Run-off: Protecting life insurance customers
The subject of run-off has become more relevant since an article on it was featured in the March 2014 edition of the BaFinJournal (only available in German). In 2017, several major insurance groups revealed that they were considering selling their life insurance portfolios to run-off specialists.
This resulted in run-off in the area of life insurance being widely discussed for the first time in Germany. Mostly, the topic elicited reactions ranging from hostile to outraged.
In light of developments on the capital markets since the financial crisis, an intense preoccupation on the part of all insurance groups with their own business models can be observed in recent years. Along with low interest rates, the increasing pace of change in the societal, regulatory and technical framework is also contributing to this. It is understandable that the undertakings will examine all their business lines to see whether they can continue to be operated successfully in their current form.
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.
In particular in the case of the most important life insurance product in Germany, i.e. traditional with-profits life insurance, the providers are faced with the problem that earnings prospects are falling at the same time as the requirements for modernisation of business processes and capital requirements have increased. The undertakings' reactions to this vary, with some of them deciding to no longer offer traditional life insurance. In the case of insurance groups, this can mean that one or – if there is more than one life insurer in the group – several life insurance undertakings will de facto or even officially cease writing new business and go into "internal run-off". Similar considerations may also arise in relation to Pensionskassen (occupational pension providers) which belong to the group. It is important to stress that the transition from being an active insurer to internal run-off is fluid.
On the other hand, there are currently many investors which are willing to invest in closed life insurance books. In total, it appears that billions of euros are available for investment. These actual or potential investors come mainly, though not exclusively, from outside Europe. The transactions themselves, however, are concluded via holding companies (run-off platforms) in Germany. Closed life insurance books are interesting to investors primarily because the cash flows that result from them can be easily forecasted, even for decades to come. In particular, money may be made in this area if the portfolios can be managed effectively using modern approaches. Run-off platforms do not have any old, and therefore difficult to master, management systems and do not expend any resources on product development and distribution.
The business model thus influences whether or not closed insurance books are viewed as being loss-making or worthwhile. Whether or not concrete transactions are concluded also depends of course on the prices which the undertakings concerned have in mind.
Good or bad for customers?
Is this good or bad for the customers? The dominant opinion held by the general public is that it is clearly "bad". However, this blanket judgement does not stand up to closer scrutiny.
First, one must make a differentiation between internal and external run-off. It is external run-off that is currently dominating the public debate. The fears that exist on the matter are based primarily on the assumption that run-off specialists are not dependent on potential customers having a positive image of them. The worry is that, because of this, they would reduce profit participation as far as legally possible and that their customer service would deteriorate. However, run-off specialists can by no means afford to be indifferent about their image. Their business model requires them to maintain an interest in managing the portfolios for the long term. A high lapse rate is not lucrative. Moreover, they usually want to take over further portfolios, and a good reputation is crucial for the success of future transactions. The customers' interests are also of vital importance to the sellers: no insurance group planning a sale will be under the illusion that their reputation would remain unharmed if its customers' interests were abandoned just after the sale. This is because all groups which are in line for an external run-off remain active in Germany. In addition, it must be remembered that, even in the case of an internal run-off, the incentives for new business are lacking. It should also be borne in mind that there have been insurers writing new business whose profit participation was not any higher than that required under the German Minimum Allocation Regulation (Mindestzuführungsverordnung – MindZV - only available in German).
For existing customers, it can also be a plus initially if an insurer focuses fully on their interests. Efficiency gains from the management of the portfolio and from the investment largely benefit them. However, the decreasing size of the portfolio leads in the long term to higher expense ratios and to a decreasing capacity of the portfolio to balance risks. Nevertheless, through taking over further portfolios, which is a key component of the business strategy of run-off specialists, the point in time after which these problems are felt can be postponed until the future.
