Dutch slide shows peril of lower solvency ratios

Europe's insurers have been guessing for some time how investors might react to the publication of Solvency II ratios, but they need speculate no longer. The market reaction to European firms' half-year results – some of which lowered expectations for these numbers – has been a mixture of ominous silence and loud disappointment, forging what looks to be an unbreakable bond between share prices and solvency ratios.

Before now equity analysts had tended to focus on cash generation and new business, rather than insurance companies' surplus regulatory capital. But they are increasingly linking solvency ratios – an insurer's capital as a percentage of its Solvency II solvency capital requirement (SCR) – with the ability to upstream cash from subsidiaries to group level, to be paid as dividends. In theory, cutting dividends is a board decision unless a firm breaches its SCR, but some analysts are concerned that coming close to a breach could see pre-emptive regulatory intervention.

Analysts have been scrutinising Dutch firms in particular, as several reported lower-than-expected solvency ratios in August. On August 11, for example, Delta Lloyd said it was reducing its expected solvency ratio from between 140% and 180% to "slightly below appetite level", in other words below 140%. The firm's share price subsequently fell by a quarter from €7.2 ($8.11) on August 10 to €5.3 on August 24.

Aegon followed suit on August 13, reducing its expected solvency ratio from between 150% and 200% to between 140% and 170%, also experiencing a dip in share price – from €6.6 a share on August 12 to €5.2 on August 24.

Annemarie Mijer, chief risk officer at Delta Lloyd, revealed little when presenting to analysts, but did say the firm will use a partial rather than full internal model, using the Solvency II standard formula for operational risk in particular. The firm said its solvency ratio was also affected by market movements, without elaborating further. The insurer did, however, say that "to achieve an optimal balance between yield and risk" under Solvency II, it had sold a large part of its private equity portfolio and would review its commercial real estate portfolio. The firm also reduced its equity investments by €100 million.

Analysts have been scrutinising Dutch firms in particular, as several reported lower-than-expected solvency ratios in August

Meanwhile, Aegon said it had obtained more clarity from regulators on several points, leading the firm to revise its expected Solvency II ratio. This included the calibration of the conversion of its US risk-based capital ratio to Solvency II at 250%, the use of the matching adjustment for its UK business, and modelling for the volatility adjustment in the Netherlands.

"There appears to be a change in thinking from the Dutch regulator, which from a stock market perspective is deeply unnerving," says Trevor Moss, senior insurance specialist on the sales desk at Berenberg Bank in London. "If one reads between the lines on commentary, one can infer the situation with the regulator is one of some delicacy, which is why I think the firms were reluctant to say too much."

Although the focus for now is on the Dutch regulator De Nederlandsche Bank (DNB) tightening up internal models, analysts say other European regulators could do the same. In the UK, for example, the PRA's final ruling on internal models remains uncertain, with approval not being given to firms until early December, one month before Solvency II goes live.

Analysts and rating agencies are keen to point out that the disclosure of Solvency II figures from UK firms in first-half results was poor, possibly owing to uncertainty about what the PRA will decide about internal models. Prudential and Standard Life chose not to disclose Solvency II ratios, for example. But they also chose to hold back economic capital ratios that had been published in previous reports, which investors had been treating as indicative of the likely Solvency II ratio. Legal & General and Aviva reported an economic capital ratio of 220% and 176% respectively, but did not give a Solvency II figure.

Dividends

Returning to the Netherlands, what is worrying investors mainly is the ability of firms to stabilise or increase dividend payments to shareholders. "If the Delta Lloyd board has come up with a desirable Solvency II range, because the company is at the lower end of that range, the board will be less comfortable paying away capital in dividends," says Moss at Berenberg.

In its half-year results, Delta Lloyd says it "aims to pay out a stable annual dividend, subject to internal solvency targets". To resolve the potential conflict between solvency thresholds and dividend policy, the firm says it will raise Tier 1 and Tier 2 capital, hedge key risks and reduce capital-intensive products.

"The point is, why would you buy Delta Lloyd if dividend policy is uncertain while it is worried about capital raising?" says Ashik Musaddi, insurance equity analyst at JP Morgan in London.

For Aegon, although the firm increased its interim dividend to €0.12 per share from €0.11 in 2014, analysts fear its ability to upstream dividends from Dutch and UK subsidiaries will be limited for a couple of years. A reduced solvency ratio and uncertainty around Solvency II rules could also impact the ability of the firm to buy back shares, Musaddi says.

Across Europe, even if Solvency ratios remain above 100%, analysts might still have reason to worry about regulatory action. "We don't look at just the present value of the solvency ratio, we also have a forward-looking perspective," says Romain Paserot, director of insurance supervision at the Autorité de Contrôle Prudentiel et de Résolution (ACPR) in Paris. "If we have the feeling the SCR could be breached in the future, we will ask the undertaking's board for an action plan. We could discuss things like changing investment policy or increasing reinsurance."

The DNB in the Netherlands looks ready to take an even tougher approach, potentially limiting dividends before an SCR breach. Dutch law says an insurer needs explicit permission from the DNB to pay any dividends if its solvency falls below the minimum requirement. Further, the DNB could intervene if it is foreseeable that this will be the case within the next 12 months, says Neal Hegeman, director of asset-liability management at Royal Bank of Scotland (RBS) in Amsterdam.

