Things will get serious on 1 January 2032 – at the latest. By this date, all life insurers will have to be able to meet their solvency capital requirement (SCR) with own funds. No ifs or buts, and to a minimum of 100%. This is what is required under Solvency II, the European supervisory regime for insurers. Roughly 75% of German life insurers can already do this on their own. The rest can only achieve a 100% SCR ratio thanks to the transitional measures offered by the framework up to the end of 2031 (see the info box below).

The companies concerned must also achieve a sustainable and adequate solvency position without resorting to these measures by the end of this transitional period. However, the general situation has continued to deteriorate since the end of 2019. The coronavirus pandemic has cemented the low interest rate environment. As is well known, this poses a particular problem for life insurers, because the interest rates they have guaranteed their customers are often significantly higher than the rates they can now generate on the capital markets.

So what should they do? Hope and pray that everything will be all right by the beginning of 2032? BaFin strongly advises companies not to try for a precision landing in this area. There are too many uncertainties as to how the capital market will develop for this to be a sensible move. Rather, insurers should aim to comply with their SCR without transitional measures before the start of 2032. BaFin expects more than ever before that they will implement concrete, ambitious measures – and deliver plausible and clear progress reports that it can use to see precisely what insurers are planning to do when, and how this will impact their solvency position. However, BaFin is of the opinion that there are recurring problems in terms of clarity. It will therefore require the companies whose progress reports are less than optimal to improve these promptly.

What does a progress report have to look like to satisfy BaFin’s requirements? The following gives an overview:

The progress report: from measures through assumptions to forecasts

Companies submit annual progress reports to BaFin to document that they will be able to meet their SCR by the beginning of 2032. The VAG (section 353 (3)) requires this, and for good reason: BaFin must use these progress reports to assess whether an insurer’s goal of achieving adequate coverage by the beginning of 2032 is realistic. Consequently, the reports must contain all the information needed to be able to assess the company’s development. This includes the measures planned by the company, the assumptions underlying its forecast, and the detailed presentation and explanation of the outcomes of the forecast.

Measures: the right presentation is vital

A key component of the phasing-in plan that companies originally had to submit were the concrete individual measures that the company has planned or taken in order to sustainably improve its SCR ratio. The progress report builds on this phasing-in plan. Insurers must present the measures in such a way that BaFin can analyse whether they are suited to ensuring that the insurer concerned can meet its SCR without transitional measures by the beginning of 2032. However, these measures have been presented in a suboptimal manner in many cases.

For example, it is important for BaFin to be able to determine whether an insurer has implemented its measures as planned. Therefore, in their own interests, insurers should establish milestones so that both BaFin and they can assess the success of these measures over time.

Also, the timing of measures is one thing, but their impact is another. Companies must therefore present the actual effect that the implemented and planned measures have on their solvency position. Insurers must provide an assessment in their progress reports as to whether the measures that they have already taken are sufficient so that they can meet the SCR at the end of the transitional period. If this is unlikely to be the case, the company must modify its current measures or take supplementary ones, and must adapt its progress report.

Companies must explain for all ongoing and planned measures what their expectations are with respect to each individual measure, which potential interdependencies exist between the measures, and what uncertainties there are. Any interdependencies between the German Commercial Code (Handelsgesetzbuch – HGB) and Solvency II must be analysed in this context.

If the company lists measures whose success depends on external conditions, it must also include a description of what would happen if these conditions do not materialise. For example, whether reinsurance can be purchased on the terms it envisages is not solely up to the primary insurer concerned. If a measure is particularly relevant for an insurer’s progress, then the latter must also calculate what would happen if it does not work.

Assumptions: these must be well-founded and realistic

BaFin also sees room for improvement regarding the assumptions underlying forecasts. These must be well-founded and realistic. BaFin must also be able to assess whether this is in fact the case. Therefore, insurers must explain and validate them in their progress reports, for example by comparing their assumptions with past outcomes. A detailed explanation must be provided in cases where assumptions differ from those made in the prior-year report. In addition, insurers must analyse the uncertainties surrounding the assumptions in the progress report. And if the outcome of the forecast depends heavily on a particular assumption, this must also be clear from the progress report.

