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
Source: Goldman Sachs Global Investment Research.
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
• Dutch Group Pensions:
− Pricing: VA pricing is more “market-based” and usually less attractive
− Capital/profit: Capital and profit largely earned through
Source: Company data, Goldman Sachs Global Investment Research.
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
• Dutch Group Pensions:
− Asset Mix: More conservative driven by liability profile & liquidity (duration)
− Aggregation of credit risk: Spread is earned through
Source: Company data, Goldman Sachs Global Investment Research.
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
Source: Company data, Goldman Sachs Global Investment Research.
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
Source: Goldman Sachs Global Investment Research.
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
Source: Goldman Sachs Global Investment Research.
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
Source: Goldman Sachs Global Investment Research.
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)
Source: Goldman Sachs Global Investment Research.
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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