The answer to the question whether a run-off is good or bad for customers ultimately depends on how it is executed. Both in the case of changes of ownership and in the case of portfolio transfers, the supervisory authority is called upon to act. In its actions, it applies the standard of upholding the interests of the insured. If these are safeguarded, it must approve the transaction or allow it to take place. Both internal and external run-offs are in any case taking place in insurance undertakings to which all statutory requirements apply and which are subject to BaFin's insurance supervision.
Forms of external run-off
As explained above, an insurance portfolio can be sold by selling the undertaking to a new owner, by transferring the portfolio or by merging with and into an existing insurer.
Portfolio transfer and merger have much in common. In both cases, the customer receives a new counterparty, although nothing else changes in the insurance contract itself. The new undertaking is naturally different from the previous counterparty. The transfer or merger requires the approval of BaFin's insurance supervision directorate, which ensures that the customers' interests remain well safeguarded. If the insurer acquiring the additional contracts already has an insurance portfolio, its policyholders must not be disadvantaged in any way either.
If the undertaking is sold on the other hand, the customer retains the same counterparty while the undertaking merely falls under new ownership. In practice, however, this is associated with further changes, such that the differences from a portfolio transfer may be materially insignificant from the point of view of the customer. For example, the undertaking will in future be part of another group of undertakings with a different business orientation. The new owners will appoint different persons to the management board and the supervisory board and many outsourcing contracts will be amended. BaFin's insurance supervision directorate must be notified of the sale in good time in advance so that it can prohibit said sale if the customers' interests are not adequately safeguarded.
The same provisions and the same powers of intervention on the part of the supervisory authority apply to run-off specialists as apply to all other insurers.
In particular, they must have adequate capital, have an effective risk management system in place and fulfil extensive reporting requirements. BaFin has ample options for obtaining information and reacting to irregularities. In the case of with-profit contracts, the Minimum Allocation Regulation (MindZV) applies.
Protecting customers' interests in the case of an external run-off
In the case of transactions which have taken place to date in Germany, some questions have emerged which may also be expected to arise in future cases.
The first question is that of the ability of the new insurer or the new group of undertakings to appropriately manage the portfolio. In the event of this question not being answered in the affirmative a transaction would be prohibited. This depends on whether existing systems and employees of the ceding undertaking are also transferred. Any gaps that may appear must be closed by way of appropriate measures on the part of the acquiring company.
The level of customer safety in the previous insurance group does not only depend on the financial resources of the individual undertaking but also on the ability of the group to support an undertaking that gets into difficulty. Naturally, different conditions prevail in the accepting group, which may mean more or less safety for policyholders. If the safety level is expected to drop, the supervisory authority will demand safeguards. One example of such safeguards is that the acquiring company must make a commitment that for a certain period of time its capital resources will not fall below a level significantly higher than the legal minimum required. In order for such commitments to be recoverable, the company must prove that they are backed up by sufficient funds. Another possible safeguard can consist of a preclusion (by way of contractual relationships within the new group) of customers being burdened with higher administrative costs than before. Here, too, capital adequacy in the group may be required. BaFin ensures that the safeguards are implemented in undertakings to which the German Insurance Supervision Act (Versicherungsaufsichtsgesetz – VAG) applies and which are subject to its supervision, for example German holding companies.
An important gauge that can be used to answer the question of whether an external run-off would make the continuing fulfilment of the obligations discernibly more uncertain is the own funds situation before and after the transaction. This requires extensive and complex calculations to be performed, in relation to which the undertakings and BaFin must maintain intensive dialogue. The safeguards mentioned above also require intensive examination, which means that the undertakings should allow for sufficient time in deciding for and implementing an external run-off.
At a glance:Facts and figures
To date, six life insurers in Germany have external run-off portfolios. They belong to three different groups of undertakings. The first transaction took place in 2013, the most recent in the summer of 2017. In five cases, the transaction took the form of a change of ownership. Only one case consisted of a portfolio transfer. In addition, there are three other life insurers which are officially in internal run-off.
All nine undertakings are rather small; their market share, measured by premium income, is less than three per cent. If all those intentions to sell life insurance portfolios to run-off specialists which were reported on in the press last year were realised, this share would of course increase.
