Financial Engineering - Institute and Faculty of …...Insurers manage multiple balance sheets 02...

Financial Engineering

Is the long term cost too high?Johnny Vo & Ed Gunby, Insurance Research, Goldman Sachs

02 October 2018

A Case Study

02 October 2018

UK Annuities & Dutch Group Pensions

New entrants in UK…departures from NL

02 October 2018 3

UK Annuities: A number of new entrants

Dutch Group Pensions: Foreign players have largely exited

ERGO AXA Anbang

Zurich (NHL NL) Swiss Life (Vivat purchase) Generali

Univé Wüstenrot & Würt. Aviva L&G

(Life portfolio) (Erasmus)

Winterthur

2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 2015 2016 2017

2

5

8

7

9

8

7

9

7

8

L&G

Pru

2005

Aviva

Paternoster

PIC

2006

Lucida

MetLife

Rothesay Life

2007

2011

Paternoster

Just Retirement

Partnership

2012

2013

Lucida 2014

MetLife

Canada Life

Scottish Widows

2015

2016

Prudential leaves

Just/Partnership merge

Phoenix Life

2017

Capital intensity

Low barriers to entry

Source: Company data, Goldman Sachs Global Investment Research.

UK AnnuitiesIntermediated, competitive & commoditised

02 October 2018 4

UK Annuities are competitive

Asset-based valuation - degree of transparency New business creates a capital strain

Deals are intermediated and brand power is limited

Best Estimate Liabilities

Risk Margin7-10%

SCR 6-12%

Buffer 2-4%

Net Premium Received

Equity 2-8%

Solvency II Liability Assets

New

business

strain

Pension

Scheme EBCs Insurer

Trustees

Sponsors

33%

28%

22%

6%

6%5% Legal & General

PIC

Rothesay Life

Aviva

Prudential

Just Group

Source: ABI, Company data, Datastream, Goldman Sachs Global Investment Research, IFoA

Bond spread

Default cost

FundamentalSpread

Downgrade cost

Matching Adjustment

Dutch Group PensionsIntermediated, competitive & commoditised

02 October 2018 5

The Dutch insurance market is highly concentrated

Market-based valuation creates price transparency Delta Lloyd had written business at negative NBM

Distribution is largely intermediated

77% 79% 77% 75% 73%

23% 21% 23% 25% 27%

0%

20%

40%

60%

80%

100%

2010 2011 2012 2013 2014

Intermediaries Direct writing

22%

13% 15%

7%

12%

8%

11%

7%

19% 13%

47%

16%

0% 20% 40% 60% 80% 100%

Non-Life

Life

Achmea Aegon ASRDelta Lloyd NN Group SNS ReaalOther

-1.0%

0.0%

1.0%

2.0%

3.0%

1 3 5 7 9

11

13

15

17

19

21

23

25

27

29

Yie

ld (

%)

Duration

Solvency II curve Illiquidity premium

Example pricing

-4.5%

-2.4%

2.3%3.0%

1.1% 1.5% 1.8% 1.4%

-6%

-4%

-2%

0%

2%

4%

1H14 FY14 1H15 FY15 1H16 FY16

Defined benefit NBM Life NBM

Source: DNB, Company data, Datastream, Goldman Sachs Global Investment Research.

Operational performance drivers“Five forces” dictate performance

02 October 2018 6

Capital is at the epicenter of any insurance company

1. Distribution: Ability to attract policyholders vis-a-vis competitors

2. Assets: Current asset mix and ability to optimize further

3. Liabilities: Constitution and composition of liability profile

4. Expenses: Cost base and efficiency by reserves

5. Capital: The aggregation of assets/liabilities and ability to grow reserves

1) Distribution

2) Assets 5) Capital 3) Liabilities

4) Expenses

Solvency Unencumbered liquidity Leverage capacity

Source: Goldman Sachs Global Investment Research.

What influences company behaviour?

