Reduction in German life insurers' bonus rates is credit positive – Moody’s

Over the past month, the 10 largest German life insurers reduced their bonus rates for policyholders (not including bonuses paid out at maturity) for 2020 by approximately 20 basis points to 2.1 percent from 2.3 percent on average.  The move is credit positive because it shows that insurers are taking action to moderate the effect of falling interest rates over 2019 on their capitalisation, according to credit rating agency Moody’s. However, a new Sector Comment report from Moody’s notes that the sector is still likely to report materially lower Solvency II ratios for the end of 2019 compared with a year earlier because the 10-year German government bond yield fell by 90 basis points over the same period.
Interest rates fell significantly in 2019 and bottomed out in the third quarter of the year. Because the relevant reference rate for full-year 2019 additional “interest rate reserve” requirements (Zinszusatzreserve, or ZZR) was fixed at 30 September 2019, insurers' ZZR funding requirements will be materially higher than most market participants, said Moody’s.
“We expect German life insurers to report additional ZZR funding requirements of around €9 billion in 2019 following €5.9 billion in 2018, putting pressure on their earnings,” said Moody’s. “However, we also expect insurers to have generated realised capital gains by selling off higher-yielding fixed-income investments for funding purposes.
“We believe insurers have felt comfortable keeping bonus rates for 2019 relatively stable because of recovering interest rates in 2018 and changes to ZZR rules that took effect at the end of 2018. Higher interest rates reduced immediate pressure on ordinary investment returns, while, more importantly, there was a wide consensus in the sector that further interest rate increases were likely, resulting in more stable ordinary investment returns in the longer term.”
Moody’s said the implementation of new ZZR rules also resulted in significantly lower funding requirements for the ZZR, greatly easing pressure on insurers' profit and loss statements for 2018 and, based on expected further interest rate increases, their profit and loss statements for subsequent years.
“German life insurers are generally hesitant to reduce their bonus rate because they commonly use the tool to differentiate themselves from domestic competitors (customers often choose an insurer based on the bonus rate they offer),” said Moody’s. “Lowering the bonus rate can strengthen capital because it reduces the amount of committed funds in the Rückstellung für Beitragsrückerstattung (RfB1) for future policyholder participation in the first year, resulting in higher free RfB at the end of the year, and because lower withdrawals from the RfB in subsequent years result in higher free RfB in those years. Reducing the bonus rate also helps bottom-line profitability because it allows insurers to allocate a smaller share of gross profit to the RfB before policyholder participation.”
Because free RfB forms part of insurers' own funds under Solvency II, preserving it helps strengthen insurers' own funds. Although life insurers’ Solvency II ratios on average were strong at the end of 2018 (albeit flattered by the use of transitional measures, which do not reflect the full interest rate risk associated with life insurers' traditional guaranteed in-force book), they are still highly sensitive to falling interest rates, Moody’s said.
“As a result, the fall in interest rates in 2019 will severely hamper insurers' Solvency II ratios, particularly those with large in-force books of traditional guaranteed savings products,” said Moody’s. “Countermeasures, including reducing bonus rates, are unlikely to offset the effect of low interest rates.”