Free Capital Generation · 2020-02-25 · their dividend policy. The basis for dividend remains the...

Free Capital GenerationBest practices in reporting on Free Capital Generation—November 2019

2© 2019 KPMG Advisory N.V., registered with the trade register in the Netherlands under number 33263682, is a member firm of the KPMG network of independent member firms affiliated with KPMG International Cooperative (‘KPMG International’), a Swiss entity. All rights reserved.

Free Capital Generation (FCG)

Free Capital Generation (FCG) is becoming the most important disclosure metric for European insurance companies. An insurance company’s ability to generate 'Free Capital' reflects the potential to pay out dividends or make strategic investments in the future.

This survey shows:― how FCG is taken into account in the communication

towards external stakeholders;― how companies rank in terms of FCG generated

throughout the year; ― how this relates to dividend payments;― what management actions were taken to achieve a

higher FCG; and― the trends in FCG.

Survey scope

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 FCG is a very relevant metric in internal management reporting as well, the survey is solely based on public disclosures in 2019 on YE2018 numbers.

Introduction

Concept of FCG in this report1 Page 4

FCG as a performance metric2 Page 7

FCG and dividend3 Page 11

Improving balance sheet and FCG4 Page 14

Deep dive 1: Assets5 Page 17

Deep dive 2: Benefits of diversification6 0

FCG risks7 Page 23


Key messages

1

2

3

4

5

7

6

FCG reporting is a key element in analyst presentations, limited appetite for providing FCG forecasts

All companies reporting on FCG now also report on the ‘sustainable’ component of the FCG

Positive trend in the ‘sustainable’ FCG (2016-2018)

Dividend policies remain IFRS-oriented

Improving FCG is seen as a key management goal

No clear trend in SCR market risk that indicates substantial re-risking or de-risking of the asset portfolio

KPMG’s Free Capital Generation framework can help to identify opportunities to improve the FCG position, and the ability to generate FC in the future.

Diversification benefit is generally stable over time

1. Concept of FCG in this report


The total FCG in a year is the net result of several elements, e.g. expected investment return, updates of assumptions, model changes or new business. A distinction can be made between elements that are considered to be ‘sustainable’ and ‘non-sustainable’:

Sustainable FCG 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).

Non-sustainable FCG elements complement the sustainable FCG in the actual change in the Free Capital Position. Sources of non-sustainable FCG are: economic variance, external circumstances or one-off actions.

The next page includes an overview of different sources of Free Capital Generation.

1. Introduction to Free Capital Generation (FCG)

FC

FC

Total Free Capital Generation

2018 2019

Dividend Paid

Sustainable FCG

Non-sustainable FCG

TC

FC

SCR

EOF

To determine the Free Capital (FC) generated, an insurer starts by determining the Eligible Own Funds (EOF). EOF entail the surplus of assets over liabilities available to absorb shocks as prescribed in Solvency II.

The Solvency II regulation also prescribes the capital an insurer is required to maintain on its balance sheet, the Solvency Capital Requirement (SCR). Insurers typically have more own funds, depending on the Target Capital (TC) defined by the risk appetite, typically 150%-190% of the SCR. FC is any EOF in excess of TC.

This definition of FC is based on Solvency II, which is a prudential framework based on prescribed estimates (e.g. yield curve and contract boundaries), which do not necessarily reflect an economic view. However, as the Solvency II position is generally the main constraint for dividend payments, it is a more relevant framework than, for example, IFRS profit.

Determination of Free Capital

Generation of Free Capital

Free Capital is the amount of Eligible Own Funds above the internal Target Capital.


Sources of FCG

SCROwn Funds

(+) Expected investment return

(+/-) New business

(+) Release of RM

(-) UFR drag

(+) Release of TVOG

(-) Financing costs

(+) SCR release

(-) SCR new business

(-) Transitionals

Sustainable FCG

Actual FCG

Non-economic variance

Economic variance

Assumption changes

Model changes

Regulatory changes

Management actions*

* Management actions can be placed in different categories, depending on the nature of the action.