02 October 2018

A multitude of factors

Insurers need to manage many metricsIt’s a balancing act

02 October 2018 8

Insurance is a multi-dimensional balancing act

• IFRS: What investors believe drives business decisions and capital distributions

• Leverage: IFRS is a key input but, regulatory restrictions also apply

• Solvency: A headline binding constraint

• Local Statutory: Needs to be managed from a remittance perspective

• Liquidity: Supports shareholder distributions

Economic View / Internal Model

Significant planning requiredManaging Solvency II such

that it is not a constraint

Hidden element needs

significant management

IFRS

What investors believe drives

business decisions and capital

distributions

IFRS is a key input for rating

agencies. Regulatory

restrictions also apply

A headline binding constraint

for dividends and M&A

Local GAAP needs to be

managed in order to create

dividend "flow"

Holding company liquidity

supports shareholder dividends

Leverage Solvency Local Statutory Liquidity


Balancing Solvency II and IFRSCapital generation and IFRS profits differ

02 October 2018 9

MA means UK capital generation is mostly run-off Dutch is largely run-off, with some “excess spread”

New

busin

ess

valu

e

SC

R r

ele

ase

Ris

k m

arg

inre

lea

se

Tra

nsitio

na

la

mo

rtis

atio

n

Retu

rn o

no

wn fu

nds

Oth

er

*

An

nu

ity c

ap

ita

lg

en

era

tio

n

New

busin

ess

valu

e

Exce

ss fix

ed

inco

me

sp

rea

d

Unw

ind

UF

R,

VA

, C

RA

etc

.

Rele

ase

of

SC

R

Rele

ase

of

risk m

arg

in

Oth

er

asse

tre

turn

s

Life

ca

pita

lg

en

era

tio

n

• UK Annuities:

− Capital generation: Excess spread recognised upfront under (MA); capital release key

− IFRS: Profit recognised upfront (MSSB)

• Dutch Group Pensions:

− Capital generation: Excess spread partly earned through (VA); capital release key

− IFRS: Accrued and earned through

Source: Goldman Sachs Global Investment Research. *includes release of default provision.

Many factors determine growthPricing, profit and capital dynamics key considerations

02 October 2018 10

APE has been rising for UK insurers (L&G UK) APE has been falling for Dutch insurers (NN NL Life)

• UK annuities:

− Pricing: MA facilitates aggressive pricing for new business based on target asset mix

− Capital/profit: New business incurs a capital strain, but profit is recognised upfront


− Pricing: VA pricing is more “market-based” and usually less attractive

− Capital/profit: Capital and profit largely earned through


0

100

200

300

400

2011 2012 2013 2014 2015 2016 2017

0

750

1,500

2,250

3,000

2011 2012 2013 2014 2015 2016 2017

Is growth good?Asset risk is an important consideration

02 October 2018 11

MA asset gearing is relatively high (L&G UK) VA asset gearing is more conservative (NN NL Life)

• UK Annuities:

− Asset Mix: Skewed to riskier asset classes

− Aggregation of credit risk: Aggregates credit risk & greater asset leverage


− Asset Mix: More conservative driven by liability profile & liquidity (duration)

− Aggregation of credit risk: Spread is earned through


4.4x

1.9x 1.8x

0.8x0.4x

4.5x

2.0x 1.8x

0.8x0.4x

0x

1x

2x

3x

4x

5x

Governmentbonds

Mortgagebonds

Corporatebonds

Property Equity

Assets/EOF Assets/EOF (ex. VA)

3.4x

2.1x

0.8x 0.6x 0.2x

6.4x

3.9x

1.4x1.0x

0.3x

0x

2x

4x

6x

8x

Corporatebonds(rated)

Corporatebonds

(unrated)

Equity Governmentbonds

Property& other

Assets/EOF Assets/EOF (ex. MA)

What drives investor returns?

02 October 2018

“Economic value” creation and capital returns

IFRS profit growth has been strong and stableShare price movements have been more nuanced

02 October 2018 13

European insurers have seen strong earnings growth However, valuation (multiples) have shown little trend

• Reported metrics:

− Current IFRS and Traditional Embedded Value metrics provide a view of stability

− Historic book value approach (“locked-in”) creates smooth profit and “cash”

• Share price movements:

− Continue to be influenced by underlying economic factors

75

100

125

150

175

200

Jan-1

0

Jan-1

1

Jan-1

2

Jan-1

3

Jan-1

4

Jan-1

5

Jan-1

6

Jan-1

7

Jan-1

8

Allianz AXA Generali Zurich

0

50

100

150

200

250

Jan-1

0

Jan-1

1

Jan-1

2

Jan-1

3

Jan-1

4

Jan-1

5

Jan-1

6

Jan-1

7

Jan-1

8

Allianz AXA Generali Zurich

Source: Datastream, Goldman Sachs Global Investment Research.

