% Δ OF / OF 16
6. Improving the FC position This page mentions the main actions taken by insurance companies in the benchmark to increase the existing Free Capital, or to increase the future Free Capital Generation. Rebalance/re-risking investment portfolio Improve combined ratio/pricing Capture growth in fast-growing geographies Acquisitions/divestments Model updates Optimise reinsurance Capital-light/fee business Realise cost- and capital synergies 17
The contacts at KPMG in connection with this report are: Jeroen van Wageningen Financial Risk Management Partner KPMG Advisory N.V. Tel: +31 (0)20 656 24 09 E-Mail: vanwageningen.jeroen@kpmg.nl Jeroen Gielen Financial Risk Management Sr. Manager KPMG Advisory N.V. Tel: +31 (0)20 656 71 23 E-Mail : gielen.jeroen@kpmg.nl
Appendix I: Insurance groups in the survey Selection criteria The survey group consists of all CRO Forum members and large Dutch insurance groups. Insurance groups are excluded from the survey when: Solvency II is not the prevailing regulatory framework; When the financial structure does not require or incentivize reporting Free Capital Generation on Solvency II principles. Reporting The survey is based on reporting per YE2017, or HY2018 if available. Sources are the companies analyst presentations. Annual reports and SFCRs were used for additional information. Group members A.S.R. ACHMEA AEGON AGEAS ALLIANZ AVIVA AXA GENERALI GROUPAMA HANNOVER RE LEGAL & GENERAL MAPFRE MUNICH RE NN GROUP PRUDENTIAL RSA SCOR UNIPOL SAI UNIQA CRO Forum members AIG, LLOYD S, SWISS RE, and ZURICH, and Dutch insurer VIVAT were not included in the survey because of the selection criteria. 19
Appendix II: Glossary Actual FCG Economic variance FCG (Excess) Investment return OF Non-economic variance RM RM release SCR SCR release SFCR Sustainable FCG TVOG The amount of Free Capital that is generated by the company in a certain period. This will be the net effect of the Sustainable Free Capital generation and external/one-off effects. A change in FCG because the financial market conditions evolved in a different way (compared to the expectation). Free Capital Generation The investment return that is expected on the asset portfolio that exceeds the risk free rate used for discounting the liabilities. Own Funds A change in FCG because the portfolio/claims evolved in a different way than expected. Risk Margin as defined by Solvency II. Release of risk margin (RM) over time due to run-off of the portfolio. Solvency Capital Requirement Release of required capital (SCR) over time due to run-off of the portfolio. Solvency and Financial Condition Report The amount of Free Capital that is generated by the company on its own account and net of external and one-off effects. Other terminology used is: organic capital creation, operating capital creation. Time value of options and guarantees; typically only a small contribution to the FCG. 20
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