BaFin has defined clearer and stricter expectations of how life insurers operating under Solvency II and Pensionskassen (both those with and without a restructuring clause in place) are to draft their conditions for subordinated loans and other subordinated liabilities.

Many insurers take out subordinated loans or issue subordinated bonds to raise their level of own funds. In normal economic times, this would not be any reason for special attention from insurance supervisors. However, the situation is different when market trends mean that supervisory action is required in order to protect the interests of the beneficiaries under the insurance policies. In BaFin’s opinion, this situation has now arisen.

Present situation: preferential treatment of subordinated creditors over beneficiaries

The reason BaFin reached this opinion is that in many cases the conditions for subordinated debt currently in use in the market stipulate that, as a rule, subordinated creditors can only be called on in an insolvency situation. This represents an important difference between subordinated creditors and beneficiaries of insurance contracts. In order to safeguard the interests of beneficiaries, BaFin can decide to prevent the insolvency of life insurers or Pensionskassen by ordering benefit reductions under section 314 (2) of the Insurance Supervision Act (Versicherungsaufsichtsgesetz – VAG) or by agreeing to benefit reductions based on the restructuring clause. This would lead to the beneficiaries suffering financial losses. At the same time, if BaFin takes this step, subordinated creditors cannot be called on for these contracts. This, however, would result in the preferential treatment of subordinated creditors, which would be incompatible with BaFin’s statutory mandate to protect the interests of the beneficiaries under the insurance policies.

The situation is aggravated when insurers pay interest on subordinated capital that is considerably higher than the average interest rates currently achievable on the capital market. The contracting parties usually justify the higher interest rate on the grounds of both the fact that the subordinated debtor does not have a credit rating, as is commonly the case, and the higher default risk they claim is inherent to subordinated agreements.

In BaFin’s opinion, particularly the second argument is not viable. Given the preferential treatment of subordinated creditors of life insurers and Pensionskassen, this argument has no substance, because no part of the higher interest rate is in fact attributable to a risk component; rather, the subordinated creditor receives an excess return.

Wording for life insurers and Pensionskassen without a restructuring clause

BaFin therefore expects it to be possible in the future for subordinated creditors of life insurers and Pensionskassen to be called on even before insolvency proceedings are initiated. It therefore expects the following wording to be included in any new conditions for the raising of subordinated capital by life insurers and Pensionskassen that have no restructuring clause in place (to be adjusted accordingly in the case of subordinated bonds):

“Creditors of subordinated loans are subject to losing their claim to repayment even before insolvency proceedings are initiated if BaFin would otherwise order a reduction of benefits in accordance with section 314 (2) of the VAG. BaFin will inform the subordinated creditor about the occurrence of the event that has triggered the creditor’s loss. In terms of amount, the creditor’s loss is to correspond to the amount of the loss that the creditor would have incurred had insolvency proceedings been initiated at that time. If a benefit reduction is ordered then subordinated creditors lose any claim to repayment at that point at the latest.“

Wording for Pensionskassen with a restructuring clause

BaFin expects Pensionskassen with a restructuring clause to use the following wording:

“Creditors of subordinated loans are subject to losing their claim to repayment even before insolvency proceedings are initiated if BaFin would otherwise agree to a benefit reduction suggested by the company or order a reduction of benefits in accordance with section 314 (2) of the VAG. BaFin will inform the subordinated creditor about the occurrence of the event that has triggered the creditor’s loss. In terms of amount, the creditor’s loss is to correspond to the amount of the loss that the creditor would have incurred had insolvency proceedings been initiated at that time. If a benefit reduction is ordered then subordinated creditors lose any claim to repayment at that point at the latest.“

In the case of subordinated bonds, the clause is to be adjusted accordingly.

Moreover, it must be ensured that the clause does not contradict the articles of association of the company.

New and existing contracts

BaFin emphasises that both life insurers and Pensionskassen will be required in the future to submit drafts of their conditions for subordinated liabilities in advance. In order to enable BaFin to verify that the agreed interest rates comply with the arm’s length principle, the companies must provide BaFin with a clear explanation of how the rates were calculated. They must submit the relevant documents together with the draft of the conditions for subordinated debt in good time before the intended transaction or issuance.

BaFin will contact companies that have taken up subordinated loans or issued subordinated bonds and expects them to make the appropriate amendments should their conditions favour subordinated creditors. As regards existing contracts which are to be amended, amendments that are initiated by the supervisory authority do not affect any existing grandfathering provisions as set out in section 234g (3) sentence 1 in conjunction with section 214 (8) of the VAG for Pensionskassen or section 345 of the VAG for life insurers subject to Solvency II.