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An easier pill to swallow

Sebastian Dany and Silke Longoni explain the German Ministry of Finance’s new method for calculating the Zinszusatzreserve.


06 DECEMBER 2018 | SEBASTIAN DANY & SILKE LONGONI

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In October 2018, following intense discussions with the German life insurance sector, the German Ministry 
of Finance published a new method for calculating the additional reserve requirement, the Zinszusatzreserve (ZZR), which will be effective by year-end 2018. The new method follows arguments from several stakeholders – including insurance companies, the German Federal Financial Supervisory Authority, the German Insurance Association (GDV) and the German Actuarial Society – that the previous calculation method forced insurers to build up an excessive amount of reserves in a very short period of time. As a consequence, to finance the ZZR, most German life insurers had to realise a large amount of gains on their fixed-income investments, subsequently losing the income-generating power of those investments. In contrast, the new calculation method is intended to reduce the ZZR allocation for the whole life insurance industry, making ZZR buildup more affordable. 


A new calculation 

ZZR was first introduced by the German regulator in 2010. The goal was to ensure that German life insurers were able to build additional buffers to meet future commitments to policyholders, stemming from their traditional guaranteed endowment and annuity products. So far, ZZR build-up has exceeded expectations at the time of introduction. The total amount of ZZR reached €60bn in 2017, and the allocation that year was a record high €17bn. To put this into perspective, the German life insurers’ shareholders’ fund was €16.1bn in total as of year-end 2017, according to the GDV.

One of the main components used to calculate the ZZR is the so-called reference yield. Under the old method, the reference yield was calculated as the 10-year average of the 10-year zero-coupon euro swap rate. For each insurance contract with a guaranteed rate above the reference yield, life insurance companies must build an additional reserve, on top of the standard reserving requirement. The sum of these additional reserves is the ZZR. All else being equal, the lower the reference yield, the greater the amount that must be reserved for the ZZR.

Under the old method, the reference yield has declined sharply due to the low interest rate environment in the Eurozone since the Global Financial Crisis. In practice, as the old high 10-year interest rate values are replaced with lower ones, the moving average declines. For instance, in 2017, the reference yield value was 0.86%, compared with 4.23% in 2008.

The ZZR pre-finances the guarantees provided by German life insurers. As a whole, these have been reducing the average guarantee over time, from 2.89% to 2.0% at the end of 2017. However, the rapidly declining reference yield has led to much higher ZZR requirements than originally expected. Therefore, most German life insurers have had to realise high amounts of valuation reserves on fixed-income assets to finance the ZZR.  

The main goal of the new calculation method is to smooth the increase of the ZZR by adjusting the calculation of the reference yield. The starting point for the calculation is the reference yield under the old method. Then, upper and lower boundaries are defined. The new method includes three possibilities:

  • If the old reference yield is below the lower boundary, the new reference yield is set to the lower boundary. 
  • Symmetrically, if the old reference yield is above the upper boundary, the new reference yield is set to the upper boundary. 

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If the old reference yield is within the upper and lower boundaries, the new reference yield equals the old yield.

The upper and lower boundaries depend on the previous year’s reference yield, the underlying yield of the current year, and the so-called ‘X-factor’ (set to 9%), which defines the width of the corridor. Under the new method, we expect the reference yield per 2018 will be 2.09%, compared with 1.88% under the previous method

The ZZR for individual companies can vary due to the composition of their back books and the reserve practices they have used to date (for example, the inclusion of surrender and cash options, and individual reserve strengthening).

There are currently nine tariff generations in the German life insurance market, with maximum guaranteed rates between 4% and 0.9%. Overall, the larger the difference between the guaranteed rate and the reference yield, the higher the ZZR. Under the old method, in 2018, the amount of tariff generations with a guaranteed rate above the reference yield would be more than 87% (for S&P Global Ratings-rated German life insurers). Under the new method, the reference yield will not fall below 2% for 2018, so the amount of tariff generations with a guaranteed rate above the reference yield will stay closer to 80% – which is comparable to 2017 (see Figure 1).

Finally, the ZZR build-up and release pattern is dependent on the development of the underlying yield. Figure 2 shows the consequences of gradually rising yields – 0.96% in 2018, 1.4% in 2019 and 1.7% in 2020 and beyond. 


Supporting and preserving

Due to a higher reference yield under the new calculation method, allocation to the ZZR in 2018 will likely only be €6bn-€8bn, compared with about €24bn under the old method (see Figure 3). Asset valuation reserves and capital buffers will be better preserved. Moreover, insurers may also be able to retain bond portfolios with large capacity to generate income, which they can maintain in their investment portfolios instead of realising them to preserve higher running investment yields. Simultaneously, the ZZR still supports life insurers’ capacity to meet future guaranteed payments to policyholders, while its buildup will be better aligned with the long-term nature of the guaranteed liabilities.

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In the stochastic cashflow projections for Solvency II, local GAAP (HGB) requirements also need to be considered, including ZZR financing. This is important because it reduces insurers’ own funds and the overall solvency ratio. This is particularly relevant under unfavourable economic scenarios in the Solvency II calculations. In certain cases, this could lead to extraordinary measures, such as capital injections being necessary to finance ZZR. Overall, however, the proposed method reduces the financing needs in the projections, especially in unfavourable economic scenarios such as equity shocks combined with prevailing low yields. 

We expect the new method to have a positive effect on solvency ratios in the long term, with some insurers experiencing improvements of over 10% of the solvency ratio (a solvency ratio of 150% might increase to more than 165%). This depends on the back book composition, and also on calibrations within Solvency II calculations. 


For more information, see here. 


Sebastian Dany is associate director, S&P Global Ratings

Silke Longoni is an associate at S&P Global Ratings