Following ultra-low interest rates over the past decade, German life insurers now face new challenges as they keep rising bringing with them both favourable and unfavourable consequences for the sector, according to a recent report by S&P Ratings.
On the one hand, higher rates will mean a rise in net investment yields, while on the other the sector’s exposure to unrealized losses and less-liquid assets may present risk, coupled with pressure on business volumes, the rating agency pointed out.
As a response to the ultra-low, and partly negative, interest rate environment seen in the past few years, the sector and legislation took several measures to withstand the pressure.
These included the introduction of additional reserving requirements, which totalled €93bn at year-end 2022 (ZZR), use of transitional measures under Solvency II (SII) with an average ratio uplift of 240 percentage points in 2022, and a consequent shift in new business to more flexible savings products with lower or no guarantee commitments.
SII ratios increased substantially last year as a result of the rising interest rates, which have benefited German life insurers due to their long-term commitments for traditional products, according to the report.
S&P said: “With Germany’s 10-year government bond yields exiting negative territory in 2022 to reach 1.2% from -0.3% in 2021 and inflation jumping to 8.7% from 3.2%, it’s been a drastically different 12 months. And our forecasts of GDP growth slowing to 0.0%, inflation slightly moderating to a still-high 6.7%, and interest rates rising further to 2.8% this year suggest more adjustment will be needed.”
However, higher rates have also led to unrealized losses on fixed-income investments, and the sector’s exposure to less liquid assets such as property, private debt, and private equity bears depreciation risk in 2023-2024.
As a result of Germany’s reaction to low interest rates, according to analysts, the average guarantee in the back book has gradually declined and including the ZZR was about 1.4% in 2022.
“With currently less challenging interest rates, German life insurers’ interest margins will improve due to rising reinvestment yields over time. This particularly reflects the sector’s concentration on fixed-income securities, and we assume running yields will increase about 10 bps per year in 2023-2025,” said S&P.
“However, in our base case, we believe the net investment yield (running yield plus unrealized gains/losses) will decline 15 bps in 2023 and 2024, reflecting assumed market pressure on illiquid assets such as property or private equity investments.”
Additionally, inflation and rising interest rates have pressured new business which has led S&P analysts to believe the sector will face another year of declining volumes, mainly in single premiums.
The report also noted that, although investment performance may only improve in the medium term, there are some short-term risks in the current capital market environment.
The sharp rise in interest rates has wiped out asset value reserves in the sector’s fixed-income investments, which has led to unrealized losses. At year-end 2022, most German life insurers had unrealized losses in their bond portfolios.
Although insurers do not typically have to sell their bonds before they mature – which allows time for the market value to return to par – if a hypothetical sharp rise in lapses forced life insurers to sell large amounts of bonds to cover the outflows, they could realise market losses, analysts explained.
“That said, we believe this risk is remote,” S&P noted. “Savings products benefit from a tax benefit but only if the contracts span at least 12 years. In case of a cancellation in that timeframe, the tax benefit would be lost.
“Moreover traditional savings products offer a terminal bonus that is only granted if the policy is held until maturity, which is an additional incentive not to lapse. In addition to losing these benefits, policyholders usually carry further lapse costs for distribution and administration. Consequently the lapse ratio has remained low in recent years and even in 2022 it was stable at about 2.6%.”
Analysts added: “As mentioned previously, we also believe the sector’s annual crediting rates are still reasonably competitive compared to other savings products and insurers can adjust them up every year. We note that some life insurers might choose to sell bonds and record unrealized losses to benefit from reinvestment into higher-yielding bonds rather than waiting for holdings to reach maturity.”
Another area of focus this and next year according to the report will be the sector’s exposure to less liquid assets such as real estate, private debt, and private equity.
S&P said: “In our view, liquidity risk remains well contained for rated German life insurers amid stable and low lapse rates, better product design, Zinszusatzreserve (ZZR) releases, shifting business mixes, and still reasonably competitive crediting rates compared to non insurance savings products.”
After analysing the effects from the current macroeconomic environment, S&P concluded that its ratings on German life insurers to be broadly unchanged, balancing the long-term benefits of higher reinvestment rates and ZZR releases with short-term challenges due to pressure on new business and illiquid assets.
