Capital efficiency and maximising returns on capital/embedded value

Capital efficiency and maximising returns on

capital/embedded value

Capital efficiency and maximising returns on

capital/embedded value

Deon de KlerkChief financial officer Liberty Group Limited

October 2004

Deon de KlerkChief financial officer Liberty Group Limited

October 2004

• Some background• Lessons from the UK• What we’ve done so far• Our thoughts on level of capital• Our thoughts on mix of capital• Our thoughts on composition of

shareholders’ funds• Conclusion



Capital management

Capital adequacy requirement (CAR)Capital adequacy requirement (CAR)

• Capital considered necessary to ensure obligations to policyholders are met under the majority of adverse and plausible (although unlikely) conditions

• Ensure that likelihood of not meeting obligations is sufficiently low (5% for a number of adverse events)

• Capital considered necessary to ensure obligations to policyholders are met under the majority of adverse and plausible (although unlikely) conditions

• Ensure that likelihood of not meeting obligations is sufficiently low (5% for a number of adverse events)

Some background …

Ordinary CAR (“OCAR”)Ordinary CAR (“OCAR”)

• Capital required to ensure that the company can withstand specific adverse events, each with a 95% confidence interval. Calculation allows for the fact that not all events will occur at the same time.

• Capital required to ensure that the company can withstand specific adverse events, each with a 95% confidence interval. Calculation allows for the fact that not all events will occur at the same time.

Risks addressed

Partial discontinuance

40% iro lapse20% iro surrender

Risk assumptions and fluctuations

MortalityMorbidity

MedicalExpenses

Resilience -30% equities-20% props

3% gilts

Foreign exchange

+ or - 20% negative only

OtherSome background …

Terminal CAR (“TCAR”)Terminal CAR (“TCAR”)

• Capital required if all policies were to lapse or surrender immediately (ie. the difference between the liabilities and the greater of zero and the surrender value)

• Capital required if all policies were to lapse or surrender immediately (ie. the difference between the liabilities and the greater of zero and the surrender value)

31 December 2003 2002

Rm Rm

TCAR 3 403 2 857

Some background …

Why is Liberty on TCAR?Why is Liberty on TCAR?

• High proportion of market-related business vs smoothed bonus business

• Policy reserves in some cases less than surrender values

• Effect of lower discount rate on policy reserves vs surrender values

• Risk product in early years

• Gap between OCAR and TCAR is closing

• High proportion of market-related business vs smoothed bonus business

• Policy reserves in some cases less than surrender values

• Effect of lower discount rate on policy reserves vs surrender values

• Risk product in early years

• Gap between OCAR and TCAR is closing

83

17

69

12

19

0%10%20%30%40%50%60%70%80%90%

100%

Grou

p

Individu

al

Mix of business

Market related Smoothed bonus

Non-profit

83

17

69

12

19

0%10%20%30%40%50%60%70%80%90%

100%

Grou

p

Individu

al

Mix of business

Market related Smoothed bonus

Non-profit

Some background …

Liberty Life’s CAR coverLiberty Life’s CAR cover

0

2

4

6

8

10

12

14

16

19971998199920002001200220031H04

0.00%

5.00%

10.00%

15.00%

20.00%

25.00%

30.00%

CAR multiple ROE

0

2

4

6

8

10

12

14

16

19971998199920002001200220031H04

0.00%

5.00%

10.00%

15.00%

20.00%

25.00%

30.00%

CAR multiple ROE • Unbundled SBIC and Libint in 1999

• Transfer of general reserves to shareholders’ funds in 1999

• Capital reduction by way of special dividend in 2000

• Unbundled SBIC and Libint in 1999

• Transfer of general reserves to shareholders’ funds in 1999

• Capital reduction by way of special dividend in 2000

Some background …

Previous capital reductionsPrevious capital reductions

• R17 billion in total• Capital reduced from R18,3 billion

in 1998 to R8,3 billion in 2001• Headline ROE increased from 13%

in 1998 to 25% in 2001

• R17 billion in total• Capital reduced from R18,3 billion

in 1998 to R8,3 billion in 2001• Headline ROE increased from 13%

in 1998 to 25% in 2001

Some background …

Liberty Life’s headline ROE vs share priceLiberty Life’s headline ROE vs share price

