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S&P: German life insurers may save up to €18B in 2018 thanks to rule change

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S&P: German life insurers may save up to €18B in 2018 thanks to rule change

The German life insurance industry is set to save €16 billion to €18 billion in 2018 as the government looks to reform rules that require providers to build up additional reserves to ensure their ability to pay long-term guaranteed policies, S&P Global Ratings has estimated.

Life insurers, trade associations and the German financial market watchdog, Bafin, have called on the government to change the way the additional reserves, known as the Zinszusatzreserve, or ZZR, are calculated, as the original method led to the premature accumulation of excessively high buffers and increased the burden on the industry. Between 2011, when the ZZR requirement took effect, and the end of 2017, the industry set aside €60 billion to ensure that it meets its future policy obligations, S&P Global Ratings analysts said in a report Oct. 8.

The amount is higher than legislators had envisioned, and in 2017, the buffer hit a record €17 billion, compared to shareholder funds for the entire industry of €16.1 billion, the analysts noted.

Changing the calculation will considerably slow the buildup of the buffer, reducing the necessary amount to between €6 billion and €8 billion in 2018, compared to €24 billion under the original calculation, they said. This will help ease the pressure on the industry while still maintaining life insurers' ability to meet long-term policy obligations, the analysts added.

A promise made

German life insurers' back books are saddled with a large number of with-profits endowment policies, which guarantee a minimum return to policyholders. Guaranteed rates reached up to 4% in the past, but the prolonged spell of low benchmark interest rates in Europe has depressed investment returns and made the promises increasingly difficult to keep.

The average guaranteed rate in German life insurance back books is the third-highest in Europe at between 2.5% and 2.9%, according to S&P Global Ratings estimates. New business has a significantly lower average guarantee of 0.9%. German insurers also have the widest mismatch in the duration of assets and liabilities in Europe, according to the European Insurance and Occupational Pensions Authority, or EIOPA. This means low reinvestment yields further widen the gap between investment income and the amount due to policyholders.

The ZZR is therefore intended to help insurers meet these obligations, yet the methodology for calculating it has led to unintended consequences. The current method is based on a reference yield, representing the 10-year average of the 10-year zero coupon euro swap rate set by the German central bank. If the guaranteed rate on an insurance policy is higher than the yield, additional reserves are required.

The lower the yield, therefore, the higher the additional reserves must be. The yield has dropped more than expected over the past few years, which has led to the unexpectedly high buildup of additional reserves.

To help meet the requirement, life insurers have been forced to deploy a portion of their valuation reserves on fixed-income assets, a buffer held to mitigate potential deterioration in investment values. However, after realizing gains on longer-duration fixed-income assets, insurers must reinvest the proceeds into lower-yielding assets, undermining the purpose of the ZZR, S&P noted.

Unrealized fixed-income gains are also declining as interest rates rise, and with projections calling for rates to continue gradually increasing, building up additional reserves under the current method would become even more difficult, the analysts said.

Easing the burden

The new proposal is for a so-called "corridor method" of calculating the yield. It takes the current calculation of the yield as a starting point, but introduces an upper and lower end, allowing for more flexibility year to year. The upper and lower limits are based on the previous year's reference yield, the underlying yield of the current year, and a so-called X-factor, defining the spread between the upper and lower ends. The X-factor can range between zero and 100%, and has been set at 9% in the current proposal.

S&P Global Ratings calculated that in a base-case scenario of gradually rising benchmark yields, the reference yield under the current method would decline to less than 1.3% by 2023 before slowly growing to just over 1.6% by roughly 2029. Using the new method, the reference yield would not fall below 1.8% in that timespan, even when set to the lower boundary calculated using a higher X-factor.

Slowing the required buildup of reserves over the next three to five years will make the ZZR mandate "a less bitter pill" to swallow for German life insurers, the analysts said. The proposed change is important enough that the agency expects it to be made law by the end of 2018.

The change will also have a positive effect on life insurers' capital positions and improve their individual solvency ratios in the long term, S&P Global Ratings said.

This S&P Global Market Intelligence news article contains information released by S&P Global Ratings, a separately managed division of S&P Global. Descriptions in this news article were not prepared by S&P Global Ratings. The original S&P Global Ratings document referred to in this article can be found in the sources section.