After suffering from ultra-low interest rates over the past decade, German life insurers now face new challenges. On the one hand, higher rates will mean a rise in net investment yields, while on the other the sector's exposure to unrealized losses and less-liquid assets may present risk, coupled with pressure on business volumes.

As a response to the ultra-low and partly negative interest rate environment, in the past few years the sector and legislation reacted with several measures to withstand the pressure. These included the introduction of additional reserving requirements, which totaled €93 billion at year-end 2022 (ZZR), use of transitional measures under SII with an average ratio uplift of 240 percentage points in 2022, and a consequent shift in new business to more flexible savings products with lower or no guarantee commitments (in 2021 only about 14% of new business was traditional guaranteed business but this still represents about 70% of the portfolio). We've also seen the emergence of run-off platforms and diligent back book management, and an increase in more illiquid assets.

With Germany's 10-year government bond yields exiting negative territory in 2022 to reach 1.2% from -0.3% in 2021 and inflation jumping to 8.7% from 3.2%, it's been a drastically different 12 months. And our forecasts of GDP growth slowing to 0.0%, inflation slightly moderating to a still-high 6.7%, and interest rates rising further to 2.8% this year suggest more adjustment will be needed.

Table 1

Table 2

Chart 1

ZZR Releases Will Benefit The Sector But Investment Performance May Only Improve In The Long Term

As noted, the sector undertook several measures to respond to low interest rates in recent years. Consequently, the average guarantee in the back book has gradually declined and including the ZZR was about 1.4% in 2022 (see chart 1). With currently less challenging interest rates, German life insurers' interest margins will improve due to rising reinvestment yields over time. This particularly reflects the sector's concentration on fixed-income securities, and we assume running yields will increase about 10 bps per year in 2023-2025. However, in our base case, we believe the net investment yield (running yield plus unrealized gains/losses) will decline 15 bps in 2023 and 2024, reflecting assumed market pressure on illiquid assets such as property or private equity investments.

At the same time, crediting rates for traditional life insurance policies have reached a turning point in 2023. The largest life, insurer, Allianz Lebensversicherungs AG, has increased its running crediting rate 20 bps for these products, while we estimate smaller increases of about 5 bps-10 bps for the wider market to about 2.6%. This still compares well with other savings products in Germany although banks have started to increase short-term deposit rates, which selectively reached about 3% for a limited period. As interest rates continue to rise, we believe the sector could further increase crediting rates to keep up with other savings products.

German life insurers' solvency ratios also increased substantially in 2022. At year end, the sector's average SII ratio reached about 510%-530%, including transitional measures, from 455% in 2021 and to 270%-290%, excluding transitional measures, from 262% (see chart 2). Due to our interest rate forecast and the sector's focus on more flexible and less-capital-intense savings products, we believe the average SII ratio will remain comfortable in 2023-2024. Similarly, we believe rated life insurers' capital adequacy will be stable over the same period compared to prior years, since we look through market value fluctuations on bond investments matched with nonlinked (or general account) life insurance liabilities (see "Refined Methodology And Assumptions For Analyzing Insurer Capital Adequacy Using The Risk-Based Insurance Capital Model" §38, published June 7, 2010, on RatingsDirect).

Chart 2

Another upside for the life insurance sector is the ZZR mechanism. In times of low interest rates, the reserve is mainly funded via realized gains on fixed-income securities. Last year, the sector was able to release ZZR for the first time, partly driven by portfolio compositions and a stagnating reference yield (1.57% for 2021 and 2022; a lower reference yield means a potential higher contribution to the ZZR; see chart 3). Our interest rate forecasts and the sector's focus on more flexible life insurance products in new business mean we also assume ZZR releases in the coming years. This will allow more flexibility in earning policyholder guarantees and crediting rates for German life insurers. In 2022, the ZZR reached €93 billion, which is close to 10% of the sector's total balance sheet.

Chart 3

Liquidity And Impairment Risk Has Increased For Certain Assets

Although investment performance may only improve in the medium term, there are short-term risks in the current capital market environment. Firstly, the sharp rise in interest rates has wiped out asset value reserves in the sector's fixed-income investments and led to unrealized losses. At year-end 2022, most German life insurers had unrealized losses in their bond portfolios. Insurers do not typically have to sell their bonds before they mature, which allows time for the market value to return to par. However, if a (hypothetical) sharp rise in lapses forced life insurers to sell large amounts of bonds to cover the outflows, they could realize market losses. That said, we believe this risk is remote. Savings products benefit from a tax benefit but only if the contracts span at least 12 years. In case of a cancellation in that timeframe, the tax benefit would be lost. Moreover traditional savings products offer a terminal bonus that is only granted if the policy is held until maturity, which is an additional incentive not to lapse. In addition to losing these benefits, policyholders usually carry further lapse costs for distribution and administration. Consequently the lapse ratio has remained low in recent years and even in 2022 it was stable at about 2.6% (see chart 4). As mentioned previously, we also believe the sector's annual crediting rates are still reasonably competitive compared to other savings products and insurers can adjust them up every year. We note that some life insurers might choose to sell bonds and record unrealized losses to benefit from reinvestment into higher-yielding bonds rather than waiting for holdings to reach maturity.

Chart 4

In our view, another area of focus this and next year will be the sector's exposure to less liquid assets such as real estate, private debt, and private equity. In the ultra-low interest rate environment, life insurers increased their exposure to these assets to generate higher yields. However, we believe they could suffer some impairments in 2023-2024 due to our forecast of higher interest rates and lower economic growth. Despite this, we believe potential depreciation pressure on property and private equity will be partly offset via higher reinvestment yields for new investments. Therefore, we assume a moderate decline in net investment yields of 15 bps annually in 2023-2024.

Chart 5

Inflation And Lower GDP Growth Hit New Business Potential

The current economic environment, with heightened inflation and lower growth prospects, has affected German life insurers' new business and overall volumes. Gross written premiums (GWP) declined 6% in 2022 to about €97 billion, mainly driven by a sharp (18%) decline in single premium business. This was due to rising consumer prices and less capacity for putting savings into life insurance products. Under our assumption of still-high inflation over 2023, we believe this trend will continue and the sector's top line will decline again. That said, it will mainly be visible in single premium business, leaving other growth areas such as group life business. In that context, we believe the sector is facing a period of negative growth and we will particularly watch expense ratio developments in times of lower premium incomes. We also believe insurers will continue to focus on more flexible guaranteed products and that traditional static guarantees are unlikely to make a comeback (see chart 6).

Chart 6

Ratings Are Expected To Be Unchanged

After analyzing the effects from the current macroeconomic environment, we conclude that our ratings on German life insurers are likely to be broadly unchanged in the next two years. This is because short-terms challenges, such as pressure on new business from inflation and the poorer performance of illiquid investments, appear manageable and are partly offset via the higher reinvestment rates we expect from 2025. Moreover, we expect lapse risk to remain contained for the German life insurers we rate, leaving no liquidity concerns.

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