• Unbundlings of 1999 resulted in re-rating of share

• Questionable whether capital reduction in 2000/01 had a sustainable impact

• Unbundlings of 1999 resulted in re-rating of share

• Questionable whether capital reduction in 2000/01 had a sustainable impact

0.00%

5.00%

10.00%

15.00%

20.00%

25.00%

30.00%

1998

1999

2000

2001

2002

2003

1H04

Current

0

10

20

30

40

50

60

70

Headline ROE Share price

0.00%

5.00%

10.00%

15.00%

20.00%

25.00%

30.00%

1998

1999

2000

2001

2002

2003

1H04

Current

0

10

20

30

40

50

60

70

Headline ROE Share price

Some background …

Value created for shareholders due to capital restructuringValue created for shareholders due to capital restructuring

R 0.00

R 20.00

R 40.00

R 60.00

R 80.00

R 100.00

R 120.00

R 140.00

R 160.00

R 180.00

Cash R 8.45 R 9.08 R 9.77 R 12.52 R 12.39 R 12.25 R 11.57 R 13.16

Liberty International R 20.66 R 21.56 R 26.11 R 39.40 R 36.74 R 37.30 R 40.14 R 44.62

Standard Bank R 21.11 R 29.96 R 35.77 R 36.59 R 35.36 R 45.95 R 50.43 R 59.23

Liberty Life R 30.78 R 61.92 R 57.74 R 55.20 R 54.65 R 54.00 R 51.00 R 58.05

1998 1999 2000 2001 2002 2003 1H04 04-OctR 0.00

R 20.00

R 40.00

R 60.00

R 80.00

R 100.00

R 120.00

R 140.00

R 160.00

R 180.00

Cash R 8.45 R 9.08 R 9.77 R 12.52 R 12.39 R 12.25 R 11.57 R 13.16

Liberty International R 20.66 R 21.56 R 26.11 R 39.40 R 36.74 R 37.30 R 40.14 R 44.62

Standard Bank R 21.11 R 29.96 R 35.77 R 36.59 R 35.36 R 45.95 R 50.43 R 59.23

Liberty Life R 30.78 R 61.92 R 57.74 R 55.20 R 54.65 R 54.00 R 51.00 R 58.05

1998 1999 2000 2001 2002 2003 1H04 04-Oct

Some background …





Capital management

Lessons from the UKLessons from the UK

• CAR covers at around 5,0 times to 7,0 times in late 90’s

• Underlying investments mostly long equities (about 70% of shareholders’ funds)

• Economic changes in 2002 resulted in pressure (equity market fell by 40%)

• Switch from equities to bonds created a spiral

• Subsequent capital raising as a result

• CAR covers at around 5,0 times to 7,0 times in late 90’s

• Underlying investments mostly long equities (about 70% of shareholders’ funds)

• Economic changes in 2002 resulted in pressure (equity market fell by 40%)

• Switch from equities to bonds created a spiral

• Subsequent capital raising as a resultThe UK …


• Aviva raised Euro 1,3bn and GBP 1,4bn at rates between 5,7% and 6,125%

• ZFS raised Euro 0,5bn and GBP 0,5bn at rates between 5,750% and 6,625%

• Allianz raised Euro 4,5bn at rates between 5,5% and 6,5%

• Munich Re raised Euro 3,0bn and GBP 0,3bn at rates between 6,75% and 7,625%

• Cost of raising capital when you need it most is high

• Aviva raised Euro 1,3bn and GBP 1,4bn at rates between 5,7% and 6,125%

• ZFS raised Euro 0,5bn and GBP 0,5bn at rates between 5,750% and 6,625%

• Allianz raised Euro 4,5bn at rates between 5,5% and 6,5%

• Munich Re raised Euro 3,0bn and GBP 0,3bn at rates between 6,75% and 7,625%

• Cost of raising capital when you need it most is high

The UK …


• Equitable Life (the most pronounced example) wrote products in the 1980’s with little consideration for the impact of underlying guarantees and capital requirements. Economic changes up to 2002 highlighted this