Calculation of the technical provisions
Pursuant to the provisions of Solvency II, the available own funds are calculated on the basis of the excess of assets over liabilities, both of which are determined at their market-consistent values. Calculating the market-consistent values for the technical provisions – i.e. the present value of future benefits to customers, including future profit participation – as well as the costs associated with servicing the contracts is complex. The values are influenced by a range of circumstances.
It may appear astonishing at first glance that the cessation of new business can lead to a change in the value of the technical provisions, even though the contractual obligations vis-à-vis the portfolio remain the same. This is due primarily to the fact that all expenses associated with servicing the insurance contracts influence the calculation of the technical provisions. Full consideration must therefore be given to the fact that the cost situation in a run-off portfolio will conceivably get worse. This ensures that the undertakings always have the funds available which are necessary to run-off the portfolio.
In the case of an external run-off in the form of a change of ownership, ostensibly only the owners change. This has per se no impact on the amount of the technical provisions. However, with the separation from the previous insurance group, the outsourcing of particular activities also typically changes, with the result that the future costs will be different. In addition, the new owner will deploy a new management, which will react differently to future developments. Insofar as typical reactions can already be predicted today, they are considered by means of management rules in the calculation of the technical provisions. This may lead either to an increase or a decrease in the technical provisions.
By way of example, a guarantee granted by a group undertaking regarding future administrative costs would have to be considered in the calculations. On the one hand, such a guarantee would lead to a situation where the future expenses for management of the contracts would decrease while, on the other hand, the customers' participation in these gains in efficiency would have to be represented. Changes in relation to future profit participation also influence the value of the technical provisions. Should the new management plan to significantly change its profit strategy, this would be directly reflected in the technical provisions. Thus, a planned decrease in future profit participation in particular would be foreseeable.
The calculation of the technical provisions can therefore change significantly as a result of a change of ownership. However, the provisions of Solvency II ensure that all measures taken by the new owner as well as future developments which can already be foreseen must be backed up by sufficient assets. Furthermore, the calculations include much information which BaFin can use when making its decision on a potential transaction in order to ensure that the interests of the policyholders are safeguarded.
Own funds requirements and adequacy
Based on these assessments, the solvency capital requirements under Solvency II are derived from the change to economic own funds in the event of unfavourable events occurring (a 200-year event). Thus, all factors which influence the technical provisions are also reflected in the solvency capital requirements. This ensures that changes brought about by the change of ownership must be backed up by sufficient capital. The adequacy of own funds can therefore change significantly as a result of a change of ownership.
In the case of portfolio transfers, the own funds situation changes even more, since all interactions between the existing portfolio and the newly transferred portfolio must be represented in the calculation. In particular, all of BaFin's requirements must be appropriately reflected both in the technical provisions and in the solvency capital requirements – for example maintaining the portfolios separately for a certain time, which is commonly done in the context of a portfolio transfer. This guarantees that the requirements which are intended to protect the interests of the policyholders are at all times backed up by sufficient capital and that the commitments made can be fulfilled, both in the base case and in case of a 200-year event.
Own funds situation at group level
In the case of an external run-off, a portfolio of one insurance group is moved to another. Consequently, both the available own funds as well as the capital requirements change for both groups. In the process, some very surprising effects can occur. For example, the position of both groups can improve or deteriorate. This depends both on the changes at the level of the individual undertaking outlined above and on the effects of intra-group transactions. For example, the solvency capital requirements can significantly increase as a result of the outsourcing of contract management to the group (which is usually associated with a cost guarantee), since loss absorption capacity which had existed before can no longer be used.
In this context, it must also be stressed that any obligations on the part of superordinate undertakings which have been agreed in order to protect customers' interests must be considered both in the own funds and in the solvency capital requirements at the group level. This also ensures – in a manner that goes beyond the mechanisms already described – that the agreed guarantees and measures are recoverable.
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