"This is subjective, but if an insurer has a very low solvency ratio and runs a pretty risky asset mix then the regulator could express a view whether that firm should be paying dividends," he says.

Meanwhile, Solvency II numbers are likely to have an increasingly direct impact on credit investors too. From a credit point of view, lower dividends are better, says Benjamin Serra, senior credit officer at Moody's in Paris. If firms decrease dividends and use their earnings to improve solvency ratios, the agency would see that as credit positive because it reduces the risk of insolvency, he says.

But Moody's has chosen to make an explicit connection between solvency ratios and its capitalisation rating, which will make up around 20% of an insurer's overall financial strength rating, says Serra.

The agency outlined an indicative mapping process in a March paper, where solvency ratios will form part of the capitalisation assessment. Assuming transitional measures are not applied, and with little volatility in the ratio, a solvency ratio of less than 130% would be seen as indicative of a capital adequacy rating of Baa. A firm between 130% and 200% would get an A rating, and above 200% a rating at Aa.

Serra says the calibration relies on the assumption that a 100% Solvency II ratio is equivalent to a 0.5% probability of the firm defaulting on its policyholders' obligations, as per the principle of the Solvency II directive. "The ratio including transitional measures will certainly not be economic, so we would probably not use that for the mapping," he adds.

"The bar has been set pretty high by Moody's," says Paul Fulcher, managing director, ALM structuring at Nomura in London. "Insurers have been quite surprised by the mapping, given that 100% of SCR, excluding transitionals, is needed for a low- to mid-Baa rating. So a firm relying on transitionals to meet its SCR would not qualify."

Instead of mapping capitalisation ratings directly to solvency ratios, Fitch Ratings and Standard & Poor's (S&P) use their own capital models to assess a firm's solvency position, closely related to, but not calibrated with, the calculation of Solvency II ratios. As with Moody's, transitional measures are not taken into account when assessing the adequacy of solvency capital.

"We know there will be discrepancies between those firms using transitional measures and those that are not, but this is not a major concern as our ratings won't be driven by Solvency II metrics," says David Prowse, insurance actuary at Fitch in London. "We assess capital using our own risk-based model, which treats all insurers on a consistent basis unaffected by distortions from transitional measures."

The same goes for S&P. "The use of transitional measures will have no direct impact on the capital adequacy based on our capital model," says Miroslav Petkov, credit analyst at S&P in London. How far equity investors will take into account or put aside the effect of transitional measures when analysing insurers, meanwhile, remains uncertain.

Volatility

The final headache for analysts and rating agencies is how to react to the volatility of firms' solvency ratios. An insurer's position can change quickly if the firm is exposed to unhedged risks with capital charges that might swing dramatically if markets move against them.

Moss at Berenberg says it is possible to "have a stab" at assessing the volatility of the solvency ratio if a firm reports its market-consistent embedded value (MCEV) numbers, a valuation method thought by many to be the most indicative of a firm's performance relative to market volatility. However, not all firms report this, he says. "Aegon no longer produces an MCEV balance sheet and Delta Lloyd never has," Moss says.

Investors could therefore be left in the dark on SCR volatility. This could worsen the negative impact on a firm's share price if, after a period of market stress, it reports a reduced solvency ratio that comes as a shock to investors. One answer could be to target a lower solvency ratio, but one that does not change much if markets move. For example, a firm might choose to allocate more capital hedging risks such as longevity risk, rather than hold it as surplus.

"We were talking to one life insurer that is targeting only around 130% solvency - which might appear somewhat weak – but considering the resilience of their capital to financial markets, the risk of falling close to 100% is negligible," says Prowse at Fitch. "Our capital model, and therefore the rating this firm receives, will reflect this."

From a regulatory perspective, the market's obsession with solvency ratios seems unjustified. Insurers are keen to point out the SCR was designed as a target that firms would fluctuate above and below. They point out that a breach of the minimum capital requirement (MCR) rather than the SCR should be seen as the trigger for regulatory intervention. However, because equity investors are focused on the ability of firms to continue paying dividends, the SCR has become almost a de facto minimum standard.

"Because solvency ratios are volatile, firms need to hold a capital buffer on top, essentially a buffer for capital volatility above the 99.5% confidence level SCR," says Fulcher at Nomura. "It could take time before the market appreciates just how volatile solvency ratios might be. Dutch insurers are already disclosing Solvency II ratios so may be suffering from being the bearers of bad news because analysts have little to benchmark the numbers against."

Meanwhile, Paserot at ACPR argues that investors need to see solvency ratios as just one of many indicators of solvency and performance. "The market needs to learn the meaning of the SCR. The SCR is a complex calculation that aggregates different risks, and it not easy to foresee the impact of only one risk driver on it."

"One should be reminded that the SCR was meant to be a target, not an absolute minimum, so volatility in the ratio should not mean panic from investors," he adds.

Because it is early days in understanding the expected solvency ratio outputs of internal models, Delta Lloyd and Aegon have borne the brunt of investors' anxieties about Solvency II. As investors and analysts are given more information and become comfortable with some volatility in solvency ratios, share price might become less heavily influenced by this one indicator.

"The situation should improve once firms start Pillar 3 reporting next year and disclose the full Solvency II package of information to the market," Paserot says. "An SCR ratio should not be the one and only definitive measure for a firm's adequacy under Solvency II."