• Equitable Life (the most pronounced example) wrote products in the 1980’s with little consideration for the impact of underlying guarantees and capital requirements. Economic changes up to 2002 highlighted this

The UK …

The UK (current trends)The UK (current trends)

• Prudential announced a GBP 1,0bn rights offer on 19 October 2004 to bolster capital. The share price reduced by 10% within hours even though most investors expected capital raising at some stage

• UK environment cautious, with average capital adequacy cover of around 2,0 to 2,5 times for with-profits dominated businesses (total failure probability of 0,5% built into the capital adequacy requirements!)

• Prudential announced a GBP 1,0bn rights offer on 19 October 2004 to bolster capital. The share price reduced by 10% within hours even though most investors expected capital raising at some stage

• UK environment cautious, with average capital adequacy cover of around 2,0 to 2,5 times for with-profits dominated businesses (total failure probability of 0,5% built into the capital adequacy requirements!) The UK …





Capital management

What we’ve done so farWhat we’ve done so far

• Capital management committee established in November 2003

• Cleaned up shareholders’ funds and unnecessary structures

• Regular monitoring of shareholders’ assets

• Long-term equity portfolio established• Cash accumulation for BEE transaction

• Capital management committee established in November 2003

• Cleaned up shareholders’ funds and unnecessary structures

• Regular monitoring of shareholders’ assets

• Long-term equity portfolio established• Cash accumulation for BEE transaction

What we’ve done so far …

What we’ve done so far (continued)What we’ve done so far (continued)

• Non-core equity concentration – one opportunity to sell* Edcon* GoldFields* SABMiller* Metcash

• BV Bond redeemed• BEE transaction in progress

• Non-core equity concentration – one opportunity to sell* Edcon* GoldFields* SABMiller* Metcash

• BV Bond redeemed• BEE transaction in progress

What we’ve done so far …





Capital management

Our thoughts on level of capitalOur thoughts on level of capital

30 June 2004 Rm CAR cover

Capital adequacy requirement (CAR) 3 502

Shareholders’ funds 8 922 2,6

Empowerment transaction - 1 251

Shareholders’ funds after empowerment transaction

7 671 2,2

Excess capital with CAR at 1,5 2 418

Excess capital with CAR at 1,7 1 718

Level of capital . . .


• ASSA currently reviewing guidelines for CAR calculation

• Capital covers potential additional tax charges, frauds, errors, uninsured risks, etc

• Stochastic modelling of embedded guarantees results in volatility

• New risk product requires more capital• International accounting standards

could influence ratios

• ASSA currently reviewing guidelines for CAR calculation

• Capital covers potential additional tax charges, frauds, errors, uninsured risks, etc

• Stochastic modelling of embedded guarantees results in volatility

• New risk product requires more capital• International accounting standards

could influence ratiosLevel of capital . . .


• Find balance between ROE and security• Take Liberty Life’s lower risk business

mix into account• Take BEE transaction treatment into

account• No offshore expansion – less “just in

case” capital required• Currently (and previously) no

management action assumed• Avoid forced raising of capital later on

• Find balance between ROE and security• Take Liberty Life’s lower risk business

mix into account• Take BEE transaction treatment into

account• No offshore expansion – less “just in

case” capital required• Currently (and previously) no

management action assumed• Avoid forced raising of capital later onLevel of capital . . .


• Shareholders’ investments to “seed” new products from time to time

• Strong parent

• Shareholders’ investments to “seed” new products from time to time

• Strong parent


Level of capital – Theoretical ROE on minimum CARLevel of capital – Theoretical ROE on minimum CAR30 June 2004 Rm

Life fund operating profit as disclosed 335

Approximate effects of:

Guarantee reserve strain 30

AC133 20

Expense profit -20

10% participation 70

“Contextualised” life fund operating profit 435

For a full year* 870

Capital adequacy requirement 3 501

Theoretical ROE of life business (%) 25%

Level of capital . . . *Excludes return on CAR net of expenses

Level of capital and dividend policyLevel of capital and dividend policy

• Conflict between upfront capital reduction/buy-back/special dividend vs security

• Insurer valuations to revert to dividend yields?

