Is it true, as the Germans say, that paper is long-suffering? Not when the subject is specific assumptions in the forecasts with which insurers calculate whether they will be able to meet the solvency requirements under Solvency II as of 1 January 2032. The transitional period may seem generous. However, BaFin requires undertakings that are dependent on transitional measures (see info box “Transitional period for the solvency requirements under Solvency II”) to submit repeated, regular remediation plans and progress reports throughout this period showing whether they are on track to achieve this goal. The supervisory authority reviews these reports in detail. And it predefines one of their key inputs – the assumptions for the development of risk-free interest rates.

The remediation plans and progress reports are assessed on the basis of the probable situation as of 1 January 2032. Both documents therefore regularly include forecast calculations stretching over a long period. These calculations are based on a large number of assumptions. However, forecasts as to how the capital markets and insurers’ own business will perform in future entail a high degree of uncertainty. This means that undertakings should ensure that their underlying assumptions are well-founded, and should provide detailed reasons for them. They must also examine the extent to which the results depend on specific positive developments assumed in the forecasts.

When performing these sensitivity analyses, it should be borne in mind that undertakings can influence some of the measures – such as their ability to enter into reinsurance treaties, to raise equity or hybrid capital, or to transfer portfolios – only to a certain extent. They must therefore explain what the effect on the undertaking will be if they cannot implement a planned measure in whole or in part.

The reports submitted are not always realistic

Experience to date has shown in particular that the assumptions as to the future development of risk-free interest rates play a key role in the forecasts. They serve as a basis for forecasting future returns on investments and the undertakings’ asset portfolio. They are also the starting point for measuring technical provisions in a market-consistent manner.

To date, undertakings’ assumptions as to future risk-free interest rates were frequently based on the premise that interest rates would rise – in other words, they assumed that the current low-interest rate environment is merely temporary and that interest rates will recover significantly by the end of the transitional period. Typically, undertakings implemented this assumption by implicitly extrapolating the current yield curve to the future using existing forward interest rates. However, the weakness of this approach is that it generally assumes that interest rates will rise significantly by the end of the transitional period, although past experience has already shown that this method does not provide a good forecast of actual future interest rate developments. Equally, there is insufficient theoretical justification for this approach.

BaFin is required to revoke its approval of transitional measures under sections 351 and 352 of the VAG if the progress report clearly shows that the undertaking concerned will not realistically be able to meet the Solvency Capital Requirement at the end of the transitional period. It is therefore crucial for the assessment that the forecasts submitted are well-founded. And it goes without saying that insurers must meet the Solvency Capital Requirement even if interest rates do not recover but remain permanently low.

BaFin introduces uniform specification of interest rate assumptions

The legislators’ objective in requiring undertakings to submit remediation plans and progress reports was to ensure that they take effective measures to ultimately be able to comply with the capital requirement without transitional instruments. The goal is to reduce the undertakings’ risk profile and increase their own funds. The assumptions and measures included in the plans are largely undertaking-specific. However, this will no longer apply in future to the assumptions regarding the development of interest rates. In order to ensure coherence in supervisory activities, BaFin has now decided to issue an interpretative decision introducing uniform specifications for the assumptions as to the development of risk-free interest rates (see the “Interest rate assumptions” news item on page xy). All users of transitional measures must take these specifications into account in future.

The supervisory authority has specified three different interest rate scenarios that the undertakings must use as the basis for the forecast calculations required in the future. The idea is for these scenarios to be used in other supervisory forecasts as well – for example in the case of status reports during intensified supervision. The undertakings must address all three scenarios and explain how the measures they are taking will ensure that they can comply with the Solvency Capital Requirement at the end of the transitional period and hence fulfil the solvency requirements over the long term.

There is no reliable methodology for forecasting future interest rate trends. Consequently, the prescribed interest rate scenarios cover a broad range of cases: BaFin has defined a conservative, a medium and a more optimistic scenario. These employ the actual level of interest rates since Solvency II came into force and are therefore expressly not based on the assumption that interest rates will rise in future. Specifying three interest rate scenarios appropriately reflects the uncertainty associated with future interest rate trends. The undertakings are naturally free to calculate and submit additional undertaking-specific scenarios.

Other assumptions

The undertakings also make a large number of other relevant assumptions in their remediation plans. One example is the spread on risk-bearing investments, which has to be set individually for each undertaking due to the different investment strategies followed. The same applies to the yield assumptions for non-fixed income investments. In addition, the forecasts include aspects such as assumptions on future new business, future costs, and policyholders’ surrender behaviour.

Here, too, undertakings have to explain how realistic their assumptions are and what uncertainties exist. For example, if an undertaking is assuming that it can write substantially more term life insurance policies in its new business, it must provide detailed reasons for this and show that it can actually generate this increase in production. In the case of individual undertakings, sensitivity analyses for surrender and cost assumptions may also be necessary, depending on their risk profile. For example, this obligation relates to undertakings that assume that they will be able to make significant cost savings.

Other supervisory instruments

Revoking its approval for the transitional measures is BaFin’s last resort among the supervisory instruments at its disposal. If the supervisor thinks that the measures taken by an undertaking are insufficient to ensure the latter's compliance with the Solvency Capital Requirement at the end of the transitional period, it will start by examining other supervisory measures.

In the case of the transitional measure for technical provisions under section 352 of the VAG, insurance undertakings may “subject to the approval of the supervisory authority temporarily apply a deduction to technical provisions” and hence reduce the pressure on their balance sheets. However, section 352 (3) states that BaFin can require the undertaking to recalculate the deduction every 24 months. In this case, the deduction also takes into account updated assumptions such as any change in the reference interest rate under the German Regulation on the Principles Underlying the Calculation of the Premium Reserve (Deckungsrückstellungsverordnung), and therefore provides a more transparent overview of the undertaking’s financial situation.

In addition, section 301 (1) no. 4 of the VAG permits the supervisory authority to stipulate a capital add-on to the capital requirement for an insurance undertaking if the latter’s risk profile deviates considerably from the assumptions underlying the transitional measure. Consequently, such a capital add-on can be an option in particular if BaFin doubts, based on a progress report, whether an undertaking is adequately adapting its risk profile during the transitional period and whether it will comply with the supervisory capital requirements as from 1 January 2032.

BaFin leaves it at these measures where it is still considered possible that the undertaking will achieve its goal. If this is not the case, BaFin will revoke its approval.

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