Best practices for free capital generation

Introduction

Since the implementation of Solvency II there is an ongoing shift from the IFRS accounting framework to the solvency ratio as metric of choice, to assess the financial performance of European insurers. Analysts, regulators, and other stakeholders are nowadays mostly interested in the performance and future ability for 'free (or net) capital generation' (FCG), which is related to the Solvency ratio.

An insurance company's ability to generate 'free capital' reflects the potential to pay out dividends or make strategic investments in the future.

What are the strongest drivers for future FCG? And what are the main risks that diminish this ability? How beneficial is the current and projected business and investment strategy from the perspective of FCG?

A clear and consistent framework of how (free) capital is generated enhances an insurer's understanding of the drivers of capital generation, and identify opportunities to improve FCG. This article provides insights in the best practices on how to address this topic.

Consistent framework for free capital generation

Under Solvency II, 'free capital' is defined as the amount of Eligible Own Funds in excess of either the regulatory solvency capital requirement (SCR) or, to be more prudent, the target capital (typically 150 to 190% of the SCR). An insurer's ability for FCG is hence defined as the change in the amount of free capital over time excluding dividend payments.

Drivers of free capital generation are divided into two categories: 'sustainable' drivers and external or unique events (e.g. regulatory requirements or model changes). Management of this sustainable capital creation is essential for stable solvency ratio and dividend payments over time. A multi-year horizon is important, since management actions could improve the short-term solvency position but deteriorate the business profitability in the long run.

A 3-step approach supports insurance companies to construct a consistent framework to manage FCG:

1. Identify drivers of sustainable capital generation
2. Define management actions
3. Confront capital generation expectations with the actual results

1. Identify drivers of sustainable capital generation

The sustainable part of FCG is a way to compare the financial performance of insurance companies. The graph shows an overview of the main drivers of sustainable free capital. For both Life (green) and Non-Life (blue) an insurer's investment return is one of the most important drivers of (sustainable) FCG.

Which of these drivers are the strongest for future sustainable FCG of a specific insurance company? And which diminishes this ability?

Forward looking analysis of change is a beneficial tool to provide these insights. This is mostly used for past performance analysis, e.g. Market Consistent Embedded Value (MCEV) reporting. However, it is also a powerful tool for a holistic forward-looking analysis to identify the main drivers and risks of sustainable capital generation.

Obviously such an analysis requires additional levels of detail per driver, e.g. for changes in the Time Value of Options and Guarantees (TVOG) this is the attribution to time-, interest-, UFR-, VA and CRA effects. A proper assessment of the risks requires the use of forward looking analysis based on stochastic economic and financial market scenarios. This provides insight in the short and long term sustainability of free capital generation in different economic and financial market circumstances.

2. Define management actions

The insights from step 1 are relevant in revising the strategy and/or defining management actions to utilize the sustainable capital drivers. E.g. to (re-)assess the profitability of specific product offerings. Or to assess the balance between a stable capital position, (dynamic) asset allocation and dividend payments. It is important to test the short and long term effectiveness and robustness of these management actions for FCG in the same framework as step 1.

3. Confront capital generation expectations with the actual results

Finally, insurance companies can analyze the realized performance on FCG from the perspective of this consistent framework. looking back, which sustainable drivers provided the most added value? How does this relate to the specific (market) circumstances? And how could one use this information to adjust future estimates and decision-making, all to support the future ability for FCG?

Concluding remarks

The capacity of sustainable free capital generation is a way to compare the financial performance of insurance companies. A consistent framework to analyze both the performance (ex-post) as well as the forward looking (ex-ante) expected and uncertain development is crucial to utilize the opportunities for future free capital generation and thereby for shareholder and policyholder value creation.