BaFin’s interpretative decision on interest rate assumptions last year ensured uniformity in this area. Assumptions for the development of spreads on risky assets also play an important role in forecasting future investment income. However, the latter does not just depend on general market trends, but also on the company’s planned investment strategy. For example, if the company is planning to adopt a more risky investment strategy in the attempt to increase its returns, BaFin expects it to address the risks associated with these assets, such as potential defaults and downgrades. If capital market assumptions affect the liabilities side of the balance sheet, e.g. because a stock market rally changes the performance of hybrid life insurance policies, insurers must analyse these interdependencies in their report.

The forecasts to be produced also depend on purely company-specific assumptions, such as those relating to an insurer’s new business in the future. Insurance companies must be particularly careful when making assumptions as to their new business, especially for years in the forecast that go beyond the company’s individual planning period. If insurers assume that they can substantially expand their business or modify their product portfolio, they must explain in detail how they intend to achieve this. Since it is extremely uncertain how much new business an insurer will generate and what its composition will be, the insurer must generally perform a sensitivity analysis to reveal what the effects on its ability to meet its future SCR will be if its new business does not perform as expected.

With respect to costs, insurers must do more than merely voice their intention to cut costs in future to satisfy BaFin’s requirements. They may only assume cost savings if these are also realistic – in which case they must also be included in the insurer’s multi-year planning. If investments are required before cost savings can be made, the insurer must also provide information on them, and include them in its calculations.

Forecasts: clarity is the watchword

Third parties with knowledge of the subject must be able to understand the forecasts in the progress reports. However, even BaFin has had to follow up repeatedly with a number of insurers in order to be able to understand the outcomes and to be able to assess for itself whether the company will be able to comply with its SCR without recourse to transitional measures at the beginning of 2032. BaFin therefore considers it important to underline once again that insurers should provide it with detailed information on the forecasting methods they have used and what simplifications were applied. They must also demonstrate to BaFin that such simplifications are justified.

Coverage improves when the SCR declines, when own funds increase, or both. Therefore, the company must specifically state what could influence its SCR and own funds. The reasons for and the determining factors underlying the improvement in solvency coverage inferred in the forecast must be explained. Sensitivities must be stated for particularly important factors.

The plausibility of information on how own funds are expected to develop can only be reviewed if the insurer also provides details of the individual core components – such as the surplus funds, the own funds under the HGB and the reconciliation reserve.

Insurers must also provide details in their progress reports of how the expiration of older contracts, changes to the average technical interest rate, or modifications to profit participation will impact their forecast technical provisions.

The key components of the SCR must also be clear from the report. These generally comprise the interest rate SCR, spread SCR and the lapse SCR. These represent major risks for the company, and their development should therefore be explained. In this context, the company should also take the future portfolio composition into account with respect to both underwriting and investment.

BaFin expects insurers not to recognise any deferred tax assets in excess of their deferred tax liabilities during the transitional period. The uncertainties associated with the recognition test that would be needed to confirm these are too significant, since the test is not based on actual current circumstances but on forecast future situations.

Sound mathematical methodologies

BaFin expects insurance companies to explicitly calculate the own funds and SCR for future reporting dates and – as described above – expects them to start with their measures and then move on through their assumptions to arrive at their forecasts. It is generally not sufficient to simply refer to selected drivers such as a decline in the actuarial reserve, to assume that this will have a positive impact, and then to simply extrapolate current own funds or the SCR to the future. A suitable basis for forecasts is, for example, the annual projections set out in section 44 of the VAG.

It is conceivable that there will be cases in which it would be too laborious and unreasonable to explicitly calculate the own funds and the SCR for each individual year of the forecast. But even in this case, the explanations provided by the insurer must allow BaFin to understand and assess changes in solvency coverage in the course of and up to the end of the transitional period. Merely looking at a single year is not enough – and especially not if the year in question is 2031.

If the company simplifies the SCR – in other words if it doesn’t calculate it with all submodules – it must explain why it believes that the SCR still adequately reflects the company’s risk profile and hence can be used as the benchmark for the own funds to be furnished.