Regulatory Ambiguity: When Is a Dividend Foreseeable?

The official guidance under Solvency II and SAM states that foreseeable dividends must be deducted from Basic Own Funds (BOF). But when does a dividend become foreseeable?

The European Insurance and Occupational Pensions Authority (EIOPA) defines it as follows:

“A dividend is foreseeable when the payment becomes likely considering the dividend payment history of the company, the business development throughout the year, the reference date of the assessment and, where appropriate, other relevant circumstances.†

Similarly, the South African Prudential Authority (PA) states:

“A dividend is foreseeable at the latest when it is declared or approved by the board of directors, regardless of any requirement for formal approval at an annual general meeting.†

On the surface, this sounds reasonable. But what does “likely† mean in this context? More than a 50% probability? Should a dividend that is merely probable be deducted against a 1-in-200 stress scenario? The dividend itself is not independent of financial stress—if an insurer were actually facing a severe loss event, that dividend likely wouldn’t be paid.

Defining the latest time to recognise a dividend as foreseeable doesn’t help in deciding when a typical or expected time might be. The PA released “technical observations” on this a little while back. Even while taking pains to highlight that technical observations don’t count as regulation, they were still unclear around what is expected.

The crux is that the regulatory guidance provides no clear answer on whether insurers should assume dividends payable from the preceding financial period, or always consider the next 12 months of “likely” or expected dividends. Equally, they also aren’t clear that insurers should not take a multi-year view. Some regulations on subordinated debt require a five-year term to prove permanence. Should insurers also be considering a 3- to 5-year horizon for foreseeable dividends? That doesn’t seem to be expected, but the reasoning and application aren’t consistent across different parts of the regulations.

The Problem of Capital Permanence, Availability, and Loss Absorption

Under Solvency II and SAM, regulatory capital must meet three key criteria:

1. Permanence – Capital should be available for the foreseeable future.
2. Availability – It must be accessible to absorb losses when needed.
3. Loss Absorption – It should genuinely absorb financial shocks.

The rationale in deducting foreseeable dividends is that once a dividend has been communicated to the market or approved by internal management structures, even before shareholder approval, it is nearly impossible not to pay it. That capital is no longer available.

However, requiring insurers to deduct a full year’s dividend in advance assumes earnings have already been generated. If those earnings fail to emerge (as they wouldn’t in a 1-in-200 scenario), then the dividend would likely not be paid. The dividends can absorb these future losses. There’s a parallel here for liquidity risk – Should cash be held now to ensure liquidity for dividends months into the future, even though expected premium receipts will exceed even adverse claims—meaning the dividend could be comfortably funded from future positive cash flow?

Are insurers being asked to treat dividends like senior debt obligations rather than discretionary equity distributions? If so, does that undermine the core purpose of equity funding?

Divergent Industry Practice and Alternative Approaches

Given this uncertainty, industry practice varies widely:

• Many insurers argue that only dividends expected in terms of prior financial periods should be deducted, and then only once the decision has been made to pay the dividend.
• Some insurers take a conservative approach, deducting dividends 12 months ahead, taking a double hit from recently declared dividends and dividends for another year. This depresses reported SCR cover ratios, but should not change absolute required capital levels. Targeted SCR cover levels will often be determined using earnings at risk or economic capital models, or adverse scenarios from an ORSA – all of which will factor in the economic reality that distant future dividends are loss absorbing.
• Other insurers accrue foreseeable dividends based on assumed payout ratio and earnings retained to date. This approach has much to recommend it, including being consistent with many banks’ treatment.

The FCA’s approach under Capital Requirements Regulation (CRR, which applies to banks, not insurers) summarises this last option:

“Before the management body has formally taken a decision or proposed a decision on the distribution of dividends, the amount of foreseeable dividends to be deducted shall equal the amount of interim or year-end profits multiplied by the dividend payout ratio.†

This effectively accrues foreseeable dividends over time rather than imposing a sudden drop in solvency ratios when dividends are declared. While not part of Solvency II or SAM, it is an interesting approach that could bring greater stability to insurance solvency ratios.

