The question facing insurance shareholders since Europe’s Solvency II rules took effect in January 2016 has been how exactly an insurer should be run under the new regime. This year, Allianz emerged as a popular template.
Analysts at firms such as Deutsche Bank, Goldman Sachs, Keefe, Bruyette & Woods (KBW) and UBS have extolled the insurer’s approach, in particular its use of forward-looking stress tests and capital-sensitive management metrics.
Shareholders have responded well, too. The insurer’s stock outperformed the Stoxx Europe 600 insurance index by 18 percentage points over the 12 months to late November.
“They have presented a very credible story to the market,” says an insurance consultant. “They embody what you’re supposed to do under Solvency II, which is use your model to drive business decisions: to make investments; write products; and allocate capital to different business units.”
In essence, Allianz has understood – and helped build – the emerging industry consensus on how an insurer’s solvency position affects shareholder value.
The genesis of its approach was in 2015, says Thomas Wilson, the insurer’s chief risk officer. “We realised there was going to be shareholder attention on dividends but that capital was going to be a binding constraint – and a much more volatile binding constraint – on paying them,” he explains.
“If people believe you will be forced to do a capital raising, or that events might impact the dividend streams they’ve come to love, the share price will drop precipitously,” he says.
With these pressures in mind, Allianz overhauled how it sets the firm’s risk appetite, with a revised approach coming into effect in 2016.
At its heart is a programme of forward-looking stress tests, to ensure Allianz could get through scenarios such as a repeat of the 2008 crisis without being pressured to raise capital.
Solvency II had arrived, markets were not friendly and there was a learning process that shareholders, analysts, companies and management needed to go throughThomas Wilson, Allianz
Internally, it was a tough sell at times. Wilson says the board questioned the 205% Solvency II coverage ratio he proposed in its 2016 planning round for this year. “[It] seems a high number,” he says, “but it depends what risk you are taking. It could be weak if you have big asset/liability interest rate mismatches or re-risking in real assets.”
But as stakeholders have got used to the new environment, Allianz’s methods have gathered admirers.
“[Allianz’s] discussion about capital management at the beginning of this year was … a watershed moment,” KBW analysts wrote following the insurer’s analyst presentation in February.
A July report from UBS used Allianz’s methodology for determining its Solvency II capital target range as the basis for a cross-industry comparison of firms’ solvency positions. Goldman Sachs analysts commended the insurer for its “particularly clear exposition of its planned target capital coverage ratios post a stress event”.
As Wilson describes the past 18 months: “Solvency II had arrived, markets were not friendly and there was a learning process that shareholders, analysts, companies and management needed to go through.”
The details of Allianz’s new approach bear similarities to the Comprehensive Capital Analysis and Review process required of US banks, though it is “quite radical” for an insurer, Wilson says.
To set incentives to change the new business mix – to shift the business quickly – you have to use forward-looking metricsThomas Wilson, Allianz
So, how does it work?
The firm targets a minimum 135% solvency coverage ratio in all five of its stress scenarios, since anecdotal evidence shows shareholders react to worsening conditions below that level, he explains. Allianz will review its dividend if the ratio falls below 160%.
At the same time, the insurer has switched to using management ratios designed to steer it away from business lines that might weaken this capital position.
“To set incentives to change the new business mix – to shift the business quickly – you have to use forward-looking metrics,” Wilson says. He draws a parallel with the introduction of measuring risk-adjusted return on capital by banks in the late 1980s, at a time when they were trying to switch their focus to trading over traditional banking.
In addition to traditional measures such as revenue, earnings growth or return on equity, the firm uses return on risk capital to make sure new business is capital efficient and adds value for shareholders, he says.
With these metrics in place, Allianz’s business has changed markedly. The company has raised its new business margin to more than 3% despite the current low-rate environment, with a return on risk capital for new business of 15%. Simply put, it is writing much less of the capital-heavy business typical of European insurers in the past.
Losing legacy business
In mid-2017, capital-light alternative guarantee and unit-linked retirement products comprised 68% of life new business, compared with 41% in 2014. Allianz has also been ruthless in divesting legacy business such as its Korean life insurance business and parts of its Taiwanese life portfolio.
On the asset side, the insurer has been an enthusiastic player in alternative assets such as private equity, renewable energy and infrastructure – increasing its holdings to 6% of total assets in alternative equity and 8% in alternative debt.
These products are attractive from a return on risk capital perspective because of the liquidity premium they yield.
Looking forward, Wilson says IFRS 17, C-Ross in China and the NAIC’s review of capital charges for credit and variable annuities mean this narrative of change can be expected to play out for insurers and investors elsewhere. “Regulation, headwinds to earnings growth and shareholder expectations are putting risk and capital management in the lead role for delivering shareholder value,” he says.