Dividend payment

Definitions used by insurers can be quite different, and are subject to change. We distinguish the following components:

(+/-) Management actions*

(+/-) Management actions*

1

3 1

2

3

3

2

2

2

#

#

Life insurer’s main sources of FCG

Non-Life insurer’s main sources of FCG

2. FCG as a performance metric


FCG is generally disclosed as part of the bridge between two (consecutive) years of Solvency II ratios.

― FCG has a prominent place in nearly all investor reports. The share of insurers reporting on Free Capital Generation as a performance metric has grown in 2016 and 2017, but has stabilized last year.

― We observe that once insurers start to disclose FCG for a certain year, they generally will keep on disclosing the FCG in the years forward. In 2018, none of the insurers in our survey stopped disclosing FCG.

― Companies are reluctant to provide forecasts for future FCG. In some cases, companies have difficulties in defining a stable definition and framework, in other cases companies seem reluctant to create additional expectations.

― For all Dutch insurance companies, FCG has a prominent place in the public reporting.

2.1 FCG disclosure

Not reporting16%

Reporting84%

Share of insurers reporting on FCG


Clear communication on FCG means showing to investors what part of the FCG was sustainable, and what part was caused by external influences or one-offs.

― For the first time since this survey was started, all companies reporting FCG figures show the ‘sustainable’ component.

― The way publications 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.

― Dutch insurance companies are relatively open with respect to the sources of their sustainable FCG.

2.2 Sustainable FCG

Yes48%

Yes74%

Yes84%

No 29%

No 11%

No Ref24%

No Ref16%

No Ref16%

0%

20%

40%

60%

80%

100%

2016 2017 2018

Sustainable FCG shown separately


The sustainable part of the FCG is a way to compare the financial performance of insurance companies. The larger the sustainable FCG (as a part of SCR), the better the performance of the company.

― For all companies included in this survey, the sustainable FCG has increased over the past three years. The median values of the sustainable FCG (as a % of SCR) were 10% (2016), 16% (2017) and 18% (2018). The increase could relate to the increasing relevance of FCG as a reporting metric, an increased ‘grip’ on Solvency II figures and drivers, or a general positive trend for the sector.

― As definitions of the sustainable part can vary significantly, caution is required when interpreting the figures.

― New business may skew the sustainable FCG if volumes are material.

― The Dutch companies perform in line with the European market.

2.3 Performance

-

10%

20%

30%

40%

50%

60%

70%

< 0% 0%-10% 10%-20% >20%

% o

f ins

urer

s

Sustainable FCG as percentage of SCR

2016 2017 2018

3. FCG and dividend


Management knows that analysts will consider a decrease in the dividends as a sign of weakness. So, management’s priority is to maintain dividends, in contrast to the regulator whose priority is to require an adequate level of Own Funds. The impact of dividend on the Solvency II ratio is considered on this page.

― For FY2018, on average, dividend pay-outs amount to a deterioration of 8.5% of the Solvency II ratio (see graph)*. This is slightly higher than in previous years (7.9% in 2017; and 7.6% in 2016).

― 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).

3.1 Dividends and Solvency II ratio

*The graph shows the actual paid dividend in FY2018, applied to the Solvency II ratio at YE2018. Share-buy-back is not taken into account.

-14%

-12%

-10%

-8%

-6%

-4%

-2%

0%

Deterioration of SII ratio following dividend pay-out in 2018

Average: -8.5%

Dynamics of dividend on the SII ratio is due to cash leaving the insurance company.

EOFSCR


The vast majority of the insurers did not change the sources in their dividend policy. The basis for dividend remains the IFRS Net Profit. Some companies have expressed a higher ambition or dividend target.

― Only one company in the survey group revised the policy regarding dividend payments. Achmea has excluded the result of their Health business from the dividend basis.

― Aegon stands out by giving FCG a prominent role in their dividend policy.

3.2 Dividend policy changes

Yes5%

No95%

Did the dividend policy change since last year?

4. Improving balance sheet and FCG


4.1 Improving the FC position

Internalmodel

Und

erw

ritin

g/Pr

icin

g

Cro

ss-s

ellin

g

This word-cloud shows the management actions referred to in analyst presentations and annual reports of the companies in the survey group.

