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How Solvency II is shaking up the insurance investment world

Published March, 2016 |

Conduct and consequences Print

From 2012 up until the market turbulence of early 2016, European insurers have seen strong share-price growth, driven by improved profitability and healthy dividend payouts. This growth has been underpinned by a simplification of business models and metrics, with cash generation being central to the investment proposition.

Insurers, however, have been forced to reappraise that proposition due to the introduction of Solvency II on 1 January this year. The EU-wide insurance regulatory regime has replaced 14 Europe-wide insurance directives and introduced a new-harmonized EU-wide insurance regulatory regime.

The new regime, which varies significantly from that of Solvency I, acts as a catalyst for investors to re-examine the sustainability of ever-increasing dividends in a prolonged low growth, low interest rate environment.

What Solvency II means for an investor in the sector is not yet fully understood. Much of the early disclosure from companies has been explanatory: how it works; the components of capital (own funds) and solvency capital requirements; and high-level reconciliation to previous capital metrics. In particular, this includes Solvency I and economic capital. Underpinning this has been a reassurance that everything is under control, while pointing to significant uncertainties (for example, internal model approvals were only received in Q4 2015).

In our view, insurers need to address five critical questions to determine expectations for dividends and value:

1. Does the insurer have adequate and stable solvency to an extent that current and future dividend streams aren’t constrained?

2. What is the expected run rate of capital generation and how does that translate to investor returns?

3. Can insurers continue to grow earnings and dividends in a low growth, low interest rate environment?

4. How are earnings and capital generation converted to free cash flow that’s available to shareholders?

5. Is the insurer pricing new business rationally and ‘earning’ their future margins embedded in the base balance sheet through best-estimate assumptions?

It’s clear that both insurers and investors are at an early phase in bringing these themes together – and that, in light of Solvency II, insurers have yet to fully articulate their value proposition and provide the means for investors to assess strategic implementation. There will be a real need for greater cooperation across finance, risk and actuarial functions in order to provide coherent information to internal and external stakeholders. This is likely to require more agile and efficient processes to deliver information in a timely and cost-effective manner.

Schematic of the investment proposition and the linkage between capital generation, cash and dividends