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Improving life insurers’ risk-bearing capacity

28 May 2013

The Federal Government and BaFin have long been aware of the risks posed to the insurance industry by any continuation of the period of low interest rates. The Federal Government already took a range of measures in the past to allow the life insurers to continue meeting their long-term payment obligations in a period of persistently low interest rates.

Since 2011, for example, the life insurers have had to build up a Zinszusatzreserve (an additional provision to the premium reserve introduced in response to the lower interest rate environment) to offset their lower investment income in the future.

Partial collectivisation of the provision for bonuses and rebates

A decision was also taken to ‟partially collectivise” the provision for bonuses and rebates (Rückstellung für BeitragsrückerstattungRfB). The insurance contracts of the life insurers had been split into existing and new contracts in the course of deregulation in 1994. This division led to differences in the way the RfB for the existing contracts and the RfB for the new contracts developed. Partial collectivisation will enable the levels of the RfB for the different groups of contracts to converge again.

Policyholder participation in the valuation reserves

In case the unfavourable conditions for the insurers on the capital markets persist, the Bundestag decided at the beginning of November to amend the provisions governing the participation of policyholders in the valuation reserves as part of the SEPA Accompanying Act (SEPA-Begleitgesetz). In the end, though, the Bundestag and the Bundesrat decided to postpone the issue for the time being and to first conduct a fundamental review of the supervisory framework.

It had been planned to take greater account of the interests of all policyholders collectively as regards participation in the valuation reserves: where valuation reserves funded by fixed-income securities and interest rate hedges are necessary to safeguard the guaranteed return, they should not be included in participation in the valuation reserves, meaning that they should not be paid out successively to policyholders whose policies mature.

Since 2008, life insurers have had to allow their customers to participate in the valuation reserves when their policies mature. Any valuation reserves funded by fixed-income securities have to be included in this calculation. This requirement is based on a ruling by the Federal Constitutional Court in 2005. As a general principle, valuation reserves funded by fixed-income securities arise only if capital market rates are falling. Paradoxically, this has the economically irresponsible effect of forcing life insurers to pay out extremely high amounts to their outgoing customers precisely in an environment of declining – and now very low – interest rates. This runs counter to the objective of safeguarding funds for existing policyholders. Additionally, the current rule means that a considerable portion of interest due on securities in the future has to be paid out ahead of time to the outgoing policyholders. This siphons off funds from the remaining policyholders.

Industry-wide valuation reserves funded by fixed-income securities amounted to €2.7 billion at the end of the first quarter of 2011. They had already risen to €87.8 billion by the end of 2012 because capital market rates had fallen further. Payments to outgoing policyholders were correspondingly high. The amounts are now frequently in the order of 10 to 15% of the endowment benefit.

The amendment to the VAG originally resolved by the Bundestag would have eliminated the current mechanism for automatic participation in the valuation reserves, which is economically inappropriate. Under the planned revision, a life insurer would always have to determine the amount needed to safeguard the interests of the existing policyholders whenever it calculates the level of the valuation reserves. Put simply, the amount needed to safeguard the interests of the existing policyholders would have been the difference between a notional Zinszusatzreserve – based on a market-oriented reference interest rate – and the actual Zinszusatzreserve. Only those policies would be included in the calculation for individual policies whose guaranteed return is higher than the reference interest rate. Valuation reserves funded by fixed-income securities and interest rate hedges would only be included in participation in the valuation reserves to the extent that they exceed the amount needed to safeguard the interests of the existing policyholders.

The winners under this new arrangement would have been the policyholders as a whole, because there would have been a proper balance between the interests of outgoing policyholders and those of the remaining policyholders. On the one hand, the policyholders as a whole could have relied on the fact that funds would continue to be made available to ensure the insurers’ long-term ability to meet their guaranteed return obligations, even in the event of a prolonged period of low interest rates. On the other hand, the outgoing policyholders would have continued to participate as before in the valuation reserves funded by equities and real estate, whilst the valuation reserves funded by fixed-income securities and interest rate hedges would have been only paid out in a responsible manner in a low interest rate environment.

Zinszusatzreserve

Life insurers have had to establish and add to their Zinszusatzreserve since 2011. This is a precautionary measure. Low interest rates are negatively impacting the life insurers’ return on investment. In the long term, it may happen that an insurer’s net investment income is no longer sufficient for it to meet its guaranteed return obligations. As a result, funds must be appropriated now to the Zinszusatzreserve so that an insurer can use them to fund its guaranteed returns in subsequent years.

The detailed requirements for the Zinszusatzreserve are governed by the Regulation on the Principles Underlying the Calculation of the Premium Reserve (Deckungsrückstellungsverordnung – DeckRV). Based on a ten-year average yield on government bonds, the first step is to calculate the uniform ‟reference interest rate” that applies to all insurers. The insurers must then establish the Zinszusatzreserve for policies whose guaranteed return is higher than this reference interest rate. In such a case, the insurer appropriates to the Zinszusatzreserve an amount equal to the interest shortfall that will arise over the next 15 years.

The reference interest rate in financial year 2011 was 3.92%. The Zinszusatzreserve therefore only had to be established for policies with a guaranteed return of 4%; this cost the industry as a whole around €1.5 billion. In the 2012 annual financial statements, the Zinszusatzreserve also affects only policies with a guaranteed return of 4%. Because of the low interest rates, however, the reference interest rate declined sharply to 3.64%, requiring an additional amount of more than €5 billion to be added to the Zinszusatzreserve. A similar expense can be expected for financial year 2013 if interest rates on the capital markets remain as low as they were in the fourth quarter of 2012.

Although building up the Zinszusatzreserve represents a considerable burden for the life insurers, this effort is indispensable to ensure that they can continue to meet their guaranteed return obligations in the long term.

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