The German insurance industry has been dealing with the topic of run-off for almost ten years – initially of reinsurers, but later also non-life insurers. Today, run-off is also relevant for Germany’s most important class of insurance – life insurance. Seven of the around 90 life insurance undertakings under BaFin’s supervision have announced that they either do not want to underwrite any new business or do not want to underwrite any significant amount of it any more. The public’s negative reaction to this shows that run-off continues to be seen in Germany as failure on the insurer’s part. It is rarely seen as a deliberate corporate decision.

Definition: Run-Off

The term “run-off” describes a variety of related scenarios for winding up part or all of an insurance undertaking’s book of business. Beyond cessation of underwriting in certain business lines or regions, the term run-off includes an active element: the insurer endeavours to end the business activities in question as profitably – or at least with as little loss – as possible. The undertaking can also work with external parties to this end. The spectrum ranges from consulting to outsourcing activities to spinning off operating activities, transferring portfolios and, if an undertaking’s whole portfolio is in run-off, the sale of the undertaking.

Run-Off in supervisory law

There is no definition of run-off in German supervisory law. The law recognises the much narrower circumstances of the discontinuation of operations (section 86 of the Insurance Supervision Act (Versicherungsaufsichtsgesetz – VAG)). Under the Act, operations terminate through voluntary cessation (return of the authorisation) or intervention by BaFin (revocation of the authorisation or prohibition of operations). Normally, the undertakings then go into liquidation. They are not allowed to conclude new insurance contracts or to extend existing contracts or increase the sum insured. However, the existing contracts continue to be processed i.e. continued, until the contract ends. This can take several decades with life and health insurance. In very rare cases, the Supervisory Authority announces the insolvency of an insurer; it is only then that existing contracts end prematurely. However, the discontinuation of operations, and insolvency even more so, are currently side issues, as none of the insurance undertakings about which there has been public discussion in recent years was or is in such circumstances.

All other run-off cases are based on a business decision. The same supervisory rules which apply to all other insurers still apply to them and also to undertakings in liquidation. This is also true for insurance undertakings whose sole business object is to take over and run-off closed books.

There are two exemptions, however. The first relates to the introduction of the European supervisory regime of Solvency II: following the agreement on the Omnibus II Directive, the new provisions largely do not apply to undertakings which do not write any new business from 2016 and intend to terminate their activities within three years. The possibility of life and health insurers making use of the exemption is, however, likely to be excluded because it requires portfolios to be run off quickly. The second exemption comprises the grandfathering provision for reinsurance undertakings which have gone into run-off from 2008 onwards in the context of implementing the Reinsurance Directive. Only specific provisions of the VAG apply to these undertakings.¹⁾

Consequences of ceasing to write new business

Voluntary or forced cessation of writing new business has economic consequences that are relevant for the insurance Supervisory Authority. This also applies to the cases in life insurance where certain contracts are typically still concluded or increased, for instance in collective contracts, contracts that offer automatic increases in line with inflation and in supplementary insurance contracts.

The immediate consequence of ceasing to write new business is that the portfolio and the premium income decrease. This can – depending on the business line and the size of the portfolio affected – happen quickly or slowly and continually. Particularly in the case of a complete run-off, the diversification in the portfolio may decrease and the technical results may therefore become more volatile. That can endanger the balancing of the portfolio in the long term. If the public sees the insurer as less reliable due to the run-off, there is also a risk that more existing customers will leave, meaning that the life insurer needs increased liquidity.

As there are no longer any acquisition commissions when new business is discontinued, the costs temporarily fall. However, overheads mean that it is questionable whether the costs can be covered in the long-term in the case of a complete run-off. By contrast, if an insurer with several business lines only discontinues some of them, the costs can permanently fall.

Own funds

Ceasing to write new business also has an impact on own funds. A distinction needs to be drawn between the present supervisory law (Solvency I) and the future supervisory law (Solvency II). When premium payments cease, non-life insurers only continue to settle claims provisions. Thus under Solvency I, the premium index is 0 and the claims index is in fact negative. Under section 1 (6) of the Capital Resources Regulation (Kapitalausstattungs-Verordnung – KapAusstV), the own funds requirement nevertheless does not fall quickly, but essentially decreases at the same rate as the loss provision in the previous year. For life insurers, the solvency provisions under Solvency I tend not to take the risks that increase in run-off into account. The most important risk here is the lapse risk.

The own funds requirements for the individual business lines are differentiated more under Solvency II. For this reason there will tend to be more business lines which are not sufficiently profitable. In non-life insurance, the reserve risk dominates the underwriting risk when the premium payments cease. In the case of complete run-offs, diversification effects tend to decrease.