Usually no information is provided on the exact impact of these management actions. To determine the impact, a clear split between short term (sometimes called the FCG 'stock') and the long term ('flow') needs to be made.


This overview shows the 'menu' used by KPMG to optimize insurers’ FCG and balance sheet. For each topic, a detailed list of items is available that can be benchmarked, to give insight in the actions to improve the Free Capital Generation.

4.2 KPMG Capital Generation framework

Create Stable definition

Provide Clear communication

5. Deep dive 1: Assets


5.1 Asset allocation among insurers For both Life and Non-Life insurers investment income is one of the most important sources of (sustainable) Free Capital Generation. This stresses the importance for an optimized asset allocation.

― The figures indicate that the asset allocation shows a huge variability (i.e. allocation of government bonds between 20% and 70%.

― The Dutch market shows a significantly different allocation compared to the overall survey group. Dutch insurers typically invest more in Loans and Mortgages at the expense of Corporate bonds.

― There is no evident correlation between the (sustainable) Free Capital Generation and the allocation to a certain investment category in 2019 (not shown).

Asset allocation distribution of all insurers in the survey Asset allocation distribution of Dutch insurers in the survey

Amounts of assets, expressed as a % of total investments in equity, government bonds, corporate bonds, other bonds, property, and loans and mortgages. The box represents the 25th percentile, 50th

percentile (median) and 75th percentile. The whiskers show the minimum/maximum of the observations with outliers excluded.


-

20%

40%

60%

80%

100%

120%

SCR Market Risk (as % of total SCR) over time

SCR Market Risk as % of total SCR (2016) SCR Market Risk as % of total SCR (2017) SCR Market Risk as % of total SCR (2018))

5.2 SCR market riskThe SCR market risk can be seen as a measure of market risk taken by an insurer. For comparability purposes, the SCR Market Risk is expressed as a percentage of the Total SCR.

― Typically, the SCR market risk as a % of SCR lies in the range of 40%-75%.

― The search for yield has not resulted in an increase in SCR market risk. In 2016 and 2017, the SCR market risk increased for 50%-60% of the insurers, whilst only for 25% the risk increased both years (not shown). This suggests that if insurers are looking for yield, they are able to optimize their asset management in such a way that the impact on SCR is limited.

― Exploring the relationship between the SCR for market risk (as a percentage of the total SCR) and the Free Capital Generation, did not show any particular trend (not shown).

Dutch insurers

0% 10% 20% 30% 40% 50% 60% 70% 80% 90% 100%

From 2016 to 2017

From 2017 to 2018

Did the Market SCR (as % of the total SCR) increase or decrease?

Yes No

6. Deep dive 2: Benefits of diversification


6.1 Diversification benefits per insurer

0%

20%

40%

60%

80%

100%

120%

1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16

Diversification benefit as % of gross SCR

Average: 54%

Most companies disclose the diversification benefits between individual risks in terms of SCRs.

― Depending on their composition, there is a wide range of outcomes. The most diversified companies are the Reinsurers in the benchmark, followed by Insurance groups.

― The average benefit amounts to 54%. Please note that this includes diversification between the main risk types: market, Life and Non-Life risk, not within one risk type. Please note that within one risk type, companies may seek further diversification benefits. These numbers are, however, often not publicly available.


6.2 Trend in diversification benefitsOptimizing diversification seems a logical way to help generate Free Capital. Changes in the asset mix or product mix, or acquisitions, can lead to additional future FCG with a limited impact on the available Free Capital.

― No clear trend towards more diversification is visible in the available data. The average diversification benefits are quite stable (2017: 53%; 2018: 54%), although for some companies changes of more than 10% are noted.

― Although the diversification benefits change slightly over time, there is not a clear trend towards maximization of the diversification benefits. The changes in benefits are likely to be a result of market changes, rather than the result of a strategy to improve diversification.

― The overview does not show a change in diversification between the assets (within the market risk category), only the top level diversification.