Determining SCR Cover Targets: A Practical Approach

Given the uncertainty in regulatory guidance, insurers should ensure that foreseeable dividends are integrated into a broader capital strategy rather than treated as a compliance checkbox. The key is to align foreseeable dividends with SCR cover targets, earnings at risk, and capital models that reflect economic reality.

Rather than simply applying rigid deductions, insurers should consider:

• Economic Capital and Earnings at Risk: Many insurers set target SCR cover ratios based on earnings at risk, ensuring capital sufficiency over a medium-term horizon. Since distant future dividends are inherently loss-absorbing, capital models should reflect that rather than treating them like fixed obligations.
• Scenario-Based Capital Planning: Insurers often use adverse scenario testing to set SCR cover targets. These scenarios should reflect dividend flexibility—how payouts might adjust in stress events rather than assuming mechanical deductions.
• Aligning Regulatory and Economic Views: The disconnect between regulatory capital and economic capital is well known. A structured approach to foreseeable dividends should integrate both perspectives, avoiding artificial volatility in reported solvency while maintaining a robust risk framework.

Insurers that take a strategic approach to SCR cover target setting—factoring in foreseeable dividends dynamically rather than through arbitrary deductions—are better positioned to maintain both solvency resilience and investor confidence. In a regulatory environment that lacks precise guidance, a clear, defensible methodology can differentiate well-managed insurers from the rest.

Messages? This time isn’t different, sovereign debt crises happen all the time, ignore currency risk at your peril and there are many reasons governments can default on their debt.

In South Africa, we’ve had incredibly few corporate bond defaults and most market participants don’t even know that the South African government “restructured” some of its debt in 1984 and so has, in fact, defaulted on contractual bond obligations.

In a recent credit risk and capital workshop, I raised the issue of Russia defaulting on Ruble-denominated debt in 1998, a big part of what led to the collapse of LTCM. Again, these events are often figured as “exceptionally unlikely” and not even worth holding capital.

Well, in the news, Argentina is about to default. Again. They have been one of the most regular defaulters on sovereign debt in the last couple of centuries. They’re also an example I often use of “currency pegs” doing precious little to mitigate currency risk except on a day to day basis.

More on that in another post (yes, I’m hoping to post a little more regularly in the coming months.)

Meanwhile, it seems the FSB is still committed to a 2014 deadline for SAM. Given the range and size of stumbling blocks still to be traversed, I expect if we do go live in 2014 it will be with some transitional measures.

Key amongst these new considerations is the limitation of mismatches between the term of assets and liabilities, which would limit the danger of a removal of deposits and wholesale funding in a crisis scenario. The problem is that this has been fundamental to the business model of banks for decades. Short-term assets (call, overnight, 30 day deposits) have been used to finance long-term liabilities (vehicle loans, home loans, business loans).

Retail deposits, even those technically call deposits, are generally quite sticky. This is in spite of the easily recallable image of queues of depositors wanting to get their money back. Typically, this is still a small fraction of total depositors (certainly in countries with retail deposit protection). Further, other banks have usually pulled or tried to pull their short-term funding (or simply not renewed overnight lending) well before the public even gets wind that there might be risks. As banks rely increasingly on wholesale finance, the risks of a liquidity and credit crisis are amplified as this money is teflon-coated and greased in terms of stickiness.

The banks argue there are other ways of managing the risk. It’s understandable that regulators around the world have had their confidence in banks’ risk management ability dented.

The real danger of overregulation of banks is not “too safe banks”, but rather an increase in the cost of providing banking and credit services to the economy (individual countries as well as the global economy) which could make limit economic growth and the replacement of jobs lost during the recession.

It’s going to be interesting to see how this develops.