Two components to investor returnsGrowth in “economic equity” and capital returns

02 October 2018 14

Schematic of insurance company investor returns

• “Market-consistent” roll-forward:

− Provides a holistic view of capital creation

• Cash dynamics:

− Ability to fund cash flows to shareholders

Source: Goldman Sachs Global Investment Research. ROEE = Return on Economic Equity.

Economic Value Creation Capital Returns

Investor Returns

Holding Company Flexibility Remittance Profile

Market Value of AssetsMarket Value of Liabilities

(iii) Solvency II Capital (iii) Available Liquid Assets

Economic Equity

Including ROEE

Driving returns on economic capital Driving cashflows to shareholders

(i) Unencumbered Liquidity

(ii) Leverage Capacity (ii) Solvency II Capital Generation

(i) Local GAAP & IFRS earnings

Should dividend policies be linked to IFRS?IFRS focus creates unusual incentives

02 October 2018 15

Dividend policies are predominantly linked to IFRS With remittances expressed as an IFRS ratio

• Dividend policies:

− IFRS based: Most insurers continue to tie capital returns to IFRS

− Growing: Steadily rising IFRS profit has translated to robust dividend growth

• Cash dynamics:

− Remittance ratio: Insurers tend to describe remittances in terms of an IFRS ratio

− Cash upstream: True cash emergence is less linear


Policy Target Basis

Ageas Pay-out 40-50%IFRS net profit on

insurance activities

ASR Pay-out 45-55%IFRS net operating

profit

Aviva Pay-out 55-60% (by 2020)IFRS net continuing

operating profit

L&G Progressive 7% CAGRAnnual growth in

dividend

NN Group Pay-out 40-50%IFRS net ongoing

operating result

c.85%

>80% c.75-85%

c.75%

60%

65%

70%

75%

80%

85%

90%

Zurich Allianz AXA Aviva

Insurance Capital Structure

02 October 2018

Engineering Returns & Dividends

Internal capital structures maximise returnsInsurers manage multiple balance sheets

02 October 2018 17

Insurers need to manage subsidiary and group balance sheets in parallel


Sub. SCR

Sub. SCR

Sub. SCR

Sub. SCR

+ =

EOF = 400 SCR = 300 EOF = (100) SCR = (100) EOF = 300 SCR = 200

Group

EOF

Solvency Ratio = 133% Solvency Ratio = 150%

Subsidiary Capitalisation Linking Items Group Capitalisation

Sum of Subsidiaries Consolidation Adjustments Group Capitalisation

Group

SCRUsed to materialise

Group Diversification

benefits

Diversification between

subsidiaries

"Trapped" capital

(2) Group

Diversification

(3) Double

Leverage

(4) Intra-group

Transactions

(1) Transferability

& Fungibility

Ea

ch

lo

ca

l su

bsid

iary

must

be a

dequate

ly c

apitalis

ed

on a

sta

nd

alo

ne

ba

sis

Sub. EOF

Sub. EOF

Sub. EOF

Sub. EOF

• Solvency II is not a one balance sheet approach

− Differential capital treatment still exists at both a subsidiary and group level

• Converting subsidiary capital to central cash

− Four factors to consider

Solvency only one part of financial flexibilityCentral liquidity is a hidden constraint

02 October 2018 18

Are insurers “long liquidity” from a shareholder perspective?