Changed incentives

As the discontinued business lines no longer look interesting from the insurer’s or insurance group’s point of view, the incentive to transfer portfolios and sell undertakings rises. The incentive to outsource functions in order to streamline administration in parallel with the portfolio also increases. In addition, the quality of customer service can decrease, as customer satisfaction is generally of lesser importance for an undertaking without new business. At the same time, the undertaking may potentially become an uninteresting employer, which can reduce the quality of staff.

In the with-profit business lines, i.e. in life and health insurance and accident insurance with premium refunds², the size of the bonus is no longer a competitive factor in the run-off phase. For this reason, the undertaking has little interest in distributing to customers a higher share of the surplus than necessary. Thus, only the provisions of the Minimum Allocation Regulation (Mindestzuführungsverordnung – MindZV) and the Regulation on the Calculation and Distribution of Surplus in Health Insurance (Überschussverordnung – ÜbschV) and contractual obligations continue to have an impact. There is therefore also an incentive for the undertaking to “minimise” the bonuses for policyholders.

Focal points of supervisory inspection

While there are hardly any legal differences between active insurers and insurers with portfolios in run-off, the economic differences can be major. Due to the aforementioned effects, the Supervisory Authority must be able to analyse the run-off undertaking’s individual situation precisely and decide on a case by case basis whether and how it will intervene.

If, for example, a sale is planned, it will check that the investor will not endanger the Supervisory Authority’s objectives, i.e. that the undertaking will continue to protect the interests of the policyholders and will be able to and wants to fulfil the contracts. To this end, BaFin inspects, inter alia, the reliability, business model and structures of the investor, which must be sufficiently transparent, and inspects the investor’s ability to sufficiently capitalise the insurer. The investor’s home country or sector alone are not usually the definitive factor in BaFin’s decision. BaFin does not have any fundamental reservations regarding run-off specialists as investors.

The requirements for portfolio transfers and mergers are set out in sections 14 and 14a of the VAG. Fundamentally, any insurer could be an accepting company, including specialised run-off insurers. Here too, however, it must be ensured that the undertaking is sufficiently capitalised to meet all obligations and to be able to protect the interests of policyholders. For mutual companies, the Supervisory Authority will also make sure that the loss of membership rights will be compensated for. It must also be ensured that the value of bonuses does not fall as a result of the transfer. For this reason, the Supervisory Authority cannot approve cross-border transfers in the with-profit business lines, as MindZV and ÜbSchV do not apply abroad.

BaFin will consent to the outsourcing of portfolio management and other functions to special service providers when two things are ensured: control is retained by management and the interests of the policyholders remain safeguarded. With regard to management and staff, the Supervisory Authority will fundamentally also question whether a reduced administrative structure is efficient and whether the holders of key functions continue to be suitable for their position.

Investments and risk management

The Supervisory Authority will additionally look at the insurer’s investments and make sure that the run-off is taken into account in asset/liability management. Ultimately, it must be ensured by the end of the run-off that the capitalisation is sufficient to meet all the agreed obligations. This might not be ensured by Solvency I and Solvency II standards alone. If necessary, the Supervisory Authority can stipulate capital add-ons.

Under Solvency II, the undertakings must conduct an undertaking-specific Own Risk and Solvency Assessment (ORSA) as a core component of risk management. As run-off changes the undertaking’s risk profile, BaFin will check whether this has been taken suitably into account.

In life and health insurance and in accident insurance with premium refunds, sufficient provisions in accordance with commercial law must be formed to ensure that the administrative expenses and greater fluctuations of the risk results do not endanger the risk-bearing capacity. In this context, it must also be checked whether the level of reinsurance needs to be adjusted. In life insurance, due to the potentially increased lapse risk, particular attention must be paid to liquidity management.

For with-profit contracts, BaFin will take particular care that these are not undermined. The breakdowns of profits and the actuarial documents are examined particularly carefully.

If the portfolio keeps decreasing, it must be investigated whether it would be sensible to transfer the portfolio, for example to special run-off insurers. In life and health insurance, the Protektor life insurance guarantee scheme and the Medicator health insurance guarantee scheme are available as a last resort.

Role of run-off specialists

Run-off specialists can act as investors, as accepting insurance undertakings or as service providers. They thus create additional opportunities for insurance undertakings to change their strategy or respond to difficult economic situations. For this reason, if all the rules are complied with, they can play a positive role in such circumstances.

Footnotes

1) cf. Article 62 of the Reinsurance Directive (Grandfathering provision).

2) cf. section 11d of the VAG. Fundamentally, the same rules as for life insurance apply to the savings element included in these contracts.