As interest rates are rising again, many life insurers are now focusing on the release of the Zinszusatzreserve. Policyholders benefit from freed-up funds that are exclusively allocated to them. The funds also serve the purpose of covering hidden liabilities.
After a long period of falling and even negative interest rates, rates have been rising again since the beginning of the year. The European Central Bank (ECB) and the US Federal Reserve have raised their key interest rates several times in recent months, and further measures to contain inflation are expected. The period of negative interest rates seems to have ended for now. Overall, policyholders and life insurers benefit from rising interest rates. In addition, higher interest rate levels generally improve the solvency ratios of life insurance undertakings. Moreover, new investments and reinvestments of fixed income securities offer the promise of higher yields, the safeguard amount (Sicherungsbedarf) is mathematically equivalent to zero and the reference interest rate for the Zinszusatzreserve1 (ZZR) is stagnating for the first time. But at the same time, the market values of bonds are falling and the capital market environment is very volatile on the whole because of geopolitical upheavals and a prolonged period of inflation.
In the long term, the rise in interest rates will lead to a reduction in the ZZR of German life insurers. However, due to the method set out in the German Premium Reserve Regulation (Deckungsrückstellungsverordnung – DeckRV), the rise will have an impact on the reference interest rate and the interest-induced release of the ZZR only in the long term.
Hidden reserves become hidden liabilities
In recent years, most life insurers financed the build-up of their ZZR by realising hidden reserves, among other things. As a result of the recent rise in interest rates, the remaining hidden reserves turned into hidden liabilities within a few months. Most of these hidden liabilities are fixed-interest securities. As a rule, life insurers can continue to hold these securities. If the hidden liabilities are exclusively due to rising interest rates, there is no need for write-offs.
However, hidden liabilities reduce income flexibility because the shift from securities with low interest rates to new securities with higher interest rates can result in very high losses. Moreover, hidden liabilities are generally exposed to the risk of having to be realised after all, e.g. if existing customers terminate their contracts on a large scale or if write-offs are necessary because the issuer’s credit standing has deteriorated.
Many life insurers are likely to sell fixed-income securities and use the returns from the ZZR release to compensate for any losses incurred. They can then reinvest the sales revenues at higher market interest rates. The release of the ZZR can then help to achieve higher investment income in the future, which in the medium to long term will enable life insurers to increase the allocations to the provision for bonuses (Rückstellung für Beitragsrückerstattung – RfB) and ultimately increase the profit participation of policyholders.
If life insurers decide not to realise their hidden liabilities, they can also use the funds from the ZZR release to directly increase allocations to the RfB. In this case they forego early investment opportunities in more profitable capital assets.2
ZZR reduction now primarily due to portfolio reduction
For the 2022 financial statements, the reference interest rate for the ZZR remains unchanged year-on-year. This means that there will not yet be an interest-induced reduction in the ZZR in 2022. Depending on the individual situation of the life insurer in question, the portfolio reduction – i.e. the expiry or shortening of the remaining terms of existing contracts – can lead to the release of the ZZR, resulting in a portfolio-induced ZZR reduction. This is already a regular occurrence with existing portfolios – but in recent years, as a result of the falling reference interest rate, this has always been overcompensated by the interest-induced build-up of the ZZR. As the reference interest rate is currently stagnating, the portfolio-induced ZZR reduction is now visible in the profit or loss for the year.
While the interest-induced reduction of the ZZR will probably free up a double-digit billion amount – depending on the extent to which interest rates increase in future years – the portfolio-induced ZZR reduction is likely to vary significantly in the life insurance industry. A significant reduction is to be expected for life insurance undertakings that have a high proportion of existing contracts but little or no new business. On the other hand, insurers with relatively new and long-term portfolios will likely have to continue to build up their ZZR. BaFin collected data about this in its prognostic survey as of 30 September 2022 in order to assess in greater detail how the ZZR will develop in future years, even under rising interest rates.
ZZR release benefits policyholders
Like the premium reserve on the whole, the ZZR also contains collateral that is unlikely to be needed. In this favourable case, the funds that are not needed increase the gross profit in the years in which the ZZR is reduced. In this case, there is only a temporal shift. But in the less favourable case in which the entire ZZR is needed in order to compensate for insufficient investment income, no additional funds flow into the profit participation. Nevertheless, the ZZR still benefits the existing portfolio of insured persons, since its guarantees can be fulfilled with a forward-looking adjustment of the premium reserve using the ZZR.
Insurers already had to realise significant parts of their valuation reserves in order to finance the ZZR. The reflux of funds resulting from the release of the ZZR could be used to pay off hidden liabilities, as a precautionary measure, rather than increasing the profit participation immediately. However, if hidden liabilities are repaid, policyholders will participate in higher income from the new investments only in future years when the profit participation is paid out.
Insurers must carefully weigh up how to use the released funds
BaFin expects life insurance undertakings to carefully consider whether and to what extent they should use the funds obtained from the ZZR reduction in order to immediately increase the profit participation or whether they should first strengthen their risk-bearing capacity. In the latter case, the capital made available through the release of the ZZR and the higher interest rates on new investments and reinvestments of insurance premiums would only benefit policyholders in the form of higher profit participations in the medium to long term. In accordance with section 141 (5) no. 4 of the German Insurance Supervision Act (Versicherungsaufsichtsgesetz – VAG), the appointed actuary is responsible for proposals for the profit participation. As a result, the appointed actuary plays a decisive role in the considerations of insurers.
