,This Guidance Notice addresses the quantitative requirements under the supervisory regime Solvency II (Directive 2009/138/EC) and is therefore intended for German life insurance undertakings as well as primary insurance undertakings that provide accident insurance with premium refund in accordance with section 1 (1) no. 1 in conjunction with section 7 nos. 33 and 34 of the German Insurance Supervision Act (Versicherungsaufsichtsgesetz – VAG), unless these are funeral expenses funds under section 218 (1) of the VAG, Pensionskassen under section 232 of the VAG or small insurance undertakings under section 211 of the VAG.

Section 75 (1) of the VAG provides that technical provisions must be calculated in a prudent, reliable and objective manner. In accordance with section 75 (2) of the VAG, the value of the technical provisions must correspond to the current amount that insurance undertakings would have to pay if they were to immediately transfer their insurance obligations to another insurance undertaking.

In accordance with section 84 of the VAG, all expenses that will be incurred in servicing insurance and reinsurance obligations, as well as inflation, including expenses and claims inflation must be taken into account. In accordance with Article 28 of Commission Delegated Regulation (EU) 2015/35 (DR), the relevant cash flows must be included in the valuation of the technical provisions. The expenses to be taken into account are specified in more detail in Article 31 of the DR. In particular, they include expenses incurred in the administration of the insurance and reinsurance obligations, investment management expenses, claims management expenses and acquisition expenses; in this context, any overhead expenses incurred must also be taken into consideration. Under Article 31 (2) of the DR, these overhead expenses must be allocated in a realistic and objective manner and on a consistent basis over time to the parts of the portfolio to which they relate.

Article 22 of the DR specifies the circumstances under which an assumption underlying the valuation of the technical provisions is considered realistic. In accordance with Article 22(1)(c) of the DR, all assumptions must be based on the characteristics of the portfolio of insurance and reinsurance obligations, where possible regardless of the insurance or reinsurance undertaking holding the portfolio. In accordance with Article 22(1) of the DR, information specific to the undertaking, including information on claims management and expenses, must only be used in cases where that information better reflects the characteristics of the portfolio of insurance or reinsurance obligations than information that is not limited to the specific undertaking or where the calculation of technical provisions in a prudent, reliable and objective manner without using that information is not possible.
The legal bases set out above must be adequately taken into account when defining the assumptions on the expenses for the valuation of the technical provisions.

1. General principles

In accordance with Article 22(1)(c) of the DR, insurance undertakings must base the assumptions for the expenses to be taken into account for the valuation of the technical provision on information specific to the undertaking in cases where the calculation of technical provisions in a prudent, reliable and objective manner without using that information is not possible or where that information better reflects the characteristics of the portfolio of insurance or reinsurance obligations than information that is not limited to the specific undertaking. Since future discretionary benefits depend in particular on the future expenses, it must be assumed that the undertakings will have to base the valuation of the technical provisions on undertaking-specific expenses. These also include the expenses for investment management.

This is particularly relevant when a primary insurance undertaking has decided to discontinue or severely reduce its new business, as well as for newly established insurance undertakings. The use of undertaking-specific expenses is necessary to take account of a possible increase in the fixed cost burden when new business is discontinued or reduced in order to better reflect the characteristics of the liabilities and to ensure a prudent and reliable valuation. In this regard, the expected cost development for the individual undertaking must be analysed on a regular basis. Particular attention must be paid to ensure that any management actions taken into account that may counteract rising fixed cost burdens meet the requirements of Article 23 of the DR. Similarly, it must be ensured that increasing cost burdens caused by the high fixed costs incurred by newly established insurance undertakings are also taken into account.

For the purposes of the valuation of technical provisions, it is necessary to allocate the future expenses to the portfolio to be valued. As a rule, this requires an apportionment between the existing portfolio of insurance and reinsurance obligations and future new business. Future new business includes those insurance obligations that result from newly concluded contracts as well as liabilities from contracts already in the portfolio that fall outside the boundaries set out in Article 18 of the DR. The apportionment of the expenses to the portfolio to be valued and the new business must be realistic.
When deriving the expenses, the undertakings are to eliminate verifiable one-off effects that occurred in the past and were caused by special, non-recurring circumstances and have no significance for the future, e.g. past restructuring measures or special effects arising from legal changes. However, expenses that recur at irregular intervals, such as expenses for IT projects, need to be taken into account in an appropriate way.

2. Future development of expenses

The derivation of future expenses is typically based on so-called “drivers” – unless the respective undertaking is in run-off. The expenses are then set in relation to the drivers and projected into the future. The projection must ensure that the overall future burden on the portfolio caused by the expenses is appropriately modelled. For this purpose, it is necessary to analyse future changes in the composition of the portfolio, since the type of insurance and also the stage of the contract (e.g. whether the contract is in the accumulation phase or the distribution phase) can result in different expenses. This is the case, for example, with occupational disability insurance in the active and benefit periods or current annuities compared with annuities in the accumulation phase. The nature of the relevant business transactions must be taken into account in the extrapolation of expenses.

Such aspects must therefore be taken into account when setting the drivers. In particular, it should be examined whether the expenses incurred are influenced by the number (“units”) and/or, for example, the amount of the benefits (“volume”).

In accordance with section 84 (1) no. 2 of the VAG, inflation, along with inflation for the expenses, must be taken into account. Article 29 of the DR requires that the expected future developments in the external environment taken into account for the calculation of the best estimate also include inflation, while Article 30 of the DR provides that the uncertainty in expected future developments must, explicitly or implicitly, be taken into account in an appropriate manner.

