Being well capitalized is key for insurers. Both insurers and investors have realized that traditional metrics (i.e. IFRS profits) do not sufficiently take this into account, and that the ability to create (free) capital is more important than traditional definitions of profitability. This caused a shift in their focus from traditional metrics to those taking into account the level of capitalization, such as ‘Free Capital Generation’ (FCG). A positive capital generation means there is an upward trend in the solvency position, which means an insurer has the capacity to distribute dividend and reward shareholders, as well as make investments for future growth. Despite its technical appearance and relation with the prudential regime (Solvency II), optimizing capital generation is not just an exercise for the Finance and Actuarial departments. It is directly related to the insurers’ strategy and operations and, therefore, requires the involvement of multiple fields of expertise within the organization.
Why FCG is becoming more important
The overall performance of the insurance sector is under pressure due to several factors, such as increased competitiveness, the push towards digitization, changing market circumstances (i.e. low interest rates), the run-off of profitable closed life books and changing customer demands. Insurers are now, more than ever, reconsidering their business model. This has led to a dynamic environment in which new entrants are closing in on the market (e.g. digital insurer Lemonade) and M&A activity is increasing, whereas Private Equity plays an important role (e.g. acquisition of Vivat). This dynamic environment drives insurers to critically rethink their strategy and profitability in their search for success. Success in this respect can be measured by one’s capability to grow their Solvency II ratio (i.e. generate free capital). In turn, the magnitude of ‘success’ dictates the firm’s ability to pay dividends or make future (strategic) investments. The solvency position is typically the main restriction on dividend payments.
“FCG is the amount of free capital an insurer can make, in excess of its Target Capitalization. FCG is the main constraint for dividend payments and strategic investments, which makes it one of the most important financial metrics for investors.”
What differentiates sustainable and non-sustainable FCG?
Insurance companies typically distinguish between sustainable and non-sustainable FCG. The distinction between the two is essential as sustainable FCG shows the insurer’s structural ability to generate capital whilst non-sustainable FCG shows variation as a result of unexpected and uncontrollable circumstances.
Subdividing the two is not trivial, and often insurers struggle with this. The main criterion for distinction is management’s ability to control it: i.e. economic variance (in its deviation from expectation) is often regarded as non-sustainable whereas the expected (excess) return is considered to be sustainable.
Why the whole C-suite should drive FCG performance (and not only the CFO)?
With the increased focus from investors and regulators on FCG, insurers’ management needs to have a strong focus on (the improvement of) FCG as well. This can only be achieved if FCG, as a metric, is embedded in strategy, processes and decision making throughout the insurer’s organization. Clear examples of strategic decisions and measures where FCG played a crucial role are reflected in Nationale-Nederlanden’s choice to reinsure (part of) its longevity risk and Aegon’s decision to outsource its individual life policies. By outsourcing its individual life policies, Aegon was able to lower its operational cost base significantly, whilst also increasing their free capital due to decreases in the expense reserves and Solvency Capital Requirements. This clearly shows that these decisions have a much wider impact than solely the Finance, Risk or Actuarial domain, and will therefore be on the agenda of the entire boardroom.
It is important that the board gains insights into the levers that can be used to enhance capital generation. These levers go beyond the traditional levers for financial performance (e.g. cost savings), but include advanced levers such as balance sheet management, business process outsourcing, M&A, and tax. It should be noted that there is no one-size-fits-all approach as the levers vary in effectiveness per insurer. Therefore, KPMG has developed a FCG Maturity Scan, which analyzes the different FCG areas that are relevant for an insurance company (see the figure below), and is designed to specifically point out the relevant areas to improve upon.