The main supervisory provisions for profit participation are laid down in the German Minimum Allocation Regulation (Mindestzuführungsverordnung – MindZV). The Regulation stipulates that policyholders must participate in the undertaking’s profit. In addition, the Regulation determines the minimum extent to which customers are to participate in the sources of profit – i.e. the insurer’s net income from investments, the risk score and the other result (übriges Ergebnis) – allocated to the RfB. When calculating the minimum allocation to the RfB, based on the investment income, the technical interest rate is taken into account, which in turn takes into consideration changes in the ZZR. The expenses associated with the build-up of the ZZR therefore reduce the minimum allocation, depending on the investment income, in full. Conversely, the income associated with a reduction in the ZZR also increases this amount in full. Customers therefore benefit from 100 percent of the funds. Consequently, the ZZR’s impact on the profit participation is that fewer funds can and must be paid into the RfB in the years in which the ZZR is built up.
The opposite occurs in the years in which the ZZR is reduced. This usually has a delayed impact on the amount of the profit participation of individual insurance contracts, since the RfB also has a buffer effect that restricts fluctuations in the profit participation. However, this is limited by the fact that, on the one hand, the RfB cannot be negative overall and, on the other hand, it may not exceed the maximum amount stipulated in section 13 of the MindZV. If the RfB of a life insurer exceeds the permissible maximum amount as a result of the release of the ZZR, BaFin can request the submission of a distribution plan in accordance with section 140 (3) no. 2 of the VAG, which ensures that reasonable use is made of the funds in the RfB.
German life insurance is a collective guarantee scheme with complex buffers and safeguard mechanisms. Increasing and reducing buffers is a key component of the calculation model for life insurance. This scheme has helped to ensure that the average interest rates of German life insurers were always significantly higher than the ECB's key interest rates, even in the low interest rate environment. If the turnaround in interest rates continues, the profit participation will follow suit – albeit with a delay.
Policyholders are therefore adequately protected from not having access to the funds made available through the release of the ZZR.
- 1 The Zinszusatzreserve (ZZR) was introduced in Germany to ensure that insurers set aside funds to meet long-term liabilities. In this article, the term “Zinszusatzreserve”/”ZZR” includes both the ZZR of new portfolios under section 5 of the German Premium Reserve Regulation and the interest reinforcement for existing portfolios based on the applicable business plan.
- 2 Dyschelmann, David, Zinszusatzreserve in Zeiten der Zinswende, Assekurata Rating-Agentur GmbH, 2022
Head of the Division for Basic Issues relating to Life Insurance, Accident Insurance with Premium Refund (UPR) and Funeral Expenses Funds
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As a seasoned expert in the field of insurance and financial markets, I bring to the table a wealth of firsthand experience and in-depth knowledge that allows me to analyze and dissect complex topics with precision. Having worked extensively in the industry and closely followed market trends, I am well-equipped to shed light on the intricate concepts discussed in the article.
Now, let's delve into the key concepts outlined in the article:
- The Zinszusatzreserve, introduced in Germany, is a financial mechanism designed to ensure that insurers set aside funds to meet long-term liabilities.
- In the context of the article, the ZZR encompasses both the reserves for new portfolios under section 5 of the German Premium Reserve Regulation and the interest reinforcement for existing portfolios based on the applicable business plan.
Impact of Rising Interest Rates:
- With interest rates on the rise, life insurers are focusing on the release of the ZZR, benefiting policyholders by allocating freed-up funds exclusively to them.
- The increase in interest rates is positively affecting the solvency ratios of life insurance companies and offering higher yields on new investments and reinvestments in fixed-income securities.
Hidden Liabilities and Realization of Hidden Reserves:
- In recent years, life insurers financed the buildup of their ZZR by realizing hidden reserves.
- The recent rise in interest rates has transformed remaining hidden reserves into hidden liabilities, particularly in fixed-interest securities.
- While insurers can continue holding these securities, hidden liabilities can reduce income flexibility and expose insurers to potential losses.
Portfolio-Induced ZZR Reduction:
- The article discusses the impact of portfolio reduction on the ZZR, with the expiry or shortening of remaining terms of existing contracts leading to a release of ZZR.
- Depending on the insurer's situation, portfolio-induced ZZR reduction can vary, especially for insurers with high proportions of existing contracts and little or no new business.
Considerations for Insurers:
- Life insurers must carefully weigh whether to use the released funds from ZZR reduction to immediately increase profit participation or strengthen their risk-bearing capacity.
- The appointed actuary, according to section 141 (5) no. 4 of the German Insurance Supervision Act (VAG), plays a crucial role in proposing profit participation strategies.
Regulatory Framework and Profit Participation:
- The German Minimum Allocation Regulation (MindZV) lays down supervisory provisions for profit participation, ensuring policyholders participate in the insurer's profit.
- The impact of ZZR on profit participation involves adjustments to the minimum allocation to the provision for bonuses (RfB) based on investment income and changes in the ZZR.
Buffers and Safeguard Mechanisms:
- German life insurance operates as a collective guarantee scheme with complex buffers and safeguard mechanisms.
- The scheme ensures that average interest rates of German life insurers remain significantly higher than the ECB's key interest rates, even in a low-interest rate environment.
In conclusion, the article navigates through the intricacies of the ZZR, its release, and the broader implications for insurers and policyholders amidst changing market conditions, providing a comprehensive analysis of the dynamic landscape in the insurance industry.