In accordance with Article 22(3) of the DR, assumptions on financial market parameters must be consistent with the relevant risk-free interest rate term structure used. This also applies in particular to the financial market-dependent inflation assumption and the resulting assumptions for the future development of expenses. The convergence to the Ultimate Forward Rate (UFR), as well as the assumptions underlying the calculation of the UFR must therefore be adequately taken into account when setting the assumptions on inflation and thus on the future development of expenses. The inflation assumption explicitly or implicitly taken into account for the assumptions must be reviewed for plausibility against this background.

If future efficiency gains are taken into account when mapping the future development of expenses, it must be ensured that the assumptions regarding efficiency gains meet the requirements of Article 22 of the DR in conjunction with Article 23 of the DR. In particular, the realisation of efficiency gains requires active management action, which means that the requirements of Article 23 of the DR regarding the modelling of future management actions are applicable. In accordance with the requirements of Article 23 of the DR, the assumptions on future management actions must be realistic and determined in an objective manner. They must also be sufficiently specific to be able to meet the requirements of Article 23(3) of the DR.

If the valuation of technical provisions includes future efficiency gains, it must be demonstrated that these gains result specifically from the business planning determined by the management. In addition, the extent of the assumed efficiency gains needs to be validated, for example by a comparison with previous cost-saving programmes implemented by the management. The overall inclusion of potential future cost savings not yet actually planned is ruled out, since a prudent, reliable and objective valuation of the technical provisions would not be possible under this approach.

3. Inclusion of investment management expenses

In accordance with section 84 (1) no. 1 of the VAG in conjunction with Article 31(1)(b) of the DR, all expenses for the investment management that are incurred in servicing the insurance obligations must in principle be taken into account in the valuation of technical provisions. As a rule, the starting point for the derivation of the appropriate actuarial assumptions is the investment expenses determined in accordance with the requirements of the German Commercial Code (Handelsgesetzbuch – HGB) and the German Regulation on the Accounting of Insurance Undertaking (Verordnung über die Rechnungslegung von Versicherungsunternehmen – RechVersV), respectively. These determine the investment management expenses to be taken into account in the valuation of the technical provisions on the basis of the following schematic reconciliation calculation:

The individual components of the reconciliation calculation are to be substantiated by appropriate qualitative and quantitative evidence.

The necessity to recognise all expenses incurred in connection with the holding and management of investments arises irrespective of the type of investment. In this context, it is not the formal legal structure of the investment that is decisive, but the economic substance as defined in the look-through principle. This is particularly relevant for all forms of investment units, irrespective of their legal structure (contractual form (“Sondervermögen”) / corporate form (investment companies, etc.)): investment expenses incurred in relation to investment units that are to be borne directly or indirectly by the insurance undertaking must be taken into account.

Since future discretionary benefits depend on the assets held by the insurance undertaking, Article 24 of the DR provides that the calculation of the best estimate must be based on the assets currently held by the undertaking. Assumptions of future changes of the asset allocation must meet the requirements of Article 23 of the DR. The assumptions on investment management expenses and on future management actions with regard to asset allocation must be consistent with each other. In particular, the assumption on administration expenses must be consistent with the undertaking’s current or changed business practice and business strategy including, in particular, the strategic asset allocation.

If management actions are applied for the valuation that influence the investment management, and thus possibly also the expenses incurred for investment management, these may not be adjusted ex-ante to the characteristics of risk-neutral valuation. The approach to use management actions for investment management can only take that information into account that is available to the management at the time the management decision is applied to the specific economic capital market scenario under consideration. The management actions cannot assume knowledge of future developments (such as a specific economic capital market scenario) or the distribution of the risk-neutral capital market scenarios used.

Individual expenses that are actually incurred in accordance with the planned investment strategy and are not non-recurring (see also section 1 above) may not be disregarded. When determining the expenses incurred, the undertaking-specific expenses actually incurred are to be taken as a basis. The use of market-consistent capital market assumptions and the resulting investment income does not mean that certain expenses, e.g. the costs attributable to a planned generation of excess returns, can be factored out.

4. Inadmissible inclusion of contractual arrangements relating to risk mitigation

If the management of the portfolio of insurance and reinsurance obligations or assets is transferred to a third party, the relevant expenses incurred by the primary insurance undertaking after the transferral are to be taken into account when deriving the assumptions. In principle, the cost assumptions can then be derived on the basis of the respective contractual conditions.

However, this only applies to the extent that this does not result in the inclusion of risk mitigation techniques in the valuation of the technical provisions.

If, for example, an adjustment is made to the fees to be paid by the undertaking to a third party for the management of insurance obligations which is in line with the economic situation of the insurance company but not based on the actual cost situation, the relevant agreement is, from an economic point of view, a risk mitigation technique, even if the contractual form of a cost agreement was chosen. The agreed adjustments to the fees to be paid are not to be treated as risk-mitigating in the valuation of the technical provisions and/or the cost assumptions. The same applies if a third party – whether in connection with a service agreement or separately – promises to take on possible negative cost results of the undertaking. In economic terms, this would also be a risk mitigation technique. Risk mitigation techniques are to be taken into account in the solvency balance sheet separately from the technical provisions and in a manner as transparent as possible in order to comply with the requirements of Articles 208 – 215 of the DR.

5. Allocation of expenses between existing and new business

When determining the assumptions for taking into account the effects of the pre-financing of acquisition costs for the purpose of reflecting the interaction between discretionary benefits (profit participation) and new business in accordance with BaFin’s interpretative decision of 4 December 2015, the assumptions about future new business must be determined in an objective and prudent manner. The uncertainty associated with the assumptions and their significance for the amount of the provision must be quantified. Foreseeable or specifically planned changes in the product mix and the volume of new business, or relating to the structure and amount of the acquisition costs must be explicitly taken into account. Furthermore, the determination must be consistent with the contract boundaries, for example, when future dynamics lie within the contract boundaries.