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Capital efficiency and maximising returns on capital/embedded value

Capital efficiency and maximising returns on capital/embedded value. Deon de Klerk Chief financial officer Liberty Group Limited October 2004. Capital management. Some background Lessons from the UK What we’ve done so far Our thoughts on level of capital Our thoughts on mix of capital

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Capital efficiency and maximising returns on capital/embedded value

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  1. Capital efficiency and maximising returns on capital/embedded value Deon de Klerk Chief financial officer Liberty Group Limited October 2004

  2. Capital management • 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

  3. 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) Some background …

  4. 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. Ordinary CAR (“OCAR”) Some background …

  5. 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) Terminal CAR (“TCAR”) Some background …

  6. 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 Some background …

  7. Liberty Life’s CAR cover • 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 …

  8. Previous 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 Some background …

  9. Liberty 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 Some background …

  10. Value created for shareholders due to capital restructuring Some background …

  11. Capital management • 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

  12. Lessons 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 The UK …

  13. Lessons from the 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 The UK …

  14. Lessons from 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 The UK …

  15. 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!) The UK …

  16. Capital management • 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

  17. What 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 What we’ve done so far …

  18. 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 What we’ve done so far …

  19. Capital management • 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

  20. Our thoughts on level of capital Level of capital . . .

  21. Our thoughts on 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 Level of capital . . .

  22. Our thoughts on level 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 Level of capital . . .

  23. Our thoughts on level of capital • Shareholders’ investments to “seed” new products from time to time • Strong parent Level of capital . . .

  24. Level of capital – Theoretical ROE on minimum CAR *Excludes return on CAR net of expenses Level of capital . . .

  25. Level 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 Level of capital . . .

  26. Level 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 Level of capital . . .

  27. Capital management • 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

  28. Our 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 Mix of capital . . .

  29. Our 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 capital . . .

  30. Capital management • 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

  31. Composition of shareholders’ funds Shareholders’ funds . . .

  32. 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 Shareholders’ funds . . .

  33. Our 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 Shareholders’ funds . . .

  34. Conclusion • 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

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