0

2

4

6

8

10

12

# In

sure

rs

Histogram of diversification benefits % change over time

2016 to 2017

2017 to 2018

7. FCG risks


7.1 Interest rate sensitivity shocksInterest rate risk is one of the key drivers of balance sheet volatility.

― For most companies, there is a negative impact on the ratio between 0% and -/- 10% (percentage points). For some companies, a decrease in interest rates has a positive impact on the Solvency II ratio.

― The sensitivity shown for interest rate decreases explains, with the sharp decrease in interest rates between YE2018 and September 2019, the negative trend in Solvency II ratios during that period in the industry.

― For long durations, insurance companies need to choose between hedging the Solvency II ratio, or hedging on an economic basis.

Change in Ultimate Forward Rate (UFR).

― The UFR is currently decreasing by 15 bps per year. Several companies anticipate a future decrease in UFR compared to the 4.05% level at YE2018 by calculating sensitivities.

― The impact of a 15 bps decrease in UFR varies throughout the overall survey group between 0% and -/- 4% (percentage points)

― The impact of a change in UFR is relatively large for the Dutch insurance companies in the survey group.

0%

30%

<-15% [-15%; -10%] [-10%; -5%] [-5%; 0%] >0%

Impact on SII ratio of a change in interest rates of -/- 50 bps (parallel)

0%

40%

<-3% [-3%; -2%] [-2%; -1%] [-1%; 0%]

Impact on SII ratio of a change in UFR of -/- 15 bps


7.2 Other sensitivitiesOne of the key measures taken to improve the Free Capital Generation, is to optimize the assets in terms of return and SCR. With the focus on high-yield assets, additional market risks get a more prominent place.

― Most companies report on the impact of a change in equity prices on the Solvency II ratio.

― Typically, the impact is between -/- 10% and 0% (percentage points). This is somewhat higher than expected, if one considers only the reported investments in equity.

― Compared to the market, the Dutch insurance companies have a relatively small equity exposure.

Corporate bonds are a popular investment category throughout Europe. As a result, changing credit spreads can have a significant impact on the Free Capital position.

― A wide range in credit spread sensitivities is reported. Typically, an increase in credit spread leads to a decrease in the market value of the assets, with a negative influence on the Solvency II ratio.

― Due to the compensating effect of the volatility adjustment (VA), or a dynamic VA, an increase in spreads can also have a positive impact on the Solvency II ratio.

0%

50%

<-10% [-10%; -5%] [-5%; 0%] >0%

Impact on SII ratio of a change in equity prices of -/- 20%

0%

40%

<-10% [-10% ; -5%] [-5%; 0%] [0%; 5%] >5%

Impact on SII ratio of a change in credit spread of +50 bps

The contacts at KPMG in connection with this report are:

Jeroen van WageningenFinancial Risk ManagementPartnerKPMG Advisory N.V.Tel: +31 (0)20 656 2409Email: [email protected]

Jeroen GielenFinancial Risk ManagementSenior ManagerKPMG Advisory N.V.Tel: +31 (0)20 656 7123Email : [email protected]


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;

― the financial structure does not require or incentivize reporting Free Capital Generation on Solvency II principles.

Reporting

The survey is based on reporting per YE2018. 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― UnipolSai― VIVAT

CRO Forum members Swiss Re and Zurich were not included in the survey because of the selection criteria.

Appendix I: Insurance groups in the survey


Appendix II: GlossaryActual FCG 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.

Economic variance A change in FCG because the financial market conditions evolved in a different way (compared to the expectation).

FCG Free Capital Generation.

(Excess) Investment return The investment return that is expected on the asset portfolio that exceeds the risk free rate used for discounting the liabilities.

OF Own Funds.

Non-economic variance A change in FCG because the portfolio/claims evolved in a different way than expected.

RM Risk Margin as defined by Solvency II.

RM release Release of Risk Margin (RM) over time due to run-off of the portfolio.

SCR Solvency Capital Requirement.

SCR release Release of required capital (SCR) over time due to run-off of the portfolio.

SFCR Solvency and Financial Condition Report.

Sustainable FCG 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.

TVOG Time value of options and guarantees; typically only a small contribution to the FCG.

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