• Group Solvency:

− Solvency II produces a capital amount, which is not a cash metric

• Unencumbered Liquidity:

− Long-term central (unencumbered) liquidity is needed to materialise “capital surplus”

• Leverage Capacity:

− Leverage is the easiest way to create central liquidity


Leverage is the easiest way to create Unencumbered Liquidity

Holding

Company

Unencumbered LiquidityGroup

Solvency

Leverage

Capacity

Holding company flexibility is criticalCash “flow” and cash “stock”

02 October 2018 19

Local “capital generation” remitted to a central pool Central pool acts as a shock absorber

• Cash “flow”:

− Subsidiary capital: Local capital generation key determinant of remittance potential

− Other gating items: Local GAAP remains important for ensuring dividend flow

• Cash “stock”

− Materialising solvency: Unencumbered Liquidity needed to materialise group solvency

− Subsidiary shocks: Managing many local balance sheets


Holding Company

Group solvency

Commercial level: e.g. 130% (a)

Target level: 150% (a+b)

Commercial level: e.g. 130% (a)

Target level: 150% (a+b)

Subsidiary Solvency Subsidiary Solvency

Buffer: e.g. 20% (b) Buffer: e.g. 20% (b)

Remittances help

build central buffer

Central buffers can

be used to

strengthen subs

Leverage capacity (a)

Unencumbered Liquidity (b)

Central liquidity buffer (a+b)

External

financing

Capital returns

M&A potential

Entity 1 Entity 2 Entity 3 Entity 4Capitaliz

ation

Reg.

minimum

+ buffer

Group

Local

Central Liquidity Buffer

Ris

k C

apital

Ris

k C

apital

Ris

k C

apital

Ris

k C

apital

Is the long term cost too high?

02 October 2018

Taking stock of change

UK insurers are at a cross roadThe market is bifurcating

02 October 2018 21

Insurers are choosing their business model Investors appear to value simplicity

• A tale of two markets:

− UK Wealth: Greater scope for product differentiation and pricing power

− UK Annuities: Heavily intermediated and largely commoditized product

• Considerations:

− Conduct risk: Regulation is driving unbundling in UK Wealth

− Prudential risk: Capital intensity/asset risk in UK Annuities

Source: Company data, Datastream, Goldman Sachs Global Investment Research.

UK WEALTH UK COMPOSITE UK ANNUITIES

Aegon (Cofunds) Just Group

IntegraFin (Transact) Legal & General

Old Mutual (Quilter) Aviva Lloyds Bank (Scottish Widows)

Prudential (M&G Prudential) PIC

St. James's Place Phoenix Grop

Standard Life Aberdeen Rothesay Life

33.2x

24.2x

12.6x 12.2x8.3x 8.7x 5.2x

0x

10x

20x

30x

40x

Transact SJP SLA Quilter Aviva L&G Just

UK wealth UK annuities

1-year forward P/E

Wealth average

Annuity average

Evolving reporting standardsIFRS17 has potential to provide a better view of “economic value” creation

02 October 2018 22

Timeline of required/optional reporting standards

• How have reporting standards evolved?

− The never ending question of “costs of goods sold”

− Market-based approaches provide a more realistic view

• Are reporting standards converging?

− IFRS17 provides an opportunity to more closely align profit, capital and economics

− But, insurers still have flexibility (e.g. top-down approach)


Required

disclosure

Optional

disclosure

US GAAP /

Local GAAP IFRS 4

Traditional

Embedded

Value

European

Embedded

Value

Market

Consistent

Embedded

Value

Solvency II IFRS 17

Deterministic-based approach Market-based approach

An agency problem?Balancing policyholder and shareholder interests

02 October 2018 23

• Simply an insurer can be considered an asset manager with guarantees

− Long-term nature of business makes it easy to conceal long- term difficulties

− Link between returns for policyholders and returns for shareholders provides incentive

to maximise returns

− However market consistency & risk based capital incentivises management to reduce

risk

− Linking capital requirements to asset portfolio risk helps align policyholder and

shareholder interests

− A move further away from market consistent principles may provide incentive for

excessive risk taking and financial engineering

02 October 2018 24

The views expressed in this presentation are those of invited contributors and not necessarily those of the IFoA. The IFoA do not

endorse any of the views stated, nor any claims or representations made in this presentation and accept no responsibility or liability

to any person for loss or damage suffered as a consequence of their placing reliance upon any view, claim or representation made

in this presentation.

The information and expressions of opinion contained in this publication are not intended to be a comprehensive study, nor to

provide actuarial advice or advice of any nature and should not be treated as a substitute for specific advice concerning individual

situations. On no account may any part of this presentation be reproduced without the written permission of the IFoA or Goldman

Sachs.

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