Life insurers can look back on years of falling and historically low capital market interest rates. In spite of this, the industry has proven to be robust. Since 2022, interest rates have been rising again. In the eurozone, the key interest rate is currently 3.75%. How is this affecting life insurers? This article provides an overview.

Write-downs and losses to begin with

In the short term, rising interest rates led to an increase in write-downs at life insurers, which was partly also due to the general market turbulence. Insurance companies were able to absorb these losses through extraordinary investment income. In the medium to long term, the opportunities to generate income from new investments and reinvestments in fixed-interest investments will improve as a result of the increase in interest rates. Companies will also continuously release their Zinszusatzreserve (see info box). Furthermore, insurers’ key figures show significantly higher projected gross surplus, which will also benefit policyholders. After years of falling profit participation, the increase in interest rates has already resulted in some life insurers moderately increasing profit participation for the year 2023.

Improved SCR coverage

The increased capital market interest rates also resulted in an improvement in SCR coverage (see Figure 1). As a result, for the first time since the introduction of Solvency II in 2016, all life insurers were able to report adequate SCR coverage in the second quarter of 2022 without making use of the transitional measures under the directive. At the end of 2022, only one life insurer under BaFin’s supervision fell short of the solvency capital requirements without the application of transitional measures. Some companies had already stopped using the transitional measures. However, since the business model of life insurers is very sensitive to interest rate changes, variations in the solvency ratios are to be expected in future.

Figure 1 : SCR coverage of German life insurers with transitional measures (quarterly notifications)

Source: BaFin

Intensified supervision currently no longer needed

During the period of low interest rates, legislators, supervisors and life insurers themselves took numerous measures to reduce risks and to ensure companies’ internal capital adequacy. As a result, the industry proved to be robust in spite of the difficult environment. The increase in interest rates has further improved the situation for insurers. For BaFin, this means that there is currently no need for intensified supervision of life insurers. This was a tool applied during the period of low interest rates. Its purpose was to mitigate the risks arising from low interest rates and to make these risks manageable. It has fulfilled this purpose. BaFin is continuing to monitor life insurers that react particularly sensitively to interest rate changes as part of its regular ongoing supervision.

Risks of increasing interest rates

An increase in interest rates also brings risks – particularly when rates rise sharply and suddenly. That is why BaFin considers an abrupt and significant increase in interest rates to be one of the key risks for the financial system (see “Risks in BaFin’s Focus 2023 “). Three points are critical here: hidden liabilities in capital investments, policyholders’ lapse behaviour, and life insurers’ liquidity management.

Hidden reserves turn into hidden liabilities

The market values of fixed-interest investments held by insurers have fallen as a result of increased interest rates. As a result, net valuation reserves have reduced and net hidden liabilities have formed (see Figure 2).

Figure 2: Development of hidden reserves and hidden liabilities in life insurers’ capital investments

Source: BaFin

Hidden liabilities limit life insurers’ flexibility with regard to their capital investments. However, hidden liabilities from fixed-interest investments do not in themselves have a negative impact on companies’ results as long as the hidden liabilities are due to interest rates and the insurers hold the investment until maturity, which is usually the case. A negative impact arises only if the insurers (have to) realise their hidden liabilities. They might be forced to do this in the event of a liquidity shortfall, for example. This can happen if the rise in interest rates renders existing insurance contracts financially unattractive to policyholders, leading them to terminate their contracts. As a result, insurers would lose funds and their need for liquidity would increase.

High inflation: more exemptions from premium payments, less new business

As a result of high inflation and more attractive alternative investments, there is also an increasing risk that policyholders will apply for exemptions from premium payments. At the same time, new business may suffer. The numbers of life insurance policies taken out with single premium payments is already in decline. In combination, these changes will reduce the funds received by insurers, rendering their liquidity planning more difficult. In this changed market environment, effective liquidity management is key.

BaFin is systematically monitoring the development of lapse rates and exemptions from premium payments at life insurers. At selected companies, BaFin carries out liquidity monitoring on a quarterly basis – based on the liquidity monitoring carried out by the European Insurance and Occupational Pensions Authority (EIOPA). The results as at 31 December 2022 show that, so far, no negative developments are expected in 2023. And insurers have sufficient liquid investments to cover additional liquidity requirements.