• Dividend policy based on earnings cover does not work

• Predictability is key• An increasing, sustainable dividend

over time would be a strong value driver

• Conflict between upfront capital reduction/buy-back/special dividend vs security

• Insurer valuations to revert to dividend yields?

• Dividend policy based on earnings cover does not work

• Predictability is key• An increasing, sustainable dividend

over time would be a strong value driver


Level of capital and dividend policyLevel of capital and dividend policy

• Operational indicators to back dividend payouts:* New business volumes* Value of new business and new business

margins* Net cashflows from insurance operations* Management expenses (per policy)* Headline earnings* Embedded value* CAR cover

• Operational indicators to back dividend payouts:* New business volumes* Value of new business and new business

margins* Net cashflows from insurance operations* Management expenses (per policy)* Headline earnings* Embedded value* CAR cover






Capital management

Our thoughts on mix of capitalOur thoughts on mix of capital

• FSB would be required to approve subordinated debt to qualify as capital

• Subordinated debt is used extensively by insurance companies offshore, for a variety of reasons

• Terms and conditions of these instruments are substantially in line with those employed by banks. A significant amount of secondary capital has been issued by the local banks

• FSB would be required to approve subordinated debt to qualify as capital

• Subordinated debt is used extensively by insurance companies offshore, for a variety of reasons

• Terms and conditions of these instruments are substantially in line with those employed by banks. A significant amount of secondary capital has been issued by the local banks

Mix of capital . . .

Our thoughts on mix of capitalOur thoughts on mix of capital

• Mix of debt/equity may reduce cost of capital and enhance ROE

• Rating may be required• Provides some flexibility for capital

management into the future• Provides access to new capital

sources

• Mix of debt/equity may reduce cost of capital and enhance ROE

• Rating may be required• Provides some flexibility for capital

management into the future• Provides access to new capital

sources

Mix of capital . . .





Capital management

Composition of shareholders’ fundsComposition of shareholders’ funds

30 June 2004 Rm % of total

Subsidiaries and associates 2 066 23

Equity portfolio 1 597 18

Cash, preference shares and unit trusts 2 361 26

Unlisted investments 76 -

Net foreign assets less redeemable bonds 47 -

Share of pooled portfolios 1 564 18

Other net assets 1 211 15

Total 8 922 100

Shareholders’ funds . . .

Our thoughts on the composition of shareholders’ funds (continued)Our thoughts on the composition of shareholders’ funds (continued)• Depending on the level of capital,

assets backing CAR should be invested in equities to prevent cost of capital in embedded value

• Dividend income ranks for STC credits

• Financial services subsidiaries’ capital should be managed at optimum levels

• Depending on the level of capital, assets backing CAR should be invested in equities to prevent cost of capital in embedded value

• Dividend income ranks for STC credits

• Financial services subsidiaries’ capital should be managed at optimum levels


Our thoughts on the composition of shareholders’ assetsOur thoughts on the composition of shareholders’ assets• Property assets are not very liquid• Managed portfolio view for the

remainder of assets• Lower cover, more liquidity• Avoid concentration

• Property assets are not very liquid• Managed portfolio view for the

remainder of assets• Lower cover, more liquidity• Avoid concentration


ConclusionConclusion

• Second phase of capital management under way

• Level of capital (target CAR cover) to be finalised and addressed

• Working capital management and capital allocation models

• Fuller disclosure to “contextualise” earnings

• Continued active management of capital

• Second phase of capital management under way

• Level of capital (target CAR cover) to be finalised and addressed

• Working capital management and capital allocation models

• Fuller disclosure to “contextualise” earnings

• Continued active management of capital

Documents

Capital efficiency and maximising returns on capital/embedded value